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EX-95 - EXHIBIT 95 - MATERION Corpmtrn-ex95_2016q210q.htm
EX-32 - EXHIBIT 32 - MATERION Corpmtrn-ex32_2016q210q.htm
EX-31.2 - EXHIBIT 31.2 - MATERION Corpmtrn-ex312_2016q210q.htm
EX-31.1 - EXHIBIT 31.1 - MATERION Corpmtrn-ex311_2016q210q.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
____________________________________________ 
FORM 10-Q
(Mark One)
 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended July 1, 2016
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from             to             
Commission file number 001-15885
MATERION CORPORATION
(Exact name of Registrant as specified in charter)
 
Ohio
 
34-1919973
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
6070 Parkland Blvd., Mayfield Hts., Ohio
 
44124
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code:
216-486-4200
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  þ        No  ¨
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  þ        No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer  þ
Accelerated filer   ¨
Non-accelerated filer  ¨
Smaller reporting company  ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨        No  þ
As of July 22, 2016 there were 19,967,266 common shares, no par value, outstanding.




PART I FINANCIAL INFORMATION
MATERION CORPORATION AND SUBSIDIARIES
 
Item 1.
Financial Statements
The consolidated financial statements of Materion Corporation and its subsidiaries for the second quarter and six months ended July 1, 2016 are as follows:
 
 
Second quarter and six months ended July 1, 2016 and July 3, 2015

 
 
 
 
 
 
Second quarter and six months ended July 1, 2016 and July 3, 2015
 
 
 
 
 


 
July 1, 2016 and December 31, 2015
 
 
 
 
 
 
Six months ended July 1, 2016 and July 3, 2015
 




1



Materion Corporation and Subsidiaries
Consolidated Statements of Income
(Unaudited)
 
 
 
Second Quarter Ended
 
Six Months Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands, except per share amounts)
 
2016
 
2015
 
2016
 
2015
Net sales
 
$
249,776

 
$
276,855

 
$
485,287

 
$
566,879

Cost of sales
 
204,470

 
225,528

 
396,624

 
463,197

Gross margin
 
45,306

 
51,327

 
88,663

 
103,682

Selling, general, and administrative expense
 
32,437

 
34,594

 
62,924

 
72,527

Research and development expense
 
3,171

 
3,586

 
6,623

 
6,934

Other—net
 
3,921

 
36

 
5,807

 
(2,122
)
Operating profit
 
5,777

 
13,111

 
13,309

 
26,343

Interest expense—net
 
512

 
650

 
927

 
1,307

Income before income taxes
 
5,265

 
12,461

 
12,382

 
25,036

Income tax (benefit) expense
 
(284
)
 
3,394

 
1,465

 
6,985

Net income
 
$
5,549

 
$
9,067

 
$
10,917


$
18,051

Basic earnings per share:
 
 
 
 
 
 
 
 
Net income per share of common stock
 
$
0.28

 
$
0.45

 
$
0.55

 
$
0.90

Diluted earnings per share:
 
 
 
 
 
 
 
 
Net income per share of common stock
 
$
0.27

 
$
0.44

 
$
0.54

 
$
0.88

Cash dividends per share
 
$
0.095

 
$
0.090

 
$
0.185

 
$
0.175

Weighted-average number of shares of common stock outstanding:
 
 
 
 
 
 
 
 
Basic
 
20,015

 
20,153

 
20,016

 
20,149

Diluted
 
20,214

 
20,499

 
20,220

 
20,491





















Refer to Notes to Consolidated Financial Statements.




2



Materion Corporation and Subsidiaries
Consolidated Statements of Comprehensive Income
(Unaudited)
 
 
 
Second Quarter Ended
 
Six Months Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands)
 
2016
 
2015
 
2016
 
2015
Net income
 
$
5,549

 
$
9,067

 
$
10,917

 
$
18,051

Other comprehensive income:
 
 
 
 
 
 
 
 
Foreign currency translation adjustment
 
1,167

 
316

 
2,451

 
(1,254
)
Derivative and hedging activity, net of tax
 
302

 
(1,104
)
 
(621
)
 
(601
)
Pension and post-employment benefit adjustment, net of tax
 
675

 
902

 
2,250

 
1,804

Other comprehensive income
 
2,144

 
114

 
4,080

 
(51
)
Comprehensive income
 
$
7,693

 
$
9,181

 
$
14,997

 
$
18,000





































Refer to Notes to Consolidated Financial Statements.




3



Materion Corporation and Subsidiaries
Consolidated Balance Sheets
 
 
(Unaudited)
 
 
 
 
July 1,
 
Dec. 31,
(Thousands)
 
2016
 
2015
Assets
 
 
 
 
Current assets
 
 
 
 
Cash and cash equivalents
 
$
20,985

 
$
24,236

Accounts receivable
 
111,752

 
97,236

Inventories
 
211,965

 
211,820

Prepaid expenses
 
13,663

 
12,799

Total current assets
 
358,365

 
346,091

Long-term deferred income taxes
 
27,443

 
25,743

Property, plant, and equipment
 
856,795

 
833,834

Less allowances for depreciation, depletion, and amortization
 
(592,117
)
 
(570,205
)
Property, plant, and equipment—net
 
264,678

 
263,629

Intangible assets
 
10,936

 
13,389

Other assets
 
5,760

 
6,716

Goodwill
 
86,725

 
86,725

Total Assets
 
$
753,907

 
$
742,293

Liabilities and Shareholders’ Equity
 
 
 
 
Current liabilities
 
 
 
 
Short-term debt
 
$
14,823

 
$
8,990

Accounts payable
 
30,213

 
31,888

Salaries and wages
 
21,665

 
27,494

Other liabilities and accrued items
 
23,355

 
22,035

Income taxes
 
4,254

 
2,373

Unearned revenue
 
2,953

 
3,695

Total current liabilities
 
97,263

 
96,475

Other long-term liabilities
 
18,049

 
18,435

Retirement and post-employment benefits
 
86,864

 
92,794

Unearned income
 
43,661

 
45,953

Long-term income taxes
 
1,293

 
1,293

Deferred income taxes
 
167

 
110

Long-term debt
 
13,884

 
4,276

Shareholders’ equity
 


 


Serial preferred stock
 

 

Common stock
 
211,275

 
208,967

Retained earnings
 
506,872

 
499,659

Common stock in treasury
 
(152,755
)
 
(148,559
)
Accumulated other comprehensive loss
 
(76,625
)
 
(80,705
)
Other equity transactions
 
3,959

 
3,595

Total shareholders' equity
 
492,726

 
482,957

Total Liabilities and Shareholders’ Equity
 
$
753,907

 
$
742,293

Refer to Notes to Consolidated Financial Statements.



4



Materion Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited) 
 
 
Six Months Ended
 
 
July 1,
 
July 3,
(Thousands)
 
2016
 
2015
Cash flows from operating activities:
 
 
 
 
Net income
 
$
10,917

 
$
18,051

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
 
Depreciation, depletion, and amortization
 
23,497

 
20,117

Amortization of deferred financing costs in interest expense
 
281

 
331

Stock-based compensation expense
 
1,919

 
3,357

(Gain) loss on sale of property, plant, and equipment
 
(695
)
 
308

Deferred income tax (benefit) expense
 
(1,489
)
 
1,931

Changes in assets and liabilities net of acquired assets and liabilities:
 
 
 
 
Decrease (increase) in accounts receivable
 
(13,013
)
 
(4,622
)
Decrease (increase) in inventory
 
1,153

 
2,150

Decrease (increase) in prepaid and other current assets
 
(782
)
 
(4,037
)
Increase (decrease) in accounts payable and accrued expenses
 
(7,871
)
 
(16,882
)
Increase (decrease) in unearned revenue
 
(743
)
 
(283
)
Increase (decrease) in interest and taxes payable
 
1,310

 
3,240

Increase (decrease) in long-term liabilities
 
(6,221
)
 
(1,801
)
Other-net
 
771

 
(817
)
Net cash provided by operating activities
 
9,034

 
21,043

Cash flows from investing activities:
 
 
 
 
Payments for purchase of property, plant, and equipment
 
(14,326
)
 
(16,564
)
Payments for mine development
 
(7,806
)
 
(10,100
)
Proceeds from sale of property, plant, and equipment
 
827

 
18

Net cash used in investing activities
 
(21,305
)
 
(26,646
)
Cash flows from financing activities:
 
 
 
 
Proceeds from issuance of short-term debt
 
5,805

 
2,346

Proceeds from issuance of long-term debt
 
10,000

 
51,000

Repayment of long-term debt
 
(399
)
 
(33,110
)
Principal payments under capital lease obligations
 
(425
)
 
(404
)
Cash dividends paid
 
(3,704
)
 
(3,523
)
Repurchase of common stock
 
(2,663
)
 
(2,748
)
Net cash provided by financing activities
 
8,614

 
13,561

Effects of exchange rate changes
 
406

 
(479
)
Net change in cash and cash equivalents
 
(3,251
)
 
7,479

Cash and cash equivalents at beginning of period
 
24,236

 
13,150

Cash and cash equivalents at end of period
 
$
20,985

 
$
20,629


Refer to Notes to Consolidated Financial Statements.



5


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)



Note A — Accounting Policies
(Dollars in thousands)
Basis of Presentation: In management’s opinion, the accompanying consolidated financial statements of Materion Corporation and its subsidiaries (the Company) contain all of the adjustments necessary to present fairly the financial position, results of operations, and cash flows for the interim periods reported. All adjustments were of a normal and recurring nature. Certain amounts in prior years have been reclassified to conform to the 2016 consolidated financial statement presentation.
These financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company's 2015 Annual Report on Form 10-K. The interim period results are not necessarily indicative of the results to be expected for the full year.
New Pronouncements Adopted: In April 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires companies to present debt issuance costs associated with a debt liability as a deduction from the carrying amount of that debt liability on the balance sheet rather than being capitalized as an asset. The Company adopted this ASU effective January 1, 2016, and applied the new guidance on a retrospective basis which resulted in a decrease to Intangible assets, Short-term debt, and Long-term debt, at December 31, 2015, of $347, $8, and $339, respectively.
In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory. Inventory within the scope of this update is required to be measured at the lower of its cost or net realizable value, with net realizable value being the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. This ASU is effective prospectively for fiscal years and interim periods beginning after December 15, 2016, with early adoption permitted. We early adopted this ASU effective January 1, 2016. The adoption did not have a material effect on the consolidated financial statements.
New Pronouncements Issued: In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which impacts several aspects of accounting for share-based payment transactions, including income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. Under the new standard, income tax benefits and deficiencies are to be recognized as income tax expense or benefit in the income statement, and the tax effects of exercised or vested awards will be treated as discrete items in the reporting period in which they occur. An entity will also recognize excess tax benefits regardless of whether the benefit reduces taxes payable in the reporting period. Excess tax benefits will be classified, along with other income tax cash flows, as an operating activity. In regards to forfeitures, the entity may make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest or account for forfeitures as they occur. The ASU, which is required to be applied on a modified retrospective basis, will be effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2016, with early adoption permitted. The Company is currently evaluating the impact of adopting this new guidance on the consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases, which eliminates the off-balance-sheet accounting for leases. The new guidance will require lessees to report their operating leases as both an asset and liability on the balance sheet and disclose key information about leasing arrangements. The ASU, which is required to be applied on a modified retrospective basis, will be effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently evaluating the impact of adopting this new guidance on the consolidated financial statements.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which supersedes previous revenue recognition guidance. The new standard requires that a company recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those goods or services. Companies will need to use more judgment and estimates than under the guidance currently in effect, including estimating the amount of variable revenue to recognize over each identified performance obligation. Additional disclosures will be required to help users of financial statements understand the nature, amount, and timing of revenue and cash flows arising from contracts. This ASU is effective beginning in fiscal year 2018 with a provision for early adoption in 2017. The standard can be adopted either retrospectively or as a cumulative-effect adjustment as of the date of adoption. The Company is currently evaluating the impact of adopting this new guidance on the consolidated financial statements.



6


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


No other recently issued or effective ASUs had, or are expected to have, a material effect on the Company's results of operations, financial condition, or liquidity.
Note B — Segment Reporting
 
 
 
 
 
 
 
Other
 
 
(Thousands)
 
Performance
Alloys and
Composites
 
Advanced Materials
 
Other (1)
 
Corporate (2)
 
Subtotal
 
Total
Second Quarter 2016
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
97,696

 
$
113,557

 
$
38,523

 
$

 
$
38,523

 
$
249,776

Intersegment sales (3)
 
117

 
17,429

 

 

 

 
17,546

Value-added sales
 
83,350

 
46,993

 
25,111

 
(1,520
)
 
23,591

 
153,934

Operating profit (loss)
 
234

 
7,320

 
2,272

 
(4,049
)
 
(1,777
)
 
5,777

Second Quarter 2015
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
107,682

 
$
131,370

 
$
38,265

 
$
(462
)
 
$
37,803

 
$
276,855

Intersegment sales (3)
 
365

 
16,129

 

 

 

 
16,494

Value-added sales
 
91,511

 
46,705

 
25,203

 
(1,060
)
 
24,143

 
162,359

Operating profit (loss)
 
9,327

 
7,436

 
564

 
(4,216
)
 
(3,652
)
 
13,111

 
 
 
 
 
 
 
 
 
 
 
 
 
First Six Months 2016
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
188,325

 
$
221,677

 
$
75,285

 
$

 
$
75,285

 
$
485,287

Intersegment sales (3)
 
179

 
32,605

 

 

 

 
32,784

Value-added sales
 
161,552

 
89,059

 
49,745

 
(2,564
)
 
47,181

 
297,792

Operating profit (loss)
 
1,746

 
12,503

 
6,371

 
(7,311
)
 
(940
)
 
13,309

First Six Months 2015
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
210,941

 
$
281,287

 
$
74,882

 
$
(231
)
 
$
74,651

 
$
566,879

Intersegment sales (3)
 
542

 
33,514

 

 

 

 
34,056

Value-added sales
 
177,101

 
98,432

 
49,767

 
(310
)
 
49,457

 
324,990

Operating profit (loss)
 
16,130

 
16,339

 
2,239

 
(8,365
)
 
(6,126
)
 
26,343

(1) 
Other represents the Precision Coatings group, which is a business included in the Other reportable segment.
(2) 
Costs associated with the Company's unallocated corporate functions have been shown separately to better illustrate the financial information for the businesses within the Other reportable segment.
(3) 
Intersegment sales are eliminated in consolidation.



7


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Note C — Other-net
Other-net (income) expense for the second quarter and first six months of 2016 and 2015 is summarized as follows: 
 
 
Second Quarter Ended
 
Six Months Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands)
 
2016
 
2015
 
2016
 
2015
Foreign currency exchange/translation loss (gain)
 
$
650

 
$
(1,729
)
 
$
641

 
$
(3,313
)
Amortization of intangible assets
 
1,148

 
1,257

 
2,296

 
2,513

Metal consignment fees
 
1,653

 
1,833

 
3,186

 
3,868

Net loss (gain) on disposal of fixed assets
 
25

 
234

 
(695
)
 
308

Recovery from insurance
 

 

 

 
(3,800
)
Legal settlements
 

 
(1,325
)
 

 
(1,325
)
Other items
 
445

 
(234
)
 
379

 
(373
)
Total
 
$
3,921

 
$
36

 
$
5,807

 
$
(2,122
)
Note D — Income Taxes
The Company recorded an income tax benefit of $0.3 million in the second quarter of 2016, a negative effective tax rate of 5.4% against income before income taxes, and income tax expense of $3.4 million in the second quarter of 2015, with an effective tax rate of 27.2% against income before income taxes.
In the first six months of 2016, income tax expense of $1.5 million was calculated using an effective tax rate of 11.8%, while income tax expense of $7.0 million in the first six months of 2015 was calculated using an effective tax rate of 27.9%.
The difference between the statutory and effective rates in the second quarter and first six months of both years was primarily due to the impact of percentage depletion, the foreign rate differential, and other items. The research and development credit also had a favorable effect on the Company's 2016 effective tax rate.
The Company recorded a discrete tax benefit of $0.9 million in the second quarter of 2016, resulting from international tax planning initiatives. Discrete items for the first six months of 2016 were a net benefit of $0.8 million.



8


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Note E — Earnings Per Share
The following table sets forth the computation of basic and diluted EPS:
 
 
Second Quarter Ended
 
Six Months Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands, except per share amounts)
 
2016
 
2015
 
2016
 
2015
Numerator for basic and diluted EPS:
 
 
 
 
 
 
 
 
Net income
 
$
5,549

 
$
9,067

 
$
10,917

 
$
18,051

Denominator:
 
 
 
 
 
 
 
 
Denominator for basic EPS:
 
 
 
 
 
 
 
 
Weighted-average shares outstanding
 
20,015

 
20,153

 
20,016

 
20,149

Effect of dilutive securities:
 
 
 
 
 
 
 
 
Stock appreciation rights
 
63

 
207

 
63

 
198

Restricted stock units
 
75

 
83

 
90

 
95

Performance-based restricted stock units
 
61

 
56

 
51

 
49

Diluted potential common shares
 
199

 
346

 
204

 
342

Denominator for diluted EPS:
 

 

 
 
 
 
Adjusted weighted-average shares outstanding
 
20,214

 
20,499

 
20,220

 
20,491

Basic EPS
 
$
0.28

 
$
0.45

 
$
0.55

 
$
0.90

Diluted EPS
 
$
0.27

 
$
0.44

 
$
0.54

 
$
0.88


Stock appreciation rights totaling 1,018,778 and 478,048 for the quarters ended July 1, 2016 and July 3, 2015, respectively, and 1,018,778 and 480,985 for the six months ended July 1, 2016 and July 3, 2015, respectively, were excluded from the dilution calculation as their effect would have been anti-dilutive.
Note F — Depreciation and Amortization
The Company received an aggregate of $63.5 million from the U.S. Department of Defense (DoD) in previous periods for reimbursement of the DoD's share of the cost of the equipment in property, plant, and equipment, and the reimbursements are reported as unearned income, a liability on the Consolidated Balance Sheets. The equipment was placed in service during 2012, and its full cost is being depreciated in accordance with Company policy. The unearned income liability is being reduced ratably with the depreciation expense recorded over the life of the equipment.
In the first six months of 2016, the depreciation expense reimbursed for this equipment was $2.3 million. Unearned income was reduced by $2.3 million, accordingly, with the offset recorded as a credit to cost of sales. Depreciation, depletion, and amortization expense on the Consolidated Statements of Cash Flows is shown net of the reduction in unearned income.



9


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Note G — Inventories
Inventories on the Consolidated Balance Sheets are summarized as follows:
 
 
July 1,
 
Dec. 31,
(Thousands)
 
2016
 
2015
Raw materials and supplies
 
$
36,613

 
$
37,463

Work in process
 
176,842

 
180,458

Finished goods
 
41,211

 
38,135

Subtotal
 
$
254,666

 
$
256,056

Less: LIFO reserve balance
 
42,701

 
44,236

Inventories
 
$
211,965

 
$
211,820

The liquidation of last in, first out (LIFO) inventory layers reduced cost of sales by $0.5 million and $0.8 million in the second quarter of 2016 and 2015, respectively. In the first six months of 2016 and 2015, cost of sales was reduced by $3.2 million and $1.9 million, respectively.
Note H — Pensions and Other Post-employment Benefits
The following is a summary of the net periodic benefit cost for the second quarter and first six months of 2016 and 2015 for the domestic pension plans (which include the defined benefit pension plan and the supplemental retirement plans) and the domestic retiree medical plan.
 
 
Pension Benefits
 
Other Benefits
 
 
Second Quarter Ended
 
Second Quarter Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands)
 
2016
 
2015
 
2016
 
2015
Components of net periodic benefit cost
 
 
 
 
 
 
 
 
Service cost
 
$
1,946

 
$
2,231

 
$
25

 
$
29

Interest cost
 
2,595

 
2,500

 
141

 
138

Expected return on plan assets
 
(3,488
)
 
(3,354
)
 

 

Amortization of prior service benefit
 
(115
)
 
(112
)
 
(374
)
 
(374
)
Amortization of net loss
 
1,430

 
1,819

 

 

Net periodic benefit cost (benefit)
 
$
2,368

 
$
3,084

 
$
(208
)
 
$
(207
)
 
 
 
 
 
 
 
 
 
 
 
Pension Benefits
 
Other Benefits
 
 
Six Months Ended
 
Six Months Ended
 
 
July 1,
 
July 3,
 
July 1,
 
July 3,
(Thousands)
 
2016
 
2015
 
2016
 
2015
Components of net periodic benefit cost
 
 
 
 
 
 
 
 
Service cost
 
$
3,891

 
$
4,461

 
$
51

 
$
58

Interest cost
 
5,190

 
5,000

 
282

 
276

Expected return on plan assets
 
(6,976
)
 
(6,708
)
 

 

Amortization of prior service benefit
 
(230
)
 
(224
)
 
(748
)
 
(748
)
Amortization of net loss
 
2,861

 
3,639

 

 

Net periodic benefit cost (benefit)
 
$
4,736

 
$
6,168

 
$
(415
)
 
$
(414
)
The Company made contributions to the domestic defined benefit pension plans of $8.0 million and $4.0 million in the first six months of 2016 and 2015, respectively.



10


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Note I — Accumulated Other Comprehensive Income
Changes in the components of accumulated other comprehensive income, including the amounts reclassified, for the second quarter and first six months of 2016 and 2015 are as follows:
(Thousands)
 
Gains and Losses on Cash Flow Hedges
 
Pension and Post-Employment Benefits
 
Foreign Currency Translation
 
Total
Balance at April 1, 2016
 
$
656

 
$
(75,221
)
 
$
(4,204
)
 
$
(78,769
)
Other comprehensive income (loss) before reclassifications
 
98

 

 
1,167

 
1,265

Amounts reclassified from accumulated other comprehensive income
 
382

 
1,016

 

 
1,398

Net current period other comprehensive income (loss) before tax
 
480


1,016


1,167


2,663

Deferred taxes on current period activity
 
178

 
341

 

 
519

Net current period other comprehensive income (loss) after tax
 
302


675


1,167


2,144

Balance at July 1, 2016
 
$
958


$
(74,546
)

$
(3,037
)

$
(76,625
)
 
 
 
 
 
 
 
 
 
Balance at April 3, 2015
 
$
4,081

 
$
(80,760
)
 
$
(5,723
)
 
$
(82,402
)
Other comprehensive income (loss) before reclassifications
 
(197
)
 

 
316

 
119

Amounts reclassified from accumulated other comprehensive income
 
(1,555
)
 
1,395

 

 
(160
)
Net current period other comprehensive income (loss) before tax
 
(1,752
)

1,395


316


(41
)
Deferred taxes on current period activity
 
(648
)
 
493

 

 
(155
)
Net current period other comprehensive income (loss) after tax
 
(1,104
)

902


316


114

Balance at July 3, 2015
 
$
2,977


$
(79,858
)

$
(5,407
)

$
(82,288
)
 
 
 
 
 
 
 
 
 
Balance at December 31, 2015
 
$
1,579

 
$
(76,796
)
 
$
(5,488
)
 
$
(80,705
)
Other comprehensive income (loss) before reclassifications
 
(1,445
)
 

 
2,451

 
1,006

Amounts reclassified from accumulated other comprehensive income
 
457

 
2,030

 

 
2,487

Net current period other comprehensive income (loss) before tax
 
(988
)
 
2,030

 
2,451

 
3,493

Deferred taxes on current period activity
 
(367
)
 
(220
)
 

 
(587
)
Net current period other comprehensive income (loss) after tax
 
(621
)
 
2,250

 
2,451

 
4,080

Balance at July 1, 2016
 
$
958

 
$
(74,546
)
 
$
(3,037
)
 
$
(76,625
)
 
 
 
 
 
 
 
 
 
Balance at December 31, 2014
 
$
3,578

 
$
(81,662
)
 
$
(4,153
)
 
$
(82,237
)
Other comprehensive income (loss) before reclassifications
 
2,439

 
14

 
(1,254
)
 
1,199

Amounts reclassified from accumulated other comprehensive income
 
(3,392
)
 
2,790

 

 
(602
)
Net current period other comprehensive income (loss) before tax
 
(953
)
 
2,804

 
(1,254
)
 
597

Deferred taxes on current period activity
 
(352
)
 
1,000

 

 
648

Net current period other comprehensive income (loss) after tax
 
(601
)
 
1,804

 
(1,254
)
 
(51
)
Balance at July 3, 2015
 
$
2,977

 
$
(79,858
)
 
$
(5,407
)
 
$
(82,288
)
Reclassifications from accumulated other comprehensive income of gains and losses on foreign currency cash flow hedges are recorded in Other-net in the Consolidated Statements of Income. Refer to Note L for additional details on cash flow hedges.
Reclassifications from accumulated other comprehensive income for pension and post-employment benefits are included in the computation of the net periodic pension and post-employment benefit expense. Refer to Note H for additional details on pension and post-employment expenses.



11


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Note J — Stock-based Compensation Expense
Stock-based compensation expense, which includes awards settled in shares and in cash, was $1.1 million and $2.3 million in the second quarter and first six months of 2016, respectively, compared to $1.3 million and $5.4 million in the same periods of 2015.
The Company granted 221,065 stock appreciation rights (SARs) to certain employees during the first six months of 2016. The weighted average exercise price per share and weighted average fair value per share of the SARs granted during the six months ended July 1, 2016 were $25.19 and $8.07, respectively. The Company estimated the fair value of the SARs using the following assumptions in the Black-Scholes model:
Risk-free interest rate
 
1.25
%
Dividend yield
 
1.4
%
Volatility
 
38.0
%
Expected term (in years)
 
5.7

The Company granted 69,212 stock-settled restricted stock units (RSUs) and 24,780 cash-settled RSUs to certain employees and non-employee directors during the first six months of 2016. The Company measures the fair value of grants of RSUs based on the closing market price of a share of Materion common stock on the date of the grant. The weighted average fair value per share was $25.96 for stock-settled RSUs granted during the six months ended July 1, 2016. Cash-settled RSUs are accounted for as liability-based compensation awards and adjusted based on the closing price of Materion’s common stock over the vesting period of three years.
The Company granted stock-settled and cash-settled performance-based restricted stock units (PRSUs) to certain employees in the first six months of 2016. The weighted-average fair value of the stock-settled PRSUs was $22.77 per share and will be expensed over the vesting period of three years. The liability for cash-settled PRSUs is re-measured at fair value each reporting period, and the expense is recorded accordingly. The final payout to the employees for all PRSUs will be based upon the Company’s return on invested capital and the total return to shareholders over the vesting period relative to a peer group’s performance over the same period.
At July 1, 2016, unearned compensation cost related to the unvested portion of all stock-based awards was approximately $7.0 million, and is expected to be recognized over the remaining vesting period of the respective grants.
Note K — Fair Value of Financial Instruments
The Company measures and records financial instruments at fair value. A fair value hierarchy is used for those instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and the Company’s assumptions (unobservable inputs). The hierarchy consists of three levels:
Level 1 — Quoted market prices in active markets for identical assets and liabilities;
Level 2 — Inputs other than Level 1 inputs that are either directly or indirectly observable; and
Level 3 — Unobservable inputs developed using estimates and assumptions developed by the Company, which reflect those that a market participant would use.



12


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


The following table summarizes the financial instruments measured at fair value in the Consolidated Balance Sheets as of July 1, 2016 and December 31, 2015: 
 
 
 
 
 
 
 
 
 
(Thousands)
 
Total Carrying Value in the Consolidated Balance Sheets
 
Quoted Prices
in  Active
Markets  for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
2016
 
2015
 
2016
 
2015
 
2016
 
2015
 
2016
 
2015
Financial Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deferred compensation investments
 
$
1,574

 
$
2,524

 
$
1,574

 
$
2,503

 
$

 
$
21

 
$

 
$

Foreign currency forward contracts
 
176

 
462

 

 

 
176

 
462

 

 

Total
 
$
1,750

 
$
2,986

 
$
1,574

 
$
2,503

 
$
176

 
$
483

 
$

 
$

Financial Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deferred compensation liability
 
$
1,574

 
$
2,524

 
$
1,574

 
$
2,503

 
$

 
$
21

 
$

 
$

Foreign currency forward contracts
 
881

 
180

 

 

 
881

 
180

 

 

Total
 
$
2,455

 
$
2,704

 
$
1,574

 
$
2,503

 
$
881

 
$
201

 
$

 
$

The Company uses a market approach to value the assets and liabilities for financial instruments in the table above. Outstanding contracts are valued through models that utilize market observable inputs, including both spot and forward prices, for the same underlying currencies and metals. The carrying values of the other working capital items and debt in the Consolidated Balance Sheet approximate fair values as of July 1, 2016.
Note L — Derivative Instruments and Hedging Activity
The Company uses derivative contracts to hedge portions of its foreign currency exposures and may also use derivatives to hedge a portion of its precious metal exposures. The objectives and strategies for using derivatives in these areas are as follows:
Foreign Currency.    The Company sells a portion of its products to overseas customers in their local currencies, primarily the euro and yen. The Company secures foreign currency derivatives, mainly forward contracts and options, to hedge these anticipated sales transactions. The purpose of the hedge program is to protect against the reduction in the dollar value of foreign currency sales from adverse exchange rate movements. Should the dollar strengthen significantly, the decrease in the translated value of the foreign currency sales should be partially offset by gains on the hedge contracts. Depending upon the methods used, hedge contracts may limit the benefits from a weakening U.S. dollar.
The use of forward contracts locks in a firm rate and eliminates any downside risk from an adverse rate movement as well as any benefit from a favorable rate movement. The Company may from time to time choose to hedge with options or a tandem of options, known as a collar. These hedging techniques can limit or eliminate the downside risk but can allow for some or all of the benefit from a favorable rate movement to be realized. Unlike a forward contract, a premium is paid for an option; collars, which are a combination of a put and call option, may have a net premium but can be structured to be cash neutral. The Company will primarily hedge with forward contracts due to the relationship between the cash outlay and the level of risk.
The use of foreign currency derivative contracts is governed by policies approved by the Audit Committee of the Board of Directors. A team consisting of senior financial managers reviews the estimated exposure levels, as defined by budgets, forecasts, and other internal data, and determines the timing, amounts, and instruments to use to hedge that exposure within the confines of the policy. Management analyzes the effective hedged rates and the actual and projected gains and losses on the hedging transactions against the program objectives, targeted rates, and levels of risk assumed. Hedge contracts are typically layered in at different times for a specified exposure period in order to minimize the impact of rate movements.



13


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


Precious Metals.    The Company maintains the majority of its precious metal production requirements on consignment in order to reduce its working capital investment and the exposure to metal price movements. When a precious metal product is fabricated and ready for shipment to the customer, the metal is purchased out of consignment at the current market price. The price paid by the Company forms the basis for the price charged to the customer. This methodology allows for changes in either direction in the market prices of the precious metals used by the Company to be passed through to the customer, and reduces the impact changes in prices could have on the Company's margins and operating profit. The consigned metal is owned by financial institutions that charge the Company a financing fee based upon the current value of the metal on hand.
In certain instances, a customer may want to establish the price for the precious metal at the time the sales order is placed rather than at the time of shipment. Setting the sales price at a different date than when the material would be purchased potentially creates an exposure to movements in the market price of the metal. Therefore, in these limited situations, the Company may elect to enter into a forward contract to purchase precious metal. The forward contract allows the Company to purchase metal at a fixed price on a specific future date. The price in the forward contract serves as the basis for the price to be charged to the customer. By doing so, the selling price and purchase price are matched, and the Company's price exposure is reduced.
The Company refines precious metal containing materials for its customers and typically will purchase the refined metal from the customer at current market prices. In limited circumstances, the customer may want to fix the price to be paid at the time of the order as opposed to when the material is refined. The customer may also want to fix the price for a set period of time. The Company may then elect to enter into a hedge contract, either a forward contract or a swap, to fix the price for the estimated quantity of metal to be purchased, thereby reducing the exposure to adverse movements in the price of the metal.
The Company may from time to time elect to purchase precious metal and hold in inventory rather than on consignment due to potential credit line limitations or other factors. These purchases are typically held for a short duration. A forward contract will be secured at the time of the purchase to fix the price to be used when the metal is transferred back to the consignment line, thereby limiting any price exposure during the time when the metal was owned.
The Company will only enter into a derivative contract if there is an underlying identified exposure. Contracts are typically held until maturity. The Company does not engage in derivative trading activities and does not use derivatives for speculative purposes. The Company only uses currency hedge contracts that are denominated in the same currency as the underlying exposure and precious metal hedge contracts denominated in the same metal as the underlying exposure.
All derivatives are recorded on the balance sheet at fair value. If the derivative is designated and effective as a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income (OCI) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s fair value, if any, is recognized in earnings immediately. If a derivative is not a hedge, changes in the fair value are adjusted through income. The fair values of the outstanding derivatives are recorded on the balance sheet as assets (if the derivatives are in a gain position) or liabilities (if the derivatives are in a loss position). The fair values will also be classified as short-term or long-term depending upon their maturity dates.











14


Materion Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Unaudited)


The following table summarizes the notional amount and the fair value of the Company’s outstanding derivatives and balance sheet classification as of July 1, 2016 and December 31, 2015:
 
 
July 1, 2016
 
December 31, 2015
(Thousands)
 
Notional
Amount
 
Fair
Value
 
Notional
Amount
 
Fair
Value
Prepaid expenses
 
 
 
 
 
 
 
 
Foreign currency forward contracts - yen
 
$

 
$

 
$
5,138

 
$
60

Foreign currency forward contracts - euro
 
11,813

 
166

 
18,181

 
402

 
 
11,813

 
166

 
23,319

 
462

Other assets
 
 
 
 
 
 
 
 
Foreign currency forward contracts - yen
 

 

 

 

Foreign currency forward contracts - euro
 
915

 
10

 

 

 
 
915

 
10

 

 

Other liabilities and accrued items
 
 
 
 
 
 
 
 
Foreign currency forward contracts - yen
 
5,242

 
(714
)
 
5,102

 
(94
)
Foreign currency forward contracts - euro
 
7,503

 
(148
)
 
10,514

 
(86
)
 
 
12,745

 
(862
)
 
15,616

 
(180
)
Other long-term liabilities

 
 
 
 
 
 
 
 
Foreign currency forward contracts - yen
 
541

 
(19
)
 

 

Foreign currency forward contracts - euro
 

 

 

 

 
 
541

 
(19
)
 

 

Total
 
$
26,014

 
$
(705
)
 
$
38,935

 
$
282

All of these contracts were designated and effective as cash flow hedges. No ineffective expense was recorded in the second quarter or first six months of 2016 or 2015.
Changes in the fair value of outstanding cash flow hedges recorded in OCI for the first six months of 2016 and 2015 totaled a decrease of $1.4 million and an increase of $2.4 million, respectively. The Company expects to relieve substantially the entire balance in OCI as of July 1, 2016 to the Consolidated Statements of Income during the twelve-month period beginning July 2, 2016. Refer to Note I for additional OCI details.
Note M — Contingencies
Materion Brush Inc., one of the Company's wholly-owned subsidiaries, is a defendant from time to time in proceedings where the plaintiffs allege they have contracted chronic beryllium disease (CBD) or related ailments as a result of exposure to beryllium. The Company will record a reserve for CBD or other litigation when a loss from either settlement or verdict is probable and estimable. Claims filed by third-party plaintiffs may be covered by insurance subject to deductibles which vary based on when the exposure occurred. Reserves are recorded for asserted claims only, and defense costs are expensed as incurred. One CBD case remains outstanding and one case is on appeal as of the end of the second quarter of 2016, and the Company does not expect the resolution of these matters to have a material impact on the consolidated financial statements.
The Company has an active environmental compliance program and records reserves for the probable cost of identified environmental remediation projects. The reserves are established based upon analyses conducted by the Company’s engineers and outside consultants and are adjusted from time to time based upon ongoing studies, the difference between actual and estimated costs, and other factors. The reserves may also be affected by rulings and negotiations with regulatory agencies. The undiscounted reserve balance was $6.1 million at July 1, 2016 and $5.7 million at December 31, 2015. Environmental projects tend to be long term, and the final actual remediation costs may differ from the amounts currently recorded.




15



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
We are an integrated producer of high-performance advanced engineered materials used in a variety of electrical, electronic, thermal, and structural applications. Our products are sold into numerous end markets, including consumer electronics, industrial components, medical, automotive electronics, defense, telecommunications infrastructure, energy, commercial aerospace, science, services, and appliance.
RESULTS OF OPERATIONS
Second Quarter
 
 
Second Quarter Ended
 
 
July 1,
 
July 3,
 
$
 
%
(Thousands, except per share data)
 
2016
 
2015
 
Change
 
Change
Net sales
 
$
249,776

 
$
276,855

 
$
(27,079
)
 
(10
)%
Value-added sales
 
153,934

 
162,359

 
(8,425
)
 
(5
)%
Gross margin
 
45,306

 
51,327

 
(6,021
)
 
(12
)%
Gross margin as a % of value-added sales
 
29
%
 
32
%
 
N/A

 
N/A

Selling, general, and administrative (SG&A) expense
 
32,437

 
34,594

 
(2,157
)
 
(6
)%
SG&A expense as a % of value-added sales
 
21
%
 
21
%
 
N/A

 
N/A

Research and development (R&D) expense
 
3,171

 
3,586

 
(415
)
 
(12
)%
R&D expense as a % of value-added sales
 
2
%
 
2
%
 
N/A

 
N/A

Other—net
 
3,921

 
36

 
3,885

 
10,792
 %
Operating profit
 
5,777


13,111

 
(7,334
)
 
(56
)%
Interest expense—net
 
512

 
650

 
(138
)
 
(21
)%
Income before income taxes
 
5,265

 
12,461

 
(7,196
)
 
(58
)%
Income tax (benefit) expense
 
(284
)
 
3,394

 
(3,678
)
 
(108
)%
Net income
 
$
5,549

 
$
9,067

 
$
(3,518
)
 
(39
)%
 
 
 
 
 
 
 
 
 
Diluted earnings per share
 
$
0.27

 
$
0.44

 
$
(0.17
)
 
(39
)%
N/A = Not Applicable

Net sales of $249.8 million in the second quarter of 2016 were $27.1 million lower than the $276.9 million recorded in the second quarter of 2015. The decrease in net sales in the second quarter of 2016 was due to lower sales volume offset by the impact of pass-through precious metal and copper prices. Sales volume was lower due primarily to decreased shipments of raw material beryllium hydroxide, weaker demand in the oil and gas sector of the energy end market, and weakness in the automotive electronics end markets. Changes in precious metal and copper prices favorably impacted net sales in the second quarter of 2016 by $3.6 million when compared to the second quarter of 2015.

Value-added sales is a non-GAAP measure that removes the impact of pass-through metal costs and allows for analysis without the distortion of the movement or volatility in metal prices. Internally, we manage our business on this basis, and a reconciliation of net sales to value-added sales is included herein. Value-added sales of $153.9 million in the second quarter of 2016 decreased $8.4 million, or 5% compared to the second quarter of 2015. Value-added sales to the consumer electronics and defense end markets, which collectively accounted for 38% of our total value added sales, increased $4.5 million year-over-year. These increases were more than offset by decreased shipments of raw material beryllium hydroxide of $7.9 million, lower value-added sales to the energy end market of $1.6 million, and weakness in the automotive electronics end markets of $1.4 million.

Gross margin in the second quarter of 2016 was $45.3 million, or $6.0 million below the $51.3 million gross margin recorded during the second quarter of 2015. Expressed as a percentage of value-added sales, gross margin declined from 32% in the second



16



quarter of 2015 to 29% in the second quarter of 2016. The decrease in gross margin was primarily due to lower sales volume and unfavorable product mix.

SG&A expense was $32.4 million in the second quarter of 2016, or $2.2 million lower than $34.6 million in the second quarter of 2015. The decrease in SG&A expense was due primarily to a $1.6 million reduction in stock-based and annual incentive compensation expense driven by a reduction in operating profit and lower stock prices as compared to the prior-year period. In addition, selling expenses were also lower due to the decrease in sales volume.

R&D expense consists primarily of direct personnel costs for pre-production evaluation and testing of new products, prototypes, and applications. R&D expense was flat as a percentage of value-added sales at approximately 2% in the second quarter of both 2016 and 2015.

Other-net was $3.9 million of expense in the second quarter of 2016, or a $3.9 million increase from the second quarter of 2015. Other-net in the second quarter of 2015 included foreign currency exchange gains of $1.7 million due primarily to the maturity of foreign currency forward contracts compared to a foreign currency exchange loss of $0.7 million in the second quarter of 2016. Additionally, Other-net in the second quarter of 2015 included a gain of $1.3 million related to a favorable legal settlement. Refer to Note C to the Consolidated Financial Statements for details of the major components within Other-net.

Interest expense-net was $0.5 million in the second quarter of 2016 and $0.7 million in the second quarter of 2015 due to lower average debt outstanding.

Income tax expense for the second quarter of 2016 was a benefit of $0.3 million versus expense of $3.4 million in the second quarter of 2015. The negative effective tax rate for the second quarter of 2016 was 5.4% compared to an effective tax rate of 27.2% in the prior-year period. The effects of a discrete item, percentage depletion, the foreign rate differential, and other items were the primary factors for the difference between the effective and statutory rates in the second quarter of 2016 and 2015. The R&D tax credit also had a favorable effect on the Company's second quarter 2016 effective tax rate.

Six Months
 
 
Six Months Ended
 
 
July 1,
 
July 3,
 
$
 
%
(Thousands, except per share data)
 
2016
 
2015
 
Change
 
Change
Net sales
 
$
485,287

 
$
566,879

 
$
(81,592
)
 
(14
)%
Value-added sales
 
297,792

 
324,990

 
(27,198
)
 
(8
)%
Gross margin
 
88,663

 
103,682

 
(15,019
)
 
(14
)%
Gross margin as a % of value-added sales
 
30
%
 
32
%
 
N/A

 
N/A

SG&A expense
 
62,924

 
72,527

 
(9,603
)
 
(13
)%
SG&A expense as a % of value-added sales
 
21
%
 
22
%
 
N/A

 
N/A

R&D expense
 
6,623

 
6,934

 
(311
)
 
(4
)%
R&D expense as a % of value-added sales
 
2
%
 
2
%
 
N/A

 
N/A

Other—net
 
5,807

 
(2,122
)
 
7,929

 
(374
)%
Operating profit
 
13,309

 
26,343

 
(13,034
)
 
(49
)%
Interest expense—net
 
927

 
1,307

 
(380
)
 
(29
)%
Income before income taxes
 
12,382

 
25,036

 
(12,654
)
 
(51
)%
Income tax expense
 
1,465

 
6,985

 
(5,520
)
 
(79
)%
Net income
 
$
10,917

 
$
18,051

 
$
(7,134
)
 
(40
)%
 
 
 
 
 
 
 
 
 
Diluted earnings per share
 
$
0.54

 
$
0.88

 
$
(0.34
)
 
(39
)%
N/A = Not Applicable

Net sales of $485.3 million in the first six months of 2016 were $81.6 million lower than the $566.9 million recorded in the first six months of 2015. The decrease in net sales in the first six months of 2016 was due to lower sales volume and lower pass-through precious metal and copper prices. Sales volume was lower due primarily to decreased shipments of raw material beryllium hydroxide, weaker demand in the oil and gas sector of the energy end market, and weakness in the consumer electronics, industrial components, and automotive electronics end markets. Changes in precious metal and copper prices negatively impacted net sales in the first six months of 2016 by approximately $11.7 million when compared to the first six months of 2015.



17




Value-added sales of $297.8 million in the first six months of 2016 decreased $27.2 million, or 8% compared to the first six months of 2015. Value-added sales to the defense end market increased $8.3 million year-over-year. This increase was more than offset by decreased shipments of raw material beryllium hydroxide of $10.9 million and lower value-added sales to the energy end market of $5.1 million.

Value-added sales to the consumer electronics end market, our largest end market accounting for approximately 27% of our total value-added sales in the first half of 2016, decreased $5.5 million or 6% from the first half of 2015. This decrease was primarily related to lower sales volume of our products used in hand-held devices and weakness in the projector display market within our Precision Coatings group due to a transition to new technology.

The industrial components and automotive electronics end market sales, which collectively accounted for 24% of our total value-added sales in the first six months of 2016, decreased $7.0 million or 9% as compared to the first six months of 2015.

Gross margin in the first six months of 2016 was $88.7 million, or $15.0 million below the $103.7 million gross margin recorded during the first six months of 2015. Expressed as a percentage of value-added sales, gross margin declined from 32% in the first six months of 2015 to 30% in the first six months of 2016. The decrease in gross margin was primarily due to a combination of lower sales volume and unfavorable product mix.

SG&A expense was $62.9 million in the first six months of 2016, or $9.6 million lower than $72.5 million in the first six months of 2015. The decrease in SG&A expense was due primarily to a $6.7 million reduction in stock-based and annual incentive compensation expense driven by a reduction in operating profit and lower stock prices as compared to the prior-year period. In addition, selling expenses were also lower due to the decrease in sales volume.

R&D expense was flat as a percentage of value-added sales at approximately 2% in the first half of both 2016 and 2015.

Other-net was $5.8 million of expense in the first six months of 2016 as compared to $2.1 million of income in the first six months of 2015. Other-net in the first half of 2015 included foreign currency exchange gains of $3.3 million compared to a foreign currency exchange loss of $0.6 million in the first half of 2016. Additionally, Other-net in the first half of 2015 included recognized gains of $5.1 million from settlement agreements on insurance and legal claims in connection with construction of our beryllium pebble facility in Elmore, Ohio. Refer to Note C to the Consolidated Financial Statements for details of the major components within Other-net.

Interest expense-net was $0.9 million in the first six months of 2016 and $1.3 million in the first six months of 2015 due to lower average debt outstanding.

Income tax expense for the first six months of 2016 was $1.5 million versus $7.0 million in the first six months of 2015. The effective tax rates for the first half of 2016 and 2015 were 11.8% and 27.9%, respectively. The effects of a discrete item, percentage depletion, the foreign rate differential, and other items were the primary factors for the difference between the effective and statutory rates in the first half of 2016 and 2015. The R&D tax credit also had a favorable effect on the Company's effective tax rate in the first six months of 2016.




18



Value-Added Sales - Reconciliation of Non-GAAP Measure
A reconciliation of net sales to value-added sales, a non-GAAP measure, for each reportable segment and for the total Company for the first quarter of 2016 and 2015 is as follows:
 
 
Second Quarter Ended
 
Six Months Ended
 
 
July 1,

July 3,
 
July 1,
 
July 3,
(Thousands)
 
2016

2015
 
2016
 
2015
Net sales
 
 
 
 
 
 
 
 
Performance Alloys and Composites
 
$
97,696

 
$
107,682

 
$
188,325

 
$
210,941

Advanced Materials
 
113,557

 
131,370

 
221,677

 
281,287

Other
 
38,523

 
37,803

 
75,285

 
74,651

Total
 
$
249,776

 
$
276,855

 
$
485,287

 
$
566,879

 
 
 
 
 
 
 
 
 
Less: pass-through metal costs
 
 
 
 
 
 
 
 
Performance Alloys and Composites
 
$
14,346

 
$
16,171

 
$
26,773

 
$
33,840

Advanced Materials
 
66,564

 
84,665

 
132,618

 
182,855

Other
 
14,932

 
13,660

 
28,104

 
25,194

Total
 
$
95,842

 
$
114,496

 
$
187,495

 
$
241,889

 
 
 
 
 
 
 
 
 
Value-added sales
 
 
 
 
 
 
 
 
Performance Alloys and Composites
 
$
83,350

 
$
91,511

 
$
161,552

 
$
177,101

Advanced Materials
 
46,993

 
46,705

 
89,059

 
98,432

Other
 
23,591

 
24,143

 
47,181

 
49,457

Total
 
$
153,934

 
$
162,359

 
$
297,792

 
$
324,990

The cost of gold, silver, platinum, palladium, and copper can be quite volatile. Our pricing policy is to directly pass the cost of these metals on to the customer in order to mitigate the impact of metal price volatility on our results from operations. Trends and comparisons of net sales are affected by movements in the market prices of these metals, but changes in net sales due to metal price movements may not have a proportionate impact on our profitability.
Internally, management reviews net sales on a value-added basis. Value-added sales are a non-GAAP measure that deducts the value of the pass-through metal costs from net sales. Value-added sales allow management to assess the impact of differences in net sales between periods, segments, or markets, and analyze the resulting margins and profitability without the distortion of movements in pass-through metal costs. The dollar amount of gross margin and operating profit is not affected by the value-added sales calculation. We sell other metals and materials that are not considered direct pass-throughs, and these costs are not deducted from net sales when calculating value-added sales.
Our net sales are also affected by changes in the use of customer-supplied metal. When we manufacture a precious metal product, the customer may purchase metal from us or may elect to provide its own metal, in which case we process the metal on a toll basis and the metal value does not flow through net sales or cost of sales. In either case, we generally earn our margin based upon our fabrication efforts. The relationship of this margin to net sales can change depending upon whether or not the product was made from our metal or the customer’s metal. The use of value-added sales removes the potential distortion in the comparison of net sales caused by changes in the level of customer-supplied metal.
By presenting information on net sales and value-added sales, it is our intention to allow users of our financial statements to review our net sales with and without the impact of the pass-through metals.

Segment Results
The Company consists of three reportable segments: Performance Alloys and Composites, Advanced Materials, and Other. The Other reportable segment includes the results of our Precision Optics and Large Area Coatings operating segments, which do not meet the quantitative thresholds for separate disclosure and are collectively referred to as our Precision Coatings group. The Other reportable segment also includes unallocated corporate costs. Refer to Note B to the Consolidated Financial Statements for additional business segment information.



19




Performance Alloys and Composites
Second Quarter
 
 
Second Quarter Ended
 
 
July 1,
 
July 3,
 
$
 
%
(Thousands)
 
2016
 
2015
 
Change
 
Change
Net sales
 
$
97,696

 
$
107,682

 
$
(9,986
)
 
(9
)%
Value-added sales
 
83,350

 
91,511

 
(8,161
)
 
(9
)%
Operating profit
 
234

 
9,327

 
(9,093
)
 
(97
)%
Net sales from the Performance Alloys and Composites segment of $97.7 million in the second quarter of 2016 were 9% lower than net sales of $107.7 million in the second quarter of 2015 primarily due to lower sales volume and the impact of lower pass-through metal prices of $2.2 million.
Value-added sales of $83.4 million in the second quarter of 2016 were 9% lower than value-added sales of $91.5 million in the second quarter of 2015. The decrease in value-added sales was primarily driven by lower raw material sales of beryllium hydroxide of $7.9 million.
Performance Alloys and Composites generated operating profit of $0.2 million in the second quarter of 2016 compared to