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 SEPTEMBER 30, 2004, 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.) 1400 MARSH LANDING PARKWAY, SUITE 112 JACKSONVILLE, FLORIDA 32250 (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 October 15, 2004 is 33,196,008. 1 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.... 38 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................ 57 ITEM 4. CONTROLS AND PROCEDURES............................. 59 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS................................... 60 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................... 64 ITEM 6. EXHIBITS ........................................... 64 SIGNATURES 65 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 (consisting only of normal recurring accruals and the elimination of all material intercompany accounts and transactions) which management considers necessary for a fair presentation of operating results and financial position as of September 30, 2004 and for the three month and nine months periods ended September 30, 2004 and September 30, 2003. These unaudited condensed consolidated financial statements should be read in conjunction with the financial statements included in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003. 3 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) SEPTEMBER 30, 2004 DECEMBER 31, 2003 (UNAUDITED) * ------------------ ----------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $234,487 $111,850 Restricted cash - 2,600 Accounts receivable (net of allowance for doubtful accounts of $2,540 and $1,673) 126,185 72,635 Costs and earned gross profit in excess of billings 157 - Inventories 139,820 80,527 Prepaid expenses and other current assets 26,482 22,032 Current assets of discontinued operations (Note 2) - 753 -------- -------- Total current assets 527,131 290,397 PROPERTY AND EQUIPMENT (net of accumulated depreciation of $24,710 and $19,046) 62,006 57,576 GOODWILL (net of accumulated amortization of $4,024 and $4,024) 181,613 175,707 PATENTS, LICENSES AND TRADEMARKS (net of accumulated amortization of $5,518 and $2,627) 45,070 44,174 OTHER ASSETS 16,631 16,169 LONG-TERM ASSETS OF DISCONTINUED OPERATIONS (Note 2) - 1,603 -------- -------- TOTAL ASSETS $832,451 $585,626 ======== ======== * 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) SEPTEMBER 30, 2004 DECEMBER 31, 2003 (UNAUDITED) * ------------------ ----------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Current portion of long-term debt $ 612 $ 32,107 Short-term debt 973 498 Accounts payable 50,469 30,304 Accrued expenses and other current liabilities 73,625 58,218 Income taxes payable 22,283 - Current liabilities of discontinued operations (Note 2) - 626 --------- --------- Total current liabilities 147,962 121,753 LONG-TERM LIABILITIES: Long-term debt, less current portion 155,436 158,300 Other long-term liabilities 8,671 10,208 --------- --------- 312,069 290,261 Total liabilities COMMITMENTS AND CONTINGENCIES (NOTE 11) 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 50,000,000 shares authorized; 39,135,873 and 34,337,034 issued and 33,075,651 and 28,276,812 outstanding at September 30, 2004 and December 31, 2003, respectively 392 344 Additional paid-in capital 489,293 318,460 Retained earnings 99,127 44,942 Accumulated other comprehensive income 3,887 3,936 Treasury stock (72,317) (72,317) --------- --------- Total stockholders' equity 520,382 295,365 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 832,451 $ 585,626 ========= ========= * 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) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ REVENUES: Aerospace & Defense $160,238 $21,136 $ 371,019 $ 52,839 Products 64,659 49,804 184,242 143,158 Mobile Security 31,906 19,942 86,874 57,018 -------- ------- --------- -------- Total Revenues 256,803 90,882 642,135 253,015 -------- ------- --------- -------- COSTS AND EXPENSES: Cost of revenues 185,457 61,953 456,771 176,396 Cost of warranty revision 5,000 - 5,000 - Operating expenses 22,695 15,977 69,332 44,505 Amortization 984 72 2,937 201 Integration and other charges 932 368 9,736 4,565 -------- ------- --------- -------- OPERATING INCOME 41,735 12,512 98,359 27,348 Interest expense, net 1,400 1,475 5,185 2,291 Other expense (income), net 154 96 (121) 181 -------- ------- --------- -------- INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES 40,181 10,941 93,295 24,876 PROVISION FOR INCOME TAXES 16,307 4,832 39,072 10,044 -------- ------- --------- -------- INCOME FROM CONTINUING OPERATIONS 23,874 6,109 54,223 14,832 DISCONTINUED OPERATIONS (NOTE 2): INCOME (LOSS) FROM DISCONTINUED OPERATIONS, NET OF TAX - 6 (38) 983 -------- ------- --------- -------- NET INCOME $ 23,874 $ 6,115 $ 54,185 $ 15,815 ======== ======= ========= ======== NET INCOME PER COMMON SHARE - BASIC INCOME FROM CONTINUING OPERATIONS $ 0.73 $ 0.22 $ 1.79 $ 0.52 INCOME FROM DISCONTINUED OPERATIONS 0.00 0.00 0.00 0.04 -------- ------- --------- -------- BASIC EARNINGS PER SHARE $ 0.73 $ 0.22 $ 1.79 $ 0.56 ======== ======= ========= ======== 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) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ NET INCOME PER COMMON SHARE - DILUTED INCOME FROM CONTINUING OPERATIONS $ 0.70 $ 0.22 $ 1.72 $ 0.52 INCOME FROM DISCONTINUED OPERATIONS 0.00 0.00 0.00 0.04 ---------- ---------- ---------- ---------- DILUTED EARNINGS PER SHARE $ 0.70 $ 0.22 $ 1.72 $ 0.56 ========== ========== ========== ========== WEIGHTED AVERAGE SHARES - BASIC 32,861 27,811 30,221 28,106 ========== ========== ========== ========== WEIGHTED AVERAGE SHARES - DILUTED 34,198 28,249 31,498 28,438 ========== ========== ========== ========== See notes to condensed consolidated financial statements. 7 ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS) NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Income from continuing operations $ 54,223 $ 14,832 Adjustments to reconcile income from continuing operations to cash provided by operating activities: Depreciation and amortization 9,954 5,380 Loss on disposal of fixed assets 426 167 Deferred income taxes 2,785 3,676 Non-cash charge for acceleration of performance-based restricted stock awards 6,294 - Non-cash impairment charge 1,408 - Non-cash termination charge - 2,093 Changes in operating assets and liabilities, net of acquisitions: (Increase) in accounts receivable (52,331) (1,556) (Increase) decrease in inventories (58,848) 2,173 (Increase) in prepaid expenses and other assets (7,723) (3,682) Increase in accounts payable, accrued expenses and other current liabilities 37,594 11,808 Increase (decrease) in income taxes payable 28,235 (1,999) --------- --------- Net cash provided by operating activities 22,017 32,892 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (11,061) (5,645) Purchase of patents and trademarks (117) (99) Purchase of equity investment (5,275) - Proceeds from sale of equity investment 5,823 - Collection of note receivable 975 - Decrease in restricted cash 2,600 - Sale of business, net of cash disposed 125 - Additional consideration for purchased businesses (2,323) (740) Purchase of business, net of cash acquired (8,373) (5,828) --------- --------- Net cash used in investing activities (17,626) (12,312) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the exercise of stock options 11,448 6,588 Proceeds from the issuance of common stock 142,500 - Cash paid for common stock offering costs (1,339) - Repurchases of treasury stock - (22,684) Proceeds from the issuance of long-term debt - 147,504 Cash paid for financing costs - (4,020) Repayments of long-term debt (34,339) (1,399) Borrowings under lines of credit 18,507 31,744 Repayments under lines of credit (18,054) (32,070) --------- --------- Net cash provided by financing activities 118,723 125,663 --------- --------- Effect of exchange rate changes on cash and cash equivalents 240 478 Net cash used in discontinued operations (717) (4,868) --------- --------- NET INCREASE IN CASH AND CASH EQUIVALENTS 122,637 141,853 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 111,850 12,913 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 234,487 $ 154,766 ========= ========= CASH AND CASH EQUIVALENTS, END OF PERIOD CONTINUING OPERATIONS $ 234,487 $ 154,766 DISCONTINUED OPERATIONS - 5,051 --------- --------- $ 234,487 $ 159,817 ========= ========= 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 generally accepted accounting principles for interim information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, and do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals and the elimination of all material intercompany accounts and transactions) considered necessary by management to present a fair presentation have been included. The results of operations for the three month and nine month period is 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/A for the year ended December 31, 2003. The amounts disclosed in the footnotes are related to continuing operations unless otherwise indicated. Effective in the first quarter 2004, we instituted a new segment reporting format to include three reportable business segments: Aerospace & Defense Group, the Products Division ("Armor Holdings Products"), and the Mobile Security Division ("Armor Mobile Security"). The Aerospace & Defense Group was formed upon the completion of our acquisition of Simula, Inc. on December 9, 2003, and results have been included since the acquisition date. The Aerospace & Defense Group also includes the military business, including armor and blast protection systems for M1114 Up-Armored High Mobility Multi-Purpose Wheeled Vehicles ("HMMWVs"), and other military vehicle armor programs, which previously were included in the Mobile Security Division. The Aerospace & Defense Group also includes the small arms protective insert ("SAPI") plate produced by our Protech subsidiary in Pittsfield, Massachusetts, which was previously reported as part of the Products Division. The historical results of these businesses have been reclassified as part of the Aerospace & Defense Group. This reporting change was made to better reflect management's approach to operating and directing the businesses, and, in certain instances, to align financial reporting with our market and customer segments. The reporting change had no impact on consolidated revenues, gross profit, operating income or net income. As discussed in Note 2, 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"). The assets and liabilities of the Services Division have been classified as assets and liabilities of discontinued operations on our condensed consolidated balance sheets and the results of their operations classified as income (loss) from discontinued operations in the accompanying unaudited condensed consolidated statements of operations. 9 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 2 - DISCONTINUED OPERATIONS On April 17, 2003, we announced that we had completed the sale of our ArmorGroup Integrated Systems business through the sale of 100% of the stock of ArmorGroup Integrated Systems, Inc. and Low Voltage Systems Technologies, Inc. to Aerwav Integration Systems, Inc. ("AIS"). AIS is a wholly owned subsidiary of Aerwav Holdings, LLC. As consideration for the integrated systems business, we received a $4.1 million collateralized note due in two years and a warrant for approximately 2.5% of AIS. $475,000 of the balance due was paid in advance through September 30, 2004. In accordance with Statement of Financial Accounting Standards No. 144, we recorded a loss of $366,000 on the sale in the second quarter of 2003. On November 26, 2003, we announced that we completed the sale of ArmorGroup, our security service division, for $33,660,000 in total consideration to a group of private investors led by Granville Baird Capital Partners of London, England and Management. We received $31,360,000 in cash at closing and are scheduled to receive another $2,300,000 by the end of 2004, of which we have received $1.4 million through October 15, 2004. We recorded a loss of $8.8 million on the sale in the fourth quarter of 2003 primarily due to unrealized foreign currency translation loss. In accordance with generally accepted accounting principles, unrealized foreign currency translation gains and losses, which are included in equity as accumulated other comprehensive income or loss, are not recognized until the period in which the related assets and liabilities are disposed of. On June 30, 2004, our litigation support services subsidiary, NTI, was the last remaining business in discontinued operations. On July 2, 2004, we sold the security consulting division of NTI. In the second quarter of 2004, we recorded an impairment charge of $1.4 million in integration and other charges in continuing operations to reduce the carrying value of the remaining portion of NTI to its estimated fair value. 10 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED A summary of the operating results of the discontinued operations for the three months and nine months ended September 30, 2004 and 2003 is as follows. THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS) (IN THOUSANDS) Revenue $ - $ 26,039 $ 1,733 $ 75,738 Cost of revenues - 18,078 697 53,447 Operating expenses - 4,882 821 16,299 Charge for impairment of long-lived assets - 11,258 - 11,258 Integration and other charges - 104 - 598 -------- -------- ------- -------- Operating (loss) income - (8,283) 215 (5,864) Interest expense, net - 18 2 71 Other expense, net - 20 273 472 -------- -------- ------- -------- Loss from discontinued operations before - (8,321) (60) (6,407) for income tax benefit Income tax benefit - (8,327) (22) (7,390) -------- -------- ------- -------- Income (loss) from discontinued operations $ - $ 6 $ (38) $ 983 ======== ======== ======= ======== 11 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED The following is a summary of the assets and liabilities of our discontinued operations: SEPTEMBER 30, DECEMBER 31, 2004 2003 ------------- ------------ (IN THOUSANDS) Assets Cash and cash equivalents $ - $ 76 Accounts receivable, net - 549 Other current assets - 128 ------ ------ Total current assets - 753 Property and equipment, net - 1,206 Goodwill, net - 356 Other assets - 41 ------ ------ Total assets of discontinued operations $ - $2,356 ====== ====== Liabilities Current portion of long-term debt $ - $ 125 Accounts payable - 5 Accrued expenses and other current liabilities - 496 ------ ------ Total current liabilities - 626 ------ ------ Total liabilities of discontinued operations $ - $ 626 ====== ====== Based upon our analysis and discussions with our advisors regarding the estimated realizable value, net of selling costs, of the Services Division, we reduced its carrying value and recorded net impairment charges of $11.3 million in the third quarter of fiscal 2003. The 2003 impairment charges consisted of a non-cash goodwill reduction. The benefit for income taxes for discontinued operations was $7.4 million for fiscal 2003. The reductions in the carrying value of the Services Division were management's best estimate based upon the information available at the time, including discussions with our investment bankers. 12 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 provision of zero and $31,000 for the three months ended September 30, 2004 and 2003, respectively, and zero and $255,000 for the nine months ended September 30, 2004 and 2003, respectively, are listed below: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS) (IN THOUSANDS) Net income $23,874 $6,115 $ 54,185 $15,815 Other comprehensive income (loss): Foreign currency translations, net of tax 507 34 (51) 2,265 ------- ------ -------- ------- Comprehensive income: $24,381 $6,149 $ 54,134 $18,080 ======= ====== ======== ======= NOTE 4 - INVENTORIES Inventories are stated at the lower of cost or market using the first-in, first-out (FIFO) method and are summarized as follows: SEPTEMBER 30, 2004 DECEMBER 31, 2003 ------------------ ----------------- (IN THOUSANDS) Raw material $ 85,098 $ 40,397 Work-in-process 36,284 25,422 Finished goods 18,438 14,708 -------- -------- Total inventories $139,820 $ 80,527 ======== ======== NOTE 5 - ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities are summarized as follows: SEPTEMBER 30, 2004 DECEMBER 31, 2003 --------------------- -------------------- (IN THOUSANDS) Accrued expenses and other current liabilities $53,426 $ 40,787 Deferred consideration for acquisitions 4,383 2,780 Customer deposits 15,816 14,651 ------- -------- Total accrued expenses and other current liabilities $73,625 $ 58,218 ======= ======== 13 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 "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 Notes for a variable interest rate equal to six-month LIBOR (2.20% at September 30, 2004), 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 Notes. Accordingly, changes in the fair value of the interest rate swap agreements offset changes in the fair value of the 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 Notes. The fair value of the interest rate swap agreements was approximately $5.7 million and $5.9 million at September 30, 2004 and December 31, 2003, 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. NOTE 7 - 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. We are organized and operated under three business segments: Aerospace & Defense Group, Armor 14 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED Holdings Products, also referred to as our Products Division, and Armor Mobile Security, also referred to as our 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. Our 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 military aviation safety, military personnel safety, and land and marine safety. Under the brand name O'Gara-Hess & Eisenhardt, we are the sole-source provider to the U.S. military of the armor and blast protection systems for M1114 Up-Armored HMMWVs. We are also under contract with the U.S. Army to provide spare parts, logistics and ongoing field support services for the currently installed base of approximately 7,000 Up-Armored HMMWVs. Additionally, we provide blast and ballistic protection kits for the standard HMMWVs, which are installed on existing equipment in the field. Our Aerospace & Defense Group is also subcontracted to develop a ballistic and blast protected armored and sealed truck cab for the High Mobility Artillery Rocket System ("HIMARS"), a program recently transitioned by the U.S. Army and U.S. Marine Corps from developmental to a low rate of initial production, deliveries of which commenced in 2003. We also supply armor sub-systems for other tactical wheeled vehicles. Through Simula, we provide military helicopter seating systems, helicopter cockpit airbag systems, aircraft and land vehicle armor kits, body armor and other protective equipment for military personnel, emergency bailout parachutes and survival ensembles worn by military aircrew. The primary customers for the Aerospace & Defense Group products are the U.S. Army, U.S. Marine Corps, Boeing, and Sikorsky Aircraft. Most of Simula's aviation safety products are provided on a sole source basis. The U.S. armed forces have adopted ceramic body armor as a key element of the protective ensemble worn by our troops in Iraq and Afghanistan. Simula was the developer of this specialized product called SAPI, and is the largest supplier to U.S. forces. Armor Holdings Products. Our Armor Holdings Products division manufactures and sells a broad range of high quality equipment marketed under brand names that are well known and respected 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 lighting products, forensic products, firearms' accessories, weapon maintenance products, foldable ladders, and specialty gloves. Armor Mobile Security. Our Armor Mobile Security division manufactures and installs ballistic and blast protection armoring systems for a variety of commercial vehicles including limousines, sedans, sport utility vehicles, commercial trucks, and cash-in-transit vehicles, to protect against varying degrees of ballistic and blast threats. Our customers in this business include the U.S. and foreign governments, international corporations, non-government organizations and high net worth individuals. In addition, we supply ballistic and blast protected armoring systems to U.S. federal law enforcement and intelligence agencies and foreign heads of state. We have invested resources outside of the United States and plan to continue to do so in the future. The Armor Mobile Security Division has invested 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, 15 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED 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. Revenues, operating income and total assets for each of our continuing operating segments are as follows (net of intercompany eliminations): THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS) (IN THOUSANDS) Revenues: Aerospace & Defense $ 160,238 $ 21,136 $ 371,019 $ 52,839 Products 64,659 49,804 184,242 143,158 Mobile Security 31,906 19,942 86,874 57,018 --------- -------- --------- --------- Total revenues $ 256,803 $ 90,882 $ 642,135 $ 253,015 ========= ======== ========= ========= Operating income (loss): Aerospace & Defense $ 35,146 $ 5,088 $ 86,177 $ 12,431 Products 6,849 9,588 23,793 24,247 Mobile Security 3,699 638 8,619 1,432 Corporate (3,959) (2,802) (20,230) (10,762) --------- -------- --------- --------- Total operating income $ 41,735 $ 12,512 $ 98,359 $ 27,348 ========= ======== ========= ========= SEPTEMBER 30, 2004 DECEMBER 31, 2003 ------------------ ----------------- (IN THOUSANDS) Total assets: Aerospace & Defense $305,782 $209,834 Products 197,417 183,972 Mobile Security 88,912 63,161 Corporate 240,340 126,303 -------- -------- Total assets $832,451 $583,270 ======== ======== 16 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED The following unaudited information with respect to revenues, operating income from continuing operations (geographic operating income from continuing operations before amortization expense and integration and other charges) and total assets from continuing operations to principal geographic areas are as follows: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS) (IN THOUSANDS) Revenues: North America $217,143 $68,924 $537,148 $186,754 South America 4,390 4,456 12,051 10,547 Africa 351 774 2,032 1,578 Europe/Asia 34,919 16,728 90,904 54,136 -------- ------- -------- -------- Total revenues $256,803 $90,882 $642,135 $253,015 ======== ======= ======== ======== Geographic operating income: North America $ 37,524 $10,313 $ 96,906 $ 24,973 South America 810 513 1,428 618 Africa 128 183 334 377 Europe/Asia 5,189 1,943 12,364 6,146 -------- ------- -------- -------- Total geographic operating Income $ 43,651 $12,952 $111,032 $ 32,114 ======== ======= ======== ======== SEPTEMBER 30, 2004 DECEMBER 31, 2003 ------------------ ----------------- (IN THOUSANDS) Total assets: North America $756,590 $523,954 South America 8,793 6,433 Africa - - Europe/Asia 67,068 52,883 -------- -------- Total assets $832,451 $583,270 ======== ======== A reconciliation of consolidated geographic operating income from continuing operations to consolidated operating income from continuing operations follows: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS) (IN THOUSANDS) Consolidated geographic operating income $ 43,651 $ 12,952 $ 111,032 $ 32,114 Amortization (984) (72) (2,937) (201) Integration and other charges (932) (368) (9,736) (4,565) -------- -------- --------- -------- Operating income $ 41,735 $ 12,512 $ 98,359 $ 27,348 ======== ======== ========= ======== 17 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 8 - 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: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Numerator for basic and diluted earnings per share: Income from continuing operations $23,874 $ 6,109 $54,223 $14,832 ------- ------- ------- ------- Denominator for basic earnings per share - weighted average shares outstanding: 32,861 27,811 30,221 28,106 Effect of shares issuable under stock option and stock grant plans, based on the treasury stock method 1,337 438 1,277 332 ------- ------- ------- ------- Denominator for diluted earnings per share- Adjusted weighted average shares outstanding 34,198 28,249 31,498 28,438 ======= ======= ======= ======= Basic earnings per share from continuing operations $ 0.73 $ 0.22 $ 1.79 $ 0.52 ======= ======= ======= ======= Diluted earnings per share from continuing operations $ 0.70 $ 0.22 $ 1.72 $ 0.52 ======= ======= ======= ======= NOTE 9 - NEW ACCOUNTING PRONOUNCEMENT In April 2004, the FASB issued FASB Staff Position No. 129-1, Disclosure Requirements under FASB Statement No. 129, "Disclosure of Information about Capital Structure," relating to contingently convertible securities ("FSP 129-1"). The purpose of FSP 129-1 is to interpret how the disclosure provisions of FASB Statement No. 129 apply to contingently convertible securities and to their potentially dilutive effects on earnings per share. The guidance in FSP 129-1 is effective April 2004 and applies to all existing and newly created securities. This pronouncement has no effect on us. 18 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 10 - STOCKHOLDERS' EQUITY On July 15, 2004, our stockholders approved the increase in number of shares in our 2002 Stock Incentive Plan by 4,000,000, however, we will not issue more than 2,000,000 of these shares without additional stockholder approval. On June 22, 2004, our stockholders approved an amendment to our Certificate of Incorporation that increased the number of shares of our authorized common stock to 75,000,000. The amendment was filed with the Secretary of State of the State of Delaware and became effective on July 22, 2004. On June 15, 2004, we sold 4,000,000 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 intend to use the net proceeds from the offering to fund future acquisitions, to take advantage of business development opportunities, 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, certificates of deposits, and other investment grade securities until needed. 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 and nine month periods ended September 30, 2004 and 2003 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: 19 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------------ ------------------ ------------------ ------------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income as reported: $ 23,874 $ 6,115 $ 54,185 $ 15,815 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (1,368) (671) (3,902) (2,985) Add: Employee compensation expense for modification of stock option awards included in reported net income, net of income taxes - 506 57 506 -------- ------- -------- -------- Pro-forma net income $ 22,506 $ 5,950 $ 50,340 $ 13,336 ======== ======= ======== ======== Earnings per share: Basic - as reported $ 0.73 $ 0.22 $ 1.79 $ 0.56 ======== ======= ======== ======== Basic - pro-forma $ 0.68 $ 0.21 $ 1.67 $ 0.47 ======== ======= ======== ======== Diluted - as reported $ 0.70 $ 0.22 $ 1.72 $ 0.56 ======== ======= ======== ======== Diluted - pro-forma $ 0.66 $ 0.21 $ 1.60 $ 0.47 ======== ======= ======== ======== 20 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 11 - LEGAL PROCEEDINGS On January 16, 1998, our Services Division ceased operations in Angola and subsequently became involved in various disputes with SHRM S.A. ("SHRM"), its minority joint venture partner relating to the Angolan joint venture known as Defense System International Africa ("DSIA"). On March 6, 1998, SIA (a subsidiary of SHRM) filed a complaint against Defense Systems France, SA ("DSF") before the Commercial Court of Nanterre (Tribunal de Commerce de Nanterre) seeking to be paid an amount of $577,286 corresponding to an alleged debt of DSIA to SIA. In October 2002, the Commercial Court of Nanterre stayed the proceedings before it, pending the decisions of the Court of Appeal and the Paris Commercial Court. In February 2003, the Court of Appeal ruled against SHRM and its parent entity, Compass Group, effectively ending all further proceedings on the merits of Compass' claims. Compass has appealed the decision before the French Court of Cassation, which reviews only matters of law. In 1999 and prior to our acquisition of O'Gara-Hess & Eisenhardt Armoring Company (which has been converted to a limited liability company and is now known as O'Gara-Hess & Eisenhardt Armoring Company, L.L.C.) ("OHEAC") in 2001, O'Gara-Hess & Eisenhardt Armoring de Brasil Ltda. ("OHE Brazil") was audited by the Brazilian federal tax authorities and assessed over Ten Million Reals (US$3.5 million based on the exchange rate as of September 30, 2004). OHE Brazil has appealed the tax assessment and the case is pending. To the extent that there may be any liability resulting from the 1999 audit, we believe that we are entitled to indemnification from Kroll, Inc. under the terms of our purchase agreement dated April 20, 2001, despite the denial by Kroll, Inc. of any such liability, because the events occurred prior to our purchase of the O'Gara Companies from Kroll, Inc. However, to the extent that the appeal relating to 1999 activity results in an unfavorable ruling, we could be liable for unpaid taxes incurred subsequent to the acquisition from Kroll. In 1999 and prior to our acquisition of OHEAC in 2001, several of the former employees of Kroll O'Gara Company de Mexico, S.A. de C.V. ("O'Gara Mexico"), a subsidiary of OHEAC, commenced labor claims against O'Gara Mexico seeking damages for unjustified termination. These cases are still pending before the labor board in Mexico City. The terminated employees are seeking back pay and benefits since the date of termination amounting to approximately US $2.9 million, and accruing at approximately US $50,400 per month. To the extent that there may be any liability, we believe that we are entitled to indemnification from Kroll, Inc. under the terms of our purchase agreement dated April 20, 2001, despite the denial by Kroll, Inc. of any such liability, because the events occurred prior to our purchase of the O'Gara Companies from Kroll, Inc. Although we do not have any insurance coverage for this matter, at this time, we do not believe this matter will have a material impact on our financial position, operations or liquidity. In December 2001, O'Gara-Hess & Eisenhardt France S.A. ("OHE France") sold its industrial bodywork business operated under the name Labbe/Division de O'Gara Hess & Eisenhardt France/ Carrosserie Industriells to SNC Labbe. Subsequent to the sale, the Labbe Family Trust ("LFT"), owner of the leasehold interest upon which the Carrosserie business is operated, sued OHE France and SNC Labbe claiming that the transfer of the leasehold was not valid because LFT had not given its consent to the transfer as required under the terms of the lease. Further, LFT seeks to have OHE France, as the sole tenant, maintain and repair the leased building. The approximate cost of renovating the building is 21 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED estimated to be between US $3.8 and US $7.5 million, based on the exchange rate as of September 30, 2004. The case is currently pending, and while we are contesting the allegations vigorously, we are unable to predict the outcome of this matter. Although we do not have any insurance coverage for this matter, at this time, we do not believe this matter will have a material impact on our financial position, operations or liquidity. On October 18, 2002, we were notified by the Internal Revenue Service that our tax return for the tax year ended December 31, 2000 had been selected for examination. Further, on January 30, 2003 we were notified that our tax return for the tax year ended December 31, 2001 had been selected for examination. In April 2004, we reached an agreement with the Internal Revenue Service regarding our tax returns for the years ended December 31, 2000 and 2001 that did not have a material impact on our financial position, operations or liquidity. In October 2002, we were sued in the United States District Court for the District of Wyoming with respect to one of our subsidiaries' Casper, Wyoming tear gas plant. The plaintiffs in the lawsuit asserted various state law tort claims and federal environmental law claims under the Resource Conservation and Recovery Act and the Clean Air Act stemming from the tear gas plant. In February 2004, we agreed with the plaintiffs to settle the lawsuit for an amount of money that is not material to us, and on April 19, 2004, the court dismissed the lawsuit with prejudice. In September 2003, Second Chance Body Armor, Inc. ("Second Chance"), a body armor manufacturer and competitor to Armor Holdings, notified its customers of a potential safety issue with its Ultima(R) and Ultimax(R) models. Second Chance has claimed that Zylon(R) fiber, which is made by Toyobo, a Japanese corporation, and used in the ballistic fabric construction of those two models, degraded more rapidly than originally anticipated. Second Chance has also stated that the Zylon(R) degradation problem affects the entire body armor industry, not just its products. Both private claimants and State Attorneys General have already commenced legal action against Second Chance based upon its Ultima(R) and Ultimax(R) model vests. We use Zylon(R) fiber in a number of concealable body armor models for law enforcement, but our vest design and construction are different from Second Chance. The National Institute of Justice ("NIJ") tests and has certified each of our body armor designs before we begin to produce or sell any particular model. In the Fall of 2003, following the assertions made by Second Chance, several law enforcement associations raised this issue to the U.S. Attorney General ("USAG"), who then asked the U.S. Department of Justice ("DOJ") through the NIJ to investigate these concerns and attempt to clarify the issues. We have and continue to support the Attorney General's directive and investigation. In 2004 we received investigative demands from state agencies in Texas and Connecticut to which we have complied, as well as letters from two private attorneys threatening potential litigation. As a result of the USAG's and DOJ's initiative, the NIJ commenced an inquiry and investigation regarding the protocol for testing used vests, as well as the reliability of Zylon(R) and other ballistic fibers. We have consulted and continue to cooperate fully with the NIJ in this endeavor. To date, the NIJ 22 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED has embarked only in its first phase of testing, which entails vests that have been heavily worn or exposed to adverse conditions, and which utilized the ballistic testing standard applicable to new vests. Although some of the vests tested, including ours, experienced a penetration, the NIJ specifically warned against the misuse and misinterpretation of these results, emphasizing that the data produced so far is preliminary in nature, applies to a very small sample size and therefore it is not possible to draw any definitive conclusions from these results. The NIJ will continue to conduct further testing and analyze these issues in order to determine if any conclusions can be reached as to the performance and reliability of aged vests. We have requested the NIJ to provide us with its testing data, and we intend to evaluate and review the NIJ's results upon our receipt of such data in our continuing effort to assist the NIJ in developing uniform standards for certification of new vests and the testing of used vests. In April 2004, two class action complaints were filed against us in Florida state court by police organizations and individual police officers, alleging, among other things, that our bullet-resistant soft body armor (vests) manufactured and sold under the American Body Armor, Safariland and ProTech(TM) brands, do not have the qualities and performance characteristics as warranted, thereby breaching express warranty, implied warranty of merchantability, implied warranty of fitness for a particular purpose and duty to warn. On August 12, 2004, we announced that we had reached a preliminary settlement with respect to the class action lawsuit filed in Duval County, Florida by the Southern States Police Benevolent Association ("Southern States PBA"), subject to final court approval. After a fairness hearing held on September 30, 2004, the Florida Circuit Court gave final approval to that settlement as to all purchasers of Zylon(R)-containing body armor manufactured under the brand name American Body Armor, and scheduled a final fairness hearing for November 5, 2004, with regard to purchasers of all other Zylon(R)-containing body armor manufactured by our subsidiaries, Safariland(R) and ProTech(TM). Pursuant to the terms of the class action settlement, the warranty on the American Body Armor Xtreme ZX(R) vest (both NIJ threat level II and IIIA) has been reduced from 5 years to 2 1/2 years. In addition, a purchaser of the Xtreme ZX(R) vest has one of the following two options: (1) receive a new American Body Armor Xtreme ZX(R) vest (either threat level II or IIIA) with a 2 1/2 year warranty, an extra carrier and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech(TM); or (2) receive any new vest of his/her choosing from American Body Armor, Safariland, or ProTech, which must be the same threat level as the original vest purchased, and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech. The exchange for the new vest will be at no additional cost to the purchaser. In addition, if the purchase price of the new vest is less than the credit (based upon a court approved formula) for the original vest, the purchaser will receive a cash refund for the difference. We will also make available on our website, and pursuant to a request made from the NIJ or a bona fide law enforcement agency to our customer service department, testing data and protocols, and results relating to the testing of our vests. We will also continue to test all of our Zylon(R)-containing vests, and if such testing demonstrates that the tested vests fail to perform in accordance with their warranties, we will implement an exchange program for those models on a reasonably comparable basis to the American Body Armor Xtreme ZX(R) exchange program outlined above. All of the potential class members in the other Zylon(R)-related class action lawsuit filed against us by the National Association of Police Organizations, Inc. ("NAPO"), in Lee County, Florida, are also 23 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED among the class members in the Southern States PBA case and are therefore covered by the terms of the settlement. Accordingly, we believe that the NAPO lawsuit should be dismissed and we are seeking a voluntary discontinuance from plaintiffs' counsel, and if necessary, will move to dismiss that action. It should be stressed that our vests are certified by the NIJ, have never suffered any penetration in the field and continue to save lives and protect officers from injury. In fact, neither of the two recent lawsuits alleged personal injuries of any kind, but instead speculated that our vests which contained Zylon(R) were defective without the benefit of any scientific studies that supported any claim of defect. Second Chance Body Armor, one of our competitors in the bullet-resistant market, licenses from Simula a certain patented technology which is used in some of the body armor it manufactures, but to our knowledge, no lawsuit has yet been brought against Second Chance based upon this licensed technology. Although Simula may be impacted by the pending suits filed against Second Chance regarding its Zylon(R)-containing vests, the licensed technology is not specifically related to the use of Zylon(R) fiber. Any adverse resolution of these matters, however, could have a material adverse effect on our business, financial condition, results of operations and liquidity. In addition to the above, 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 and liquidity. Reference is made to Part I, Item 3, Legal Proceedings, in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003, for a description of other legal proceedings. 24 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 12 -GUARANTOR AND NONGUARANTOR FINANCIAL STATEMENTS On August 12, 2003 we sold $150 million of Senior Subordinated Notes in private placements pursuant to Rule 144A and Regulation S. The Senior Subordinated Notes are uncollateralized obligations and rank junior in right of payment to our existing and future senior debt. The Senior Subordinated Notes are guaranteed, jointly and severally on a senior subordinated and uncollateralized basis, by certain domestic subsidiaries. The following condensed consolidating financial information presents the condensed consolidating balance sheets as of September 30, 2004 and December 31, 2003, the related condensed consolidating statements of operations for each of the three and nine month periods ended September 30, 2004 and September 30, 2003 and the related condensed consolidating statements of cash flows for the nine month periods ended September 30, 2004 and September 30, 2003 for: a) Armor Holdings, Inc., the parent, b) the guarantor subsidiaries, c) the nonguarantor subsidiaries, and d) 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. 25 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS SEPTEMBER 30, 2004 -------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ---------- ------------ --------------- ------------- ------------- (IN THOUSANDS) ASSETS Current Assets: Cash and cash equivalents $214,731 $ 8,350 $ 11,406 $ - $ 234,487 Accounts receivable, net - 111,599 14,586 - 126,185 Costs and earned gross profit in excess of billings - 157 - - 157 Intercompany receivables 67,215 78,395 38,354 (183,964) - Inventories - 109,789 30,031 - 139,820 Prepaid expenses and other current assets 2,999 20,369 3,114 - 26,482 Current assets of discontinued operations - - - - - ---------- ------------ --------------- ------------- ------------- Total Current Assets 284,945 328,659 97,491 (183,964) 527,131 Property and equipment, net 3,365 38,958 19,683 - 62,006 Goodwill, net - 179,536 2,077 - 181,613 Patents, licenses and trademarks, net - 44,896 174 - 45,070 Other assets 14,241 2,115 275 - 16,631 Long-term assets of discontinued operations - - - - - Investment in subsidiaries 467,713 11,887 - (479,600) - ---------- ------------ --------------- ------------- ------------- Total Assets $770,264 $ 606,051 $119,700 $ (663,564) $ 832,451 ========== ============ =============== ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current portion of long-term debt $ - $ 466 $ 146 $ - $ 612 Short-term debt - - 973 - 973 Accounts payable 787 43,316 6,366 - 50,469 Accrued expenses and other current liabilities 7,028 42,787 23,810 - 73,625 Income taxes payable 7,294 13,561 1,428 - 22,283 Intercompany payables 82,816 52,135 49,013 (183,964) - Current liabilities of discontinued operations - - - - - ---------- ------------ --------------- ------------- ------------- Total Current Liabilities 97,925 152,265 81,736 (183,964) 147,962 Long-term debt, less current portion 153,444 1,521 471 - 155,436 Other long-term liabilities (1,487) 8,988 1,170 - 8,671 Long-term liabilities of discontinued operations - - - - - ---------- ------------ --------------- ------------- ------------- Total Liabilities 249,882 162,774 83,377 (183,964) 312,069 Stockholders' Equity: Preferred stock - 1,450 - (1,450) - Common stock 392 3,792 7,854 (11,646) 392 Additional paid in capital 489,293 265,353 46,094 (311,447) 489,293 Retained earnings (accumulated deficit) 99,127 172,682 (17,625) (155,057) 99,127 Accumulated other comprehensive loss 3,887 - - - 3,887 Treasury stock (72,317) - - - (72,317) ---------- ------------ --------------- ------------- ------------- Total Stockholders' Equity 520,382 443,277 36,323 (479,600) 520,382 ---------- ------------ --------------- ------------- ------------- Total Liabilities and Stockholders' Equity $770,264 $ 606,051 $119,700 $ (663,564) $ 832,451 ========== ============ =============== ============= ============= 26 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS DECEMBER 31, 2003 -------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ---------- ------------ --------------- ------------- ------------- ASSETS (IN THOUSANDS) Current Assets: Cash and cash equivalents $ 90,764 $ 11,084 $ 10,002 $ - $ 111,850 Restricted cash 2,600 - - - 2,600 Accounts receivable, net 1,201 59,470 11,964 - 72,635 Costs and earned gross profit in excess of billings - - - - - Intercompany receivables 60,974 2,600 38,352 (101,926) - Inventories - 61,494 19,033 - 80,527 Prepaid expenses and other current assets 20,241 1,844 2,600 (2,653) 22,032 Current assets of discontinued operations - 753 - - 753 --------- --------- --------- --------- --------- Total Current Assets 175,780 137,245 81,951 (104,579) 290,397 Property and equipment, net 2,122 34,853 20,601 - 57,576 Goodwill, net - 173,640 2,067 - 175,707 Patents, licenses and trademarks, net - 43,991 183 - 44,174 Other assets 14,092 1,924 153 - 16,169 Long-term assets of discontinued operations - 1,603 - - 1,603 Investment in subsidiaries 320,034 10,038 - (330,072) - --------- --------- --------- --------- --------- Total Assets $ 512,028 $ 403,294 $ 104,955 $(434,651) $ 585,626 ========= ========= ========= ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current portion of long-term debt $ - $ 31,960 $ 147 $ - $ 32,107 Short-term debt - - 498 - 498 Accounts payable 1,584 20,941 7,779 - 30,304 Accrued expenses and other current liabilities 12,403 27,113 18,702 - 58,218 Income taxes payable - - - - - Intercompany payables 44,251 47,073 9,933 (101,257) - Current liabilities of discontinued operations - (35,714) 37,009 (669) 626 --------- --------- --------- --------- --------- Total Current Liabilities 58,238 91,373 74,068 (101,926) 121,753 Long-term debt, less current portion 153,452 4,257 591 - 158,300 Other long-term liabilities 4,973 4,008 1,227 - 10,208 Long-term liabilities of discontinued operations - 2,653 - (2,653) - --------- --------- --------- --------- --------- Total Liabilities 216,663 102,291 75,886 (104,579) 290,261 Stockholders' Equity: Preferred stock - 1,450 - (1,450) - Common stock 344 4,143 7,854 (11,997) 344 Additional paid in capital 318,460 191,781 46,095 (237,876) 318,460 Retained earnings (accumulated deficit) 44,942 103,629 (24,880) (78,749) 44,942 Accumulated other comprehensive loss 3,936 - - - 3,936 Treasury stock (72,317) - - - (72,317) --------- --------- --------- --------- --------- Total Stockholders' Equity 295,365 301,003 29,069 (330,072) 295,365 --------- --------- --------- --------- --------- Total Liabilities and Stockholders' Equity $ 512,028 $ 403,294 $ 104,955 $(434,651) $ 585,626 ========= ========= ========= ========= ========= 27 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2004 ----------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ---------- ----------- -------------- ------------- ------------- (IN THOUSANDS) REVENUES: Aerospace & Defense $ - $160,238 $ - $ - $ 160,238 Products - 53,621 11,038 - 64,659 Mobile Security - 6,556 26,103 (753) 31,906 ---------- ----------- -------------- ------------- ------------- Total revenues - 220,415 37,141 (753) 256,803 ---------- ----------- -------------- ------------- ------------- COSTS AND EXPENSES: Cost of revenues - 156,777 29,433 (753) 185,457 Cost of warranty revision - 5,000 - - 5,000 Operating expenses 3,295 16,301 3,099 - 22,695 Amortization - 981 3 - 984 Integration and other charges 658 274 - - 932 Related party management (income) fees - - - - - ---------- ----------- -------------- ------------- ------------- OPERATING (LOSS) INCOME: (3,953) 41,082 4,606 - 41,735 Interest expense, net 1,317 23 60 - 1,400 Other expense, net (4) 96 62 - 154 Equity in (earnings) losses of subsidiaries (28,303) (1,214) - 29,517 - ---------- ----------- -------------- ------------- ------------- INCOME FROM CONTINUING OPERATIONS BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 23,037 42,177 4,484 (29,517) 40,181 (BENEFIT) PROVISION FOR INCOME TAXES (837) 15,593 1,551 - 16,307 ---------- ----------- -------------- ------------- ------------- INCOME FROM CONTINUING OPERATIONS 23,874 26,584 2,933 (29,517) 23,874 DISCONTINUED OPERATIONS: Income from discontinued operations, net of tax - - - - - ---------- ----------- -------------- ------------- ------------- NET INCOME $ 23,874 $ 26,584 $ 2,933 $(29,517) $ 23,874 ========== =========== ============== ============= ============= 28 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2003 ----------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ---------- ------------ -------------- ------------ ------------ (IN THOUSANDS) REVENUES: Products $ - $42,110 $ 8,676 $ - $50,786 Mobile Security - 24,338 15,758 - 40,096 ------- ------- -------- ------- ------- Total revenues - 66,448 24,434 - 90,882 ------- ------- -------- ------- ------- COSTS AND EXPENSES: Cost of revenues - 42,120 19,833 - 61,953 Operating expenses 2,661 10,945 2,371 - 15,977 Amortization - 69 3 - 72 Integration and other non-recurring charges 107 261 -- - 368 Related party management (income) fees (1,859) - 2,339 (480) - ------- ------- -------- ------- ------- OPERATING (LOSS) INCOME (909) 13,053 (112) 480 12,512 Interest expense, net 1,371 59 45 - 1,475 Other expense (income), net - 129 (33) - 96 Equity in (earnings) losses of subsidiaries (7,603) 256 -- 7,347 - ------- ------- -------- ------- ------- INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE PROVISION (BENEFIT) FOR INCOME TAXES 5,323 12,609 (124) (6,867) 10,941 PROVISION (BENEFIT) FOR INCOME TAXES (792) 4,748 876 - 4,832 ------- ------- -------- ------- ------- INCOME (LOSS) FROM CONTINUING OPERATIONS 6,115 7,861 (1,000) (6,867) 6,109 DISCONTINUED OPERATIONS: Net income (loss) from discontinued operations - 995 (509) (480) 6 ------- ------- -------- ------- ------- NET INCOME (LOSS) $ 6,115 $ 8,856 $ (1,509) $(7,347) $ 6,115 ======= ======= ======== ======= ======= 29 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2004 ----------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ---------- ----------- -------------- ------------- ------------- (IN THOUSANDS) REVENUES: Aerospace & Defense $ - $371,019 $ - $ - $ 371,019 Products - 151,237 33,005 - 184,242 Mobile Security - 18,139 70,639 (1,904) 86,874 ---------- ----------- -------------- ------------- ------------- Total revenues - 540,395 103,644 (1,904) 642,135 ---------- ----------- -------------- ------------- ------------- COSTS AND EXPENSES: Cost of revenues - 375,920 82,755 (1,904) 456,771 Cost of warranty revision - 5,000 - - 5,000 Operating expenses 12,043 47,940 9,349 - 69,332 Amortization - 2,928 9 - 2,937 Integration and other charges 8,179 1,557 - - 9,736 Related party management fees (income) 16 (18) 2 - - ---------- ----------- -------------- ------------- ------------- OPERATING (LOSS) INCOME (20,238) 107,068 11,529 - 98,359 Interest expense, net 4,863 199 123 - 5,185 Other expense (income), net 23 (226) 82 - (121) Equity in (earnings) losses of subsidiaries (74,464) (1,844) - 76,308 - ---------- ----------- -------------- ------------- ------------- INCOME FROM CONTINUING OPERATIONS BEFORE (BENEFIT) PROVISION FOR INCOME TAXES 49,340 108,939 11,324 (76,308) 93,295 (BENEFIT) PROVISION FOR INCOME TAXES (4,845) 39,848 4,069 - 39,072 ---------- ----------- -------------- ------------- ------------- INCOME FROM CONTINUING OPERATIONS 54,185 69,091 7,255 (76,308) 54,223 DISCONTINUED OPERATIONS: (Loss) from discontinued operations, net of tax - (38) - - (38) ---------- ----------- -------------- ------------- ------------- NET INCOME $ 54,185 $ 69,053 $ 7,255 $ (76,308) $ 54,185 ========== =========== ============== ============= ============= 30 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS NINE MONTHS ENDED SEPTEMBER 30, 2003 ----------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------------ ------------ ------------ ------------- ------------ (IN THOUSANDS) REVENUES: Products $ - $ 117,863 $26,277 $ - $144,140 Mobile Security - 63,110 45,765 - 108,875 -------- --------- ------- -------- -------- Total revenues - 180,973 72,042 - 253,015 -------- --------- ------- -------- -------- COSTS AND EXPENSES: Cost of revenues - 117,278 59,118 - 176,396 Operating expenses 7,203 29,732 7,570 - 44,505 Amortization - 193 8 - 201 Integration and other non-recurring charges 3,456 1,109 - - 4,565 Related party management (income) fees (1,859) - 2,339 (480) - -------- --------- ------- -------- -------- OPERATING (LOSS) INCOME (8,800) 32,661 3,007 - 27,348 Interest expense, net 1,866 250 175 - 2,291 Other expense, net - 131 50 - 181 Equity in (earnings) losses of subsidiaries (22,688) 419 - 22,269 - Related parting interest expense (income), net 16 (16) - - - -------- --------- ------- -------- -------- INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION (BENEFIT) FOR INCOME TAXES 12,006 31,877 2,782 (21,789) 24,876 PROVISION (BENEFIT) FOR INCOME TAXES (3,809) 12,011 1,842 - 10,044 -------- --------- ------- -------- -------- INCOME FROM CONTINUING OPERATIONS 15,815 19,866 940 (21,789) 14,832 -------- --------- ------- -------- -------- DISCONTINUED OPERATIONS: Net income from discontinued operations - 542 921 (480) 983 -------- --------- ------- -------- -------- NET INCOME $ 15,815 $ 20,408 $ 1,861 $(22,269) $ 15,815 ======== ========= ======= ======== ======== 31 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2004 ------------------------------------------------------------------------------ GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ----------- ----------- -------------- ------------- ------------- (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Income from continuing operations $ 54,185 $69,091 $ 7,255 $ (76,308) $ 54,223 Adjustments to reconcile income from continuing operations to cash provided by (used in) operating activities: Depreciation and amortization 1,176 6,879 1,899 - 9,954 Loss on disposal of fixed assets - 251 175 - 426 Deferred income taxes 883 1,961 (59) - 2,785 Non-cash charge for acceleration of performance-based restricted stock awards 6,294 - - - 6,294 Non-cash impairment charge 1,408 - - - 1,408 Changes in operating assets & liabilities, net of acquisitions: Decrease (increase) in accounts receivable 1,201 (50,910) (2,622) - (52,331) Decrease (increase) in intercompany receivables & payables 30,866 (32,934) 2,068 - - Increase in inventory - (47,850) (10,998) - (58,848) Increase in prepaid expenses & other assets (3,589) (3,848) (286) - (7,723) (Decrease) increase in accounts payable, accrued expenses and other current liabilities (4,040) 37,939 3,695 - 37,594 Increase (decrease) in income taxes payable 28,762 (1,607) 1,080 - 28,235 ----------- ----------- -------------- ------------- ------------- Net cash provided by (used in) operating 117,146 (21,028) 2,207 (76,308) 22,017 activities ----------- ----------- -------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (1,683) (7,890) (1,488) - (11,061) Purchase of patents and trademarks - (117) - - (117) Purchase of equity investment - (5,275) - - (5,275) Proceeds from sale of equity investment - 5,823 - - 5,823 Collection of note receivable 975 - - - 975 Decrease in restricted cash 2,600 - - - 2,600 Sale of business, net of cash disposed - 125 - - 125 Additional consideration for purchased businesses - (2,323) - - (2,323) Investment in subsidiaries (147,680) 71,372 - 76,308 - Purchase of businesses net of cash acquired - (8,373) - - (8,373) ----------- ----------- -------------- ------------- ------------- Net cash (used in) provided by investing activities (145,788) 53,342 (1,488) 76,308 (17,626) ----------- ----------- -------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 11,448 - - - 11,448 Proceeds from the issuance of common stock 142,500 - - - 142,500 Cash paid for common stock offering costs (1,339) - - - (1,339) Repayments of long-term debt - (34,232) (107) - (34,339) Borrowings under lines of credit 17,705 - 802 - 18,507 Repayments under lines of credit (17,705) - (349) - (18,054) ----------- ----------- -------------- ------------- ------------- Net cash provided by (used in) financing 152,609 (34,232) 346 - 118,723 activities ----------- ----------- -------------- ------------- ------------- Effect of exchange rate on cash and cash - (99) 339 - 240 equivalents Net cash used in discontinued operations - (717) - - (717) ----------- ----------- -------------- ------------- ------------- NET INCREASE (DECREASE) IN CASH AND CASH 123,967 (2,734) 1,404 - 122,637 EQUIVALENTS CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 90,764 11,084 10,002 - 111,850 ----------- ----------- -------------- ------------- ------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $214,731 $ 8,350 $11,406 $ - $ 234,487 =========== =========== ============== ============= ============= 32 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED ARMOR HOLDINGS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, 2003 ------------------------------------------------------------------------------- GUARANTOR NONGUARANTOR CONSOLIDATED PARENT SUBSIDIARIES SUBSIDIARIES ELIMINATIONS TOTAL ------------ ------------ ------------ ------------ ------------ (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Income from continuing operations $ 15,815 $ 19,866 $ 940 $(21,789) $ 14,832 Adjustments to reconcile income from continuing operations to cash provided by operating activities Depreciation and amortization 974 2,972 1,434 - 5,380 Loss on disposal of fixed assets - 58 109 - 167 Deferred income taxes (4,379) 6,428 1,627 - 3,676 Non-cash termination charge 2,093 - - - 2,093 Changes in operating assets & liabilities, net of acquisitions: (Increase) decrease in accounts receivable - (3,915) 2,359 - (1,556) Decrease (increase) in intercompany receivables & payables 19,723 (19,090) (153) (480) - Decrease in inventory - 1,206 967 - 2,173 (Increase) decrease in prepaid expenses & other assets (7,347) 4,848 (1,183) - (3,682) Increase in accounts payable, accrued expenses and other current liabilities 5,043 2,620 4,145 - 11,808 (Decrease) increase in income taxes payable (2,227) 148 80 - (1,999) --------- -------- -------- -------- --------- Net cash provided by operating activities 29,695 15,141 10,325 (22,269) 32,892 --------- -------- -------- -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (126) (3,330) (2,189) - (5,645) Purchase of patents and trademarks - (99) - - (99) Additional consideration for purchased businesses - (740) - - (740) Investment in subsidiaries (22,337) 203 (135) 22,269 - Purchase of businesses, net of cash acquired - (5,828) - - (5,828) --------- -------- -------- -------- --------- Net cash used in investing activities (22,463) (9,794) (2,324) 22,269 (12,312) --------- -------- -------- -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 6,588 - - - 6,588 Treasury stock repurchases (22,684) - - - (22,684) Cash paid for financing costs (4,020) - - - (4,020) Proceeds from the issuance of long-term debt 147,504 - - - 147,504 Repayments of long-term debt - (1,399) - - (1,399) Borrowings under lines of credit 30,406 168 1,170 - 31,744 Repayments under lines of credit (30,406) (484) (1,180) - (32,070) --------- -------- -------- -------- --------- Net cash provided by (used in) financing activities 127,388 (1,715) (10) - 125,663 --------- -------- -------- -------- --------- Effect of exchange rate on cash and cash equivalents 2,265 (186) (1,601) - 478 Net cash used in discontinued operations - (4,382) (486) - (4,868) --------- -------- -------- -------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 136,885 (936) 5,904 - 141,853 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 7,152 3,556 2,205 - 12,913 --------- -------- -------- -------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 144,037 $ 2,620 $ 8,109 $ - $ 154,766 ========= ======== ======== ======== ========= 33 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 13 - CREDIT AGREEMENT AMENDMENT On January, 9, 2004, we amended our credit agreement to broaden our ability make additional open-market purchases of publicly-traded securities subject to certain limitations. On March 29, 2004, we amended our credit agreement to allow us to pay dividends subject to certain limitations. NOTE 14 - COMMITMENTS AND CONTINGENCIES On September 24, 2004, we entered into an off-balance sheet leasing arrangement for an aircraft for company use. Upon expiration of this lease on September 24, 2009, a subsidiary of the Company has the option to renew the lease at fair market value subject to approval by the lessor, or, buy the aircraft for approximately $10.0 million, or return the aircraft to the lessor and, under a guarantee, pay any shortfall in sales proceeds from a third party in an amount not to exceed $8.2 million. Annual rental expense related to this agreement is approximately $1.0 million. 34 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 15 - WARRANTY REVISION AND PRODUCT EXCHANGE PROGRAM As a result of our recently announced warranty revision and product exchange program relating to our Zylon(R)-containing vests (see Note 11), we have recorded a pre-tax charge of $5.0 million, which is net of $4.0 million of cost reimbursements from our suppliers and includes all the legal costs associated with the class action lawsuits. This liability has been classified in accrued expenses and other current liabilities on the condensed consolidated balance sheet and will be funded through cash provided by operating activities. A summary of the warranty revision and product replacement accrual follows: WARRANTY REVISION AND PRODUCT REPLACEMENT ACCRUAL ----------------- (IN THOUSANDS) Beginning balance $ 5,000 Payments (1,214) --------- Balance at September 30, 2004 $ 3,786 ========= 35 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED NOTE 16 - ACQUISITIONS On March 5, 2004, Armor Holdings, through a wholly-owned subsidiary, acquired a majority of the assets and assumed certain liabilities of Vector Associates, Inc. (dba ODV, Inc.) , a leading manufacturer and distributor of narcotics identification kits, for $3,289,000 in cash, of which $2,739,000 was paid at closing with the remaining consideration of $550,000 deferred through two hold-back tranches. On August 19, 2004, Armor Holdings, through a wholly-owned subsidiary, acquired 100% of the stock of Kleen-Bore, Inc., a leading manufacturer and distributor of firearms cleaning kits and related accessories, for $7,414,000 in cash, of which $6,214,000 was paid at closing with the remaining consideration of $1,200,000 deferred through two hold-back tranches. On September 28, 2004, we entered into a merger agreement with The Specialty Group, Inc. pursuant to which we agreed to acquire Specialty Group for an aggregate purchase price of $92,000,000 in cash, subject to certain adjustments as set forth in the merger agreement. Specialty Group, which is based in Dunmore, Pennsylvania, is a supplier to military and law enforcement customers in the United States and overseas. Specialty Group manufactures, among other things, Modular Lightweight Load-Carrying Equipment ("MOLLE") systems, Outer Tactical Vests and Warrior Helmets. Specialty Group's core products are made of Kevlar(R) and heavy-duty nylon fabric and webbing and require special cutting and sewing techniques. Specialty Group and its subsidiaries own and operate a total of five manufacturing facilities located in Pennsylvania, Kentucky and Tennessee. Specialty Group is currently the largest supplier of MOLLE systems for the U.S. Army. The MOLLE system consists of a modular rucksack with removable compartments and components, and a fighting load vest with removable pockets for the Rifleman, Pistol, Squad Automatic Weapon Gunner, Medic and Grenadier configurations. Specialty manufactures Outer Tactical Vests which, when used with SAPI plates, provide enhanced armor protection for U.S. armed forces against mines, grenades, mortar shells, artillery fire, and rifle projectiles. Specialty Group is also one of the three largest suppliers of Warrior Helmets for the U.S. Army. Specialty manufactures NATO PASGT helmets, the Advanced Combat Vehicle Crewman helmet and the Warrior Helmet (the U.S. Army's next generation helmet), along with related liners and accessories. Specialty Group currently has a funded backlog of approximately $90.7 million and options on existing contracts of approximately $137.1 million. We will pay the purchase price for Specialty Group in full in cash when the merger closes. However, pursuant to the terms of the merger agreement among the parties, we will place $10,000,000 of the purchase price in escrow at closing in order to secure the indemnification obligations of the shareholders of Specialty Group to us, which amount will be released to the sellers from escrow in 36 ARMOR HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (UNAUDITED) CONTINUED tranches ending three years and sixty days from the closing date; provided, that no claims have been made by us. The merger agreement contains customary indemnification provisions, which terminate at varying times unless the indemnified party has, before the expiration of a right to indemnification, provided notice of a claim for indemnification to the indemnifying party. In connection with the execution of the merger agreement, certain shareholders of Specialty Group owning, in the aggregate, approximately 57% of the issued and outstanding shares of common stock of Specialty Group, have executed voting agreements pursuant to which they have agreed to, among other things, vote in favor of the acquisition and against any alternative transaction. We intend to close the acquisition upon the satisfaction of the conditions to closing, which include Hart-Scott-Rodino Act clearance (the filings for which were made on or about October 14, 2004), approval by the shareholders of Specialty Group and other customary conditions set forth in the merger agreement. 37 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED 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 months and nine months ended September 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/A for the year ended December 31, 2003, as filed with the Securities and Exchange Commission. CRITICAL ACCOUNTING POLICIES (INCLUDING NEW 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 revenue from our Aerospace & Defense Group and Mobile Security Division when the vehicle is shipped, except for larger commercial contracts typically longer than four months in length and the contract for the delivery of HMMWVs to the U.S. Government, which continues through 2005. Revenue from such contracts is recognized on the percentage of completion, units-of-work performed method. HMMWV units sold to the U.S. Government are considered complete when the onsite Department of Defense officer finishes the inspection of the HMMWV and approves it for delivery. Should such 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. Comprehensive income and foreign currency translation. 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. In accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), we record changes in the market value of available-for-sale securities in the accumulated other comprehensive income caption of stockholders' equity in the condensed consolidated balance sheet, until we dispose of the securities. Once these securities are disposed of, either by sale or maturity, the gain or loss is recognized in other income or expense. The cumulative translation adjustment, which represents the effect of translating assets and liabilities of our foreign operations is recorded as an increase of equity of $3,887,000 and $3,936,000 as of September 30, 2004 and December 31, 2003, respectively, and is classified as accumulated other comprehensive income, in accordance with Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS 130"). The current year change in the accumulated amount is included as a component of comprehensive income. 38 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Stock options and Grants. SFAS 123, as amended by 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 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 date for September 30, 2004 and 2003 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: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 SEPTEMBER 30, 2004 SEPTEMBER 30, 2003 ------------- ---- ------------------ ------------------ ------------------ (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income as reported: $ 23,874 $ 6,115 $ 54,185 $ 15,815 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (1,368) (671) (3,902) (2,985) Add: Employee compensation expense for modification of stock option awards included in reported net income, net of income taxes - 506 57 506 -------- ------- -------- -------- Pro-forma net income $ 22,506 $ 5,950 $ 50,340 $ 13,336 ======== ======= ======== ======== Earnings per share: Basic - as reported $ 0.73 $ 0.22 $ 1.79 $ 0.56 ======== ======= ======== ======== Basic - pro-forma $ 0.69 $ 0.21 $ 1.67 $ 0.47 ======== ======= ======== ======== Diluted - as reported $ 0.70 $ 0.22 $ 1.72 $ 0.56 ======== ======= ======== ======== Diluted - pro-forma $ 0.66 $ 0.21 $ 1.60 $ 0.47 ======== ======= ======== ======== 39 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED 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 gain or loss recognized in accordance with SFAS 144, in discontinued operations. The results of discontinued operations, less applicable income taxes (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 is presented separately in the asset and liability sections, respectively, of the statement of financial position. See Note 2 to the Condensed Consolidated Financial Statements included in Part I Item 1. Derivative Instruments and Hedging Activities. We account for derivative instruments in accordance with SFAS 133. 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. We do not hold or issue interest rate swap agreements or other derivative instruments for trading purposes. 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 Condensed Consolidated Balance Sheet as of September 30, 2004 decreased by $0.2 million from December 31, 2003, which reflected a decrease in the fair value of the interest rate swap agreements. The corresponding decrease 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 $124.8 million in goodwill resulting from acquisitions made subsequent to June 30, 2001 was immediately subjected to the non-amortization provisions of SFAS 142. Estimates. The preparation of financial statements in conformity with generally accepted accounting principles 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 condensed consolidated financial statements include periodic testing of the carrying value of long-lived assets for impairment, valuation allowances for receivables, inventories and deferred income tax assets, liabilities for warranty revision and product replacement, liabilities for 40 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED potential litigation claims and settlements, and contract contingencies and obligations. Actual results could differ from those estimates. Impairment. Long-lived assets including certain identifiable intangibles, and the goodwill related to those assets, are reviewed annually for impairment 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. Management reviewed our long-lived assets and has taken an impairment charge of $12.4 million in fiscal 2003 to reduce the carrying value of the Services Division to estimated realizable value. The method used to determine the existence of an impairment would generally be discounted operating cash flows estimated over the remaining useful lives of the related long-lived assets for continuing operations in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." Impairment is measured as the difference between fair value and unamortized cost at the date impairment is determined. On June 30, 2004, our litigation support services subsidiary, New Technologies Armor, Inc. ("NTI"), was the last remaining business in discontinued operations. On July 2, 2004, we sold the security consulting division of NTI. The remaining division in NTI, consisting primarily of training services, is included as part of the Products Division segment. In the second quarter of 2004, we recorded an impairment charge of $1.4 million in integration and other charges in continuing operations to reduce the carrying value of remaining portion of NTI to its estimated fair value. NEW ACCOUNTING PRONOUNCEMENT: In April 2004, the FASB issued FASB Staff Position No. 129-1, Disclosure Requirements under FASB Statement No. 129, "Disclosure of Information about Capital Structure," relating to contingently convertible securities ("FSP 129-1"). The purpose of FSP 129-1 is to interpret how the disclosure provisions of FASB Statement No. 129 apply to contingently convertible securities and to their potentially dilutive effects on earnings per share. The guidance in FSP 129-1 is effective April 2004 and applies to all existing and newly created securities. This pronouncement has no effect on us. 41 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2003. Net income. Net income increased $17.8 million, or 290.4%, to $23.9 million for the three months ended September 30, 2004, compared to $6.1 million for the three months ended September 30, 2003. Net income for the three months ended September 30, 2003, includes income from continuing operations of $6.1 million and income from discontinued operations of $6,000 for the three months ended September 30, 2003. CONTINUING OPERATIONS Total revenues. Total revenues increased $165.9 million, or 182.6%, to $256.8 million in the three months ended September 30, 2004, compared to $90.9 million in the three months ended September 30, 2003. For the three months ended September 30, 2004, total revenue increased 111.9% internally, including year over year changes in acquired businesses. Aerospace & Defense Group revenues. Aerospace & Defense Group revenues increased $139.1 million, or 658.1%, to $160.2 million in the three months ended September 30, 2004, compared to $21.1 million in the three months ended September 30, 2003. For the three months ended September 30, 2004, Aerospace & Defense Group revenue increased 237.4% internally, including year-over-year changes in acquired businesses. Internal growth was primarily due to strong demand for the M1114 Up-Armored HMMWV, supplemental armor for other military vehicles, and small arms protective inserts (SAPI) plates, while acquired growth was a function of the Simula, Inc. acquisition on December 9, 2003. Products Division revenues. Products Division revenues increased $14.9 million, or 29.8%, to $64.7 million in the three months ended September 30, 2004, compared to $49.8 million in the three months ended September 30, 2003. For the three months ended September 30, 2004, Products Division revenue increased 20.3% internally, including year-over-year changes in acquired businesses. Acquired growth was a function of the acquisitions of Kleen Bore, Inc., which was completed during the third quarter of 2004; Vector Associates, Inc. (dba ODV, Inc.), which was completed during the first quarter of 2004; and Hatch Imports, Inc., which was completed during the fourth quarter of 2003. Internal growth was primarily due to strong sales of international body armor, providing protection to troops and private sector employees within Iraq, strong military and international sales within duty gear and the sales of ballistic reinforced enclosures within the energy sector. Mobile Security revenues. Mobile Security Division revenues increased $12.0 million, or 60.0%, to $31.9 million in the three months ended September 30, 2004, compared to $19.9 million in the three months ended September 30, 2003, primarily due to the increasing threat of terrorism. All of Mobile Security Division's 60.0% revenue growth was internal. Cost of revenues. Cost of revenues increased $123.5 million, or 199.4%, to $185.4 million for the three months ended September 30, 2004, compared to $62.0 million for the three months ended September 30, 2003. As a percentage of total revenues, cost of revenues increased to 72.2% of total 42 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED revenues for the three months ended September 30, 2004, from 68.2% for the three months ended September 30, 2003. Gross margins in the Aerospace & Defense Group were 25.7% for the three months ended September 30, 2004, compared to 32.3% for the three months ended September 30, 2003, primarily due to reduced selling prices for the M1114 Up-Armored HMMWV, and significant changes in our product mix as we have diversified beyond up-armored HMMWVs. Gross margins in the Products Division were 35.8% for the three months ended September 30, 2004, compared to 36.1% for the three months ended September 30, 2003. The small decrease was primarily a result of product mix. Gross margins in the Mobile Security Division were 21.7% in the three months ended September 30, 2004, compared to 20.7% for the three months ended September 30, 2003. 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. Cost of warranty revision. As a result of our recently announced warranty revision and product exchange program relating to our Zylon(R)-containing vests, we have recorded a pre-tax charge of $5.0 million, which is net of $4.0 million of cost reimbursements from our suppliers and includes all the legal costs associated with the class action lawsuits. This liability has been classified in accrued expenses and other current liabilities on the condensed consolidated balance sheet and will be funded through cash provided by operating activities. In April 2004, two class action complaints were filed against us in Florida state court by police organizations and individual police officers, alleging, among other things, that our bullet-resistant soft body armor (vests) manufactured and sold under the American Body Armor, Safariland and ProTech(TM) brands, do not have the qualities and performance characteristics as warranted, thereby breaching express warranty, implied warranty of merchantability, implied warranty of fitness for a particular purpose and duty to warn. On August 12, 2004, we announced that we had reached a preliminary settlement with respect to the class action lawsuit filed in Duval County, Florida by the Southern States Police Benevolent Association ("Southern States PBA"), subject to final court approval. After a fairness hearing held on September 30, 2004, the Florida Circuit Court gave final approval to that settlement as to all purchasers of Zylon(R)-containing body armor manufactured under the brand name American Body Armor, and scheduled a final fairness hearing for November 5, 2004, with regard to purchasers of all other Zylon(R)-containing body armor manufactured by our subsidiaries, Safariland(R) and ProTech(TM). Pursuant to the terms of the class action settlement, the warranty on the American Body Armor Xtreme ZX(R) vest (both NIJ threat level II and IIIA) has been reduced from 5 years to 2 1/2 years. In addition, a purchaser of the Xtreme ZX(R) vest has one of the following two options: (1) receive a new American Body Armor Xtreme ZX(R) vest (either threat level II or IIIA) with a 2 1/2 year warranty, an extra carrier and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech(TM); or (2) receive any new vest of his/her choosing from American Body Armor, Safariland, or ProTech, which must be the same threat level as the original vest purchased, and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech. The exchange for the new vest will be at no additional cost to the purchaser. In addition, if the purchase price of the new vest is less than the credit (based upon a court approved formula) for the original vest, the purchaser will receive a cash refund for the difference. We will also make available on our website, and pursuant to a request made from the NIJ or a bona fide law enforcement agency to our customer service department, testing data and protocols, and results relating to the testing of our vests. We will also continue to test all of our Zylon(R)-containing vests, and if such testing demonstrates that the tested vests fail to perform in accordance with their warranties, we will implement an exchange program for those models on a reasonably comparable basis to the American Body Armor Xtreme ZX(R) exchange program outlined above. Operating expenses. Operating expenses increased $6.7 million, or 42.0%, to $22.7 million (8.8% of total revenues) for the three months ended September 30, 2004, compared to $16.0 million (17.6% of total revenues) for the three months ended September 30, 2003. The decrease as a percentage of revenues was largely a function of our ability to achieve scale as revenues have increased, and the acquisition of Simula, which operates with lower operating expenses as a percentage of revenues than the Products Division and the Mobile Security Division. Aerospace & Defense Group operating expenses increased $3.4 million, or 199.6%, to $5.1 million (3.2% of Aerospace & Defense Group revenues) for the three months ended September 30, 2004, compared to $1.7 million (8.1% of Aerospace & Defense Group revenues) for the three months ended September 30, 2003. The increase in operating expenses is due primarily to the acquisition of Simula on December 9, 2003, as well as additional operating expenses associated with increased production of the M1114 Up-Armored HMMWV and supplemental armor for other military vehicles. The decrease in operating expense as a percentage of revenue was due to leveraging of the operating expenses over a much larger revenue base. 43 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Products Division operating expenses increased $2.9 million, or 34.9%, to $11.0 million (17.1% of Products Division revenues) for the three months ended September 30, 2004, compared to $8.2 million (16.4% of Products Division revenues) for the three months ended September 30, 2003. This increase is due primarily to acquisitions, a one-time settlement charge related to the early cancellation of an exclusive distribution agreement, higher sales expenses as related to increased sales volumes, higher insurance cost, and bonus expenses that in the prior year were allocated to corporate operating expenses. Mobile Security Division operating expenses decreased $0.2 million, or 5.0%, to $3.2 million (10.1% of Mobile Security Division revenues) for the three months ended September 30, 2004, compared to $3.4 million (17.0% of Mobile Security Division revenues) for the three months ended September 30, 2003. Corporate operating expenses increased $0.6 million, or 22.4%, to $3.3 million (1.3% of total revenues) for the three months ended September 30, 2004, compared to $2.7 million (3.0% of total revenues) for the three months ended September 30, 2003. This increase in administrative expenses is associated with the overall growth of the Company, increased travel expenses, bonus provision, and Sarbanes-Oxley requirements. Amortization. Amortization expense increased $912,000, or 1,266.7% to $984,000 for the three months ended September 30, 2004, compared to $72,000 for the three months ended September 30, 2003, primarily due to the acquisitions of Simula and Hatch Imports in December 2003. 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 and other charges. Integration and other charges increased $564,000, or 153.3%, to $932,000 for the three months ended September 30, 2004, compared to $368,000 for the three months ended September 30, 2003. Included in integration and other charges in the third quarter of 2004 were charges for the integration of Simula, Inc., Hatch Imports, Inc., Kleen Bore, Inc., and ODV, Inc., which were all acquired subsequent to the third quarter of fiscal year 2003, and an increase of $381,000 in the charge related to non-cash, performanced-based stock grants, which were expensed in the second quarter of 2004. Operating income. Operating income from continuing operations increased $29.2 million, or 233.6%, to $41.7 million for the three months ended September 30, 2004, compared to $12.5 million in the three months ended September 30, 2003, due to the factors discussed above. Interest expense, net. Interest expense, net decreased $0.1 million, or 5.1%, to $1.4 million for the three months ended September 30, 2004, compared to $1.5 million for the three months ended September 30, 2003. This decrease was due primarily to additional interest income generated from our June 2004 equity offering proceeds which partially offset interest expense associated with the $150 million aggregate principal amount of 8.25% senior subordinated notes due 2013 issued in August 2003. On September 2, 2003, we entered into interest rate swap agreements that effectively exchanged the 8.25% fixed rate for a variable rate of six-month LIBOR (2.20% at September 30, 2004), set in arrears, plus a spread of 2.735% to 2.75%. Other expense (income), net. Other expense, net, was $154,000 for the three months ended September 30, 2004, compared to other expense, net, of $96,000 for the three months ended September 30, 2003, primarily due to loss on disposal of fixed assets and losses related to foreign currency fluctuations. 44 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Income from continuing operations before provision for income taxes. Income from continuing operations before provision for income taxes increased $29.2 million, or 267.3%, to $40.2 million for the three months ended September 30, 2004, compared to $10.9 million for the three months ended September 30, 2003, due to the reasons discussed above. Provision for income taxes. Provision for income taxes was $16.3 million for the three months ended September 30, 2004, compared to $4.8 million for the three months ended September 30, 2003. The effective tax rate was 40.6% for the three months ended September 30, 2004, compared to 44.2% for the three months ended September 30, 2003. The decreased tax rate relates primarily to the non-recurring nature of prior year tax charges associated with, among other things, the revaluation of certain intellectual property utilized in our discontinued operations to comply with tax code provisions. The increased tax expense associated with the prior year revaluation was recorded in continuing operations as required by generally accepted accounting principles. Income from continuing operations. Income from continuing operations increased $17.8 million, or 290.8%, to $23.9 million for the three months ended September 30, 2004, compared to $6.1 million for the three months ended September 30, 2003, due to the factors discussed above. DISCONTINUED OPERATIONS On April 17, 2003, we announced that we had completed the sale of our ArmorGroup Integrated Systems business through the sale of 100% of the stock of ArmorGroup Integrated Systems, Inc. and Low Voltage Systems Technologies, Inc. to Aerwav Integration Services, Inc. ("AIS"). AIS is a wholly owned subsidiary of Aerwav Holdings, LLC. As consideration for the integrated systems business, we received a $4.1 million collateralized note due in two years and a warrant for approximately 2.5% of AIS. Through September 30, 2004, we have received $475,000 in prepayments on the note receivable. We have previously recorded a loss of $366,000 on the sale during the second quarter of 2003. On November 26, 2003, we announced that we completed the sale of ArmorGroup, our security service division, for $33.7 million in consideration to a group of private investors led by Granville Baird Capital Partners of London, England and Management. We received $31.4 million in cash at closing and are scheduled to receive another $2.3 million by the end of 2004, of which we have received $500,000 through July 23, 2004. We have previously recorded a loss of $8.8 million on the sale in the fourth quarter of 2003. In accordance with generally accepted accounting principles, foreign currency translation unrealized gains and losses, which are included in equity as accumulated other comprehensive income or loss, are not recognized until the period of disposition of the related assets and liabilities (which was a large component of the loss). On June 30, 2004, our litigation support services subsidiary, New Technologies Armor, Inc. ("NTI"), was the last remaining business in discontinued operations. On July 2, 2004, we sold the security consulting division of NTI. The remaining division in NTI, consisting primarily of training services, is included as part of the Products Division segment. In the second quarter of 2004, we recorded an impairment charge of $1.4 million in integration and other charges in continuing operations to reduce the carrying value of remaining portion of NTI to its estimated fair value. 45 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED We had no discontinued operations in the three months ended September 30, 2004. Please see Footnote 2, Discontinued Operations, in Part I, Item 1 for a summary of the income statement of discontinued operations for three months ended September 30, 2003. 46 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2003. Net income. Net income increased $38.4 million, or 242.6%, to net income of $54.2 million for the nine months ended September 30, 2004, compared to net income of $15.8 million for the nine months ended September 30, 2003. Net income for the nine months ended September 30, 2004, includes income from continuing operations of $54.2 million and loss from discontinued operations of $38,000, compared to income from continuing operations of $14.8 million and income from discontinued operations of $983,000 for the nine months ended September 30, 2003. CONTINUING OPERATIONS Total revenues. Total revenues increased $389.1 million, or 153.8%, to $642.1 million in the nine months ended September 30, 2004, compared to $253.0 million in the nine months ended September 30, 2003. For the nine months ended September 30, 2004, total revenue increased 99.8% internally, including year-over-year changes in acquired businesses. Aerospace & Defense Group revenues. Aerospace & Defense Group revenues increased $318.2 million, or 602.2%, to $371.0 million in the nine months ended September 30, 2004, compared to $52.8 million in the nine months ended September 30, 2003. For the nine months ended September 30, 2004, Aerospace & Defense Group revenue increased 232.4% internally, including year-over-year changes in acquired businesses. Internal growth was primarily due to strong demand for the M1114 Up-Armored HMMWV, supplemental armor for other military vehicles, and small arms protective inserts (SAPI) plates, while acquired growth was a function of the Simula, Inc. acquisition on December 9, 2003. Products Division revenues. Products Division revenues increased $41.1 million, or 28.7%, to $184.2 million in the nine months ended September 30, 2004, compared to $143.2 million in the nine months ended September 30, 2003. For the nine months ended September 30, 2004, Products Division revenue increased 20.7% internally, including year-over-year changes in acquired businesses. Acquired growth was a function of the acquisitions of Kleen Bore, Inc., during the third quarter of 2004; Vector Associates, Inc. (dba ODV, Inc.), which was completed during the first quarter of 2004; and Hatch Imports, Inc., which was completed during the fourth quarter of 2003. Internal growth was due to strong sales of International body armor, and other soft armor and hard armor sectors, providing protection to troops and private sector employees within Iraq, strong military and international sales within duty gear and the sales of ballistic reinforced enclosures within the energy sector. Mobile Security revenues. Mobile Security Division revenues increased $29.9 million, or 52.4%, to $86.9 million in the nine months ended September 30, 2004, compared to $57.0 million in the nine months ended September 30, 2003. All of the revenue growth was generated internally, primarily as a result of the increasing threat of terrorism. Cost of revenues. Cost of revenues increased $280.4 million, or 158.9%, to $456.8 million for the nine months ended September 30, 2004, compared to $176.4 million for the nine months ended September 30, 2003. As a percentage of total revenues, cost of revenues increased to 71.1% of total 47 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED revenues for the nine months ended September 30, 2004, from 69.7% for the nine months ended September 30, 2003. Gross margins in the Aerospace & Defense Group were 28.3% for the nine months ended September 30, 2004, compared to 30.9% for the nine months ended September 30, 2003, primarily due to reduced selling prices for the M1114 Up-Armored HMMWV, and significant changes in our product mix as we have diversified beyond up-armored HMMWV. Gross margins in the Products Division were 33.7% for the nine months ended September 30, 2004, compared to 34.5% for the nine months ended September 30, 2003. The decrease in Products Division gross margins resulted primarily from product mix, certain large lower margin international and governmental orders and additional inventory provisions. Gross margins in the Mobile Security Division were 21.1% in the nine months ended September 30, 2004, compared to 19.2% for the nine months ended September 30, 2003. The increase in the Mobile Security Divisions gross margins resulted primarily from improved fixed-cost absorption benefits associated with increased manufacturing volumes, and a richer sales mix of high-end, higher margin vehicles. Cost of warranty revision. As a result of our recently announced warranty revision and product exchange program relating to our Zylon(R)-containing vests, we have recorded a pre-tax charge of $5.0 million, which is net of $4.0 million of cost reimbursements from our suppliers and includes all the legal costs associated with the class action lawsuits. This liability has been classified in accrued expenses and other current liabilities on the condensed consolidated balance sheet and will be funded through cash provided by operating activities. See also three months ended September 30, 2004 compared to September 30, 2003 results of operations for further details regarding the warranty revision. Operating expenses. Operating expenses increased $24.8 million, or 55.8%, to $69.3 million (10.8% of total revenues) for the nine months ended September 30, 2004, compared to $44.5 million (17.6% of total revenues) for the nine months ended September 30, 2003. The decrease as a percentage of revenues was largely a function of our ability to achieve scale as revenues have increased, and the acquisition of Simula, which operates with lower operating expenses as a percentage of revenues than the Products Division and the Mobile Security Division. Aerospace & Defense Group operating expenses increased $11.2 million, or 291.6%, to $15.1 million (4.1% of Aerospace & Defense Group revenues) for the nine months ended September 30, 2004, compared to $3.9 million (7.3% of Aerospace & Defense Group revenues) for the nine months ended September 30, 2003. The increase in operating expenses is due primarily to the acquisition of Simula on December 9, 2003, as well as additional operating expenses associated with increased production of the M1114 Up-Armored HMMWV and supplemental armor for other military vehicles. The decrease in operating expense as a percentage of revenue was due to leveraging of the operating expenses over a much larger revenue base. Products Division operating expenses increased $8.2 million, or 33.9%, to $32.4 million (17.6% of Products Division revenues) for the nine months ended September 30, 2004, compared to $24.2 million (16.9% of Products Division revenues) for the nine months ended September 30, 2003. This increase is due primarily to acquisitions, a one time settlement charge related to the early cancellation of 48 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED an exclusive distribution agreement, increased research and development spending, higher sales expenses as related to increased sales volumes, higher insurance costs, increased bad debt provisions, and bonus expenses that in the prior year were allocated to corporate operating expenses. Mobile Security Division operating expenses increased $0.6 million, or 6.6%, to $9.7 million (11.2% of Mobile Security Division revenues) for the nine months ended September 30, 2004, compared to $9.1 million (16.0% of Mobile Security Division revenues) for the nine months ended September 30, 2003. This increase is due primarily to increased operating expenses related to significant revenue growth and increased warranty provisions. The decrease in operating expense as a percentage of revenue was due to leveraging the operating expenses over larger revenue base and management's ability to scale its business. Corporate operating expenses increased $4.8 million, or 64.9%, to $12.1 million (1.9% of total revenues) for the nine months ended September 30, 2004, compared to $7.3 million (2.9% of total revenues) for the nine months ended September 30, 2003. This increase in administrative expenses is associated with the overall growth of the Company, increased travel expenses, accounting fees, investor relations, bonus provision, and Sarbanes-Oxley requirements. Amortization. Amortization expense increased $2.7 million, or 1,361.2% to $2.9 million for the nine months ended September 30, 2004, compared to $201,000 for the nine months ended September 30, 2003, primarily due to the acquisitions of Simula and Hatch Imports in December 2003. 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 and other charges. Integration and other charges increased $5.2 million, or 113.3%, to $9.7 million for the nine months ended September 30, 2004, compared to $4.6 million for the nine months ended September 30, 2003, primarily due to a non-cash charge of $6.3 million for the acceleration of performance based, long-term restricted stock awards granted to certain executives in 2002. In the second quarter of 2004, we recorded an impairment charge of $1.4 million in integration and other charges in continuing operations to reduce the carrying value of remaining portion of NTI to its estimated fair value. $2.0 million of the integration and other charges in the nine months ended September 30, 2004, were primarily for the integration of Simula, Inc., Hatch Imports, Inc., Kleen Bore Inc., and ODV, Inc., which were all acquired subsequent to the third quarter of fiscal year 2003. Operating income. Operating income from continuing operations increased $71.1 million, or 259.7%, to $98.4 million for the nine months ended September 30, 2004, compared to $27.3 million in the nine months ended September 30, 2003, due to the factors discussed above. Interest expense, net. Interest expense, net increased $2.9 million, or 126.3%, to $5.2 million for the nine months ended September 30, 2004, compared to $2.3 million for the nine months ended September 30, 2003. This increase was due primarily to interest expense associated with the $150 million aggregate principal amount of 8.25% senior subordinated notes due 2013 issued in August 2003 partially offset by interest income generated from our June 2004 equity offering proceeds. On 49 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED September 2, 2003, we entered into interest rate swap agreements that effectively exchanged the 8.25% fixed rate for a variable rate of six-month LIBOR (2.20% at September 30, 2004), set in arrears, plus a spread of 2.735% to 2.75%. Other (income) expense, net. Other (income), net, was ($121,000) for the nine months ended September 30, 2004, compared to other expense, net, of $181,000 for the nine months ended September 30, 2003. The other (income), net, for the nine months ended September 30, 2004, was primarily a result of the realization of a gain on the sale of a certain equity investment partially offset by losses on disposal of fixed assets and losses related to foreign currency fluctuations. Income from continuing operations before provision for income taxes. Income from continuing operations before provision for income taxes increased $68.4 million, or 275.0%, to $93.3 million for the nine months ended September 30, 2004, compared to $24.9 million for the nine months ended September 30, 2003, due to the reasons discussed above. Provision for income taxes. Provision for income taxes was $39.1 million for the nine months ended September 30, 2004, compared to $10.0 million for the nine months ended September 30, 2003. The effective tax rate was 41.9% for the nine months ended September 30, 2004, compared to 40.4% for the nine months ended September 30, 2003. The increased tax rate relates primarily to an increased mix of profitability generated by our Ohio, Arizona and Massachusetts locations, which operate in higher-taxed jurisdictions, and the non-tax deductible charge due to the accelerated vesting of performance based, long-term restricted stock awards. Income from continuing operations. Income from continuing operations increased $39.4 million, or 265.6%, to $54.2 million for the nine months ended September 30, 2004, compared to $14.8 million for the nine months ended September 30, 2003 due to the factors discussed above. DISCONTINUED OPERATIONS Services revenues. Services Division revenue decreased $74.0 million to $1.7 million for the nine months ended September 30, 2004, compared to $75.7 million for the nine months ended September 30, 2003. Exclusive of ArmorGroup Integrated Systems, which we sold on April 17, 2003, and ArmorGroup, which we sold on November 26, 2003, revenue decreased $422,000, or 19.6%, to $1.7 million for the nine months ended September 30, 2004, compared to $2.2 million for the nine months ended September 30, 2003. This decrease was primarily due to the sale of the security consulting business of NTI on July 2, 2004. Cost of revenues. Cost of revenues decreased $52.8 million to $697,000 for the nine months ended September 30, 2004, compared to $53.4 million for the nine months ended September 30, 2003. Exclusive of ArmorGroup Integrated Systems and ArmorGroup, cost of revenues decreased $103,000, or 12.9%, to $697,000 for the nine months ended September 30, 2004, compared to $800,000 for the nine months ended September 30, 2003. This decrease was primarily due to the sale of the security consulting business of NTI on July 2, 2004. Operating expenses. Operating expenses decreased $15.5 million to $821,000 (47.4% of Services revenues) for the nine months ended September 30, 2004, compared to $16.3 million (21.5% of 50 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED Services revenues) for the nine months ended September 30, 2003. Exclusive of ArmorGroup Integrated Systems and ArmorGroup, operating expenses decreased $418,000, or 33.7%, to $821,000 for the nine months ended September 30, 2004, compared to $1.2 million for the nine months ended September 30, 2003. This decrease was primarily due to the sale of the security consulting business of NTI on July 2, 2004. Charge for impairment of long-lived assets. Charge for impairment of long-lived assets was zero for the nine months ended September 30, 2004, compared to $11.3 million for the nine months ended September 30, 2003. The charge in the prior year related to a reduction in the carrying value of the Services division to its estimated realizable value. Integration and other charges. Integration and other charges decreased to zero for the nine months ended September 30, 2004, compared to $598,000 for the nine months ended September 30, 2003. Excluding ArmorGroup Integrated Systems and ArmorGroup, there were no integration and other charges for the nine months ended September 30, 2003. Operating income (loss). Operating income was $215,000 for the nine months ended September 30, 2004, compared to an operating loss of $(5.9) million for the nine months ended September 30, 2003, due to the factors discussed above. Excluding the ArmorGroup Integrated Systems and ArmorGroup, the balance of the assets held for sale generated operating income of $215,000 for the nine months ended September 30, 2004, compared to operating income of $117,000 for the nine months ended September 30, 2003, due to the reasons discussed above. Interest expense, net. Interest expense, net, decreased $69,000, or 97.2%, to $2,000 for the nine months ended September 30, 2004, compared to $71,000 for the nine months ended September 30, 2003, primarily due to the sale of ArmorGroup Integrated Systems and ArmorGroup. All interest bearing liabilities in discontinued operations have been repaid. Other expense, net. Other expense, net, decreased $199,000, or 42.2%, to $273,000 for the nine months ended September 30, 2004, compared to other expense, net, of $472,000 for the nine months ended September 30, 2003. Excluding the ArmorGroup Integrated Systems and ArmorGroup, the balance of the assets held for sale generated other expense, net, from discontinued operations of $273,000 for the nine months ended September 30, 2004, compared to other income, net, of ($17,000) for the nine months ended September 30, 2003, due to additional accounting fees incurred in connection with the sale of ArmorGroup. Loss from discontinued operations before income tax benefit. Loss from discontinued operations before income tax benefit was $60,000 for the nine months ended September 30, 2004, compared to a loss of $6.4 million for the nine months ended September 30, 2003, due to the reasons discussed above. Excluding the ArmorGroup Integrated Systems and ArmorGroup, the balance of the assets held for sale generated a loss from discontinued operations before provision for income taxes of $60,000 for the nine months ended September 30, 2004, compared to income of $127,000 for the nine months ended September 30, 2003, due to the reasons discussed above. Income tax benefit. Income tax benefit was $22,000 for the nine months ended September 30, 2004 compared to an income tax benefit of $7.4 million for the nine months ended September 30, 2003. The effective tax rate for the three months ended September 30, 2004 was a benefit of 36.7% compared to a benefit of 115.3% for the nine months ended September 30, 2003. Excluding the ArmorGroup Integrated Systems and ArmorGroup, the balance of the assets held for sale benefit was $22,000 for the nine months ended September 30, 2004, compared to a provision of $49,000 for the nine months ended September 30, 2003. 51 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED (Loss) income from discontinued operations. Loss from discontinued operations was $38,000 for the nine months ended September 30, 2004, compared to income from discontinued operations of $983,000 for the nine months ended September 30, 2003, due to the factors discussed above. Excluding the ArmorGroup Integrated Systems and ArmorGroup, the balance of the assets held for sale generated a loss from discontinued operations $38,000 for the nine months ended September 30, 2004, compared to income of $78,000 for the nine months ended September 30, 2003, due to the reasons discussed above. 52 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED LIQUIDITY AND CAPITAL RESOURCES 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, 75,000,000 shares of which are common stock and 5,000,000 shares of which are 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 intend to use the net proceeds from the offering to fund future acquisitions, to take advantage of business development opportunities, 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, certificates of deposits, and other investment grade securities until needed. 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% senior subordinated notes due 2013 (the "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 as of September 30, 2004 decreased by $193,000 from December 31, 2003, which reflected a decrease in the fair value of the interest rate swap agreements. The corresponding decrease 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 Notes. The Notes are guaranteed by almost all of our domestic subsidiaries, on a senior subordinated basis. The 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 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., and ODV, 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 Notes and exchanged the Notes for new Notes that were registered under the Securities Act of 1933, as amended. On August 12, 2003, in concert with our high yield 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 53 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED (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 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. As of September 30, 2004, we were in compliance with all of our negative and affirmative covenants contained in the Credit Facility and the indenture governing the Notes. 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. Through October 15, 2004, 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 3.8 million shares of our common stock. Repurchases may be made in the open market, in privately negotiated transactions or otherwise. At September 30, 2004, we had 33.1 million shares of common stock outstanding. We expect to continue our policy of repurchasing our common stock from time to time, subject to the restrictions contained in our Credit Facility and the indenture governing the Notes. Our Credit Facility permits us to repurchase shares of our common stock with no limitation if our ratio of Consolidated Total 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. At ratios 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. Our indenture governing the Notes also permits us to repurchase shares of our common stock, subject to certain limitations, as long as we satisfy the conditions to such repurchase contained therein. Working capital for continuing operations was $379.2 million and $168.5 million as of September 30, 2004, and December 31, 2003, respectively. The increase in working capital is largely a 54 ARMOR HOLDINGS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED function of increases in cash from our June $150.0 million equity offering and increases in inventory of $59.3 million and accounts receivable of $53.6 million to support the growth in revenues from demand for M1114 Up-Armored HMMWV, supplemental armor for other military vehicles, and SAPI plates. Our fiscal 2004 capital expenditures for continuing operations are expected to be approximately $13.9 million, of which we have spent approximately $11.1 million through the nine months ended September 30, 2004. Such expenditures include leasehold improvements, information technology and communications infrastructure equipment and software, and manufacturing machinery and equipment. We anticipate that the cash generated from operations, cash on hand 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. 55 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. 56 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 and foreign currency exchange rates, 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. We do not utilize financial instruments for trading purposes. 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 2.20% on October 14, 2004. 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 $1,125,000 for a nine 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 September 30, 2004, we recorded the fair value of the interest rate swap agreements of $5.7 million and recorded the corresponding fair 57 ARMOR HOLDINGS, INC. AND SUBSIDIARIES QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - CONTINUED value 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. 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. 58 ARMOR HOLDINGS, INC. AND SUBSIDIARIES ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance that the information that we must disclose in our reports filed under the Securities Exchange Act of 1934, as amended, is communicated and processed in a timely manner. Warren B. Kanders, Chairman and Chief Executive Officer, and Glenn J. Heiar, Chief Financial Officer, participated in this evaluation. Based on such evaluation, Mr. Kanders and Mr. Heiar concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective. During the period covered by this report, there have not been any significant changes in our internal controls over financial reporting or in other factors that could significantly affect those controls. 59 ARMOR HOLDINGS, INC. AND SUBSIDIARIES PART II ITEM 1. LEGAL PROCEEDINGS On January 16, 1998, our Services Division ceased operations in Angola and subsequently became involved in various disputes with SHRM S.A. ("SHRM"), its minority joint venture partner relating to the Angolan joint venture known as Defense System International Africa ("DSIA"). On March 6, 1998, SIA (a subsidiary of SHRM) filed a complaint against Defense Systems France, SA ("DSF") before the Commercial Court of Nanterre (Tribunal de Commerce de Nanterre) seeking to be paid an amount of $577,286 corresponding to an alleged debt of DSIA to SIA. In October 2002, the Commercial Court of Nanterre stayed the proceedings before it, pending the decisions of the Court of Appeal and the Paris Commercial Court. In February 2003, the Court of Appeal ruled against SHRM and its parent entity, Compass Group, effectively ending all further proceedings on the merits of Compass' claims. Compass has appealed the decision before the French Court of Cassation, which reviews only matters of law. In 1999 and prior to our acquisition of O'Gara-Hess & Eisenhardt Armoring Company (which has been converted to a limited liability company and is now known as O'Gara-Hess & Eisenhardt Armoring Company, L.L.C.) ("OHEAC") in 2001, O'Gara-Hess & Eisenhardt Armoring de Brasil Ltda. ("OHE Brazil") was audited by the Brazilian federal tax authorities and assessed over Ten Million Reals (US$3.5 million based on the exchange rate as of September 30, 2004). OHE Brazil has appealed the tax assessment and the case is pending. To the extent that there may be any liability resulting from the 1999 audit, we believe that we are entitled to indemnification from Kroll, Inc. under the terms of our purchase agreement dated April 20, 2001, despite the denial by Kroll, Inc. of any such liability, because the events occurred prior to our purchase of the O'Gara Companies from Kroll, Inc. However, to the extent that the appeal relating to 1999 activity results in an unfavorable ruling, we could be liable for unpaid taxes incurred subsequent to the acquisition from Kroll. In 1999 and prior to our acquisition of OHEAC in 2001, several of the former employees of Kroll O'Gara Company de Mexico, S.A. de C.V. ("O'Gara Mexico"), a subsidiary of OHEAC, commenced labor claims against O'Gara Mexico seeking damages for unjustified termination. These cases are still pending before the labor board in Mexico City. The terminated employees are seeking back pay and benefits since the date of termination amounting to approximately US $2.9 million, and accruing at approximately US $50,400 per month. To the extent that there may be any liability, we believe that we are entitled to indemnification from Kroll, Inc. under the terms of our purchase agreement dated April 20, 2001, despite the denial by Kroll, Inc. of any such liability, because the events occurred prior to our purchase of the O'Gara Companies from Kroll, Inc. Although we do not have any insurance coverage for this matter, at this time, we do not believe this matter will have a material impact on our financial position, operations or liquidity. In December 2001, O'Gara-Hess & Eisenhardt France S.A. ("OHE France") sold its industrial bodywork business operated under the name Labbe/Division de O'Gara Hess & Eisenhardt France/ Carrosserie Industriells to SNC Labbe. Subsequent to the sale, the Labbe Family Trust ("LFT"), owner of the leasehold interest upon which the Carrosserie business is operated, sued OHE France and SNC Labbe claiming that the transfer of the leasehold was not valid because LFT had not given its consent to the transfer as required under the terms of the lease. Further, LFT seeks to have OHE France, as the sole tenant, maintain and repair the leased building. The approximate cost of renovating the building is estimated to be between US $3.8 and US $7.5 million, based on the exchange rate as of September 30, 60 ARMOR HOLDINGS, INC. AND SUBSIDIARIES 2004. The case is currently pending, and while we are contesting the allegations vigorously, we are unable to predict the outcome of this matter. Although we do not have any insurance coverage for this matter, at this time, we do not believe this matter will have a material impact on our financial position, operations or liquidity. On October 18, 2002, we were notified by the Internal Revenue Service that our tax return for the tax year ended December 31, 2000 had been selected for examination. Further, on January 30, 2003 we were notified that our tax return for the tax year ended December 31, 2001 had been selected for examination. In April 2004, we reached an agreement with the Internal Revenue Service regarding our tax returns for the years ended December 31, 2000 and 2001 that did not have a material impact on our financial position, operations or liquidity. In October 2002, we were sued in the United States District Court for the District of Wyoming with respect to one of our subsidiaries' Casper, Wyoming tear gas plant. The plaintiffs in the lawsuit asserted various state law tort claims and federal environmental law claims under the Resource Conservation and Recovery Act and the Clean Air Act stemming from the tear gas plant. In February 2004, we agreed with the plaintiffs to settle the lawsuit for an amount of money that is not material to us, and on April 19, 2004, the court dismissed the lawsuit with prejudice. In September 2003, Second Chance Body Armor, Inc. ("Second Chance"), a body armor manufacturer and competitor to Armor Holdings, notified its customers of a potential safety issue with its Ultima(R) and Ultimax(R) models. Second Chance has claimed that Zylon(R) fiber, which is made by Toyobo, a Japanese corporation, and used in the ballistic fabric construction of those two models, degraded more rapidly than originally anticipated. Second Chance has also stated that the Zylon(R) degradation problem affects the entire body armor industry, not just its products. Both private claimants and State Attorneys General have already commenced legal action against Second Chance based upon its Ultima(R) and Ultimax(R) model vests. We use Zylon(R) fiber in a number of concealable body armor models for law enforcement, but our vest design and construction are different from Second Chance. The National Institute of Justice ("NIJ") tests and has certified each of our body armor designs before we begin to produce or sell any particular model. In the Fall of 2003, following the assertions made by Second Chance, several law enforcement associations raised this issue to the U.S. Attorney General ("USAG"), who then asked the U.S. Department of Justice ("DOJ") through the NIJ to investigate these concerns and attempt to clarify the issues. We have and continue to support the Attorney General's directive and investigation. In 2004 we received investigative demands from state agencies in Texas and Connecticut to which we have complied, as well as letters from two private attorneys threatening potential litigation. As a result of the USAG's and DOJ's initiative, the NIJ commenced an inquiry and investigation regarding the protocol for testing used vests, as well as the reliability of Zylon(R) and other ballistic fibers. We have consulted and continue to cooperate fully with the NIJ in this endeavor. To date, the NIJ has embarked only in its first phase of testing, which entails vests that have been heavily worn or exposed to adverse conditions, and which utilized the ballistic testing standard applicable to new vests. Although some of the vests tested, including ours, experienced a penetration, the NIJ specifically warned 61 ARMOR HOLDINGS, INC. AND SUBSIDIARIES against the misuse and misinterpretation of these results, emphasizing that the data produced so far is preliminary in nature, applies to a very small sample size and therefore it is not possible to draw any definitive conclusions from these results. The NIJ will continue to conduct further testing and analyze these issues in order to determine if any conclusions can be reached as to the performance and reliability of aged vests. We have requested the NIJ to provide us with its testing data, and we intend to evaluate and review the NIJ's results upon our receipt of such data in our continuing effort to assist the NIJ in developing uniform standards for certification of new vests and the testing of used vests. In April 2004, two class action complaints were filed against us in Florida state court by police organizations and individual police officers, alleging, among other things, that our bullet-resistant soft body armor (vests) manufactured and sold under the American Body Armor, Safariland and ProTech(TM) brands, do not have the qualities and performance characteristics as warranted, thereby breaching express warranty, implied warranty of merchantability, implied warranty of fitness for a particular purpose and duty to warn. On August 12, 2004, we announced that we had reached a preliminary settlement with respect to the class action lawsuit filed in Duval County, Florida by the Southern States Police Benevolent Association ("Southern States PBA"), subject to final court approval. After a fairness hearing held on September 30, 2004, the Florida Circuit Court gave final approval to that settlement as to all purchasers of Zylon(R)-containing body armor manufactured under the brand name American Body Armor, and scheduled a final fairness hearing for November 5, 2004, with regard to purchasers of all other Zylon(R)-containing body armor manufactured by our subsidiaries, Safariland(R) and ProTech(TM). Pursuant to the terms of the class action settlement, the warranty on the American Body Armor Xtreme ZX(R) vest (both NIJ threat level II and IIIA) has been reduced from 5 years to 2 1/2 years. In addition, a purchaser of the Xtreme ZX(R) vest has one of the following two options: (1) receive a new American Body Armor Xtreme ZX(R) vest (either threat level II or IIIA) with a 2 1/2 year warranty, an extra carrier and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech(TM); or (2) receive any new vest of his/her choosing from American Body Armor, Safariland, or ProTech, which must be the same threat level as the original vest purchased, and a transferable rebate coupon for $100 applicable toward the next purchase of any soft body armor from American Body Armor, Safariland, or ProTech. The exchange for the new vest will be at no additional cost to the purchaser. In addition, if the purchase price of the new vest is less than the credit (based upon a court approved formula) for the original vest, the purchaser will receive a cash refund for the difference. We will also make available on our website, and pursuant to a request made from the NIJ or a bona fide law enforcement agency to our customer service department, testing data and protocols, and results relating to the testing of our vests. We will also continue to test all of our Zylon(R)-containing vests, and if such testing demonstrates that the tested vests fail to perform in accordance with their warranties, we will implement an exchange program for those models on a reasonably comparable basis to the American Body Armor Xtreme ZX(R) exchange program outlined above. All of the potential class members in the other Zylon(R)-related class action lawsuit filed against us by the National Association of Police Organizations, Inc. ("NAPO"), in Lee County, Florida, are also among the class members in the Southern States PBA case and are therefore covered by the terms of the settlement. Accordingly, we believe that the NAPO lawsuit should be dismissed and we are seeking a voluntary discontinuance from plaintiffs' counsel, and if necessary, will move to dismiss that action. It should be stressed that our vests are certified by the NIJ, have never suffered any penetration in 62 ARMOR HOLDINGS, INC. AND SUBSIDIARIES the field and continue to save lives and protect officers from injury. In fact, neither of the two recent lawsuits alleged personal injuries of any kind, but instead speculated that our vests which contained Zylon(R) were defective without the benefit of any scientific studies that supported any claim of defect. Second Chance Body Armor, one of our competitors in the bullet-resistant market, licenses from Simula a certain patented technology which is used in some of the body armor it manufactures, but to our knowledge, no lawsuit has yet been brought against Second Chance based upon this licensed technology. Although Simula may be impacted by the pending suits filed against Second Chance regarding its Zylon(R)-containing vests, the licensed technology is not specifically related to the use of Zylon(R) fiber. Any adverse resolution of these matters, however, could have a material adverse effect on our business, financial condition, results of operations and liquidity. In addition to the above, 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 and liquidity. Reference is made to Part I, Item 3, Legal Proceedings, in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003, for a description of other legal proceedings. 63 ARMOR HOLDINGS, INC. AND SUBSIDIARIES ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Reference is hereby made to the disclosure contained in Part II, Item 4, Submission of Matters to a Vote of Security Holders, of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 with respect to the matters submitted to a vote of our security holders during the quarter ended September 30, 2004, which disclosure is incorporated herein by reference. ITEM 6. EXHIBITS (a) Exhibits The following exhibits are filed as part of this quarterly report on Form 10-Q. 2.1 Agreement and Plan of Merger, dated as of September 28, 2004, by and among Armor Holdings, Inc., Specialty Acquisition Corp., The Specialty Group, Inc., and Joseph F. Murray, Jr. and John P. Sweeney, as the Shareholders' Agent. (filed as Exhibit 2.1 to our Current Report on Form 8-K filed on October 4, 2004 and incorporated herein by reference). 4.1 Fifth Supplemental Indenture, dated as of August 16, 2004, among Armor Holdings, Inc., the subsidiary guarantors parties thereto, Kleen Bore, Inc., and Wachovia Bank, National Association, a national banking association, as trustee. 4.2 Sixth Supplemental Indenture, dated as of September 24, 2004, among Armor Holdings, Inc., the subsidiary guarantors parties thereto, Armor Holdings Aircraft, LLC, and Wachovia Bank, National Association, a national banking association, as trustee. 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). 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). 64 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: October 20, 2004 /s/ Glenn J. Heiar ------------------------------------- Glenn J. Heiar Chief Financial Officer Dated: October 20, 2004 65