-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, PwdsI5zqZIRqaXbC8jr+fIaQD93qX26tWMrWICRUkcMD3BNB8lIhyPEw/JeB9HCb ZeclvQUtju/7NtJTUIUnFg== 0001017062-99-000546.txt : 19990402 0001017062-99-000546.hdr.sgml : 19990402 ACCESSION NUMBER: 0001017062-99-000546 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CERADYNE INC CENTRAL INDEX KEY: 0000018937 STANDARD INDUSTRIAL CLASSIFICATION: ABRASIVE ASBESTOS & MISC NONMETALLIC MINERAL PRODUCTS [3290] IRS NUMBER: 330055414 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-13059 FILM NUMBER: 99579684 BUSINESS ADDRESS: STREET 1: 3169 RED HILL CITY: COSTA MESA STATE: CA ZIP: 92626 BUSINESS PHONE: 7145490421 MAIL ADDRESS: STREET 2: 3169 RED HILL CITY: COSTA MESA STATE: CA ZIP: 92626 10-K405 1 FORM 10-K FOR PERIOD ENDING 12/31/1998 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ending December 31, 1998 [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (No fee required) For the transition period from _______ to _______ Commission File No. 000-13059 CERADYNE, INC. -------------- (Exact name of Registrant as specified in its charter) Delaware 33-0055414 ------------------------------- ---------------------------- (State or other jurisdiction of (I.R.S. Employer Identifica- incorporation or organization) tion Number) 3169 Red Hill Avenue, Costa Mesa, California 92626 --------------------------------------------------- (Address of principal executive offices) Registrant's telephone number, including area code: (714) 549-0421 -------------- Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 par value (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [_] Indicate by check mark 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. [X] The aggregate market value (based on the closing price at which stock was sold) of the voting shares held by non-affiliates of the registrant as of March 3, 1999 was $19,291,216. As of March 3, 1999, the number of shares of the registrant's Common Stock outstanding was 8,054,838. DOCUMENTS INCORPORATED BY REFERENCE: None PART I This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results may differ materially from the results projected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in "Item 1 - Business," including the section therein entitled "Certain Factors that May Affect the Company's Business and Future Results," and in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations." Item 1. Business -------- Introduction Ceradyne, Inc. ("Ceradyne" or the "Company") develops, manufactures and markets advanced technical ceramic products and components for industrial, defense, consumer and microwave applications. In many high performance applications, products made of advanced technical ceramics meet specifications that similar products made of metals or plastics cannot achieve. Advanced technical ceramics can withstand extremely high temperatures, combine hardness with light weight, are highly resistant to corrosion and wear, and have excellent electrical insulation capability and other special electronic properties. Ceradyne's technology was originally developed primarily for defense and aerospace applications which have historically represented a substantial portion of its business. However, the Company has diversified its product lines on the development of new applications and markets, domestic and international, for its advanced technical ceramic technology, while continuing to serve its historical customer base which continues to account for a substantial portion of the Company's business. The Company continues to derive a substantial portion of its revenues from its traditional products, such as lightweight ceramic armor for military helicopters and microwave tube products. However, newer products developed or being developed by the Company for defense, industrial and consumer applications have represented a growing share of its business. Examples of these newer products include (i) large corrosion resistant ceramic components sold to semiconductor equipment manufacturers; (ii) lightweight ceramic armor vests for military personnel; (iii) a modified translucent ceramic orthodontic bracket, which is sold to Unitek Corporation, a subsidiary of 3M, under an exclusive marketing agreement and marketed by Unitek under its brand name "Clarity", (iv) wear resistant components for industrial machinery, such as paper making equipment, made from the Company's Ceralloy(R) 147 silicon nitride advanced technical ceramic; and (v) missile nose cones or radomes for the defense industry. The Company has a strategic relationship with the Ford Motor Company, pursuant to which Ford acquired a 15.0% equity interest in the Company, and transferred ceramic-related technology to the Company with a long-term objective of developing ceramic components for automobile engines. The Company's efforts in automotive applications are still in the experimental stage and the Company's ability to generate significant revenues from these applications is uncertain and may not occur for several years, if at all. 1 Industry Background Developments in industrial processing, military systems, microwave electronics, consumer electronics and orthodontics have generated a demand for high performance materials with certain properties not readily available in metals or plastics. In certain high performance applications, this demand has been met by products made of advanced technical ceramics. The following table compares certain favorable properties of selected advanced technical ceramics commonly used by the Company with those of other selected materials.
==================================================================================================================== MELTING POINT HARDNESS CHEMICAL DENSITY (DEGREES (VICKERS RESISTANCE ELECTRICAL (GMS MATERIALS FAHRENHEIT) SCALE) TO ACIDS PROPERTIES PER CC) - -------------------------------------------------------------------------------------------------------------------- Advanced technical From conductors to ceramics 2,500 to 6,900 1,600 to 7,000 Excellent excellent insulators 2.5 to 4.5 - -------------------------------------------------------------------------------------------------------------------- High strength alloy steel 2,500 to 2,700 250 to 900 Fair Conductors 7.0 to 9.0 - -------------------------------------------------------------------------------------------------------------------- High performance Good to Excellent Good to excellent plastics 275 to 750 5 to 10 insulators 1.0 to 2.0 ====================================================================================================================
Ceramics such as earthenware, glass, brick and tile have been made for centuries and are still in common use today. The inertness and lasting qualities of ceramics are illustrated by the artifacts uncovered intact in modern times. Almost all traditional ceramics, including those of ancient times, were based on clay. In recent years, significant advances have been made in ceramic technology through the application of specialized processes to produce man-made ceramic powders. In the 1950's and 1960's, developments in aluminum oxide and other oxides provided ceramics that were excellent electrical insulators and were capable of withstanding high temperatures. In the 1970's, these and other developments resulted in the ability to manufacture advanced technical ceramics with great strength at elevated temperatures and reduced brittleness, historically a primary limitation of ceramics. The industry that has emerged from these advances is known as advanced technical (or structural) ceramics. The properties of advanced technical ceramics present a compelling case for their use in a wide array of applications. However, manufacturing costs associated with the production of these materials need to be reduced in order to accelerate the use of advanced technical ceramics as a direct replacement for metals, plastics or other ceramics. A portion of these costs are related to the need for diamond grinding finished components to exacting tolerances. Industry cost reduction efforts have included the production of blanks or feed stock to "near net shape" configurations, thus reducing the need for final finishing. Manufacturers are also seeking to reduce costs through the use of high volume automated processing and finishing equipment and techniques, and to achieve economies of scale in areas such as powder processing, blank fabrication, firing, finishing and inspection. The automobile industry is particularly sensitive to initial as well as life cycle costs. Although the current state of the art of advanced technical ceramics suggests potential automotive acceptance, the cost factors currently will not permit automobile related production. The industry goal is to reduce advanced technical ceramics costs as close as possible to the cost of equivalent current metal parts. 2 Ceradyne Strategy The Company's strategy is to capitalize on its existing technologies, developed originally for defense and aerospace applications, and to broaden its product and customer base through increased marketing efforts both domestically and internationally. The Company is focusing on additional customer opportunities for existing products, and on emerging markets and products which require or can benefit from the physical, chemical or electronic properties of advanced technical ceramics. To support this strategy, the Company's Advanced Ceramic Operations in Costa Mesa, California created a new Research & Development Department in early 1998 to focus on new materials technology. Ceradyne seeks to increase sales of its traditional products primarily through expanded domestic and global marketing efforts. Examples of these products and market applications include: . Lightweight ceramic armor for military applications. . Industrial ceramics utilizing fused silica ceramics for the glass tempering and steel making markets. . Microwave cathodes, microwave absorbing Ceralloy(R) ceramics and samarium cobalt magnets for use in microwave power tubes in communications, radar and electronic countermeasure applications. In addition to the Company's strategy to leverage its existing technologies, the Company expects much of its future growth to come from products which are currently in early production or still in development. There can be no assurance, however, that products still under development will be successfully completed, or that any of these newer products, including those already in production, will achieve wide market acceptance. See "Certain Factors That May Affect the Company's Business and Future Results". The following table illustrates these newer and planned products and the markets for which they are intended. 3
MARKET OPPORTUNITY TECHNICAL DEMANDS OF MARKET CERADYNE'S STRATEGIC RESPONSE - ---------------------------------------------------------------------------------------------------------------------------------- INDUSTRIAL - ---------------------------------------------------------------------------------------------------------------------------------- Corrosion resistant non The industry has historically used silicon metal, Ceradyne has created a new business unit oxide ceramics for use as quartz, and aluminum oxide ceramics to fabricate called "Semiconductor Equipment Components" semiconductor equipment chamber components. Next generation equipment may and has begun supplying high density and chamber components that have operating conditions that may deteriorate high purity nitride and carbide ceramics to handle wafers. currently used materials in some sections. several equipment suppliers. A newly created R & D group is attempting to develop compositions tailored to each equipment manufacturer's environment. Wear resistant components Failure of industrial equipment is often caused by Ceralloy 147 Sintered Reaction Bonded Silicon required on the rubbing or premature wearing out of surfaces due to abrasive Nitride (SRBSN) industrial wear parts and cutting surfaces of action. Examples include paper making where the cutting tool inserts are designed to replace industrial machinery, such pulp slurry runs at 5000 feet per minute, or in hard metal or even oxide ceramic wear as in paper making equipment, metal cutting where as much as .125 inch depth of surfaces, resulting in great productivity, centrifuges, and cutting tool cut are removed in a single pass. quality and longer "uptime." inserts. - ------------------------------------------------------------------------------------------------------------------------------------ DEFENSE - ------------------------------------------------------------------------------------------------------------------------------------ Lightweight armor for military As tactical conflicts as well as terrorist and Ceralloy 546 (boron carbide) or Ceralloy 146 and law enforcement personnel. other activities result in the increased use of (silicon carbide) backed with Kevlar(TM), automatic weapons, it has become necessary to stop Spectra(TM) or other laminates are designed bullets as great as a .50 caliber machine gun to provide lightweight ballistic protection round. However, vests or other armor must be greater than Kevlar alone at an acceptable light enough in weight to allow freedom of weight. movement without undue fatigue. Missile nose cones (radomes). Next generation tactical missiles (Standard The Company's advanced technical ceramic Missile Block IV and PAC-3) will be required to radomes are designed to address demanding fly at extremely high velocities, tight turning specifications of next generation missile radii, and severe weather conditions. These nose cones. operating conditions may preclude the use of conventional polymer materials. - ------------------------------------------------------------------------------------------------------------------------------------ CONSUMER - ------------------------------------------------------------------------------------------------------------------------------------ Orthodontic brackets. Traditional stainless steel orthodontic ceramic Ceradyne's Transtar translucent orthodontic brackets are often considered unsightly. brackets are inert, pick up the color of the Substitute clear plastic materials can be weak and patient's teeth and allow the orthodontist to may stain. Some orthodontic patients prefer correct the patient's bite. The Company and aesthetically pleasing brackets which can be its marketing partner, 3M/Unitek, introduced affixed to each tooth to support the archwire. an enhanced version of this ceramic bracket in 1996, which is marketed by Unitek under the brand name "Clarity". - ------------------------------------------------------------------------------------------------------------------------------------ AUTOMOTIVE - ------------------------------------------------------------------------------------------------------------------------------------ Automobile internal combustion In order to achieve diesel engine life of one Ceradyne's Ceralloy 147 SRBSN is a candidate engine and diesel engine valve million miles and automobile engine life of over for a variety of engine components including train and other engine 100,000 miles without major maintenance, it may be bucket tappet inserts, engine valves, clevis components. necessary to replace metal engine components with pins and fuel injection pump parts. The longer lasting, lighter weight, higher temperature Company is in prototype development of parts resistant parts at acceptable unit costs. for Detroit Diesel Corp., Caterpillar Inc., and Ford Motor Company. Volume production orders may not occur for several years, if at all, and will depend on significant cost reduction and other factors. - ------------------------------------------------------------------------------------------------------------------------------------
4 As part of the Company's strategy, management intends to establish additional sales representative and distributor relationships, particularly in international markets. The Company will also seek to develop strategic product development or marketing relationships with other manufacturing companies or key customers whose expertise, marketing or financial resources will assist the Company in accomplishing these objectives. See "Certain Factors That May Affect the Company's Business and Future Results". Strategic Relationships The Company has established two strategic relationships which have been, and the Company expects will continue to be, important factors in the Company's efforts to develop and expand its advanced technical ceramic technology into new products and markets. These relationships are described below. Ford Motor Company Joint Product Development Program. Ceradyne completed a series of transactions with the Ford Motor Company ("Ford") in March 1986 with a long-term objective of developing ceramic components for automobiles. Key to this venture was the transfer of technology developed by Ford relating to technical ceramics, including a portfolio of United States and corresponding foreign patents and patent applications, and the investment of $10 million in the Company in exchange for Common Stock which eventually resulted in an ownership interest in Ceradyne of approximately 15%. Ford and the Company also entered into a joint development program pursuant to which Ceradyne has been applying its experience and expertise in technical ceramics to develop this technology into commercial products with a view to eventually develop components for automobile engines. Through fiscal 1998, Ford has contributed to the Company, on a cost sharing basis, a total of $4.5 million in cash and equipment under this joint development program. The technology acquired from Ford and the efforts of this joint development program have led to the development of Ceradyne's Ceralloy(R) 147 sintered reaction bonded silicon nitride (SRBSN) advanced technical ceramic, from which the Company now produces a line of industrial wear components and has made prototype parts for evaluation and testing in internal combustion and diesel engines. 3M/Unitek Orthodontic Bracket Joint Program. In March 1986, Ceradyne entered into a joint development and supply agreement with Unitek Corporation, a subsidiary of Minnesota Mining and Mfg ("3M/Unitek") for the development of a translucent ceramic bracket for orthodontic appliances commonly known as braces. Under this agreement, 3M/Unitek, which is a major manufacturer of stainless steel orthodontic brackets, provided Ceradyne with information regarding the functional specifications and properties which ceramic brackets would be required to satisfy. Based on this information and utilizing its experience with translucent ceramics originally produced by Ceradyne for defense electronic countermeasure applications, Ceradyne developed, and in 1987 began manufacturing, translucent ceramic brackets. These brackets cosmetically blend with the natural color of the patient's teeth while performing the structural functions formerly performed by traditional stainless steel brackets. Ceradyne and 3M/Unitek have obtained and jointly own two United States patents covering the basic use of translucent ceramics for an orthodontic bracket. 3M/Unitek has an exclusive right to market brackets based on this technology until 2007. 5 Market Applications The Company's products can be categorized by the principal market applications they address: (i) industrial, (ii) defense, (iii) consumer, (iv) microwave tube products and (v) automotive. These markets accounted for approximately 31.3%, 27.9%, 11.9%, 28.5% and .4%, respectively, of net sales for the year ended December 31, 1996, 43.6%, 13.8%, 17.1%, 21.4%, and 4.1%, respectively, of net sales for the year ended December 31, 1997, and 46.2%, 14.0%, 16.0%, 22.8%, and 1.0%, respectively, of net sales for the year ended December 31, 1998. Set forth below is a description of the Company's principle products itemized by market: Industrial Industrial Wear Components. Ceradyne's industrial wear components are made primarily of its Ceralloy(R) 147 sintered reaction bonded silicon nitride (SRBSN). These SRBSN ceramic components are generally incorporated in industrial machinery where severe abrasive conditions exist which wear out vital components. The Ceradyne wear resistant parts are used to replace conventional wear materials such as tungsten carbide or ceramics such as alumina or zirconia. Often these parts are incorporated in high wear areas at the original equipment manufacturer's plant. Applications include metal cutting tool inserts, paper and can making equipment, abrasive blasting nozzles as well as custom applications. Semiconductor Equipment Components. This is a new market that may offer Ceradyne growth opportunities. The equipment used to make semiconductor devices (wafers) is extremely advanced and the newest generation has operating environments that are harsh enough to severely limit the life of the traditional ceramic and metal components. Ceradyne is positioned to offer a new generation of non oxide ceramics which have exceptional corrosion resistance. Tempered Glass Furnace Components and Metallurgical and Industrial Tooling. Fused silica ceramic is a ceramic which does not materially expand when heated, nor materially contract when cooled. Therefore, it is used to produce industrial tooling and molds where complicated shapes and dimensions must be maintained over a wide range of temperatures. Such applications include the forming and shaping of titanium metal, used in the manufacturing of aircraft. Other applications take advantage of fused silica's excellent thermal shock resistance and inertness when in contact with glass. These applications include components for equipment used in the fabrication of flat plate and tempered glass or contoured shapes such as automobile windshields. Fused silica ceramic shapes of up to 14 feet in length are produced in the Company's facility located near Atlanta, Georgia. Defense Lightweight Ceramic Armor. Although armor has progressed through the centuries from animal skin shields to metal armored suits, to Kevlar(TM) vests (for light arms), to heavy steel plates, the requirements for light weight and maximum projectile stopping capability vary little. Ceradyne has developed and currently produces lightweight ceramic armor capable of protecting against threats as great as .50 caliber armor piercing machine gun bullets at 50% of the equivalent steel plate weight. Utilizing hot pressed Ceralloy(R) ceramic, the Company's armor plates are laminated with either Kevlar(TM), Spectra(TM) or fiberglass and formed into a wide variety of shapes, structures and components. To date, ceramic armor manufactured by the Company has been used principally for military helicopter crew seats and airframe panels. The Company currently supplies ceramic 6 armor systems for the following helicopter programs: the Blackhawk helicopter manufactured by Sikorsky Aircraft, the Apache helicopter manufactured by McDonnell-Douglas Helicopters, Inc., the Cobra helicopter manufactured by the Bell Helicopter division of Textron Inc., and the Sea King helicopter manufactured by Westland Helicopters. The Company believes it is a leader in producing lightweight ceramic armor for military helicopters. See "Certain Factors That May Affect the Company's Business and Future Results". The Company received its first production contract for ceramic armor vests for military personnel in January 1995. This order, from the Defense Logistics Agency of the United States Government, was for $3.5 million in vests which the Company shipped during 1996. On March 2, 1998, a U.S. government agency selected Ceradyne to provide certain ceramic armor products over a multi-year period. Ceradyne received its first production order under this program in October 1998 in the amount of $2.4 million. Before this order may be shipped, the government must give final approval to the Company's initial product samples. Such approval is expected, but cannot be assured. The government has indicated that total orders over the 5-year life of this program could exceed $100 million. However, there can be no assurances as to the exact quantities or deliveries under this program because the government is not required to purchase any minimum amount and all orders are at the full discretion of the government. Missile Nose Cones (Radomes). The Company produces conical shaped, precision machined ceramic components, which are designed to be mounted by its customers on the front end of tactical missiles. These nose cones, or radomes, are designed for applications where the velocities and operating environments are severe enough that the thermal shock and erosion resistance, high strength and microwave transparency properties of advanced technical ceramics are required. Revenues from sales of radomes have not been material to date. However, radomes manufactured by the Company have been qualified for the Standard Missile Block IV missile program and are currently undergoing early testing for the PAC-3 missile program. Consumer Ceramic Orthodontic Brackets. In the orthodontic process of correcting a patient's tooth alignment, typically small (about 1/4'') stainless steel brackets are adhered to each individual tooth in order to serve as a guide to the archwire which is the wire that sets into each bracket. The cosmetic appearance of all this metal is often considered quite unattractive. Ceradyne, together with its marketing partner, 3M/Unitek, have developed and are marketing ceramic orthodontic brackets made of Ceradyne's translucent ceramic, Transtar(R). The translucency of this ceramic bracket, together with the classic ceramic properties of hardness, chemical inertness and imperviousness, have resulted in a cosmetic substitute for traditional stainless steel brackets. These products are generally sold as aesthetic alternatives to conventional metal brackets and have been in production since 1987. Ceradyne and 3M/Unitek introduced a new enhanced ceramic bracket called "Clarity" in October of 1996. This product has patent protection and offers new features which improve the bracket's strength and functionality, compared to earlier designs manufactured by the Company. Comments from orthodontists who have purchased Clarity brackets have been positive. The Company believes Clarity brackets offer the orthodontist a more robust product that will minimize treatment and chair time while providing superior aesthetic appearance. Microwave Tube Products Microwave Ceramic-Impregnated Dispenser Cathodes. The Company manufactures ceramic-impregnated dispenser cathodes which are used in microwave tubes for applications in radar, satellite communications, 7 electronic countermeasures and other uses. Dispenser cathodes, when heated, provide the stream of electrons which are magnetically focused into an electron beam. Microwave frequency signals which interact with this beam of electrons are substantially increased in power. Microwave dispenser cathodes are primarily composed of a porous tungsten matrix impregnated with ceramic oxide compounds. Samarium Cobalt Permanent Magnets. The Company's samarium cobalt magnets are sold as components primarily for microwave tube applications. Electron beams in microwave tubes generated by the dispenser cathodes described above can be controlled by the magnetic force provided by these powerful permanent magnets. The magnets are generally small sub-components of microwave traveling wave tubes. Precision Ceramics. Ceradyne produces a wide variety of hot pressed Ceralloy(R) ceramic compositions, precision diamond ground to close tolerances, primarily for microwave tube applications. The interior cavities of microwave tubes often require ceramic components capable of operating at elevated temperatures and in high vacuums. Automotive Market Internal Combustion and Diesel Engine Components. The demand for higher performance, more efficient and more durable engines for heavy duty diesel trucks and automobiles creates additional opportunities for advanced technical ceramics. For instance, the Company believes that if engines could be produced using certain advanced technical ceramic components, they could be lighter and longer lasting than those using metal components and could operate at higher temperatures, with reduced cooling and lubrication requirements. As a result, engines would use less fuel, achieve more complete combustion, thereby reducing emissions, and be less costly to maintain. Because of these potential benefits, industry-wide efforts are being made to develop advanced technical ceramic technology to replace critical steel components in diesel and automobile engines. Ceradyne has provided a number of prototype parts made of Ceralloy(R) 147 SRBSN materials for evaluation and testing in internal combustion and diesel engines. In the fourth quarter of 1998, the Company received a letter of intent for the production of diesel engine components made from Ceradyne's Ceralloy 147-31N sintered reaction bonded silicon nitride (SRBSN). Production is expected to begin in the second quarter 1999 and shipments are expected to be $1 million during the first 12 months after shipments commence. Contingent upon Ceradyne's 1999 performance, including meeting certain customer quality and delivery milestones, the Company expects to receive orders for significantly higher volumes in the future. Also, Ceradyne is engaged in a joint development program with Ford to develop ceramic components for automobile engines. Ford is not obligated to purchase any minimum quantities of components developed under this program, and Ceradyne's efforts in this area are still in the experimental stage with future success greatly dependent on achieving cost reductions while maintaining high quality levels. See "Certain Factors That May Affect the Company's Business and Future Results". Other Utilizing its advanced technical ceramics technologies and facilities, the Company also manufactures a number of other products related to the foregoing markets, such as dispenser cathodes for ion laser applications, samarium cobalt permanent magnets for motors and instruments, and other precision advanced technical ceramics. None of these products provide a material amount of revenue to the Company. 8 Marketing and Customers Each of Ceradyne's three manufacturing locations maintains an autonomous sales and marketing force promoting their individual products. The Company has more than 10 employees directly involved in marketing and has agreements with manufacturers' representatives in the United States and other countries who are compensated as a percent of sales in their territory. Ceradyne is focusing much of its marketing effort outside the United States through direct involvement of senior management personnel from the Company's U.S. facilities in concert with local manufacturing representatives. Revenues from export sales represented approximately 20% of total net sales in 1996, 20% in 1997 and 16% in 1998. Generally, the Company sells components to contractors or original equipment manufacturers. To a lesser extent, Ceradyne sells its products directly to the end user. The Company sells its translucent ceramic orthodontic brackets only to 3M/Unitek pursuant to an exclusive marketing agreement with that customer. See "Certain Factors That May Affect the Company's Business and Future Results". For fiscal year 1996, DLA Finance Center, which purchases Ceradyne armor from the Company, accounted for approximately 17% of net sales. For fiscal year 1997, 3M/Unitek accounted for approximately 17% of net sales. For fiscal year 1998, 3M/Unitek accounted for approximately 16% of net sales, and CPI, which purchases microwave cathodes, accounted for approximately 11% of net sales. The Company continues to explore various domestic and international marketing, and other relationships to increase its sales and market penetration. Furthermore, Ceradyne is attempting to create long-term relationships with its customers to promote a smoother, more predictable flow of orders and shipments by entering into multi-year agreements or exclusive relationships where possible. Manufacturing Processes Ceradyne has a number of manufacturing processes which are dedicated to specific products and markets. These processes and the product applications are described below. Hot Pressing. The Company's hot pressing process is generally used to fabricate ceramic shapes for lightweight ceramic armor and semiconductor equipment components. Ceradyne has developed and constructed induction heated furnaces capable of operating at temperatures exceeding 4000F in inert atmospheres at pressures up to 5000 lbs. per square inch. This equipment enables Ceradyne to fabricate parts more than 26 inches in diameter, which is considered large for advanced technical ceramics. Through the use of multiple cavity dies and special tooling, the Company can produce a number of parts in one furnace during a single heating and pressing cycle. Ceradyne procures its raw materials (fine powders) from several outside suppliers. After processing by the Company, the powders are either loaded directly into the hot pressing molds or are shaped into preforms prior to loading into the hot pressing molds. The powders are placed in specially prepared graphite tooling, most of which is produced by Ceradyne. Heat and pressure are gradually applied to the desired level, carefully maintained and finally reduced. The furnace is removed from the press while cooling to permit the press to be used with another furnace. For most products, approximately 20 hours are required to perform this cycle. The resultant ceramic product generally has mechanical, chemical and electrical properties of a quality approaching that only theoretically obtainable. Almost all products are then finished by diamond grinding to meet precise dimensional specifications. 9 Sintering of Fused Silica Ceramics. Sintering of fused silica ceramics is the process Ceradyne uses to fabricate fused silica ceramic shapes for applications in glass tempering furnaces, metallurgical tooling and other industrial uses. To fabricate fused silica ceramic shapes, fused silica powders are made into unfired shapes through slip casting or other ceramic compaction processes. These unfired "green" shapes are fired as they move through a continuously operated 150 foot long tunnel kiln at temperatures up to 2500 degrees F. The final shapes are often marketed in the "as fired" condition or, in some cases, precision diamond ground to achieve specific dimensional tolerances or surface finishes required by certain customers. See "Business, Manufacturing Processes- Diamond Grinding". Ceramic-Impregnated Dispenser Cathode Fabrication. Ceramic-impregnated dispenser cathode fabrication is used to produce cathodes for microwave power tube applications. To produce ceramic-impregnated dispenser cathodes, both tungsten metal powders and ceramic powders are used. The tungsten metal powders are isostatically pressed in polymer tooling, removed and fired in special atmospheres at temperatures in excess of 4000 degrees F. The tungsten billets are machined into precision shapes with exacting tolerances. The tungsten machined shapes are impregnated with a ceramic composite and fired at high temperatures in special atmospheres. The ceramic impregnated components are assembled and furnace brazed. Final processing includes the insertion of a metal heating element within a ceramic insulating compound and the addition of an extremely thin layer of precious metals to the surface. The Company's final quality inspection often includes a test of the cathode's electron emitting capabilities at normal operating temperatures. Sintering and Reaction Bonding of Silicon Nitride. The Sintering of reaction bonding silicon nitride results in the Company's Ceralloy(R) 147 SRBSN, which is used in industrial and automotive applications. Ceradyne SRBSN is based on technology acquired from Ford. See "Strategic Relationships". This SRBSN process begins with relatively inexpensive high purity elemental silicon (Si) powders, which contrasts sharply with most other competitors manufacturing techniques which start with relatively more expensive silicon nitride (Si3N4) powders. After additives are incorporated by milling and spray drying, the silicon powders are formed into shapes through conventional ceramic processing such as dry pressing. These shapes are then fired in a nitrogen atmosphere which converts the silicon part to a silicon nitride part. At this step (reaction bonding), the silicon nitride is pressure sintered in an inert atmosphere increasing the strength of the component three fold. As a result of SRBSN processing, the ceramic crystals grow in an intertwining "needle-like" fashion which the Company has named NeedleLok(TM). Ceradyne's NeedleLok(TM) structure results in a tough, high fracture energy part. The process is economical due to the low cost of the starting powders and can be used to produce extremely high production volumes of parts due to the use of conventional pressing processes. Fabrication of Translucent Ceramics (Transtar(R)). Ceradyne produces translucent aluminum oxide (Transtar(R)) components primarily for use as orthodontic ceramic brackets. The high purity powders are purchased from outside vendors and processed by dedicated conventional ceramic mechanical dry presses. The formed blanks are then fired in a segregated furnace in a hydrogen atmosphere at 1800 degrees C until the ceramics enter to a strong translucent condition. These fired aesthetic appearing brackets then have certain critical features diamond ground into them. The final step is a proprietary treatment of the bonding side in order to permit a sound mechanical seal when bound to the patient's teeth. Diamond Grinding. Many of Ceradyne's advanced technical ceramic products must be finished by diamond grinding because of their extreme hardness. The Company's finished components typically are machined to 10 tolerances of +/- .001 inch and occasionally are machined to tolerances up to +/- .0001 inch. To a limited extent, the Company also performs diamond grinding services for customers independently of its other manufacturing processes to specifications provided by the customer. The Company's diamond grinding department can perform surface grinding, diameter grinding, ultrasonic diamond grinding, diamond lapping, diamond slicing and honing. The equipment includes manual, automatic and computer numerically controlled (CNC) grinders. The CNC grinders have been specially adapted by the Company for precision grinding of ceramic contours to exacting tolerances. Fabrication of Samarium Cobalt Permanent Magnets. The fabrication of samarium cobalt permanent magnets results in various magnet shapes which are primarily used in microwave tube applications. The Company procures premixed samarium cobalt powder either as SmCo5 or Sm2Co17 compositions. The powders are then milled and formed into the final configuration by pressing in a magnetic field using a specially designed magnet press. These "pre-fire" or "green" magnets are then sintered at 2000 degrees F in helium or vacuum. The magnets may then be subsequently diamond ground and characterized as to each individual magnet's strength. Raw Materials. The starting raw materials for Ceradyne's manufacturing operations are generally fine, man-made powders available from several domestic and foreign sources. The raw materials, such as Kevlar(TM), graphite, metal components and ceramic powders are readily available from several commercial sources. Quality Control. Ceradyne products are made to a number of exacting specifications. In order to meet both internal quality criteria and customer requirements, the Company has implemented a number of quality assurance and in- process statistical process control programs. These quality programs are implemented separately at each of Ceradyne's three manufacturing locations. Thermo Materials Division in Scottdale, Georgia received its ISO 9002 Certification in 1997. Advanced Ceramic Operations in Costa Mesa, California received its ISO 9001 Certification in 1998. Engineering and Research Ceradyne's engineering and research efforts consist primarily of application engineering in response to customer requirements and to a new Research and Development Department to focus on new materials technology. These efforts are directed to the creation of new products, the modification of existing products to fit specific customer needs, or the development of enhanced ceramic process technology. The Company is also engaged in internally-funded research to improve and reduce the cost of production and to develop new products. Costs associated with application engineering and internally-funded research are generally expensed as incurred and are included in cost of product sales. Costs associated with Company-funded research were approximately $400,000 in 1996, $380,000 in 1997 and $728,000 in 1998. The 1998 total consists of $344,000 from the Research and Development Department, and $384,000 from the Application Engineering Department. Competition Ceradyne competes on the basis of product performance, material specifications, application engineering capabilities, customer support, reputation and price. Competitive pressures vary in each specific product market, depending on the product and program. In many instances, the competitors are well-known companies with greater financial, marketing and technical resources than Ceradyne. Ceradyne intends to continue to focus on selected business areas in which it can exploit its technological, manufacturing and 11 marketing strengths. Some of Ceradyne's competitors often are divisions of larger companies with each of Ceradyne's product lines subject to completely different competitors. Some of the competitors of the Company include Kyocera Corporation's Industrial Ceramics Group, Vesuvius, Mc Danel Refractories, Cercom, Coors Ceramics Company, Spectromat, and others. In many applications the Company also competes with manufacturers of non-ceramic materials. For future automotive applications, there is a wide range of both current and potential domestic and international competitors. See "Certain Factors That May Affect the Company's Business and Future Results". Backlog Ceradyne records an item as backlog when it receives a contract or purchase order indicating the number of units to be purchased, the purchase price, specifications and other customary terms and conditions. Ceradyne customarily includes unexercised options as a separate item in its backlog because the purchase orders are given on the basis of the total order, including options. Total backlog as of December 31, 1998 was approximately $17.0 million, consisting of $13.9 million of firm scheduled orders and $3.1 million of unexercised options. As of December 31, 1997 total backlog approximated $18.6 million consisting of $14.4 million of firm scheduled orders and $4.2 million of unexercised options. Typically, firm orders are scheduled to be shipped within 12 to 18 months from receipt of order. Patents, Licenses and Trademarks The Company relies primarily on trade secrecy to protect compositions and processes that it believes are proprietary. In certain cases, the disclosure of information concerning such compositions or processes in issuing a patent could be competitively disadvantageous. However, management believes that patents are important for technologies where trade secrecy alone is not a reliable source of protection. Accordingly, Ceradyne has applied for, or has been granted, several United States patents relating to compositions, products or processes that management believes are proprietary, including lightweight ceramic armor. Two U.S. patents have been issued to the Company relating to translucent ceramics for orthodontic brackets. The earliest of these patents expires in 2007. These patents are co-invented and co-owned by Ceradyne and 3M/Unitek. Ceradyne and 3M/Unitek have granted licenses to eight companies whose ceramic orthodontic brackets infringe the Ceradyne-3M/Unitek patents, wherein those companies pay royalties to Ceradyne and 3M/Unitek based on sales of their orthodontic ceramic brackets for the remaining life of the patents. See "Certain Factors That May Affect the Company's Business and Future Results", and "Strategic Relationships". Ceradyne has been issued two U.S. patents and has one patent pending relating to its CRT ceramic-impregnated dispenser cathode and has applied for corresponding foreign patents in various foreign countries. The earliest of these patents expires in 2006. Through its association with Ford, Ceradyne acquired in excess of 80 U.S. patents, of which 19 are still active, and corresponding foreign patents and applications relating to technical ceramics for automotive technology. The last of these patents will expire in August 2007. See "Strategic Relationships". "Ceralloy(R)," the name of Ceradyne's technical ceramics, "Ceradyne(R)" and the Ceradyne logo, comprising the stylized letters "CD(R)", are major trademarks of the Company which have been registered in the United States and various foreign countries. The Company also has other trademarks, including "Transtar(R)", "Semicon(R)", "Thermo(R)", "Isomolded(R)" and "NeedleLok(TM) ". 12 Employees At December 31, 1998, Ceradyne employed approximately 300 persons, including 14 employees with undergraduate or graduate degrees in ceramic engineering. Management considers its employee relations to be excellent. The Company has not experienced difficulty in attracting personnel. None of the Company's employees are represented by a labor union. Certain Factors That May Affect the Company's Business and Future Results This annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results may differ materially from the results projected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, the following: We Have a History of Losses Although We Have Been Profitable Since Fiscal Year 1995 We were profitable in fiscal 1995, 1996, 1997 and 1998, after losing approximately $21.4 million during fiscal years 1987 through 1994. A number of factors caused our losses. Foremost was a decline in revenues due in part to reduced government spending on defense-related products. In the past, these products represented the majority of our business. We expect defense-related products to represent a substantial portion of our business in the foreseeable future. Therefore, future declines in government defense-related expenditures may adversely affect our future profitability. Past losses were also caused by declines in sales of our translucent ceramic orthodontic bracket, from peak revenues of $6.2 million in 1988 to $.4 million in 1994. Sales of this bracket declined in part because our exclusive bracket distributor, Unitek Corporation, a subsidiary of Minnesota Mining & Mfg. Co., had accumulated excess inventory levels. Sales also declined because technical problems caused some orthodontists to resist using earlier versions of the bracket. To maintain profitability and achieve revenue growth, we must, among other things: . develop the capacity to manufacture ceramic body armor in volume and to address other opportunities for the use of our ceramics in armor applications . sell significant amounts of the newest version of our translucent orthodontic bracket product, marketed by Unitek under the brand name "Clarity"; . develop the capacity to successfully manufacture semiconductor equipment components in volume and at acceptable profit margins; and . continue to upgrade our technologies and commercialize products and services incorporating such technologies. If we do not successfully manage the factors that led to our losses, if we fail to develop, manufacture and market profitable, high-quality ceramic products, or if factors beyond our control reduce sales or profitability, we may not improve, or even sustain, our current profitability. 13 We Must Successfully Develop and Market New Products; We have Limited Volume Manufacturing Experience for Products Under Development Our future prospects will depend to a large extent on the success of products which currently provide little revenue or which remain under development. These products include: . semiconductor equipment components; . lightweight ceramic armor vests for military personnel; and . ceramic components for automobile and diesel engines. We are developing ceramic automotive and diesel engine components based on our belief that a significant market for these products will emerge. However, predicting future demand for such components is fraught with uncertainties. This is a new and evolving market and advanced technical ceramics are not currently used in any significant automotive applications. It is possible that such applications will never emerge. Even if a market emerges, our efforts to produce ceramic components for automobile and diesel engines remain in the experimental stage. To successfully produce these components, we must significantly lower manufacturing costs and develop high volume manufacturing capabilities while maintaining component quality. If we meet our production goals, it typically takes several years to introduce new materials and components into production automobiles. Thus, demand for these products and our ability to service such demand are subject to a high degree of uncertainty. Nevertheless, we believe that such a market will emerge eventually and that we will be well-positioned to capitalize on it. We have received a letter of intent for the production of diesel engine components made from Ceradyne's Ceralloy 147-lN sintered reaction bonded silicon nitride (SRBSN). We expect to begin production late in the first quarter of 1999 and to ship approximately $1 million annually starting in the second quarter of 1999. Contingent upon our 1999 performance, including meeting certain customer quality and delivery milestones, we anticipate significantly higher sales volumes in the year 2000 and beyond. Failure to Manage Our Growth Could Adversely Affect Us Our current introduction of new products is placing, and will continue to place, a significant strain on our resources and personnel. To continue our growth, we must introduce new products that apply our core advanced technical ceramic technologies. Managing this transition to new products will strain our operational, financial and managerial resources into the foreseeable future. To effectively manage growth, particularly given the increasingly international scope of our operations, we must: . add manufacturing capacity and personnel; . continue to implement and improve our operational, financial and management information systems; . develop the management skills of our managers and supervisors; . add new management personnel and improve the expertise of existing management personnel; and . train, motivate and manage our employees. 14 Any failure to effectively manage growth could have material adverse effects on our business, operating results and financial condition. We Depend on Joel P. Moskowitz and Our Other Key Personnel Our success largely depends on the continued service of our principal managers. Many of these managers, and in particular Joel P. Moskowitz, who is Chairman, Chief Executive Officer and President, and a principal stockholder of Ceradyne, would be extremely difficult to replace. We also depend on other key personnel, and our ability to attract, motivate and retain highly qualified personnel. Competition for skilled employees is intense and there can be no assurance that we will be able to recruit and retain such personnel. In addition, although Mr. Moskowitz has an employment agreement with us that expires in July 1999, no other employee has an agreement for a specified term of employment with Ceradyne. If we are unable to retain our existing managers and employees or hire and integrate new employees, it could have material adverse effects on our business, operating results and financial condition. The Advanced Technical Ceramics Markets Are Highly Competitive The markets for applications of advanced technical ceramics are competitive. We believe the principal competitive factors in these matters are: . product performance; . material specifications; . application engineering capabilities . customer support . reputation; and . price At present, while we believe that we compete favorably with respect to these factors, this may change. If we fail to address our competitive challenges, there could be material adverse effects on our business, financial condition and results of operations. Our competitors include divisions of larger companies and manufacturers of non- ceramic materials. Many of these competitors, both domestic and international, have greater financial, marketing and technical resources than we do. Our primary competitors include Kyocera Corporation's Industrial Ceramics Group, Vesuvius, McDanel Refractories, Cercom, Coors Ceramics Company, Spectromat, and others. No only do we compete with many large companies, but each of our product lines competes with completely different companies. We cannot guaranty that we will be able to compete successfully against our current or future competitors or that competition will not have material adverse effects on our business, operating results and financial condition We Could Be Liable for Violations of Environmental Laws and Regulations We are subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous materials used to manufacture our products. Authorities could impose fines, suspend production, alter our manufacturing processes, or stop our operations if we do not comply with these regulations. 15 In the past, we produced certain products using beryllium oxide, which is highly toxic in powder form. This powder, if inhaled, can cause chronic beryllium disease in a small percentage of the population. In recent years, we have been sued by former employees and a family member of a former employee alleging that they had contracted chronic beryllium disease as a result of exposure to beryllium oxide powders used in our products. We settled several of these claims without incurring material liability, but several lawsuits are still pending. We cannot guaranty that we will avoid future liability to persons who allege that they contracted chronic beryllium disease as a result of exposure to beryllium oxide utilized by Ceradyne. While we believe we are in material compliance with all applicable environmental statutes and regulations, any failure to comply with current or subsequently enacted statutes and regulations could subject us to liabilities, fines or the suspension of production. Furthermore, claims asserted against us related to exposure to beryllium oxide powder may not be covered by insurance. Even if covered, the amount of insurance may be inadequate to cover any adverse judgment. Fines and other punishments imposed in connection with environmental violations and expenses related to remediation or compliance with environmental regulations and future liability for incidences of chronic beryllium disease contracted by employees could have material adverse effects on our business, operating results and financial condition. We were recently notified by the United States Environmental Protection Agency that Ceradyne is a responsible party in the federal Superfund cleanup of the Casmalia Disposal Site located in Santa Barbara County, California. The notification states that Ceradyne, along with approximately 10,000 other companies, has been designated as a de minimus waste generator due to the relatively small quantity of the waste disposed at the Casmalia Disposal Site. We properly disposed of this waste material in the 1970s and 1980s. However, waste materials disposed at the Casmalia Disposal Site have leaked into the water table. Under federal law, all parties who have disposed of waste materials at the Casmalia Site must pay their proportional share of the cost of the cleanup effort. In the fourth quarter of 1998, we recorded an expense in the amount of $0.2 million as the estimated amount of our share of the cleanup costs. We are currently investigating whether we are entitled to reimbursement for this cost under our insurance policies. We Depend Upon Sales to Agencies of the United States Government; We Face the Risk That a Key Government Contract May be Terminated We have a $17.0 million backlog of orders as of December 31, 1998. Of this amount, approximately $8.5 million, or 50%, represents orders for defense applications. These orders are closely tied to the level of U.S. defense spending. Certain contracts for helicopter armor are directly or indirectly with agencies of the United States government. Moreover, we anticipate that a significant percentage of our revenues for the foreseeable future will derive from direct or indirect sales to government agencies. In recent years, the budgets of many government agencies have been reduced, causing some of our customers and potential customers to re-evaluate their needs. However, this trend was partially arrested in the first quarter of 1998. A U.S. government agency selected Ceradyne to provide certain ceramic armor products over a 5-year period. We received our first production order under this program in October 1998 in the amount of $2.4 million. The government has indicated that it may order as much as $100 million or more in products from us over the 5-year life of this program, but there is no minimum amount that the government is required to purchase and all orders are at the full discretion of the government. 16 Under U.S. law, defense-related contracts may be canceled by the government for convenience at any time and without cause. If that happens, we receive reimbursement only for the expenses we actually incurred. Any such cancellations could have material adverse effects on our business, operating results and financial condition. Sales of our Ceramic Orthodontic Brackets Depend on Our Exclusive Marketing and Sales Relationship with Unitek We developed our translucent ceramic orthodontic bracket pursuant to a joint development agreement with Unitek. We sell this product only to Unitek pursuant to an exclusive marketing agreement which expires in 2007. Consequently, our sales of this product depend entirely on Unitek's marketing and sales efforts. We also depend on customer and technical feedback from Unitek for the design of improvements to the bracket. Some orthodontists were reluctant to use early versions of this product. They preferred using traditional stainless steel brackets and were wary of certain technical problems associated with earlier versions of our ceramic bracket. These problems included: . difficulty in removing, or debonding, the bracket from the tooth; . breakage of brackets during the treatment process more often than experience with stainless steel brackets; and . slower movement of the metal arch wire through the ceramic brackets, resulting in longer treatment times than with stainless steel brackets. Designs introduced in October 1996 under the Unitek brand name "Clarity" are intended to improve certain features of earlier versions of the bracket, but we cannot guaranty that these new products will completely eliminate the aforementioned problems or will receive wide market acceptance. Furthermore, we cannot guaranty that Unitek will devote substantial marketing efforts to sales of our orthodontic products, or that Unitek will not reassess its commitment to our technologies or develop its own competitive technologies. If Unitek fails to actively market our orthodontic brackets, or such brackets fail to achieve market acceptance, there may be material adverse effects on our business, operating results and financial condition. We Depend on Our International Sales; We are Subject to Risks Associated with Operating in International Markets Shipments to customers outside of the United States accounted for approximately 20% of our sales in 1996, 20% in 1997, and 10% in 1998. We anticipate that international shipments will account for a significant portion of our sales for the foreseeable future. Therefore, the following risks associated with international business activities could have material adverse effects on our performance: . burdens of comply with multiple and potentially conflicting foreign laws and regulations, including export requirements, tariffs and other barriers, health and safety requirements, and unexpected changes in any of the foregoing. . difficulty in obtaining export licenses from the U.S. government; . differences in intellectual property protections; . longer accounts receivable payment cycles; 17 . potentially adverse tax consequences due to overlapping or differing tax structures; . fluctuations in currency exchange rates; and . risks associated with sales to foreign government agencies similar to the risks associated with dealing with U.S. government agencies. We have traditionally invoiced all of our foreign sales in U.S. dollars. Accordingly, we do not currently engage in foreign currency hedging transactions that could protect against the risk of currency fluctuations. This approach could pose risks. If the U.S. dollar were to become more expensive relative to the currencies of our foreign customers, the price of our products in those countries rises and our sales into those countries, or our profitability within those countries, may fall. Future international activity may require that we denominate foreign sales in the local currencies of our customers. In that case, if the U.S. dollar were to become more expensive relative to the currencies of our foreign customers, we would receive fewer U.S. dollars for each unit of foreign currency that we receive when our customers pay us. Therefore, a more expensive U.S. dollar would cause us to incur losses upon the conversion of accounts receivable denominated in foreign currencies. Such losses could harm our results of operations We cannot export some of our products to certain foreign countries without an export license obtained from the U.S. government. We have experienced difficulty in obtaining licenses to export our products to certain countries. Similar difficulties may arise again in the future. If any of the above risks emerge, there may be material adverse effects on our business, operating results and financial condition. We May be Adversely Affected If We Are Unable to Adequately Safeguard Our Intellectual Property or If We Infringe on Other's Intellectual Property We rely on a combination of patents, trade secrets, trademarks, and other intellectual property law, nondisclosure agreements and other protective measures to preserve our proprietary rights to our products and production processes. These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Although we implement protective measures and intend to defend our proprietary rights, there can be no assurance that these efforts will succeed. We may have to litigate within the United States or abroad to enforce patents issued or licensed to us, to protect trade secrets or know-how owned by us or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive and might not bring us timely and effective relief. Furthermore, there can be no assurance that our products or processes are not in violation of the patent rights of third parties, or that any of our patents will not be challenged, invalidated or circumvented. Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we cannot guarantee that any such licenses could be obtained on acceptable terms, if at all. 18 If we fail to adequately protect our intellectual property, or if we face claims for infringement on the intellectual property of third parties, there may be material adverse effects on our business, operating results, and financial condition. Item 2. Properties ---------- The Company serves its markets from three manufacturing facilities across the United States. The Company's Advanced Ceramic Operations, located in Costa Mesa, California, primarily produces armor and orthodontic products, components for semiconductor equipment, and houses the Company's SRBSN research and development activities. The Company's cathode development and production are handled through its Semicon Associates division located in Lexington, Kentucky. Fused silica products, including missile radomes, are produced at the Company's Thermo Materials division located in Scottdale, Georgia. These three facilities comprise approximately 74,000, 35,000 and 85,000 square feet, respectively. The Company's Costa Mesa and Scottdale facilities are held under long-term leases which expire in October 2000 and December 2000, respectively. The Company owns its Lexington, Kentucky facilities. Ceradyne's manufacturing structure is summarized in the following table:
==================================================================================================================================== FACILITY LOCATION PRODUCTS - ------------------------------------------------------------------------------------------------------------------------------------ Advanced Ceramic Operations . Semiconductor Equipment Components Costa Mesa, California . Lightweight ceramic armor Approximately 74,000 square feet . Orthodontic ceramic brackets . Ceralloy(R) 147 SRBSN wear parts . Precision ceramics . Ceralloy(R) 147 SRBSN diesel/automotive engine parts (R&D) ----------------------------------------------------------------------------------------------------------------------------------- Semicon Associates . Microwave ceramic-impregnated dispenser cathodes Lexington, Kentucky . Ion laser ceramic-impregnated dispenser cathodes Approximately 35,000 square feet . Samarium cobalt magnets Thermo Materials . Glass tempering rolls (fused silica ceramics) Scottdale, Georgia . Metallurgical tooling (fused silica ceramics) Approximately 85,000 square feet . Missile radomes (fused silica ceramics) . Castable and other fused silica product ====================================================================================================================================
Item 3. Legal Proceedings ----------------- The Company is, from time to time, involved in various legal and other proceedings that relate to the ordinary course of operating its business, including, but not limited to, employment-related actions and workers' compensation claims. In October 1995 the Company was served with a complaint that was filed by four persons and the spouses of those persons, who are/were employed by one of the Company's customers. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the employees contracted chronic beryllium disease as a result of their exposure, during the course of their employment with the Company's customer, to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $3.0 million for each of the four plaintiffs who were employed by the Company's customer, compensatory damages of $1.0 million each for the two spouses, and punitive damages in the amount of $5.0 million. Based upon information currently available, the Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of 19 the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing a defense subject to a reservation of rights. There can be no assurance, however, that this claim or any of the claims related to exposure to beryllium oxide will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In February 1997 the Company was served with a complaint that was filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic beryllium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing a defense subject to a reservation of rights. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In August 1997 the Company was served with a complaint filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic beryllium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing defense and indemnification subject to a reservation of rights. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In February 1999 the Company was served with a complaint filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic beryllium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. Item 4. Submission of matters to a vote of security holders --------------------------------------------------- Not applicable 20 MANAGEMENT Executive Officers of the Registrant. The executive officers of the Company as of March l, 1999 are as follows:
Name Age Position - ---------------------- --- -------- Joel P. Moskowitz..... 59 Chairman of the Board, President and Chief Executive Officer Earl E. Conabee....... 61 Vice President, and Director of Marketing at Thermo Materials Garry DeBoer......... 62 Vice President, and President of Semicon Associates Howard F. George...... 54 Vice President Finance, Chief Financial Officer and Secretary Donald A. Kenagy...... 57 Vice President, and President of Thermo Materials David P. Reed......... 44 Vice President, and General Manager of Advanced Ceramic Operations
Joel P. Moskowitz co-founded the Company's predecessor in 1967. He served as President of the Company from 1974 until January 1987, and from September 1987 to the present. Mr. Moskowitz currently serves as Chairman of the Board, President and Chief Executive Officer of the Company, which positions he has held since 1983. Mr. Moskowitz currently serves on the Board of Trustees of Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from Alfred University in 1961 and an M.B.A. from the University of Southern California in 1966. Earl E. Conabee joined the Company in July 1985, and has served as Vice President of the Company since June 1986. Mr. Conabee serves as Vice President of Marketing for the Company's Thermo Materials division, where he is responsible for the overall marketing and sales effort for fused silica ceramics. Prior to joining the Company, Mr. Conabee served as General Manager of Ceramatec, a manufacturer of technical ceramics, from 1983 to 1985, and as Director of Refinery Operations for Englehard Minerals Corporation from 1973 to 1983. Mr. Conabee obtained a B.S. in Ceramic Engineering from Alfred University in 1960. Garry DeBoer joined the Company as President of its Semicon Associates Division in September 1997. Mr. DeBoer attended Newark College of Engineering, majoring in Metallurgy. He has spent most of his career in the field of microwave electronics, used primarily in military defense systems and commercial satellite communications. For the past twenty-five years prior to joining the Company, Mr. DeBoer was employed by Varian Associates and Communications and Power Industries in various Senior Technical and Management positions, and also served as Manager of Commercial Products for CPI's Traveling Wave Tube Product Division. 21 Howard F. George joined the Company in December 1995 and serves in the positions of Vice President Finance, Chief Financial Officer, and Corporate Secretary. Prior to joining Ceradyne, Mr. George was Chief Financial Officer of Richmond Technology, Inc. and Chief Operating Officer of its subsidiary, Static Control Services from 1992 to 1995. From 1990 to 1992, Mr. George was Vice President of Finance for Sunset Richards, a subsidiary of Hanson, PLC. Mr. George earned his B.A. degree in Business and Economics in 1970 at California State University Long Beach, and an MBA from Pepperdine University, Malibu in 1980. Donald A. Kenagy joined the Company in December 1986 when the Company acquired Thermo Materials, and has served as Vice President of the Company since July 1991. Mr. Kenagy is currently President of the Company's Thermo Materials division, and as such is responsible for the operations, finances and marketing of Thermo Materials. Mr. Kenagy joined Thermo Materials in 1972. Mr. Kenagy received a B.S. in Ceramic Technology from Penn State in 1963, an M.S. in Metallurgy from the Massachusetts Institute of Technology in 1965, and a Met. Eng. degree from MIT in 1968. David P. Reed joined the Company in November 1983, and has served as Vice President since January 1988. Mr. Reed is responsible for the operations, finances and marketing of the Company's Costa Mesa, California operations. Prior to joining the Company, Mr. Reed served as Manager, Process Engineering for the Industrial Ceramic Division of Norton Co. from 1980 to 1983. Mr. Reed obtained a B.S. in Ceramic Engineering from Alfred University in 1976 and an M.S. in Ceramic Engineering from the University of Illinois in 1978. Officers serve at the discretion of the Board of Directors except for Mr. Moskowitz, who serves pursuant to a five-year employment agreement which expires in July 1999. 22 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder ----------------------------------------------------------------- Matters ------- The Company's Common Stock is traded on the Nasdaq National Market under the symbol CRDN. The following table sets forth for the calendar quarters indicated the high and low closing sale prices per share on the National Market as reported by Nasdaq. As of January 2, 1999, the Company had approximately 529 record holders of its Common Stock.
High Low -------- --------- Year ended December 31, 1998 First Quarter............................... 8 1/8 3 5/8 Second Quarter.............................. 7 1/2 4 1/2 Third Quarter............................... 5 9/16 3 Fourth Quarter.............................. 5 1/8 3 1/8 Year ended December 31, 1997 First Quarter............................... 9 1/8 5 7/8 Second Quarter ............................ 6 3/8 4 1/4 Third Quarter............................... 9 5/8 4 5/8 Fourth Quarter.............................. 6 31/64 3 3/4
The present policy of Ceradyne is to retain earnings for the operation and expansion of its business. Ceradyne has never paid cash dividends, and management does not anticipate that it will do so in the foreseeable future. The Company did not sell any equity securities during the year ended December 31, 1998 that were not registered under the Securities Act of 1933. 23 Item 6. Selected Financial Data ----------------------- Statements of Operations Data: (Amounts in thousands, except per share data) - -----------------------------
Year Ended December 31, ------------------------------------------------ 1998 1997 1996 1995 1994 -------- -------- -------- -------- -------- Net Sales $26,279 $28,693 $28,212 $23,404 $17,996 Cost of product sales 21,292 23,274 21,065 16,948 15,867 ------- ------- ------- ------- ------- Gross profit 4,987 5,419 7,147 6,456 2,099 ------- ------- ------- ------- ------- Operating expenses: Selling 1,494 1,515 1,571 1,492 1,502 General & administrative 3,239 3,660 3,137 2,748 2,535 Research and development 344 -- -- -- -- ------- ------- ------- ------- ------- 5,077 5,175 4,708 4,240 4,037 ------- ------- ------- ------- ------- Income (loss) from operations (90) 244 2,439 2,216 (1,938) Other income (expense): Other income 382 265 1,890 265 366 Interest expense -- (134) (162) (342) (294) ------- ------- ------- ------- ------- Income (loss) before provision (benefit) for income taxes 292 375 4,167 2,139 (1,866) Provision (benefit) for income taxes 10 (1,675) 127 50 ---- ------- ------- ------- ------- ------- Net income (loss) $ 282 $ 2,050 $ 4,040 $ 2,089 (1,866) ======= ======= ======= ======= ======= Basic income (loss) per share $ .04 $ .26 $ .52 $ .32 $ (.30) ======= ======= ======= ======= ======= Diluted income (loss) per share $ .04 $ .26 $ .51 $ .32 $ (.30) ======= ======= ======= ======= ======= Weighted average shares outstanding 8,068 8,035 7,985 6,607 6,238
December 31, ------------------------------------------------ Balance Sheet Data: 1998 1997 1996 1995 1994 - ------------------ -------- -------- -------- -------- -------- Working Capital $15,051 $15,327 $15,892 $13,216 $ 5,053 Total assets 29,493 29,017 28,398 24,880 16,862 Long-term obligations -- -- -- 555 905 Stockholder's equity $27,352 $26,760 $24,440 $19,852 $11,602
24 Item 7. Management's Discussion and Analysis of Financial Condition and Results ----------------------------------------------------------------------- of Operations ------------- Overview The Company's technology was developed primarily for defense and aerospace applications, which have historically represented and continue to represent a substantial portion of its business. Utilizing this historical base, the Company has transitioned over several years to a more balanced product offering, including industrial, consumer, microwave tube products, automotive, semiconductor, and defense applications. The Company's cost of product sales includes the cost of materials, direct labor expenses and manufacturing overhead expenses. The Company's business requires that it maintain a relatively high fixed manufacturing overhead. As a result, the Company's gross profit, in absolute dollars and as a percentage of net sales, is greatly impacted by the Company's sales volume and the corresponding absorption of fixed manufacturing overhead expenses. Furthermore, due to the customized nature of many of its products, the Company is frequently required to devote resources to sustaining engineering expenses, which are also included in cost of product sales and are generally expensed as incurred. 25 Results of Operations The percentage relationships to net sales of certain income and expense items for the three years ended December 31, 1998 are contained in the following table.
Year Ended December 31, -------------------------- 1998 1997 1996 ------ ------ ------ Net Sales 100.00% 100.00% 100.00% Cost of product sales 81.02 81.11 74.67 ------ ------ ------ Gross Profit 18.98 18.89 25.33 ------ ------ ------ Operating Expenses: R&D 1.30 -- -- Selling 5.69 5.28 5.57 General & Administration 12.33 12.76 11.11 ------ ------ ------ 19.32 18.04 16.68 ------ ------ ------ Income from operations (.34) .85 8.65 Other income (expenses): Other income 1.45 .93 6.69 Interest expense -- (47) (.57) ------ ------ ------ 1.45 .46 6.12 ------ ------ ------ Income before provision (benefit) for income taxes 1.11 1.31 14.77 Provision (benefit) for income taxes .04 (5.83) .45 ------ ------ ------ Net income 1.07% 7.14% 14.32% ====== ====== ======
26 Years Ended December 31, 1998 and 1997 Net Sales. Net sales for the year ended December 31, 1998 were $26.3 million, a decrease of $2.4 million, or 8.4%, compared to the prior year. The decrease in sales is primarily related to the Advanced Ceramics Operations in Costa Mesa, California. Lightweight armor sales decreased due to delays in new Government production releases. Wear resistant component sales decreased because of the downturn in capital equipment shipments, and the low price of crude oil reduced the demand for exploration components. Orthodontic bracket sales decreased because the Company's customer increased its inventory levels in 1997 due to the introduction of the new "Clarity" orthodontic bracket, and reduced the level of inventory in 1998 because of "just in time" inventory practices. Structural ceramics for semiconductor equipment decreased from the comparable prior year net sales because of the world-wide downturn in the semiconductor industry. The Company's Semicon Associates Division in Lexington, Kentucky posted a decrease in net sales of approximately $.1 million from the prior comparable period. This was mainly caused by reduced demand for the first three quarters of 1998 (as compared to the same period in the comparable prior year), for dispenser cathodes and samarium cobalt permanent magnets. However, for the 4th Quarter 1998, demand for these products increased over the comparable prior year's fourth quarter due to replacement parts procurement. The Company's Thermo Materials Division in Scottdale, Georgia posted an increase in net sales from the prior comparable period by approximately $.75 million. The increase is due to missile radome shipments that are a result of the prior year pilot production and an increase in fused silica ceramic components due to an aggressive sales effort. Also, and to a lessor extent, net sales increased due to the purchase of the Masrock and Fusil Foam assets and business from Harbison Refractories Company. This was a small asset acquisition that the Company completed in the 4th Quarter of 1998. International sales have and continue to be an important part of the Company's business, representing 16% of the Company's net sales for the period ended December 31, 1998. This compares to 20% of net sales in the comparable prior year period. The decrease was mainly attributable to the Asian downward economic trend in the current year. Gross Profit. The Company's gross profit was $5.0 million, or 19.0% of net sales, for the year ended December 31, 1998, compared to $5.4 million, or 18.9% of net sales, for the comparable prior year. The decrease in gross profit for the year ended December 31, 1998 as compared to the prior year was $.4 million or 8.0%. All of the major product lines at the Company's Advanced Ceramics Operations in Costa Mesa, California had decreases in gross profit as compared to the prior year period due to lower volume and lower capacity utilization resulting in unfavorable overhead absorption. This resulted in a gross profit decrease of $2.3 million as compared to the prior year. Another key element that contributed to the decrease was the charge of approximately $.3 million for start-up costs associated with the semiconductor product line. Gross profit for Semicon Associates in Lexington, Kentucky had an increase of $1.8 million from the comparable prior year period. The reason for the increase was that in the prior year an adjustment of approximately $1.7 million to write off inventory and to reduce inventory carrying amounts to net realizable values was recorded. 27 Gross profit for Thermal Materials in Scottdale, Georgia increased approximately $.4 million from the comparable prior year period. The increase was the result of increased volume, production yields, and greater capacity utilization. Research and Development Expenses. Research and development expenses were approximately $.35 million for the year ended December 31, 1998. The Company established a new research and development department in 1998 to focus on new materials technology. The expenses incurred related to salaries, travel, outside services, materials and small tools. In addition, the Company historically has and continues to engage in application engineering and internally-funded research to improve and reduce the cost of production and to develop new products. The costs associated with application engineering and internally-funded research are generally expensed as incurred and are included in cost of product sales. Selling Expenses. Selling expenses were $1.5 million for the year ended December 31, 1998 and 1997. Increases in direct salaries and travel expenses were offset by a reduction in commission expense for the current year over the prior comparable period. General and Administrative Expenses. General and administrative expenses were $3.2 million for the year ended December 31, 1998, a $.4 million decrease from the prior year. The key elements for the decrease between the years was a non- recurring charge in the prior year of $.2 million related to legal fees associated with a legal settlement, coupled with a favorable settlement with a customer in the current year resulting in net proceeds of $.4 million. The above decreases in expenses from the prior year were offset by a non-recurring charge of $.2 million in the current year's 4th quarter. This charge was the result of written notification from the United States Environmental Protection Agency that the Company was a responsible party in the Superfund cleanup of the Casmalia Disposal Site in Santa Barbara County, CA. The notification states that Ceradyne, along with approximately 10,000 other parties, has been designated as "de minimus" waste generator due to the relatively small quantities of its waste disposal. The Company properly disposed of this waste material in the 1970's and 1980's, however the Casmalia Disposal Site leaked into the water table. Thus the waste generators must pay their share of the cost of the cleanup effort. The Company is investigating its insurance policies for possible reimbursement of this charge. Other Income and Expense. Other income was approximately $.4 million for the year ended December 31, 1998 compared to $.3 million for the prior year. The significant difference for the increase was the reduction of non-operational miscellaneous expense that was incurred in the prior year. Interest Expense. The Company had no interest expense for the year ended December 31, 1998. The prior year had interest expense of $134,000. The reason for the decrease is the payment of all debt outstanding in the prior year. Income Taxes. The Company has recorded $10,000 provision for income tax for the year ended December 31,1998. The Company in the prior year reversed a portion of the previously established valuation allowance, primarily related to net operating losses from prior years to offset tax provisions at statutory rates. The Company has approximately $12.4 million remaining in net operating loss carryforwards for Federal income tax purposes. 28 Net Income. Reflecting all of the matters discussed above, net income was $282,000 (or $.04 per share basic and diluted) for the year ended December 31, 1998 compared to a net income of $2,050,000 (or $.26 per share basic and diluted) for the prior year. Years Ended December 31, 1997 and 1996. Net Sales. Net sales for the year ending December 31, 1997 were $28.7 million, a modest increase of $.5 million, or 1.7%, compared to the prior year. Key elements of the 1997 product mix compared to 1996 reflects the following: Structural ceramics for semiconductor equipment, a virtually new product line, increased from $.l million in 1996 to $2.3 million in 1997. The introduction of "Clarity" orthodontic ceramic brackets resulted in sales of $4.9 million in 1997, a 118% increase over 1996. This increase was due to increasing product acceptance by orthodontists and the requirement by Ceradyne's customer, Unitek (a Division of 3M), to meet its inventory levels. Armor sales decreased to $3.4 million in 1997 from $7.5 million in 1996 due to a decline in lightweight ceramic armor vest shipments caused by the government's decision to not exercise its option for $6.1 million, which lapsed in March 1997. Sales of the company's cathodes for use in television and related uses fell to $.25 million from $1.1 million in 1996. Management believes that the potential for large scale production of its cathodes for television and related applications may not materialize in the near future, if at all. International sales have and are expected to continue to be an important part of the Company's business, representing 20% of the Company's net sales for the period ending December 31, 1997, and is the same percentage as for the prior year. The decrease in international shipments for cathodes for television from the Semicon Associates Division has been offset by an increase of international shipments for fused silica ceramics by the Thermo Materials Division. Gross Profit. The Company's gross profit was $5.4 million, or 18.9% of net sales, for the year ended December 31, 1997, compared to $7.1 million, or 25.3% of net sales, for the year ended December 31, 1996. The decrease in gross profit for the year ended December 31, 1997 as compared to the prior year was $1.7 million or 24.2%. The major reason for the decrease in gross profit was an adjustment of approximately $1.7 million to write off inventory and establish inventory reserves related to product lines at Semicon Associates Division in Kentucky. Management has determined that obsolete inventory in the cathode product line, and the CRT ceramic-impregnated dispenser cathode for television applications, needs to be reserved in the amount of $.8 million. Of this amount, $.5 million relates to inventory related to a contract with a Korean manufacturer and was due to a contract dispute. Also, a write down of $.9 million resulting from net realizable value analyses was recorded in the cathode product line. The Company has shifted production among different product lines and now buys certain assemblies, which were previously manufactured in house, from outside sources. Except for the above adjustments, the gross profit change was slight between the 2 years. The orthodontic ceramic product line had increased gross profit because of a sales volume increase of over 118%, and better process yields over the prior year. The industrial product line also showed improvement in its process yields over the prior year. The above increases were offset by decreases in gross profit by the semiconductor product line which experienced initial start up costs and low production yields. Also, the armor product line had a lower profit margin in 1997 than in 1996 because of sales volume decreases which did not absorb as much of the Company's fixed overhead as in the prior year. 29 Selling Expenses. Selling expenses were $1.5 million for the year ended December 31, 1997, a decrease of $56,000 from the comparable period of the prior year. This decrease was primarily due to reduced commission expense. General and Administrative Expenses. General and Administrative Expenses were $3.6 million for the year ended December 31, 1997, a $483,000 increase from the comparable period of the prior year. The increases were primarily due to legal fees associated with a litigation settlement, and to a write off of an account receivable from a Far East customer. Other Income and Expense. Other income was $265,000 for the year ended December 31, 1997 compared to $1,890,000 for the year ended December 31, 1996. The decrease was mainly attributable to last year's reimbursement of $.2 million from an insurance carrier for legal expenses, and a settlement with an insurance carrier which netted approximately $1.3 million to the Company. Interest Expense. For the year ended December 31, 1997 interest expense was $134,000, a 17.3% decrease over the comparable period of the prior year, primarily attributable to a decrease in debt. Income Taxes. The Company, in conformance with its adopted Statement of Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes", has reversed a portion of the valuation allowance previously established applicable to the net deferred tax asset. The income tax benefit resulting from the reversal results from the Company's recent history of profitable operations. The Company has available net operating loss carryforwards of approximately $11.6 million as of December 31, 1997 for federal income tax purposes. Net Income. Reflecting all of the matters discussed above, net income was $2,050,000 (or $.26 per share) for the year ended December 31, 1997 compared to a net income of $4,040,000 (or $.51 per share) for the prior year. Year 2000 Disclosure. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. These date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. This inability to recognize or properly treat the Year 2000 may cause the company's systems and applications to process critical financial and operational information incorrectly. The Company continues to assess the impact of the Year 2000 issue on its reporting systems and operations. The Company is currently in the process of investigating and determining whether its internal accounting systems and other operational systems are Year 2000 compliant. A new software system which is Year 2000 compliant was installed at the Corporate Headquarters and its Advanced Ceramic Operations located in Costa Mesa, California in 1996. The Company expects to complete the conversion of its internal accounting system at its Kentucky and Georgia divisions to such upgraded software in 1999. The costs associated with these conversions are approximately $150,000. As of February 10, 1999, the conversion plans were underway at the Kentucky and Georgia locations. The estimated completion date is set for May 1, 1999. The Company is taking steps to ensure that all of its customers, suppliers, associates and affiliates will be in compliance with the Year 2000 issue. This process includes a questionnaire confirming the status of compliance with the Year 2000 criteria set forth by the Company. The criteria that the Company will use to determine compliance with the Year 2000 is the accurate processing of date/time information from, into, and between the twentieth and twentieth-first centuries, and the years 1999 and 2000, including leap year calculations that will affect the processing of information, scheduling, manufacturing, and the quality of all products. Also, the Company is in 30 the process of developing a contingency plan to minimize the risks associated with non Year 2000 readiness. This plan is to be completed by 3rd Quarter 1999. The Company is exposed to the following worst case Year 2000 scenario: That several of the Company's customers and suppliers may experience Year 2000 non- compliance issues that affect the Company. However, as the Company does have a wide customer base, and no sole source suppliers, it believes the non-compliance issue to be minimal. However, there can be no assurance that certain of the Company's internal computer systems or networks or those of its key vendors and customers will not be adversely affected by such Year 2000 issues, which could have a material adverse effect on the Company's business, operating results or financial condition. Liquidity and Capital Resources The Company generally meets its operating and capital requirements for cash flow from operating activities and borrowings under its credit facility. In November, 1997 the Company entered into a revolving credit agreement with Comerica Bank. The new credit facility amount remains at $4,000,000 as of year ended December 31, 1998 and no collateral is required of the Company. As of December 31, 1998 there had been no borrowing under the credit facility. Management believes that its current cash and cash equivalents on hand, as well as cash generated from operations and the ability to borrow under the existing credit facility, will be sufficient to finance anticipated capital and operating requirements for at least the next 12 months. Item 7A. Quantitative and Qualitative Disclosure About Market Risk --------------------------------------------------------- SEC Regulation S-K, Rule 3-05 requires expanded disclosure related to market risk. The company as of year ended December 31, 1998 has no debt borrowing and does not intend to borrow in the next twelve months. However, the Company does have assets in cash and cash equivalents, and changes in interest rates would affect earnings on these assets. As of December 31,1998, the Company had $2.9 million in a money market account based upon U.S. Treasury Bonds. The interest on this cash has earned 5.40% APR for year ended December 31, 1998, and this interest has been recorded in the Company's financial statements as part of other income in the amount of $175,000. If the interest rate were to decrease by 10% to 4.86% APR, the effect on other income and cash flow would result in decreases of approximately $18,000. Item 8. Consolidated Financial Statements and Supplementary Data -------------------------------------------------------- The Consolidated Financial Statements and Supplementary Data commence at page 46 of this report and an index thereto in included in Part IV, Item 14 of this report. Item 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure -------------------- Not applicable 31 PART III Item 10. Directors and Executive Officers of Registrant ---------------------------------------------- Information regarding executive officers of the Company is included in Part I of this report. The Directors of the Company are as follows:
Name Age Position - ---------------------- --------- ------------------------------------ Joel P. Moskowitz..... 59 Chairman of the Board, President and Chief Executive Officer Leonard M. Allenstein. 60 Director Richard A. Alliegro... 68 Director Peter Beardmore....... 62 Director Frank Edelstein....... 73 Director Milton L. Lohr........ 73 Director Melvin A. Shader...... 73 Director
Joel P. Moskowitz co-founded the Company's predecessor in 1967. He served as President of the Company from 1974 until January 1987, and from September 1987 to the present. Mr. Moskowitz currently serves as Chairman of the Board and Chief Executive Officer of the Company, which positions he has held since 1983. Mr. Moskowitz currently serves on the Board of Trustees of Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from Alfred University in 1961 and an M.B.A. from the University of Southern California in 1966. Leonard M. Allenstein has served on the Board of Directors of the Company since 1983. Mr. Allenstein has been a private investor and businessman for more than the past five years. Mr. Allenstein was a founder and general partner of Bristol Restaurants, which owns and operates restaurants in the Southern California area, from 1978 until December 1986. Richard A. Alliegro has served on the Board of Directors of the Company since 1992. Mr. Alliegro retired from Norton Company in 1990 after 33 years, where his last position was Vice President, Refractories and Wear, for Norton's Advanced Ceramics operation. He served as President of Lanxide Manufacturing Co., a subsidiary of Lanxide Corporation, from May 1990 to February 1993. Mr. Alliegro currently is the owner of AllTec Consulting, Inc., a ceramic technology consulting firm. Mr. Alliegro obtained B.S. and M.S. degrees in Ceramic Engineering from Alfred University in 1951 and 1952, respectively, and serves as a member of the Board of Trustees of that university. Dr. Peter Beardmore is the director of the Chemical and Physical Sciences Laboratory of Ford Motor Company. He has been associated with Ford since 1966. Dr. Beardmore has a B. MET. in Metallurgy from the University of Sheffield, and a Ph.D. in Metallurgy from the University of Liverpool. Dr. Beardmore was elected to the Board of Directors of the Company in 1996. 32 Frank Edelstein has served on the Board of Directors of the Company since 1984. Mr. Edelstein has been a Vice President of Gordon + Morris Group (a spinoff of Kelso & Company), an investment banking firm, since November 1986. From 1979 to November 1986, he was Chairman of the Board of International Central Bank & Trust Company, which was acquired by Continental Insurance Co. in July 1983. Mr. Edelstein is currently a director of Arkansas Best Corp. and IHOP Corp. Milton L. Lohr served as a director of the Company from 1986 until October 1988, when he resigned to accept a position as Deputy Undersecretary of Defense for Acquisitions. He held that position until May 1989 and was re-elected as a director of the Company in July 1989. Mr. Lohr is currently the President of Defense Development Corporation, a defense-related research and development company. Mr. Lohr previously held the position of Senior Vice President of Titan Systems, a defense-related research and development company, from 1986 to 1988, and was founder and President of Defense Research Corporation, a defense consulting firm, from 1983 to 1986. Mr. Lohr served from 1969 to 1983 as Executive Vice-President of Flight Systems, Inc., a firm engaged in aerospace and electronic warfare systems. Mr. Lohr has over thirty-five years experience in government positions and aerospace and defense management. He currently serves as a panel member of the President's Science Advisory Committee, a member of the Office of the Secretary of Defense, Army Science Board, as well as other ad hoc government related assignments. Melvin A. Shader has served on the Board of Directors of the Company since 1984. Dr. Shader retired in 1991 from TRW, Inc., where he was Vice President, Business Development and Vice President, International at the Space and Defense Sector of TRW, Inc. Dr. Shader had been with TRW, Inc. since 1970. From 1969 to 1970, Dr. Shader was Director of Planning in the Information Network Division of Computer Sciences Corp. From 1954 to 1968, he was an executive with International Business Machines Corp. Directors are elected annually and hold office until the next annual meeting of stockholders and until their successors have been elected and qualified. The Company has agreed to nominate a representative of Ford for election as a director pursuant to an agreement made in March 1986, pursuant to which agreement Ford acquired a total of 1,207,299 shares of the Company's Common Stock. Joel P. Moskowitz and members of his family have agreed to vote a portion of their shares of the Company's Common Stock, if necessary, for the election of Ford's nominee. Dr. Peter Beardmore is Ford's current representative. Officers serve at the discretion of the Board of Directors except for Mr. Moskowitz, who serves pursuant to a five-year employment agreement which expires in July 1999. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and executive officers, and persons who own more than ten percent of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission ("SEC") initial reports of ownership and reports of changes in ownership of Common Stock and other equity securities of the Company. Officers, directors and greater than ten percent shareholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required during the fiscal year ended December 31, 1998, its officers, directors and greater than ten percent beneficial owners complied with all Section 16(a) filing requirements. 33 Item 11. Executive Compensation ---------------------- Summary Compensation Table - -------------------------- The following table shows certain information concerning the compensation of the Chief Executive Officer and five other most highly compensated executive officers of the Company whose aggregate compensation for services in all capacities rendered during the year ended December 31, 1998 exceeded $100,000 (collectively, the "Named Executive Officers"):
Long Term Compensation ------------------------ Annual Compensation Securities --------------------------------------- Underlying Name & Options Principal Position Year Salary Bonus (# of Shares) - ---------------------- -------- ------------ ------------- ------------------------ Joel P. Moskowitz 1998 $228,191 $ 2,920 - Chairman of the 1997 212,988 19,976 - Board, Chief 1996 196,145 35,584 - Executive Officer - and President David P. Reed 1998 $121,295 - 10,000 Vice President 1997 118,056 $24,594 13,500 1996 109,734 26,566 - Howard F. George 1998 $101,062 - 5,000 Vice President 1997 94,300 $ 6,210 - 1996 90,000 6,984 25,000 Earl E. Conabee 1998 $101,220 - 4,000 Vice President 1997 96,731 - 2,000 1996 93,144 - - Donald A. Kenagy 1998 $103,142 - 4,000 Vice President 1997 98,411 - 2,000 1996 94,384 - - Gerhart D. DeBoer(1) 1998 $102,270 - 5,000 Vice President 1997 36,705 - 20,000
(1) Mr. DeBoer's employment with the Company commenced in September 1997. 34 Option Grants in Last Fiscal Year - --------------------------------- The following table sets forth certain information concerning grants of options to each of the Named Executive Officers during the year ended December 31, 1998. In addition, in accordance with the rules and regulations of the Securities and Exchange Commission, the following table sets forth the hypothetical gains or "option spreads" that would exist for the options. Such gains are based on assumed rates of annual compound stock appreciation of 5% and 10% from the date on which the options were granted over the full term of the options. The rates do not represent the Company's estimate or projection of future Common Stock prices, and no assurance can be given that any appreciation will occur or that the rates of annual compound stock appreciation assumed for the purposes of the following table will be achieved.
Potential Realizable Value at Assumed Annual Percent of Rates of Stock Price Total Options Appreciation for Granted to Exercise Option Term(2) Options Granted Employees in Price Expiration ----------------------- Name (# of Shares)(1) Fiscal Year ($/Share) Date 5%($) 10%($) - ---- ---------------- ------------- --------- ---------- --------- --------- Joel P. Moskowitz - - - - - - David P. Reed 5,000 3.9% 3.781 1/27/08 1,895 30,145 5,000 3.9% 3.500 9/04/08 1,000 27,900 Howard F. George 5,000 3.9% 3.500 9/04/08 1,000 27,900 Earl E. Conabee 2,000 1.6% 5.813 3/10/08 7,314 18,534 2,000 1.6% 3.500 9/04/08 4,400 11,160 Donald A. Kenagy 2,000 1.6% 5.813 3/10/08 7,314 18,534 2,000 1.6% 3.500 9/04/08 4,400 11,160 Gerhart D. DeBoer 5,000 3.9% 3.781 1/27/05 7,695 17,945
(1) The per share exercise price of all options granted is the fair market value of the Company's Common Stock on the date of grant. Options have a term of 10 years and become exercisable in five equal installments, each of which vests at the end of each year after the grant date, except for Mr. DeBoer, whose options have a term of seven years and become exercisable in two equal installments, each of which vests at the end of each year after the grant date. (2) The potential realizable value is calculated from the exercise price per share, assuming the market price of the Company's Common Stock appreciates in value at the stated percentage rate from the date of grant to the expiration date. Actual gains, if any, are dependent on the future market price of the Common Stock. 35 Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option - -------------------------------------------------------------------------- Values - ------ The following table sets forth certain information regarding option exercises during the year ended December 31, 1998 by the Named Executive Officers, the number of shares covered by both exercisable and unexercisable options as of December 31, 1998 and the value of unexercised in-the-money options held by the Named Executive Officers as of December 31, 1998:
Value of Unexercised Number of Securities Underlying In-the-Money Options at Unexercised Options at Fiscal Year-End Fiscal Year-End(1) -------------------------------------- ----------------------- No. of Shares Acquired on Value Name Exercise Realized Exercisable Unexercisable Exercisable Unexercisable ----- ------------- -------- ----------- ------------- ----------- ------------- Joel P. Moskowitz - - - - - - David P. Reed 7,000 $19,250 33,200 24,800 $38,125 $3,375 Howard F. George - - 15,000 15,000 - - Earl E. Conabee 5,000 13,750 3,400 5,600 2,625 - Donald A. Kenagy 10,000 27,500 4,400 6,600 6,500 1,875 Gerhart D. DeBoer - - 10,000 15,000 - -
(1) Based upon the closing price of the Common Stock on December 31, 1998, as reported by the Nasdaq National Market ($3.625 per share). 36 Employment Agreement - -------------------- In July 1994, the Company entered into a five-year employment agreement with Mr. Moskowitz, pursuant to which he will serve as Chairman of the Board of Directors, Chief Executive Officer and President of the Company. The agreement provides for a base salary at the rate of $175,000 per year; however, Mr. Moskowitz voluntarily agreed to accept a reduced salary at the rate of $150,000 per year through March 31, 1995 to aid the Company in its cost-cutting efforts. His annual base salary was reinstated to $175,000 as of April 1, 1995, and was increased to $200,000 effective February 12, 1996. Effective February 10, 1997, Mr. Moskowitz' base annual salary was increased to $215,000, and was further increased to $230,000 effective February, 1998. Effective February 9, 1999, the annual base salary was further increased to $242,000. Under the agreement, if Mr. Moskowitz' employment is terminated by the Company (other than as a result of death, incapacity or for "good cause" as defined in the agreement) or if Mr. Moskowitz elects to resign for "good reason" (as defined in the agreement), Mr. Moskowitz will be entitled to receive severance pay in an amount equal to his annual base salary, at the rate in effect on the date of termination, payable on normal pay dates for the remainder of the term of the agreement. "Good reason" includes a "change in control" of the Company, a removal of Mr. Moskowitz from any of his current positions with the Company without his consent, or a material change in Mr. Moskowitz' duties, responsibilities or status without his consent. A "change in control" of the Company shall be deemed to occur if (1) there is a consolidation or merger of the Company where the Company is not the surviving corporation and the shareholders prior to such transaction do not continue to own at least 80% of the common stock of the surviving corporation, (2) there is a sale of all, or substantially all, of the assets of the Company, (3) the stockholders approve a plan for the liquidation or dissolution of the Company, (4) any person becomes the beneficial owner, directly or indirectly, of 30% or more of the Company's outstanding Common Stock or (5) if specified changes in the composition of the Company's Board of Directors occur. Compensation of Directors - ------------------------- Directors are paid fees for their services on the Board of Directors in such amounts as are determined from time to time by the Board. During 1998, a fee of $500 per month plus $1000 for each Board meeting attended was paid to each non- employee director other than the Ford representative, Dr. Beardmore, who did not receive a fee. Compensation Committee Interlocks and Insider Participation - ----------------------------------------------------------- The Board of Directors has established Audit, Compensation and Stock Option Committees. The Compensation Committee's function is to review and make recommendations to the Board regarding executive officers' compensation. This committee is composed of Messrs. Beardmore, Edelstein, Alliegro, Shader and Lohr. The Audit Committee meets with the Company's independent public accountants to review the Company's financial condition and internal accounting controls. This committee is composed of Messrs. Edelstein, Beardmore, Shader and Lohr. The Stock Option Committee is composed of Mr. Moskowitz and Dr. Beardmore. This committee administers the Company's 1994 Stock Incentive Plan and the 1995 Employee Stock Purchase Plan. Dr. Beardmore is serving as Ford's representative on the Board of Directors. 37 Item 12. Security Ownership of Certain Beneficial Owners and Management ------------------------------------------------ The following table sets forth information as of March 3, 1999, regarding the beneficial ownership of the common stock of the Company by (i) each person or group known by the Company to be the beneficial owner of more than 5% of the outstanding shares of common stock, (ii) each of the directors of the Company, (iii) each of the executive officers named in the Summary Compensation Table, and (iv) all current executive officers and directors of the Company as a group. Name of Amount and Nature of Percent Beneficial Owner Beneficial Ownership(1) of Class - ------------------------------- ----------------------- -------- Joel P. Moskowitz 1,163,110 14.4% 3169 Redhill Avenue Costa Mesa, CA 92626 Ford Motor Company 1,207,299 15.0% The American Road Dearborn, MI 48121 Dimensional Fund Advisors, Inc. 466,000 (2) 5.8% 1299 Ocean Ave., 11th Floor Santa Monica, CA 90401 Leonard M. Allenstein 110,000 (3) 1.4% Richard A. Alliegro 19,500 (4) * Earl E. Conabee 24,834 (5) * Dr. Peter Beardmore - - Garhart D. DeBoer 10,000 (6) * Frank Edelstein 40,400 (7) * Donald A. Kenagy 15,595 (8) * Melvin A. Shader 23,000 (9) * Milton L. Lohr 20,000 (10) * David P. Reed 53,667 (11) * Howard F. George 15,557 (12) * 38 All current executive 1,495,663 18.6% officers and directors as a group (12 persons above) * Less than 1% (1) Except as otherwise noted, the beneficial owners have sole voting and investment powers with respect to the shares indicated, subject to community property laws where applicable. (2) Based on information contained in a statement on Schedule 13G dated February 11, 1999, as filed with the Securities and Exchange Commission. As stated in such Schedule 13G, all shares are held on behalf of advisory clients of Dimensional Fund Advisors, Inc., which disclaims beneficial ownership of such shares. (3) Includes 20,000 shares subject to options held by Mr. Allenstein which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (4) Includes 15,000 shares subject to options held by Mr. Alliegro which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (5) Includes 3,400 shares subject to options held by Mr. Conabee which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (6) Includes 10,000 shares subject to options held by Mr. DeBoer which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (7) Includes 22,500 shares subject to options held by Mr. Edelstein which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (8) Includes 14,800 shares subject to options held by Mr. Kenagy which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (9) Includes 10,000 shares subject to options held or will become exercisable within 60 days of by Dr. Shader which are currently exercisable March 3, 1999. (10) Includes 20,000 shares subject to options held by Mr. Lohr which are currently exercisable or will become exercisable within 60 days of March 3, 1999. (11) Includes 34,200 shares subject to options held will become exercisable within 60 days of March by Mr. Reed which are currently exercisable or 3, 1999. (12) Includes 15,000 shares subject to options held or will become exercisable within 60 days of by Mr. George which are currently exercisable March 3, 1999. 39 Item 13. Certain Relationships and Related Transactions ---------------------------------------------- On March 11, 1986, the Company sold 526,316 shares of its Common Stock to Ford Motor Company ("Ford") at a price of $19.00 per share, for a total purchase price of $10,000,000. At the same time, the Company and Ford created a new corporation, Ceradyne Advanced Products, Inc. ("CAPI"), and entered into agreements involving a broad-based technology transfer, licensing and joint development program. Under the agreements, Ford contributed technology and a portfolio of United States and foreign patents relating to technical ceramics to CAPI in exchange for 80% of CAPI's capital stock, and Ceradyne acquired the remaining 20% of CAPI in exchange for $200,000. The technology and patents contributed by Ford were developed in the Ford Research Laboratories over a 15- year period. Under the March 11, 1986 agreements, the Company was granted an option to acquire Ford's 80% interest in CAPI in exchange for an additional 680,983 shares of Ceradyne Common Stock, which the Company exercised effective February 12, 1988. As a result, Ceradyne now owns 100% of CAPI and Ford owns a total of 1,207,299 shares of the Company's Common Stock. The Company and Ford also entered into a joint development agreement which includes a commitment by Ford to contribute up to $5,000,000, on a matching value basis with Ceradyne, for the development by Ceradyne of technical ceramic products oriented towards the automotive market. Through December 31, 1998, Ford has contributed to the Company, on a cost sharing basis, a total of $4.5 million in cash and equipment under this joint development program. So long as Ford continues to own 5%, or more, of the Company's outstanding common stock, Ceradyne has agreed to use its best efforts to cause one person designated by Ford to be elected a member of the Ceradyne Board of Directors and, under certain circumstances in the event the Company issues additional shares of its Common Stock in a public or private transaction, to permit Ford to purchase, at the same price and terms upon which sold by the Company in such transaction, additional shares of Ceradyne Common Stock to enable Ford to maintain its percentage ownership of the Company. In connection with the sale of stock to Ford, Joel P. Moskowitz, Chairman of the Board, Chief Executive Officer and President of the Company, and members of his immediate family agreed to vote shares of the Company's Common Stock owned by them in favor of the election of Ford's nominee to the Board of Directors. However, they may first vote that number of shares that is necessary to assure the election of Joel P. Moskowitz as a director of the Company, and any shares that are not necessary to assure the election of Mr. Moskowitz and a Ford nominee to the Board of Directors may be voted by them without restriction. 40 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K --------------------------------------------------------------- (a) List of documents filed as part of this report: (1) Financial Statements: Page --------------------- ---- Report of Independent Public Accountants 45 Consolidated Balance Sheets at December 31, 1998 and 1997 46-47 Consolidated Statements of Operations for 48 the Years Ended December 31, 1998, 1997 and 1996 Consolidated Statements of Stockholders Equity for 49 the Years Ended December 31, 1998, 1997, and 1996 Consolidated Statements of Cash Flows for the Years ended 50-51 December 31, 1998, 1997 and 1996 Notes to Consolidated Financial Statements 52-64 (2) Financial Statement Schedules: Schedule VIII -- Valuation and Qualifying Accounts 65 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements and Notes thereto. (b) The following reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1998: None (c) List of Exhibits 3.1 Certificate of Incorporation of the Registrant. Incorporated herein by reference to Exhibit 3.1 to the Registrant's Registrant Statement on Form 8-B. 3.2 Bylaws of Registrant. Incorporated herein by reference to Exhibit 3.2 to the Registrant's Form 10-Q Report for the period ended June 30, 1996. 3.3 Amendment to Bylaws of Registrant, adopted April 29, 1996. Incorporated herein by reference to Exhibit 3.3 to the Registrant's Form 10-Q Report for the period ended June 30, 1996. 4.1 Form of Representatives' Common Stock Purchase Warrant. Incorporated herein by reference to Exhibit 4.1 to the Registrant's Registration Statement on Form S-1 (File No. 33-62345). 41 10.1* Ceradyne, Inc. 1983 Stock Option Plan as amended and restated. (Incorporated by reference from Exhibit 10.13 to the Company's Registration Statement on Form S-1 (File No. 2-99930) filed on September 25, 1985 (the "1985 S-1"). 10.2 Lease between Trico Rents and the Registrant dated March 23, 1984, covering premises located at 235 Paularino Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.14 to the Registrant's Registration Statement on Form S-1 (File No. 2-90821). 10.3 Lease covering premises located at 3169-A Red Hill Avenue, Costa Mesa, California dated October 28, 1985. Incorporated herein by reference to Exhibit 10.30 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.4 Stock Sale Agreement between the Registrant and Ford Motor Company dated March 11, 1986. Incorporated herein by reference to Exhibit 10.31 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.5 Agreement between certain shareholders of the Registrant and Ford Motor Company dated March 11, 1986. Incorporated herein by reference to Exhibit 10.32 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10.6 Stock Purchase Agreement between Ceradyne Advanced Products, Inc., the Registrant and Ford Motor Company dated March 11, 1986. Incorporated herein by reference to Exhibit 10.33 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.7 Patent and Technology Transfer Agreement between Ford Motor Company and Ceradyne Advanced Products, Inc. dated March 11, 1986. Incorporated herein by reference to Exhibit 10.34 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.8 License Agreement between the Registrant and Ceradyne Advanced Products, Inc. dated March 11, 1986. Incorporated herein by reference to Exhibit 10.35 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.9 License Agreement between Ford Motor Company and the Registrant dated March 11, 1986. Incorporated herein by reference to Exhibit 10.36 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.10 Joint Development Agreement between the Registrant and Ford Motor Company dated March 11, 1986. Incorporated herein by reference to Exhibit 10.37 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985. 10.11 Lease dated March 31, 1986 covering premises located at 3163 Red Hill Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.45 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 42 10.12 Lease dated August 5, 1986 covering premises located at 225 Paularino Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.46 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.13 Short-form Memorandum of Lease Assignment dated December 15, 1986, and Lease dated June 23, 1980, covering premises located at 3449 Church Street, Scottdale, Georgia. Incorporated herein by reference to Exhibit 10.47 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.14* Amendment dated June 3, 1986 to the Ceradyne, Inc. 1983 Stock Option Plan. Incorporated herein by reference to Exhibit 10.50 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.15* Amendment dated March 16, 1987 to the Ceradyne, Inc. 1983 Stock Option Plan. Incorporated herein by reference to Exhibit 10.51 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.16 Joint Development Agreement dated March 28, 1986 between Unitek Corporation and the Registrant, and First and Second Amendments thereto. Incorporated herein by reference to Exhibit 10.52 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. 10.17* Amendment dated April 30, 1987 to the Ceradyne, Inc. 1983 Stock Option Plan. Incorporated herein by reference to Exhibit 10.56 to the Registrant's Registration Statement on Form 8-B. 10.18* Employment Agreement entered into as of July 5, 1994 by and between Joel P. Moskowitz and the Registrant. Incorporated herein by reference to Exhibit 10.30 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. 10.19* Ceradyne, Inc. 1994 Stock Incentive Plan. Incorporated herein by reference to Exhibit 10.31 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1994. 10.20* Amendment No. 1 to the Ceradyne, Inc. 1994 Stock Incentive Plan. Incorporated herein by reference to Exhibit 4.2 to Registrant's Registration Statement on Form S-8 (File No. 33-61675). 10.21* Ceradyne, Inc. 1995 Employee Stock Purchase Plan. Incorporated herein by reference to Exhibit 4.1 to Registrant's Registration Statement on Form S-8 (File No. 33-61677). 10.22 Amendment No. 2, dated June 5, 1995, to Lease between Trico Rents and the Registrant covering premises located at 235 Paularino Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.32 to the Registrant's Registration Statement on Form S-1 (File No. 33-62345). 43 10.23 Amendment No. 2, dated June 5, 1995, to Lease covering premises located at 3169-A Red Hill Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.33 to the Registrant's Registration Statement on Form S-1 (File No. 33-62345). 10.24 Amendment No. 2, dated June 5, 1995, to Lease dated March 31, 1986 covering premises located at 3163 Red Hill Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.34 to the Registrant's Registration Statement on Form S-1 (File No. 33-62345). 10.25 Amendment No. 2, dated June 5, 1995, to Lease dated August 5, 1986 covering premises located at 225 Paularino Avenue, Costa Mesa, California. Incorporated herein by reference to Exhibit 10.35 to the Registrant's Registration Statement on Form S-1 (File No. 33-62345). 10.26* Amendment No. 2 to the Ceradyne, Inc. 1994 Stock Incentive Plan incorporated herein by reference to Exhibit 10.36 to the Registrant's Annual report on Form 10-K for the fiscal year ended December 31, 1996. 10.27* Amendment No. 3 to the Ceradyne, Inc. 1994 Stock Incentive Plan. Incorporated herein by reference to Exhibit 4.4 to Registrant's Registration Statement on Form S-8 (File No. 333-31679). 10.28* Amendment No. 4 to the Ceradyne, Inc. 1994 Stock Incentive Plan. 21.1 Subsidiaries of the Registrant. Incorporated herein by reference to Exhibit 23.2 to the Registrant's Statement on Form S-1 (File No. 33- 62345). 23.1 Consent of Arthur Andersen LLP. 27.1 Financial Data Schedule. * Each of these exhibits constitutes a management contract, compensatory plan, or arrangement required to be filed as an exhibit to this Report pursuant to Item 14(c) of this Report. 44 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Directors of Ceradyne, Inc.: We have audited the accompanying consolidated balance sheets of Ceradyne, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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 financial position of Ceradyne, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP ARTHUR ANDERSEN LLP Orange County, California March 5, 1999 45 CERADYNE, INC. -------------- CONSOLIDATED BALANCE SHEETS --------------------------- DECEMBER 31, 1998 AND 1997 -------------------------- ASSETS ------ (Amounts in thousands)
1998 1997 ------- ------- CURRENT ASSETS: Cash and cash equivalents $ 2,870 $ 3,569 Accounts receivable, net of allowances of approximately $92 and $179 for doubtful accounts in 1998 and 1997, respectively 4,381 4,685 Other receivables 167 96 Inventories 7,520 7,366 Production tooling 1,104 882 Prepaid expenses and other 880 716 ------- ------- Total current assets 16,922 17,314 ------- ------- PROPERTY, PLANT AND EQUIPMENT: Land 422 422 Buildings and improvements 1,825 1,825 Machinery and equipment 20,664 18,456 Leasehold improvements 1,723 1,629 Office equipment 2,210 2,001 Construction in progress 103 401 ------- ------- 26,947 24,734 Less--Accumulated depreciation and amortization 18,090 16,768 ------- ------- 8,857 7,966 ------- ------- COSTS IN EXCESS OF NET ASSETS ACQUIRED, net of accumulated amortization of $1,908 and $1,751 in 1998 and 1997, respectively 2,009 1,923 ------- ------- OTHER ASSETS, net of accumulated amortization of $618 and $592 in 1998 and 1997, respectively 1,705 1,814 ------- ------- Total assets $29,493 $29,017 ======= =======
The accompanying notes are an integral part of these consolidated balance sheets. 46 CERADYNE, INC. -------------- CONSOLIDATED BALANCE SHEETS --------------------------- DECEMBER 31, 1998 AND 1997 -------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ (Amounts in thousands, except share data)
1998 1997 -------- -------- CURRENT LIABILITIES: Accounts payable $ 1,084 $ 1,197 Accrued expenses: Payroll and payroll related 553 622 Other 234 168 -------- -------- Total current liabilities 1,871 1,987 -------- -------- DEFERRED REVENUE 270 270 -------- -------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY Common stock, $.01 par value: Authorized--12,000,000 shares Outstanding--8,054,838 and 7,963,459 shares in 1998 and 1997, respectively 37,718 37,408 Accumulated deficit (10,366) (10,648) -------- -------- Total stockholders' equity 27,352 26,760 -------- -------- Total liabilities and stockholders' equity $ 29,493 $ 29,017 ======== ========
The accompanying notes are an integral part of these consolidated balance sheets. 47 CERADYNE, INC. -------------- CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 ---------------------------------------------------- (Amounts in thousands, except per share data)
1998 1997 1996 ------- ------- ------- NET SALES $26,279 $28,693 $28,212 COST OF PRODUCT SALES 21,292 23,274 21,065 ------- ------- ------- Gross profit 4,987 5,419 7,147 ------- ------- ------- OPERATING EXPENSES: Selling 1,494 1,515 1,571 General and administrative 3,239 3,660 3,137 Research and development 344 --- --- ------- ------- ------- 5,077 5,175 4,708 ------- ------- ------- Income from operations (90) 244 2,439 ------- ------- ------- OTHER INCOME (EXPENSE): Other income 382 265 1,890 Interest expense --- (134) (162) ------- ------- ------- 382 131 1,728 ------- ------- ------- Income before provision (benefit) for income taxes 292 375 4,167 PROVISION (BENEFIT) FOR INCOME TAXES 10 (1,675) 127 ------- ------- ------- Net income $ 282 $ 2,050 $ 4,040 ======= ======= ======= BASIC INCOME PER SHARE $.04 $.26 $ .52 ======= ======= ======= DILUTED INCOME PER SHARE $.04 $.26 $ .51 ======= ======= =======
The accompanying notes are an integral part of these consolidated statements. 48 CERADYNE, INC. -------------- CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ------------------------------------------------ FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, and 1996 ----------------------------------------------------- (Amounts in thousands, except share data)
Common Stock ------------------- Number Accumulated of Shares Amount Deficit --------- ------- ------------- BALANCE, December 31, 1995 7,715,624 $36,590 $(16,738) Issuance of common stock 25,521 147 --- Exercise of stock options 160,645 401 --- Net Income --- --- 4,040 --------- ------- -------- BALANCE, December 31, 1996 7,901,790 $37,138 $(12,698) Issuance of common stock 37,469 202 --- Exercise of stock options 24,200 68 --- Net Income --- --- 2,050 --------- ------- -------- BALANCE, December 31, 1997 7,963,459 37,408 (10,648) Issuance of common stock 50,179 197 --- Exercise of stock options 41,200 113 --- Net Income --- --- 282 --------- ------- -------- BALANCE, December 31, 1998 8,054,838 $37,718 $(10,366) ========= ======= =========
The accompanying notes are an integral part of these consolidated statements. 49 CERADYNE, INC. -------------- CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 ---------------------------------------------------- (Amounts in thousands)
1998 1997 1996 -------- -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 282 $ 2,050 $ 4,040 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,505 1,361 1,284 Changes in operating assets and liabilities: (Increase) decrease in accounts receivable, net 304 169 (1,095) (Increase) decrease in other receivables (71) 1,301 (1,385) (Increase) decrease in inventories (154) 390 (1,007) Increase in production tooling (222) (344) (172) Increase in prepaid expenses and other assets (324) (1,683) (78) Increase (decrease) in accounts payable (113) (465) 20 Increase (decrease) in accrued expenses (3) (245) 66 Increase in deferred revenue --- 9 --- ------- ------- ------- Net cash provided by operating activities 1,204 2,543 1,673 ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property, plant and equipment (2,213) (2,887) (2,641) ------- ------- ------- Net cash used in investing activities (2,213) (2,887) (2,641) ------- ------- -------
The accompanying notes are an integral part of these consolidated statements. 50 CERADYNE, INC. -------------- - 2 -
1998 1997 1996 ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock, net $ 310 $ 270 $ 548 Net payments on long-term debt --- (1,000) (1,156) ------- ------- ------- Net cash provided by (used in) financing activities 310 (730) (608) ------- ------- ------- Decrease in cash and cash equivalents (699) (1,074) (1,576) Cash and cash equivalents, beginning of period 3,569 4,643 6,219 ------- ------- ------- Cash and cash equivalents, end of period $ 2,870 $ 3,569 $ 4,643 ======= ======= ======= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest paid $ --- $ 134 $ 150 ======= ======= ======= Income taxes paid $ 10 $ 33 $ 177 ======= ======= =======
The accompanying notes are an integral part of these consolidated statements. 51 CERADYNE, INC. -------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ DECEMBER 31, 1998 ----------------- 1. Summary of Significant Accounting Policies ------------------------------------------ a. Principles of Consolidation and Nature of Operations -------------------------------------------------------- The consolidated financial statements include the financial statements of Ceradyne, Inc. (a Delaware Corporation), and its subsidiaries. Ceradyne, Inc. and its subsidiaries are collectively referred to herein as the Company. All significant intercompany accounts and transactions have been eliminated. The Company develops, manufactures and markets advanced technical ceramic products and components for industrial, defense, consumer and microwave applications. The products are sold primarily to industrial, consumer, and defense concerns globally. b. Cash and Cash Equivalents ------------------------- The Company considers all highly liquid investments with an initial maturity of three months or less when purchased to be cash equivalents. c. Accounts Receivable ------------------- The allowance for doubtful accounts includes management's estimate of the amount expected to be uncollectable on specific accounts and unidentified accounts included in accounts receivable. In estimating the potential losses on specific accounts, management relies on in-house prepared analysis and review of other available information. The amounts the Company will ultimately realize could differ from the amounts assumed in arriving at the allowance for doubtful accounts in the accompanying financial statements. d. Inventories ----------- Inventories are valued at the lower of cost (first-in, first-out) or market. The write down of inventory for obsolete items is based on management's estimate of the amount considered obsolete based on specific reviews of inventory items. In estimating the allowance, management relies on its knowledge of the industry as well as its current inventory levels. The amounts the Company will ultimately realize could differ from amounts estimated by management. Inventory costs include the cost of material, labor and manufacturing overhead. The following is a summary of inventories by component:
December 31, ------------------------- 1998 1997 ---- ---- Raw materials $4,098,000 $3,338,000 Work-in-process 2,413,000 3,617,000 Finished goods 1,009,000 411,000 ---------- ---------- $7,520,000 $7,366,000 ========== ==========
52 e. Property, Plant and Equipment ----------------------------- Depreciation and amortization of property, plant and equipment are provided using the straight-line method over the following estimated useful lives: Buildings and improvements 20 years Machinery and equipment 3 to 12 years Leasehold improvements Term of lease Office equipment 5 years Maintenance, repairs and minor renewals are charged to expense as incurred. Repairs and maintenance expense approximated $729,000, $708,000, and $598,000 in 1998, 1997 and 1996, respectively. Additions and improvements are capitalized. When assets are disposed of, the applicable costs and accumulated depreciation and amortization are removed from the accounts and any resulting gain or loss is included in the results of operations. f. Sales Recognition ----------------- Sales are recorded as of the date shipments are made, or goods are accepted by customers for production contracts. g. Deferred Revenue ---------------- In September 1994, the Company finalized an agreement to manufacture and supply a specific cathode to a third party at reduced prices. In consideration for entering into this contract, the Company received a cash fee of $261,000. The fee was deferred in the financial statements and was recognized over the life of the agreement once shipments commence. At December 31, 1997, all of the fee has been recognized. In November 1997, Ford Motor Company contributed $270,000 for the year 1998 to the Joint Product Development Program (see Note 10). The Company fully amortized this amount to revenue during 1998. In October 1998, Ford Motor Company contributed an additional $270,000 for the year 1999 to the Joint Product Development Program. The Company will fully amortize this amount to revenue during 1999. h. Net Income Per Share -------------------- The Company accounts for net income per share in accordance with SFAS No. 128 "Earnings Per Share". Basic net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding plus the effect of any dilutive stock options and common stock warrants using the Treasury stock method. 53 The following is a summary of the number of shares entering into the computation of net income per common and common equivalent share:
December 31, --------------------------------- 1998 1997 1996 --------- --------- --------- Weighted average number of shares outstanding 8,005,000 7,931,000 7,807,000 Dilutive stock options and common stock warrants 63,000 104,000 178,000 --------- --------- --------- Number of shares used in diluted computation 8,068,000 8,035,000 7,985,000 ========= ========= =========
i. Accounting for Long-Lived Assets -------------------------------- As prescribed by Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of," the Company assesses the recoverability of its long-lived assets (including goodwill) by determining whether the asset balance can be recovered over the remaining depreciation or amortization period through projected undiscounted future cash flows. Cash flow projections, although subject to a degree of uncertainty, are based on trends of historical performance and management's estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. There were no impairment charges in any of the three years in the period ended December 31, 1998. j. Deferred Start-up and Preproduction Costs ----------------------------------------- Start-up costs incurred to establish the technological feasibility of a new product to be sold or otherwise marketed are charged to expense in the period incurred. Costs incurred subsequent to establishing technological feasibility but prior to commercial sales to customers are capitalized and amortized over one year from the startup completion date. During the year ended December 31, 1998, $252,000 of deferred startup costs from the semiconductor product line were expensed. In 1998 the Company incurred $188,000 in deferred costs capitalized for the armor vest product line under a new government contract. In September 1998, the Company received a commitment for the initial minimum quantity to be purchased. Statement of Position 98-5 "Reporting on the Costs of Start-up Activities" is effective for the Company's fiscal year beginning January 1, 1999. The effect of adoption will be immaterial to the Company's financial position and results of operations. k. Use of Estimates ---------------- The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates 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. Actual results could differ from those estimates. 54 l. Engineering and Research ------------------------ The costs associated with application engineering and internally-funded research are expensed as incurred and are included in cost of product sales or other operating expenses. The Company established a new research and development department in 1998 to focus on new materials technology. Costs associated with the department approximated $344,000. In addition, the Company has historically and continues to engage in application engineering and internally funded research to improve and reduce the cost of products and to develop new products. Costs associated with Company-funded research were approximately $384,000, $380,000 and $400,000 in 1998, 1997 and 1996, respectively. m. Stock Based Compensation Plans ------------------------------ Effective January 1, 1996, the Company adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". At a minimum, SFAS No. 123 requires the Company to disclose pro forma net income and earnings per share as if the fair value based accounting method of SFAS No. 123 had been used to account for stock-based compensation. These disclosures are included in Note 7. n. Fair Value of Financial Instruments ----------------------------------- The carrying value of accounts receivable and trade payables approximates the fair value due to their short-term maturities. The carrying value of the Company's line of credit is considered to approximate fair market value as the interest rates of these instruments are based predominately on variable reference rates. o. Environmental Liabilities and Expenditures ------------------------------------------ Accruals for environmental matters are recorded in operating expenses when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. In the 4th quarter of 1998, the Company recorded approximately $.2 million as an accrual for the written notification from the United States Environmental Protection Agency that the Company was a responsible party in the Superfund cleanup of the Casmalia Disposal Site in Santa Barbara County, CA. The notification states that Ceradyne, along with approximately 10,000 other parties, have been designated as "de minimus" waste generators due to the relatively small quantities of their waste disposal. The Company properly disposed of this waste material in the 1970's and 1980's, however the Casmalia Disposal Site leaked into the water table. Thus the waste generators must pay their share of the cost of the cleanup effort. The company is investigating its insurance policies for possible reimbursement of this charge. 2. Debt and Bank Borrowing Arrangements ------------------------------------ In November, 1997 the Company terminated its revolving credit agreement with an asset based lender, and entered into a revolving credit agreement with Comerica Bank. The new credit facility amount remains at $4,000,000 and no collateral will be required of the Company. The Company paid off its short-term minimum borrowing requirement debt of $1,000,000 in fiscal year 1997. As of December 31, 1998 there had been no borrowing under the credit facility. 55 3. Income Taxes ------------ The provision (benefit) for income taxes is comprised of the following:
1998 1997 1996 -------- -------- ------- Current $ 10 $ 33 $ 127 Deferred -- (1,708) -- ------- ------- ------- $ 10 $(1,675) $ 127 ======= ======= =======
The Company's deferred tax asset at December 31, 1998 relates primarily to its tax net operating loss carryforwards, which total approximately $12.4 million and expire as follows:
2003 $ 2,242,000 2004 3,015,000 2005 161,000 2006 218,000 2007 1,093,000 2008 2,050,000 2009 1,828,000 2012 1,620,000 2018 177,000 ----------- $12,404,000 ===========
The components of the Company's deferred tax asset as of December 31, 1998 and 1997 are as follows:
December 31, -------------------------- 1998 1997 ----------- ----------- Inventory adjustments $ 246,000 $ 583,000 Contingency reserves 71,000 --- Deferred revenue --- 108,000 Vacation accrual 91,000 112,000 Bad debt allowance 36,000 72,000 Net operating loss and tax credit carryforwards 4,961,000 4,630,000 Other (81,000) (83,000) ----------- ----------- 5,324,000 5,422,000 Valuation allowance (3,699,000) (3,714,000) ----------- ----------- Net deferred tax asset $ 1,625,000 $ 1,708,000 =========== ===========
Management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax asset as reduced by the valuation allowance. 56 The effective income tax rate for the years ended December 31, 1998, 1997 and 1996 differs from the Federal statutory income tax rate due to the following items:
December 31 ----------------------------------------- 1998 1997 1996 -------- ----------- ----------- Income before taxes $292,000 $ 375,000 $ 4,167,000 -------- ----------- ----------- Provision for income taxes at federal statutory rate 113,000 128,000 1,417,000 Increases (decreases) in tax resulting from: Utilization of net operating loss carryforwards (57,000) (95,000) (1,389,000) Reduction of valuation allowance --- (1,846,000) --- Other, including state taxes (46,000) 138,000 99,000 -------- ----------- ----------- Provision (benefit) for income taxes 10,000 (1,675,000) 127,000 -------- ----------- ----------- Effective tax rate 3.47% (446.67)% 3.05% ======== =========== ===========
4. Commitments and Contingencies ----------------------------- a. Operating Lease Obligations --------------------------- The Company leases certain of its manufacturing facilities under noncancelable operating leases expiring at various dates through March 2001. One of the facility leases is subject to a 4 percent annual escalation clause. The Company incurred rental expense under these leases of $667,000, $620,000 and $596,000 in 1998, 1997 and 1996, respectively. The approximate minimum rental commitments required under existing noncancelable leases as of December 31, 1998 are as follows:
1999 $ 665,200 2000 584,774 2001 16,097 2002 3,610 ---------- $1,269,681 ==========
b. Employment Agreement -------------------- The Company has an employment agreement with the Chief Executive Officer which expires on July 5, 1999. In addition to a base salary, the agreement provides for a bonus to be determined by the Compensation Committee of the Board of Directors. No maximum compensation limit exists. Compensation expense pursuant to this agreement in 1998, 1997 and 1996 was $231,111, $232,964 and $231,729, respectively. c. Legal Proceedings ----------------- The Company is, from time to time, involved in various legal and other proceedings that relate to the ordinary course of operating its business, including, but not limited to, employment-related actions and workers' compensation claims. In October 1995 the Company was served with a complaint that was filed by four persons and the spouses of those persons, who are/were employed by one of the Company's customers. The 57 complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the employees contracted chronic beryllium disease as a result of their exposure, during the course of their employment with the Company's customer, to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $3.0 million for each of the four plaintiffs who were employed by the Company's customer, compensatory damages of $1.0 million each for the two spouses, and punitive damages in the amount of $5.0 million. Based upon information currently available, the Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing a defense subject to a reservation of rights. There can be no assurance, however, that this claim or any of the claims related to exposure to beryllium oxide will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In February 1997 the Company was served with a complaint that was filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic beryllium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing a defense subject to a reservation of rights. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In August 1997 the Company was served with a complaint filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic berylliium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers, some of which are providing defense and indemnification subject to a reservation of rights. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. In February 1999 the Company was served with a complaint filed by a former employee of one of the Company's customers and his wife. The complaint, filed in the United States District Court, Eastern District of Tennessee, alleges that the husband contracted chronic beryllium disease as a result of his exposure to beryllium-containing products sold by Ceradyne. The complaint seeks compensatory damages in the amount of $5.0 million for the husband, $1.0 million for the wife, and punitive damages in the amount of $10.0 million. The Company believes that the plaintiffs' claims are without merit and that the resolution of this matter will not have a material adverse 58 effect on the financial condition or operations of the Company. Defense of this case has been tendered to the Company's insurance carriers. There can be no assurances, however, that this claim will be covered by insurance, or that, if covered, the amount of insurance will be sufficient to cover any potential judgment. 5. Disclosure About Segments of Enterprise and Related Information --------------------------------------------------------------- In June 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosures About Segments of an Enterprise and Related Information". SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments. The company has adopted No. 131 in fiscal 1998, as required. The Company serves its markets and manages its business through three divisions, each of which has its own manufacturing facilities and administrative and selling functions. The Company's Advanced Ceramic Operations, located in Costa Mesa, California, primarily produces armor and orthodontic products, components for semiconductor equipment, and houses the Company's SRBSN research and development activities. The Company's cathode development and production are handled through its Semicon Associates division located in Lexington, Kentucky. Fused silica products, including missile radomes, are produced at the Company's Thermo Materials division located in Scottdale, Georgia. Ceradyne's manufacturing structure is summarized in the following table:
==================================================================================================== FACILITY LOCATION PRODUCTS - ---------------------------------------------------------------------------------------------------- Advanced Ceramic Operations . Semiconductor Equipment Components Costa Mesa, California . Lightweight ceramic armor Approximately 74,000 square feet . Orthodontic ceramic brackets . Ceralloy(R) 147 SRBSN wear parts . Precision ceramics . Ceralloy(R) 147 SRBSN diesel/automotive engine parts (R&D) - ----------------------------------------------------------------------------------------------------- Semicon Associates . Microwave ceramic-impregnated dispenser cathodes Lexington, Kentucky . Ion laser ceramic-impregnated dispenser cathodes Approximately 35,000 square feet . Samarium cobalt magnets - ----------------------------------------------------------------------------------------------------- Thermo Materials . Glass tempering rolls (fused silica ceramics) Scottdale, Georgia . Metallurgical tooling (fused silica ceramics) Approximately 85,000 square feet . Missile radomes (fused silica ceramics) . Castable and other fused silica product =====================================================================================================
59 Ceradyne, Inc. Segment Statement of Operations for the Years Ended December 31, 1998, 1997, and 1996 (amounts in thousands)
Advanced Ceramic Ops Semicon Associates Thermo Materials TOTAL -------------------------- ----------------------- ------------------------ -------------------------- 1998 1997 1996 1998 1997 1996 1998 1997 1996 1998 1997 1996 - ---------------------------------------------------------------------------------------------------------------------------------- Revenue from $14,176 $17,202 $16,190 $5,995 $ 6,134 $6,601 $6,108 $5,357 $5,421 $26,279 $28,693 $28,212 External ------- ------- ------- ------ ------- ------ ------ ------ ------ ------- ------- ------- Customers Depreciation $ 992 $ 843 $ 612 $ 301 293 $ 441 $ 212 $ 225 $ 231 $ 1,505 $ 1,361 $ 1,284 and ------- ------- ------- ------ ------- ------ ------ ------ ------ ------- ------- ------- Amortization Segment Income $ 37 $ 2,356 $ 4,125 $ (114) $(2,045) $ (304) $ 369 $ 64 $ 346 $ 292 $ 375 $ 4,167 (loss) before ------- ------- ------- ------ ------- ------ ------ ------ ------ ------- ------- ------- provision (benefit) for income taxes Segment Assets $19,960 $19,403 $17,171 $6,398 $ 6,362 $8,188 $3,135 $3,252 $3,039 $29,493 $29,017 $28,398 ------- ------- ------- ------ ------- ------ ------ ------ ------ ------- ------- ------- Expenditures $ 1,827 $ 2,306 $ 1,766 $ 272 $ 479 $ 508 $ 114 $ 102 $ 367 $ 2,213 $ 2,887 $ 2,641 for Segment ------- ------- ------- ------ ------- ------ ------ ------ ------ ------- ------- ------- Assets -----------------------------------------------------------------------------------------------------------
Segment Statement for Net Sales by Area for the Years Ended December 31, 1998, 1997, and 1996 (in %)
Advanced Ceramic Ops Semicon Associates Thermo Materials TOTAL ------------------------- --------------------- --------------------- --------------------- 1998 1997 1996 1998 1997 1996 1998 1997 1996 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------------- U.S. Net Sales 47% 53% 51% 18% 14% 14% 19% 13% 15% 84% 80% 80% Western Europe 4% 4% 2% 3% 3% 3% 2% 3% 2% 9% 10% 7% Net Sales Asia Net Sales 1% 1% 3% 2% 4% 6% 1% --- 1% 4% 5% 10% Israel Net 2% 1% 1% --- --- --- --- --- --- 2% 1% 1% Sales Canada Net --- --- --- --- --- --- 1% 1% 1% 1% 1% 1% Sales Other --- 1% 1% --- --- --- --- 2% --- --- 3% 1% ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Total Net Sales 54% 60% 58% 23% 21% 23% 23% 19% 19% 100% 100% 100% ==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ==== --------------------------------------------------------------------------------------------------------------
60 For fiscal year 1998, two customers accounted for approximately 16% and 11% of net consolidated sales. For fiscal year 1997, one customer accounted for approximately 17% of net consolidated sales. For fiscal year 1996, one customer accounted for approximately 17% of net consolidated sales. 6. Comprehensive Income -------------------- Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" which established standards for the reporting and display of comprehensive income and its components in financial statements. Comprehensive income generally represents all changes in stockholder's equity except those resulting from investments by and distributions to owners. Currently, no difference exists between the Company's net income and its comprehensive net income. 7. Stock Options ------------- The Company has a stock option plan, the 1994 Stock Incentive Plan and an employee stock purchase plan, the 1995 Employee Stock Purchase Plan. The Company had a 1985 Employee Stock Purchase Plan which expired on July 31, 1995. The Company accounts for these plans under APB Opinion No. 25, under which no compensation cost has been recognized. Had compensation cost for these plans been determined consistent with FASB Statement No. 123, the Company's net income and earnings per share would have been reduced to the following pro forma amounts:
1998 1997 1996 -------- ---------- ---------- Net Income: As Reported $282,000 $2,050,000 $4,040,000 Pro Forma 97,371 1,888,000 3,794,000 Basic income per share As Reported $ .04 $ .26 $ .52 Pro Forma .01 .24 .49 Diluted income per share As Reported $ .04 $ .26 $ .51 Pro Forma .01 .23 .48
Because the Statement No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years. Additionally, the 1998, 1997 and 1996 pro forma net income include immaterial amounts related to the purchase discount offered under the 1995 Employee Stock Purchase Plan. The Company may sell up to 100,000 shares of stock to its full-time employees under the 1995 Employee Stock Purchase Plan. The Company has sold 24,162, 22,004 and 13,694 shares in 1998, 1997 and 1996, respectively, under the 1995 Employee Stock Purchase Plan. Employees may purchase shares at the lower of 85 percent of the quoted market value of the shares as determined on the first or last day of the plan year. The weighted average fair value of shares sold in 1998, 1997 and 1996 was $3.93, $4.63 and $4.75, respectively. The Company may grant options for up to 650,000 shares under the 1994 Stock Incentive Plan. The Company has granted options for 606,700 shares through December 31, 1998. Options are granted at or above the fair market value at the date of grant and generally become exerciseable over a five-year 61 period. A summary of the status of the Company's stock option plan at December 31, 1996, 1997 and 1998 and changes during the years then ended is presented in the table and narrative below:
Weighted Average Shares Exercise Price --------- ----------------- OUTSTANDING, December 31, 1995 542,200 $ 3.01 ======== ------ Granted 25,000 6.92 Exercised (160,645) 2.74 Canceled (22,505) 2.46 -------- ------ OUTSTANDING, December 31, 1996 384,050 $ 3.56 ======== ------ Granted 139,500 $ 6.14 Exercised (23,900) 2.85 Canceled (33,800) 4.98 -------- ------ OUTSTANDING, December 31, 1997 465,850 $ 4.26 ======== ------ Granted 128,500 $ 1.14 Exercised (41,200) ( .23) Canceled (55,000) (.65) -------- ------ OUTSTANDING, December 31, 1998 498,150 $ 3.98 ======== ======
Of the 498,150 options outstanding at December 31, 1998, 265,550 have exercise prices between $2.00 and $4.375, with a weighted average exercise price of $2.93, and a weighted average remaining contractual life of seven years. The remaining 232,600 options have exercise prices between $4.75 and $7.375, with a weighted average exercise price of $5.76, and a weighted average remaining contractual life of nine years. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 1998, 1997, and 1996, respectively: risk free interest rates of 5.4, 6.38 and 6.29 percent; expected lifes for 1998, 1997 and 1996 of 7 years; expected volatility of 94.87, 57.43 and 57.20 percent. The assumed dividend yield in 1998, 1997 and 1996 is zero percent. 8. Supplemental Retirement Plan ---------------------------- In December 1988 the Board of Directors of the Company approved the adoption of a supplemental retirement plan (Ceradyne SMART 401(K) Plan) in which substantially all employees are eligible to participate after completing 90 days of employment. Participation in the Plan is voluntary. An employee may elect to contribute up to seven percent (7%) of the employee's pretax compensation as a basic contribution. The Company may contribute any amount which the Board of Directors annually determines appropriate. Company contributions fully vest and are nonforfeitable after the participant has completed five years of service. During the years ended December 31, 1998, 1997, and 1996, the related company contribution was approximately $42,000, $116,000, and $117,000, respectively. 62 The Company's contribution is in the form of shares of its common stock. The number of shares to be contributed will be determined by dividing the total Company match for the Plan year by the higher of the market value per share of common stock as of the end of that Plan year (December 31), or the audited book value per share of common stock as of the end of that Plan year. The participants' cash contributions may be invested, at their discretion, in one or all of the following: (1) Fixed Income Fund, (2) Bond and Mortgage Fund, (3) International Stock Fund, or (4) Equity Fund. The member can elect to allocate the accumulated and future contributions to their accounts among these funds in increments of 10 percent. The Company has reserved 250,000 shares of its common stock for possible issuance under the Plan. At December 31, 1998, 125,897 shares were available for issuance under the Plan. 9. Interim Financial Information (unaudited) ----------------------------------------- The results by quarter for 1998 and 1997 are as follows:
Quarter Ending -------------- March 31, June 30, September 30, December 31, 1998 1998 1998 1998 -------------- ------------- ------------- ------------- Net sales $7,341,000 $6,342,000 $6,290,000 $6,305,000 Net income 483,000 326,000 44,000 (571,000) Diluted income per share- $ .06 $ .04 $ .01 $ (.07) ========== ========== ========== ========== Quarter Ending -------------- March 31, June 30, September 30, December 31, 1997 1997 1997 1997 ---------- ---------- ----------- ---------- Net sales $6,621,000 $7,280,000 $7,100,000 $7,692,000 Net income 284,000 759,000 508,000 499,000 Diluted income per share- $ .04 $ .10 $ .06 $ .06 ========== ========== ========== ==========
10. Joint Venture and Joint Development Agreement --------------------------------------------- On March 11, 1986, the Company sold 526,316 shares of its common stock to Ford Motor Company (Ford) for a gross sales price of $10,000,000. In addition, Ford and the Company formed a joint venture, Ceradyne Advanced Products, Inc. (CAPI), in which the Company acquired a 20 percent interest for $200,000. Ford contributed certain technology in exchange for its 80 percent interest in the joint venture. The Company granted Ford an option to put Ford's 80 percent interest in the joint venture to the Company in exchange for 608,020 shares of the Company's common stock. Ford granted the Company an option to call Ford's 80 percent interest in the joint venture in exchange for 680,983 shares of the Company's common stock. 63 On February 13, 1988, the Company exercised its call option and issued 680,983 shares of its common stock to Ford. The value of the shares issued ($2,043,000) was allocated to the technology acquired and is being amortized over a 20 year period utilizing the purchase method of accounting (see Note 1). Ford and the Company have also entered into a joint development program to develop a prototype production facility to produce ceramics with automotive applications. Under the terms of the joint development agreement, Ford and the Company share equally in the cost of this project. For the years ending December 31, 1998, 1997 and 1996, Ford agreed to contribute $270,000, $270,000 and $275,000, respectively, which have been reflected as revenue in the accompanying consolidated financial statements. 64 SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ------------------------------------------------- (Amounts in thousands)
Balance Charged Balance at to Costs at Beginning and End of Description of Period Expenses Deductions Period - ---------------------- --------- -------- ---------- ------- For the Year Ending December 31, 1998: - ---------------------- Allowance for doubtful accounts receivable $179 $ 55 $142 $ 92 ==== ==== ==== ==== For the Year Ending December 31, 1997: - ---------------------- Allowance for doubtful accounts receivable $125 $134 $ 80 $179 ==== ==== ==== ==== For the Year Ending December 31, 1996: - ------------------ Allowance for doubtful accounts receivable $150 $ 0 $ 25 $125 ==== ==== ==== ====
65 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 31, 1999 CERADYNE, INC. By /s/ JOEL P. MOSKOWITZ -------------------------------------------- Joel P. Moskowitz Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ JOEL P. MOSKOWITZ Chairman of the Board, March 31, 1999 - ------------------------- Chief Executive Officer, Joel P. Moskowitz President and Director (Principle executive officer) /s/ HOWARD F. GEORGE Chief Financial Officer March 31, 1999 - ------------------------- (Principle financial Howard F. George and accounting officer) /s/ LEONARD M. ALLENSTEIN Director March 31, 1999 - ------------------------- Leonard M. Allenstein /s/ RICHARD A. ALLIEGRO Director March 31, 1999 - ------------------------- Richard A. Alliegro /s/ FRANK EDELSTEIN Director March 31, 1999 - ------------------------- Frank Edelstein /s/ PETER BEARDMORE Director March 31, 1999 - ------------------------- Peter Beardmore /s/ MELVIN A. SHADER Director March 31, 1999 - ------------------------- Melvin A. Shader /s/ MILTON L. LOHR Director March 31, 1999 - ------------------------- Milton L. Lohr
66 EX-23.1 2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS EXHIBIT 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference in this Form 10-K of our report dated March 5, 1999 included in the previously filed Registration Statement File No. 333-31679 and Registration Statement File No. 33-61677. /s/ ARTHUR ANDERSEN LLP ARTHUR ANDERSEN LLP Orange County, California March 5, 1999 EX-27.1 3 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM 10K - YEAR ENDED DECEMBER 31, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 2,870 0 4,381 167 7,520 16,839 26,947 18,090 29,493 1,871 0 0 0 37,718 0 29,493 26,279 26,279 21,292 21,000 0 0 0 292 10 0 0 0 0 282 .04 .04
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