Kaydon (KDN)

FORM 10-K

 

United States

Securities and Exchange Commission

 

Washington, DC 20549

 

Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the fiscal year ended December 31, 2007

 

Commission file number 1-11333

Kaydon Corporation

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (734) 747-7025

 

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

 

 

Securities registered pursuant to Section 12(g) of the Exchange Act: None

 

     Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 under the Securities Act of 1933. Yes þ  No o

 

     Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o  No þ

 

     Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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 under the Exchange Act). Yes o  No þ

 

     The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant on June 30, 2007 (based on the June 29, 2007 closing sales price of $52.12 of the Registrant’s Common Stock, as reported on the New York Stock Exchange Composite Tape on such date) was approximately $1,449,000,000. For purposes of this calculation only, all executive officers and directors of the Registrant are assumed to be affiliates.

 

     Number of shares outstanding of the Registrant’s Common Stock at February 22, 2008:

 

27,821,265 Shares of Common Stock, par value $0.10 per share.

 

     Portions of the Registrant’s definitive Proxy Statement to be filed for its 2008 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report.

 

TABLE OF CONTENTS

 

 

Forward-Looking Statements

 

This Form 10-K contains forward-looking statements within the meaning of the Securities Exchange Act of 1934 regarding the Company’s plans, expectations, estimates and beliefs. Forward-looking statements are typically identified by words such as “believes,” “anticipates,” “estimates,” “expects,” “intends,” “will,” “may,” “should,” “could,” “potential,” “projects,” “approximately” and other similar expressions, including statements regarding pending litigation, general economic conditions, competitive dynamics and the adequacy of capital resources. These forward-looking statements may include, among other things, projections of the Company’s financial performance, anticipated growth, characterization of and the Company’s ability to control contingent liabilities, and anticipated trends in the Company’s businesses. These statements are only predictions, based on the Company’s current expectation about future events. Although the Company believes the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, performance or achievements or that predictions or current expectations will be accurate. These forward-looking statements involve

risks and uncertainties that could cause the Company’s actual results, performance or achievements to differ materially from those expressed or implied by the forward-looking statements.

 

In addition, the Company or persons acting on its behalf may from time to time publish or communicate other items that could also be construed to be forward-looking statements. Statements of this sort are or will be based on the Company’s estimates, assumptions, and projections and are subject to risks and uncertainties that could cause actual results to differ materially from those included in the forward-looking statements. Kaydon does not undertake any responsibility to update its forward-looking statements or risk factors to reflect future events or circumstances except to the extent required by applicable law. For a specific discussion of the risks and uncertainties that could affect the Company’s financial condition and/or operating results, please refer to Item 1A. Risk Factors herein.

ITEM 1. BUSINESS

 

General Development of Business

 

Kaydon Corporation (the “Company” or “Kaydon”) is a leading designer and manufacturer of custom-engineered, performance-critical products for a broad customer base. Kaydon was incorporated under the laws of Delaware in 1983 as a wholly-owned subsidiary of Bairnco Corporation, its former parent company. The Company became a separate public company in 1984 when it was spun-out of Bairnco Corporation as a dividend to Bairnco’s shareholders. At the time of its incorporation, Kaydon was principally involved in the design and manufacture of bearings and components, as well as filters and filter housings. Since 1984, the Company has pursued a diversified growth strategy in the manufacturing sector. The Company’s principal products now include the previously mentioned bearings and components and filters and filter housings, and also custom rings, shaft seals, linear deceleration products, specialty balls, fuel cleansing systems, gas-phase air filtration systems and replacement media, industrial presses and metal alloy products. These products are used by customers in a variety of robotics, medical, material handling, machine tool positioning, aerospace, defense, alternative-energy, security, electronic and other industrial applications. The Company performs as an extension of its customers’ engineering and manufacturing functions, with a commitment to identify and provide engineered solutions to design problems through technical innovation, cost-effective manufacturing and outstanding value-added service.

 

The Company has grown both organically through strategic investments in its business and through acquisitions. In 2007, the Company acquired all of the outstanding stock of Avon Bearings Corporation (“Avon”) in a cash transaction valued at $54.9 million. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings.

 

Industry Segments

 

We operate through operating segments for which separate financial information is available, and for which operating results are evaluated regularly by the Company’s chief operating decision maker in determining resource allocation and assessing performance. Certain of the operating segments have similar economic characteristics, as well as other common attributes, including nature of the products and production processes, distribution patterns and classes of customers. The Company aggregates these operating segments for reporting purposes. Certain other operating segments do not exhibit the common attributes mentioned above and, therefore, information about them is reported separately. Still other operating segments do not meet the quantitative thresholds for separate disclosure and their information is combined and disclosed as “Other.”

 

The Company has three reportable segments and other operating segments engaged in the manufacture and sale of the following:

 

Friction Control Products – complex components used in specialized robotics, medical, aerospace, defense, security, electronic, material handling, construction, alternative-energy, and other industrial applications. Products include anti-friction bearings, split roller bearings, and specialty balls.

 

Velocity Control Products – complex components used in specialized robotics, material handling, machine tool, medical, amusement and other industrial applications. Products include industrial shock absorbers, safety shock absorbers, velocity controls, gas springs and rotary dampers.

 

Sealing Products – complex and standard ring and seal products used in demanding industrial, aerospace and defense applications. Products include engine rings, sealing rings and shaft seals.

 

Other – filter elements and liquid and gas-phase filtration systems, metal alloys, machine tool components, presses, dies and benders used in a variety of industrial applications.

 

 

 

KAYDON CORPORATION FORM 10K 1

Net sales related to our three reportable segments and other operating segments during 2007, 2006 and 2005 are set forth in the following table:

 

 

See the Notes to Consolidated Financial Statements (Note 11) contained in Item 8. Financial Statements and Supplementary Data for additional information on the Company’s reportable segments.

 

Sophisticated technology plays a significant role in all of our reportable segments in the design, engineering and manufacturing of our products. Due to the custom-engineered, proprietary nature of the Company’s products, substantially all of the manufacturing is done in-house and subcontractors are utilized for occasional specialized services. Products are manufactured utilizing a variety of precision metalworking and other process technologies after working closely with customers to engineer the required solution to their design and performance challenges.

 

We sell our products in each reportable segment through a sales organization consisting of salespersons and representatives located primarily throughout North America, Europe and Asia. Salespersons are trained to provide technical assistance to customers, as well as to serve as a liaison between the factory engineering staffs of Kaydon and its customers. Also, a global network of specialized distributors and agents provides local availability of our products to serve the requirements of customers. During 2007, 2006 and 2005, sales to no single customer exceeded 10 percent of Kaydon net sales. However, during 2007, sales to one customer exceeded 10 percent (12.8 percent) of net sales in the Friction Control Products reporting segment, sales to two customers exceeded 10 percent (23.4 percent, and 11.2 percent) of net sales in the Sealing Products reporting segment, and sales to one customer exceeded 10 percent (15.0 percent) of net sales in the other businesses. During 2006, sales to two customers exceeded 10 percent (23.6 percent, and 12.6 percent) of net sales in the Sealing Products reporting segment, and sales to one customer exceeded 10 percent (14.2 percent) of net sales in the other businesses. During 2005, sales to two customers exceeded 10 percent (23.1 percent, and 13.8 percent) of net sales in the Sealing Products reporting segment, and sales to one customer exceeded 10 percent (11.2 percent) of net sales in the other businesses.

 

We do not consider our business in any reportable segment to be seasonal in nature or to have special working capital requirements. Compliance with federal, state and local regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment, is not expected to result in material capital expenditures by us or to have a material adverse effect on our earnings or competitive position. In general, raw materials required by the Company are attainable from various sources and in the quantities desired. Various provisions of federal law and regulations require, under certain circumstances, the renegotiations of military procurement contracts or the refund of profits determined to be excessive. The Company, based on experience, believes that no material renegotiations or refunds will be required. In 2007, we publicly announced the intention to invest an additional $48.0 million to expand our capacity and to maintain our leadership position in the supply of specialty bearings to serve the rapidly growing wind energy market. Other than this announcement, we have not made any public announcement of, or otherwise made public information about, a new product or a new industry segment which would require the investment of a material amount of our assets or which would otherwise result in a material cost.

 

Backlog

 

We sell certain products on a build-to-order basis that requires substantial order lead-time. This results in a backlog of unshipped, scheduled orders. In addition, certain products are manufactured on the basis of sales projections or annual blanket purchase orders.

 

 

2 KAYDON CORPORATION FORM 10K

Variability in backlog is affected by the timing of orders received, particularly when larger customers pull forward or push out major orders. Backlog in the Friction Control Products reporting segment was $191.2 million at December 31, 2007, including a recent acquisition, and was $110.3 million at December 31, 2006. Backlog in the Velocity Control Products reporting segment was $8.3 million at December 31, 2007 and $5.7 million at December 31, 2006. Backlog in the Sealing Products reporting segment was $27.8 million at December 31, 2007 and $24.6 million at December 31, 2006. Backlog in other businesses was $11.6 million at December 31, 2007, and $10.9 million at December 31, 2006.

 

Patents and Trademarks

 

The Company holds various patents, patent applications, licenses, trademarks and trade names. The Company considers its patents, patent applications, licenses, trademarks and trade names to be valuable, but does not believe that there is any reasonable likelihood of a loss of such rights which would have a material adverse effect on our present business as a whole.

 

Competition

 

The major domestic and foreign markets for our products in all reporting segments are highly competitive. Competition is based primarily on price, product engineering and performance, technology, quality and overall customer service, with the relative importance of such factors varying by degree among products. Our competitors include a large number of other well-established diversified manufacturers, as well as other smaller companies. Although a number of companies of varying size compete with us, no single competitor is in substantial competition with the Company with respect to more than a few of its product lines and services.

 

Employees

 

We employ approximately 2,125 people. Satisfactory relationships have generally prevailed between the Company and its employees.

 

International Operations

 

Certain friction control products are manufactured in Mexico and the United Kingdom, and certain velocity control products are assembled and distributed through a facility in Germany. In addition, within all reporting segments, we distribute an array of products principally throughout North America, Europe and Asia. Our foreign operations are subject to political, monetary, economic and other risks attendant generally to international businesses. These risks generally vary from country to country.

 

See the Notes to Consolidated Financial Statements (Note 11) contained in Item 8. Financial Statements and Supplementary Data for additional information on the Company’s operations by geographic area.

 

Available Information

 

Our internet address is www.kaydon.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and amendments to all such reports and statements are accessible at no charge on our website as soon as reasonably practicable after filing with the Securities and Exchange Commission. Also accessible on our website under “Corporate Governance” are our Corporate Governance Guidelines, our Codes of Ethics, and the charters of the various committees of our Board of Directors. These items are also available in print at no charge to those who direct a request in writing to the Company.

ITEM 1A. RISK FACTORS

 

The following risk factors could affect the Company’s financial condition and/or operating results.

 

The Company’s customers’ economic cycles may affect Kaydon’s operating results.

 

Many of our customers are in industries that are cyclical in nature and sensitive to changes in general economic conditions and other factors, including capital spending levels. Such industries include commercial aerospace, specialty electronics manufacturing equipment, power generation, off-road and heavy industrial equipment, and other capital equipment manufacturing. As a result, the demand for our products by these customers depends, in part, upon general economic conditions. Historically, downward economic cycles have reduced customer demand for our products, thereby reducing sales of our products and resulting in reductions to our revenues and net earnings. In addition, our military sales are dependent on government funding.

 

Increased competition in the Company’s key markets could result in a reduction in Kaydon’s revenues and earnings and adversely affect the Company’s financial condition.

 

The industries in which we operate are fragmented and we face competition from multiple companies across our various product lines. We expect

 

 

KAYDON CORPORATION FORM 10K 3

competitive pressures from new products and aggressive pricing to increase, which may cause us to lose market share or compel us to reduce prices to remain competitive, which could result in reduced levels of revenues and earnings. Our competitors include U.S. and non-U.S. companies, some of which benefit from lower labor costs and fewer regulatory burdens. In addition, certain competitors, including Eaton, Timken, SKF, and INA/FAG, are larger than Kaydon and may have access to greater financial, technical, development, marketing, manufacturing, sales and distribution services and other resources. Increased competition with these companies or new entrants to our key markets could prevent price increases for our products or could require price reductions for our products, which could adversely affect our financial condition, results of operations, growth or liquidity.

 

Future acquisitions may require Kaydon to incur costs and liabilities which may adversely affect the Company’s operating results.

 

In addition to internal growth, our current strategy involves growth through acquisitions of complementary businesses as well as acquisitions that would diversify our product offerings. Like other companies with similar growth strategies, we may be unable to continue to implement our growth strategy, and this strategy may be ultimately unsuccessful. A portion of our expected future growth in revenues may result from acquisitions. We frequently engage in evaluations of potential acquisitions and negotiations for possible acquisitions, certain of which, if consummated, could be significant to the Company. Although it is our policy only to acquire companies in transactions which are accretive to both earnings and cash flow, any potential acquisitions may result in material transaction expenses, increased interest and amortization expense, increased depreciation expense and increased operating expense, any of which could have a material adverse effect on our operating results. Acquisitions may entail integration and management of the new businesses to realize economies of scale and control costs. In addition, acquisitions may involve other risks, including diversion of management resources otherwise available for ongoing development of our business and risks associated with entering new markets. We may not be able to identify suitable acquisition candidates in the future, obtain acceptable financing or consummate any future acquisitions. Finally, as a result of our acquisitions of other businesses, we may be subject to the risk of unanticipated business uncertainties or legal liabilities relating to those acquired businesses for which the sellers of the acquired businesses may not indemnify the Company. Future acquisitions may also result in potentially dilutive issuances of securities.

 

Political, economic and regulatory conditions inherent in the international markets in which Kaydon participates could adversely affect the Company’s financial condition.

 

Typically, sales of our products from our foreign subsidiaries and from our domestic subsidiaries selling to foreign locations account for approximately 30-35 percent of net sales. These foreign sales could be adversely affected by changes in various foreign countries’ political and economic conditions, trade protection measures, differing intellectual property rights and changes in regulatory requirements that restrict the sales of our products or increase our costs.

 

We generate significant revenues outside the United States. Currency fluctuations between the U.S. dollar and the currencies in which those customers do business may have an impact on the demand for our products in foreign countries where the U.S. dollar has increased in value compared to the local currency. We cannot predict the effects of exchange rate fluctuations upon our future operating results because of the number of currencies involved, the variability of currency exposure and the potential volatility of currency exchange rates.

 

Relationships with customers and effective terms of sale frequently vary by country, often with longer-term receivables than are typical in the United States.

 

Kaydon’s critical performance products expose the Company to potential litigation-related costs which may adversely affect the Company’s financial position and operating results.

 

As a provider of critical performance products in a variety of industries including aerospace, defense, robotics, medical, material handling, machine tool positioning, alternative-energy and other industrial applications, we face a risk of exposure to claims in the event that the failure, use or misuse of our products results, or is alleged to result, in bodily injury and/or property damage.

 

In the past, costs related to legal proceedings and settlements have had a material effect on our business, financial condition, results of operations and liquidity. We cannot assure you that the ultimate cost of current known or future unknown litigation and claims will not exceed management’s current expectations and it is possible that such costs could

 

 

4 KAYDON CORPORATION FORM 10K

have a material adverse effect on the Company. In addition, litigation is time consuming and could divert management attention and resources away from our business.

 

Kaydon’s capacity expansion to supply custom bearings to a select group of global customers in the wind energy market may adversely affect the Company’s financial position and operating results.

 

Through 2007, we have committed to spend approximately $80 million to expand our capacity to supply custom bearings to the wind energy market. By 2009, we expect to supply well in excess of $100 million of specialty large-diameter bearings to a select group of financially strong, global wind turbine manufacturers. We face a risk of exposure to sales and earnings volatility if this rapidly growing industry attracts new competition, loses certain governmental incentives, or matures more rapidly than currently anticipated.

 

None

ITEM 2. PROPERTIES

 

The following list sets forth the location of our principal manufacturing facilities for each reportable segment:

 

 

The Company considers that its properties are generally in good condition, are well maintained, and are generally suitable and adequate to carry on the Company’s business. Except for leased facilities in Monterrey, Mexico (2 sites), Langenfeld, Germany, and LaGrange, Georgia (1 site), substantially all of the properties are owned by the Company. None of the Company’s properties are subject to significant encumbrances. The Company’s manufacturing facilities currently have sufficient capacity or are being expanded to meet increased customer demand. The Company’s leased executive offices are located in Ann Arbor, Michigan.

ITEM 3. LEGAL PROCEEDINGS

 

Various claims, arising in the normal course of business are pending against the Company. The Company’s estimated legal costs expected to be incurred in connection with claims, lawsuits and environmental matters are accrued in the consolidated financial statements contained in Item 8. Financial Statements and Supplementary Data.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2007.

 

 

KAYDON CORPORATION FORM 10K 5

SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT

(Pursuant to Instruction 3 to Item 401(b) of Regulation S-K)
The following are the executive officers of Kaydon Corporation as of December 31, 2007, except for Mr. Behrman and Ms. Crane who became executive officers on February 14, 2008.

 

 

Executive officers, who are elected by the Board of Directors, serve for a term of one year.

 

 

6 KAYDON CORPORATION FORM 10K

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Information and Dividends

 

The New York Stock Exchange is the principal market on which our common stock is traded under the symbol KDN. As of December 31, 2007, there were 735 holders of record of our common stock.

 

The following table sets forth high and low closing sales prices of our common stock as reported on the New York Stock Exchange Composite Tape and the cash dividends declared per share for the periods indicated.

 

We expect that our practice of paying quarterly dividends on our common stock will continue, although future dividends will continue to depend upon the Company’s earnings, capital requirements, financial condition and other factors.

 

The following table provides the information with respect to purchases made by the Company of shares of its common stock during each month in the fourth quarter of 2007.

 

 

 

KAYDON CORPORATION FORM 10K 7

 

Equity Compensation Plan Information

 

The following table gives information about our common stock that may be issued upon the exercise of options, warrants and rights under all of our existing equity compensation plans as of December 31, 2007, including the 1999 Long Term Stock Incentive Plan, the 2003 Non-Employee Directors Equity Plan and the Director Deferred Compensation Plan.

 

 

 

 

8 KAYDON CORPORATION FORM 10K

ITEM 6. SELECTED FINANCIAL DATA

 

 

 

 

KAYDON CORPORATION FORM 10K 9

 

ITEM 7. MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

We provide proprietary, value-added products to a diverse customer base covering a broad spectrum of industries. This strategic customer diversification means that demand for our products depends, in part, upon certain general economic conditions, which affect our markets in varying ways from year to year. Similar to 2005 and 2006, during 2007 the Company continued to benefit from a strong manufacturing economy. As a result, the Company experienced strong demand for its specialty products from various key markets including wind energy, machinery, aerospace, defense, and petrochemical processing, which resulted in record annual sales of $451.4 million. Benefiting from the record sales, the Company generated net income of $77.7 million, and cash flow from operations of $74.3 million during 2007. Despite our strong cash flow from operations, cash and cash equivalents, and short-term investments decreased $83.8 million during the year as the Company invested $54.1 million in net capital expenditures, $54.9 million on an acquisition, $30.1 million for stock repurchases, $26.1 million to fully fund its qualified pension plans, and increased its common stock dividend. The total order book for 2007 equaled $505.5 million, compared to $405.3 million in 2006, and $398.3 million in 2005. Our record 2007 year-end backlog of $238.9 million provides a firm foundation for operating performance in 2008, particularly in the latter half.

 

In 2007, the Company acquired all of the outstanding stock of Avon Bearings Corporation (“Avon”) in a cash transaction valued at $54.9 million. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings.

 

The Company continues to focus on programs intended to reduce costs, improve capacity utilization, increase efficiencies, and grow market share and cash flow, thereby positioning the Company to capitalize on future opportunities in targeted markets, especially during a period of sustained economic growth. During 2007, the Company announced two additional phases to increase its capacity to provide performance-critical specialty bearings to serve the rapidly growing wind energy market. The Company also made substantial progress on the relocation of a portion of the manufacturing of its Sealing Products segment from a higher cost facility in Baltimore, Maryland to a lower cost facility in Mocksville, North Carolina. We believe that these initiatives will be important growth drivers for both North American and international sales in the years ahead. In addition, the Company continued its Lean Sigma effort and its investments in lean manufacturing and information systems to strengthen the Company’s operational excellence.

 

The Company’s 2007 effective tax rate was 35.1 percent as compared to the 2006 effective tax rate of 34.0 percent which reflected in 2006 reductions to the tax provision totaling $1.7 million related to deductions recognized for financial reporting purposes, after examinations by certain taxing authorities, or after the expiration of applicable review periods. Absent any similar items, we currently expect the effective tax rate for 2008 to be approximately 36.0 percent.

 

Maintaining the Company’s strong balance sheet and financial flexibility remains a key strategy of the Company. The Company’s current cash and short-term investment balances, its $300.0 million revolving credit facility, and other available financial resources enhance liquidity and provide additional financial strength to support the Company’s objectives, including strategic acquisitions.

 

As disclosed in Item 8 of this Annual Report, the Company has concluded that its system of internal control over financial reporting was effective as of December 31, 2007. Our independent registered public accounting firm’s report on internal control over financial reporting is also included in Item 8 under the heading “Report of Independent Registered Public Accounting Firm – Internal Control.”

 

In summary, in the future the Company expects to benefit from a favorable manufacturing economy and resultant capital spending levels, the growth of key markets such as the wind energy and medical equipment industries, and the utilization of current liquidity levels in completing both internal growth initiatives and strategic acquisitions. However, because many of these factors are external to the Company, it is difficult to predict the specific impact they may have on the Company’s future operating results.

 

The discussion which follows should be reviewed in conjunction with the consolidated financial statements and the related Notes to consolidated financial statements contained in Item 8 of this Annual Report to assist in understanding the Company’s results of operations, its financial condition, cash flows, capital structure and other relevant financial information.

 

 

10 KAYDON CORPORATION FORM 10K

Analysis of 2007 Operations Compared to 2006 Operations

 

Selected Data For The Year 2007 Compared With The Year 2006

 

 

Record net sales of $451.4 million in 2007 increased $47.4 million or 11.7 percent compared to 2006’s net sales of $404.0 million. Specifically, the Friction Control Products reporting segment achieved sales of $261.7 million during 2007, up $27.6 million or 11.8 percent compared to 2006 sales of $234.0 million. The increase is principally the result of increased sales of custom-engineered bearings to the wind energy market of $11.7 million, the machinery market of $7.4 million, the $4.3 million of sales from recently acquired Avon Bearings Corporation, and higher sales of split roller bearings, which increased $10.7 million. Sales to the specialty electronics market declined $5.7 million compared to the prior year. Our Velocity Control Products reporting segment achieved sales of $63.9 million during 2007, up $7.2 million, or 12.7 percent from 2006 sales of $56.7 million, reflecting increased sales of gas springs, hydraulic dampers, and other products particularly in Germany and other European countries. Our Sealing Products reporting segment achieved sales of $46.7 million during 2007, an increase of $4.7 million, or 11.2 percent from 2006 sales of $42.0 million, as demand increased in aerospace, defense, and railroad markets. Demand in the petroleum processing market continued to be strong. Our other businesses achieved sales of $79.1 million during 2007, up $7.9 million or 11.1 percent from 2006 sales of $71.2 million. Sales of our other businesses increased primarily due to growth in our liquid and air filtration businesses.

 

Gross profit for 2007 equaled $184.3 million or 40.8 percent of sales as compared to $167.4 million or 41.4 percent of sales for 2006. Higher gross profit was attributable to increased demand for our products in all business segments. Lower gross margin was due to the combined effects of product mix shifts, costs to ramp up our wind energy expansion, and higher costs associated with the partially completed relocation of a portion of our Sealing Products business.

 

Selling, general and administrative expenses totaled $73.0 million, including the $5.0 million positive effect of the gain on the sale of a component of the Friction Control Products reporting segment, and equaled 16.2 percent of sales. Selling, general and administrative expenses in 2006 totaled $68.7 million or 17.0 percent of sales. Selling, general and administrative expenses increased in support of higher sales, particularly in the expansion of the Company’s sales force, and also because of accelerated amortization of stock awards associated with the retirements of two executive officers during 2007.

 

Operating income, including the aforementioned $5.0 million gain, equaled $111.3 million during 2007, compared to $98.7 million in 2006, with operating margins of 24.6 percent and 24.4 percent in 2007 and 2006.

 

On a reporting segment basis, operating income from the Friction Control Products reporting segment was $74.2 million during 2007 as compared to $67.9 million during 2006. The increase is the result of higher sales of custom-engineered bearings to the wind energy and machinery equipment markets, and of split roller bearing products used globally in various industrial markets, and the $5.0 million gain on the sale of a component of this reporting segment.

 

The Velocity Control Products reporting segment contributed $16.2 million to our consolidated operating income during 2007 as compared to $12.9 million during 2006. The Sealing Products reporting segment contributed $8.5 million to our consolidated operating income during 2007 as compared to $6.4 million during 2006. The increased operating income in both of these segments was due primarily to higher sales in 2007.

 

Our other businesses contributed $10.8 million to our consolidated operating income during 2007 as compared to $6.5 million during 2006. Each of our other businesses generated increased operating income in 2007 compared with 2006, primarily as a result of higher sales, particularly of our liquid and air filtration products.

 

During both 2007 and 2006, $9.3 million of interest and amortization of issuance costs related to our $200.0 million of 4% Contingent Convertible

 

 

KAYDON CORPORATION FORM 10K 11

Senior Subordinated Notes was charged to interest expense.

 

Because of higher investment interest rates and higher average cash and cash equivalent, and short-term investment balances, interest income increased to $18.1 million during 2007, compared with $16.3 million during 2006.

 

The effective tax rate for 2007 was 35.1 percent compared to 34.0 percent in 2006. The effective tax rate for 2006 reflects reductions to the tax provision related to deductions recognized for financial reporting purposes, after examinations by certain taxing authorities, or after the expiration of applicable review periods, totaling $1.7 million. We expect the effective tax rate for 2008 to be approximately 36.0 percent.

 

Our net income for 2007, including the $3.1 million after tax gain on the sale of a component of a reporting segment, was $77.7 million or $2.41 per share on a diluted basis, based on 34.7 million common shares outstanding, compared with net income for 2006 of $69.5 million or $2.17 per share on a diluted basis, based on 34.8 million common shares outstanding.

 

Analysis of 2006 Operations Compared to
2005 Operations

 

Selected Data For The Year 2006 Compared With The Year 2005

 

 

Net sales of continuing operations of $404.0 million in 2006 increased $49.4 million or 13.9 percent compared to 2005’s net sales of $354.6 million. Specifically, the Friction Control Products reporting segment achieved sales of $234.0 million during 2006, up $39.0 million or 20.0 percent compared to 2005 sales of $195.0 million. The increase was principally the result of higher demand for custom-engineered bearings to various defense-related markets of $15.1 million, the wind energy market of $6.8 million, the heavy equipment market of $3.9 million, the medical equipment market of $3.2 million, the specialty electronics market of $2.5 million, and the machinery market of $1.9 million. Sales of split roller bearings, used globally in various industrial markets, increased $4.8 million compared to 2005. Our Velocity Control Products reporting segment achieved sales of $56.7 million during 2006, up $2.9 million, or 5.4 percent from 2005 sales of $53.8 million, reflecting increased sales of gas springs, hydraulic dampers, and other products in Germany and other European countries. Our Sealing Products reporting segment achieved sales of $42.0 million during 2006, an increase of $3.5 million, or 9.0 percent from 2005 sales of $38.5 million, as demand increased from both the aerospace and petroleum processing markets. Our other businesses achieved sales of $71.2 million during 2006, up $4.0 million, or 6.0 percent from 2005 sales of $67.2 million. Sales growth in our other businesses was due primarily to growth in our air and liquid filtration businesses.

 

Gross profit from continuing operations for 2006 equaled $167.4 million or 41.4 percent of sales as compared to $139.0 million or 39.2 percent of sales for 2005. Compared to 2005, gross margin for 2006 was favorably impacted by the full-year effect of selling price and capacity increases implemented during the second half of 2005, increased demand, and the Company’s ongoing focus on improving operating efficiencies.

 

Selling, general and administrative expenses from continuing operations totaled $68.7 million or 17.0 percent of sales in 2006, compared to $68.9 million or 19.4 percent of sales for 2005. Primarily as a result of the Company’s effort to reduce its exposure to changes in exchange rates applicable to non-functional currency assets and liabilities, we recorded an exchange gain of $0.3 million in 2006, compared to an exchange loss of $2.9 million in 2005, resulting in a $3.2 million decrease in selling, general and administrative expenses when comparing 2006 to 2005. In addition, in 2006 the Company’s selling, general and administrative expenses were favorably impacted by $0.8 million resulting from an insurance refund, and a reduction in the Company’s environmental reserves.

 

Operating income from continuing operations equaled $98.7 million during 2006, compared to $70.2 million in 2005, with operating margins of 24.4 percent and 19.8 percent in 2006 and 2005.

 

On a reporting segment basis, operating income from the Friction Control Products reporting segment

 

 

12 KAYDON CORPORATION FORM 10K

was $67.9 million during 2006 as compared to $49.5 million during 2005. The increase is the result of increased sales of custom-engineered bearings to the wind energy, defense, heavy equipment and medical equipment markets, and of split roller bearing products used globally in various industrial markets. The growth of operating income was also positively affected by the full-year benefit of actions taken in the second half of 2005 to increase certain selling prices and achieve improved operating efficiencies.

 

The Velocity Control Products reporting segment contributed $12.9 million to our consolidated operating income during 2006 as compared to $12.2 million during 2005. Operating income growth was due primarily to higher sales in 2006.

 

The Sealing Products reporting segment contributed $6.4 million to our consolidated operating income during 2006 as compared to $5.9 million during 2005. The increased operating income was due primarily to higher sales in 2006.

 

Our other businesses contributed $6.5 million to our consolidated operating income during 2006 as compared to $4.6 million during 2005. Each of our other businesses generated increased operating income in 2006 compared with 2005, as a result of either higher sales or improved operating efficiencies.

 

During both 2006 and 2005, $9.3 million of interest and amortization of issuance costs related to our $200.0 million of 4% Contingent Convertible Senior Subordinated Notes was charged to interest expense.

 

As a result of higher investment interest rates and higher cash and cash equivalent balances, interest income increased to $16.3 million during 2006, compared with $8.7 million during 2005.

 

The effective tax rate for continuing operations for 2006 was 34.0 percent compared to 32.9 percent in 2005. The effective tax rates for both 2006 and 2005 reflect reductions to the tax provisions related to deductions recognized for financial reporting purposes, after examinations by certain taxing authorities, or after the expiration of applicable review periods, totaling $1.7 million in 2006 and $1.1 million in 2005.

 

Our income from continuing operations for 2006 was $69.5 million or $2.17 per share on a diluted basis, based on 34.8 million common shares outstanding, compared with income from continuing operations for 2005 of $46.5 million or $1.52 per share on a diluted basis, based on 34.7 million common shares outstanding.

 

Income from discontinued operations for 2005 equaled $27.4 million, including the after tax gain of $25.4 million on the sale of the Power and Data Transmission Products Group. Diluted earnings per share from discontinued operations for 2005 were $0.79, with $0.73 resulting from the gain on the sale.

 

Our net income for 2006 was $69.5 million or $2.17 per share on a diluted basis, compared with net income for 2005 of $73.9 million or $2.30 per share on a diluted basis.

 

Liquidity, Working Capital, and Cash Flows

 

One of our financial strategies is to maintain an adequate level of liquidity supported by strong cash flow, which continued in 2007. Historically, we have generated significant cash flows from operating activities to fund capital expenditures, dividends and other operating requirements. Cash flow generation has been enhanced by our continuing efforts to improve operating efficiencies, cost reductions and the management of working capital requirements. One of our strengths is our ability to generate cash from operations in excess of requirements for capital investments and dividends. Net cash from operating activities equaled $74.3 million in 2007, $89.9 million in 2006, and $41.2 million in 2005. Net cash from operating activities in 2007 declined compared to 2006 due to the full funding of our qualified pension plans in 2007 and investment in working capital associated with sales growth, which were only partially offset by higher net income. The pension funding is expected to substantially eliminate contributions to these plans for the next five years. Net capital expenditures to expand productive capacity, improve quality, and reduce costs equaled $54.1 million in 2007, $26.3 million in 2006 and $12.6 million in 2005. The increase in capital expenditures in 2007 compared to 2006 was driven principally by the wind energy growth initiative announced in 2006 and expanded in 2007. This initiative will increase the Company’s capacity to provide performance-critical specialty bearings to serve the rapidly growing wind energy industry. During 2007, the Company announced its intention to increase by $48.0 million the investment in this initiative. This investment, combined with the $30.0 million investment announced in 2006, will result in a total investment of approximately $80.0 million to expand our wind energy production capabilities. During 2007, capital expenditures totaled $29.1 million for the wind energy growth initiative. During 2008, we expect to invest approximately $70-$75 million in net capital expenditures. The Company paid common

 

 

KAYDON CORPORATION FORM 10K 13

stock dividends totaling $14.4 million in 2007 and $13.5 million in each of 2006 and 2005. The dividend payments in 2005, 2006, and through the third quarter 2007, were at a quarterly rate of $0.12 per share. The dividend declared in July 2007, and paid early in the fourth quarter, was at a quarterly rate of $0.15 per share.

 

During 2005, the Company entered into an agreement for its senior credit facility with its syndicate of lenders. The credit agreement provides for a $300.0 million senior unsecured revolving credit facility. The credit facility provides for borrowings and issuance of letters of credit by the Company and its subsidiaries in various currencies for general corporate purposes, including acquisitions. The credit facility matures on July 12, 2010 and is guaranteed by the Company and certain of the Company’s domestic subsidiaries. Interest expense incurred on borrowings under the revolving credit facility will be based on the London Interbank Offered Rate. The revolving credit facility contains restrictive financial covenants on a consolidated basis including leverage and coverage ratios, utilizing measures of earnings and interest expense as defined in the revolving credit facility agreement. Under the leverage ratio restriction, the Company may not allow the ratio of total indebtedness, net of domestic cash in excess of $15.0 million, to adjusted earnings before interest expense, taxes, depreciation and amortization to exceed 3.5 to 1.0. Under the interest coverage ratio restriction, the Company may not allow the ratio of adjusted earnings before interest expense and taxes to interest expense to be less than 3.0 to 1.0. The Company is in compliance with all restrictive covenants contained in the revolving credit facility at December 31, 2007. After consideration of the facility’s covenants and $4.9 million of letters of credit issued under the facility, the Company has available credit under its revolving credit facility of $295.1 million at December 31, 2007.

 

Fees related to the revolving credit facility of approximately $1.2 million are being amortized as a component of interest expense over a five-year period. Revolving credit facility fees included in other assets in the Consolidated Balance Sheet as of December 31, 2007, equaled $0.6 million.

 

During 2005, we completed the sale of the Power and Data Transmission Products Group for $71.4 million cash, resulting in an after tax gain of $25.4 million or $0.73 per diluted share, which is reported as a component of income from discontinued operations.

 

The Company continues its corporate development efforts to complement internal growth through the acquisition of additional companies that meet Kaydon’s well-disciplined criteria, and on October 26, 2007, acquired Avon Bearings Corporation for $54.9 million. An independent appraiser was engaged to assist management in determining the fair values of separately recognized intangible assets of Avon. After allocating cost to other assets acquired and liabilities assumed based on their estimated fair values, the excess cost of the acquisition, equal to $27.4 million, was recognized as goodwill. In January 2005, the Company acquired Purafil, Inc. for $42.7 million. An independent appraiser was engaged to assist management in determining the fair values of separately recognized intangible assets of Purafil. After allocating cost to other assets acquired and liabilities assumed based on their estimated fair values, the excess cost of the acquisition, equal to $18.5 million, was recognized as goodwill.

 

The Company’s payments to various taxing authorities were $25.1 million, $28.9 million, and $38.0 million during 2007, 2006 and 2005. Tax payments for 2005 include $16.6 million related to the gain on the sale of discontinued operations. Tax payments are estimated to be approximately $44 million during 2008.

 

The Company has outstanding $200.0 million of 4% Contingent Convertible Senior Subordinated Notes due 2023 (the “Notes”). The Notes bear interest at 4 percent per year, payable semi-annually, and under certain circumstances beginning in 2008, may bear additional contingent interest of 0.50 percent per year. The Notes are convertible into a total of 6,858,710 shares of our common stock at a conversion price of $29.16 per share, provided certain contingencies are met including that our common stock has traded above $34.99 for specified periods of time. The Notes may not be redeemed by us until May 30, 2008 but are redeemable at any time thereafter at par, plus accrued and unpaid interest. The Notes are convertible into common stock upon the issuance of a notice of redemption. Holders of the Notes will have the option to require us to purchase their Notes at par for one day each at the end of 5, 10, and 15 years after issuance. In addition, the holders have the right to require redemption of the Notes before the specified maturity dates in the event of a change of control of the Company, as identified in the Notes’ Indenture.

 

In addition, the contingent interest feature of the Notes requires the Company to deduct for tax purposes an amount of interest expense that is greater than the stated coupon rate. The additional

 

 

14 KAYDON CORPORATION FORM 10K

interest may have to be recaptured for tax purposes, in part or in whole, if the Notes are redeemed or surrendered for conversion at an amount less than the tax accreted value. Should this happen, depending on other factors, tax payments may increase. The total deferred tax liability on the additional interest deduction representing the potential tax payment from the redemption or conversion totaled $18.4 million at December 31, 2007. Redemption or conversion of the Notes may cause volatility in tax payments, cash flows and the liquidity of the Company.

 

Note issuance costs of approximately $6.5 million are being amortized as a component of interest expense over a five-year period. Unamortized note issuance costs included in other assets in the Consolidated Balance Sheet as of December 31, 2007 equaled $0.5 million.

 

We repurchased 601,974 shares of our common stock in 2007 for $30.1 million compared to 96,355 shares in 2006 for $3.4 million and 207,771 shares in 2005 for $6.1 million. In 2005, the Company’s Board of Directors authorized a new share repurchase program of up to 5,000,000 shares that replaced the existing program. Of the 5,000,000 shares currently authorized by the Board of Directors for repurchase, 718,829 shares have been repurchased as of December 31, 2007. We will continue to make opportunistic stock repurchases during 2008, the amount of which will depend on the market for our common stock and our financial position and liquidity.

 

We believe our current cash and short-term investment balances and future cash flows from operations, along with our borrowing capacity and access to financial markets are adequate to fund our strategies for future growth, including working capital, expenditures for manufacturing expansion and efficiencies, selected stock repurchases, market share initiatives and corporate development activities.

 

At December 31, 2007, the current ratio was 7.5 to 1 and working capital totaled $380.4 million, including cash and cash equivalents, and short-term investments of $287.0 million.

 

The Company has recorded in other assets a $15.0 million gross investment representing the non-current portion of the Company’s position in an investment fund. This fund has been closed by the fund issuer. The fund issuer, owned by a major bank, has restricted the redemption of the fund to permit its orderly liquidation as the underlying fund assets mature or are sold. At December 31, 2007, an unrealized loss on this investment totaling $0.3 million, $0.2 million net of tax, was recorded to reduce the value of the long-term asset, with an offset to accumulated other comprehensive income.

 

Our significant contractual obligations as of December 31, 2007 are set forth below:

 

Holders of our Notes may require us to repurchase all or a portion of their Notes on May 23, 2008. If the holders of the Notes exercise their right to require us to repurchase all or a portion of their Notes on May 23, 2008, the Company intends to refinance the obligation on a long-term basis with its revolving credit facility. Because the Company has the ability and intent to refinance the obligation on a long-term basis, the Notes continue to be reported as long-term debt at December 31, 2007. See the Notes to Consolidated Financial Statements (Note 4) for additional information about the Notes. Interest payments on the Notes, including anticipated contingent interest, are expected to be $8.6 million in 2008.

 

We do not expect to contribute to our qualified pension plans, but expect to contribute approximately $0.8 million to our postretirement benefit plans in 2008.

 

Corporate Development

 

Our corporate development efforts are aimed to complement internal growth through the acquisition of additional companies consistent with our well-disciplined criteria. We maintain a disciplined acquisition program, which has made important contributions to our growth. In 2007, the Company acquired all of the outstanding stock of Avon Bearings Corporation (“Avon”) in a cash transaction valued at $54.9 million. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings. In 2005, we acquired all

 

 

KAYDON CORPORATION FORM 10K 15

of the outstanding stock of Purafil, Inc., a manufacturer and distributor of gas phase air filtration systems and media, in a cash transaction valued at $42.7 million.

 

Litigation

 

We are a party to various other lawsuits and matters arising in the normal course of business that are pending. The Company’s estimated legal costs expected to be incurred in connection with claims, lawsuits and environmental matters are accrued in the consolidated financial statements.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles. The preparation of these financial statements requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented.

 

We continually evaluate the estimates, judgments, and assumptions used to prepare the consolidated financial statements. In general, our estimates are based on historical experience, on information from third party professionals and on various other judgments and assumptions that are believed to be reasonable under the current facts and circumstances. Actual results could differ from the current estimates made by the Company. We have identified certain accounting policies and estimates, described below, that are the most critical to the portrayal of our current financial condition and results of operations.

 

Inventories – Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions regarding future demand. We evaluate the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known or anticipated engineering change orders, new products, and other factors.

 

We believe the accounting estimates related to inventories to be critical accounting estimates because the range of assumptions used to determine the valuation of inventories, while based on reasonable and supportable information, may change causing projected outcomes based on the assumptions to vary.

 

Impairment of Long-Lived Assets – We continually evaluate whether events and circumstances have occurred that indicate the remaining estimated useful lives of long-lived assets including fixed assets and amortizable intangible assets may warrant revision or that remaining balances may not be recoverable. When factors indicate that such costs should be evaluated for possible impairment, we use an estimate of undiscounted future cash flows over the remaining lives of the long-lived assets that is compared to the carrying value of the asset to evaluate whether the asset costs are recoverable.

 

We believe the accounting estimates related to long-lived asset impairment to be critical accounting estimates because: the estimate of undiscounted future cash flows, while based on reasonable and supportable assumptions and projections, requires the Company’s subjective judgments; the time periods for estimating future cash flows is often lengthy which increases the sensitivity to assumptions made; and projected outcomes based on the assumptions made can vary.

 

To better understand this accounting policy and its impact on the Company, readers should refer to the Notes to Consolidated Financial Statements (Note 1 and Note 10) in this Annual Report for additional information regarding long-lived assets.

 

Impairment of Goodwill and Indefinite-Lived Intangible Assets – The Company annually, or more frequently if events or changes in circumstances indicate a need, tests the carrying amounts of goodwill and indefinite-lived intangible assets for impairment.

 

We identify impairment of goodwill by comparing the fair value of each of our reporting units with the reporting unit’s carrying amount. The fair value of each of our reporting units is derived from an estimate of discounted future cash flows including estimates for terminal value. In 2007 we used an 11.5 percent discount rate, and a growth assumption of 2 percent in perpetuity to calculate terminal value. In 2006 an 11 percent discount rate was utilized. The discount rate used each year is the value-weighted average of the Company’s estimated cost of equity and estimated cost of debt (“cost of capital”) derived using both known and estimated, customary, marketplace metrics. The principal marketplace metric used in the estimation of the discount rate, which changed from 2006 to 2007, was an industry capital structure that was more heavily weighted toward

 

 

16 KAYDON CORPORATION FORM 10K

the equity component, which has a higher cost. Our calculation methodology was unchanged during 2007, and the consistent application of this methodology may result in changes in the discount rate in future periods. Potential goodwill impairment is identified if a reporting unit’s carrying amount is more than a reporting unit’s fair value. If this occurs, normally a third-party valuation specialist is utilized to assist the Company in determining the implied fair value of the reporting unit’s goodwill. The amount of any actual impairment loss is calculated by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill.

 

Certain trademarks are the Company’s only indefinite-lived intangible assets. We identify impairment of these trademarks by comparing their fair value to their carrying amounts. The fair values of the trademarks are calculated based on estimates of discounted future cash flows related to the net amount of royalty expenses avoided due to the existence of the trademarks.

 

We believe the accounting estimates related to impairment of goodwill and indefinite-lived intangible assets to be critical accounting estimates because: the estimate of discounted future cash flows and terminal values, while based on reasonable and supportable assumptions and projections, requires the Company’s subjective judgments; the time periods for estimating future cash flows is often lengthy which increases the sensitivity to assumptions made; projected outcomes based on the assumptions made can vary; and the calculation of implied fair value is inherently subject to estimates.

 

To better understand this accounting policy and its impact on the Company, readers should refer to the Notes to Consolidated Financial Statements (Note 10) in this Annual Report for additional information regarding goodwill and intangible assets.

 

4% Contingent Convertible Senior Subordinated Notes – We have outstanding $200.0 million of 4% Contingent Convertible Senior Subordinated Notes due 2023 (the “Notes”). The Notes are convertible into a total of 6,858,710 shares of our common stock at a conversion price of $29.16 per share, provided certain contingencies are met. The Notes become convertible during any calendar quarter if the closing sale price of Company common stock is more than $34.99 for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter. Based on this formula, holders will be able to convert their Notes during the first quarter of 2008.

 

Holders of the Notes may require us to repurchase all or a portion of their Notes on May 23, 2008, 2013, and 2018, at 100 percent of the principal amount of the Notes, plus accrued but unpaid interest (including contingent interest and liquidated damages, if any) to the date of repurchase, payable in cash. If the holders of the Notes exercise their right to require us to repurchase all or a portion of their Notes on May 23, 2008, the Company intends to refinance the obligation on a long-term basis with its revolving credit facility. Because the Company has the ability and intent to refinance the obligation on a long-term basis, the Notes continue to be reported as long-term debt at December 31, 2007.

 

Generally accepted accounting principles require that the impact of contingently convertible instruments that are convertible into common stock upon the achievement of a specified market price of the issuer’s shares, such as the Company’s Notes, should be included in diluted earnings per share computations regardless of whether or not the market price trigger has been met. Accordingly, net income used in the calculation of diluted earnings per share amounts is adjusted by adding back the after tax interest expense, including amortization of debt issuance costs attributable to the Notes, and total shares outstanding are increased by the number of shares that would be issuable upon conversion.

 

In addition, the contingent interest feature of the Notes requires the Company to deduct for tax purposes an amount of interest expense that is greater than the stated coupon rate. The additional interest deduction on the Notes may have to be recaptured for tax purposes, in part or in whole, if the Notes are redeemed or surrendered for conversion at an amount less than the tax accreted value. Should this happen, depending on other factors, tax payments may increase. If the Notes are redeemed or surrendered for conversion at an amount less than the tax accreted value, the deferred tax liability provided for, which totals $18.4 million at December 31, 2007, would be eliminated through an adjustment to the Company’s shareholders’ equity and would not affect current tax accounts.

 

We believe that the impact the Notes have on the accounting for our diluted earnings per share calculations, and tax-related account balances as discussed above are critical to the understanding of our current financial condition and results of operations. The existence of the Notes has caused further dilution to our diluted earnings per share calculation, and redemption or surrender for conversion of the Notes at an amount less than the tax accreted value may

 

 

KAYDON CORPORATION FORM 10K 17

cause volatility in tax payments, cash flows and the liquidity of the Company.

 

To better understand the Notes and their impact on the Company’s financial reporting, readers should refer to the Notes to Consolidated Financial Statements (Note 2 and Note 4) and other discussions in this Annual Report.

 

Retirement Benefits – Our employee pension and postretirement benefit costs and obligations recorded in the financial statements are dependent on the Company’s estimates provided to and used by our actuaries in calculating such amounts.

 

We believe the accounting estimates related to retirement benefits to be critical accounting estimates because of the wide range of assumptions used in deriving yearly contribution and expense amounts as well as the amounts recorded for retirement benefits in our financial statements. Significant assumptions include judgments regarding discount rates, health care cost trend rates, salary growth rates, and long-term returns on plan assets.

 

We have developed estimates based on historical experience, on information from third party professionals and on various other judgments and assumptions that are believed to be reasonable under the current facts and circumstances. In developing the discount rate assumption used to determine the pension and postretirement benefit obligations at September 30, 2007 and 2006, the Company calculated the cash flows represented by the projected benefit obligations of three pension plans constituting greater than 90 percent of the Company’s pension plans’ total projected benefit obligation. These cash flows were discounted at corresponding interest rates derived from a hypothetical yield curve constructed using the top quartile of high rated (Aa or AA) non-callable bonds with at least $150.0 million of par value outstanding. The equivalent weighted-average discount rate is calculated by imputing the interest rate that equates the total present value with the stream of future cash flows. The discount rate applicable to the Company’s three largest pension plans was also used for all qualified pension plans and the Company’s postretirement benefit plans. In 2007 and 2006, a similar, independent development of the discount rate assumption was used for the non-qualified pension plan. Prior to using the yield curve approach, the discount rate assumptions used for the pension and postretirement net periodic benefit costs in 2005 were based on investment yields available on long-term corporate bonds. Health care cost trend assumptions are developed based on historical data, the near-term outlook, and on an assessment of likely long-term trends. Salary growth assumptions reflect our long-term experience, the near-term outlook and assumed inflation. Long-term return on plan assets is based on an evaluation of historical and expected returns of the individual asset classes comprising the total plan assets.

 

Assumed discount rates, expected rate of return on plan assets, and rate of compensation increase have a significant effect on the amounts reported for the pension plans. A 1.0 percent increase in the discount rate would have decreased the net periodic benefit cost by $1.4 million during 2007, and would have decreased the projected benefit obligation as of the measurement date by $10.7 million. A 1.0 percent decrease in the discount rate would have increased the net periodic benefit cost by $1.5 million during 2007, and would have increased the projected benefit obligation as of the measurement date by $13.1 million. A 1.0 percent increase in the expected rate of return on plan assets would have decreased the net periodic benefit cost by $0.7 million during 2007, and a 1.0 percent decrease in the expected rate of return on plan assets would have increased the net periodic benefit cost by $0.7 million during 2007. A 1.0 percent increase in the rate of compensation increase would have increased the net periodic benefit cost by $0.7 million during 2007, and would have increased the projected benefit obligation as of the measurement date by $3.2 million. A 1.0 percent decrease in the rate of compensation increase would have decreased the net periodic benefit cost by $0.6 million, and would have decreased the projected benefit obligation as of the measurement date by $2.6 million.

 

 

18 KAYDON CORPORATION FORM 10K

 

The following table summarizes certain of the Company’s assumptions:

 

 

Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in such future periods. While we believe that the assumptions used are appropriate, significant differences in actual experience or significant changes in assumptions would affect our pension and postretirement benefits costs and obligations.

 

To better understand this accounting policy and its impact on the Company, readers should refer to the Notes to Consolidated Financial Statements (Note 7)  in this Annual Report for additional information regarding costs, obligations, and assumptions for employee pension and postretirement benefits.

 

Income Taxes – We record deferred tax assets and liabilities using enacted tax rates for the effect of differences between the book and tax basis of recorded assets and liabilities. These deferred tax assets and liabilities are reviewed for recoverability by using estimates of future taxable income streams and the impact of tax planning strategies. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Reserves are also estimated for ongoing audits regarding federal, state and international issues that are currently unresolved. Income tax is provided based upon an effective tax rate that is dependent upon tax regulations governing the regions in which we conduct business, geographic composition of worldwide earnings, the availability of tax credits and other factors. In 2006 and 2005 our effective tax rate was affected by reductions to our tax provision related to deductions recognized for financial reporting purposes, after examinations by taxing authorities, or after the expiration of applicable review periods.

 

The Company has liabilities recorded for unrecognized tax benefits totaling $2.8 million as of December 31, 2007, all of which would affect the effective tax rate. It is the Company’s policy to include interest and penalties incurred due to underpayment or late payment of income taxes due to a taxing authority on a net-of-tax basis as a component of income tax expense. The Company has recorded $0.8 million in liabilities for tax related interest and penalties on its consolidated balance sheet, as of December 31, 2007. The Company does not expect that the total amounts of unrecognized tax benefits will significantly change within the next twelve months.

 

The Company, or one of its subsidiaries, operates and files income tax returns in the United States, various states, and foreign jurisdictions. Foreign jurisdictions significant to the Company include Germany and the United Kingdom. With limited exceptions, the Company is no longer subject to U.S. federal tax examinations for years before 2004, state examinations for years before 2002, German tax examinations for years before 2004, or United Kingdom tax examinations for years before 2005.

 

We believe the accounting estimates related to income taxes to be critical accounting estimates because the range of assumptions used to determine deferred tax assets and liabilities and to record current tax benefits and liabilities, while based on reasonable and supportable information, may change from year to year causing projected outcomes based on the assumptions to vary.

 

To better understand this accounting policy and its impact on the Company, readers should refer to the Notes to Consolidated Financial Statements (Note 9)  in this Annual Report for additional information regarding income taxes.

 

Forward-Looking Statements

 

This Annual Report contains forward-looking statements within the meaning of the Securities Exchange Act of 1934 regarding the Company’s plans, expectations, estimates and beliefs. Forward-looking statements are typically identified by words such as “believes,” “anticipates,” “estimates,”

 

 

KAYDON CORPORATION FORM 10K 19

“expects,” “intends,” “will,” “may,” “should,” “could,” “potential,” “projects,” “approximately,” and other similar expressions, including statements regarding pending litigation, general economic conditions, competitive dynamics and the adequacy of capital resources. These forward-looking statements may include, among other things, projections of the Company’s financial performance, anticipated growth, characterization of and the Company’s ability to control contingent liabilities and anticipated trends in the Company’s businesses. These statements are only predictions, based on the Company’s current expectation about future events. Although the Company believes the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, performance or achievements or that predictions or current expectations will be accurate. These forward-looking statements involve risks and uncertainties that could cause the Company’s actual results, performance or achievements to differ materially from those expressed or implied by the forward-looking statements.

 

In addition, the Company or persons acting on its behalf may from time to time publish or communicate other items that could also be construed to be forward-looking statements. Statements of this sort are or will be based on the Company’s estimates, assumptions, and projections and are subject to risks and uncertainties that could cause actual results to differ materially from those included in the forward-looking statements. Kaydon does not undertake any responsibility to update its forward-looking statements or risk factors to reflect future events or circumstances except to the extent required by applicable law.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to certain market risks, which exist as part of our ongoing business operations including interest rates and foreign currency exchange rates. The exposure to market risk for changes in interest rates relates primarily to investments in cash and cash equivalents, and short-term investments. All highly liquid investments, including highly liquid debt and investment instruments purchased with an original maturity of three months or less, are considered cash equivalents. Short-term investments include auction rate securities and other investments that are classified as available-for-sale and expected to be realized in cash or sold or consumed within the next twelve months. We place our investments in cash equivalents with high credit quality issuers and limit the amount of exposure to any one issuer. A 51 basis point decrease in interest rates (10 percent of the Company’s weighted-
average investment interest rate for 2007) would not have a material impact on the Company’s pre-tax earnings. We conduct business in various foreign currencies, primarily in Europe, Mexico, and Asia. Therefore, changes in the value of currencies of these countries in these regions affect our financial condition and cash flows when translated into U.S. dollars. We have mitigated and will continue to mitigate a portion of our currency exposure through operation of decentralized foreign operating companies in which certain costs are local currency based. In addition, periodically, we enter into derivative financial instruments in the form of forward foreign exchange contracts to reduce the effect of fluctuations in foreign exchange rates. A 10 percent change in the value of all foreign currencies would not have a material effect on the Company’s financial condition and cash flows. Management’s estimate of the fair value of long-term debt is determined by reference to market data. As of December 31, 2007, the fair value of long-term debt is approximately 80 percent greater than its recorded value. The change in the fair value of long-term debt, which is convertible into Company common stock, would be expected to fluctuate consistently with the market price of Company common stock.

 

 

20 KAYDON CORPORATION FORM 10K

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Kaydon’s management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined under applicable Securities and Exchange Commission rules as a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer and effected by the Company’s Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that:

 

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.

 

Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued their report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. Their report is included herein under the heading “Report of Independent Registered Public Accounting Firm – Internal Control.”

 

 

KAYDON CORPORATION FORM 10K 21

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM – INTERNAL CONTROL

 

The Board of Directors and Shareholders of Kaydon Corporation

 

We have audited Kaydon Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Kaydon Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report On Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Kaydon Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 of Kaydon Corporation and our report dated February 11, 2008 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Detroit, Michigan

February 11, 2008

 

 

22 KAYDON CORPORATION FORM 10K

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM – FINANCIAL STATEMENTS

 

The Board of Directors and Shareholders of Kaydon Corporation

 

We have audited the accompanying consolidated balance sheets of Kaydon Corporation as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Kaydon Corporation at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note 7 to the consolidated financial statements, in 2006 the Company adopted required provisions of Financial Accounting Standards Board Statement 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Kaydon Corporation’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2008 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Detroit, Michigan

February 11, 2008

 

 

KAYDON CORPORATION FORM 10K 23

KAYDON CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

December 31, 2007 and 2006

 

 

The accompanying notes are an integral part of these statements.

 

 

24 KAYDON CORPORATION FORM 10K

KAYDON CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

For the years ended December 31, 2007, 2006 and 2005

 

 

The accompanying notes are an integral part of these statements.

 

 

KAYDON CORPORATION FORM 10K 25

KAYDON CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

For the years ended December 31, 2007, 2006 and 2005

 

 

 

The accompanying notes are an integral part of these statements.

 

 

26 KAYDON CORPORATION FORM 10K

KAYDON CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31, 2007, 2006 and 2005