SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 ------------------------------------------------------- FORM 10-Q ------------------------------------------------------- (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005, or [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO . ---- ---- COMMISSION FILE NUMBER 0-18863 ARMOR HOLDINGS, INC. ------------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 59-3392443 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 13386 INTERNATIONAL PARKWAY JACKSONVILLE, FLORIDA 32218 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (904) 741-5400 ------------------------------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No --- --- The number of shares outstanding of the registrant's Common Stock as of July 25, 2005 is 34,562,910. ARMOR HOLDINGS, INC. FORM 10-Q INDEX Page PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS .................................... 3 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.......... 33 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...................................... 53 ITEM 4. CONTROLS AND PROCEDURES.................................. 55 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS........................................ 56 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS................................................ 57 ITEM 6. EXHIBITS ................................................ 58 SIGNATURES .................................................................. 60 2 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS The accompanying unaudited condensed consolidated financial statements of Armor Holdings, Inc. and its wholly-owned subsidiaries include all adjustments which management considers necessary for a fair presentation of operating results and financial position as of June 30, 2005 and for the three month and six month periods ended June 30, 2005 and June 30, 2004. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements included in our Annual Report on Form 10-K and amendments thereto for the fiscal year ended December 31, 2004. 3 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) <TABLE> JUNE 30, 2005 DECEMBER 31, 2004 (UNAUDITED) * ------------- ----------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 92,317 $ 421,209 Short-term investment securities 376,525 - Accounts receivable (net of allowance for doubtful accounts of $3,325 and $3,077) 177,870 175,452 Inventories 208,746 176,208 Prepaid expenses and other current assets 49,618 46,935 -------------- --------------- Total current assets 905,076 819,804 PROPERTY AND EQUIPMENT (net of accumulated depreciation of $32,016 and $27,917) 77,475 77,307 GOODWILL (net of accumulated amortization of $4,024 and $4,024) 265,018 262,013 PATENTS, LICENSES AND TRADEMARKS (net of accumulated amortization of $10,904 and $6,830) 108,483 112,459 OTHER ASSETS 19,272 20,768 -------------- --------------- TOTAL ASSETS $ 1,375,324 $ 1,292,351 ============== =============== </TABLE> * Condensed from audited financial statements. See notes to condensed consolidated financial statements. 4 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS - CONTINUED (IN THOUSANDS, EXCEPT FOR SHARE DATA) <TABLE> JUNE 30, 2005 DECEMBER 31, 2004 (UNAUDITED) * ------------- ----------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Current portion of long-term debt $ 424 $ 621 Short-term debt 346,678 343,756 Accounts payable 86,659 69,601 Accrued expenses and other current liabilities 100,675 107,247 Income taxes payable 7,711 9,001 ------------ ------------- Total current liabilities 542,147 530,226 LONG-TERM LIABILITIES: Long-term debt, less current portion 157,639 156,751 Other long-term liabilities 1,997 1,951 Deferred income taxes 41,210 38,227 ------------ ------------- Total liabilities 742,993 727,155 COMMITMENTS AND CONTINGENCIES (NOTE 12) STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value, 5,000,000 shares authorized; no shares issued and outstanding - - Common stock, $.01 par value; 75,000,000 and 75,000,000 shares authorized; 40,616,192 and 40,133,870 issued and 34,555,970 and 34,073,648 outstanding at June 30, 2005 and December 31, 2004, respectively 407 402 Additional paid-in capital 507,559 504,809 Retained earnings 193,925 125,481 Accumulated other comprehensive income 2,757 6,821 Treasury stock (72,317) (72,317) ------------ ------------- Total stockholders' equity 632,331 565,196 ------------ ------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,375,324 $ 1,292,351 ============ ============= </TABLE> * Condensed from audited financial statements. See notes to condensed consolidated financial statements. 5 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- REVENUES: Aerospace & Defense $ 256,688 $ 129,773 $ 517,158 $ 210,781 Products 76,805 65,743 145,363 119,583 Mobile Security 38,149 28,188 74,086 54,968 --------- --------- --------- --------- Total revenues 371,642 223,704 736,607 385,332 COSTS AND EXPENSES: Cost of revenues 275,840 157,246 549,495 271,314 Selling, general and administrative expenses 35,534 23,386 69,350 46,637 Amortization 2,038 973 4,076 1,953 Integration 834 802 1,634 1,483 Other charges - 7,321 - 7,321 --------- --------- --------- --------- OPERATING INCOME 57,396 33,976 112,052 56,624 Interest expense, net 1,514 2,057 3,759 3,785 Other income, net (3,093) (390) (1,970) (275) --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES 58,975 32,309 110,263 53,114 PROVISION FOR INCOME TAXES 21,560 14,588 41,819 22,765 --------- --------- --------- --------- INCOME FROM CONTINUING 37,415 17,721 68,444 30,349 OPERATIONS INCOME (LOSS) FROM DISCONTINUED OPERATIONS (NOTE 2), NET OF TAX - 100 - (38) --------- --------- --------- --------- NET INCOME $ 37,415 $ 17,821 $ 68,444 $ 30,311 ========= ========= ========= ========= NET INCOME PER COMMON SHARE - BASIC INCOME FROM CONTINUING OPERATIONS $ 1.09 $ 0.60 $ 1.99 $ 1.04 INCOME FROM DISCONTINUED OPERATIONS 0.00 0.00 0.00 0.00 --------- --------- ---------- --------- BASIC EARNINGS PER SHARE $ 1.09 $ 0.60 $ 1.99 $ 1.04 ========= ========= ========= ========= </TABLE> See notes to condensed consolidated financial statements. 6 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - CONTINUED (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- NET INCOME PER COMMON SHARE - DILUTED INCOME FROM CONTINUING OPERATIONS $ 1.05 $ 0.57 $ 1.93 $ 0.99 INCOME FROM DISCONTINUED OPERATIONS 0.00 0.00 0.00 0.00 ------- ------- -------- ------- DILUTED EARNINGS PER SHARE $ 1.05 $ 0.57 $ 1.93 $ 0.99 ======= ======= ======== ======= WEIGHTED AVERAGE SHARES - BASIC 34,480 29,670 34,321 29,236 ======= ======= ======== ======= WEIGHTED AVERAGE SHARES - DILUTED 35,562 31,008 35,536 30,469 ======= ======= ======== ======= </TABLE> See notes to condensed consolidated financial statements. 7 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) (IN THOUSANDS) <TABLE> SIX MONTHS ENDED ---------------------------------- JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- CASH FLOW FROM OPERATING ACTIVITIES: Income from continuing operations $ 68,444 $ 30,349 Adjustments to reconcile income from continuing operations to cash provided by operating activities: Depreciation and amortization 10,588 6,603 Loss on disposal of fixed assets 503 115 Deferred income taxes 3,640 (197) Fair value gain for put options (3,793) -- Non-cash charge for acceleration of performance-based restricted stock awards -- 5,913 Non-cash impairment charge -- 1,408 Changes in operating assets and liabilities, net of acquisitions: Increase in accounts receivable (2,648) (38,772) Increase in inventories (32,538) (31,997) Increase in prepaid expenses and other assets (1,255) (8,881) Increase in accounts payable, accrued expenses and other current liabilities 14,592 27,649 Increase in income taxes payable 498 17,475 --------- --------- Net cash provided by operating activities 58,031 9,665 --------- --------- CASH FLOW FROM INVESTING ACTIVITIES: Purchase of property and equipment (8,146) (7,104) Purchase of patents and trademarks (100) (77) Purchases of short-term investment securities (562,750) (225,125) Proceeds from sales of short-term investment securities 186,225 16,175 Sale of put options 4,790 -- Purchase of equity investment -- (5,275) Proceeds from sale of equity investment -- 5,823 Collection of note receivable -- 375 Decrease in restricted cash -- 2,600 Additional cash received from sale of business 300 -- Additional consideration for purchased businesses (4,604) (1,855) Purchase of businesses, net of cash acquired (1,362) (2,729) --------- --------- Net cash used in investing activities (385,647) (217,192) --------- --------- CASH FLOW FROM FINANCING ACTIVITIES: Proceeds from the exercise of stock options 4,304 8,310 Proceeds from the issuance of common stock -- 142,500 Cash paid for common stock offering costs -- (1,057) Taxes paid for withheld shares on restricted stock issuances (5,794) -- Repayments of long-term debt (314) (34,052) Borrowings under lines of credit 9,634 8,885 Repayments under lines of credit (6,985) (8,122) --------- --------- Net cash provided by financing activities 845 116,464 --------- --------- Effect of exchange rate changes on cash and cash equivalents (2,121) 63 Net cash used in discontinued operations -- (717) --------- --------- NET DECREASE IN CASH AND CASH EQUIVALENTS (328,892) (91,717) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 421,209 111,850 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 92,317 $ 20,133 ========= ========= CASH AND CASH EQUIVALENTS, END OF PERIOD: CONTINUING OPERATIONS $ 92,317 $ 20,133 DISCONTINUED OPERATIONS -- 157 --------- --------- $ 92,317 $ 20,290 ========= ========= </TABLE> See notes to condensed consolidated financial statements. 8 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Armor Holdings, Inc. and its wholly-owned subsidiaries (the "Company", "we", "our", "us") have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary by management to present a fair presentation have been included. The results of operations for the three month and six month periods are not necessarily indicative of the results to be expected for the full year and should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K and amendments thereto for the year ended December 31, 2004. The amounts disclosed in the footnotes are related to continuing operations unless otherwise indicated. Certain prior year amounts have been reclassified to conform to the current year presentation. NOTE 2 - DISCONTINUED OPERATIONS On July 2, 2004, we sold the security consulting division of our litigation support services subsidiary, New Technologies Armor, Inc. ("NTI"), which was the last remaining business in discontinued operations. The remaining division in NTI, consisting primarily of training services, has been included as part of the Products Division segment, where management now resides. This business represented the last remaining business in our ArmorGroup Services Division (the "Services Division"). We had no discontinued operations at June 30, 2005. A summary of the operating results of the discontinued operations for the three and six month periods ended June 30, 2005 and 2004, is as follows: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED ----------------------------------- ---------------------------------- JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS) (IN THOUSANDS) Revenues $ -- $ 1,013 $ -- $ 1,733 Cost of revenues -- 461 -- 697 Selling, general and administrative expenses -- 385 821 ------- ------- ------ ------- Operating income -- 167 -- 215 Interest expense, net -- -- -- 2 Other expense, net -- 10 -- 273 ------- ------- ------ ------- Income (loss) from discontinued operations before provision (benefit) for income taxes -- 157 -- (60) Provision (benefit) for income taxes -- 57 -- (22) ------- ------- ------ ------- Income (loss) from discontinued operations $ -- $ 100 $ -- $ (38) ======= ======= ====== ======= </TABLE> 9 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 3 - COMPREHENSIVE INCOME The components of comprehensive income, net of tax benefit of $298,000 and tax provision of zero for the three months ended June 30, 2005 and 2004, respectively, and net of tax benefit of $412,000 and tax provision of zero for the six months ended June 30, 2005 and 2004, respectively, are listed below: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED ---------------------------------- ---------------------------------- JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS) (IN THOUSANDS) Net income $ 37,415 $ 17,821 $ 68,444 $ 30,311 Other comprehensive loss: Foreign currency translations, net of tax (2,021) (230) (4,064) (558) --------- --------- --------- --------- Comprehensive income: $ 35,394 $ 17,591 $ 64,380 $ 29,753 ========= ========= ========= ========= </TABLE> NOTE 4 - INVENTORIES The components of inventory as of June 30, 2005 and December 31, 2004, are summarized as follows: JUNE 30, 2005 DECEMBER 31, 2004 ------------- ----------------- (IN THOUSANDS) Raw material $ 135,035 $ 97,528 Work-in-process 39,508 51,137 Finished goods 34,203 27,543 --------- -------- Total inventories $ 208,746 $176,208 ========= ======== NOTE 5 - ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities as of June 30, 2005 and December 31, 2004, are summarized as follows: <TABLE> JUNE 30, 2005 DECEMBER 31, 2004 ------------- ----------------- (IN THOUSANDS) Accrued expenses and other current liabilities $ 67,415 $ 70,869 Customer deposits 31,129 32,317 Deferred consideration for acquisitions 2,131 4,061 --------- --------- Total accrued expenses and other current liabilities $ 100,675 $ 107,247 ========= ========= </TABLE> 10 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 6 - DERIVATIVE FINANCIAL INSTRUMENTS We account for derivative instruments in accordance with Statement of Financial Accounting Standards No. 133, " Accounting for Derivative Instruments and Hedging Activities," as amended by Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of SFAS 133", and Statement of Financial Accounting Standards No. 149 "Amendment of SFAS 133 on Derivative Instruments and Hedging Activities" (collectively "SFAS 133"). SFAS 133 requires all freestanding and embedded derivative instruments to be measured at fair value and recognized on the balance sheet as either assets or liabilities. In addition, all derivative instruments used in hedging relationships must be designated, reassessed and accounted for as either fair value hedges or cash flow hedges pursuant to the provisions of SFAS 133. We hedge the fair value of our 8.25% $150 million Senior Subordinated Notes due 2013 (the "8.25% Notes") using interest rate swaps. We enter into these derivative contracts to manage fair value changes which could be caused by our exposure to interest rate changes. On September 2, 2003, we entered into interest rate swap agreements, designated as fair value hedges as defined under SFAS 133 with an aggregate notional amount totaling $150 million. The agreements were entered into to exchange the fixed interest rate on the 8.25% Notes for a variable interest rate equal to six-month LIBOR (3.71% at June 30, 2005), set in arrears, plus a spread ranging from 2.735% to 2.75% fixed semi-annually on the fifteenth of February and August each year through maturity. The agreements are subject to other terms and conditions common to transactions of this type. These fair value hedges qualify for hedge accounting using the short-cut method since the swap terms match the critical terms of the 8.25% Notes. Accordingly, changes in the fair value of the interest rate swap agreements offset changes in the fair value of the 8.25% Notes due to changes in the market interest rate. As a result, no ineffectiveness is expected to be recognized in our earnings associated with the interest rate swap agreements on the 8.25% Notes. The fair value of the interest rate swap agreements was approximately $7.0 million and $6.0 million at June 30, 2005 and December 31, 2004, respectively, and is included in other assets and long-term debt on the accompanying condensed consolidated balance sheets. The fair values of our interest rate swap agreements are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the agreement, taking into consideration the difference between the contract rate of interest and rates currently quoted for agreements of similar terms and maturities. On October 29, 2004, we completed the placement of $300 million aggregate principal amount of the 2% Senior Subordinated Convertible Notes due November 1, 2024 (the "2% Convertible Notes"). On November 5, 2004, Goldman, Sachs & Co. exercised its option to purchase an additional $45 million principal amount of the 2% Convertible Notes. The 2% Convertible Notes will bear interest at a rate of 2.00% per year, payable on November 1 and May 1 of each year beginning on May 1, 2005 and ending on November 1, 2011. The 2% Convertible Notes will be subject to accretion of the principal amount beginning on November 1, 2011, at a rate that provides holders with an aggregate annual yield to maturity of 2.00%, as defined in the agreement. The 2% Convertible Notes will bear contingent interest during any six-month period beginning November 1, 2011, of 15 basis points paid in cash if the average trading price of the notes is above certain levels. As defined in SFAS 133, "Accounting for Derivative Instruments and Hedge Activities" the contingent interest feature of the 2% Convertible Notes is an embedded derivative that is not considered clearly and closely related to the host contract. The fair value 11 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED of this bifurcated derivative is immaterial to our financial position based on documentation we received from our investment bank. NOTE 7 - GOODWILL AND IDENTIFIED INTANGIBLE ASSETS Under Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), goodwill and intangible assets with indefinite lives are no longer amortized, but are tested for impairment at least annually or more often if indicators of impairment arise. The changes in the carrying amount of goodwill for the six months ended June 30, 2005 are as follows: <TABLE> AEROSPACE & MOBILE DEFENSE PRODUCTS SECURITY CORPORATE TOTAL ------- -------- -------- --------- ----- (IN THOUSANDS) Balance at $154,313 $101,292 $ 6,408 $ - $262,013 December 31, 2004 Goodwill acquired during period 850 - 150 1,728 2,728 Foreign currency translation and other adjustments (70) 406 (59) - 277 -------- -------- ------- ------ -------- Balance at June 30, 2005 $155,093 $101,698 $ 6,499 $ 1,728 $265,018 ======== ======== ======= ======= ======== </TABLE> Included in patents, licenses and trademarks in the accompanying consolidated balance sheets are the following intangible assets as of June 30, 2005: <TABLE> CUSTOMER RELATIONSHIPS TECHNOLOGY MARKETING TOTAL ------------- ---------- --------- ----- Gross amount $ 58,454 $ 14,806 $ 46,127 $ 119,387 Accumulated amortization (5,768) (2,412) (2,724) (10,904) -------- -------- -------- --------- Net amount $ 52,686 $ 12,394 $ 43,403 $ 108,483 ======== ======== ======== ========= </TABLE> Included in Marketing are approximately $41.2 million of marketing-related intangible assets that have indefinite lives. 12 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 8 - INFORMATION CONCERNING BUSINESS SEGMENTS AND GEOGRAPHICAL REVENUES We are a leading manufacturer and provider of specialized security products; training and support services related to these products; vehicle armor systems; military helicopter seating systems, aircraft and land vehicle safety systems; protective equipment for military personnel; and other technologies used to protect humans in a variety of life-threatening or catastrophic situations. Our products and systems are used domestically and internationally by military, law enforcement, security and corrections personnel, as well as governmental agencies, multinational corporations and individuals. Effective in the first quarter 2004, we instituted a new segment reporting format to include three reportable business divisions: Aerospace & Defense Group, the Products Division and the Mobile Security Division. Our Services Division has been classified as discontinued operations and is no longer included in this presentation (See Note 2). Aerospace & Defense Group. The Aerospace & Defense Group supplies human safety and survival systems to the U.S. military and major aerospace and defense prime contractors. Our core markets are land, marine and aviation safety and military personnel protection. The most significant business within the Aerospace & Defense Group is armoring a variety of light, medium and heavy wheeled vehicles for the military. We are the sole-source provider to the U.S. military of the armor and blast protection systems (up-armoring) for their High Mobility Multi-purpose Wheeled Vehicles (Up-Armored HMMWV, commonly known as the Humvee). We also provide spare parts and logistical and field support services for Up-Armored HMMWVs previously shipped by us. We also provide blast and ballistic protection kits for the standard HMMWV which are installed in the field. Additionally, we develop ballistic and blast protected armored and sealed truck cabs for other military tactical wheeled vehicles. For example, we provide land vehicle armor kits for the Heavy Expanded Mobility Tactical Truck ("HEMTT"), Palletized Load System ("PLS"), Heavy Equipment Transporter ("HET"), M915 and Armored Security Vehicle ("ASV"). The Aerospace & Defense Group develops and supplies personnel equipment, including small arms protection inserts ("SAPI") and other engineered ceramic body armor, helmets, and other protective and duty equipment. Our products include, among others, Modular Lightweight Load-Carrying Equipment ("MOLLE") systems, Outer Tactical Vests ("OTVs") and Warrior Helmets. We are currently the largest supplier of MOLLE systems for the U.S. Army which is a modular rucksack that can be configured in a number of ways depending on the needs of the military mission. We also manufacture OTVs which, when used with SAPI plates, provide enhanced protection against bullets, mines, grenades and mortar and artillery shells. SAPI plates have been adopted by the U.S. military as a key element of the protective equipment worn by U.S. troops. The Aerospace & Defense Group develops and sells military helicopter seating systems, helicopter cockpit airbag systems, aircraft armor kits, emergency bailout parachutes and survival equipment worn by military aircrew. The primary customers for these products are the U.S. Army, U.S. Marine Corps, Boeing and Sikorsky Aircraft. Armor Holdings Products. Our Armor Holdings Products Division manufactures and sells a broad range of high quality equipment marketed under brand names that are known in the military and law enforcement communities. Products manufactured by this division include concealable and tactical body armor, hard armor, duty gear, less-lethal munitions, anti-riot products, police batons, emergency 13 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED lighting products, forensic products, firearms accessories, weapon maintenance products, foldable ladders, backpacks and specialty gloves. Armor Mobile Security. Our Armor Mobile Security Division manufactures and installs armoring systems for commercial vehicles to protect against varying degrees of ballistic and blast threats. We armor a variety of commercial vehicles, including limousines, sedans, sport utility vehicles, commercial trucks and cash-in-transit vehicles. Our customers in this business include U.S. federal law enforcement and intelligence agencies, foreign heads of state, multinational corporations, as well as high net worth individuals and cash-in-transit operators. We have invested substantial resources outside of the United States and plan to continue to do so in the future. The Armor Mobile Security Division has invested substantial resources in Europe and South America. These operations are subject to the risk of new and different legal and regulatory requirements in local jurisdictions, tariffs and trade barriers, potential difficulties in staffing and managing local operations, currency risks, potential imposition of restrictions on investments, potentially adverse tax consequences, including imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries, and local economic, political and social conditions. Governments of many developing countries have exercised and continue to exercise substantial influence over many aspects of the private sector. Government actions in the future could have a significant adverse effect on economic conditions in a developing country or may otherwise have a material adverse effect on us and our operating companies. We do not have political risk insurance in the countries in which we currently conduct business. Moreover, applicable agreements relating to our interests in our operating companies are frequently governed by foreign law. As a result, in the event of a dispute, it may be difficult for us to enforce our rights. Accordingly, we may have little or no recourse upon the occurrence of any of these developments. Corporate. Our Corporate Division includes the corporate management and expenses associated with managing the overall company. These expenses include compensation and benefits of corporate management and staff, legal and professional fees, and administrative and general expenses, which are not allocated to the business units. 14 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED Revenues, operating income and total assets for each of our continuing operating segments are as follows (net of intercompany eliminations): <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS) (IN THOUSANDS) Revenues: Aerospace & Defense $ 256,688 $ 129,773 $ 517,158 $ 210,781 Products 76,805 65,743 145,363 119,583 Mobile Security 38,149 28,188 74,086 54,968 ---------- ---------- ---------- ---------- Total revenues $ 371,642 $ 223,704 $ 736,607 $ 385,332 ========== ========== ========== ========== Operating income (loss): Aerospace & Defense $ 48,429 $ 31,552 $ 95,928 $ 51,031 Products 13,296 11,259 22,336 16,944 Mobile Security 5,312 3,847 10,918 4,920 Corporate (9,641) (12,682) (17,130) (16,271) ---------- ---------- ---------- ---------- Total operating income $ 57,396 $ 33,976 $ 112,052 $ 56,624 ========== ========== ========== ========== JUNE 30, 2005 DECEMBER 31, 2004 ------------- ----------------- (IN THOUSANDS) Total assets: Aerospace & Defense $ 522,599 $ 490,754 Products 287,916 278,912 Mobile Security 104,132 103,799 Corporate 460,677 418,886 ---------- ---------- Total assets $1,375,324 $1,292,351 ========== ========== </TABLE> 15 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED The following unaudited information with respect to revenues and total fixed assets, net from continuing operations to principal geographic areas are as follows: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS) (IN THOUSANDS) Revenues: United States of America $324,465 $184,985 $643,725 $309,015 North America (excluding the United States of America) 2,344 3,669 4,533 10,990 South America 5,934 4,185 10,327 7,661 Africa 5,256 475 10,000 1,681 Europe/Asia 33,643 30,390 68,022 55,985 -------- -------- -------- -------- Total revenues $371,642 $223,704 $736,607 $385,332 ======== ======== ======== ======== JUNE 30, 2005 DECEMBER 31, 2004 ------------- ----------------- (IN THOUSANDS) Total fixed assets, net: North America $ 57,251 $ 54,332 South America 1,485 1,461 Africa -- -- Europe/Asia 18,739 21,514 -------- -------- Total fixed assets, net $ 77,475 $ 77,307 ======== ======== </TABLE> 16 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 9 - EARNINGS PER SHARE The following details the numerators and denominators of the basic and diluted earnings per share computations for net income from continuing operations: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Numerator for basic and diluted earnings per share: Income from continuing operations $37,415 $17,721 $68,444 $30,349 ------- ------- ------- ------- Denominator for basic earnings per share - weighted average shares outstanding 34,480 29,670 34,321 29,236 Effect of shares issuable under stock option and stock grant plans, based on the treasury stock method 1,082 1,338 1,215 1,233 ------- ------- ------- ------- Denominator for diluted earnings per share - adjusted weighted average shares outstanding 35,562 31,008 35,536 30,469 ======= ======= ======= ======= Basic earnings per share from continuing operations $ 1.09 $ 0.60 $ 1.99 $ 1.04 ======= ======= ======= ======= Diluted earnings per share from continuing operations $ 1.05 $ 0.57 $ 1.93 $ 0.99 ======= ======= ======= ======= </TABLE> Our 2.00% Convertible Notes include net share settlement of the conversion option and cash settlement of the par amount. As a result, this requires us to use the treasury stock method to calculate the dilutive effect of our 2.00% Convertible Notes. There was no effect on our diluted share count during the six months ended June 30, 2005. 17 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 10 - STOCKHOLDERS' EQUITY Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by Statement of Financial Accounting Standard No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"), establishes a fair value based method of accounting for stock-based employee compensation plans; however, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under the fair value based method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date or other measurement date over the amount an employee must pay to acquire the stock. We have elected to continue to account for our employee stock compensation plans under APB 25 with pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS 123 had been applied. If compensation cost for stock option grants had been determined based on the fair value on the grant dates for the three month and six month periods ended June 30, 2005 and 2004, consistent with the method prescribed by SFAS 123, our net earnings and earnings per share would have been adjusted to the pro forma amounts indicated below: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income as reported $ 37,415 $ 17,821 $ 68,444 $ 30,311 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,714) (1,290) (36,650) (2,533) Add: Employee compensation expense for modification of stock option awards included in reported net income, net of income taxes -- 57 118 57 ---------- ---------- ---------- ---------- Pro-forma net income $ 34,701 $ 16,588 $ 31,912 $ 27,835 ========== ========== ========== ========== Earnings per share: Basic - as reported $ 1.09 $ 0.60 $ 1.99 $ 1.04 ========== ========== ========== ========== Basic - pro-forma $ 1.01 $ 0.56 $ 0.93 $ 0.95 ========== ========== ========== ========== Diluted - as reported $ 1.05 $ 0.57 $ 1.93 $ 0.99 ========== ========== ========== ========== Diluted - pro-forma $ 0.98 $ 0.53 $ 0.90 $ 0.91 ========== ========== ========== ========== </TABLE> 18 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED $15.3 million of the stock-based employee compensation expense for the six months ended June 30, 2005 is related to accelerated vesting of certain existing stock options and $21.3 million is related to certain stock options issued in the six months ended June 30, 2005. On June 22, 2005, our stockholders approved the 2005 Stock Incentive Plan (the "2005 Plan"). An aggregate of 2,500,000 shares of common stock is reserved for issuance and available for awards under the 2005 Plan. In addition to the limits described further in the 2005 Plan, the 2005 Plan provides that awards other than stock options and stock appreciation rights will be counted against the availability under the 2005 Plan in a 1.8 to 1 ratio. For example, if we issue 100 shares of restricted common stock under the 2005 Plan, we would reduce the availability under the 2005 Plan by 180 shares. Shares of common stock not actually issued (as a result, for example, of the lapse of an option) are available for additional grants. Shares to be issued or purchased under the 2005 Plan may be either authorized but unissued common stock or treasury shares. Shares issued with respect to awards assumed by us in connection with acquisitions do not count against the total number of shares available under the 2005 Plan. On June 22, 2004, our stockholders approved an amendment to our Certificate of Incorporation, as amended, that increased the number of shares of our authorized capital stock to 80,000,000, of which 75,000,000 shares are designated as common stock and 5,000,000 shares are designated as preferred stock. In March 2002, our Board of Directors approved a stock repurchase program authorizing the repurchase of up to a maximum 3.2 million shares of our common stock. In February 2003, the Board of Directors increased this stock repurchase program to authorize the repurchase, from time to time depending upon market conditions and other factors, of up to an additional 4.4 million shares. On March 25, 2005, our Board of Directors increased our existing stock repurchase program to enable us to repurchase, from time to time depending upon market conditions and other factors, up to an additional 3.5 million shares of its outstanding common stock. Through June 30, 2005, we repurchased 3.8 million shares of our common stock under the stock repurchase program at an average price of $12.49 per share, leaving us with the ability to repurchase up to an additional 7.3 million shares of our common stock. We have not repurchased any shares in 2004 or in the six months ended June 30, 2005. Repurchases may be made in the open market, in privately negotiated transactions utilizing various hedging mechanisms including, among others, the sale to third parties of put options our common stock, or otherwise. At June 30, 2005, we had 34.6 million shares of common stock outstanding. 19 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 11 - RECENT ACCOUNTING PRONOUNCEMENTS On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123, "Share Based Payment (revised 2004)" ("FAS 123R"). FAS 123R revises SFAS 123 and requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. In addition to revising SFAS 123, FAS 123R supersedes APB 25, and amends FASB Statement No. 95, "Statement of Cash Flows." On April 14, 2005, the Securities and Exchange Commission announced the amendment of the adoption compliance date of FAS 123R from the first interim period to the first annual period beginning after June 15, 2005. We will be required to apply the expense recognition provisions of FAS 123R beginning in the first quarter of 2006. On March 31, 2005, we announced that we accelerated the vesting of certain unvested stock options previously awarded to employees, officers and directors of the Company under various stock option plans effective March 25, 2005, subject to such employees, officers and directors entering into lock-up, confidentiality and non-competition agreements. As a result of this action, options to purchase approximately 1.6 million shares of our common stock that would otherwise have vested over the next one to five years became fully vested. Outstanding unvested options that were not accelerated will continue to vest on their normal schedule. The decision to accelerate the vesting of these options, which we believe to be in the best interest of our stockholders, was made primarily to reduce non-cash compensation expense that would have been recorded in future periods following our application of FAS 123R. Because we accelerated these options, we expect to reduce our non-cash compensation expense related to these options by approximately $12.3 million (pre-tax) between the first quarter of 2006 and 2009, based on estimated value calculations using the Black-Scholes methodology. In October 2004, the American Jobs Creation Act of 2004 ("AJCA") was signed into law. In December 2004, the FASB issued Staff Position No. 109-1 ("FSP 109-1"), Application of FASB Statement No. 109, "Accounting for Income Taxes" ("SFAS 109"), to the Tax Deduction on Qualified Production Activities Provided by the AJCA and Staff Position No. 109-2 ("FSP 109-2"), Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the AJCA. FSP 109-1 clarifies that the manufacturer's tax deduction provided for under the AJCA should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. FSP 109-2 provides accounting and disclosure guidance for the repatriation of certain foreign earnings to a U.S. taxpayer as provided for in the AJCA. Currently, uncertainty remains as to how to interpret numerous provisions of the AJCA. As such, we are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S. We expect to be in a position to make a decision on implementation, if any, later in 2005. 20 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 12 - LEGAL PROCEEDINGS In the normal course of business, we are subjected to various types of claims and currently have on-going litigations in the areas of products liability, general liability and intellectual property. Our products are used in a wide variety of law enforcement situations and environments. Some of our products can cause serious personal or property injury or death if not carefully and properly used by adequately trained personnel. We believe that we have adequate insurance coverage for most claims that are incurred in the normal course of business. In such cases, the effect on our financial statements is generally limited to the amount of our insurance deductible or self-insured retention. Our annual insurance premiums and self insurance retention amounts have risen significantly over the past several years and may continue to do so to the extent we are able to purchase insurance coverage. At this time, we do not believe any such claims or pending litigation will have a material impact on our financial position, operations or liquidity. 21 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 13 - GUARANTOR AND NONGUARANTOR FINANCIAL STATEMENTS On August 12, 2003, we sold $150 million of the 8.25% Notes in private placements pursuant to Rule 144A and Regulation S. The 8.25% Notes are uncollateralized obligations and rank junior in right of payment to our existing and future senior debt. On October 29, 2004, we completed the placement of $300 million aggregate principal amount of the 2% Convertible Notes. On November 5, 2004, Goldman, Sachs & Co. exercised its option to purchase an additional $45 million principal amount of the 2% Convertible Notes. The 8.25% Notes and 2% Convertible Notes are fully and unconditionally guaranteed, jointly and severally on a senior subordinated and uncollateralized basis, by most of our domestic subsidiaries. Each of the subsidiary guarantors is a direct or indirect 100% owned subsidiary of the parent. The following consolidating financial information presents the consolidating balance sheets as of June 30, 2005 and December 31, 2004, the related condensed consolidating statements of operations for each of the three and six month periods ended June 30, 2005 and June 30, 2004, and the related condensed consolidating statements of cash flows for the six month periods ended June 30, 2005 and June 30, 2004 for: o Armor Holdings, Inc., the parent, o the guarantor subsidiaries, o the nonguarantor subsidiaries, and o Armor Holdings, Inc. on a consolidated basis The information includes elimination entries necessary to consolidate Armor Holdings, Inc., the parent, with the guarantor and nonguarantor subsidiaries. Investments in subsidiaries are accounted for by the parent using the equity method of accounting. The guarantor and nonguarantor subsidiaries are presented on a combined basis. The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions. Separate financial statements for the guarantor and nonguarantor subsidiaries are not presented because management believes such financial statements would not be meaningful to investors. 22 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS JUNE 30, 2005 ---------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------------ ------------ ------------ ------------ ------------ (IN THOUSANDS) ASSETS Current assets: Cash and cash equivalents $ 55,216 $ 25,155 $ 11,946 $ -- $ 92,317 Short-term investment securities 376,525 -- -- -- 376,525 Accounts receivable, net -- 155,115 22,755 -- 177,870 Intercompany receivables 128,234 106,592 38,400 (273,226) -- Inventories -- 176,141 32,605 -- 208,746 Prepaid expenses and other current assets 2,743 42,408 4,467 -- 49,618 ----------- ----------- ----------- ------- ----------- Total current assets 562,718 505,411 110,173 (273,226) 905,076 Property and equipment, net 2,286 53,742 21,447 -- 77,475 Goodwill, net -- 262,946 2,072 -- 265,018 Patents, licenses and trademarks, net -- 108,313 170 -- 108,483 Other assets 17,030 2,091 151 -- 19,272 Investment in subsidiaries 675,121 25,370 -- (700,491) -- ----------- ----------- ----------- ------- ----------- Total assets $ 1,257,155 $ 957,873 $ 134,013 $ (973,717) $ 1,375,324 =========== =========== =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt $ -- $ 277 $ 147 $ -- $ 424 Short-term debt 341,665 -- 5,013 -- 346,678 Accounts payable 344 76,610 9,705 -- 86,659 Accrued expenses and other current liabilities 18,058 61,174 21,443 -- 100,675 Income taxes payable (7,252) 11,930 3,033 -- 7,711 Intercompany payable 113,594 79,495 80,137 (273,226) -- ----------- ----------- ----------- ----------- ----------- Total current liabilities 466,409 229,486 119,478 (273,226) 542,147 Long-term debt, less current portion 154,973 2,319 347 -- 157,639 Other long-term liabilities -- 1,997 -- -- 1,997 Deferred income taxes 3,442 36,779 989 -- 41,210 ----------- ----------- ----------- ----------- ----------- Total liabilities 624,824 270,581 120,814 (273,226) 742,993 Stockholders' equity: Preferred stock -- 1,450 -- (1,450) -- Common stock 407 3,192 7,853 (11,045) 407 Additional paid in capital 507,559 396,575 14,778 (411,353) 507,559 Retained earnings (accumulated deficit) 193,925 286,075 (9,432) (276,643) 193,925 Accumulated other comprehensive income 2,757 -- -- -- 2,757 Treasury stock (72,317) -- -- -- (72,317) ----------- ----------- ----------- ----------- ----------- Total stockholders' equity 632,331 687,292 13,199 (700,491) 632,331 ----------- ----------- ----------- ----------- ----------- Total liabilities and stockholders' equity $ 1,257,155 $ 957,873 $ 134,013 $ (973,717) $ 1,375,324 =========== =========== =========== =========== =========== </TABLE> 23 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS DECEMBER 31, 2004 ------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------------ ------------ ------------ ------------ ------------ (IN THOUSANDS) ASSETS Current assets: Cash and cash equivalents $ 388,727 $ 21,173 $ 11,309 $ -- $ 421,209 Short-term investment securities -- -- -- -- -- Accounts receivable, net -- 156,122 19,330 -- 175,452 Intercompany receivables 173,735 108,313 7,045 (289,093) -- Inventories -- 142,362 33,846 -- 176,208 Prepaid expenses and other current assets 1,611 42,023 3,301 -- 46,935 ----------- ----------- ----------- ----------- ----------- Total current assets 564,073 469,993 74,831 (289,093) 819,804 Property and equipment, net 5,144 47,968 24,195 -- 77,307 Goodwill, net -- 259,773 2,240 -- 262,013 Patents, licenses and trademarks, net -- 112,288 171 -- 112,459 Other assets 18,410 2,209 149 -- 20,768 Investment in subsidiaries 592,437 12,730 -- (605,167) -- ----------- ----------- ----------- ----------- ----------- Total assets $ 1,180,064 $ 904,961 $ 101,586 $ (894,260) $ 1,292,351 =========== =========== =========== =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current portion of long-term debt $ -- $ 457 $ 164 $ -- $ 621 Short-term debt 341,579 -- 2,177 -- 343,756 Accounts payable 640 58,422 10,539 -- 69,601 Accrued expenses and other current liabilities 11,216 73,314 22,717 -- 107,247 Income taxes payable (6,454) 11,513 3,942 -- 9,001 Intercompany payables 112,741 123,466 52,886 (289,093) -- ----------- ----------- ----------- ----------- ----------- Total current liabilities 459,722 267,172 92,425 (289,093) 530,226 Long-term debt, less current portion 153,897 2,377 477 -- 156,751 Other long-term liabilities -- 1,951 -- -- 1,951 Deferred income taxes 1,249 36,077 901 -- 38,227 ----------- ----------- ----------- ----------- ----------- Total liabilities 614,868 307,577 93,803 (289,093) 727,155 Stockholders' equity: Preferred stock -- 1,450 -- (1,450) -- Common stock 402 3,792 7,854 (11,646) 402 Additional paid in capital 504,809 387,229 14,771 (402,000) 504,809 Retained earnings (accumulated deficit) 125,481 204,913 (14,842) (190,071) 125,481 Accumulated other comprehensive income 6,821 -- -- -- 6,821 Treasury stock (72,317) -- -- -- (72,317) ----------- ----------- ----------- ----------- ----------- Total stockholders' equity 565,196 597,384 7,783 (605,167) 565,196 ----------- ----------- ----------- ----------- ----------- Total liabilities and stockholders' equity $ 1,180,064 $ 904,961 $ 101,586 $ (894,260) $ 1,292,351 =========== =========== =========== =========== =========== </TABLE> 24 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2005 -------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------- ------------ ------------ ------------ ------------ (IN THOUSANDS) REVENUES: Aerospace & Defense $ -- $ 257,564 $ -- $ (876) $ 256,688 Products -- 61,438 15,367 -- 76,805 Mobile Security -- 13,366 26,119 (1,336) 38,149 --------- --------- --------- --------- --------- Total revenues -- 332,368 41,486 (2,212) 371,642 COSTS AND EXPENSES: Cost of revenues -- 244,885 33,167 (2,212) 275,840 Selling, general and administrative expenses 9,236 22,672 3,626 -- 35,534 Amortization -- 2,037 1 -- 2,038 Integration 247 587 -- -- 834 Other charges -- -- -- -- -- Related party management fees (income) -- (1) 1 -- -- --------- --------- --------- --------- --------- OPERATING (LOSS) INCOME: (9,483) 62,188 4,691 -- 57,396 Interest expense (income), net 1,494 (105) 125 -- 1,514 Other (income) expense, net (3,024) (139) 70 -- (3,093) Equity in earnings of subsidiaries (42,846) (2,119) -- 44,965 -- --------- --------- --------- --------- --------- INCOME BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 34,893 64,551 4,496 (44,965) 58,975 (BENEFIT) PROVISION FOR INCOME TAXES (2,522) 22,363 1,719 -- 21,560 --------- --------- --------- --------- --------- NET INCOME $ 37,415 $ 42,188 $ 2,777 $ (44,965) $ 37,415 ========= ========= ========= ========= ========= </TABLE> 25 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2004 ---------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL -------- ------------ ------------ ------------ ------------ IN THOUSANDS) REVENUES: Aerospace & Defense $ -- $ 129,773 $ -- $ -- $ 129,773 Products -- 53,367 12,376 -- 65,743 Mobile Security -- 6,216 22,604 (632) 28,188 --------- --------- --------- --------- --------- Total revenues -- 189,356 34,980 (632) 223,704 COSTS AND EXPENSES: Cost of revenues -- 130,793 27,085 (632) 157,246 Selling, general and administrative expenses 5,246 15,252 2,888 -- 23,386 Amortization -- 970 3 -- 973 Integration 110 692 -- -- 802 Other charges 7,321 -- -- -- 7,321 Related party management fees (income) -- (1) 1 -- -- --------- --------- --------- --------- --------- OPERATING (LOSS) INCOME (12,677) 41,650 5,003 -- 33,976 Interest expense, net 1,890 144 23 -- 2,057 Other income, net (23) (338) (29) -- (390) Equity in (earnings) losses of subsidiaries (29,840) (812) -- 30,652 -- --------- --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 15,296 42,656 5,009 (30,652) 32,309 (BENEFIT) PROVISION FOR INCOME TAXES (2,525) 15,246 1,867 -- 14,588 --------- --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS 17,821 27,410 3,142 (30,652) 17,721 DISCONTINUED OPERATIONS: Income from discontinued operations -- 100 -- -- 100 --------- --------- --------- --------- --------- NET INCOME $ 17,821 $ 27,510 $ 3,142 $ (30,652) $ 17,821 ========= ========= ========= ========= ========= </TABLE> 26 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> SIX MONTHS ENDED JUNE 30, 2005 ------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL -------- ------------ ------------ ------------ ------------ (IN THOUSANDS) REVENUES: Aerospace & Defense $ -- $ 525,143 $ -- $ (7,985) $ 517,158 Products -- 118,623 26,740 -- 145,363 Mobile Security -- 25,570 50,022 (1,506) 74,086 --------- --------- --------- --------- --------- Total revenues -- 669,336 76,762 (9,491) 736,607 COSTS AND EXPENSES: Cost of revenues -- 498,347 60,639 (9,491) 549,495 Selling, general and administrative expenses 16,709 45,626 7,015 -- 69,350 Amortization -- 4,075 1 -- 4,076 Integration 394 1,240 -- -- 1,634 Other charges -- -- -- -- -- Related party management fees (income) 16 (18) 2 -- -- --------- --------- --------- --------- --------- OPERATING (LOSS) INCOME (17,119) 120,066 9,105 -- 112,052 Interest expense, net 3,687 (154) 226 -- 3,759 Other (income) expense, net (1,902) (155) 87 -- (1,970) Equity in (earnings) losses of subsidiaries (82,684) (3,888) -- 86,572 -- --------- --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 63,780 124,263 8,792 (86,572) 110,263 (BENEFIT) PROVISION FOR INCOME TAXES (4,664) 43,101 3,382 -- 41,819 --------- --------- --------- --------- --------- NET INCOME $ 68,444 $ 81,162 $ 5,410 $ (86,572) $ 68,444 ========= ========= ========= ========= ========= </TABLE> 27 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> SIX MONTHS ENDED JUNE 30, 2004 -------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------- ------------ ------------ ------------ ------------ (IN THOUSANDS) REVENUES: Aerospace & Defense $ -- $ 210,781 $ -- $ -- $ 210,781 Products -- 97,616 21,967 -- 119,583 Mobile Security -- 11,583 44,536 (1,151) 54,968 --------- --------- --------- --------- --------- Total revenues -- 319,980 66,503 (1,151) 385,332 --------- --------- --------- --------- --------- COSTS AND EXPENSES: Cost of revenues -- 219,143 53,322 (1,151) 271,314 Selling, general and administrative expenses 8,748 31,639 6,250 -- 46,637 Amortization -- 1,947 6 -- 1,953 Integration 200 1,283 -- -- 1,483 Other charges 7,321 -- -- -- 7,321 Related party management fees (income) 16 (18) 2 -- -- --------- --------- --------- --------- --------- OPERATING (LOSS) INCOME (16,285) 65,986 6,923 -- 56,624 Interest expense, net 3,546 176 63 -- 3,785 Other expense (income), net 27 (322) 20 -- (275) Equity in (earnings) losses of subsidiaries (46,161) (630) -- 46,791 -- --------- --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 26,303 66,762 6,840 (46,791) 53,114 (BENEFIT) PROVISION FOR INCOME TAXES (4,008) 24,255 2,518 -- 22,765 --------- --------- --------- --------- --------- INCOME FROM CONTINUING OPERATIONS 30,311 42,507 4,322 (46,791) 30,349 DISCONTINUED OPERATIONS: Loss from discontinued operations -- (38) -- -- (38) --------- --------- --------- --------- --------- NET INCOME $ 30,311 $ 42,469 $ 4,322 $ (46,791) $ 30,311 ========= ========= ========= ========= ========= </TABLE> 28 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOW SIX MONTHS ENDED JUNE 30, 2005 -------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL --------- ------------ ------------ ------------ ------------ (IN THOUSANDS) CASH FLOW FROM OPERATING ACTIVITIES: Income from continuing operations $ 68,444 $ 81,162 $ 5,410 $ (86,572) $ 68,444 Adjustments to reconcile income from continuing operations to cash provided by (used in) operating activities: Depreciation and amortization 1,366 7,839 1,383 -- 10,588 Loss on disposal of fixed assets -- 153 350 -- 503 Deferred income taxes 2,491 1,075 74 -- 3,640 Fair value gain for put options (3,793) -- -- -- (3,793) Changes in operating assets & liabilities, net of acquisitions: Decrease (increase) in accounts receivable -- 777 (3,425) -- (2,648) Decrease (increase) in intercompany receivables & payables 47,749 (48,127) 378 -- -- (Increase) decrease in inventory -- (33,779) 1,241 -- (32,538) Decrease (increase) in prepaid expenses & other assets 523 (624) (1,154) -- (1,255) Increase (decrease) in accounts payable, accrued expenses and other current liabilities 7,823 8,877 (2,108) -- 14,592 Increase (decrease) in income taxes payable 990 417 (909) -- 498 --------- --------- --------- --------- --------- Net cash provided by operating activities 125,593 17,770 1,240 (86,572) 58,031 --------- --------- --------- --------- --------- CASH FLOW FROM INVESTING ACTIVITIES: Purchase of property and equipment (1,516) (5,575) (1,055) -- (8,146) Purchase of patents and trademarks -- (100) -- -- (100) Purchases of short-term investment securities (562,750) -- -- -- (562,750) Proceeds from sales of short-term investment securities 186,225 -- -- -- 186,225 Sale of put options 4,790 -- -- -- 4,790 Investment in subsidiaries (82,684) (3,888) -- 86,572 -- Additional cash received from sale of business -- 300 -- -- 300 Additional consideration for purchased businesses (317) (4,287) -- -- (4,604) Purchase of businesses net of cash acquired (1,362) -- -- -- (1,362) --------- --------- --------- --------- --------- Net cash (used in) investing activities (457,614) (13,550) (1,055) 86,572 (385,647) --------- --------- --------- --------- --------- CASH FLOW FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 4,304 -- -- -- 4,304 Taxes paid for withheld shares on restricted stock issuances (5,794) -- -- -- (5,794) Repayments of long-term debt -- (238) (76) -- (314) Borrowings under lines of credit 5,485 -- 4,149 -- 9,634 Repayments under lines of credit (5,485) -- (1,500) -- (6,985) --------- --------- --------- --------- --------- Net cash (used in) provided by financing activities (1,490) (238) 2,573 -- 845 --------- --------- --------- --------- --------- Effect of exchange rate on cash and cash equivalents -- -- (2,121) -- (2,121) --------- --------- --------- --------- --------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (333,511) 3,982 637 -- (328,892) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 388,727 21,173 11,309 -- 421,209 --------- --------- --------- --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 55,216 $ 25,155 $ 11,946 $ -- $ 92,317 ========= ========= ========= ========= ========= </TABLE> 29 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED <TABLE> ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOW SIX MONTHS ENDED JUNE 30, 2004 --------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL -------- ------------ ------------ ------------ ------------ (IN THOUSANDS) CASH FLOW FROM OPERATING ACTIVITIES: Income from continuing operations $ 30,311 $ 42,507 $ 4,322 $ (46,791) $ 30,349 Adjustments to reconcile income from continuing operations to cash provided by operating activities Depreciation and amortization 556 4,735 1,312 -- 6,603 Loss on disposal of fixed assets -- 106 9 -- 115 Deferred income taxes 492 (665) (24) -- (197) Non-cash charge for acceleration of performance- based restricted stock awards 5,913 -- -- -- 5,913 Non-cash impairment charge 1,408 -- -- -- 1,408 Changes in operating assets & liabilities, net of acquisitions: (Increase) decrease in accounts receivable 1,201 (37,412) (2,561) -- (38,772) Decrease (increase) in intercompany receivables & payables 38,134 (41,229) 3,095 -- -- Increase in inventory -- (27,759) (4,238) -- (31,997) (Increase) decrease in prepaid expenses & other assets (3,678) (4,491) (712) -- (8,881) (Decrease) increase in accounts payable, accrued expenses and other current liabilities (1,153) 28,440 362 -- 27,649 Increase (decrease) in income taxes payable 17,515 (1,609) 1,569 -- 17,475 --------- --------- --------- --------- --------- Net cash provided by (used in) operating activities 90,699 (37,377) 3,134 (46,791) 9,665 --------- --------- --------- --------- --------- CASH FLOW FROM INVESTING ACTIVITIES: Purchase of property and equipment (902) (5,570) (632) -- (7,104) Purchase of patents and trademarks -- (77) -- -- (77) Purchases of short-term investment securities (225,125) -- -- -- (225,125) Proceeds from sales of short-term investment securities 16,175 -- -- -- 16,175 Purchase of equity investment -- (5,275) -- -- (5,275) Proceeds from sale of equity investment -- 5,823 -- -- 5,823 Collection of note receivable 375 -- -- -- 375 Decrease in restricted cash 2,600 -- -- -- 2,600 Investment in subsidiaries (120,224) 73,433 -- 46,791 -- Additional consideration for purchased businesses -- (1,855) -- -- (1,855) Purchase of businesses, net of cash acquired -- (2,729) -- -- (2,729) --------- --------- --------- --------- --------- Net cash used in (provided by) investing activities (327,101) 63,750 (632) 46,791 (217,192) --------- --------- --------- --------- --------- CASH FLOW FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 8,310 -- -- -- 8,310 Proceeds from the issuance of common stock 142,500 -- -- -- 142,500 Cash paid for common stock offering costs (1,057) -- -- -- (1,057) Repayments of long-term debt -- (33,981) (71) -- (34,052) Borrowings under lines of credit 8,083 -- 802 -- 8,885 Repayments under lines of credit (8,083) -- (39) -- (8,122) --------- --------- --------- --------- --------- Net cash provided by (used in) financing activities 149,753 (33,981) 692 -- 116,464 --------- --------- --------- --------- --------- Effect of exchange rate on cash and cash equivalents -- (651) 714 -- 63 Net cash used in discontinued operations -- (717) -- -- (717) --------- --------- --------- --------- --------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (86,649) (8,976) 3,908 -- (91,717) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 90,764 11,084 10,002 -- 111,850 --------- --------- --------- --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 4,115 $ 2,108 $ 13,910 $ -- $ 20,133 ========= ========= ========= ========= ========= </TABLE> 30 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 14 - PUT OPTION TRANSACTIONS We account for put option transactions in accordance with Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," ("SFAS 150"). SFAS 150 requires put options to be measured at fair value and recognized on the balance sheet as liabilities. During the six months ended June 30, 2005, we sold put options in various private transactions covering 2.5 million shares of Company stock for $4.7 million in premiums. On June 30, 2005, put options covering 1 million shares expired unexercised leaving outstanding put options covering 1.5 million shares outstanding (4.3% of outstanding shares at June 30, 2005) at a weighted average strike price of $35.00 per share, all of which expire on or before September 30, 2005. If the purchasers exercise the remaining put options, we will be required to repurchase our shares or enter into alternative cash settlement arrangements at the negotiated strike price. As of June 30, 2005, based on the existing put option strike prices, it would cost us $52.5 million ($52.5 million fair value), if we were required to repurchase our shares under these put options. If put options for all 1.5 million shares of Company stock are exercised, we would have 5.8 million shares remaining under our repurchase programs. If the remaining put options expire unexercised, we will record an additional $1 million in other income in the third quarter of 2005. If our stock price were to decline below $35.00 on the settlement date of the remaining put options, we would be required to record a loss on the put options that may be material depending on the final closing price of the Company's stock on the expiration dates. The fair values of the put options are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the put options, taking into account the consideration we received for the sale of the put options. As our stock price fluctuates the value of these contracts also fluctuates. For the three and six month periods ending June 30, 2005, we recognized fair value gains of $4.9 million and $3.8 million, respectively, recorded in other income, net. Under the terms of our put options, if our stock price were to fall to 50% of the strike price we could be required to settle the contracts prior to the expiration of the contracts. We have the ability to terminate the contracts prior to expiration by paying an early unwind amount to the counterparty. This amount is equal to the current market value of the option contract provided by the counterparty at the time of unwind. 31 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 15 - INTEREST EXPENSE, NET Interest expense, net is comprised of the following: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS) Interest expense $ 5,049 $ 2,314 $ 9,907 $ 4,381 Interest income (3,535) (257) (6,148) (596) ------- ------- ------- ------- Interest expense, net $ 1,514 $ 2,057 $ 3,759 $ 3,785 ======= ======= ======= ======= </TABLE> NOTE 16 - SUBSEQUENT EVENTS On July 26, 2005, we amended our secured revolving credit facility (the "Credit Facility") with Bank of America, N.A., Wachovia Bank, National Association and a syndicate of other financial institutions arranged by Bank of America Securities, LLC. The amendment allows for advances, loans, extensions of credit to or any other investments in key suppliers of the Company in an aggregate amount not to exceed $15 million at any time outstanding for the purpose of facilitating the sale and purchase of goods and services to the Company. In addition, the amendment allows for leases or other dispositions of assets of not more than 10% of the consolidated earnings before interest, taxes, depreciation and amortization ("EBITDA"), as defined in the Credit Facility. On July 27, 2005, we announced that we were the successful bidder at an auction to acquire substantially all of the assets of Second Chance Body Armor, Inc., a manufacturer of body armor serving the law enforcement and military markets. The total purchase price is $45 million in cash and includes the assumption of certain liabilities. The transaction is subject to final approval by the United States Bankruptcy Court, Western District of Michigan and is expected to close July 29, 2005. 32 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion of the results of operations and analysis of financial condition for the three and six month periods ended June 30, 2005 and June 30, 2004. The results of operations for purchase business combinations are included since their effective acquisition dates. The following discussion may be understood more fully by reference to the consolidated financial statements, notes to the consolidated financial statements, and management's discussion and analysis contained in our Annual Report on Form 10-K and amendments thereto for the year ended December 31, 2004, as filed with the Securities and Exchange Commission. CRITICAL ACCOUNTING POLICIES (INCLUDING RECENT ACCOUNTING PRONOUNCEMENTS): Revenue recognition. We record products revenue at the time of shipment. Returns are minimal and do not materially affect the financial statements. We record Aerospace & Defense Group revenue related to government contracts which results principally from fixed price contracts and is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collectibility is probable. Generally, all of these conditions are met when the Company ships products to its customers. Up-Armored HMMWV units sold to the U.S. Government are considered sold when the onsite Department of Defense officer finishes the inspection of the Up-Armored HMMWV, approves it for delivery and shipment occurs. We record revenue of the Aerospace & Defense Group and Mobile Security Division when a vehicle is shipped, except for larger commercial contracts typically longer than four months in length. Revenue from large commercial contracts is recognized on the percentage of completion, units-of-work performed method. Should large commercial contracts be in a loss position, the entire estimated loss would be recognized for the balance of the contract at such time. Current contracts are profitable. We record service revenue as services are provided on a contract-by-contract basis. Revenues from service contracts are recognized over the term of the contract. Allowance for Doubtful Accounts. We encounter risks associated with sales and the collection of the associated accounts receivable. As such, we review our accounts receivable aging on a monthly basis and determine a provision for accounts receivable that is considered to be uncollectible. In order to calculate the appropriate monthly provision, we review accounts on a monthly basis and estimate the amount that is uncollectible. 33 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Periodically, we compare the identified credit risks with the allowance that has been established using historical experience and adjust the allowance accordingly. Derivative Instruments and Hedging Activities. We account for derivative instruments and hedging activities in accordance with Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedge Activities" ("SFAS 133") as amended. All derivative instruments are recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, depending on the type of hedge transaction. For fair-value hedge transactions in which we hedge changes in an asset's, liability's, or firm commitment's fair value, changes in the fair value of the derivative instrument will generally be offset in the income statement by changes in the hedged item's fair value. Put options on Company stock are marked to market through the income statement at the end of each period. Changes in the fair value of the interest rate swap agreements offset changes in the fair value of the fixed rate debt due to changes in the market interest rate. Accordingly, the other assets on the Condensed Consolidated Balance Sheet as of June 30, 2005, increased by $1.0 million, which reflected an increase in the fair value of the interest rate swap agreements to $7.0 million. The corresponding increase in the hedge liability was recorded in long-term debt. The agreements are deemed to be a perfectly effective fair value hedge and therefore qualify for the short-cut method of accounting under SFAS 133. As a result, no ineffectiveness is expected to be recognized in our earnings associated with the interest rate swap agreements. Goodwill. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in a purchase business combination. Goodwill and other intangible assets are stated on the basis of cost. The $212.0 million in goodwill resulting from acquisitions made by us subsequent to June 30, 2001 was immediately subjected to the non-amortization provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). See also Impairment below. The purchase method of accounting for business combinations requires us to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the net tangible and identifiable intangible assets. Goodwill is tested for impairment annually, or when a possible impairment is indicated, using the fair value based test prescribed by SFAS 142. We performed our annual assessment of goodwill and determined that no impairment existed as of June 30, 2005. Patents, licenses and trademarks. Patents, licenses and trademarks were primarily acquired through acquisitions accounted for by the purchase method of accounting. Such assets are amortized on a straight-line basis over their useful lives. Certain of these assets with indefinite lives are not amortized. Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. Significant estimates inherent in the preparation of the accompanying consolidated financial statements include the carrying value of long-lived assets, valuation allowances for receivables, inventories and deferred income tax assets, liabilities for potential litigation claims and settlements, potential liabilities related to tax filings in the ordinary course of business, and contract contingencies and obligations. Actual results could differ from those estimates. 34 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Income taxes. We account for income taxes pursuant to Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under the asset and liability method specified thereunder, deferred taxes are determined based on the difference between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are offset by deferred tax assets relating to net operating loss carryforwards, tax credit carryforwards and deductible temporary differences. Recognition of deferred tax assets is based on management's belief that it is more likely than not that the tax benefit associated with temporary differences and operating and capital loss carryforwards will be utilized. A valuation allowance is recorded for those deferred tax assets for which it is more likely than not that the realization will not occur. Impairment. Long-lived assets including certain identifiable intangibles, and the goodwill related to those assets, are reviewed annually for impairment or whenever events or changes in circumstances indicate that the carrying amount of the asset in question may not be recoverable including, but not limited to, a deterioration of profits for a business segment that has long-lived assets, and when other changes occur which might impair recovery of long-lived assets. The method used to determine the existence of an impairment would be discounted operating cash flows estimated over the remaining useful lives of the related long-lived assets for continuing operations in accordance with SFAS 142. Impairment is measured as the difference between fair value and unamortized cost at the date impairment is determined. Discontinued Operations. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), a component classified as held for sale is reported in discontinued operations when the following conditions are met: (a) the operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction and (b) the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. In a period in which a component of an entity either has been disposed of or is classified as held for sale, the income statement for current and prior periods reports the results of operations of the component, including any estimated impairment gain or loss recognized in accordance with SFAS 144 paragraph 37, in discontinued operations. The results of discontinued operations, less applicable income tax expense (benefit), is reported as a separate component of income before extraordinary items and the cumulative effect of accounting changes (if applicable). The assets and liabilities of a disposal group classified as held for sale are presented separately in the asset and liability sections, respectively, of the statement of financial position. We had no discontinued operations at June 30, 2005. Comprehensive income and foreign currency translation. In accordance with Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS 130"), assets and liabilities denominated in a foreign currency are translated into U.S. dollars at the current rate of exchange existing at period-end and revenues and expenses are translated at the average monthly exchange rates. The cumulative translation adjustment, net of tax, which represents the effect of translating assets and liabilities of our foreign operations is $2.8 million and $6.8 million as of June 30, 2005 and December 31, 2004, respectively, and is classified as accumulated other comprehensive income. The current year change in the accumulated amount, net of tax, is included as a component of comprehensive income. 35 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Stock options and grants. Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), as amended by Statement of Financial Accounting Standard Number 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," ("SFAS 148") establishes a fair value based method of accounting for stock-based employee compensation plans; however, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under the fair value based method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date or other measurement date over the amount an employee must pay to acquire the stock. We have elected to continue to account for our employee stock compensation plans under APB 25 with pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS 123 had been applied. If compensation cost for stock option grants had been determined based on the fair value on the grant dates for the three month and six months ended June 30, 2005 and 2004, consistent with the method prescribed by SFAS 123, our net earnings and earnings per share would have been adjusted to the pro-forma amounts indicated below: <TABLE> THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, 2005 JUNE 30, 2004 JUNE 30, 2005 JUNE 30, 2004 ------------- ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income as reported $ 37,415 $ 17,821 $ 68,444 $ 30,311 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,714) (1,290) (36,650) (2,533) Add: Employee compensation expense for modification of stock option awards included in reported net income, net of income taxes -- 57 118 57 ---------- ---------- ---------- ---------- Pro-forma net income $ 34,701 $ 16,588 $ 31,912 $ 27,835 ========== ========== ========== ========== Earnings per share: Basic - as reported $ 1.09 $ 0.60 $ 1.99 $ 1.04 ========== ========== ========== ========== Basic - pro-forma $ 1.01 $ 0.56 $ 0.93 $ 0.95 ========== ========== ========== ========== Diluted - as reported $ 1.05 $ 0.57 $ 1.93 $ 0.99 ========== ========== ========== ========== Diluted - pro-forma $ 0.98 $ 0.53 $ 0.90 $ 0.91 ========== ========== ========== ========== </TABLE> 36 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED $15.3 million of the stock-based employee compensation expense for the six months ended June 30, 2005 is related to accelerated vesting of certain existing stock options and $21.3 million is related to certain stock options issued in the six months ended June 30, 2005. Restricted stock awards are generally recorded as compensation expense using fixed accounting over the vesting periods based on the market value on the date of grant except in situations where provisions of the agreements allow for acceleration of vesting upon a certain event. If the event occurs, this may result in an acceleration of vesting and recognition of associated expense. RECENT ACCOUNTING PRONOUNCEMENTS: On December 16, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Statement No. 123, "Share Based Payment (revised 2004)" ("FAS 123R"). FAS 123R revises SFAS 123 and requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. In addition to revising SFAS 123, FAS 123R supersedes APB 25, and amends FASB Statement No. 95, "Statement of Cash Flows." On April 14, 2005, the Securities and Exchange Commission announced the amendment of the adoption compliance date of FAS 123R from the first interim period to the first annual period beginning after June 15, 2005. We will be required to apply the expense recognition provisions of FAS 123R beginning in the first quarter of 2006. On March 31, 2005, we announced that we accelerated the vesting of certain unvested stock options previously awarded to employees, officers and directors of the Company under various stock option plans effective March 25, 2005, subject to such employees, officers and directors entering into lock-up, confidentiality and non-competition agreements. As a result of this action, options to purchase approximately 1.6 million shares of our common stock that would otherwise have vested over the next one to five years became fully vested. Outstanding unvested options that were not accelerated will continue to vest on their normal schedule. The decision to accelerate the vesting of these options, which we believe to be in the best interest of our stockholders, was made primarily to reduce non-cash compensation expense that would have been recorded in future periods following our application of FAS 123R. Because we accelerated these options, we expect to reduce our non-cash compensation expense related to these options by approximately $12.3 million (pre-tax) between the first quarter of 2006 and 2009, based on estimated value calculations using the Black-Scholes methodology. In October 2004, the American Jobs Creation Act of 2004 ("AJCA") was signed into law. In December 2004, the FASB issued Staff Position No. 109-1 ("FSP 109-1"), Application of SFAS 109 to the Tax Deduction on Qualified Production Activities Provided by the AJCA and Staff Position No. 109-2 ("FSP 109-2"), Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the AJCA. FSP 109-1 clarifies that the manufacturer's tax deduction provided for under the AJCA should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. FSP 109-2 provides accounting and disclosure guidance for the repatriation of certain foreign earnings to a U.S. taxpayer as provided for in the AJCA. Currently, uncertainty remains as to how to interpret numerous provisions of the AJCA. As such, we are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S. We expect to be in a position to make a decision on implementation, if any, later in 2005. SUBSEQUENT EVENT: On July 27, 2005, we announced that we were the successful bidder at an auction to acquire substantially all of the assets of Second Chance Body Armor, Inc., a manufacturer of body armor serving the law enforcement and military markets. The total purchase price is $45 million in cash and includes the assumption of certain liabilities. The transaction is subject to final approval by the United States Bankruptcy Court, Western District of Michigan and is expected to close July 29, 2005. 37 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2005 COMPARED TO THREE MONTHS ENDED JUNE 30, 2004. Net income. Net income increased $19.6 million, or 109.9%, to $37.4 million for the three months ended June 30, 2005, compared to $17.8 million for the three months ended June 30, 2004. Net income for the three months ended June 30, 2004, includes income from continuing operations of $17.7 million and income from discontinued operations of $100,000. CONTINUING OPERATIONS Total revenues. Total revenues increased $147.9 million, or 66.1%, to $371.6 million in the three months ended June 30, 2005, compared to $223.7 million in the three months ended June 30, 2004. For the three months ended June 30, 2005, total revenue increased 47.2% internally, including period-over-period changes in acquired businesses. Internal revenue growth represents period-over-period increases in revenue from businesses that were either owned or acquired by us during the periods presented. The calculation of internal revenue growth takes into consideration pro forma revenue for relevant periods of acquired entities in determining period-over-period revenue growth. Aerospace & Defense Group revenues. Aerospace & Defense Group revenues increased $126.9 million, or 97.8%, to $256.7 million in the three months ended June 30, 2005, compared to $129.8 million in the three months ended June 30, 2004. For the three months ended June 30, 2005, Aerospace & Defense Group revenue increased $109.3 million, or 74.1%, internally, including period-over-period changes in acquired businesses. Internal growth was primarily due to: (1) We experienced strong demand for the Up-Armored High Mobility Multi-purpose Wheeled Vehicles (Up-Armored HMMWV, commonly known as the Humvee), including spare part revenues, as we shipped 1,672 Up-Armored HMMWVs in the three months ended June 30, 2005, compared to 894 in the three months ended June 30, 2004, an 87.0% increase. While there continues to be new orders under our current Up-Armored HMMWV contract, currently, several military transport vehicles are in the development stage and are being evaluated by the U.S. military as possible next-generation replacements for the HMMWV. Although we believe that the HMMWV will continue for some time to be one of the primary transport vehicles in the U.S. military, there is no assurance as to when a replacement for the HMMWV may be selected. In the event the HMMWV is replaced, we anticipate that any armoring for a replacement vehicle would be part of the vehicle's original design and that eventually, our HMMWV up-armoring content on a per unit basis would likely decline. Although we anticipate making significant efforts to obtain armoring contracts for any HMMWV replacement vehicles selected by the U.S. military, at this time, we cannot determine to what degree, if any, we would be able to obtain such military contracts. See risk factor "A Replacement of the HMMWV in the U.S. Military May Affect Our Results of Operations" in Part I of our 10-K for the year ended December 31, 2004. 38 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED (2) During the three months ended June 30, 2005, add-on armor components for fielded vehicles including add-on armor kits for the light, medium and heavy truck fleet operating in Iraq increased 41.7%, compared to the three months ended June 30, 2004. We believe that vehicle armoring will play a significant role in the remainder of 2005 and is likely to play a significant role in 2006 and beyond. (3) Small arms protection inserts ("SAPI") plate volume decreased by 45.5% in the three months ended June 30, 2005 compared to the three months ended June 30, 2004. The reduction in volume was a result of short term, inability to procure certain raw materials, mainly ballistic fiber and ceramic supply, which are instrumental components to the SAPI plate. Continued growth in the SAPI plate business is dependent upon the continued level of hostilities in Iraq and Afghanistan as well as the U.S. Government's requirements for improved technology and performance of the SAPI plate. Future revenues may be constrained by our ability to procure certain raw materials necessary for the manufacture of the SAPI plate. See risk factor "There are Limited Sources for Some of Our Raw Materials, Which May Significantly Curtail our Manufacturing Operations" in Part I of our 10-K for the year ended December 31, 2004. (4) Outer Tactical Vest ("OTV") units increased by 42.3% in the three months ended June 30, 2005, over the three months ended June 30, 2004. We also experienced 73.1% unit growth in helmets. Our Modular Lightweight Load-Carrying Equipment ("MOLLE") revenue increased 28.9% due to sales of higher value MOLLE accessories. Acquired growth, which is the amount of current year revenue equal to the prior year revenue before our acquisition of the acquired company, was a function of the acquisition of Specialty Defense in November 2004, which accounted for $17.6 million of the acquired growth. Products Division revenues. Products Division revenues increased $11.1 million, or 16.8%, to $76.8 million in the three months ended June 30, 2005, compared to $65.7 million in the three months ended June 30, 2004. For the three months ended June 30, 2005, Products Division revenue decreased $67,000, or 0.1%, internally. Internal growth was flat primarily due to large, non-recurring, one time sales in the 2nd quarter of 2004 related to ballistic reinforced enclosures and a large government sale of body armor. Also the timing of large international shipments and government shipments negatively impacted the quarter over quarter comparison. Acquired growth of $11.1 million was a function of the acquisitions of Bianchi International, which was completed during the fourth quarter 2004, and Kleen Bore, Inc., which was completed during the third quarter of 2004. Mobile Security revenues. Mobile Security Division revenues increased $10.0 million, or 35.3%, to $38.1 million in the three months ended June 30, 2005, compared to $28.2 million in the three months ended June 30, 2004, primarily due to the increasing threat of terrorism. During the three months ended June 30, 2005, commercial vehicle shipments increased 42.8%, to 434 vehicles compared to 304 vehicles in the three months ended June 30, 2004. All of Mobile Security Division's revenue growth was internal. 39 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Cost of revenues. Cost of revenues increased $118.6 million, or 75.4%, to $275.8 million for the three months ended June 30, 2005, compared to $157.2 million for the three months ended June 30, 2004. As a percentage of total revenues, cost of revenues increased to 74.2% of total revenues for the three months ended June 30, 2005, from 70.3% for the three months ended June 30, 2004. Gross margins in the Aerospace & Defense Group were 22.8% for the three months ended June 30, 2005, compared to 29.0% for the three months ended June 30, 2004, primarily due to reduced selling prices for the Up-Armored HMMWV beginning in the third quarter of 2004, and significant changes in our product mix as we have diversified beyond Up-Armored HMMWVs. Gross margins in the Products Division were 36.8% for the three months ended June 30, 2005, compared to 33.5% for the three months ended June 30, 2004. The increase was primarily due to improved product mix, improved body armor margins, and, a shift in production to lower cost manufacturing facilities. Gross margins in the Mobile Security Division were 23.7% in the three months ended June 30, 2005, compared to 24.2% for the three months ended June 30, 2004. Selling, general and administrative expenses. Selling, general and administrative expenses increased $12.1 million, or 51.9%, to $35.5 million (9.6% of total revenues) for the three months ended June 30, 2005, compared to $23.4 million (10.5% of total revenues) for the three months ended June 30, 2004. The decrease as a percentage of revenues was largely a function of our ability to achieve scale as revenues have increased, and the fourth quarter of 2004 acquisition of Specialty Defense, which operates with lower selling, general and administrative expenses as a percentage of revenues than the Products Division and the Mobile Security Division. Aerospace & Defense Group selling, general and administrative expenses increased $3.7 million, or 78.3%, to $8.4 million (3.3% of Aerospace & Defense Group revenues) for the three months ended June 30, 2005, compared to $4.7 million (3.6% of Aerospace & Defense Group revenues) for the three months ended June 30, 2004. The increase in selling, general and administrative expenses is due primarily to additional selling, general and administrative expenses associated with the acquisition of Specialty Defense in November 2004, increased research and development expense, and an increase in administrative expenses as a result of increased production of the Up-Armored HMMWV and supplemental armor for other military vehicles. The decrease in selling, general and administrative expenses as a percentage of revenue was due to leveraging of the selling, general and administrative expenses over a much larger revenue base and the 2004 acquisition of Specialty Defense, which operates with lower selling, general and administrative expenses as a percentage of revenues than the pre-existing Aerospace & Defense businesses. Products Division selling, general and administrative expenses increased $3.6 million, or 34.0%, to $14.0 million (18.3% of Products Division revenues) for the three months ended June 30, 2005, compared to $10.5 million (15.9% of Products Division revenues) for the three months ended June 30, 2004. This increase is due primarily to acquisitions of $2.4 million, the inclusion of selling, general and administrative expenses related to NTI training services which were part of discontinued operations in 2004, increased research and development expenses, increased legal related to patent protection, and management severance expenses. 40 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Mobile Security Division selling, general and administrative expenses increased $0.8 million, or 25.5%, to $3.7 million (9.7% of Mobile Security Division revenues) for the three months ended June 30, 2005, compared to $3.0 million (10.5% of Mobile Security Division revenues) for the three months ended June 30, 2004. The increase in selling, general and administrative expense was primarily due to increased insurance costs, increased selling and marketing costs, increased warranty provisions, and the negative impact of a weaker U.S. dollar when converting foreign based expenses to U.S. dollars. The decrease in selling, general and administrative expenses as a percentage of revenues was due to the leveraging of the selling, general and administrative expenses over a much larger revenue base. Corporate general and administrative expenses increased $4.1 million, or 78.9%, to $9.4 million (2.5% of total revenues) for the three months ended June 30, 2005, compared to $5.3 million (2.3% of total revenues) for the three months ended June 30, 2004. This increase in administrative expenses is associated with the overall growth of the Company, including increased travel expenses, bonus provision, executive compensation planning and insurance expenses. Amortization. Amortization expense increased $1.1 million, or 109.5% to $2.0 million for the three months ended June 30, 2005, compared to $973,000 for the three months ended June 30, 2004, primarily due to the acquisitions of Specialty Defense in November 2004 and Bianchi in December 2004. SFAS 142, which we adopted on January 1, 2002, eliminated amortization of intangible assets with indefinite lives and goodwill for all acquisitions completed after July 1, 2001, as well as for all fiscal years ending after January 1, 2002. Remaining amortization expense is related to patents and trademarks with finite lives, and acquired amortizable intangible assets that meet the criteria for recognition as an asset apart from goodwill under SFAS 141. Integration. Integration expense increased $32,000, or 4.0%, to $834,000 for the three months ended June 30, 2005, compared to $802,000 for the three months ended June 30, 2004. Integration expense in the second quarter of 2005 primarily included charges for the integration of Specialty Defense and Bianchi, which were acquired in the fourth quarter of 2004. Integration expense in the second quarter of 2004 primarily included charges for integration related to the acquisitions of Simula and Hatch Imports, which were acquired in the fourth quarter of 2003. Other charges. There were no other charges in the three months ended June 30, 2005. Other charges for the three months ended June 30, 2004, were $7.3 million. Other charges in the second quarter of 2004 included a non-cash charge of $5.9 million for the acceleration of performance based, long-term restricted stock awards granted to certain executives in 2002, and a $1.4 million charge to reduce the carrying value of the remaining portion of NTI to its estimated fair value. Operating income. Operating income increased $23.4 million, or 68.9%, to $57.4 million for the three months ended June 30, 2005, compared to $34.0 million in the three months ended June 30, 2004, due to the factors discussed above. Interest expense, net. Interest expense, net, decreased $543,000, or 26.4%, to $1.5 million for the three months ended June 30, 2005, compared to $2.1 million for the three months ended June 30, 2004. This decrease is primarily due to an increase in interest income generated from the increase in investment yield from higher interest rates and the increase in investment balances primarily from our 2% Convertible Notes offering in the fourth quarter of 2004. This is partially offset by an increase in interest expense as a result of the issuance of the 2% Convertible Notes and the increase in the six-month 41 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED LIBOR. On September 2, 2003, we entered into interest rate swap agreements that effectively exchanged the 8.25% fixed rate on the 8.25% Notes for a variable rate of six-month LIBOR (3.71% at June 30, 2005 and 1.94% at June 30, 2004), set in arrears, plus a spread of 2.735% to 2.75%. Other income, net. Other income, net, which was $3.1 million for the three months ended June 30, 2005, relates primarily to an increase in the fair market value of our previously announced put option contracts, net of a non-operating asset write-off. Other income, net, of $390,000 for the three months ended June 30, 2004, relates primarily to the realization of a gain on the sale of a certain equity investment. Income from continuing operations before provision for income taxes. Income from continuing operations before provision for income taxes increased $26.7 million, or 82.5%, to $59.0 million for the three months ended June 30, 2005, compared to $32.3 million for the three months ended June 30, 2004, due to the reasons discussed above. Provision for income taxes. Provision for income taxes was $21.6 million for the three months ended June 30, 2005, compared to $14.6 million for the three months ended June 30, 2004. The effective tax rate was 36.6% for the three months ended June 30, 2005, compared to 45.2% for the three months ended June 30, 2004. The decreased tax rate relates primarily to the non-taxable fair market gain on put options in the three months ended June 30, 2005, and the non-tax deductible charge due to the accelerated vesting of performance based, long-term restricted stock awards during the three months ended June 30, 2004. Income from continuing operations. Income from continuing operations increased $19.7 million, or 111.1%, to $37.4 million for the three months ended June 30, 2005, compared to $17.7 million for the three months ended June 30, 2004, due to the factors discussed above. DISCONTINUED OPERATIONS On July 2, 2004, we sold the security consulting division of our litigation support services subsidiary, NTI, which was the last remaining business in discontinued operations. The remaining division in NTI, consisting primarily of training services, has been included as part of the Products Division segment, where management now resides. This business represented the last remaining business in our ArmorGroup Services Division (the "Services Division"). We had no discontinued operations in the three months ended June 30, 2005. Please see Note 2, Discontinued Operations, in Part I, Item 1 for a summary of the operating results of the discontinued operations for three months ended June 30, 2004. 42 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO SIX MONTHS ENDED JUNE 30, 2004. Net income. Net income increased $38.1 million, or 125.8%, to $68.4 million for the six months ended June 30, 2005, compared to $30.3 million for the six months ended June 30, 2004. Net income for the six months ended June 30, 2004, includes income from continuing operations of $30.3 million and a loss from discontinued operations of $38,000. CONTINUING OPERATIONS Total revenues. Total revenues increased $351.3 million, or 91.2%, to $736.6 million in the six months ended June 30, 2005, compared to $385.3 million in the six months ended June 30, 2004. For the six months ended June 30, 2005, total revenue increased $298.0 million, or 67.9%, internally, including period-over-period changes in acquired businesses. Aerospace & Defense Group revenues. Aerospace & Defense Group revenues increased $306.4 million, or 145.4%, to $517.2 million in the six months ended June 30, 2005, compared to $210.8 million in the six months ended June 30, 2004. For the six months ended June 30, 2005, Aerospace & Defense Group revenue increased $275.8 million, or 114.3%, internally, including period-over-period changes in acquired businesses. Internal growth was primarily due to: (1) We experienced strong demand for the Up-Armored HMMWV, including spare part revenues, as we shipped 3,167 Up-Armored HMMWVs in the six months ended June 30, 2005, compared to 1,412 in the six months ended June 30, 2004, a 124.3% increase. While we continue to receive new orders under our current contract for the Up-Armored HMMWV, there are currently, several military transport vehicles that are in the development stage and are being evaluated by the U.S. military as possible next-generation replacements for the HMMWV. Although we believe that the HMMWV will continue for some time to be one of the primary transport vehicles in the U.S. military, there is no assurance as to when a replacement for the HMMWV may be selected. In the event the HMMWV is replaced, we anticipate that any armoring for a replacement vehicle would be part of the vehicle's original design and that eventually, our HMMWV up-armoring content per vehicle would likely decline. Although we anticipate making significant efforts to obtain armoring contracts for any HMMWV replacement vehicles selected by the U.S. military, at this time, we cannot determine to what degree, if any, we would be able to obtain such military contracts. See risk factor "A Replacement of the HWWMV in the U.S. Military May Affect Our Results of Operations" in Part I of our 10-K for the year ended December 31, 2004. (2) During the six months ended June 30, 2005, add-on armor components for fielded vehicles including add-on armor kits for medium and heavy truck fleet operating in Iraq increased 412.5%, compared to the six months ended June 30, 2004. We believe that vehicle armoring will play a significant role in the remainder of 2005 and is likely to play a significant role in 2006 and beyond. (3) SAPI plate volume decreased by 25.8% in the six months ended June 30, 2005, compared to the six months ended June 30, 2004. The reduction in volume was a result of our inability to 43 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED procure certain raw materials, mainly ballistic fiber and ceramic supply, which are an instrumental component to the SAPI plate. Continued growth in the SAPI plate business is dependent upon the continued level of hostilities in Iraq and Afghanistan as well as the U.S. Government's requirements for improved technology and performance of the SAPI plate. Future revenues may be constrained by our ability to procure certain raw materials necessary for the manufacture of the SAPI plate. See risk factor "There are Limited Sources for Some of Our Raw Materials, Which May Significantly Curtail our Manufacturing Operations" in Part I of our 10-K for the year ended December 31, 2004. (4) OTV units increased by 163.0% in the six months ended June 30, 2005, over the six months ended June 30, 2004. We also experienced 10.7% in unit growth in helmets. Our MOLLE revenue increased 50.1% due to sales of higher value MOLLE accessories. Acquired growth, which is the amount of current year revenue equal to the prior year revenue before our acquisition of the acquired company, was a function of the acquisition of Specialty Defense in November 2004, which accounted for $30.5 million of the acquired growth. Products Division revenues. Products Division revenues increased $25.8 million, or 21.6%, to $145.4 million in the six months ended June 30, 2005, compared to $119.6 million in the six months ended June 30, 2004. For the six months ended June 30, 2005, Products Division revenue increased $3.0 million, or 2.1%, internally. Internal growth was primarily due to strong sales of international body armor, and strong domestic and international sales within duty gear. Acquired growth of $22.8 million was a function of the acquisitions of Bianchi International, which was completed during the fourth quarter 2004, and Kleen Bore, Inc., which was completed during the third quarter of 2004. Mobile Security revenues. Mobile Security Division revenues increased $19.1 million, or 34.8%, to $74.1 million in the six months ended June 30, 2005, compared to $55.0 million in the six months ended June 30, 2004, primarily due to the increasing threat of terrorism. During the six months ended June 30, 2005, commercial vehicle shipments increased 35.5%, to 847 vehicles compared to 625 vehicles in the six months ended June 30, 2004. All of Mobile Security Division's revenue growth was internal. Cost of revenues. Cost of revenues increased $278.2 million, or 102.5%, to $549.5 million for the six months ended June 30, 2005, compared to $271.3 million for the six months ended June 30, 2004. As a percentage of total revenues, cost of revenues increased to 74.6% of total revenues for the six months ended June 30, 2005, from 70.4% for the six months ended June 30, 2004. Gross margins in the Aerospace & Defense Group were 22.5% for the six months ended June 30, 2005, compared to 30.2% for the six months ended June 30, 2004, primarily due to reduced selling prices for the Up-Armored HMMWV beginning in the third quarter of 2004, and significant changes in our product mix as we have diversified beyond Up-Armored HMMWVs. Gross margins in the Products Division were 36.3% for the six months ended June 30, 2005, compared to 32.6% for the six months ended June 30, 2004. The increase was primarily due to improved product mix, improved body armor margins and a shift in production to lower cost manufacturing facilities. 44 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Gross margins in the Mobile Security Division were 24.6% in the six months ended June 30, 2005, compared to 20.8% for the six months ended June 30, 2004. The margin improvement was primarily due to improved fixed cost absorption associated with increased manufacturing volumes, and a richer sales mix of high-end, higher margin vehicles. Selling, general and administrative expenses. Selling, general and administrative expenses increased $22.7 million, or 48.7%, to $69.4 million (9.4% of total revenues) for the six months ended June 30, 2005, compared to $46.6 million (12.1% of total revenues) for the six months ended June 30, 2004. The decrease as a percentage of revenues was largely a function of our ability to achieve scale as revenues have increased, and the fourth quarter of 2004 acquisition of Specialty Defense, which operates with lower selling, general and administrative expenses as a percentage of revenues than the Products Division and the Mobile Security Division. Aerospace & Defense Group selling, general and administrative expenses increased $7.0 million, or 69.6%, to $16.9 million (3.3% of Aerospace & Defense Group revenues) for the six months ended June 30, 2005, compared to $10.0 million (4.7% of Aerospace & Defense Group revenues) for the six months ended June 30, 2004. The increase in selling, general and administrative expenses is due primarily to additional selling, general and administrative expenses associated with the acquisition of Specialty Defense in November 2004, increased research and development expense, and increase in administrative expenses as a result of increased production of the Up-Armored HMMWV and supplemental armor for other military vehicles. The decrease in selling, general and administrative expense as a percentage of revenue was due to leveraging of the selling, general and administrative expenses over a much larger revenue base. Products Division selling, general and administrative expenses increased $7.0 million, or 32.7%, to $28.4 million (19.5% of Products Division revenues) for the six months ended June 30, 2005, compared to $21.4 million (17.9% of Products Division revenues) for the six months ended June 30, 2004. This increase is due primarily to acquisitions of $4.9 million, the inclusion of selling, general and administrative expenses related to NTI training services which were part of discontinued operations in 2004, increased research and development expenses, increased legal related to patent protection, and management severance expenses. Mobile Security Division selling, general and administrative expenses increased $0.8 million, or 12.2% (9.9% of Mobile Security Division revenues) for the six months ended June 30, 2005, compared to $6.5 million (11.9% of Mobile Security Division revenues) for the six months ended June 30, 2004. The increase in selling, general and administrative expense was primarily due to increased insurance costs, increased selling and marketing costs, increased warranty provisions, and the negative impact of a weaker U.S. dollar when converting foreign based expenses to U.S. dollars. The decrease in selling, general and administrative expenses as a percentage of revenues was due to the leveraging of the selling, general and administrative expenses over a much larger revenue base. Corporate general and administrative expenses increased $8.0 million, or 91.2%, to $16.7 million (2.3% of total revenues) for the six months ended June 30, 2005, compared to $8.8 million (2.3% of total revenues) for the six months ended June 30, 2004. This increase in administrative expenses is associated with the overall growth of the Company, including increased travel expenses, bonus provision, executive compensation planning and insurance expenses. 45 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Amortization. Amortization expense increased $2.1 million, or 108.7% to $4.1 million for the six months ended June 30, 2005, compared to $2.0 million for the six months ended June 30, 2004, primarily due to the acquisitions of Specialty Defense in November 2004 and Bianchi in December 2004. SFAS 142, which we adopted on January 1, 2002, eliminated amortization of intangible assets with indefinite lives and goodwill for all acquisitions completed after July 1, 2001, as well as for all fiscal years ending after January 1, 2002. Remaining amortization expense is related to patents and trademarks with finite lives, and acquired amortizable intangible assets that meet the criteria for recognition as an asset apart from goodwill under SFAS 141. Integration. Integration expense increased $151,000, or 10.2%, to $1.6 million for the six months ended June 30, 2005, compared to $1.5 million for the six months ended June 30, 2004. Included in integration expenses in the six months ended June 30, 2005, were charges for the integration of Specialty Defense and Bianchi, which were acquired in the fourth quarter of 2004. Included in integration expenses in the six months ended June 30, 2004, were charges for integration related to the acquisitions of Simula and Hatch Imports, which were acquired in the fourth quarter of 2003. Other charges. There were no other charges in the six months ended June 30, 2005. Other charges for the six months ended June 30, 2004, were $7.3 million. Other charges in the second quarter of 2004 included a non-cash charge of $5.9 million for the acceleration of performance based, long-term restricted stock awards granted to certain executives in 2002, and a $1.4 million charge to reduce the carrying value of the remaining portion of NTI to its estimated fair value. Operating income. Operating income increased $55.4 million, or 97.9%, to $112.1 million for the six months ended June 30, 2005, compared to $56.6 million in the six months ended June 30, 2004, due to the factors discussed above. Interest expense, net. Interest expense, net decreased $26,000, or 0.7%, to $3.8 million for the six months ended June 30, 2005, compared to $3.8 million for the six months ended June 30, 2004. This decrease is primarily due to an increase in interest income generated from the increase in investment yield from higher interest rates and the increase in investment balances primarily from our 2% Convertible Notes offering in the fourth quarter of 2004. This is partially offset by an increase in interest expense as a result of the issuance of the 2% Convertible Notes and the increase in the six-month LIBOR. On September 2, 2003, we entered into interest rate swap agreements that effectively exchanged the 8.25% fixed rate on the 8.25% Notes for a variable rate of six-month LIBOR (3.71% at June 30, 2005 and 1.94% at June 30, 2004), set in arrears, plus a spread of 2.735% to 2.75%. Other income, net. Other income, net, was income of $2.0 million for the six months ended June 30, 2005, and related primarily due to an increase in the fair market value of our previously announced put option contracts, net of a non-operating asset write-off. Other income, net, of $275,000 for the six months ended June 30, 2004, relates primarily to the realization of a gain on the sale of a certain equity investment. Income from continuing operations before provision for income taxes. Income from continuing operations before provision for income taxes increased $57.1 million, or 107.6%, to $110.3 million for the six months ended June 30, 2005, compared to $53.1 million for the six months ended June 30, 2004, due to the reasons discussed above. 46 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Provision for income taxes. Provision for income taxes was $41.8 million for the six months ended June 30, 2005, compared to $22.8 million for the six months ended June 30, 2004. The effective tax rate was 37.9% for the six months ended June 30, 2005, compared to 42.9% for the six months ended June 30, 2004. The decreased tax rate relates primarily to the non-taxable fair market gain on put options in the six months ended June 30, 2005, and the non-tax deductible charge due to the accelerated vesting of performance based, long-term restricted stock awards during the six months ended June 30, 2004. Income from continuing operations. Income from continuing operations increased $38.1 million, or 125.5%, to $68.4 million for the six months ended June 30, 2005, compared to $30.3 million for the six months ended June 30, 2004, due to the factors discussed above. DISCONTINUED OPERATIONS On July 2, 2004, we sold the security consulting division of our litigation support services subsidiary, NTI, which was the last remaining business in discontinued operations. The remaining division in NTI, consisting primarily of training services, has been included as part of the Products Division segment, where management now resides. This business represented the last remaining business in our ArmorGroup Services Division (the "Services Division"). We had no discontinued operations in the six months ended June 30, 2005. Please see Note 2, Discontinued Operations, in Part I, Item 1 for a summary of the operating results of the discontinued operations for six months ended June 30, 2004. 47 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED LIQUIDITY AND CAPITAL RESOURCES In March 2002, our Board of Directors approved a stock repurchase program authorizing the repurchase of up to a maximum 3.2 million shares of our common stock. In February 2003, the Board of Directors increased this stock repurchase program to authorize the repurchase, from time to time depending upon market conditions and other factors, of up to an additional 4.4 million shares. On March 25, 2005, our Board of Directors increased our existing stock repurchase program to enable us to repurchase, from time to time depending upon market conditions and other factors, up to an additional 3.5 million shares of its outstanding common stock. Through July 25, 2005, we repurchased 3.8 million shares of our common stock under the stock repurchase program at an average price of $12.49 per share, leaving us with the ability to repurchase up to an additional 7.3 million shares of our common stock. We have not repurchased any shares in 2004 or in the six months ended June 30, 2005. Repurchases may be made in the open market, in privately negotiated transactions utilizing various hedging mechanisms including, among others, the sale to third parties of put options our common stock, or otherwise. At June 30, 2005, we had 34.6 million shares of common stock outstanding. During the six months ended June 30, 2005, we sold put options in various private transactions covering 2.5 million shares of Company stock for $4.7 million in premiums. On June 30, 2005, put options covering 1 million shares expired unexercised leaving outstanding put options covering 1.5 million shares outstanding (4.3% of outstanding shares at June 30, 2005) at a weighted average strike price of $35.00 per share, all of which expire on or before September 30, 2005. If the purchasers exercise the remaining put options, we will be required to repurchase our shares or enter into alternative cash settlement arrangements at the negotiated strike price. As of June 30, 2005, based on the existing put option strike prices, it would cost us $52.5 million ($52.5 million fair value), if we were required to repurchase our shares under these put options. If all 1.5 million put options are exercised, we would have 5.8 million shares remaining under our repurchase programs. If the remaining put options expire unexercised, we will record an additional $1 million in other income in the third quarter of 2005. If our stock price were to decline below $35.00 on the settlement date of the remaining put options we potentially may incur a loss on the put options depending on the final closing price on the expiration dates. Under the terms of our put options, if our stock price were to fall to 50% of the strike price we could be required to settle the contracts prior to the expiration of the contracts. We have the ability to terminate the contracts prior to expiration by paying an early unwind amount to the counterparty. This amount is equal to the current market value of the option contract provided by the counterparty at the time of unwind. The fair values of the put options are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the put options, taking into account the consideration we received for the sale of the put options. As our stock price fluctuates the value of these contracts also fluctuates. For the three and six month periods ending June 30, 2005, we incurred fair value gains of $4.9 million and $3.8 million, respectively, recorded in other income, net. We expect to continue our policy of repurchasing our common stock from time to time, subject to the restrictions contained in our Credit Facility, the indenture governing the 8.25% Notes and the indenture governing the 2% Convertible Notes. Our Credit Facility permits us to repurchase shares of 48 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED our common stock with no limitation if our ratio of Consolidated Senior Indebtedness to Consolidated EBITDA (as such terms are defined in the Credit Facility) for any rolling twelve-month period is less than 1.00 to 1. When such ratio is greater than 1.00 to 1, our Credit Facility limits our ability to repurchase shares at $15.0 million. This basket resets to $0 each time the ratio is less than 1.00 to 1. As of June 30, 2005, such ratio was 0.06 to 1. Our indentures governing the 8.25% Notes and the 2% Convertible Notes also permit us to repurchase shares of our common stock, subject to certain limitations, as long as we satisfy the conditions to such repurchase contained therein. On October 29, 2004, we completed the placement of $300 million aggregate principal amount of the 2.00% Senior Subordinated Convertible Notes due November 1, 2024 (the "2% Convertible Notes"). On November 5, 2004, Goldman, Sachs & Co. exercised its option to purchase an additional $45 million principal amount of the 2% Convertible Notes. The 2% Convertible Notes provide the holders with a seven year put option and are guaranteed by most of our domestic subsidiaries on a senior subordinated basis. The 2% Convertible Notes were initially rated B1/B+ by Moody's Investors' Service and Standard & Poor's Rating Services, respectively. The 2% Convertible Notes will bear interest at a rate of 2.00% per year, payable on November 1 and May 1 of each year beginning on May 1, 2005 and ending on November 1, 2011. The 2% Convertible Notes will be subject to accretion of the principal amount beginning on November 1, 2011, at a rate that provides holders with an aggregate annual yield to maturity of 2.00%, as defined in the agreement. The 2% Convertible Notes will bear contingent interest during any six-month period beginning November 1, 2011, of 15 basis points paid in cash if the average trading price of the notes is above certain levels. The 2% Convertible Notes will be convertible, at the bond holder's option at any time, initially at a conversion rate of 18.5151 shares of our common stock per $1,000 principal amount of notes, which is the equivalent conversion price of approximately $54.01 per share, subject to adjustment. Upon conversion, we will satisfy our conversion obligation with respect to the accreted principal amount of the notes to be converted in cash, with any remaining amount to be satisfied in shares of our common stock. The conversion rate will be subject to adjustment, without duplication, upon the occurrence of any of the following events: (1) Stock dividends in common stock, (2) Issuance of rights and warrants, (3) Stock splits and combinations, (4) Distribution of indebtedness, securities or assets, (5) Cash distributions, (6) Tender or exchange offers, and (7) Repurchases of common stock. In accordance with generally accepted accounting principles, the 2% Convertible Notes are classified as short term debt. We used the proceeds of the offering to fund the acquisitions of Specialty Defense in November 2004 and Bianchi International in December 2004, and for general corporate and working capital purposes, including the funding of capital expenditures. Funds that are not immediately used are invested in money market funds and other investment grade securities until needed. On June 22, 2004, our stockholders approved an amendment to our Certificate of Incorporation, as amended, that increased the number of shares of our authorized capital stock to 80,000,000, of which 75,000,000 shares are designated as common stock and 5,000,000 shares are designated as preferred stock. On June 15, 2004, we sold 4,000,000 primary shares of common stock at a price of $37.50 per share, raising $142.5 million of net proceeds after deducting the underwriter discounts and commissions. In addition, certain of our directors and officers granted the underwriters a 30-day option to purchase up to 600,000 shares. The 30-day option expired unexercised on July 15, 2004. We used the net proceeds from the offering to primarily to fund the acquisitions of Specialty Defense and Bianchi International in the fourth quarter of 2004. 49 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED On September 2, 2003, we entered into interest rate swap agreements, which have been designated as fair value hedges as defined under SFAS 133 with a notional amount totaling $150 million. The agreements were entered into to exchange the fixed interest rate on our 8.25% Notes for a variable interest rate equal to six-month LIBOR, set in arrears, plus a spread ranging from 2.735% to 2.75% fixed semi-annually on the fifteenth day of February and August. The agreements are subject to other terms and conditions common to transactions of this type. In accordance with SFAS 133, changes in the fair value of the interest rate swap agreements offset changes in the fair value of the fixed rate debt due to changes in the market interest rate. Accordingly, other assets on the Consolidated Balance Sheet increased by $1.0 million to $7.0 million at June 30, 2005, from $6.0 million at December 31, 2004, which reflected an increase in the fair value of the interest rate swap agreements. The corresponding increase in the hedge liability was recorded in long-term debt. The agreements are deemed to be a perfectly effective fair value hedge, and, therefore, qualify for the short-cut method of accounting under SFAS 133. As a result, no ineffectiveness is expected to be recognized in our earnings associated with the interest rate swap agreements. On August 12, 2003, we completed a private placement of $150 million aggregate principal amount of the 8.25% Notes. The 8.25% Notes are guaranteed by almost all of our domestic subsidiaries, on a senior subordinated basis. The 8.25% Notes have been sold to qualified institutional investors in reliance on Rule 144A of the Securities Act of 1933, as amended, and to non-U.S. persons in reliance on Regulation S under the Securities Act of 1933, as amended. The 8.25% Notes were initially rated B1/B+ by Moody's Investors' Service and Standard & Poor's Rating Services, respectively. We used a portion of the funds to repay debt, acquire Simula, Inc., Hatch Imports, Inc., ODV, Inc., and Kleen-Bore, Inc., and we intend to use the remaining proceeds of the offering to fund acquisitions and for general corporate and working capital purposes, including the funding of capital expenditures. On March 29, 2004, we completed a registered exchange offer for the 8.25% Notes and exchanged the 8.25% Notes for new 8.25% Notes that were registered under the Securities Act of 1933, as amended. On August 12, 2003, in concert with our 8.25% Note offering, we entered into a new secured revolving credit facility (the "Credit Facility") with Bank of America, N.A., Wachovia Bank, National Association and a syndicate of other financial institutions arranged by Bank of America Securities, LLC. The Credit Facility consists of a five-year revolving credit facility, and, among other things, provides for (i) total maximum borrowings of $60 million, (ii) a $25 million sub-limit for the issuances of standby and commercial letters of credit, (iii) a $5 million sub-limit for swing-line loans, and (iv) a $5 million sub-limit for multi-currency borrowings. All borrowings under the Credit Facility will bear interest at either (i) a rate equal to LIBOR, plus an applicable margin ranging from 1.125% to 1.625%, (ii) an alternate base rate which will be the higher of (a) the Bank of America prime rate and (b) the Federal Funds rate plus 0.50%, or (iii) with respect to foreign currency loans, a fronted offshore currency rate, plus an applicable margin ranging from 1.125% to 1.625%, depending on certain conditions. The Credit Facility is guaranteed by certain of our direct and indirect domestic subsidiaries and is collateralized by, among other things, (i) a pledge of all of the issued and outstanding shares of stock or other equity interests of certain of our domestic subsidiaries, (ii) a pledge of 65% of the issued and outstanding voting shares of stock or other voting equity interests of certain of our direct and indirect foreign subsidiaries, (iii) a pledge of 100% of the issued and outstanding nonvoting shares of stock or other nonvoting equity interests of certain of our direct and indirect foreign subsidiaries, and (iv) a first priority perfected security interest on certain of our domestic assets and certain domestic assets of certain of our direct and indirect subsidiaries that will become guarantors of our obligations under the Credit 50 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Facility, including, among other things, accounts receivable, inventory, machinery, equipment, certain contract rights, intellectual property rights and general intangibles. On January 9, 2004, we amended our Credit Facility to broaden our ability to make additional open-market purchases of publicly-traded securities subject to certain limitations. On March 29, 2004, we amended our Credit Facility to allow us to pay dividends subject to certain limitations. On October 19, 2004, we amended our Credit Facility to allow us to subtract cash equivalents from total indebtedness in calculation of our compliance covenants. On April 14, 2005, we amended our credit agreement to amend the definition of cash equivalents to include auction rate securities held by our existing bank group. On July 26, 2005, we amended our secured revolving credit facility (the "Credit Facility") with Bank of America, N.A., Wachovia Bank, National Association and a syndicate of other financial institutions arranged by Bank of America Securities, LLC. The amendment allows for advances, loans, extensions of credit to or any other investments in key suppliers of the Company in an aggregate amount not to exceed $15 million at any time outstanding for the purpose of facilitating the sale and purchase of goods and services to the Company. In addition, the amendment allows for leases or other dispositions of assets of not more than 10% of the consolidated earnings before interest, taxes, depreciation and amortization ("EBITDA"), as defined in the Credit Facility. As of June 30, 2005, we were in compliance with all of our negative and affirmative covenants contained in the Credit Facility and the indentures governing the 8.25% Notes and the 2% Convertible Notes. Working capital was $362.9 million and $289.6 million as of June 30, 2005, and December 31, 2004, respectively. The increase in working capital is largely a function of increases in accounts receivable of $2.4 million and inventory of $32.5 million to support the growth in revenues from demand for the Up-Armored HMMWV, supplemental armor for other military vehicles, and SAPI plates. Net cash provided by operating activities was $58.0 million for the six months ended June 30, 2005, compared to $9.7 million for the six months ended June 30, 2004. Net cash provided by operating activities improved due to increased net income for the six months ended June 30, 2005, and was negatively impacted due to increases in working capital in both periods. Net cash used in investing activities was $385.6 million for the six months ended June 30, 2005, compared to $217.2 million for the six months ended June 30, 2004 primarily due to an increase in the purchase of short-term investment securities in the six months ended June 30, 2005. Net cash provided by financing activities was $845,000 for the six months ended June 30, 2005, compared to $116.5 million for the six months ended June 30, 2004. The decrease in the six months ended June 30, 2005 is primarily due to net cash provided by financing activities in the six months ended June 30, 2004 including the sale of 4,000,000 shares of Company stock, partially offset by the long-term repayment of long-term debt. Our fiscal 2005 capital expenditures are expected to be $16.7 million, of which we have spent $8.1 million through the six months ended June 30, 2005. Such expenditures included additional manufacturing, office space, manufacturing machinery and equipment, leasehold improvements, information technology and communications infrastructure equipment. We anticipate that the cash on hand, cash generated from operations, and available borrowings under the Credit Facility will enable us to meet liquidity, working capital and capital expenditure requirements during the next 12 months. We may, however, require additional financing to pursue our strategy of growth through acquisitions and we are continuously exploring alternatives. If such financing is required, there are no assurances that it will be available, or if available, that it can be obtained on terms favorable to us or on a basis that is not dilutive to our stockholders. See Part II Item 1 Legal Proceedings regarding outstanding legal matters. 51 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED FORWARD LOOKING AND CAUTIONARY STATEMENTS Except for the historical information and discussions contained herein, statements contained in this Form 10-Q may constitute "forward looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including, but not limited to, our failure to continue to develop and market new and innovative products and services and to keep pace with technological change; competitive pressures; failure to obtain or protect intellectual property rights; the ultimate effect of various domestic and foreign political and economic issues on our business, financial condition or results of operations; quarterly fluctuations in revenues and volatility of stock prices; contract delays; cost overruns; our ability to attract and retain key personnel; currency and customer financing risks; dependence on certain suppliers, customers and availability of raw materials; changes in the financial or business condition of our distributors or resellers; our ability to successfully manage acquisitions, alliances and integrate past and future business combinations; regulatory, legal, political and economic changes; an adverse determination in connection with the Zylon(R) investigation being conducted by the U.S. Department of Justice and certain state agencies and/or other Zylon(R)-related litigation; and other risks, uncertainties and factors inherent in our business and otherwise discussed elsewhere in this Form 10-Q and in our other filings with the Securities and Exchange Commission or in materials incorporated therein by reference. 52 ARMOR HOLDINGS, INC. AND SUBSIDIARIES QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK As a result of our global operating and financial activities, we are exposed to changes in raw material prices, interest rates, foreign currency exchange rates and our stock price, which may adversely affect our results of operations and financial position. In seeking to minimize the risks and/or costs associated with such activities, we manage exposure to changes in raw material prices, interest rates, and foreign currency exchange rates through our regular operating and financing activities. We have entered into interest rate swap agreements to reduce our overall interest expense. MARKET RATE RISK The following discussion about our market rate risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates, foreign currency exchange rates, and equity security price risk. Interest Rate Risk. Our exposure to market rate risk for changes in interest rates relates primarily to borrowings under our $150 million senior subordinated notes, our credit facilities and our short-term monetary investments. To the extent that, from time to time, we hold short-term money market instruments, there is a market rate risk for changes in interest rates on such instruments. To that extent, there is inherent rollover risk in the short-term money market instruments as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable, because of the variability of future interest rates and business financing requirements. However, there is only a remote risk of loss of principal in the short-term money market instruments. The main risk is related to a potential reduction in future interest income. On September 2, 2003, we entered into interest rate swap agreements in which we effectively exchanged the $150 million fixed rate 8.25% interest on the senior subordinated notes for variable rates in the notional amount of $80 million, $50 million, and $20 million at six-month LIBOR, set in arrears, plus 2.75%, 2.75%, and 2.735%, respectively. The agreements involve receipt of fixed rate amounts in exchange for floating rate interest payments over the life of the agreement without an exchange of the underlying principal amount. The variable interest rates are fixed semi-annually on the fifteenth day of February and August each year through maturity. The six-month LIBOR rate was 3.86% on July 20, 2005. The maturity dates of the interest rate swap agreements match those of the underlying debt. Our objective for entering into these interest rate swaps was to reduce our exposure to changes in the fair value of senior subordinated notes and to obtain variable rate financing at an attractive cost. Changes in the six-month LIBOR would affect our earnings either positively or negatively. An assumed 100 basis point increase in the six-month LIBOR would increase our interest obligations under the interest rate swaps by approximately $750,000 for a six month period. In accordance with SFAS 133, we designated the interest rate swap agreements as perfectly effective fair value hedges and, accordingly, use the short-cut method of evaluating effectiveness. As permitted by the short-cut method, the change in fair value of the interest rate swaps will be reflected in earnings and an equivalent amount will be reflected as a change in the carrying value of the swaps, with an offset to earnings. There is no ineffectiveness to be recorded. On June 30, 2005, we recorded the fair value of the interest rate swap agreements of $7.0 million and recorded the corresponding fair value 53 ARMOR HOLDINGS, INC. AND SUBSIDIARIES QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - CONTINUED adjustment to the 8.25% senior subordinated notes in other assets and long-term debt sections of the Condensed Consolidated Balance Sheets, respectively. We are exposed to credit-related losses in the event of nonperformance by counterparties to these financial instruments. However, counterparties to these agreements are major financial institutions and the risk of loss due to nonperformance is considered by management to be minimal. We do not hold or issue interest rate swap agreements or other derivative instruments for trading purposes. Foreign Currency Exchange Rate Risk. The majority of our business is denominated in U.S. dollars. There are costs associated with our operations in foreign countries that require payments in the local currency. Where appropriate and to partially manage our foreign currency risk related to those payments we receive payment from customers in local currencies in amounts sufficient to meet our local currency obligations. We do not use derivatives or other financial instruments to hedge foreign currency risk. Stock Price Risk. The fair values of the put options are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the put options, taking into account the consideration we received for the sale of the put options. As our stock price fluctuates the value of these contracts also fluctuates. For the three and six month periods ending June 30, 2005, we incurred fair value gains of $4.9 million and $3.8 million, respectively, recorded in other income, net. Our exposure to our stock price risk is a result of the remaining unexercised put option contracts covering 1.5 million shares of our common stock. Under the terms of our put options, if our stock price were to fall to 50% of the strike price we could be required to settle the contracts prior to the expiration of the contracts. We have the ability to terminate the contracts prior to expiration by paying an early unwind amount to the counterparty. This amount is equal to the current market value of the option contract provided by the counterparty at the time of unwind. RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS We do business in numerous countries, including emerging markets in South America. We have invested resources outside of the United States and plan to continue to do so in the future. Our international operations are subject to the risk of new and different legal and regulatory requirements in local jurisdictions, tariffs and trade barriers, potential difficulties in staffing and managing local operations, potential imposition of restrictions on investments, potentially adverse tax consequences, including imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries, and local economic, political and social conditions. Governments of many developing countries have exercised and continue to exercise substantial influence over many aspects of the private sector. Government actions in the future could have a significant adverse effect on economic conditions in a developing country or may otherwise have a material adverse effect on us and our operating companies. We do not have political risk insurance in the countries in which we currently conduct business, but periodically analyze the need for and cost associated with this type of policy. Moreover, applicable agreements relating to our interests in our operating companies are frequently governed by foreign law. As a result, in the event of a dispute, it may be difficult for us to enforce our rights. Accordingly, we may have little or no recourse upon the occurrence of any of these developments. 54 ARMOR HOLDINGS, INC. AND SUBSIDIARIES ITEM 4. CONTROLS AND PROCEDURES Our management, including Warren B. Kanders, Chairman and Chief Executive Officer, and Glenn J. Heiar, Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the Chairman and Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this quarterly report, our disclosure controls and procedures, which are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable Securities and Exchange Commission rules and forms, were effective. Furthermore, our management including our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are also effective to ensure that information required to be disclosed in the reports that we file and submit under the Exchange Act is accumulated and communicated to allow timely decisions regarding required disclosure. Our management, including our Chairman and Chief Executive Officer and Chief Financial Officer, has also evaluated our internal control over financial reporting to determine whether any changes occurred during the fiscal quarter covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the fiscal quarter covered by this quarterly report. 55 PART II ITEM 1. LEGAL PROCEEDINGS In the normal course of business, we are subjected to various types of claims and currently have on-going litigations in the areas of products liability, general liability and intellectual property. Our products are used in a wide variety of law enforcement situations and environments. Some of our products can cause serious personal or property injury or death if not carefully and properly used by adequately trained personnel. We believe that we have adequate insurance coverage for most claims that are incurred in the normal course of business. In such cases, the effect on our financial statements is generally limited to the amount of our insurance deductible or self-insured retention. Our annual insurance premiums and self insurance retention amounts have risen significantly over the past several years and may continue to do so to the extent we are able to purchase insurance coverage. At this time, we do not believe any such claims or pending litigation will have a material impact on our financial position, operations or liquidity. Reference is made to Part I, Item 3, Legal Proceedings, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004, for a description of other previously disclosed legal proceedings. 56 ARMOR HOLDINGS, INC. AND SUBSIDIARIES ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS We held our annual meeting of stockholders on June 22, 2005 for the purpose of (i) electing directors, (ii) ratifying the appointment of PricewaterhouseCoopers LLP as Armor Holdings, Inc.'s independent auditors for the fiscal year ending December 31, 2005, (iii) approving the Armor Holdings, Inc. 2005 Stock Incentive Plan, and (iv) approving the Armor Holdings, Inc. 2005 Annual Incentive Plan. Each of our nominees for directors, as listed in the proxy statement, was elected with the number of votes set forth below. FOR AGAINST --- ------- Warren B. Kanders 28,730,882 2,146,361 Burtt R. Ehrlich 28,345,893 2,531,350 David R. Haas 29,583,236 1,294,007 Robert R. Schiller 29,584,298 1,292,945 Nicholas Sokolow 27,894,459 2,982,784 Thomas W. Strauss 29,583,883 1,293,360 Deborah A. Zoullas 29,581,685 1,295,558 The ratification of the appointment of PricewaterhouseCoopers LLP as Armor Holdings, Inc.'s independent auditors for the fiscal year ending December 31, 2005 was approved with the number of votes set forth below: For Against Abstentions --- ------- ----------- 30,472,429 387,733 17,081 The proposal to adopt the Armor Holdings, Inc. 2005 Stock Incentive Plan was approved with the number of votes set forth below: For Against Abstentions --- ------- ----------- 20,225,111 4,567,928 123,490 The proposal to adopt the Armor Holdings, Inc. 2005 Annual Incentive Plan was approved with the number of votes set forth below: For Against Abstentions --- ------- ----------- 23,550,774 1,341,629 124,126 57 ARMOR HOLDINGS, INC. AND SUBSIDIARIES ITEM 6. EXHIBITS The following exhibits are filed as part of this quarterly report on Form 10-Q: Exhibit No. Description ----------- ----------- 4.1 Third Supplemental Indenture, dated as of May 25, 2005, among Armor Holdings, Inc., the subsidiary guarantors listed as signatories thereto and Wachovia Bank, National Association, as trustee. 4.2 Eighth Supplemental Indenture, dated as of May 25, 2005, among Armor Holdings, Inc., the subsidiary guarantors listed as signatories thereto and Wachovia Bank, National Association, as trustee. 10.1 Amended and Restated Employment Agreement, dated as of January 1, 2005, between Armor Holdings, Inc. and Warren B. Kanders. 10.2 Employment Agreement, dated as of January 1, 2005, between Armor Holdings, Inc. and Robert R. Schiller. 10.3 Employment Agreement, dated as of May 20, 2005, between Armor Holdings, Inc. and Glenn J. Heiar. 10.4 Employment Agreement, dated as of May 20, 2005, between Armor Holdings, Inc. and Robert F. Mecredy. 10.5 Employment Agreement, dated as of May 20, 2005, between Armor Holdings, Inc. and Scott T. O'Brien. 10.6 Non-competition Agreement, dated as of May 20, 2005, between Armor Holdings, Inc. and Scott T. O'Brien. 10.7 Form of Stock Option Agreement under the 2005 Stock Incentive Plan. 10.8 Form of Stock Bonus Award Agreement under the 2005 Stock Incentive Plan. 10.9 Fourth Amendment to Credit Agreement, dated as of Apri 14, 2005, by and among Armor Holdings, Inc., as Borrower, the lenders from time to time party to the Credit Agreement, Bank of America, N.A., as Administrative Agent, Wachovia Bank, National Association, as Syndication Agent, and KeyBank National Association, as Documentation Agent. 10.10 Fifth Amendment to Credit Agreement, dated as of July 26, 2005, by and among Armor Holdings, Inc., as Borrower, the lenders from time to time party to the Credit Agreement, Bank of America, N.A., as Administrative Agent, Wachovia Bank, National Association, as Syndication Agent, and KeyBank National Association, as Documentation Agent. 31.1 Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)). 31.2 Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)). 32.1 Certification of Principal Executive Officer Pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). 58 ARMOR HOLDINGS, INC. AND SUBSIDIARIES 32.2 Certification of Principal Financial Officer Pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). 59 ARMOR HOLDINGS, INC. AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ARMOR HOLDINGS, INC. /s/ Warren B. Kanders ---------------------------------- Warren B. Kanders Chairman and Chief Executive Officer Dated: July 27, 2005 /s/ Glenn J. Heiar ---------------------------------- Glenn J. Heiar Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) Dated: July 27, 2005 60