Allied Defense Group (ADG)

 

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

 

Form 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2008

 

 

Commission File Number: 1-11376

 

The Allied Defense Group, Inc.

(Exact name of Registrant as specified in its charter)

 

 

 

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 Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 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 June 30, 2008: 8,024,851.

 

 

THE ALLIED DEFENSE GROUP, INC.

 

INDEX

 

The Allied Defense Group, Inc.

(Unaudited)
(Thousands of Dollars, except per share and share data)

 

 

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

The Allied Defense Group, Inc.

(Unaudited)
(Thousands of Dollars, except per share and share data)

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

The Allied Defense Group, Inc.

(Unaudited)
(Thousands of Dollars, except per share and share data)

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

The Allied Defense Group, Inc.

(Unaudited)
(Thousands of Dollars)

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated statements.

The Allied Defense Group, Inc.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Thousands of Dollars)

 

 

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 2007 Form 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 six months ended June 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 16, the results of operations, financial position and cash flows of SeaSpace, The VSK Group and Titan Dynamics Systems, previously reported in the Other operating segment, the ES segment and the AWE segment, respectively, have been reported as discontinued operations for all periods presented. SeaSpace was sold by the Company in July 2007, The VSK Group in September 2007 and Titan in March 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 six months ended June 30, 2008, the Company increased its revenue by $62,175, more than 400%, and improved operating income to $2,419 as compared to a loss of $22,274 in the prior period.

 

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.

 

During 2007, as MECAR worked to secure new multi-year sales contracts and reduce its fixed cost base, MECAR was also working on restructuring its credit facility. MECAR had failed to be in compliance with annual covenant requirements for the facility at December 31, 2005, 2006 and 2007 although MECAR did

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

obtain debt waivers for all years. In April 2008, MECAR reached an agreement with its existing bank group regarding its credit facility. The agreement provided for an expansion of the total credit facility from approximately $67,699 (€42,850) to $72,083 (€45,625). The credit facility was restructured and the portion designated for tax prepayments was terminated. The agreement provides for a cash line of $16,115 (€10,200) and performance bond and advance payment guarantee line of $55,968 (€35,425). The agreement requires a partial repayment of MECAR’s cash line of $8,057 (€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. 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. As agreed with its bank group, MECAR paid down €2,000 on August 6, 2008 and the Company made arrangements to repay the remaining €3,100 cash line. The Company has proposed to make the repayment in September 2008 with the earlier of the cash proceeds of certain late July shipments or the proceeds of the Company’s anticipated sale of its GMS subsidiary, both of which are expected in September. MECAR’s bank group has verbally agreed to this proposal at the time of this filing. If the Company is unable to secure a final agreement with the bank group, it will have to look to alternative funding sources to repay the remaining €3,100 cash line which may include additional borrowing.

 

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. Because MECAR’s ability to ship to certain Middle Eastern customers is limited in the summer months due to contractual restraints, the Company faces significant cash constraints in the summer months of August and September. The Company is managing through the summer months by postponing non-critical expenditures and rescheduling vendor payments. The Company’s cash projections for 2008 show that the Company should be able to generate cash from operations in the last three months of 2008.

 

In addition, as described in Note 7 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, 2008 and/or January 19, 2009 based on the date of issuance. As of June 30, 2008, the principal outstanding balance of Convertible Notes was $19,876. The Company has committed to a formal plan to sell GMS to ensure it has the funds available to meet this put feature. The Company is in active negotiation with a prospective purchaser. The Company expects to announce execution of a definitive purchase agreement in August 2008. This transaction is expected to close in September.

 

At June 30, 2008, the Company had $13,023 in cash on hand. For the six months ended June 30, 2008, the Company used $19,972 of cash for operating activities from continuing operations mainly related to increases in inventory 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 in the third and fourth quarter of 2008.

 

In general, the Company believes, that it has adequate cash sources to fund operations in 2008 based on its strong current backlog and its history of performing on a profitable basis when backlog is substantial. However, the Company will sell GMS or refinance the terms of the convertible note holders “put”, prior to year end. As noted above, MECAR’s credit facility has been refinanced for 2008. In the third quarter of 2008, management will begin 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 from the fourth quarter of 2007 to current, that adequate opportunities will be available to find a long-term solution for MECAR’s credit needs.

 

On August 14, 2008, the Company committed to a formal plan to sell GMS, which has been previously reported in the Electronic Security segment. The Company is in active negotiation with a prospective

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

purchaser. The Company expects to announce execution of a definitive purchase agreement in August 2008. This transaction is expected to close in September.

 

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 has less than $500 of firm commitments for capital expenditures outstanding as of June 30, 2008. No additional capital commitments are necessary to support the Company’s 2008 revenue projections.

 

Reclassification

 

Certain items previously reported in specific financial statement captions have been reclassified to conform to the current presentation.

 

 

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 includes its wholly-owned subsidiaries MECAR S.A. (“MECAR”), Sedachim S.I. S.A., Hendrickx S.A., and The VSK Group. The VSK Group (Discontinued Operation) is comprised of VSK Electronics N.V. and its wholly-owned subsidiaries, Télé Technique Générale S.A., Intelligent Data Capturing Systems (IDCS) N.V., VIGITEC S.A. and CMS Security Systems.

 

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. 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 and GMS. 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. GMS designs and manufactures miniature and sub-miniature FM and digital transmitters, receivers, and related equipment for investigative, surveillance, and security applications, and live TV news/sports/

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

entertainment coverage. The VSK Group was previously included in this segment. The VSK Group designs, manufactures, sells and installs security systems for government and private industry. The VSK Group was sold in September 2007 and has been eliminated from all segment reporting.

 

Other.  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.

 

 

Accounts receivable at June 30, 2008 and December 31, 2007 are comprised as follows:

 

 

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 $67,432 and $39,313 at June 30, 2008 and December 31, 2007, respectively.

 

 

Inventories at June 30, 2008 and December 31, 2007 are comprised as follows:

 

 

 

The Company had goodwill of $9,932 at both June 30, 2008 and December 31, 2007. The goodwill is solely from the ES Segment and is comprised of $6,437 related to GMS and $3,495 related to NSM. As

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 is recorded at either June 30, 2008 or December 31, 2007.

 

 

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 $72,083) 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 would require a partial repayment of MECAR’s cash line of approximately $8,057 (€5,100) in July 2008 and the remainder to be repaid by November 30, 2008. The Company did not meet this requirement on July 31, 2008 but agreed with the bank group to an extension until cash from certain July shipments are collected on open letters of credit. As agreed with its bank group, MECAR paid down €2,000 on August 6, 2008, and the Company is working with the bank group to repay the remaining €3,100 cash line. The Company has proposed to make the repayment in September 2008 with the earlier of the cash proceeds of certain late July shipments or the proceeds of the Company’s anticipated sale of its GMS subsidiary, both of which are expected in September. MECAR’s bank group has verbally agreed to this proposal at the time of this filing. If the Company is unable to secure a final agreement with the bank group, it will have to look to alternative funding sources to repay the remaining €3,100 cash line which may include additional borrowing.

 

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 $9,479 (€6,000) in the temporary period.

 

As of June 30, 2008 and December 31, 2007, the guarantees and performance bonds of approximately $55,023 and $37,523, respectively, were outstanding. Advances for working capital provided for under the bank overdraft facility and notes payable, amounted to $18,143 and $7,239 at June 30, 2008 and December 31, 2007, respectively. Performance bonds and advance payment guarantees under the Agreement are secured by restricted cash of approximately $8,442 and $12,838, at June 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 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.

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Long-term obligations as of June 30, 2008 and December 31, 2007 consist of the following:

 

 

On March 9, 2006, the Company entered into a Securities Purchase Agreement with four purchasers for the private placement of senior subordinated convertible notes (the “Initial Notes”) in the principal amount of $30,000 and related warrants to purchase common stock of the Company (the “2006 Transactions”).

 

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 155. At June 26, 2007, the Company determined the fair value of the Initial Notes was $36,979. In determining fair value, the Company considers all available information, including the terms of any potential settlement and/or modification and the probability of such settlement and/or modification occurring. As a result, the carrying amount of the Initial Notes immediately prior to the closing of the Exchange Transaction reflected the settlement provisions of Amendment Agreement so that the fair value of the Initial Notes immediately prior to the Exchange Transaction equaled the fair value of the common stock issued of $9,544 plus the fair value of the Amended Notes of $27,435.

 

In connection with the Amendment Agreement, the Company incurred debt issue 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

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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.

 

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 adopted FSP 00-19-2 Accounting for Registration Payment Arrangements. Prior to adopting FSP 00-19-2, the Company’s policy was to accrue liquidated damages when incurred. In accordance with FSP 00-19-2, the Company accrued for interest penalties under FAS 5 Accounting for Contingencies when probable and estimable. At January 1, 2007, liquidated damages under the Initial Note Registration Rights Agreement were not probable or estimable. As of December 31, 2007, the Company 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 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 June 30, 2008 and December 31, 2007 was as follows:

 

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

For the three and six months ended June 30, 2008, the Company recorded a net gain of $677 and a net loss of $515, respectively, related to the calculated fair values of the Amended Notes, First Closing and Second Closing of New Notes at June 30, 2008. For the three and six months ended June 30, 2007, the net loss related to the calculated fair values of the Amended Notes and First Closing of New Notes was $4,178 and $8,665, respectively.

 

The face value of the amount owed on the Notes as of June 30, 2008 and December 31, 2007 was as follows:

 

 

Warrants  On March 6, 2006, in conjunction with the issuance of the Initial Notes, the Company issued detachable warrants to the purchasers exercisable for an aggregate of 226,800 shares of Allied common stock. The warrants are exercisable for a term of five years at an exercise price of $27.68 per share, subject to anti-dilution provisions similar to the provisions set forth in the Notes and expire on March 9, 2011. The original exercisable shares of 226,800 and exercise price of $27.68 was adjusted to 349,297 and $17.97, respectively, to account for the December 2006 Private Placement and the Amendment Agreement. The warrants did not meet the requirement for equity classification in accordance with EITF 00-19, Accounting for Derivative Instruments Index to, and Potentially Settled in, a Company’s Own Stock, mainly because the warrants are required to settle in registered shares of the Company’s common stock. The warrants were recorded as liabilities, presented as derivative instrument on the Balance Sheet and are being recorded and carried at the fair value of the instrument. At June 30, 2008 and December 31, 2007, the Company determined the fair value of the warrants was $195 and $183, respectively. For the three and six months ended June 30, 2008, the Company recorded a gain of $28 and a loss of $12, respectively, related to the calculated fair value adjustment of the warrants at June 30, 2008. For the three and six months ended June 30, 2007, the Company recorded a loss of $214 and a gain of $899, respectively, related to the calculated fair value adjustment of the warrants at June 30, 2007.

 

Loan for Global Microwave Systems acquisition.  On November 1, 2005, the Company entered into a $6,700 loan to fund the acquisition of GMS with the prior owner of GMS. There are no significant covenants. The loan was originally payable in installments over three years bearing interest at the rate of 7.5% per year payable quarterly. On October 11, 2006, the loan was amended to defer the first installment of principal payment of $1,675 from November 1, 2006 to January 31, 2007. The Company repaid one half of the first installment of $1,675 or $838 in February 2007. On February 12, 2007, the loan was further amended to defer, until the earlier of MECAR’s receipt of a down payment on its impending contract or July 1, 2007 (“Deferral Period”), one half of the first installment payment which was due on January 31, 2007. In July 2007, the Company paid the second half of the first installment of $838. During the term of the Deferral Period, the interest rate on the entire loan was increased to 9% per year and an additional $20 per full or partial month during the Deferral Period of interest was due. The Company evaluated both amendments pursuant to the terms of EITF 96-19 Debtor’s Accounting for a Modification or Exchange of Debt Instruments and concluded that neither met the definition of a substantially different debt modification. Therefore, no gain or loss was recorded as a result of either modification. For the three and six months ended June 30, 2007, the Company incurred additional interest of $60 and $100, respectively, for the Deferral Period. On October 31, 2007, the Company repaid the scheduled principal due amount of $1,675. The outstanding principal balance of the loan was $3,350 at both June 30, 2008 and December 31, 2007. The unamortized discount of the note was $39 and $98 at June 30, 2008 and December 31, 2007, respectively.

 

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 the Société 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 $137 and $141 at June 30, 2008 and December 31, 2007, respectively. The outstanding balance due on the loan was $9,479 (€6,000) and $8,837 (€6,000) at June 30, 2008 and December 31, 2007, respectively.

 

Capital lease and other.  The Company is also obligated on various vehicle, equipment, capital lease obligations and other loans. The notes and leases are generally secured by the assets acquired, bear interest at rates ranging from 2.92% to 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 six months ended June 30, 2008.

 

Other than as disclosed above with regard to the Notes, no other debt classified as long-term contain cross-default provisions.

 

 

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 as a component of revenues and amounted to $144 for both the three and six months ended June 30, 2008. In 2007, the Company did not enter any foreign currency future contracts or forward exchange rates to minimize the foreign currency exposures.

 

 

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 Position FSP 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.

 

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)

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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:

 

 

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 June 30, 2008:

 

 

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.

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Basic earnings (loss) per share from continuing operations excludes potential common shares and is computed by dividing net earnings (loss) from continuing operations by the weighted average number of common shares outstanding for the period. The computation of diluted earnings (loss) per share from continuing operations includes the effects of stock options, warrants, restricted stock (unvested stock awards) and convertible debentures, if such effect is dilutive. The table below shows the calculation of basic and diluted earnings (loss) per share from continuing operations for the three and six months ended June 30, 2008 and 2007, respectively:

 

 

For the three and six months ended June 30, 2008, the Company has excluded convertible notes and warrants of 2,125,738 and 411,593 shares, respectively, since their effect would be anti-dilutive. The convertible notes were excluded under the if-converted method as the effect of adjusting net income from continuing operations for the associated interest expense in calculating dilutive earnings per share would have an anti-dilutive effect. At June 30, 2007, convertible notes, stock options and warrants of 3,484,450, 25,719 and 439,593 shares, respectively were excluded from the calculation of earnings per share for the three and six months ended June 30, 2007 since their effect would be anti-dilutive.

 

 

A summary of the components of Comprehensive Income (Loss) for the three and six months ended June 30, 2008 and 2007 are as follows:

 

 

The currency translation adjustment for the three and six months ended June 30, 2008 and 2007 resulted from the change in the value of the Euro during the respective periods.

 

 

Total share-based compensation was $123 (including outside directors compensation of $63) and $238 (including outside directors compensation of $45) for the three months ended June 30, 2008 and 2007, respectively. For the six months ended June 30, 2008 and 2007, respectively, the Company incurred $305 (including outside directors compensation of $126) and $500 (including outside directors compensation of $119) in total share-based compensation. The share-based compensation expense for the period includes costs

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 six months ended June 30, 2008 were as follows:

 

 

The risk free interest rate is equal to the U.S. Treasury Bill rate for the auction closest to period end. The expected volatility is calculated from the Company’s 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. No restricted shares of its common stock were granted during the six months ended June 30, 2008.

 

During the six months ended June 30, 2007, the Company granted no options but did grant 13,750 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.

 

 

 

Segment fees include all expenses at the subsidiary level in addition to management fees charged by Corporate. Corporate includes all expenses of the Corporate office less management fee income. Management fees are adjusted on an annual basis based on an allocation of each subsidiary’s use of Corporate resources.

 

 

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 six months ended June 30, 2008 and 2007. For the three and six months ended June 30, 2008, the Company’s consolidated annualized

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

effective tax rate was 18% and 16%, respectively. For the three and six months ended June 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 June 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 six months ended June 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. 109 Accounting 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 $51,036, which will begin to expire in 2010 and foreign NOLs of approximately $79,947, which may be carried forward indefinitely. A portion of the U.S. net operating loss carryforwards are subject to limitations on the amount that can be utilized each year. The Company had foreign tax credits and alternative minimum tax credits of approximately $2,290 and $458, respectively, at December 31, 2007. The foreign tax credits will begin to expire in 2012 and the alternative minimum tax credits do not expire.

 

See Note 15 — Commitments and Contingencies for disclosure on Belgian tax contingency.

 

 

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.

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

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 June 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 June 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 is subject to the escrow agreement terms.

 

On January 24, 2008, the Company entered into a Purchase Agreement to sell Titan for $4,750 in cash. The 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 June 30, 2008, no amount has been accrued related to this indemnification as a liability is not deemed probable.

 

Tax Litigation

 

As part of its 2004 tax audit with the Belgian tax authorities, the Company recorded a liability of $3,810 and $3,552 at June 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 June 30, 2008, MECAR had not paid all its Belgian social security payments related to the first, second and fourth quarters of 2007. Accordingly, the Company has accrued $3,652 and $2,184 at June 30, 2008 and December 31, 2007, respectively, related to past due social security payments which includes associated interest and penalties of $664 and $276, respectively. As of June 30, 2008, MECAR accrued an additional $2,267 for social security payments related to the second quarter of 2008. MECAR has agreed to a

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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 July MECAR has paid approximately $5,384 in social security payments ($1,088, net of foreign exchange gain of $35 for 2007 and $4,296, net of foreign exchange gain of $69, for the first and second quarter of 2008), which leaves $5,919 as the total outstanding balance relating to Belgian social security.

 

 

The Consolidated Financial Statements and related note disclosures reflect SeaSpace, The VSK Group, CMS Security Systems and Titan Dynamic Systems, Inc. as “Long-Lived Assets to be Disposed of by Sale” for all periods presented in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, our results of operations for all periods presented have been reclassified to reflect SeaSpace, The VSK Group, CMS Security Systems and Titan Dynamic Systems, Inc. as discontinued operations in the consolidated statement of operations and the assets and liabilities of such entities have been reclassified as held for sale in the consolidated balance sheets for all periods presented.

 

SeaSpace Corporation

 

In the first quarter of 2007, the Company committed to a formal plan to sell SeaSpace, which has previously been reported in the Other segment, as part of management’s plan to dispose of certain non-strategic assets of the Company. At March 31, 2007, the Company recorded a loss of $3,878 to write down SeaSpace’s assets to fair value less costs to sell based on nonbinding offers received from potential buyers during the first quarter of 2007. The loss accrual reflects the write-off of intangible assets including goodwill.

 

On July 6, 2007, the Company signed a Stock Purchase Agreement to sell SeaSpace for $1,500 in cash. The transaction closed on July 23, 2007 and generated proceeds of $1,541, net of costs to sell of $109. No gain or loss was recognized on the closing date as the loss recorded on March 31, 2007 to write down SeaSpace’s assets to fair value less cost to sell, was adjusted on July 6, 2007 to reflect the higher sales price of the Stock Purchase Agreement. The Company did not record a significant tax expense or benefit from this transaction.

 

The VSK Group

 

In the third quarter of 2007, the Company committed to a formal plan to sell The VSK Group, which has previously been reported in the Electronic Security segment, as part of management’s continuing plan to dispose of certain non-strategic assets of the Company and reduce debt and improve the Company’s liquidity.

 

On September 6, 2007, ARC Europe, a wholly-owned subsidiary of the Company, entered into a Stock Purchase Agreement to sell The VSK Group for approximately $48,737 in cash subject to a purchase price adjustment to be determined following closing. The transaction closed on September 18, 2007 and generated net proceeds of $41,843. The sales price was adjusted for disposal costs which included a working capital adjustment of $62, funds held in escrow of $2,741, investment banking and legal fees of $1,730, management retention and incentive plans of $1,645 and a final purchase price adjustment of $716. The Stock Purchase Agreement requires a total of $2,741 be held in escrow to provide for certain indemnifications as stated for the Stock Purchase Agreement. At this time, the Company is not certain of all contingencies that will be identified and whether it will be able to receive any portion of the $2,741 balance. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for any and all actions, liabilities, encumbrances, losses, damages, fines, penalties, taxes, fees, costs or expenses or amounts paid in settlement suffered or incurred arising out of any breach of or inaccuracy in any representation or warranties made by the seller or

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

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.

 

At December 31, 2007, only the assets and liabilities of Titan were classified as held for sale. The following is a summary of Titan’s assets and liabilities at December 31, 2007:

 

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following discloses the results of discontinued operations for the six months ended June 30, 2008 for Titan:

 

 

The following discloses the results of discontinued operations for the three and six months ended June 30, 2007:

 

 

 

At June 30, 2008, there were no assets or liabilities held for sale for The VSK Group, SeaSpace, CMS, or Titan as The VSK Group, SeaSpace and Titan sale transactions had been completed and CMS was fully written off in the quarter ended September 30, 2007.

 

The Allied Defense Group, Inc.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Sale of GMS

 

On August 14, 2008, the Company committed to a formal plan to sell GMS, which has been previously reported in the Electronic Security segment. The Company is in active negotiation with a prospective purchaser. The Company expects to announce execution of a definitive purchase agreement in August 2008. This transaction is expected to close in September.

 

The Company expects to reclassify GMS as discontinued operations in the third quarter of 2008. The carrying amounts of the assets and liabilities of GMS as of June 30, 2008 and December 31, 2007 are as follows (in thousands):

 

 

Bank Overdraft Credit Facility

 

As part of the April 2008 modification of the MECAR credit facility, the Company was required to make a partial repayment of MECAR’s cash line (€5,100) in July 2008. Based on the timing of MECAR’s shipments in July 2008, the Company was unable to make this repayment by July 31, 2008. As agreed with its bank group, MECAR paid down €2,000 on August 6, 2008, and the Company is working with the bank group on a repayment arrangement for the remaining €3,100 cash line. The Company has proposed to make the repayment in September 2008 with the earlier of the cash proceeds of certain late July shipments or the proceeds of the Company’s anticipated sale of its GMS subsidiary, both of which are expected in September. MECAR’s bank group has verbally agreed to this proposal at the time of this filing, and they have continued to operate under the terms of the facility. If the Company is unable to secure a final agreement with the bank group, it will have to look to alternative funding sources to repay the remaining €3,100 cash line which may include additional borrowing.

The Allied Defense Group, Inc.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

(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 main reporting segments, the Ammunition & Weapons Effects (AWE) segment and the Electronic Security (ES) segment. In addition, the Company had a third, Other segment, that solely consisted of the Company’s SeaSpace subsidiary. In July 2007, September 2007 and March 2008, the Company sold SeaSpace, The VSK Group, and Titan, respectively. Accordingly, the results of operations, financial position and cash flows of SeaSpace, The VSK Group and Titan, have been reported as discontinued operations for all periods presented and are eliminated from the segment discussion provided below. Headquarters expenses are reported separately on the segment reporting schedules.

 

The AWE segment provides conventional ammunition and other training devices to the U.S. military and 30 countries worldwide, dealing with defense departments or ministries of defense in US/European Community approved sovereign entities. The ES segment encompasses a wide range of fixed and deployable systems and equipment used to address today’s security and surveillance requirements in the U.S. The ES segment markets its products to governments, law enforcement, and commercial security personnel. In addition to having distinct differences in client base and application of products, the production processes of the segments are distinct.

 

 

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 has committed to a formal plan to sell GMS to be in a position to satisfy a potential “put” of its senior secured convertible notes which may be made in December 2008 and/or January 2009, as discussed below. In addition, the Board of Directors of the Company is evaluating a possible dissolution of all operating units of the Company and the return of the net remaining proceeds to the shareholders. At this time 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 dissolution process or a more focused, cohesive business strategy centered on the MECAR business.

 

Liquidity and Capital Resources

 

As described in the Company’s Form 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 anticipates some liquidity challenges in the summer months of 2008 as MECAR performs on its increased backlog and is limited in its ability to ship product to its largest customer during the summer months from June through August. As described below and as more fully described in Notes 1 and 7 to the Condensed Consolidated Financial Statements, in April 2008, MECAR signed an agreement with the lenders of its credit facility to finance MECAR until November 30, 2008 for its revolving cash line and until December 31, 2008 for MECAR’s performance bond and advance payment guarantee line. Management believes that this short-term financing agreement will allow MECAR the opportunity to refinance on a permanent basis once it has had more time to perform and generate cash based on the current backlog.

 

During 2007, as MECAR worked to secure new multi-year sales contracts and reduce its fixed cost base, MECAR was also working on restructuring its credit facility. MECAR had failed to be in compliance with annual covenant requirements for the facility at December 31, 2005, 2006 and 2007 although MECAR did obtain debt waivers for all years. In April 2008, MECAR reached an agreement with its existing bank group regarding its credit facility. The agreement provided for an expansion of the total credit facility from approximately $67,699 (€42,850) to $72,083 (€45,625). The credit facility was restructured and the portion designated for tax prepayments was terminated. The agreement provides for a cash line of $16,115 (€10,200) and performance bond and advance payment guarantee line of $55,968 (€35,425). The agreement requires a partial repayment of MECAR’s cash line of $8,057 (€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. 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. As agreed with its bank group, MECAR paid down €2,000 on August 6, 2008, and the Company is working with the bank group to repay the remaining €3,100 cash line. The Company has proposed to make the repayment in September 2008 with the earlier of the cash proceeds of certain late July shipments or the proceeds of the Company’s anticipated sale of its GMS subsidiary, both of which are expected in September. MECAR’s bank group has verbally agreed to this proposal at the time of this filing. If the Company is unable to secure a final agreement with the bank group, it will have to look to alternative funding sources to repay the remaining €3,100 cash line which may include additional borrowing.

 

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. Because MECAR’s ability to ship to certain Middle Eastern customers is limited in the summer months due to contractual restraints, the Company faces significant cash constraints in the summer months of August and September. The Company is managing through the summer months by postponing non-critical expenditures and rescheduling vendor payments. The Company’s cash projections for 2008 show that the Company should be able to generate cash from operations in the last three months of 2008.

 

In addition, as described in Note 7 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, 2008 and/or January 19, 2009 based on the date of issuance. As of June 30, 2008, the principal outstanding balance of Convertible Notes was $19,876. The Company has committed to a formal plan to sell GMS to ensure it has the funds available to meet this put feature. The Company is in active negotiation with a prospective purchaser. The Company expects to announce execution of a definitive purchase agreement in August 2008. This transaction is expected to close in September. The put feature requires the holders of the Convertible Notes to give at least 75 days notice of their intent to enforce this feature.

 

At June 30, 2008, the Company had $13,023 in cash on hand. For the six months ended June 30, 2008, the Company used $19,972 of cash for operating activities from continuing operations mainly related to increases in inventory 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 in the third and fourth quarter of 2008.

In general, the Company believes, that it has adequate cash sources to fund operations in 2008 based on its strong current backlog and its history of performing on a profitable basis when backlog is substantial. However, the Company will sell GMS or refinance the terms of the convertible note holders “put”, prior to year end. As noted above MECAR’s credit facility has been refinanced for 2008. In the third quarter of 2008, management will begin 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 from the fourth quarter of 2007 to current, that adequate opportunities will be available to find a long-term solution for MECAR’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 has less than $500 of firm commitments for capital expenditures outstanding as of June 30, 2008. No additional capital commitments are necessary to support the Company’s 2008 revenue projections.

 

Overview Results

 

Allied had net income of $906 in the three months ended June 30, 2008 as compared to a net loss of $24,155 in the three months ended June 30, 2007. In the six months ended June 30, 2008, Allied had a net loss of $2,389 as compared to a net loss of $42,009 for the comparable period in 2007.

 

The net income from continuing operations before income taxes was $1,099 for the three months ended June 30, 2008 as compared to a net loss from continuing operations before income taxes of $23,478 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 MECAR and GMS and reduced restructuring activities, refinancing activities and interest expenses associated with the senior convertible notes. In addition, the Company recognized net gain on the fair value senior convertible notes and warrant of $705 in the current period as compared to incurred net loss on the fair value of senior convertible notes and warrants of $7,766 in 2007.

 

The net loss from continuing operations before income taxes was $2,037 for the six months ended June 30, 2008 as compared to $38,075 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 MECAR and GMS and reduced restructuring activities, refinancing activities and interest expenses associated with the senior convertible notes. In addition, the net loss on the fair value of senior convertible notes and warrants was $7,766 in 2007 as compared to $527 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 additional multi-year contract at MECAR for $43,500. Of the $170,000, the subsidiary has already received firm contracts totaling more than $100,000 for delivery during 2007 and 2008. As to the remaining $70,000, MECAR has received a notice of funding from the client, an end user certificate and export license for the contract and is working with the bank group to establish the applicable performance bond before reclassifying the contract as funded. The backlog at MECAR USA has grown to $35,954 at June 30, 2008 as compared to

$1,096 at June 30, 2007, driven in part by new procurement contracts. On a consolidated basis, the Company had firm committed backlog of $153,070 and additional unfunded backlog of $84,699 at June 30, 2008.

 

The Company expects improved performance for MECAR and its other subsidiaries. Over the past year, the Company has engaged consultants at MECAR and NSM to restructure the operations in order to decrease the break-even point at each subsidiary. The Company estimates that the break even point is approximately $84,180 (€55,000) per year in revenue for MECAR while NSM’s break even point is estimated at annual revenue of approximately $10,000.

 

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 1.53055 and 1.32948, U.S. Dollar to 1 Euro, respectively.

 

Results of Operations for the Three Months Ended June 30, 2008 and 2007