FORM 10-K

 

United States
Securities and Exchange Commission

 

Washington, DC 20549

 

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

 

For the fiscal year ended December 31, 2009

 

Commission file number 1-11333

Kaydon Corporation

(Exact name of Registrant as specified in its charter)

 

 

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

 

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

 

 

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

 

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

 

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

 

     Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ  No o

 

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  No o

 

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

 

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

     Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 under the Exchange Act).  Yes o     No þ

 

     The aggregate market value of the Registrant’s Common Stock held by non-affiliates of the Registrant on July 4, 2009 (based on the July 2, 2009 closing sales price of $31.87 of the Registrant’s Common Stock, as reported by the New York Stock Exchange on such date) was approximately $1,055,000,000. For purposes of this calculation only, all executive officers and directors of the Registrant are assumed to be affiliates.

 

     Number of shares outstanding of the Registrant’s Common Stock at February 23, 2010:

 

33,536,473 Shares of Common Stock, par value $0.10 per share.

 

     Portions of the Registrant’s definitive Proxy Statement to be filed for its 2010 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report.

 

TABLE OF CONTENTS

 

 

Forward-Looking Statements

 

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

 

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

 

 

General Development of Business

 

Kaydon Corporation (the “Company” or “Kaydon”) is a leading designer and manufacturer of custom engineered, performance-critical products supplying a broad and diverse customer base. At the time of its 1983 incorporation, Kaydon was principally involved in the design and manufacture of bearings and components, as well as filters and filter housings. Since 1984, we have pursued a diversified growth strategy in the manufacturing sector. Our principal products now include bearings and components, filters and filter housings, custom rings, shaft seals, linear deceleration products, specialty balls, fuel cleansing systems, gas-phase air filtration systems and replacement media, industrial presses and metal alloy products. These products are used by customers in a variety of alternative energy, robotics, medical, material handling, machine tool positioning, aerospace, defense, security, electronic and other industrial applications. We perform as an extension of our customers’ engineering and manufacturing functions, with a commitment to identify and provide engineered solutions to design problems through technical innovation, cost-effective manufacturing and outstanding value-added service.

 

We have grown both organically through strategic investments in our business and through acquisitions. In 2007, we acquired all of the outstanding stock of Avon Bearings Corporation (“Avon”) in a cash transaction valued at $54.4 million, net of working capital adjustments recorded in 2008. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings. Avon is included in the Friction Control Products segment for segment reporting purposes.

 

In support of our wind energy growth initiative, during the first half of 2009 we completed our wind energy capacity expansion program. This expansion provides us with a significantly increased capability to supply specialty bearings to wind turbine manufacturers and will help us maintain our leadership position in the supply of specialty bearings. We invested approximately $80 million from 2006 through the completion of this program in 2009. Annual sales to wind energy customers, which are recorded in the Friction Control Products segment, were $103.0 million, $80.5 million, and $32.9 million in 2009, 2008, and 2007, respectively.

 

 

 

Industry Segments

 

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

 

We have three reportable segments and other operating segments engaged in the manufacture and sale of the following:

 

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

 

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

 

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

 

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

 

 

 

KAYDON CORPORATION FORM 10K 1

Net sales related to our three reportable segments and other operating segments during 2009, 2008 and 2007 are set forth in the following table:

 

 

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

 

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

 

We sell our products in each reportable segment through a sales organization consisting of salespersons and representatives located primarily throughout North America, Europe and Asia. Salespersons are trained to provide technical assistance to customers, as well as to serve as a liaison between our factory engineering staffs and our customers. Also, a global network of specialized distributors and agents provides local availability of our products to serve the requirements of customers. In 2009 and 2008, several of our operating units had sales to various business units of the General Electric Company and its affiliates (“GE”) totaling, in aggregate, approximately 19.2 percent and 12.5 percent of total sales, respectively. No other customer accounted for 10 percent or more of our total sales in fiscal 2009, 2008 or 2007. While the loss of any substantial customer, including GE, could have a material short-term impact on our business, we believe that our diverse client base and diverse product offerings should reduce the long-term impact of any such loss.

 

We do not consider our business in any reportable segment to be seasonal in nature or to have special working capital requirements. Compliance with federal, state and local regulations relating to the discharge of materials into the environment, or otherwise relating to the protection of the environment, is not expected to result in material capital expenditures by us or to have a material adverse effect on our earnings or competitive position. In general, raw materials required by the Company are attainable from various sources and in the quantities desired. Various provisions of federal law and regulations require, under certain circumstances, the renegotiations of military procurement contracts or the refund of profits determined to be excessive. The Company, based on experience, believes that no material renegotiations or refunds will be required under its contracts related to military procurement. Other than the wind energy capacity expansion completed in 2009, we have not made any other public announcement of, or otherwise made public information about, a new product or a new industry segment which would require the investment of a material amount of our assets or which would otherwise result in a material cost.

 

Backlog

 

We sell certain products on a build-to-order basis that require substantial order lead-time. This results in a backlog of unshipped, scheduled orders. In addition, certain products are manufactured on the basis of sales projections or annual blanket purchase orders. The Company defines backlog as orders shippable in the upcoming 18 months.

 

Variability in backlog is affected by the timing of orders received, particularly when larger customers pull forward or push out major orders. Backlog by reporting segment at December 31, 2009 and 2008 is presented below:

 

 

Patents and Trademarks

 

We hold various patents, patent applications, licenses, trademarks and trade names. We consider patents, patent applications, licenses, trademarks

 

 

2 KAYDON CORPORATION FORM 10K

and trade names to be valuable, but do not believe that there is any reasonable likelihood of a loss of such rights which would have a material adverse effect on our present business as a whole.

 

Competition

 

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

 

Employees

 

We employ approximately 2,084 people. Satisfactory relationships have generally prevailed between the Company and its employees.

 

International Operations

 

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

 

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

 

Available Information

 

Our internet address is www.kaydon.com.  Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and amendments to all such reports and statements are accessible at no charge on our website as soon as reasonably practicable after filing with the Securities and Exchange Commission. Also accessible on our website under “Corporate Governance” are our Corporate Governance Guidelines, our Codes of Ethics, and the charters of the various committees of our Board of Directors. These items are also available in print at no charge to those who direct a request in writing to the Company. We do not intend for the information contained on our website to be a part of this Annual Report.

 

 

The following risk factors could affect our financial condition and/or operating results.

 

Our customers’ economic cycles may affect our operating results.

 

Many of our customers are in industries that are cyclical in nature and sensitive to changes in general economic conditions and other factors, including capital spending levels. Such industries include commercial aerospace, specialty electronics manufacturing equipment, power generation, off-road and heavy industrial equipment, and other capital equipment manufacturing. As a result, the demand for our products by these customers depends, in part, upon general economic conditions. Historically, downward economic cycles have reduced customer demand for our products, thereby reducing sales of our products and resulting in reductions to our revenues and net earnings. In addition, our military sales are dependent on government funding. Business conditions worldwide worsened in late 2008 and stabilized at lower activity levels in 2009. The timing and sustainability of worldwide economic growth in 2010 is uncertain and if economic conditions do not remain at current levels or if conditions deteriorate our results of operations could be adversely affected.

 

Increased competition in our key markets could result in a reduction in our revenues and earnings and adversely affect our financial condition.

 

The industries in which we operate are fragmented and we face competition from multiple companies across our various product lines. We expect competitive pressures from new products and aggressive pricing to increase, which may cause us to lose market share or compel us to reduce prices to remain competitive, which could result in reduced levels of revenues and earnings. Our competitors include U.S. and non-U.S. companies, some of which benefit from lower labor costs and fewer

 

 

KAYDON CORPORATION FORM 10K 3

regulatory burdens. In addition, certain competitors, including Eaton, Timken, SKF, INA/FAG and ITT, are larger than Kaydon and may have access to greater financial, technical, development, marketing, manufacturing, sales and distribution services and other resources. Increased competition with these companies or new entrants to our key markets could prevent price increases for our products or could require price reductions for our products, which could adversely affect our financial condition, results of operations, growth or liquidity.

 

Future acquisitions may require us to incur costs and liabilities or have other unexpected consequences which may adversely affect our operating results.

 

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

 

Political, economic and regulatory conditions inherent in the international markets in which we participate could adversely affect our financial condition.

 

Typically, sales of our products from our foreign subsidiaries and from our domestic businesses selling to foreign locations account for approximately 30-40 percent of net sales. These foreign sales could be adversely affected by changes in various foreign countries’ political and economic conditions, trade protection measures, differing intellectual property rights and changes in regulatory requirements that restrict the sales of our products or increase our costs.

 

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

 

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

 

Our critical performance products expose us to potential litigation-related costs which may adversely affect our financial position and operating results.

 

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

 

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

 

 

4 KAYDON CORPORATION FORM 10K

and could divert management attention and resources away from our business.

 

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

 

We have invested approximately $80 million to expand our capacity to supply custom bearings to the wind energy market. We face a risk of exposure to sales and earnings volatility if this growing industry is affected by conditions in the capital markets, attracts new competition, loses certain governmental incentives, or matures more rapidly than currently anticipated.

 

The condition of the financial markets may impact the timing and extent that wind energy market customers proceed with planned projects, and, if financial markets do not improve, or improve too slowly, our financial position and operating results may be adversely affected.

 

We have completed our capacity expansion project to supply custom bearings to the wind energy market. In addition to the significant capital assets acquired, we currently have substantial accounts receivable and inventory balances related to certain wind energy customers. With respect to the wind energy market, while the near term has been impacted by issues associated with credit and financing availability, recent steps taken to repair the health of the financial markets should eventually improve visibility and end user confidence to proceed with previously planned projects. If, however, the financial markets do not improve, or they improve too slowly, the impact this may have on our customers may adversely affect our financial position and operating results. A bankruptcy filing by a significant wind energy customer may result in uncollectible accounts receivable and unusable inventory, as well as reduced utilization of our large diameter bearing manufacturing facilities.

 

 

None

 

 

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

 

 

 

KAYDON CORPORATION FORM 10K 5

 

We consider our properties to generally be in good condition, well maintained, and suitable and adequate to carry on our business. Except for leased facilities in Monterrey, Mexico (1 site), and LaGrange, GA (1 site), substantially all of the properties are owned by us. None of our properties are subject to significant encumbrances. Our manufacturing facilities currently have sufficient capacity to meet customer demand. Our leased executive offices are located in Ann Arbor, MI.

 

 

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

 

No matters were submitted to a vote of security holders during the fourth quarter of the year covered by this report.

 

 

6 KAYDON CORPORATION FORM 10K

SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT

(Pursuant to Instruction 3 to Item 401(b) of Regulation S-K)
The following are the executive officers of Kaydon Corporation as of December 31, 2009.

 

 

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

 

 

KAYDON CORPORATION FORM 10K 7

 

 

Market Information and Dividends

 

The New York Stock Exchange is the principal market on which our common stock is traded under the symbol “KDN”. As of December 31, 2009, there were 629 holders of record of our common stock.

 

The following table sets forth the high and low closing sales prices of our common stock and the cash dividends declared per share for the periods indicated.

 

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

 

There were no purchases made by the Company of shares of its common stock during any month in the fourth quarter of 2009.

 

Equity Compensation Plan Information

 

The following table gives information about our common stock that may be issued upon the exercise of options, warrants and rights under all of our existing equity compensation plans as of December 31, 2009, including the 1999 Long Term Stock Incentive Plan, the 2003 Non-Employee Directors Equity Plan and the Director Deferred Compensation Plan.

 

 

 

8 KAYDON CORPORATION FORM 10K

Stock Performance Graph

 

The following graph compares the cumulative, five-year shareholder returns on our common stock to the Standard & Poor’s 500 (“S&P 500”) Stock Composite Index for the broad equity index and the Value Line Diversified Manufacturing Index as an industry standard for the five-year period commencing January 1, 2005 and ending December 31, 2009, assuming an investment of $100.00 at the close of trading on December 31, 2004 in our common stock, the S&P 500 Stock Composite Index and the Value Line Diversified Manufacturing Index (published by Value Line, Inc). The cumulative total return assumes reinvestment of dividends.

 

 

 

 

KAYDON CORPORATION FORM 10K 9

 

 

 

 

10 KAYDON CORPORATION FORM 10K

 

 

Overview

 

Our Company, Kaydon Corporation, is a leading designer and manufacturer of custom engineered, performance-critical products, supplying a broad and diverse group of alternative energy, industrial, aerospace, medical and electronic equipment, and aftermarket customers. Demand for our products depends, in part, upon a wide range of general economic conditions, which affect our markets in varying ways from year to year.

 

The global recessionary conditions that impacted the economy during the second half of 2008 and throughout 2009 reduced demand for our products and resulted in sales volume and operating margin declines in each of our business segments. These adverse macroeconomic conditions resulted in customers acting with caution, which led to a decline in orders and requests for deferred delivery of our product. In response to these conditions, we have focused, and will continue to focus, on programs to grow market share, reduce costs and improve capacity utilization, and increase cash flow, thereby positioning us to capitalize on future opportunities in targeted markets when conditions improve.

 

While worldwide business conditions remain very challenging, our industrial markets appear to have stabilized, albeit at cyclically low levels. While we are confident in our strategic positioning in each of our markets, meaningful improvements in 2010 will be dependent on an improved economy resulting in a resumption of higher order rates in our core industrial end markets. Because of our diverse product offerings and served markets, as well as the general uncertainty as to the timing and nature of any economic recovery, the specific impact of these economic conditions on our operating results is difficult to predict.

 

With respect to the wind energy market, while growth continued in 2009, the longer term outlook will be heavily influenced by both an improved economy, and resultant need for electricity, and greater clarity on the public policy front. We believe that recent actions and policy statements regarding a sustained, committed policy towards increasing renewable energy usage in the United States supports the confidence we have in our investment in this market.

 

During 2009 our net sales totaled $441.1 million with increased wind energy sales being more than offset by the adverse effects of the worldwide recession on our remaining businesses. We generated net income of $46.0 million, and cash flow from operating activities of $66.2 million during 2009. Due to the strong cash flow from operations, cash and cash equivalents increased $29.4 million during the year even as we invested $12.0 million in capital expenditures, $8.9 million for stock repurchases, $14.8 million to fund our qualified pension plans, and increased our common stock dividend. The total order book for 2009 equaled $347.1 million, compared to $596.0 in 2008, and $505.5 million in 2007, with the decrease reflecting the macroeconomic downturn. Our 2009 year-end backlog of $218.5 million provides a foundation for operating performance in 2010; however, orders for our industrial products will continue to be impacted by the timing and nature of any economic recovery. Our investable balances provided significant interest income in 2007 and early 2008 before financial markets deteriorated. We responded to these adverse financial market conditions in 2008 and 2009 with an investment strategy focused on preserving cash balances. Market interest rates on these investments are now near zero percent. As a result, our returns on our investable balances were relatively insignificant in 2009 and will not improve significantly until market rates increase.

 

During 2009 we completed our wind energy capacity expansion program, which provides us with the flexibility to respond to customer requirements when markets improve.

 

In 2008, all of our $200.0 million 4% Contingent Convertible Senior Subordinated Notes due 2023, (the “Notes”) were converted into shares of our common stock, which made us debt-free.

 

At December 31, 2009, our current ratio was 9.3 to 1 and working capital totaled $397.7 million. We believe that our cash and cash equivalents balance of $262.4 million at December 31, 2009, and future cash flows from operations, along with our borrowing capacity are adequate to fund our strategies for future growth, including working capital, expenditures for capital expansion and efficiencies, selected stock repurchases, market share initiatives and corporate development efforts.

 

In summary, our future performance will be impacted by general economic conditions and the strength or weakness of the manufacturing

 

 

KAYDON CORPORATION FORM 10K 11

environment, the success of our efforts to continue to expand operations and improve operating efficiencies, as well as the use of available cash and borrowing capacity for future acquisitions.

 

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

 

Selected Data For The Years 2009, 2008 and 2007

 

 

Analysis of 2009 Operations Compared to 2008 Operations

 

Net Sales

 

Net sales for 2009 equaled $441.1 million, a decrease of $81.2 million or 15.5 percent, compared to net sales in 2008 of $522.4 million. During 2009, the decline in net sales was primarily attributable to a decrease in volume of $73.2 million, or 14.0 percent, compared to 2008, as sales gains to wind energy customers of $22.5 million or 28.0 percent were more than offset by the adverse impact of the global economic recession on all our reporting segments and all our other significant end markets. The adverse effects of changes in currency exchange rates had an $8.6 million, or 1.6 percent, unfavorable impact on sales. This decrease was principally attributable to a stronger U.S. dollar relative to the Euro and British pound on a year-over-year basis. Finally, net improved pricing yielded an increase of $0.6 million for the year. Pricing changes were favorable in the first half of 2009 primarily as a result of price increases on our core products, and were lower in the second half of the year primarily due to contractual adjustments associated with the contractual pass-through of decreased material costs.

 

Gross Margin

 

Gross margin in 2009 was 32.6 percent, a decrease of 4.2 points from the 36.8 percent gross margin in 2008. The decreased sales volume and higher unabsorbed fixed costs associated with lower production volumes accounted for 4.5 points of the decline in gross margin, and is largely due to the global economic downturn, partially offset by the impact of cost reduction efforts implemented across all our businesses. Unfavorable changes in product mix accounted for an additional 0.7 points of the decline due to reduced sales volume to higher margin industrial markets and increased sales volume to the wind energy market, where margins are not as high. Pricing had a favorable impact of 1.0 point on gross margin, primarily attributable to favorable selling price increases in the first half of 2009.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses were $72.5 million, or 16.4 percent of sales, in 2009, compared to $86.7 million, or 16.6 percent of sales, in 2008. During 2009, we recorded curtailment gains totaling $7.6 million that were associated with changes to certain postretirement benefit plans. The remaining decrease is primarily attributable to the preemptive and continuing steps that have been taken throughout the year to reduce discretionary costs across all reporting segments as

 

 

12 KAYDON CORPORATION FORM 10K

a result of lower sales volume, partially offset by approximately $1.8 million of one-time expenses associated with layoffs and related severance in 2009.

 

Operating Income

 

Our operating income was $71.3 million, or 16.2 percent of sales, in 2009, compared to $105.5 million, or 20.2 percent of sales, in 2008. The decrease in gross profit more than offset the decrease in selling, general and administrative expenses.

 

Interest Income

 

During 2009, interest income totaled $0.5 million on average investment balances of $225.9 million as interest rates were negligible for most of the year. This compares to $4.9 million of interest income in 2008 when we earned approximately 1.7 percent on average investment balances of $272.0 million. The decrease in average investment balances resulted from investments in our capital expenditure program, increased working capital, contributions to our qualified pension plans, the use of cash for our stock repurchase program, and an increase in our dividend rate. The decrease in average interest rates in 2009 reflects our conservative investment strategy to preserve cash balances in response to financial market conditions and prevailing historically low interest rates on short term treasury securities. Interest rates for 2010 are expected to show only modest improvement.

 

Interest Expense

 

During 2009, interest expense totaled $0.2 million and represented amortization of credit facility costs. During 2008, interest expense totaled $9.4 million. The year-over-year difference of $9.1 million is attributable to interest and amortization of issuance costs associated with the Notes that were outstanding in the prior year, including a $3.1 million adjustment of interest and amortization costs associated with the retrospective application of new accounting guidance effective January 1, 2009.

 

Provision for Income Taxes

 

The effective tax rate for 2009 was 35.8 percent compared to 35.6 percent in 2008. The effective tax rate for 2010 is expected to decrease from the level in 2009 due to the impact of tax credits and lower income taxes on foreign earnings.

 

Net Income

 

Net income for 2009 was $46.0 million or $1.37 per share on a diluted basis, which included the $4.9 million, or $0.15 per share, after tax gain associated with the curtailment of certain postretirement benefits, based on approximately 33.3 million common shares outstanding. Net income for 2008 totaled $65.1 million or $2.06 per share on a diluted basis, based on approximately 34.0 million common shares outstanding. The 2008 results have been adjusted to reflect the required retrospective application of new accounting guidance related to convertible debt and earnings per share, which were effective January 1, 2009, and reduced previously reported 2008 net income by $2.0 million and diluted earnings per share by $0.03.

 

Analysis of 2008 Operations Compared to 2007 Operations

 

Net Sales

 

Net sales of $522.4 million in 2008 increased $71.0 million or 15.7 percent compared to net sales in 2007 of $451.4 million. The increase was primarily attributable to a $47.6 million increase in sales from our wind energy initiative and increased sales of $22.7 million from the inclusion of a full year of sales from the Avon acquisition, which includes $6.4 million of increased wind energy sales, and $5.7 million in increased sales of velocity control products.

 

Gross Margin

 

Gross margin for 2008 was 36.8 percent, a decrease of 4.0 points from the 40.8 percent for 2007. The lower gross margin was due to the combined effects of product mix shifts, the incurrence of costs to ramp up our wind energy expansion, and the inclusion of Avon for which gross margins are not as high as the Company average.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses totaled $86.7 million and equaled 16.6 percent of sales. Selling, general and administrative expenses in 2007 totaled $73.0 million, which included a $5.0 million positive effect of the gain on the sale of a component of the Friction Control Products

 

 

KAYDON CORPORATION FORM 10K 13

reporting segment, and equaled 16.2 percent of sales. Selling, general and administrative expenses increased during 2008 in support of increased sales, particularly for the expansion of the Company’s sales force, and due to increased intangible amortization expense associated with the Avon acquisition.

 

Operating Income

 

Operating income totaled $105.5 million or 20.2 percent of sales compared to $111.3 million or 24.6 percent of sales during 2007, including the aforementioned $5.0 million gain.

 

Interest Income

 

Interest income declined to $4.9 million in 2008 compared to $18.1 million in 2007. The decline was due to substantially lower market interest rates, which on average were approximately 300 basis points lower than in 2007. The Company also had lower average cash and short-term investment balances due to investments in property, plant, and equipment for capacity expansion, share repurchases, pension contributions, and increased dividend payments. In addition, during 2008, the Company incurred losses totaling $1.7 million, which were recorded as a reduction to interest income.

 

Interest Expense

 

During 2008, $9.1 million of interest and amortization of issuance costs was charged to interest expense related to our then outstanding $200.0 million of 4% Contingent Convertible Senior Subordinated Notes (the “Notes”), which were converted into shares of our common stock in the third quarter of 2008. In 2007, $17.0 million of interest and amortization of issuance costs related to the Notes was charged to interest expense. The retrospective application of new accounting guidance adopted, as required, on January 1, 2009, increased previously reported interest expense by $3.1 million and $7.7 million for 2008 and 2007, respectively.

 

Provision for Income Taxes

 

The effective tax rate for 2008 was 35.6 percent compared to 35.1 percent in 2007.

 

Net Income

 

Our net income for 2008 totaled $65.1 million or $2.06 per share on a diluted basis, based on approximately 34.0 million common shares outstanding. Net income for 2007, which included a $3.1 million, or $0.09 per share, after tax gain on the sale of a component of a reporting segment, was $72.8 million or $2.39 per share on a diluted basis, based on approximately 34.6 million common shares outstanding. The retrospective application of new accounting guidance, adopted, as required, on January 1, 2009, reduced previously reported 2008 net income and diluted earnings per share by $2.0 million and $0.03 per share on a diluted basis, respectively. The application of this new accounting guidance reduced previously reported 2007 net income and diluted earnings per share by $4.9 million and $0.02 per share on a diluted basis, respectively.

 

Results by Business Segment

 

We classify our businesses into three reporting segments: Friction Control Products, Velocity Control Products, and Sealing Products. Our remaining operating segments are combined and disclosed as “Other businesses.” The segment discussions that follow describe the significant factors contributing to the changes in results for each segment.

 

The aforementioned 2009 curtailment gains resulting from changes to our postretirement benefit plans, which total $7.6 million in 2009, were not allocated to our operating segments.

 

Friction Control Products

 

 

 

14 KAYDON CORPORATION FORM 10K

2009 Compared to 2008

 

Sales in our Friction Control Products reporting segment were $296.4 million during 2009 compared to $326.0 million in 2008, reflecting a decrease of $29.5 million or 9.1 percent. Excluding sales gains to wind energy customers of $22.5 million, sales to all other markets in 2009 decreased by $52.0 million from 2008. This decline was due to the effects of volume declines of approximately $47.2 million associated with adverse economic conditions impacting industrial markets and an adverse currency exchange rate impact of $5.4 million which offset a $0.6 million benefit from increased pricing.

 

Operating income from the Friction Control Products reporting segment during 2009 totaled $50.3 million compared to $73.9 million in 2008. The $23.5 million decrease in operating income was due to a $21.2 million adverse effect of lower sales volumes, a $0.7 million adverse effect of product mix resulting from lower sales to higher margin industrial markets, and a $1.6 million decrease resulting from higher costs net of cost saving initiatives and pricing gains. The higher costs include increased depreciation associated with our investment in capacity to support the wind energy growth initiative, increased pension expense, and severance and redundancy cost incurred during 2009.

 

2008 Compared to 2007

 

In 2008, sales in our Friction Control Products reporting segment were $326.0 million, an increase of $64.3 million or 24.6 percent compared to 2007 sales of $261.7 million. Sales of custom engineered bearings to the wind energy market increased $47.6 million, to the military market increased $8.0 million, to the medical market increased $4.8 million, and to the heavy equipment market increased $6.3 million. Sales of split roller bearings increased $5.4 million compared to 2007. Sales to the machinery market declined $4.2 million, sales to the specialty electronics market declined $2.4 million, and sales to other markets declined $1.2 million compared to the 2007. The inclusion of a full year of Avon sales accounted for $22.7 million of the aforementioned $64.3 million sales increase.

 

Operating income from the Friction Control Products reporting segment was $73.9 million during 2008 as compared to $77.0 million during 2007. The lower operating margin of 22.7 percent in 2008 compared to 29.4 percent in 2007 is the result of the mix impact of increased wind energy sales and the inclusion of a full year of Avon sales, as both carry margins that are not as high as those in our core industrial business. Additionally, 2008 operating income was lower than in 2007 due to the $5.0 million gain on the sale of a component of this reporting segment that was recorded in 2007.

 

Velocity Control Products

 

 

2009 Compared to 2008

 

During 2009, sales in our Velocity Control Products reporting segment were $46.4 million compared to $69.6 million in 2008. The decrease of $23.3 million was due to a decline in volume of $20.0 million caused by decreased demand in worldwide markets for gas springs, hydraulic dampers, and other products, especially in industrial markets, and the adverse effects of changes in currency exchange rates of approximately $3.3 million.

 

The Velocity Control Products reporting segment contributed $6.5 million to our operating income during 2009 compared to $18.0 million during 2008. This decrease in operating income is principally due to the effect of the decline in sales volume and adverse effects of exchange rate changes of approximately $13.3 million and $0.4 million, respectively. This decrease was partially offset by net cost reduction savings of $2.2 million.

 

2008 Compared to 2007

 

The Velocity Control Products reporting segment achieved sales of $69.6 million during 2008, up $5.7 million, or 8.9 percent from 2007 sales of $63.9 million, reflecting a $2.7 million impact of favorable currency exchange rate changes,

 

 

KAYDON CORPORATION FORM 10K 15

$1.8 million of increased sales volume of gas springs, hydraulic dampers, and other products, particularly in European markets, and $1.1 million of increased pricing.

 

The Velocity Control Products reporting segment contributed $18.0 million to our consolidated operating income during 2008 as compared to $16.2 million during 2007 due principally to the benefit of increased sales volume.

 

Sealing Products

 

 

2009 Compared to 2008

 

Sales in our Sealing Products reporting segment in 2009 were $37.8 million compared to $45.0 million in 2008, as decreased volume associated with the global economic recession and customer deferrals of shipments of our products of $7.7 million was only partially offset by a $0.6 million increase resulting from favorable pricing.

 

The Sealing Products reporting segment contributed $3.9 million to our operating income during 2009 compared to $5.0 million during 2008. The combined effect of decreased sales volumes and an adverse change in product mix associated with lower sales of higher margin industrial seals totaled $4.9 million, and was partially offset by the impact of higher pricing of $0.6 million, net cost reductions of approximately $2.4 million, and 2008 property and equipment impairment charges of $0.8 million.

 

2008 Compared to 2007

 

Our Sealing Products reporting segment sales totaled $45.0 million during 2008, a decline of 3.6 percent from 2007 sales of $46.7 million, due to lower demand in the defense and railroad markets.

 

The Sealing Products reporting segment contributed $5.0 million to our consolidated operating income during 2008 as compared to $8.7 million during 2007 due to the decrease in sales, adverse product mix changes, and property and equipment impairment charges totaling $0.8 million.

 

Other businesses

 

 

2009 Compared to 2008

 

Sales in our other businesses were $60.5 million during 2009 compared to $81.8 million in 2008. The $21.3 million sales decline was principally due to the global economic recession which resulted in decreased sales of our liquid filtration, air filtration, metal alloy, and metal-forming products.

 

Our other businesses contributed $4.7 million to our operating income during 2009 compared to $10.5 million during 2008. This decrease in operating income is due to the effect of lower sales volumes of $9.0 million, partially offset by net cost reductions of $2.2 million, and higher pricing of $1.0 million.

 

2008 Compared to 2007

 

Sales in our other businesses were $81.8 million during 2008, up $2.7 million or 3.4 percent from 2007 sales of $79.1 million primarily due to growth in our liquid and air filtration businesses, and due to higher pricing in our metal alloys business when tin prices increased in mid-2008.

 

 

16 KAYDON CORPORATION FORM 10K

Our other businesses contributed $10.5 million to our consolidated operating income during 2008 as compared to $11.1 million during 2007 with the decrease principally due to an increase in product costs.

 

Liquidity and Capital Resources

 

At December 31, 2009, our current ratio was 9.3 to 1 and working capital totaled $397.7 million, including cash and cash equivalents of $262.4 million. At December 31, 2008 our current ratio was 6.8 to 1 and working capital totaled $365.3 million, including cash and cash equivalents of $233.0 million.

 

We have historically generated significant cash flows from operating activities to fund capital expenditures, dividends and other operating requirements. Cash flow generation has been enhanced by our continuing efforts to improve operating efficiencies, implement cost reductions, and manage working capital requirements. Net cash from operating activities equaled $66.2 million in 2009, $57.9 million in 2008, and $74.3 million in 2007. Despite difficult economic conditions, net cash from operating activities increased in 2009 compared to 2008 as reduced investments in working capital more than offset the adverse impact of decreased net income. Net cash from operating activities in 2008 declined compared to 2007 as decreased net income and increased investment in working capital associated with sales growth more than offset the benefits of decreased contributions to our qualified pension plans.

 

Net inventories at December 31, 2009 were $88.8 million, a decrease of $9.0 million from the $97.7 million of inventory at December 31, 2008. The 2009 decrease was principally attributable to the overall decline in sales volumes as inventory turns were consistent on a year-over-year basis. Net inventories at December 31, 2008 increased $28.9 million from the December 31, 2007 balance of $68.9 million. The 2008 inventory increase was attributable to sales growth and our investment in inventory to supply bearings to wind energy turbine manufacturers.

 

In considering both our long-term confidence in the wind energy market and our ongoing strategic relationships with wind energy customers, we have made significant investments in support of this initiative. We closely monitor our accounts receivable from wind energy customers and are reasonably assured that our accounts receivable are fully collectible. Additionally, we believe that our inventory as of December 31, 2009 is fully realizable. As such we have not established any reserve for inventory or any allowance for doubtful accounts related to wind energy customers as of December 31, 2009.

 

At December 31, 2009, we had approximately $8.5 million of working capital invested on behalf of an international wind energy customer, including past due accounts receivable and inventory and purchase commitments made or incurred on the customer’s behalf and designed to its agreed upon specifications. The customer has not paid us because the customer alleges that certain field performance issues of its product are attributable to the quality of our supplied bearings. We are confident that our bearings were made to the agreed upon design specifications and that the customer’s field performance issues relate to factors outside of our control. Under the documents which comprise the sales contract, the customer is obligated to pay its liability and to reimburse us for inventory costs incurred and lost profits. In order to expedite the resolution of this matter, we have agreed with the customer to enter into a mediation process, and if necessary, binding arbitration. As we are confident in the quality of our supplied product and the customer’s financial ability to pay, we have concluded that the receivables and inventory are fully realizable and the purchase commitments are fully recoverable.

 

Capital expenditures to expand productive capacity, improve quality, and reduce costs equaled $12.0 million in 2009, $60.7 million in 2008, and $54.2 million in 2007. The decrease in capital expenditures in 2009 compared to 2008 reflects the completion of our wind energy capital expansion in 2009 and our disciplined approach to managing capital expenditures during challenging economic conditions. The increase in 2008 compared to 2007 reflects the capital spending on the wind energy growth initiative. During 2009, 2008, and 2007, capital expenditures for the wind energy growth initiative totaled $5.4 million, $33.7 million, and $29.1 million, respectively. During 2010 we expect to invest approximately $30 million in aggregate capital expenditures for all segments.

 

At December 31, 2008, we had a net position of $4.9 million in an enhanced cash investment. The fund issuer had restricted the redemption of the

 

 

KAYDON CORPORATION FORM 10K 17

fund to permit its orderly liquidation. During 2009, we received $5.1 million in proceeds from the redemption of the remaining portion of this investment and recorded a $0.2 million gain on the liquidation, which was recorded as interest income. In 2008 we recorded $0.6 million in losses as a reduction of interest income on the partial liquidation of the fund. Also in 2008, we recorded charges as a reduction of interest income totaling $1.0 million to reduce the gross investment to fair value.

 

We continue our corporate development efforts to complement internal growth through the acquisition of additional companies that meet our well-disciplined criteria. In October 2007, we acquired Avon Bearings Corporation for $54.4 million, net of working capital adjustments recorded in 2008. An independent appraiser was engaged to assist management in determining the fair values of separately recognized intangible assets of Avon. After allocating cost to other assets acquired and liabilities assumed based on their estimated fair values, the excess cost of the acquisition, equal to $27.4 million, was recognized as goodwill at December 31, 2007. In 2008 we recorded purchase price adjustments of $1.1 million associated with this acquisition which increased the associated goodwill.

 

The Company paid common stock dividends totaling $23.2 million, $18.2 million, and $14.4 million in 2009, 2008, and 2007, respectively. The dividends paid through the third quarter of 2007 were at a quarterly rate of $0.12 per share. The dividends paid in the fourth quarter of 2007 and the first three quarters of 2008 were at a quarterly rate of $0.15 per share. The dividends paid in the fourth quarter of 2008 and in the first three quarters of 2009 were at a quarterly rate of $0.17 per share. The dividend declared in July 2009, paid early in the fourth quarter of 2009, was at a quarterly rate of $0.18 per share.

 

We repurchased 314,047 shares of our common stock in 2009 for $8.9 million, 937,941 shares of our common stock in 2008 for $35.9 million and 601,974 shares of our common stock in 2007 for $30.1 million. In 2005, the Company’s Board of Directors authorized a share repurchase program of up to 5,000,000 shares. Of the 5,000,000 shares currently authorized by the Board of Directors for repurchase, 1,970,817 shares have been repurchased as of December 31, 2009. We will make opportunistic stock repurchases over time, the amount of which will depend on the market for our common stock and our financial position and liquidity.

 

Our payments to various taxing authorities were $16.7 million, $27.4 million, and $25.1 million during 2009, 2008, and 2007. Tax payments are expected to be approximately $20 million during 2010. As part of governmental efforts to react to climate change and stimulate economic growth, The American Reinvestment and Recovery Act of 2009 authorized the Department of Treasury to award tax credits for qualified investments in advanced energy projects, to support new, expand, or re-equip domestic manufacturing facilities. In 2010 we were awarded $1.8 million in tax credits for our qualifying advanced energy investment which we expect to utilize beginning in 2010.

 

In 2003, we issued $200.0 million of 4% Contingent Convertible Senior Subordinated Notes due 2023 (the “Notes”). The Notes were convertible into shares of Company common stock provided certain contingencies were met. During 2008, holders of the Notes converted their Notes into Company common stock, which were issued from treasury stock.

 

We had no debt outstanding at any time during 2009, and accordingly paid no cash interest. Cash paid for interest totaled $4.0 million in 2008 and $8.0 million in 2007. During 2008, $9.1 million of interest and amortization of issuance costs was charged to interest expense related to the Notes. In 2007, $17.0 million of interest and amortization of issuance costs related to the Notes was charged to interest expense. The retrospective application of new accounting guidance adopted, as required, on January 1, 2009, increased previously reported interest expense by $3.1 million and $7.7 million for 2008 and 2007, respectively.

 

We have a senior credit facility with a syndicate of lenders providing for a $300.0 million senior unsecured revolving credit facility. The credit facility provides for borrowings and issuances of letters of credit by the Company and its subsidiaries in various currencies for general corporate purposes, including acquisitions. The credit facility matures on July 12, 2010 and is guaranteed by the Company and certain of our domestic subsidiaries. Interest accrues on borrowings under the revolving credit facility based on the London Interbank Offered Rate. The revolving credit facility contains restrictive financial covenants on a consolidated basis including leverage and coverage ratios, utilizing

 

 

18 KAYDON CORPORATION FORM 10K

measures of earnings and interest expense as defined in the revolving credit facility agreement. We are in compliance with all restrictive covenants contained in the revolving credit facility at December 31, 2009. We have available credit under our revolving credit facility of $300.0 million at December 31, 2009. We are planning on establishing a new credit facility during the first half of 2010.

 

Fees related to our existing revolving credit facility of approximately $1.2 million are being amortized as a component of interest expense over a five-year period. Revolving credit facility fees included in other assets in the Consolidated Balance Sheet as of December 31, 2009, equaled $0.1 million.

 

We expect that our planned capital requirements, which consist of capital expenditures, dividend payments and our stock repurchase program, will be financed by operations and existing cash balances. In addition, our revolving credit facility provides additional financial strength to support our objectives, including future acquisitions.

 

Our significant contractual obligations as of December 31, 2009 are set forth below:

 

 

We expect to make cash contributions of approximately $2.9 million to our pension plans in 2010. We review our funding strategy for our pension plans on an ongoing basis. We expect to contribute approximately $0.6 million to our postretirement benefit plans in 2010. We have $2.5 million of liabilities for unrecognized tax benefits which are excluded from the above table because the timing of settlement of these liabilities cannot be reasonably estimated.

 

Corporate Development

 

Our corporate development efforts are intended to complement internal growth through the acquisition of additional companies consistent with our well-disciplined criteria. We maintain a disciplined acquisition program, which has made important contributions to our growth. In 2007, we acquired all of the outstanding stock of Avon Bearings Corporation (“Avon”) in a cash transaction valued at $54.4 million, net of $0.5 million of working capital adjustments recorded in 2008. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings.

 

Litigation

 

We are a party to various pending lawsuits and other matters arising in the normal course of business. Our estimated legal costs expected to be incurred in connection with claims, lawsuits and environmental matters are accrued in the consolidated financial statements. The costs accrued at December 31, 2009 and 2008 were not material.

 

Critical Accounting Policies and Estimates

 

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

 

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

 

Inventories – Inventories are stated at the lower of cost or market, with cost determined on a

 

 

KAYDON CORPORATION FORM 10K 19

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

 

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

 

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

 

We believe the accounting estimates related to long-lived asset impairment to be critical accounting estimates because the estimate of undiscounted future cash flows, while based on reasonable and supportable assumptions and projections, requires our subjective judgments and the time periods for estimating future cash flows is often lengthy, increasing the sensitivity of assumptions made, thus projected outcomes may vary.

 

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

 

Impairment of Goodwill and Indefinite-Lived Intangible Assets – We test goodwill for impairment at the reporting unit level, which represents an operating segment or a component of an operating segment for which discrete financial information is available and segment management regularly reviews the operating results. Currently eight of our reporting units have goodwill balances.

 

We test for impairment of goodwill on an annual basis by comparing the fair value of each reporting unit with the reporting unit’s carrying amount. The fair value of the reporting unit is derived from an estimate of discounted future cash flows. The discounted cash flow model for each reporting unit requires judgmental assumptions regarding each reporting unit’s specific projected revenue growth, future operating margins, and working capital and capital expenditure requirements, in addition to assumptions of appropriate discount rates and terminal values based on growth rates in perpetuity. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. While we believe we have made reasonable estimates and assumptions to calculate the fair value of our reporting units, it is possible a material change could occur. Goodwill of a reporting unit is tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.

 

In 2009, as of our annual assessment date, we used a 12 percent discount rate to calculate fair value for all of our reporting units. In 2008 an 11 percent discount rate was utilized. The discount rate used each year is the value-weighted average of our estimated cost of equity and estimated cost of debt (“cost of capital”) derived using both known and estimated, customary, marketplace metrics, including a size risk premium. The one percent increase in the discount rate used for 2009 compared to 2008 is driven by the use of an additional market risk premium to account for the increased level of systematic risk prevailing in the market and the low yield for risk-free securities as of the valuation date. We currently utilize the same discount rate to estimate the fair value of all of our reporting units because we believe that the underlying similarities in the businesses within our portfolio result in a common risk profile with regard to assumed variability of estimated future undiscounted cash flows. Our calculation methodology was unchanged during 2009, and the consistent application of this methodology may result in changes in the discount rate in future periods.

 

In arriving at future discounted cash flows for each reporting unit, we evaluate the appropriate

 

 

20 KAYDON CORPORATION FORM 10K

growth rate in perpetuity for each of our reporting units to calculate a terminal value of cash flows following each reporting unit’s five year planning period. The terminal value for each reporting unit is determined based on that unit’s specific operating cash flow at the end of the planning period and the unit’s assumed growth rate in perpetuity. We currently utilize the same assumed growth rate in perpetuity of two percent in the discounted cash flow model of each of our reporting units. This is based on our assumption that the long term growth rates following our planning periods no longer benefit from specifically-planned reporting unit initiatives and therefore only reflect the overall approximate long term economic growth rate.

 

Potential goodwill impairment is identified if a reporting unit’s carrying amount is more than a reporting unit’s fair value. If this occurs, normally a third-party valuation specialist is utilized to assist us in determining the implied fair value of the reporting unit’s goodwill. The amount of any actual impairment loss is calculated by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill.

 

Our goodwill impairment testing in 2009 revealed that the excess of the estimated fair value of each of the reporting units tested over their carrying value (expressed as a percentage of the carrying amount) as of the July 31st annual testing date ranged from approximately 22 percent to approximately 475 percent. Assumptions regarding discount rate, revenue growth rates, operating profit margins and perpetuity growth rate may have a significant effect on the estimated fair value of our reporting units. In order to evaluate the sensitivity of the fair value calculations on the goodwill impairment test, we applied a hypothetical ten percent decrease to the fair values of each reporting unit. The results of this ten percent hypothetical change in fair values would not have changed our conclusion that fair values exceeded carrying values in each case by a material amount.

 

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

 

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

 

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

 

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

 

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

 

We have developed estimates based on: historical experience, information from third party professionals, and various other judgments and assumptions that are believed to be reasonable under the current facts and circumstances. In developing the discount rate assumption used to determine the pension and postretirement benefit obligations, we use the weighted average of market-observed yields for high quality fixed income securities with maturities that correspond to the payment of benefits. The equivalent weighted-average discount rate is calculated by imputing the interest rate that equates the total present value with the stream of future cash flows. Health care cost trend assumptions are developed based on historical data, the near-term outlook, and on an assessment of likely long-term trends. Salary growth assumptions reflect our long-term experience, the near-term outlook and assumed inflation.

 

 

KAYDON CORPORATION FORM 10K 21

Long-term return on plan assets is based on an evaluation of historical and expected returns of the individual asset classes comprising the total plan assets. For individual categories of equity securities, historical total and real rates of return are considered, together with inflation and overall market factors including dividend yield, earnings growth, changes in price to earnings ratios and volatility of returns. For various fixed income asset categories, expected long-term returns are determined after consideration of current yields on fixed income securities, inflation, historical yields relative to benchmarks, and long-term default rates. For other asset classes, including real estate, expected long-term returns are determined through consideration of certain factors, which may include historical returns, dividend yields, inflation, benchmark returns and net asset values.

 

Assumed discount rates, expected rate of return on plan assets, and rate of compensation increases have a significant effect on the amounts reported for the pension plans. The effect of a one percentage point increase or decrease in each factor on the projected benefit obligation and net periodic pension cost would have been:

 

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

 

 

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

 

The current market conditions for highly rated corporate bonds has a significant effect on our assumption for the discount rate used to determine projected benefit obligations and net periodic benefit cost, where an increase (decrease) in interest rates will result in a decrease (increase) in the projected benefit obligation and decrease (increase) in net periodic benefit cost. At December 31, 2009 the discount rates assumed were lower than those at December 31, 2008, affecting plan benefit obligations at December 31, 2009 and the net periodic pension cost for 2010 accordingly.

 

Changes in current conditions in financial markets do not significantly alter the underlying long-term expected return on plan assets each year. However, actual returns compared to the expected return on plan assets have a significant effect on the funded status of the plans, and consequently the net periodic pension cost and plan contributions in future periods. The actual rate of return on plan assets in 2008 was significantly below the expected long-term rate of return on plan assets reducing the funded status at December 31, 2008 and increasing the net periodic pension cost in 2009. We chose to make a voluntary contribution to our qualified pension plans in 2009 using cash generated from operations. The actual rate of return on plan assets in 2009 significantly exceeded the expected long-term rate of return on plan assets. The combined effect

 

 

22 KAYDON CORPORATION FORM 10K

of our voluntary contribution and the actual rate of return on plan assets resulted in a relative improvement in the funding status of our qualified plans at December 31, 2009 and will result in reduced net periodic pension cost in 2010. Our cash contributions required to fund our pension plans in 2010 are expected to be $2.9 million. The 2010 cash contributions and future expected contributions are expected to have only a minor impact on our current and future liquidity as we expect to meet funding requirements from cash generated in our operations or our available cash resources.

 

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

 

Income Taxes – We record deferred tax assets and liabilities using enacted tax rates for the effect of differences between the book and tax basis of recorded assets and liabilities. These deferred tax assets and liabilities are reviewed for recoverability by using estimates of future taxable income streams and the impact of tax planning strategies. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Reserves are also estimated for ongoing audits regarding federal, state and international issues that are currently unresolved. Income tax is provided based upon an effective tax rate that is dependent upon tax regulations governing the regions in which we conduct business, geographic composition of worldwide earnings, the availability of tax credits and other factors.

 

We have liabilities recorded for unrecognized tax benefits totaling $2.5 million as of December 31, 2009, all of which would affect the effective tax rate. It is our policy to include interest and penalties incurred due to underpayment or late payment of income taxes due to a taxing authority on a net-of-tax basis as a component of income tax expense. We have recorded $1.0 million in liabilities for tax-related interest and penalties on our consolidated balance sheet, as of December 31, 2009. The Company does not expect that the total amounts of unrecognized tax benefits will significantly change within the next twelve months.

 

The Company, or one or more of its subsidiaries, operates and files income tax returns in the United States, various states, and foreign jurisdictions. Foreign jurisdictions significant to the Company include Germany and the United Kingdom. With limited exceptions, we are no longer subject to U.S. federal tax examinations for years before 2006, state examinations for years before 2004, German tax examinations for years before 2006, or United Kingdom tax examinations for years before 2007.

 

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

 

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

 

Forward-Looking Statements

 

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

 

 

KAYDON CORPORATION FORM 10K 23

performance or achievements to differ materially from those expressed or implied by the forward-looking statements.

 

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

 

We are exposed to certain market risks, which exist as part of our ongoing business operations including interest rates and foreign currency exchange rates. The exposure to market risk for changes in interest rates relates primarily to investments in cash and cash equivalents, and short-term investments. All highly liquid investments, including highly liquid debt and investment instruments purchased with an original maturity of three months or less, are considered cash equivalents. We place our investments in cash equivalents with high credit quality issuers and limit the amount of exposure to any one issuer. A decrease in interest rates would not have a material impact on our pre-tax earnings. We conduct business in various foreign currencies, primarily in Europe, Mexico, and Asia. Therefore, changes in the value of currencies in these regions affect our financial condition and cash flows when translated into U.S. dollars. We have mitigated and will continue to mitigate a portion of our currency exposure through operation of decentralized foreign operating companies in which certain costs are local currency based. In addition, periodically, we enter into derivative financial instruments in the form of forward foreign exchange contracts to reduce the effect of fluctuations in foreign exchange rates. A 10 percent change in the value of all foreign currencies would not have a material effect on our financial condition and cash flows.

 

 

24 KAYDON CORPORATION FORM 10K

 

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

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

 

 

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

 

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2009.

 

Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued their report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. Their report is included herein under the heading “Report of Independent Registered Public Accounting Firm – Internal Control.”

 

 

KAYDON CORPORATION FORM 10K 25

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM –
INTERNAL CONTROL

 

The Board of Directors and Shareholders of Kaydon Corporation

 

We have audited Kaydon Corporation’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Kaydon Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report On Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

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

 

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

 

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

 

In our opinion, Kaydon Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2009 and 2008, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009 of Kaydon Corporation and our report dated February 26, 2010 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Detroit, Michigan

February 26, 2010

 

 

26 KAYDON CORPORATION FORM 10K

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM – FINANCIAL STATEMENTS

 

The Board of Directors and Shareholders of Kaydon Corporation

 

We have audited the accompanying consolidated balance sheets of Kaydon Corporation as of December 31, 2009 and 2008, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Kaydon Corporation at December 31, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note 1 to the consolidated financial statements, the accompanying consolidated financial statements have been retrospectively adjusted for the adoption of a new accounting standard related to the Company’s previously outstanding 4% Contingent Convertible Senior Subordinated Notes. Also, as discussed in Note 1, there have been retrospective adjustments relating to the adoption of a new accounting standard related to the earnings allocation to participating securities included in calculating earnings per share under the two-class method.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Kaydon Corporation’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2010 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Detroit, Michigan

February 26, 2010

 

 

KAYDON CORPORATION FORM 10K 27

KAYDON CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
December 31, 2009 and 2008

 

 

The accompanying notes are an integral part of these statements.

 

 

28 KAYDON CORPORATION FORM 10K

KAYDON CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
For the years ended December 31, 2009, 2008 and 2007

 

 

The accompanying notes are an integral part of these statements.

 

 

KAYDON CORPORATION FORM 10K 29

KAYDON CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
For the years ended December 31, 2009, 2008 and 2007

 

 

 

The accompanying notes are an integral part of these statements.

 

 

30 KAYDON CORPORATION FORM 10K

 

KAYDON CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2009, 2008 and 2007