XNAS:CRDN Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549  

 
FORM 10-Q

 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2012
 
Or
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
 
For the transition period from                      to                     
 
Commission File No. 000-13059
 
(Exact name of Registrant as specified in its charter)
 
Delaware
33-0055414
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)
   
3169 Red Hill Avenue, Costa Mesa, CA
92626
(Address of principal executive)
(Zip Code)
   
 
Registrant’s telephone number, including area code (714) 549-0421
 
N/A
(Former name, former address and former fiscal year, if changed since last report)
 
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   x   No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Yes  x    No  ¨
 
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 definitions of “large accelerated filer”, “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

            Large accelerated filer  x
Accelerated filer  ¨
Non-accelerated filer  ¨
Smaller reporting company  ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).
 
Yes  ¨    No  x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
Class
 
 Outstanding as of April 20, 2012
Common Stock, $0.01 par value
 
  24,280,505 Shares
 
Exhibit Index on Page 32
 
 

 
CERADYNE, INC.
 
INDEX
 
     
PAGE NO.
 
PART I.
FINANCIAL INFORMATION
     
         
Item 1.
Unaudited Consolidated Financial Statements
    3  
           
 
Consolidated Balance Sheets – March 31, 2012 and December 31, 2011
    3  
           
 
Consolidated Statements of Income – Three Months Ended March 31, 2012 and 2011
    4  
           
 
Consolidated Statements of Comprehensive Income – Three Months Ended March 31, 2012 and 2011
    5  
           
 
Consolidated Statements of Cash Flows – Three Months Ended March 31, 2012 and 2011
    6  
           
 
Notes to Consolidated Financial Statements
    7-16  
           
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    17-27  
           
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
    28-29  
           
Item 4.
Controls and Procedures
    29  
           
PART II.
OTHER INFORMATION
       
           
Item 1.
Legal Proceedings
    30  
           
Item 1A.
Risk Factors
    30  
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    30  
           
Item 3.
Defai;ts I[pm Senior Securities     30  
           
Item 4.
Mine Safety Disclosures
    30  
           
Item 5.
Other Information
    30  
           
Item 6.
Exhibits
    30  
           
SIGNATURE
    31  

 
2

 
 
CERADYNE, INC.
FORM 10-Q
FOR THE QUARTER ENDED
March 31, 2012
 
PART I. FINANCIAL INFORMATION
 
Item 1.
Unaudited Consolidated Financial Statements
 
CERADYNE, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share data)
   
March 31, 2012
   
December 31, 2011
 
   
(Unaudited)
 
CURRENT ASSETS
           
Cash and cash equivalents
  $ 40,285     $ 50,275  
Short-term investments
    229,816       224,772  
Accounts receivable, net of allowances for doubtful accounts of $1,950
               
and $1,547 at March 31, 2012 and December 31, 2011, respectively
    61,377       73,646  
Other receivables
    8,232       6,040  
Inventories
    135,936       117,273  
Production tooling, net
    10,406       11,792  
Prepaid expenses and other
    44,355       43,860  
Deferred tax asset
    4,960       5,782  
TOTAL CURRENT ASSETS
    535,367       533,440  
PROPERTY, PLANT AND EQUIPMENT, net
    244,046       243,376  
LONG TERM INVESTMENTS
    21,834       15,026  
INTANGIBLE ASSETS, net
    99,623       100,690  
GOODWILL
    43,191       42,926  
OTHER ASSETS
    12,491       12,673  
TOTAL ASSETS
  $ 956,552     $ 948,131  
 
CURRENT LIABILITIES
           
Accounts payable
  $ 28,938     $ 29,191  
Accrued expenses
    26,713       30,470  
Income taxes payable
    6,853       5,331  
Short-term debt
    90,264       89,294  
         TOTAL CURRENT LIABILITIES
    152,768       154,286  
EMPLOYEE BENEFITS
    24,931       24,462  
OTHER LONG TERM LIABILITIES
    37,295       37,224  
DEFERRED TAX LIABILITY
    23,613       23,461  
TOTAL LIABILITIES
    238,607       239,433  
                 
COMMITMENTS AND CONTINGENCIES (Note 12)
               
STOCKHOLDERS’ EQUITY
               
Common stock, $0.01 par value, 100,000,000 authorized, 24,280,505 and 24,175,051 shares issued and outstanding at March 31, 2012 and December 31, 2011, respectively
    243       242  
Additional paid-in capital
    123,797       121,940  
Retained earnings
    583,573       583,420  
Accumulated other comprehensive income
    10,332       3,096  
TOTAL STOCKHOLDERS’ EQUITY
    717,945       708,698  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 956,552     $ 948,131  
 
See accompanying condensed notes to Consolidated Financial Statements
 
3

 
 
CERADYNE, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except per share data)
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(Unaudited)
 
NET SALES
  $ 106,309     $ 150,102  
COST OF GOODS SOLD
    77,165       92,014  
Gross profit
    29,144       58,088  
OPERATING EXPENSES
               
Selling, general and administrative
    17,510       18,836  
Research and development
    3,630       3,067  
Restructuring – plant closure and severance
    673       -  
Acquisition related charge
    -       584  
TOTAL OPERATING EXPENSES
    21,813       22,487  
INCOME FROM OPERATIONS
    7,331       35,601  
                 
OTHER INCOME (EXPENSE):
               
Interest income
    1,066       798  
Interest expense
    (1,743 )     (1,448 )
Miscellaneous
    (658 )     (87 )
      (1,335 )     (737 )
INCOME BEFORE PROVISION FOR INCOME TAXES
    5,996       34,864  
PROVISION FOR INCOME TAXES
    2,214       11,269  
NET INCOME
  $ 3,782     $ 23,595  
NET INCOME PER COMMON SHARE:
               
BASIC
  $ 0.16     $ 0.95  
DILUTED
  $ 0.16     $ 0.94  
SHARES USED IN COMPUTING PER COMMON SHARE AMOUNTS:
               
BASIC
    24,211       24,839  
DILUTED
    24,360       25,130  
 

See accompanying condensed notes to Consolidated Financial Statements
 
4

 
 
CERADYNE, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands)
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(Unaudited)
 
NET INCOME
  $ 3,782     $ 23,595  
FOREIGN CURRENCY TRANSLATION
    5,565       10,935  
UNREALIZED GAIN ON INVESTMENTS
    1,671       121  
COMPREHENSIVE INCOME
  $ 11,018     $ 34,651  
 
 
See accompanying condensed notes to Consolidated Financial Statements
 
5

 

CERADYNE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
(Unaudited)
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 3,782     $ 23,595  
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES:
               
Depreciation and amortization
    9,143       9,749  
Amortization of bond premium
    109       375  
Non cash interest expense on convertible debt
    971       889  
Deferred income taxes
    (99 )     382  
Stock compensation
    1,225       972  
(Gain) loss on marketable securities
    (54 )     113  
Loss on equipment disposal
    22       49  
Change in operating assets and liabilities (net of effect of businesses acquired):
               
Accounts receivable, net
    12,682       (16,694 )
Other receivables
    (2,137 )     (2,984 )
Inventories
    (17,502 )     (2,502 )
Production tooling, net
    1,399       (3,424 )
Prepaid expenses and other assets         
    (298 )     477  
Accounts payable and accrued expenses
    (4,571 )     4,222  
Income taxes payable
    1,344       1,249  
Other long term liability
    73       1,086  
Employee benefits
    325       205  
NET CASH PROVIDED BY OPERATING ACTIVITIES
    6,414       17,759  
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Purchases of property, plant and equipment
    (5,924 )     (7,677 )
Purchases of marketable securities
    (20,187 )     (240 )
Proceeds from sales and maturities of marketable securities
    11,019       7,000  
Proceeds from sale of equipment
    (1 )     1,339  
Acquisition of business, net of cash acquired
    -       (27,673 )
NET CASH USED IN INVESTING ACTIVITIES
    (15,093 )     (27,251 )
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Proceeds from issuance of stock due to exercise of options
    85       897  
Common stock cash dividends paid
    (3,629 )     -  
Excess tax benefit due to exercise of stock options
    203       1,771  
NET CASH (USED) PROVIDED BY FINANCING ACTIVITIES
    (3,341 )     2,668  
EFFECT OF EXCHANGE RATES ON CASH AND CASH EQUIVALENTS
    2,030       2,473  
DECREASE IN CASH AND CASH EQUIVALENTS
    (9,990 )     (4,351 )
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    50,275       53,436  
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 40,285     $ 49,085  
 
 
See accompanying condensed notes to Consolidated Financial Statements
 
6

 
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2012
(Unaudited)
 
1.  
Basis of Presentation
 
The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.
 
The balance sheet at December 31, 2011 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. For further information, refer to the Consolidated Financial Statements and Notes to Financial Statements included in Ceradyne’s annual report on Form 10-K for the year ended December 31, 2011.
 
2.  
Share Based Compensation
 
Share-based compensation expense was $1.0 million for both the three months ended March 31, 2012 and 2011 and was related to restricted stock units only as the Company did not have any share-based compensation expense for stock options.
 
Share-based compensation expense is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Forfeitures are estimated at the time of grant in order to estimate the amount of share-based awards that will ultimately vest. The forfeiture rate is based on historical rates. Share-based compensation expense recognized in the Company’s Consolidated Statements of Income for the three month period ended March 31, 2012 includes compensation expense for share-based payment awards based on the estimated grant-date fair value. Since share-based compensation expense recognized in the Consolidated Statements of Income for the three month period ended March 31, 2012 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.
 
The Company maintains the 1994 Stock Incentive Plan and 2003 Stock Incentive Plan.
 
The Company was authorized to grant options for up to 2,362,500 shares under its 1994 Stock Incentive Plan. The Company has granted options for 2,691,225 shares and has had cancellations of 397,811 shares through March 31, 2012. There are no remaining stock options available to grant under this plan. The options granted under this plan generally became exercisable over a five-year period for incentive stock options and six months for nonqualified stock options and have a maximum term of ten years.
 
The 2003 Stock Incentive Plan was amended in 2005 to allow the issuance of Restricted Stock Units (the “Units”) to eligible employees and non-employee directors. The Units are payable in shares of the Company’s common stock upon vesting. For directors, the Units typically vest annually over three years following the date of their issuance. For officers and employees, the Units typically vest annually over five years following the date of their issuance.
 
The Company may grant options and Units for up to 1,875,000 shares under the 2003 Stock Incentive Plan. The Company has granted options for 475,125 shares and Units for 961,369 shares under this plan through March 31, 2012. There have been cancellations of 134,793 shares and Units associated with this plan through March 31, 2012. The options under this plan have a life of ten years.
 
During the three months ended March 31, 2012 and 2011, the Company issued Units to certain directors, officers and employees with weighted average grant date fair values and Units issued as indicated in the table below. The Company records compensation expense for the amount of the grant date fair value on a straight line basis over the vesting period.
 
Share-based compensation expense reduced the Company’s results of operations as follows (dollars in thousands, except per share amounts):

   
Three Months Ended
March 31,
 
   
2012
   
2011
 
Share-based compensation expense recognized:
           
General and administrative, restricted stock units
  $ 981     $ 972  
Related deferred income tax benefit
    (391 )     (387 )
Decrease in net income
  $ 590     $ 585  
Decrease in basic earnings per share
  $ 0.02     $ 0.02  
Decrease in diluted earnings per share
  $ 0.02     $ 0.02  
 
7

 
 
The amounts above include the impact of recognizing compensation expense related to non-qualified stock options.
 
As of March 31, 2012, all stock options were vested, consequently there was no unrecognized compensation cost related to   them. The aggregate intrinsic value of stock options exercised was $129,000 and $3.8 million for the three months ended March 31, 2012 and 2011, respectively.
 
As of March 31, 2012, there was approximately $9.7 million of total unrecognized compensation cost related to non-vested Units granted under the 2003 Stock Incentive Plan. That cost is expected to be recognized over a weighted average period of 3.3 years.
 
The following is a summary of stock option activity:
 
   
Three Months Ended
March 31, 2012
 
   
Number of
Options
   
Weighted Average
Exercise
Price
 
Outstanding, December 31, 2011
    259,150     $ 15.80  
Options exercised
    (6,875 )   $ 12.17  
Outstanding, March 31, 2012
    252,275     $ 15.89  
Exercisable, March 31, 2012
    252,275     $ 15.89  

The following is a summary of Unit activity:

   
Three Months Ended
March 31, 2012
 
   
Number of
Units
   
Weighted Average
Grant Fair Value
 
Non-vested Units at December 31, 2011
    362,727     $ 31.43  
Granted
    91,504       31.10  
Forfeited
    (12,384 )     31.71  
Vested
    (80,483 )     30.71  
Non-vested Units at March 31, 2012
    361,364     $ 31.49  

The following table summarizes information regarding options outstanding and options exercisable at March 31, 2012:

     
Outstanding and Exercisable
 
Range of Grant Prices
   
Number of
Options
   
Average Remaining
Contractual Life (Years)
   
Weighted Average
Exercise Price
   
Aggregate Intrinsic
Value (000s)
 
  $2.98 - $4.58       51,975       0.44     $ 3.43     $ 1,514  
  $16.89 - $18.80       113,950       1.59     $ 17.06     $ 1,766  
  $21.46 - $22.67       86,350       2.37     $ 21.86     $ 924  
          252,275       1.62     $ 15.89     $ 4,204  
 
8

 
 
The following table summarizes information regarding Units outstanding at March 31, 2012:

     
Outstanding
 
Range of Grant Prices
   
Number of
Units
   
Average
Remaining
Contractual
Life (Years)
   
Weighted
Average
Grant
Fair Value
 
  $16.53 - $28.10       149,069       2.02     $ 21.02  
  $30.99 - $39.43       128,075       3.79     $ 33.98  
  $40.73 - $45.70       79,000       2.94     $ 44.66  
  $66.35 - $81.18       5,220       0.22     $ 70.42  
          361,364       2.82     $ 31.49  
 
3.  
Net Income Per Share
 
Basic net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding plus the effect of any dilutive stock options and restricted stock units using the treasury stock method and the net share settlement method for the convertible debt. During the three months ended March 31, 2012 and 2011, the average trading price of the Company’s stock did not exceed the conversion price of the convertible debt, therefore there was no impact to the calculation of diluted shares.
 
The following is a summary of the number of shares entering into the computation of net income per common and potential common shares:

   
Three Months Ended
March 31,
 
   
2012
   
2011
 
Weighted average basic number of shares outstanding
    24,210,913       24,839,424  
Dilutive stock options
    117,413       219,839  
Dilutive restricted stock units
    32,124       70,661  
Dilutive contingent convertible debt common shares
    -       -  
Number of shares used in fully diluted computations
    24,360,450       25,129,924  
 
Not included in the number of shares used in the fully diluted computation for the three months ended March 31, 2012 and 2011 are 209,795 and 93,062 shares, respectively, pertaining to restricted stock units as their impact would be anti-dilutive.
 
9

 
 
4.  
Composition of Certain Financial Statement Captions
 
Inventories are valued at the lower of cost (first in, first out) or market. Inventory costs include the cost of material, labor and manufacturing overhead. The following is a summary of the inventory components as of March 31, 2012 and December 31, 2011 (in thousands):
 
   
March 31, 2012
   
December 31, 2011
 
Raw materials
  $ 8,994     $ 8,533  
Work-in-process
    82,606       65,645  
Finished goods
    44,336       43,095  
    $ 135,936     $ 117,273  
 
Property, plant and equipment are recorded at cost and consist of the following (in thousands):
 
   
March 31, 2012
   
December 31, 2011
 
Land
  $ 18,811     $ 18,550  
Buildings and improvements
    119,519       117,961  
Machinery and equipment
    237,957       233,702  
Leasehold improvements
    8,514       8,482  
Office equipment
    38,762       37,906  
Construction in progress
    14,134       11,961  
      437,697       428,562  
Less accumulated depreciation and amortization
    (193,651 )     (185,186 )
    $ 244,046     $ 243,376  
 
The components of intangible assets are as follows (in thousands):

   
March 31, 2012
   
December 31, 2011
 
   
Gross
Amount
   
Accumulated
Amortization
   
Net
Amount
   
Gross
Amount
   
Accumulated
Amortization
   
Net
Amount
 
Amortizing Intangible Assets
                                   
Backlog
  $ 1,824     $ 1,824     $ -     $ 1,808     $ 1,808     $ -  
Developed technology
    70,739       7,758       62,981       70,590       7,233       63,357  
Tradename
    4,110       722       3,388       4,110       698       3,412  
Customer relationships
    47,604       16,944       30,660       47,604       16,212       31,392  
Non-compete agreement
    1,100       775       325       1,100       775       325  
    Non-amortizing tradename
    2,269       -       2,269       2,204       -       2,204  
Total
  $ 127,646     $ 28,023     $ 99,623     $ 127,416     $ 26,726     $ 100,690  
 
The estimated useful lives for intangible assets are:

Identified Intangible Asset
 
Estimated Useful Life in Years or Months
Developed technology
 
10 years – 20 years
Tradename
 
10 years
Customer relationships
 
10 years – 12.5 years
Backlog
 
1 month – 3 months
Non-compete agreement
 
15 months

Amortization of definite-lived intangible assets will be approximately (in thousands): $7,479 in fiscal year 2012, $6,381 in fiscal year 2013, $8,412 in fiscal year 2014, $10,745 in fiscal year 2015 and $13,209 in fiscal year 2016.
 
10

 
 
The roll forward of the goodwill balance by segment during the three months ended March 31, 2012 is as follows (in thousands):

   
ACO
   
Thermo
   
ESK
   
Boron
   
Total
 
Balance at December 31, 2011
                             
Goodwill
  $ 13,108     $ 10,331     $ 9,033     $ 22,083     $ 54,555  
Accumulated impairment losses
    (7,797     -       -       (3,832 )     (11,629 )
                     5,311       10,331       9,033       18,251       42,926  
Translation and other                     265               265  
Balance at March 31, 2012
                                       
Goodwill
  $ 13,108       10,331     $ 9,298       22,083       54,820  
Accumulated impairment losses
    (7,797     -       -       (3,832 )     (11,629 )
      5,311     $ 10,331       9,298     $ 18,251     $ 43,191  
 
The Company is required to test annually whether the estimated fair value of its reporting units is sufficient to support the goodwill assigned to those reporting units; the Company performs the annual test in the fourth quarter. The Company is also required to test goodwill for impairment before the annual test if an event occurs or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying amount, such as a significant adverse change in the business climate. The Company determined that a test of goodwill for impairment was not required as of March 31, 2012.

5.  
Fair Value Measurements
 
The Company measures fair value and provides required disclosures about fair value measurements as it relates to financial and nonfinancial assets and liabilities in accordance with a framework specified by GAAP. This framework addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP. The framework also includes additional guidance to provide greater clarity about the credit and noncredit component of an other-than-temporary impairment event.
 
The fair value framework requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
 
Level 1:  quoted market prices in active markets for identical assets and liabilities
 
Level 2:  observable market based inputs or unobservable inputs that are corroborated by market data
 
Level 3:  unobservable inputs that are not corroborated by market data
 
The carrying value of cash and cash equivalents, accounts receivable and trade payables approximates the fair value due to their short-term maturities.
 
For recognition purposes, on a recurring basis, the Company measures available for sale short-term and long-term investments at fair value. Approximately $1.7 million of the unrealized losses in short term investments as of March 31, 2012 have been in a loss position for more than 12 months. The fair value of the following investments is determined using quoted prices in active markets (Level 1):
 
   
Level 1 Investments
    at March 31, 2012   
 
(In thousands)
 
Amortized Cost
   
Unrealized Gains
   
Unrealized Losses
   
Fair Value
 
Short term investments:
                               
  Investment funds – debt securities
 
$
  222,794
   
$
        122
   
$
      (2,704
 
$
     220,212
 
  Corporate bonds
   
      9,598
     
              9
     
             (3
   
         9,604
 
    Total short term investments
 
$
  232,392
   
$
          131
   
$
      (2,707
 
$
     229,816
 
Long term investments:
                               
  Corporate bonds
 
$
  6,351
   
$
          14
   
$
      (10
 
$
     6,355
 
   
Level 1 Investments
    at December 31, 2011   
 
(In thousands)
 
Amortized Cost
   
Unrealized Gains
   
Unrealized Losses
   
Fair Value
 
Short term investments:
                               
  Investment funds – debt securities
 
$
  220,778
   
$
          30
   
$
      (4,881
)  
$
     215,927
 
  Corporate bonds
   
      8,851
     
              1
     
             (7
)    
         8,845
 
    Total short term investments
 
$
  229,629
   
$
            31
   
$
      (4,888
)  
$
     224,772
 
 
11

 

The fair value of long-term investments in auction rate securities is based on a Level 3 valuation technique that includes the present value of future cash flows (principal and interest payments), review of the underlying collateral, and considers relevant probability weighted and risk adjusted observable inputs and minimizes the use of unobservable inputs. The fair values of auction rate securities at March 31, 2012 and December 31, 2011 were $15.5 million and $15.0 million, respectively.
 
During the three months ended March 31, 2012 and 2011 there were no charges due to other-than-temporary reductions in the value of investments in auction rate securities. The Company also recognized pre-tax credits of $453,000 and $111,000 in other comprehensive income during the three months ended March 31, 2012 and 2011, respectively, due to temporary increases in the value of its investments in auction rate securities.
 
Cumulatively to date, the Company has incurred $4.7 million in pre-tax charges due to other-than-temporary reductions in the value of its investments in auction rate securities, realized losses of $8.8 million from sales of auction rate securites and pre-tax temporary impairment charges of $2.6 million reflected in other comprehensive income. As of March 31, 2012, the fair value of the Company’s investments in auction rate securities was below cost by approximately $7.3 million. The fair value of the auction rate securities has been below cost for more than one year.
 
For disclosure purposes, the Company is required to measure the fair value of outstanding debt on a recurring basis. The fair value of outstanding debt is determined using quoted prices in active markets. The fair value of long-term debt, based on quoted market prices, was $93.5 million at both March 31, 2012 and December 31, 2011.
 
6.  
Recent Accounting Pronouncements
 
In May 2011, the FASB issued new guidance which changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between U.S. GAAP and International Financial Reporting Standards (“IFRS”). This new guidance also expands the disclosures for fair value measurements that are estimated using significant unobservable (Level 3) inputs. The Company adopted this standard in the first quarter of 2012 which did not materially expand its consolidated financial statement footnote disclosures.
 
 
In June 2011, the FASB issued new guidance which eliminates the option to report other comprehensive income and its components in the statement of changes in equity. This new guidance requires that all nonowner changes in stockholders’ equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted this standard in the first quarter of 2012 which change the presentation of its consolidated financial statements with the inclusion of a new separate statement labeled “Consolidated Statements of Comprehensive Income”.
 
7.  
Convertible Debt and Credit Facility

During December 2005, the Company issued $121.0 million of 2.875% senior subordinated convertible notes (“Notes”) due December 15, 2035. The Company subsequently repurchased $27.9 million of the Notes during 2009 which reduced the outstanding principal amount to $93.1 million. Since the Notes are convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement), the Company separately accounts for the liability and equity components of the Notes in a manner that reflects the Company’s nonconvertible debt borrowing rate as interest cost is recognized.
 
As of March 31, 2012 and December 31, 2011, long-term debt and the equity component (recorded in additional paid in capital, net of income tax benefit), determined in accordance with the accounting guidance for convertible debt, comprised the following (in thousands):
 
12

 
 
   
March 31, 2012
   
December 31, 2011
 
Outstanding debt
           
  Principal amount
  $ 93,100     $ 93,100  
  Unamortized discount
    (2,836 )     (3,806 )
      Net carrying amount
    90,264       89,294  
Current portion of outstanding debt
    90,264       89,294  
Noncurrent  portion of outstanding debt
  $ -     $ -  
Equity component, net of income tax benefit
  $ 16,399     $ 16,399  
 
The discount on the liability component of long-term debt is being amortized using the effective interest method based on an annual effective rate of 7.5%, which represented the market interest rate for similar debt without a conversion option on the issuance date, through December 2012, which coincides with the first date that holders of the Notes can exercise their put option as discussed below. Interest expense on the Notes, excluding capitalized interest, for the three months ended March 31, 2012 and 2011 included the following (in thousands):
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Contractual interest coupon
  $ 665     $ 662  
Non-cash amortization of discount on the liability component
    971       892  
Non-cash amortization of debt issuance costs
    98       92  
    $ 1,734     $ 1,646  

The Notes contain put options, which may require the Company to repurchase in cash all or a portion of the Notes on December 15, 2012, December 15, 2015, December 15, 2020, December 15, 2025, and December 15, 2030 at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased plus accrued and unpaid interest up to but excluding the repurchase date.

In December 2005, the Company established an unsecured $10.0 million line of credit (“2005 LOC”) which will expire on May 1, 2014. As of March 31, 2012, there were no outstanding amounts on the 2005 LOC. However, the available line of credit at March 31, 2012 has been reduced by outstanding letters of credit in the aggregate amount of $49,000. The interest rate on the 2005 LOC was 1.2% as of March 31, 2012 which was based on the LIBOR rate for a period of one month, plus a margin of 1.0%. In June 2011, the Company established a separate unsecured $5.0 million line of credit (“2011 LOC”) that was increased to $7.0 million on December 19, 2011 and will mature on April 1, 2013. The Company expects to renew the 2011 LOC at that time for multiple years. As of March 31, 2012, there were no outstanding amounts on the 2011 LOC. However, the available line of credit at March 31, 2012 has been reduced by outstanding letters of credit in the aggregate amount of $5.7 million. The interest rate on the 2011 LOC was 1.2% as of March 31, 2012 which was based on the LIBOR rate for a period of one month, plus a margin of 1.0% percent. In April 2012, the Company finalized the transfer of the outstanding letters of credit under the 2005 LOC to the 2011 LOC and closed the 2005 LOC.
 
Pursuant to the bank line of credit, the Company is subject to certain covenants, which include, among other things, the maintenance of specified minimum amounts of net income and liquidity. The Company was in compliance with all covenants at March 31, 2012.
 
During the three months ended March 31, 2011, the Company capitalized interest of approximately $198,000 in connection with the construction of its new manufacturing plant in Tianjin, China. No interest was capitalized during the three months ended March 31, 2012.
 
8.  
Disclosure About Segments of an Enterprise and Related Information
 
The Company serves its markets and manages its business through four operating segments, each of which has its own manufacturing facilities and administrative and selling functions.
 
13

 
The financial information for all segments is presented below (in thousands):
   
Three Months Ended March 31,   
 
   
2012
   
2011
 
Revenue from External Customers
           
Advanced Ceramic Operations
  $ 48,705     $ 76,630  
ESK Ceramics
    42,408       40,123  
Thermo Materials
    14,866       31,111  
Boron
    7,203       7,940  
Inter-segment elimination
    (6,873 )     (5,702 )
Total
  $ 106,309     $ 150,102  
                 
Depreciation and Amortization
               
Advanced Ceramic Operations
  $ 2,293     $ 2,871  
ESK Ceramics
    2,975       3,139  
Thermo Materials
    2,020       1,686  
Boron
    1,855       2,053  
Total
  $ 9,143     $ 9,749  

Segment Income (Loss) from Operations and Income before Provision for Income Taxes
           
Advanced Ceramic Operations
  $ 3,395     $ 17,014  
ESK Ceramics
    7,177       7,805  
Thermo Materials
    (1,783 )     10,854  
Boron
    (876 )     -  
Inter-segment elimination
    (582 )     (72 )
Total segment income from operations
  $ 7,331     $ 35,601  
Other expense
    (1,335 )     (737 )
Total Income before Provision for Income Taxes
  $ 5,996     $ 34,864  
                 
Segment Assets
               
Advanced Ceramic Operations
  $ 489,861     $ 453,886  
ESK Ceramics
    172,755       185,070  
Thermo Materials
    171,672       161,065  
Boron
    122,264       126,509  
Total
  $ 956,552     $ 926,530  
                 
Expenditures for Property, Plant & Equipment
               
Advanced Ceramic Operations
  $ 1,823     $ 1,400  
ESK Ceramics
    2,183       678  
Thermo Materials
    559       4,949  
Boron
    1,359       650  
Total
  $ 5,924     $ 7,677  
                 
Percentage of U.S. net sales from external customers
               
Advanced Ceramic Operations
    38 %     43 %
ESK Ceramics
    5 %     6 %
Thermo Materials
    9 %     4 %
Boron
    5 %     4 %
Total percentage of U.S. net sales from external customers
    57 %     57 %
                 
Percentage of foreign net sales from external customers
               
Advanced Ceramic Operations
    7 %     6 %
ESK Ceramics
    29 %     20 %
Thermo Materials
    5 %     16 %
Boron
    2 %     1 %
Total percentage of foreign net sales from external customers
    43 %     43 %
                 
Percentage of total net sales from external customers
               
Advanced Ceramic Operations
    45 %     49 %
ESK Ceramics
    34 %     26 %
Thermo Materials
    14 %     20 %
Boron
    7 %     5 %
Total percentage of total net sales from external customers
    100 %     100 %
 
14

 
 
Foreign sales are determined by the country to which the shipment is delivered.
 
The following is revenue by market application for the Advanced Ceramic Operations segment (in thousands):
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Defense
  $ 29,386     $ 56,427  
Industrial
    9,273       7,204  
Energy
    4,320       8,423  
Automotive/Diesel
    1,828       2,502  
Commercial
    3,898       2,074  
    $ 48,705     $ 76,630  
 
9.  
Pension and Other Post-retirement Benefit Plans
 
The Company provides pension benefits to its employees in Germany. These pension benefits are rendered for the time after the retirement of the employees by payments into legally independent pension and relief facilities. They are generally based on length of service, wage level and position in the company. The direct and indirect obligations comprise obligations for pensions that are already paid currently and expectations for those pensions payable in the future. The Company has four separate plans in Germany: a) Pensionskasse - Old; b) Pensionskasse - New; c) Additional Compensation Plan; and d) Deferred Compensation Plan. For financial accounting purposes, the Additional and Deferred Compensation Plans are accounted for as single-employer defined benefit plans, Pensionskasse - Old is a multiemployer defined benefit plan and the Pensionskasse - New is a defined contribution plan. The Company also provides pension benefits to its employees of Ceradyne Boron Products located in Quapaw, Oklahoma. There are two defined benefit retirement plans, one for eligible salaried employees and one for hourly employees. The benefits for the salaried employee plan are based on years of credited service and compensation. The benefits for the hourly employee plan are based on stated amounts per year of service.
 
Components of net periodic benefit costs under these defined benefit plans were as follows (in thousands):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Service cost
  $ 192     $ 192  
Interest cost
    332       332  
Expected return on plan assets
    (139 )     (139 )
Amortization of unrecognized (gain) loss
    (10 )     (10 )
Net periodic benefit cost
  $ 375     $ 375  
 
10.  
Financial Instruments
 
The Company occasionally enters into foreign exchange forward contracts to reduce earnings and cash flow volatility associated with foreign exchange rate changes to allow management to focus its attention on its core business operations. Accordingly, the Company enters into contracts which change in value as foreign exchange rates change to economically offset the effect of changes in value of foreign currency assets and liabilities, commitments and anticipated foreign currency denominated sales and operating expenses. The Company enters into foreign exchange forward contracts in amounts between minimum and maximum anticipated foreign exchange exposures, generally for periods not to exceed one year. These derivative instruments are not designated as accounting hedges. The Company had an outstanding foreign exchange forward contract at March 31, 2012 for 55 million Euros.
 
15

 
 
11.  
Income Taxes
 
The Company classifies accrued interest and penalties as part of the accrued liability for uncertain tax positions and records the corresponding expense in the provision for income taxes.

Components of the required reserve at March 31, 2012 and December 31, 2011 are as follows (in thousands):
 
   
March 31, 2012
   
December 31, 2011
 
Federal, state and foreign unrecognized tax benefits (“UTBs”)
  $ 1,844     $ 1,791  
Interest
    105       80  
Federal/State Benefit of Interest
    (41 )     (31 )
Total reserve for UTBs
  $ 1,908     $ 1,840  
 
It is anticipated that any change in the above UTBs will impact the effective tax rate. At March 31, 2012, the 2007 through 2011 years are open and subject to potential examination in one or more local jurisdictions and 2009 through 2011 years are open for federal income tax purposes. The Company does not expect any significant release of UTBs within the next twelve months.

Effective January 1, 2008, the Company was granted an income tax holiday for a manufacturing facility in China. The tax holiday allows for tax-free operations through December 31, 2009, followed by operations at a reduced income tax rate of 12.5% on the profits generated in 2010 through 2012, with a return to the full statutory rate of 25% for periods thereafter. This manufacturing facility in China incurred a pre-tax loss for the three months ended March 31, 2012, accordingly, there was no tax holiday for this period. Income tax expense for the three months ended March 31, 2011 was reduced by $0.9 million from the tax holiday in China.

Income taxes are determined using an annual effective tax rate, which generally differs from the United States federal statutory rate, primarily because of state taxes, research and development tax credits and the income tax holiday in China. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial and tax reporting of the Company's assets and liabilities, along with net operating loss and credit carry forwards.
 
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The factors used to assess the likelihood of realization of the deferred tax assets are the reversal of deferred tax liabilities, the Company’s forecast of future taxable income, and available tax planning strategies that are prudent and feasible. The Company evaluated positive and negative evidence and, although realization is not assured, management determined that it is more likely than not that the net deferred tax asset will be realized through future taxable income and tax planning strategies. Failure to achieve the forecasted taxable income and successful implementation of tax planning strategies in the applicable taxing jurisdictions could affect the ultimate realization of deferred tax assets and could result in an increase in the Company’s effective tax rate on future earnings.
 
12.  
Commitments and Contingencies
 
The Company leases certain of its manufacturing facilities under noncancelable operating leases expiring at various dates through June 2014. The Company incurred rental expense under these leases of $1.0 million for the three months ended March 31, 2012 and $0.9 million for the three months ended March 31, 2011. The approximate minimum rental commitments required under existing noncancelable leases as of March 31, 2012 are as follows (in thousands):
              
2012
  $ 2,668  
2013
    2,340  
2014
    778  
2015
    173  
2016
    -  
Thereafter
    -  
    $ 5,959  
 
16

 
 
 
 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
 
Preliminary Note Regarding Forward-Looking Statements
 
This Quarterly Report on Form 10-Q contains statements which may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. One generally can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “may,” “will,” “expects,” “intends,” “estimates,” “anticipates,” “plans,” “seeks,” or “continues,” or the negative thereof, or variations thereon, or similar terminology. Forward-looking statements regarding future events and the future performance of the Company involve risks and uncertainties that could cause actual results to differ materially. Reference is made to the risks and uncertainties which are described in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in Part II, Item 1A under the caption “Risk Factors.” Reference is also made to the risks and uncertainties described in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011, as filed with the Securities and Exchange Commission, in Item 1A under the caption “Risk Factors,” and in Item 7 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Overview
 
We develop, manufacture and market advanced technical ceramic products, ceramic powders and components for defense, industrial, energy, automotive/diesel and commercial applications. Our products include:
 
 
lightweight ceramic armor for soldiers and other military applications;
 
 
ceramic industrial components for erosion and corrosion resistant applications;
 
 
ceramic powders, including boron carbide, boron nitride, titanium diboride, calcium hexaboride, zirconium diboride and fused silica, which are used in manufacturing armor and a broad range of industrial products and  consumer products;
 
 
evaporation boats for metallization of materials for food packaging and other products;
 
 
durable, reduced friction, ceramic diesel engine components;
 
 
functional and frictional coatings primarily for automotive applications;
 
 
translucent ceramic orthodontic brackets;
 
 
ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes;
 
 
ceramic crucibles for melting silicon in the photovoltaic solar cell manufacturing process;
 
 
specialty glass compositions for solar, electronic, industrial and health care markets;
 
 
ceramic missile radomes (nose cones) for the defense industry;
 
 
fused silica powders for precision investment casting (PIC);
 
 
neutron absorbing materials, structural and non-structural, in combination with aluminum metal matrix composite that serve as part of a barrier system for spent fuel wet and dry storage in the nuclear industry, and non-structural neutron absorbing materials for use in the transport of nuclear fresh fuel rods;
 
 
nuclear chemistry products for use in pressurized water reactors and boiling water reactors;
 
 
boron dopant chemicals for semiconductor silicon manufacturing and for ion implanting of silicon wafers;
 
 
ceramic bearings and bushings for oil drilling and fluid handling pumps;
 
 
ceramic micro-reactors used to process chemicals;
 
 
PetroCeram® sand filters for oil and gas recovery; and
 
 
enhanced combat helmets for soldiers.
 
Our customers include the U.S. government, prime government contractors, companies engaged in solar energy, oil and natural gas exploration and nuclear energy, and large industrial, automotive, diesel and commercial manufacturers in both domestic and international markets.
 
17

 
 
The tables below show, for each of our four operating segments, revenues and income before provision for income taxes in the periods indicated.

Segment revenues (in millions):
   
Three Months Ended March 31,
 
   
2012
   
2011
   
Change
 
Advanced Ceramic Operations
  $ 48.7     $ 76.6       (36.4 %)
ESK Ceramics
    42.4       40.1       5.7 %
Thermo Materials
    14.9       31.1       (52.2 %)
Boron
    7.2       7.9       (9.3 %)
Inter-segment elimination
    (6.9 )     (5.6 )     20.5 %
Total
  $ 106.3     $ 150.1       (29.2 %)
 
Segment operating income (loss) (in millions):
   
Three Months Ended March 31,
 
   
2012
   
2011
   
Change
 
Advanced Ceramic Operations
  $ 3.4     $ 17.0       (80.0 %)
ESK Ceramics
    7.2       7.8       (8.0 %)
Thermo Materials
    (1.8 )     10.9       n/m  
Boron
    (0.9 )     -       n/m  
Inter-segment elimination
    (0.6 )     (0.1 )     708.3 %
Total
  $ 7.3     $ 35.6       (79.4 %)
* Not meaningful
                       
 
We categorize our products into five market applications. The table below shows our sales by market application and the percentage contribution to our total sales of each market application in the different time periods.

   
Three Months Ended March 31,
 
   
2012
   
2011
 
   
Sales
   
%
   
Sales
   
%
 
Defense
  $ 36.6       34.4     $ 64.8       43.1  
Industrial
    40.1       37.7       39.5       26.3  
Energy
    14.9       14.0       33.1       22.1  
Automotive/Diesel
    9.8       9.3       9.7       6.5  
Commercial
    4.9       4.6       3.0       2.0  
Total
  $ 106.3       100.0 %   $ 150.1       100.0 %
 
The principal factor contributing to our growth in sales from 2002 through 2007 was increased demand by the U.S. military for ceramic body armor that protects soldiers, which was driven primarily by military conflicts such as those in Iraq and Afghanistan. This demand was driven by recognition of the performance and life saving benefits of utilizing advanced technical ceramics in lightweight body armor. Our sales declined in 2008 primarily because of a reduction in shipments of body armor. Our sales declined in 2009 primarily because of a continued reduction in shipments of body armor and also due to a decline in sales of our industrial, automotive/diesel and commercial market product lines due to the severe economic recession. In 2010, sales of body armor continued to decline. However, sales from energy related products grew by 61.6% in 2010 when compared to 2009. Most of this growth in energy sales was generated by sales of our ceramic crucibles used in the production of photovoltaic cells for solar panels. Additionally, sales of industrial and automotive/diesel products rebounded sharply in 2010, particularly at our ESK Ceramics subsidiary. In 2011, our sales increased due to higher shipments of body armor due to the increased demand for ESAPI body armor, an increase of sales to the nuclear industry, and continuing growth of sales at our ESK Ceramics subsidiary.
 
Commencing in 2004, several strategic acquisitions also have contributed to our sales growth. These include our acquisition of ESK Ceramics in August 2004, our acquisition of Minco, Inc. in July 2007, our acquisition of EaglePicher Boron, LLC in August 2007, which we renamed Boron Products, LLC and our acquisition of VIOX Corporation in January 2011.
 
18

 
 
To illustrate the impact of body armor, energy-related products, and our acquisitions, the following table shows our sales from body armor, energy-related products, from our acquisitions, and from all other sources for each of the years 2002 through 2011 (in millions).
 
   
2011
   
2010
   
2009
   
2008
   
2007
   
2006
   
2005
   
2004
   
2003
   
2002
 
Sales from body armor
  $ 193.8     $ 70.4     $ 170.0     $ 385.0     $ 535.3     $ 479.4     $ 199.5     $ 120.3     $ 58.2     $ 26.2  
Sales from energy products:
                                                                               
 Gross sales from energy products
    129.0       99.9       62.2       57.7       20.9       11.9       9.8       5.3       2.5       1.7  
 Less sales from energy products included in acquisitions
    (66.2 )     (28.5 )     (24.5 )     (11.4 )     (4.5 )     (3.2 )     (3.2 )     (0.7 )     -       -  
Sales from energy products due to organic growth
    62.8       71.4       37.7       46.3       16.4       8.7       6.6       4.6       2.5       1.7  
Sales generated from acquisitions
    254.5       191.1       136.8       177.1       142.6       110.2       109.8       36.0       -       -  
All other sales
    60.9       70.0       56.1       71.8       62.5       64.6       52.4       54.7       40.8       33.3  
Total sales
  $ 572.0     $ 402.9     $ 400.6     $ 680.2     $ 756.8     $ 662.9     $ 368.3     $ 215.6     $ 101.5     $ 61.2  
 
Sales declined sharply in the first quarter of 2012, especially the shipments of our products for defense and energy applications. The principal factors contributing to the decline of shipments to the defense industry were a reduction in the amount of body armor scheduled for delivery during the first quarter of 2012 to the U.S. government and  delays in receiving approval of first article testing of our ESAPI design in connection with the ceramic armor plates ordered by the Defense Logistics Agency Troop Support group. We received approval during the first half of March 2012 but incurred further delays in shipments due to slower than expected results from the U.S. government’s lot testing program causing $10.0 million of body armor shipments to be deferred into the second quarter of 2012. Based on scheduled deliveries of existing orders, we expect shipments of body armor to rebound in the second quarter and for the balance of 2012. Shipments of energy products to the solar industry declined significantly due to the continued pronounced slowdown of demand in the solar energy market due to a reduction of government subsidies for the installation of solar panels and a buildup of inventories of solar cells and solar wafers in end market distribution channels causing a severe reduction of sales of our ceramic crucibles. Our sales to the industrial and automotive/diesel sectors of the economy were flat during the first quarter of 2012 while our sales to the commercial sector of the economy expanded due to the increased sales of our bio-glass product for use as an ingredient in toothpaste.
 
In October 2008, we were awarded an Indefinite Delivery/Indefinite Quantity, or ID/IQ, contract by the U.S. Army for the next ballistic threat generation of ceramic body armor plates, called XSAPI, as well as for the current generation ESAPI plates. This five-year contract has a maximum value of $2.37 billion and allows the U.S. Army to order either XSAPI or ESAPI body armor from us.
 
Through March 31, 2012, we have received delivery orders under the October 2008 ID/IQ contract totaling $278.8 million. Of this amount, we have shipped $278.4 million of body armor through March 31, 2012 and we expect to ship the balance of approximately $0.4 million in 2012. With less than two years remaining under this ID/IQ contract, the war in Iraq concluded, and the war in Afghanistan winding down, we expect that the total amount of body armor that we ultimately ship under this contract will be substantially less than the maximum amount.
 
In September 2011, we were awarded a three-year ID/IQ contract for ESAPI ceramic armor plates from Defense Logistics Agency Troop Support group. This purchasing group services the United States Army, Navy, Air Force and Marine Corps. This award was in response to our bid to the Defense Supply Center Philadelphia (DSCP) in response to their requirement for a three-year sustainment order for the replacement of body armor inserts. Simultaneously with the receipt of this award, we received an initial delivery order for $127.3 million for ESAPI ceramic body armor plates.  Of this amount, we have shipped $5.2 million of body armor through March 31, 2012 and we expect to ship the balance of approximately $122.1 million by March 31, 2013. This ID/IQ contract includes options for additional deliveries of up to $127.3 million in each of the second and third years. Initial comments from the contracting officer of the U.S. Military indicate that the 2013 ESAPI order will be similar to the 2012 order, but this is a preliminary estimate with no guarantee.
 
In October 2011, we announced the receipt of a delivery order for approximately $6.9 million for ceramic body armor plates from the United States Special Operations Command. During March 2012, we received a stop work order notice due to ballistic lot testing failures. We anticipate that we will resolve this issue during either the second or third quarter of this year.
 
19

 
 
For 2012 and for the next several years, we expect that our sales of body armor will continue in a range of approximately $50.0 to $150.0 million per year. We will continue to bid on Foreign Military Sales (FMS) for the first generation of SAPI body armor through our existing ID/IQ contract with Aberdeen Proving Grounds.
 
Although we believe that demand for ceramic body armor will continue for many years, the quantity and timing of government orders depends on a number of factors outside of our control, such as the amount of U.S. defense budget appropriations, positions and strategies of the current U.S. government, the level of international conflicts and the deployment of armed forces. Moreover, ceramic armor contracts generally are awarded in an open competitive bidding process and may be cancelled by the government at any time without penalty. Therefore, our future level of sales of ceramic body armor will depend on our ability to successfully compete for and retain this business.
 
In June 2009, we acquired substantially all of the business and assets and all technology and intellectual property related to ballistic combat and non-combat helmets of Diaphorm Technologies, LLC, based in Salem, New Hampshire. Based on this technology, we submitted a proposal to the U.S. Marine Corps Systems Command in June 2009 in response to a solicitation for the procurement of Enhanced Combat Helmets (ECH), which are intended to provide substantially increased levels of protection compared to combat helmets now in use. In response to our proposal, the U.S. Marine Corps Systems Command in July 2009 awarded us a contract for up to a maximum of 246,840 helmets. After an extended period of First Article Testing, our helmets have been approved by the U.S. Government. In March 2012, we received the first of possibly two low rate initial production ECH Helmet orders. The initial release has a value of approximately $3.0 million. The full multi-year production order is expected by the end of the second quarter of calendar year 2012. The total for the initial orders plus full production is expected to exceed $170.0 million. Our strategy regarding this acquisition is to combine our successful track record in body armor programs with the proprietary helmet-forming technologies acquired from Diaphorm to create a world class manufacturer of Enhanced Combat Helmets.
 
New orders for the three months ended March 31, 2012 were $80.8 million, compared to $231.7 million for the same period last year. There were no new orders for ceramic body armor for the three months ended March 31, 2012 compared to $93.1 million for the same period last year.

Our order backlog was $259.5 million as of March 31, 2012 and $267.4 million as of  March 31, 2011. The backlog for ceramic body armor represented approximately $140.8 million, or 54.3%, of the total backlog as of March 31, 2012 and $117.4 million, or 43.9%, of the total backlog as of March 31, 2011. We expect that substantially all of our order backlog as of March 31, 2012 will be shipped during 2012.
 
Based on our current backlog and anticipated orders for ceramic body armor and the level of shipments to date in 2012, we expect our sales of ceramic body armor to be lower in fiscal year 2012 than in 2011. For the next three quarters, the level of shipments of ceramic body armor is likely to be the most significant factor affecting our total sales during 2012.
 
Results of Operations for the Three Months Ended March 31, 2012 and 2011
 
Net Sales
 
Our total net sales for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Net sales
  $ 106.3     $ 150.1  
Increase (decrease) in net sales
  $ (43.8 )   $ 40.1  
Percentage change in net sales
    (29.2 %)     36.4 %
 
Sales declined sharply in the first quarter of 2012, primarily from declines in shipments of body armor and ceramic crucibles. Net sales for the three months ended March 31, 2012 of our defense related products were $36.6 million, a decrease of $28.2 million, or 43.6%, from $64.8 million in the prior year as shipments of body armor were lower due to a reduction in the amount of body armor scheduled for delivery to the U.S. government during the first quarter and delays in shipments. The principal factors contributing to the delays in shipments of body armor were slower than anticipated approval of the first article testing of our ESAPI design in connection with the ceramic armor plates ordered by the Defense Logistics Agency Troop Support group, and further delays caused by slower than expected results from the U.S. government’s lot testing program, causing $10.0 million of body armor shipments to be deferred into the second quarter of 2012.
 
20

 
 
Sales for the three months ended March 31, 2012 of energy products amounted to $14.9 million, a decrease of $18.2 million, or 55.2%, from $33.1 million in the prior year as sales of ceramic crucibles to the solar industry continued to significantly decline due to a reduction of government subsidies for the installation of solar panels and a buildup of inventories of solar cells and solar wafers in end market distribution channels, causing a severe reduction of sales of our ceramic crucibles.
 
Sales for the three months ended March 31, 2012 of industrial products amounted to $40.1 million, an increase of $0.6 million, or 1.8%, from $39.5 million in the prior year. Sales of industrial products represented 37.7% of sales for the three months ended March 31, 2012 and 26.3% of sales for the three months ended March 31, 2011.
 
Sales of automotive/diesel products for the three months ended March 31, 2012 were $9.8 million, an increase of $0.1 million, or 1.4% from $9.7 million compared to the same period last year. Sales to the automotive/diesel market represented 9.3% of sales for the three months ended March 31, 2012 and 6.5% of sales for the three months ended March 31, 2011.
 
Our net sales of commercial products for the three months ended March 31, 2012 were $4.9 million, an increase of $1.9 million, or 61.9%, from $3.0 million in the prior year. This increase was caused by increase demand for our bio-glass product for use as an ingredient in tooth paste.
 
Advanced Ceramic Operations Segment
 
Our Advanced Ceramic Operations segment had net sales for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Net sales
  $ 48.7     $ 76.6  
Increase (decrease) in net sales
  $ (27.9 )   $ 22.5  
Percentage change in net sales
    (36.4 %)     41.7 %
 
Contributing to the decrease of $27.9 million in sales at our Advanced Ceramic Operations segment were lower shipments of ceramic body armor in the first quarter of 2012 that totaled $27.4 million, a decrease of $26.6 million, or 49.2%, from $54.0 million in the first quarter of 2011. The primary reasons for the decrease in shipments of ceramic body armor were a reduction in the amount of body armor scheduled for delivery to the U.S. government during the first quarter and delays in both receiving first article testing approval and lot testing results from the U.S. government, causing $10.0 million of planned shipments to be deferred into the second quarter of 2012.
 
Net sales of our orthodontic brackets product line for the three months ended March 31, 2012 were $2.5 million, an increase of $0.4 million, or 19.1%, from $2.1 million in the corresponding quarter of the prior year. The increase was due to special marketing programs by our customer generating more end market sales of orthodontic brackets.
 
ESK Ceramics Operations Segment
 
Our ESK Ceramics segment had net sales for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Net sales
  $ 42.4     $ 40.1  
Increase (decrease) in net sales
  $ 2.3     $ 8.4  
Percentage change in net sales
    5.7 %     26.4 %
 
On a constant currency basis, sales for the three months ended March 31, 2012 were $43.7 million, an increase of $3.6 million, or 9.0%, from the corresponding quarter of the prior year. Sales of industrial products for the three months ended March 31, 2012 were $21.7 million, a decrease of $1.9 million, or 8.2%, from $23.6 million in the corresponding quarter of the prior year. This decrease was the result of lower demand for composite coatings, a decrease in shipments of industrial parts for the packaging industry, a decrease in shipments of industrial wear parts and a decrease in shipments of boron nitride ceramic powders. Sales of defense products for the three months ended March 31, 2012 were $9.4 million, an increase of $3.3 million, or 53.9%, from $6.1 million in the corresponding quarter of the prior year. Included in sales of defense products for the three months ended March 31, 2012 were inter-segment sales of $6.5 million compared to $4.8 million in the prior year. The increase of $1.7 million in inter-segment sales was due to an increase in demand for boron carbide powder used in body armor plates manufactured by our Advanced Ceramic Operations division. Sales of automotive/diesel products for the three months ended March 31, 2012 were $8.0 million, an increase of $0.8 million , or 11.2%, from $7.2 million in the corresponding quarter of the prior year. Increased demand from automotive original equipment manufacturers accounted for the increase in sales.
 
21

 
 
Thermo Materials Segment
 
Our Thermo Materials segment had net sales for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Net sales
  $ 14.9     $ 31.1  
Increase (decrease) in net sales
  $ (16.2 )   $ 11.3  
Percentage change in net sales
    (52.2 %)     56.7 %
 
 
The decrease in sales at our Thermo Materials segment was due to lower shipments of crucibles to the solar energy market and decreased sales of refractory products to the metallurgy industry. Sales of crucibles used in the manufacture of photovoltaic cells for the three months ended March 31, 2012 were $3.5 million, a decrease of $19.5 million, or 84.7%, from $23.0 million in the corresponding prior year period. The decrease was due to a reduction of government subsidies for the installation of solar panels and a buildup of inventories of solar cells and solar wafers in end-market distribution channels.
 
Sales to the defense industry for the three months ended March 31, 2012 were $4.3 million, an increase of $2.1 million, or 99.0%, from $2.2 million when compared to the corresponding prior year period. This increase was caused by higher shipments of ceramic missile radomes compared to the same period last year.
 
Boron  Segment
 
Our Boron segment had net sales for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Net sales
  $ 7.2     $ 7.9  
Increase (decrease) in net sales
  $ (0.7 )   $ 1.4  
Percentage change in net sales
    (9.3 %)     21.8 %

Our Boron business segment comprises the business units Ceradyne Boron Products, SemEquip, Inc. and Ceradyne Canada. Almost all of the sales in this segment during the three month period ended March 31, 2012 were from Ceradyne Boron Products, which had net sales of  $6.9 million, a decrease of  $0.1 million, or 1.4%, from $7.0 million in the three months ended March 31, 2011.  This slight decrease was the result of lower shipments to the semiconductor industry.
 
Gross Profit
 
Our total gross profit for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Gross profit
  $ 29.1     $ 58.1  
Increase (decrease) in gross profit
  $ (29.0 )   $ 32.7  
Gross profit percentage
    27.4 %     38.7 %
 
Several factors caused the decrease in gross profit and gross profit as a percentage of net sales during the three months ended March 31, 2012. These factors include substantially lower sales of body armor, ceramic solar crucibles, solar paste products, refractory products, and decreased operating leverage resulting in lower absorption of manufacturing overhead expenses in the production of these product lines.
 
22

 
 
Advanced Ceramic Operations Segment
 
Our Advanced Ceramic Operations segment had total gross profit for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Gross profit
  $ 11.6     $ 26.7  
Increase (decrease) in gross profit
  $ (15.1 )   $ 16.7  
Gross profit percentage
    23.8 %     34.8 %
 
The primary reasons for the decrease in gross profit and gross profit as a percentage of net sales during the three months ended March 31, 2012 were lower volumes of production of body armor and industrial products resulting in lower absorption of manufacturing overhead expenses and an unfavorable sales mix caused by shipments during the first quarter of 2012  of body armor products with lower gross margins compared to the same period prior year.
 
ESK Ceramics Segment
 
Our ESK Ceramics segment had total gross profit for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Gross profit
  $ 13.9     $ 13.1  
Increase (decrease) in gross profit
  $ 0.8     $ 5.7  
Gross profit percentage
    32.8 %     32.6 %
 
Gross profits increased during the three months ended March 31, 2012 due to increased gross profits in the armor and automotive product lines which resulted from an increase in sales of these lines while gross profits of other product lines were unchanged during the three months ended March 31, 2012. Gross profit as a percentage of sales were nearly unchanged for the quarter ended March 31, 2012 as increases in armor gross profit percentage were offset by declines in industrial product gross profit percentage while other segments were unchanged.
 
Thermo Materials Segment
 
Our Thermo Materials segment had total gross profit for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Gross profit
  $ 2.3     $ 15.3  
Increase (decrease) in gross profit
  $ (13.0 )   $ 7.7  
Gross profit percentage
    15.3 %     49.3 %
 
Gross profit decreased during the three month period ended March 31, 2012 primarily because of a severe decrease in unit sales and production of solar crucibles and a decline of $32.5% in unit sales prices of these products due to pricing pressure from customers when compared to the prior year period.
 
Boron Segment
 
Our Boron segment had total gross profit for the three months ended March 31, 2012 and 2011 as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Gross profit
  $ 1.9     $ 3.1  
Increase (decrease) in gross profit
  $ (1.2 )   $ 2.7  
Gross profit percentage
    27.0 %     38.8 %
 
23

 
 
The decrease in gross profit in the first quarter of 2012 was the result of lower sales to the nuclear and semiconductor industries which caused a lower absorption of manufacturing overhead.
 
Selling, General and Administrative Expenses
 
Our selling, general and administrative expenses for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Selling, general and administrative expenses
  $ 17.5     $ 18.8  
Increase (decrease) in selling, general and administrative expenses
  $ (1.3 )   $ 4.9  
Percentage change in selling, general and administrative expenses
    (7.0 %)     35.5 %
Selling, general and administrative expenses; as a percentage of net sales
    16.5 %     12.5 %
 
The decrease in selling, general and administrative expenses during the three months ended March 31, 2012 was primarily caused by lower bonuses to employees due to the reduced financial results when compared to the prior year period.
 
Research and Development Expenses
 
Our research and development expenses for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Research and development expenses
  $ 3.6     $ 3.1  
Increase (decrease) in research and development expenses
  $ 0.5     $ 0.2  
Percentage change in research and development expenses
    18.4 %     4.2 %
Research and development expenses as a percentage of net sales
    3.4 %     2.0 %
 
The primary reasons for the increase in research and development expenses during the three months ended March 31, 2012 were additional expenses to advance our industrial products by our ESK Ceramics subsidiary and expenses at our Advanced Ceramic Operations for energy products for the oil and gas industry.
 
Restructuring – Plant Closure and Severance.
 
Our restructuring – plant closure and severance expenses for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):
 
   
Three Months Ended March 31,
 
   
2012
   
2011
 
Restructuring – plant closure and severance
  $ 0.7     $ 0.0  
Increase (decrease) in restructuring – plant closure and severance
  $ 0.7     $ 0.0  
Percentage change in restructuring – plant closure and severance
    n/m       n/m  
Restructuring – plant closure and severance expenses as a percentage of net sales
    0.6 %     0.0 %
 
We recorded pre-tax restructuring and severance charges of $0.6 million and $0.1 million for the closure of our manufacturing facilities in India and Utah, respectively. We closed the India facilities and moved the equipment associated with that facility because the cost of manufacturing orthodontic products was lower in the United States than in India. In order to gain synergies and reduce costs in our police helmet operation, we closed our Utah facility and combined its operations with our Diaphorm business unit in Salem, New Hampshire.
 
Acquisition Related Charge (Credit)
 
Our acquisition related charges and credits for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):
 
24

 

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Acquisition related charges and credits
  $ 0.0     $ 0.6  
Increase (decrease) in acquisition related charges and credits
  $ (0.6 )   $ 0.7  
Percentage change in acquisition related charges and credits
    n/m       n/m  
Acquisition related charges and credits as s percentage of net sales
    0.0 %     0.4 %
* Not meaningful
               
 
There were no acquisition related charges and credits during the three months ended March 31, 2012. During the three months ended March 31, 2011, we recorded acquisition-related charges of $0.6 million to reflect the fair value of contingent purchase price consideration for SemEquip, Inc., acquired in 2008, Diaphorm Technologies, LLC, acquired in 2009 and VIOX Corporation, acquired on January 3, 2011.
 
Other Income (Expense)
 
Our net other income (expense) for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Other income (expense)
  $ (1.3 )   $ (0.7 )
(Increase) decrease in other income (expense)
  $ (0.6 )   $ 1.4  
Percentage change in other income (expense)
    81.1 %     (64.7 %)
Other income (expense) as percentage of net sales
    (1.3 %)     (0.5 %)
 
 
The increase in other income and expense during the three months ended March 31, 2012 was caused by foreign currency losses of $0.8 million offset by a $0.2 million increase in gains on sales of investments.
 
Income Taxes
 
Our provision for income taxes for the three months ended March 31, 2012 and 2011 were as follows (dollars in millions):

   
Three Months Ended March 31,
 
   
2012
   
2011
 
Provision for income taxes
  $ 2.2     $ 11.3  
Increase (decrease) in provision for income taxes
  $ (9.1 )   $ 9.8  
Percentage change in provision for income taxes
    (80.4 %)     636.1 %
Provision for income taxes as a percentage of net sales
    2.1 %     7.5 %
Effective tax rate
    36.9 %     32.3 %
 
The increase in our effective tax rate for the three months ending March 31, 2012 compared to the prior year period was caused by an increase in our effective tax rate in China due to the change in mix of pre-tax reults between our two Chinese subsidiaries, each of which is taxed at different rates.
 
Liquidity and Capital Resources
 
We generally have met our operating and capital requirements with cash flow from operating activities and borrowings under our credit facility.
 
The following table presents selected financial information and statistics as of March 31, 2012 and December 31, 2011 and for the three months ended March 31, 2012 and 2011 (in thousands):

 
March 31, 2012
   
December 31, 2011
 
Cash, cash equivalents and short term investments
$ 270,101     $ 275,047  
Accounts receivable, net
  61,377       73,646  
Inventories
  135,936       117,273  
Working capital
  382,599       379,154  
               
 
For the Three Months Ended
 
 
March 31, 2012
   
March 31, 2011
 
Quarterly operating cash flow
$ 6,414     $ 17,759  
 
 
25

 
During the three months ended March 31, 2012, we generated $6.4 million of cash from operations compared to $17.8 million for the three months ended March 31, 2011. The $6.4 million of cash flow from operations during 2012 is primarily comprised of net income totaling $3.8 million, with $11.3 million of non-cash charges included therein, offset by an increase in net operating assets and liabilities of $8.7 million. The major contributing factor to the increase in net operating assets and liabilities was an increase in our inventories of $17.5 million due to testing delays for body armor products . Partially offsetting this increase in inventories was a decrease of $12.7 million of accounts receivables as our business contracted during the current quarter.
 
We also invested $5.9 million to expand manufacturing capacity in selected product lines. We received $11.0 million from proceeds and maturities of marketable securities, however, this was offset by the investment of $20.2 million in marketable securities. During the quarter, we paid our first common stock dividend of $3.6 million. As a result, our net cash at March 31, 2012 decreased by $10.0 million as compared to a $4.4 million decrease during the three months ended March 31, 2011.
 
During December 2005, we issued $121.0 million principal amount of 2.875% senior subordinated convertible notes due December 15, 2035. During 2009, we purchased and retired an aggregate of $27.9 million principal amount of our convertible debt for $23.2 million, which reduced the outstanding balance of the notes to $93.1 million. We have not purchased any of the notes since 2009. Since the notes are convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement), we separately account for the liability and equity components of the notes in a manner that reflects the nonconvertible debt borrowing rate as interest cost is recognized.

As of March 31, 2012 and December 31, 2011, long-term debt and the equity component (recorded in additional paid in capital, net of income tax benefit), determined in accordance with the accounting guidance for convertible debt, comprised the following (in thousands):

   
March 31, 2012
   
December 31, 2011
 
Outstanding debt
           
  Principal amount
  $ 93,100     $ 93,100  
  Unamortized discount
    (2,836 )     (3,806 )
      Net carrying amount
    90,264       89,294  
Current portion of outstanding debt
    90,264       89,294  
Noncurrent  portion of outstanding debt
  $ -     $ -  
Equity component, net of income tax benefit
  $ 16,399     $ 16,399