[August 12, 2011] AMERICAN PACIFIC CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in Thousands) Tweet (Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the safe harbor created by those sections. These forward-looking statements include, but are not limited to: our expectations regarding changes in cash flow and working capital and related variances in the future, our potential incurrence of additional debt, including through refinancing, or legal or other costs in the future, our belief that our cash flows and debt will be adequate for the foreseeable future to satisfy the needs of our operations and that existing circumstances will not materially affect our ability to meet future liquidity requirements, our expectations regarding anticipated contributions and obligations with respect to our defined benefit pension plans and supplemental executive retirement plan, our estimates and expectations regarding anticipated costs, timing and funding in the short and long term for environmental remediation in connection with our former Henderson, Nevada site, our statement regarding one of the significant factors that will affect comparisons of our consolidated gross margins in the future, our statement regarding the timing of improvements on production throughput and efficiencies on a significant core product of our Fine Chemicals segment, our expectations with respect to revenues from development products, our expectations with respect to the substantial fulfillment of existing backlog within the next twelve months, our statement regarding anticipated capital activities for calendar 2011, our belief regarding pharmaceutical controlled substances as an area of expansion for us, statements regarding the potential impact of future changes in critical accounting policies and accounting standards and judgments, estimates and assumptions relating thereto, and all plans, objectives, expectations and intentions contained in this report that are not historical facts. We usually use words such as "may," "can," "will," "could," "would," "should," "continue," "expect," "anticipate," "believe," "estimate," or "future," or the negative of these terms or similar expressions to identify forward-looking statements. Discussions containing such forward-looking statements may be found throughout this document. These forward-looking statements involve certain risks and uncertainties, such as, for example, with respect to the actual placement, timing and delivery of orders for new and/or existing products, that could cause actual results to differ materially from future results or outcomes expressed or implied in such forward-looking statements. Please see the section titled "Risk Factors" in Part II, Item 1A of this Quarterly Report on Form 10-Q for further discussion of factors that could affect future results. All forward-looking statements in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement, unless otherwise required by law. Any business risks discussed later in this Item 2, among other things, should be considered in evaluating our prospects and future financial performance. The terms "Company," "we," "us," and "our" are used herein to refer to American Pacific Corporation and, where the context requires, one or more of the direct and indirect subsidiaries or divisions of American Pacific Corporation. The following discussion and analysis is intended to provide a narrative discussion of our financial results and an evaluation of our financial condition and results of operations with respect to the third fiscal quarter and nine-month period of the year ending September 30, 2011 ("Fiscal 2011") as compared to the third fiscal quarter and nine-month period of the year ended September 30, 2010 ("Fiscal 2010"). The discussion should be read in conjunction with our Annual Report on Form 10-K for Fiscal 2010 filed with the Securities and Exchange Commission (the "SEC") and the condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q. A summary of our significant accounting policies is included in Note 1 to our consolidated financial statements in our Annual Report on Form 10-K for Fiscal 2010. - 23 - -------------------------------------------------------------------------------- Table of Contents OUR COMPANY We are a leading custom manufacturer of fine chemicals, specialty chemicals and propulsion products within our focused markets. Our fine chemicals products represent the active pharmaceutical ingredient ("API") or registered intermediate in certain anti-viral, oncology and central nervous system drugs. Our specialty chemicals and aerospace equipment products are utilized in national defense programs and provide access to, and movement in, space, via solid propellant and propulsion thrusters. Our technical and manufacturing expertise and customer service focus has gained us a reputation for quality, reliability, technical performance and innovation. Given the mission critical nature of our products, we maintain long-standing strategic customer relationships. We work collaboratively with our customers to develop customized solutions that meet rigorous federal and international regulatory standards. We generally sell our products through long-term contracts under which we are the sole-source or limited-source supplier. We are the only North American producer of ammonium perchlorate, or "AP," which is the predominant oxidizing agent for solid propellant rockets, booster motors and missiles used in space exploration, commercial satellite transportation and national defense programs. In order to diversify our business and leverage our strong technical and manufacturing capabilities, we have made three strategic acquisitions in recent years. Each of these acquisitions provided long-term customer relationships with sole-source and limited-source contracts and leadership positions in growing markets. On October 1, 2004, we acquired the former Atlantic Research Corporation's liquid in-space propulsion business from Aerojet-General Corporation, which became our Aerospace Equipment segment. Effective October 1, 2008, we further expanded our Aerospace Equipment segment with the acquisition of Marotta Holdings Limited (subsequently renamed Ampac ISP Holdings Limited) and its wholly-owned subsidiaries (collectively "AMPAC ISP Holdings"). Our U.S.-based Aerospace Equipment operation is one of two major North American manufacturers of monopropellant and bipropellant liquid propulsion systems and thrusters for satellites, launch vehicles, and interceptors. AMPAC ISP Holdings designs, develops and manufactures high performance valves, pressure regulators, cold-gas propulsion systems, and precision structures for space applications, especially in the European space market. On November 30, 2005, we acquired GenCorp Inc.'s fine chemicals business, through our wholly-owned subsidiary Ampac Fine Chemicals LLC, which is now our Fine Chemicals segment. Our Fine Chemicals segment is a leading custom manufacturer of certain APIs and registered intermediates for pharmaceutical and biotechnology companies. OUR BUSINESS SEGMENTS Our operations comprise four reportable business segments: Fine Chemicals, Specialty Chemicals, Aerospace Equipment and Other Businesses. The following table reflects the revenue contribution percentage from our business segments and each of their major product lines: Three Months Ended Nine Months Ended June 30, June 30, 2011 2010 2011 2010 Fine Chemicals 59 % 54 % 47 % 48 % Specialty Chemicals: Perchlorates 17 % 18 % 20 % 23 % Sodium Azide 2 % 1 % 2 % 1 % Halotron 2 % 3 % 2 % 3 % Total Specialty Chemicals 21 % 22 % 24 % 27 % Aerospace Equipment 20 % 23 % 28 % 21 % Other Businesses: Real Estate 0 %* 0 %* 0 %* 0 %* Water Treatment Equipment 0 %* 1 % 1 % 4 % Total Other Businesses 0 % 1 % 1 % 4 % Total Revenues 100 % 100 % 100 % 100 % * less than 1% - 24 - -------------------------------------------------------------------------------- Table of Contents FINE CHEMICALS. Our Fine Chemicals segment, operated through our wholly-owned subsidiaries Ampac Fine Chemicals LLC and AMPAC Fine Chemicals Texas, LLC (collectively "AFC"), is a custom manufacturer of APIs and registered intermediates for commercial customers in the pharmaceutical industry. The products we manufacture are used by our customers in drugs with indications in three primary areas: anti-viral, oncology, and central nervous system. We generate nearly all of our Fine Chemicals segment sales from manufacturing chemical compounds that are proprietary to our customers. We operate in compliance with the U.S. Food and Drug Administration's (the "FDA") current Good Manufacturing Practices ("cGMP") and the requirements of certain other regulatory agencies such as the European Union's European Medicines Agency and Japan's Pharmaceuticals and Medical Devices Agency. Our Fine Chemicals segment's strategy is to focus on high growth markets where our technological position, combined with our chemical process development and engineering expertise, leads to strong customer allegiances and limited competition. In addition, our unique location in Rancho Cordova, California provides us with advantages for the production of chemicals for pharmaceutical controlled substances. We believe that this will be an area of expansion for us. We have distinctive competencies and specialized engineering capabilities in performing chiral separations, manufacturing chemical compounds that require high containment and performing energetic chemistries at commercial scale. We have invested significant resources in our facilities and technology base. We believe we are the U.S. leader in performing chiral separations using commercial-scale simulated moving bed, or "SMB," technology and own and operate two large-scale SMB machines, both of which are among the largest in the world operating under cGMP. We believe our distinctive competency in manufacturing chemical compounds that require specialized high containment facilities and handling expertise provide us a significant competitive advantage in competing for various opportunities associated with high potency, highly toxic and cytotoxic products. Many oncology drugs are made with APIs that are high potency or cytotoxic. AFC is one of the few companies in the world that can manufacture such compounds at a multi-ton annual rate. Moreover, our significant experience and specially engineered facilities make us one of the few companies in the world with the capability to use energetic chemistry on a commercial-scale under cGMP. We use this capability in development and production of products such as those used in anti-viral drugs, including HIV-related and influenza-combating drugs. We have established long-term, sole-source and limited-source contracts, which help provide us with earnings stability and visibility. In addition, the inherent nature of custom pharmaceutical fine chemicals manufacturing encourages stable, long-term customer relationships. We work collaboratively with our customers to develop reliable, safe and cost-effective, custom solutions. Once a custom manufacturer has been qualified as a supplier on a cGMP product, there are several potential barriers that discourage transferring the manufacturing of the product to an alternative supplier, including the following: • Alternative Supply May Not Be Readily Available. We are currently the sole-source supplier on several of our fine chemicals products. • Regulatory Approval. Applications to and approvals from the FDA and other regulatory authorities generally require the chemical contractor to be named. Switching contractors may require additional regulatory approvals and could take as long as two years to complete. • Significant Financial Costs. Switching contractors and amending various filings can result in significant costs associated with technology transfer, process validation and re-filing with the FDA and other regulatory authorities. SPECIALTY CHEMICALS. Our Specialty Chemicals segment is principally engaged in the production of AP, which is the predominant oxidizing agent for solid propellant rockets, booster motors and missiles used in space exploration, commercial satellite transportation and national defense programs. In addition, we produce and sell sodium azide, a chemical primarily used in pharmaceutical manufacturing, and Halotron®, a series of clean fire extinguishing agents used in fire extinguishing products ranging from portable fire extinguishers to total flooding systems. - 25 - -------------------------------------------------------------------------------- Table of Contents We have supplied AP for use in space and defense programs for over 50 years and we have been the only AP supplier in North America since 1998, when we acquired the AP business of our principal competitor, Kerr-McGee Chemical Corporation. A significant number of existing and planned space launch vehicles use solid propellant and thus depend, in part, upon our AP. Many of the rockets and missiles used in national defense programs are also powered by solid propellant. Alliant Techsystems Inc. or "ATK" is a significant AP customer. We sell Grade I AP to ATK under a long-term contract that requires us to maintain a ready and qualified capacity for Grade I AP and that requires ATK to purchase its Grade I AP requirements from us, subject to certain terms and conditions. The contract, which expires in 2013, provides fixed pricing in the form of a price volume matrix for annual Grade I AP volumes ranging from 3 million to 20 million pounds. Pricing varies inversely to volume and includes annual escalations. AEROSPACE EQUIPMENT. Our Aerospace Equipment segment reflects the operating results of our wholly-owned subsidiary Ampac-ISP Corp. and its wholly-owned subsidiaries. Our U.S.-based Aerospace Equipment operation is one of two major North American manufacturers of monopropellant and bipropellant liquid propulsion systems and thrusters for satellites, launch vehicles, and interceptors. Our products are utilized on various satellite and launch vehicle programs such as Space Systems/Loral's 1300 series geostationary satellites. Our European-based Aerospace Equipment operation designs, develops and manufactures liquid propulsion thrusters, high performance valves, pressure regulators, cold-gas propulsion systems, and precision structures for space applications, especially in the European space market. These products are used on various satellites and spacecraft, as well as on the Ariane 5 launch vehicle. OTHER BUSINESSES. Our Other Businesses segment contains our water treatment equipment division and real estate activities. Our water treatment equipment business markets, designs, and manufactures electrochemical On Site Hypochlorite Generation, or OSHG systems. These systems are used in the disinfection of drinking water, control of noxious odors, and the treatment of seawater to prevent the growth of marine organisms in cooling systems. We supply our equipment to municipal, industrial and offshore customers. Our real estate activities are not material. RESULTS OF OPERATIONS REVENUES June 30, Increase Percentage 2011 2010 (Decrease) Change Three Months Ended: Fine Chemicals $ 30,838 $ 19,951 $ 10,887 55 % Specialty Chemicals 10,931 8,168 2,763 34 % Aerospace Equipment 10,105 8,647 1,458 17 % Other Businesses 43 481 (438 ) (91 %) Total Revenues $ 51,917 $ 37,247 $ 14,670 39 % Nine Months Ended: Fine Chemicals $ 60,792 $ 63,128 $ (2,336 ) (4 %) Specialty Chemicals 30,800 35,057 (4,257 ) (12 %) Aerospace Equipment 35,929 27,140 8,789 32 % Other Businesses 1,434 5,381 (3,947 ) (73 %) Total Revenues $ 128,955 $ 130,706 $ (1,751 ) (1 %) Fine Chemicals. Fine Chemicals segment revenues increased substantially in the Fiscal 2011 third quarter as compared to the Fiscal 2010 third quarter reflecting increases in revenues from core products in each of our key therapeutic areas. In particular, revenues from anti-viral products increased 139% as we began substantial deliveries under a recently renewed three-year supply agreement for a key core product. - 26 --------------------------------------------------------------------------------- Table of Contents For the Fiscal 2011 nine-month period as compared to the Fiscal 2010 nine-month period, Fine Chemicals revenues declined slightly. The significant lag in anti-viral product revenues during the first six months of Fiscal 2011 is the primary contributor to the decline. The 58% decline in anti-viral product revenues for the Fiscal 2011 nine-month period was substantially offset by proportionate increases in revenues from our oncology and development products. The increase in oncology revenues is largely due to timing shifts from Fiscal 2010 into the Fiscal 2011 nine-month period, driven by customer inventory levels and production line availability. Revenues from development products continue to become an increasing component of Fine Chemicals segment revenues. Growth in this area has resulted from an intensified focus on core technologies and diversification of products and customers. Specialty Chemicals. Specialty Chemicals segment revenues include the operating results from our perchlorate, sodium azide and Halotron product lines, with our perchlorate product lines comprising 82% and 87% of Specialty Chemicals segment revenues in the Fiscal 2011 and Fiscal 2010 nine-month periods, respectively. The variance in Specialty Chemicals segment revenues reflects the following factors: • A 60% increase in perchlorate volume and a 15% decrease in the related average price per pound for the Fiscal 2011 third quarter compared to the prior fiscal year third quarter. • A 12% decrease in perchlorate volume and a 6% decrease in the related average price per pound for the Fiscal 2011 nine-month period compared to the prior fiscal year nine-month period. • Sodium azide revenues increased by $489 for the Fiscal 2011 third quarter and $697 for the Fiscal 2011 nine-month period. • Halotron revenues decreased $101 for the Fiscal 2011 third quarter and increased $118 for the Fiscal 2011 nine-month period. The decrease in total perchlorate volume for the Fiscal 2011 nine-month period is primarily due to limited demand for Grade I AP for usage on space programs. Tactical and strategic missile program demand continues to be stable and accounts for the largest component of Grade I AP volume in the Fiscal 2011 periods. The Ares program was the largest component of volume in the Fiscal 2010 periods. The decline in Grade I AP demand is offset by an increase in volume for our other perchlorate products, which was approximately 44% higher in the Fiscal 2011 nine-month period than in the comparable Fiscal 2010 period. The increase in perchlorate volume for the Fiscal 2011 third quarter was due to a 131% increase in sales volume of our non-Grade I AP products. The decrease in the average price per pound of perchlorates between the Fiscal 2011 and Fiscal 2010 periods reflects two offsetting factors. • Revenues from our other lower-value perchlorate products, such as sodium perchlorate and potassium perchlorate, accounted for a substantially greater percentage of all perchlorate product volume in the Fiscal 2011 periods. This has the effect of reducing the average unit price for perchlorates. • The decrease was partially offset by an increase in the average price per pound of Grade I AP which increased approximately proportionate and inverse to the decrease in Grade I AP volume consistent with the contractual Grade I AP price-volume matrix, under which price and volume move inversely, and comparable catalog pricing. Aerospace Equipment. Revenue growth of 17% and 32% for the Aerospace Equipment segment during the Fiscal 2011 third quarter and nine-month period, respectively, as compared to the prior fiscal year periods, was generated primarily by increases in revenues from space propulsion systems contracts from the segment's U.S. operations, which continue to be successful in penetrating this market. Increases in revenues from in-space propulsion engines also contributed to the revenue growth in the Fiscal 2011 periods. - 27 --------------------------------------------------------------------------------- Table of Contents COST OF REVENUES AND GROSS MARGIN June 30, Increase Percentage 2011 2010 (Decrease) Change Three Months Ended: Revenues $ 51,917 $ 37,247 $ 14,670 39 % Cost of Revenues 40,376 28,920 11,456 40 % Gross Margin 11,541 8,327 3,214 39 % Gross Margin Percentage 22 % 22 % Nine Months Ended: Revenues $ 128,955 $ 130,706 $ (1,751 ) (1 %) Cost of Revenues 100,631 93,054 7,577 8 % Gross Margin 28,324 37,652 (9,328 ) (25 %) Gross Margin Percentage 22 % 29 % In addition to the factors detailed below, one of the most significant factors that affects, and should continue to affect, the comparison of our consolidated gross margins from period to period is the change in revenue mix between our segments. Fine Chemicals. The Fine Chemicals segment gross margin as a percentage of segment revenues declined twelve points for the Fiscal 2011 nine-month period as compared to the Fiscal 2010 nine-month period. Several factors have contributed to the decline in the gross margin percentage, including: • Customer pricing on a significant core product was based on targeted production throughput and efficiencies. These targets have not yet been achieved and as a consequence this product is incurring a loss and, because of its size, negatively affecting overall segment performance. We anticipate that it will take at least another quarter for this situation to improve. • During the first six months of Fiscal 2011, low capacity utilization resulted in reduced absorption of fixed manufacturing overhead costs and a corresponding reduction in gross margin. The low utilization was largely due to the lag in production of our core anti-viral product and downtime associated with facility maintenance and upgrades. For the Fiscal 2011 third quarter, the Fine Chemicals segment gross margin as a percentage of segment revenues, for the Fiscal 2011 third quarter as compared to the Fiscal 2010 third quarter, improved by three points but has not yet reached targeted levels. Specialty Chemicals. Specialty Chemicals segment gross margin as a percentage of segment revenues for the Fiscal 2011 third quarter and nine-month period, as compared to the corresponding Fiscal 2010 periods, declined one point and four points, respectively, each compared to the Fiscal 2010 periods. The primary reason for the declines in gross margin is the reduction in Grade I AP volume in the Fiscal 2011 periods and the corresponding effects of the volume decline on profits. These effects include increases in manufacturing cost per pound from reduced absorption of fixed manufacturing overhead. Aerospace Equipment. The Aerospace Equipment segment gross margin percentage for the Fiscal 2011 nine-month period improved three points compared to the Fiscal 2010 nine-month period. The improvement in gross margin is primarily due to process improvement actions implemented for space propulsion systems contracts. - 28 --------------------------------------------------------------------------------- Table of Contents OPERATING EXPENSES June 30, Increase Percentage 2011 2010 (Decrease) Change Three Months Ended: Operating Expenses $ 9,811 $ 11,946 $ (2,135 ) (18 %) Percentage of Revenues 19 % 32 % Nine Months Ended: Operating Expenses $ 33,054 $ 35,697 $ (2,643 ) (7 %) Percentage of Revenues 26 % 27 % For our Fiscal 2011 nine-month period, operating expenses decreased $2,643 to $33,054 from $35,697 for the prior fiscal year nine-month period as a result of our company-wide cost savings initiatives. • Corporate operating expenses were reduced by approximately $1,227. Cost reduction activities generated savings of approximately $1,700 which were offset somewhat by increases in board of directors and other strategic expenses. • Fine Chemicals segment operating expenses were reduced by approximately $513, reflecting property tax and insurance savings. • Specialty Chemicals segment operating-expense reductions of approximately $602 reflect lower personnel costs. • Aerospace Equipment segment operating expenses reflect an approximately $374 reduction in intangible amortization expense. For our Fiscal 2011 third quarter, operating expenses decreased $2,135 to $9,811 from $11,946 for the prior fiscal year third quarter. The quarterly variance is largely due to the timing of the above-mentioned cost reductions. ENVIRONMENTAL REMEDIATION CHARGES Late in the fiscal year ended September 30, 2009 ("Fiscal 2009"), we expanded the planned scope of our remediation efforts in Henderson, Nevada to include installation of additional groundwater extraction wells, construction of a pipeline to move extracted groundwater to our treatment facility, and the addition of above-ground ex situ bioremediation treatment equipment (the "Expansion Project"). Through June 2011, and in cooperation with the Nevada Division of Environmental Protection ("NDEP"), we worked to develop the formal design, engineering and permitting of the Expansion Project. Based on data obtained to date, which is largely comprised of firm quotations, we determined that significant modifications to our Fiscal 2009 assumptions were required. As a result, in June 2011, we accrued an additional $6,000 for the estimated increase in cost of the capital component of the Expansion Project, offset slightly by reductions in operating and maintenance ("O&M") cost estimates. The estimated capital costs of the Expansion Project increased by approximately $6,400. The increase reflects (i) an increase in the capacity of the above-ground treatment equipment to accommodate technical requirements based on the testing of new extraction wells in the fall of 2010, and (ii) higher than initially anticipated cost associated with the installation of the equipment and construction of the pipeline. Our estimate of total O&M costs was reduced by approximately $400. This change in estimate reflects (i) a reduction in the estimated life of the project by four years, offset by (ii) an increase in the estimated annual O&M cost to approximately $1,900 per year once the Expansion Project is placed in service. We anticipate that the Expansion Project will be placed in service during the spring of 2012. Due to uncertainties inherent in making estimates, our estimates of capital and O&M costs may later require significant revision as new facts become available and circumstances change. Including this $6,000 increase in our accruals, our total estimated cost of the Henderson, Nevada remediation activities is $45,700, of which, approximately $19,000 was spent from September 2005 through June 2011. We anticipate that the project will take at least eight years to complete. See further discussion below under the heading "Environmental Remediation - AMPAC Henderson Site". - 29 --------------------------------------------------------------------------------- Table of Contents OTHER OPERATING GAINS During our Fiscal 2011 nine-month period, our Fine Chemicals segment reported other operating gains of $2,929 that resulted from the resolution of gain contingencies. The total reported gain is comprised of the following two matters. We made a series of filings with the County of Sacramento, California, to appeal the assessed values in prior years of our real and personal property located at our Fine Chemicals segment's Rancho Cordova, California facility. During the nine months ended June 30, 2011, we received $2,671 for cash property tax refunds resulting from our appeals and the related favorable reassessment of historical property values. Our Fine Chemicals segment is undertaking several mandatory capital projects. Certain of the capital activities are complete and others are anticipated to be completed during the calendar year 2011. In connection with these projects, our Fine Chemicals segment held, and continues to hold, negotiations with the former owner of the facilities. During the nine months ended June 30, 2011, we received from the former owner cash consideration in the amount of $258 for a limited release of liability of the former owner with respect to one of the completed projects. SEGMENT OPERATING INCOME (LOSS) June 30, Favorable Percentage 2011 2010 (Unfavorable) Change Three Months Ended: Fine Chemicals $ (452 ) $ (2,458 ) $ 2,006 (82 %) Specialty Chemicals 4,849 2,796 2,053 73 % Aerospace Equipment 699 (120 ) 819 NM Other Businesses (539 ) (286 ) (253 ) 88 % Segment Operating Income 4,557 (68 ) 4,625 NM Corporate Expenses (2,827 ) (3,551 ) 724 20 % Environmental Remediation Charges (6,000 ) - (6,000 ) 100 % Operating Income (Loss) $ (4,270 ) $ (3,619 ) $ (651 ) 18 % Nine Months Ended: Fine Chemicals $ (4,923 ) $ (698 ) $ (4,225 ) 605 % Specialty Chemicals 11,948 15,140 (3,192 ) (21 %) Aerospace Equipment 2,784 (457 ) 3,241 NM Other Businesses (1,041 ) (234 ) (807 ) 345 % Segment Operating Income 8,768 13,751 (4,983 ) (36 %) Corporate Expenses (10,569 ) (11,796 ) 1,227 (10 %) Environmental Remediation Charges (6,000 ) - (6,000 ) 100 % Operating Income (Loss) $ (7,801 ) $ 1,955 $ (9,756 ) NM NM=Not meaningful Segment operating income or loss includes all sales and expenses directly associated with each segment. Environmental remediation charges, corporate general and administrative costs and interest are not allocated to segment operating results. Fluctuations in segment operating income or loss are driven by changes in segment revenues, gross margins and operating expenses. Each significant fluctuation in these items is discussed in greater detail above. BACKLOG Agreements with our Fine Chemicals segment customers typically include multi-year supply agreements. These agreements may contain provisional order volumes, minimum order quantities, take-or-pay provisions, termination fees and other customary terms and conditions, which we do not include in our computation of backlog. Fine Chemicals segment backlog includes unfulfilled firm purchase orders received from a customer, including both purchase orders which are issued against a related supply agreement and stand-alone purchase orders. Fine Chemicals segment backlog was $63,800 and $49,700 as of June 30, 2011 and September 30, 2010, respectively. We anticipate order backlog as of June 30, 2011 to be substantially filled during the next twelve months. - 30 --------------------------------------------------------------------------------- Table of Contents Our Aerospace Equipment segment is a government contractor, and accordingly, total backlog includes both funded backlog (contracts, or portions of contracts, for which funding is contractually obligated by the customer) and unfunded backlog (contracts, or portions of contracts, for which funding is not currently contractually obligated by the customer). We compute Aerospace Equipment segment total and funded backlog as the total contract value less revenues that have been recognized under the percentage-of-completion method of accounting. Aerospace Equipment segment total backlog and funded backlog were approximately $52,700 and $50,800 as of June 30, 2011 and $67,900 and $61,100 as of September 30, 2010, respectively. We anticipate the majority of funded backlog as of June 30, 2011 to be completed during the next twelve months, with any remainder to be completed in the fiscal year ending September 30, 2012. Backlog is not a meaningful measure for our other business lines. LIQUIDITY AND CAPITAL RESOURCES CASH FLOWS Nine Months Ended June 30, Percentage 2011 2010 Change Change Cash Provided (Used) By: Operating activities $ 10,771 $ 23,011 $ (12,240 ) (53 %) Investing activities (10,195 ) (7,382 ) (2,813 ) 38 % Financing activities (849 ) (5,037 ) 4,188 (83 %) Effect of changes in exchange rates on cash 61 (112 ) 173 NM Net change in cash for period $ (212 ) $ 10,480 $ (10,692 ) NM NM=Not meaningful Operating Cash Flows - Operating activities provided cash of $10,771 for the Fiscal 2011 nine-month period compared to $23,011 for the prior fiscal year nine-month period, a decrease of $12,240. Significant components of the change in cash flow from operating activities include: • A decrease in cash due to a decline in the cash profits provided by our operations. • A decrease in cash provided by working capital accounts of $5,318, excluding the effects of interest and income taxes. • An increase in cash income taxes refunded of $1,680. • A decrease in cash interest payments of $445. • An increase in cash used for environmental remediation of $1,683. • An increase in cash used to fund pension obligations of $2,397. • Other decreases in cash provided by operating activities of $920. Cash provided by working capital during the Fiscal 2011 nine-month period decreased due to additional working capital requirements for growth in inventory levels and Aerospace Equipment segment systems contracts. We consider the working capital changes to be routine and within the normal production cycle of our products. The production of most fine chemical products requires a length of time that exceeds one quarter. In addition, the timing of Aerospace Equipment segment revenues recognized under the percentage-of-completion method differs from the timing of the related billings to customers. Therefore, in any given quarter, accounts receivable, work-in-progress inventory or deferred revenues and customer deposits can increase or decrease significantly. We expect that our working capital may vary normally by as much as $10,000 from quarter to quarter. - 31 --------------------------------------------------------------------------------- Table of Contents The increase in cash income taxes refunded is a result of federal income tax carryback claims that were filed and collected in the Fiscal 2011 first quarter. The increase in cash used for environmental remediation relates to expenditures for the above-mentioned Expansion Project. Cash used to fund pension obligations increased because the return on pension plan assets alone was not sufficient to maintain the minimum funding requirements. Investing Cash Flows - Capital expenditures of $10,195 for the Fiscal 2011 nine-month period reflect an increase of $2,803 from capital expenditures of $7,392 in the Fiscal 2010 nine-month period. The increase in capital expenditures relates to our Fine Chemicals segment, and in particular, to additional equipment to support a new three-year core product agreement for the supply of anti-viral products and facilities improvements to enhance quality compliance. Financing Cash Flows - Cash used for financing activities for the Fiscal 2011 nine-month period relates primarily to costs associated with the establishing of our asset based lending facility in January 2011. Cash used for financing activities for the Fiscal 2010 nine-month period relates to our repurchase and cancellation of $5,000 in principal amount of our 9.0% Senior Notes (described below). LIQUIDITY AND CAPITAL RESOURCES. As of June 30, 2011, we had cash of $23,773. Our primary source of working capital is cash flows from operations. In addition, as of June 30, 2011, we had availability of approximately $17,649 under our asset based lending credit facility which provides for a committed revolving credit line, up to a maximum of $20,000, based on our eligible accounts receivable and inventories. For further discussion of this facility, see below under the heading "ABL Credit Facility". We believe that changes in cash flow from operations during our fiscal periods reflect short-term timing and as such do not represent significant changes in our sources and uses of cash. Because our revenues, and related customer invoices and collections, are characterized by relatively few individually significant transactions, our working capital balances can vary normally by as much as $10,000 from period to period. We may incur additional debt to fund capital projects, strategic initiatives or for other general corporate purposes, subject to our existing leverage, the value of our unencumbered assets and borrowing limitations imposed by our lenders. The availability of our cash inflows is affected by the timing, pricing and magnitude of orders for our products. From time to time, we may explore options to refinance our borrowings. The timing of our cash outflows is affected by payments and expenses related to the manufacture of our products, capital projects, pension funding, interest on our debt obligations and environmental remediation or other contingencies, which may place demands on our short-term liquidity. Although we are not currently party to any material pending legal proceedings, we are from time to time subject to claims and lawsuits related to our business operations and we have incurred legal and other costs as a result of litigation and other contingencies. We may incur material legal and other costs associated with the resolution of litigation and contingencies in future periods, and, to the extent not covered by insurance, they may adversely affect our liquidity. In contemplating the adequacy of our liquidity and available capital, we consider factors such as: • current results of operations, cash flows and backlog; • anticipated changes in operating trends, including anticipated changes in revenues and margins; • cash requirements related to our debt agreements and pension plans; and • cash requirements related to our remediation activities, including amounts that we expect to spend through spring 2012 for the capital component of the remediation expansion project and amounts we expect to spend annually thereafter for operating and maintenance. See further discussion under the heading "Environmental Remediation - AMPAC Henderson Site" below. - 32 - -------------------------------------------------------------------------------- Table of Contents We do not currently anticipate that the factors noted above will have material effects on our ability to meet our future liquidity requirements. We anticipate funding the capital component of the remediation expansion project with cash on hand or equipment financing. We continue to believe that our cash flows from operations, existing cash balances and existing or future debt arrangements will be adequate for the foreseeable future to satisfy the needs of our operations on both a short-term and long-term basis. LONG TERM DEBT AND CREDIT FACILITIES Senior Notes. In February 2007, we issued and sold $110,000 aggregate principal amount of 9.0% Senior Notes due February 1, 2015 (collectively, with the exchange notes issued in August 2007 as referenced below, the "Senior Notes"). Proceeds from the issuance of the Senior Notes were used to repay our former credit facilities. The Senior Notes accrue interest at an annual rate of 9.0%, payable semi-annually in February and August. The Senior Notes are guaranteed on a senior unsecured basis by all of our existing and future material U.S. subsidiaries. The Senior Notes are: • ranked equally in right of payment with all of our existing and future senior indebtedness; • ranked senior in right of payment to all of our existing and future senior subordinated and subordinated indebtedness; • effectively junior to our existing and future secured debt to the extent of the value of the assets securing such debt; and • structurally subordinated to all of the existing and future liabilities (including trade payables) of each of our subsidiaries that do not guarantee the Senior Notes. The Senior Notes may be redeemed by us, in whole or in part, under the following circumstances: • at any time on or after February 1, 2011 at redemption prices beginning at 104.5% of the principal amount to be redeemed and reducing to 100% by February 1, 2013; and • under certain changes of control, we must offer to purchase the Senior Notes at 101% of their aggregate principal amount, plus accrued interest. The Senior Notes were issued pursuant to an indenture which contains certain customary events of default, including cross-default provisions if we default under our existing and future debt agreements having, individually or in the aggregate, a principal or similar amount outstanding of at least $10,000, and certain other covenants limiting, subject to exceptions, carve-outs and qualifications, our ability to: • incur additional debt; • pay dividends or make other restricted payments; • create liens on assets to secure debt; • incur dividend or other payment restrictions with regard to restricted subsidiaries; • transfer or sell assets; • enter into transactions with affiliates; • enter into sale and leaseback transactions; • create an unrestricted subsidiary; • enter into certain business activities; or • effect a consolidation, merger or sale of all or substantially all of our assets. In connection with the closing of the sale of the Senior Notes, we entered into a registration rights agreement which required us to file a registration statement to offer to exchange the Senior Notes for notes that have substantially identical terms as the Senior Notes and are registered under the Securities Act of 1933, as amended. In July 2007, we filed a registration statement with the SEC with respect to an offer to exchange the Senior Notes as required by the registration rights agreement, which registration statement was declared effective by the SEC. In August 2007, we completed the exchange of 100% of the Senior Notes for substantially identical notes which are registered under the Securities Act of 1933, as amended. - 33 --------------------------------------------------------------------------------- Table of Contents ABL Credit Facility. On January 31, 2011, American Pacific Corporation, as borrower, entered into an asset based lending credit agreement (the "ABL Credit Facility") with Wells Fargo Bank, National Association, as agent and as lender, and certain domestic subsidiaries of the Company, as guarantors, which provides a secured revolving credit facility in an aggregate principal amount of up to $20,000 at any time outstanding with an initial maturity to be the earlier of (i) January 31, 2015 and (ii) 90 days prior to the maturity date of the Senior Notes, which is February 1, 2015. The ABL Credit Facility also provides for the issuance of new letters of credit with a letter of credit sublimit of $5,000. The maximum borrowing availability under the ABL Credit Facility is based upon a percentage of our eligible account receivables and eligible inventories. We may prepay and terminate the ABL Credit Facility at any time, without premium or penalty. The ABL Credit Facility contains certain mandatory prepayment provisions. The annual interest rates applicable to loans under the ABL Credit Facility will be, at our option, either at a Base Rate or LIBOR Rate (each as defined in the ABL Credit Facility) plus, in each case, an applicable margin of 2.50 percentage points. In addition, we will pay commitment fees, other fees related to the issuance and maintenance of the letters of credit, and certain agency fees. The ABL Credit Facility is guaranteed by our current and future domestic subsidiaries and is secured by substantially all of our assets and the assets of our current and future domestic subsidiaries, subject to certain exceptions as set forth in the ABL Credit Facility. The ABL Credit Facility contains certain negative covenants, subject to customary exceptions and exclusions, restricting and limiting our ability to, among other things: • incur debt, incur contingent obligations and issue certain types of preferred stock, or prepay certain debt; • create liens; • pay dividends, distributions or make other specified restricted payments; • make certain investments and acquisitions; • enter into certain transactions with affiliates; • enter into sale and leaseback transactions; and • merge or consolidate with any other entity or sell, assign, transfer, lease, convey or otherwise dispose of assets. The ABL Credit Facility also contains financial covenants which are only triggered by utilization of the ABL Credit Facility and borrowing availability not exceeding a designated threshold amount. If the financial covenants are triggered, then we would be subject to the following financial covenants: • Minimum EBITDA. We would be required to achieve a minimum level of EBITDA for the twelve-month period then ended. This covenant may become applicable through September 30, 2011. • Fixed Charge Coverage Ratio. We would be required to maintain a minimum fixed charge coverage ratio on a rolling trailing twelve-month basis of at least 1.10:1.00. This covenant may become applicable beginning with the twelve-month period ending October 31, 2011 and through the remaining term of the ABL Credit Facility. • Maximum Capital Expenditures. The ABL Credit Facility limits our capital expenditures in any fiscal year to amounts set forth in the ABL Credit Facility. The ABL Credit Facility also contains usual and customary events of default (in some cases, subject to certain threshold amounts and grace periods), including cross-default provisions that include the Senior Notes. If an event of default occurs and is continuing, we may be required to repay the obligations under the ABL Credit Facility prior to the ABL Credit Facility's stated maturity and the related commitments may be terminated. On June 30, 2011, under the ABL Credit Facility, we had no outstanding borrowings, had availability of $17,649, and were not subject to compliance with the financial covenants. Letters of Credit. As of June 30, 2011, we had $561 in outstanding standby letters of credit which mature through July 2015. These letters of credit principally secure performance of certain water treatment equipment sold by us. The letters of credit are collateralized by cash on deposit with the issuing bank in the amount of 105% of the outstanding letters of credit. Collateral deposits are classified as other assets on our consolidated balance sheets. - 34 --------------------------------------------------------------------------------- Table of Contents PENSION BENEFITS. We maintain three defined benefit pension plans which cover substantially all of our U.S. employees, excluding employees of our Aerospace Equipment segment: the Amended and Restated American Pacific Corporation Defined Benefit Pension Plan, the Ampac Fine Chemicals LLC Pension Plan for Salaried Employees, and the Ampac Fine Chemicals LLC Pension Plan for Bargaining Unit Employees, each as amended to date. Collectively, these three plans are referred to as the "Pension Plans". In May 2010, our board of directors approved amendments to our Pension Plans which effectively closed the Pension Plans to participation by any new employees. Retirement benefits for existing U.S. employees and retirees through June 30, 2010 are not affected by this change. Beginning July 1, 2010, new U.S. employees began participating solely in one of the Company's 401(k) plans. Pension Plan benefits are paid based on an average of earnings, retirement age, and length of service, among other factors. Benefit obligations are measured annually as of September 30. As of September 30, 2010, the Pension Plans had an unfunded benefit obligation of $30,005. For Fiscal 2010, we made contributions to the Pension Plans in the amount of $3,300. We anticipate making Pension Plan contributions in the amount of $5,824 during Fiscal 2011. We are required to make minimum contributions to our Pension Plans pursuant to the minimum funding requirements of the Internal Revenue Code of 1986, as amended, and the Employee Retirement Income Security Act of 1974, as amended. In accordance with federal requirements, our minimum funding obligations are determined annually based on a measurement date of October 1. The fair value of Pension Plan assets is a key factor in determining our minimum funding obligations. Holding all other variables constant, a 10% decline in asset value as of September 30, 2010 would increase our minimum funding obligations for Fiscal 2011 by approximately $200. In addition, we maintain the American Pacific Corporation Supplemental Executive Retirement Plan, as amended and restated (the "SERP") that includes five participants comprised of active and former executive officers. The SERP is an unfunded plan and as of September 30, 2010, the SERP obligation was $7,683. For Fiscal 2010, we paid SERP retirement benefits of $427. We anticipate contributing the amount of $527 to the SERP during Fiscal 2011 for the payment of retirement benefits. Payments for retirement benefits should increase in future years when each of the three current active participants retires. The future increase in such retirement benefits will be determined based on certain variables including each participating individual's actual retirement date, rate of compensation and years of service. During Fiscal 2010, our aggregate Pension Plans and SERP liability increased significantly primarily due to changes in actuarial assumption such as the discount rate. The change was recorded as an increase in Pension Obligations and a corresponding decrease in Shareholders' Equity (Accumulated Other Comprehensive Loss). The effect of the change in the discount rate increased our anticipated Fiscal 2011 funding requirements by approximately $2,800. ENVIRONMENTAL REMEDIATION - AMPAC HENDERSON SITE. During the fiscal years ended September 30, 2005 and 2006, we recorded aggregate charges for $26,000 representing our then estimates of the probable costs of our remediation efforts at our former perchlorate chemicals manufacturing facility in Henderson, Nevada (the "AMPAC Henderson Site"), including the costs for capital equipment and on-going "O&M". Late in Fiscal 2009, we gained additional information from groundwater modeling that indicates groundwater emanating from the AMPAC Henderson Site in certain areas in deeper zones (more than 150 feet below ground surface) is moving toward our existing remediation facility at a much slower pace than previously estimated. Utilization of our existing facilities alone, at this lower groundwater pace, could, according to this groundwater model, extend the life of our remediation project to well in excess of fifty years. As a result of this additional data, related model interpretations and consultations with NDEP, we re-evaluated our remediation operations and determined that we should be able to improve the effectiveness of the treatment program and significantly reduce the total project time by expanding the then existing treatment system. The Expansion Project consists of installing additional groundwater - 35 --------------------------------------------------------------------------------- Table of Contents extraction wells in the deeper, more concentrated areas, construction of a pipeline to move extracted groundwater to our treatment facility, and the addition of above-ground ex situ bioremediation treatment equipment that will enhance, and in some cases replace, primary components of the existing in situ bioremediation treatment system. In our Fiscal 2009 fourth quarter, we accrued $13,700 as our initial estimate of the capital cost of the Expansion Project and the related estimates of the effects of the enhanced operations on the on-going O&M costs and project life. Through June 2011, and in cooperation with NDEP, we worked to develop the formal design, engineering and permitting of the Expansion Project. Based on data obtained to date, which is largely comprised of firm quotations, we determined that significant modifications to our Fiscal 2009 assumptions were required. As a result, in June 2011, we accrued an additional $6,000 for the estimated increase in cost of the capital component of the Expansion Project, offset slightly by reductions in O&M cost estimates. The estimated capital costs of the Expansion Project increased by approximately $6,400. The increase reflects (i) an increase in the capacity of the above-ground treatment equipment to accommodate technical requirements based on the testing of new extraction wells in the fall of 2010, and (ii) higher than initially anticipated cost associated with the installation of the equipment and construction of the pipeline. Our estimate of total O&M costs was reduced by approximately $400. This change in estimate reflects (i) a reduction in the estimated life of the project by four years, offset by (ii) an increase in the estimated annual O&M cost to approximately $1,900 per year once the Expansion Project is placed in service. We anticipate that the Expansion Project will be placed in service during the spring of 2012. Due to uncertainties inherent in making estimates, our estimates of capital and O&M costs may later require significant revision as new facts become available and circumstances change. The estimated life of the project is a key assumption underlying the accrued estimated cost of our remediation activities. Groundwater modeling and other information regarding the characteristics of the surrounding land and demographics indicate that at our targeted processing rate of 450 gallons per minute for the new groundwater extraction wells (750 gallons per minute in the aggregate with existing wells), the life of the project could range from 5 to 18 years from the date that the Expansion Project is placed in service. Further, the data indicates that within that range, 7 to 14 years is the more likely range. In accordance with generally accepted accounting principles, if no point within the more likely range is considered more likely than another, then estimates should be based on the low end of the range. Accordingly, our accrued remediation cost includes estimated O&M costs though 2019, which is the low end of the likely range of the project life. Groundwater speed, perchlorate concentrations, aquifer characteristics and forecasted groundwater extraction rates will continue to be key factors considered when estimating the life of the project. If additional information becomes available in the future that lead to a different interpretation of the model, thereby dictating a change in equipment and operations, our estimate of the resulting project life could change significantly. The estimate of the annual O&M cost of the project is a key assumption in our computation of the estimated cost of our remediation activities. To estimate O&M costs, we consider, among other factors, the project scope and historical expense rates to develop assumptions regarding labor, utilities, repairs, maintenance supplies and professional services costs. If additional information becomes available in the future that is different than information currently available to us and thereby leads us to different conclusions, our estimate of O&M expenses could change significantly. In addition, certain remediation activities are conducted on public lands under operating permits. In general, these permits require us to return the land to its original condition at the end of the permit period. Estimated costs associated with removal of remediation equipment from the land are not material and are included in our range of estimated costs. As of June 30, 2011, the aggregate range of anticipated environmental remediation costs was from approximately $22,800 to approximately $47,300. This range represents a significant estimate and is based on the estimable elements of cost for capital and O&M costs, and an estimated remaining operating life of the project through a range from the years 2017 to 2030. As of June 30, 2011, the accrued amount was $26,659, based on an estimated remaining life of the project through the year 2019, or the low end of the more likely range of the expected life of the project. Cost estimates are based on our - 36 --------------------------------------------------------------------------------- Table of Contents current assessments of the facility configuration. As we proceed with the project, we have, and may in the future, become aware of elements of the facility configuration that must be changed to meet the targeted operational requirements. Certain of these changes may result in corresponding cost increases. Costs associated with the changes are accrued when a reasonable alternative, or range of alternatives, is identified and the cost of such alternative is estimable. Our estimated reserve for environmental remediation is based on information currently available to us and may be subject to material adjustment upward or downward in future periods as new facts or circumstances may indicate. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires that we adopt accounting policies and make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. Application of the critical accounting policies discussed below requires significant judgment, often as the result of the need to make estimates of matters that are inherently uncertain. If actual results were to differ materially from the estimates made, the reported results could be materially affected. However, we are not currently aware of any reasonably likely events or circumstances that would result in materially different results. SALES AND REVENUE RECOGNITION. Revenues from our Specialty Chemicals segment, Fine Chemicals segment, and Other Businesses segment are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, title passes, the price is fixed or determinable and collectability is reasonably assured. Almost all products sold by our Fine Chemicals segment are subject to customer acceptance periods. Specifically, these customers have contractually negotiated acceptance periods from the time they receive certificates of analysis and compliance ("Certificates") to reject the material based on issues with the quality of the product, as defined in the applicable agreement. At times we receive payment in advance of customer acceptance. If we receive payment in advance of customer acceptance, we record deferred revenues and deferred costs of revenue upon delivery of the product and recognize revenues in the period when the acceptance period lapses or the customer's acceptance has occurred. Some of our perchlorate and fine chemicals products customers have requested that we store materials purchased from us in our facilities ("Bill and Hold" transactions or arrangements). We recognize revenue prior to shipment of these Bill and Hold transactions when we have satisfied the applicable revenue recognition criteria, which include the point at which title and risk of ownership transfer to our customers. These customers have specifically requested in writing, pursuant to a contract, that we invoice for the finished product and hold the finished product until a later date. For our Bill and Hold arrangements that contain customer acceptance periods, we record deferred revenues and deferred costs of revenues when such products are available for delivery and Certificates have been delivered to the customers. We recognize revenue on our Bill and Hold transactions in the period when the acceptance period lapses or the customer's acceptance has occurred. The sales value of inventory, subject to Bill and Hold arrangements, at our facilities was $20,451 and $19,606 as of June 30, 2011 and September 30, 2010, respectively. Revenues from our Aerospace Equipment segment are derived from contracts that are accounted for using the percentage-of-completion method and measure progress on a cost-to-cost basis. Contract revenues include change orders and claims when approved by the customer. The percentage-of-completion method recognizes revenue as work on a contract progresses. Revenues are calculated based on the percentage of total costs incurred in relation to total estimated costs at completion of the contract. For fixed-price and fixed-price-incentive contracts, if at any time expected costs exceed the value of the contract, the loss is recognized immediately. We do not incur material pre-contract costs. DEPRECIABLE OR AMORTIZABLE LIVES OF LONG-LIVED ASSETS. Our depreciable or amortizable long-lived assets include property, plant and equipment and intangible assets, which are recorded at cost. - 37 --------------------------------------------------------------------------------- Table of Contents Depreciation or amortization is recorded using the straight-line method over the shorter of the asset's estimated economic useful life or the lease term, if the asset is subject to a capital lease. Economic useful life is the duration of time that we expect the asset to be productively employed by us, which may be less than its physical life. Significant assumptions that affect the determination of estimated economic useful life include: wear and tear, obsolescence, technical standards, contract life, and changes in market demand for products. The estimated economic useful life of an asset is monitored to determine its appropriateness, especially in light of changed business circumstances. For example, changes in technological advances, changes in the estimated future demand for products, or excessive wear and tear may result in a shorter estimated useful life than originally anticipated. In these cases, we would depreciate the remaining net book value over the new estimated remaining life, thereby increasing depreciation expense per year on a prospective basis. Likewise, if the estimated useful life is increased, the adjustment to the useful life decreases depreciation expense per year on a prospective basis. IMPAIRMENT OF LONG-LIVED ASSETS. We test our property, plant and equipment and amortizable intangible assets for recoverability when events or changes in circumstances indicate that their carrying amounts may not be recoverable. Examples of such circumstances include, but are not limited to, operating or cash flow losses from the use of such assets or changes in our intended uses of such assets. To test for recovery, we group assets (an "Asset Group") in a manner that represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. Our Asset Groups are typically identified by facility because each facility has a unique cost overhead and general and administrative expense structure that is supported by cash flows from products produced at the facility. The carrying amount of an Asset Group is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the Asset Group. If we determine that an Asset Group is not recoverable, then we would record an impairment charge if the carrying value of the Asset Group exceeds its fair value. Fair value is based on estimated discounted future cash flows expected to be generated by the Asset Group. The assumptions underlying cash flow projections would represent management's best estimates at the time of the impairment review. Some of the factors that management would consider or estimate include: industry and market conditions, sales volume and prices, costs to produce and inflation. Changes in key assumptions or actual conditions which differ from estimates could result in an impairment charge. We would use reasonable and supportable assumptions when performing impairment reviews but cannot predict the occurrence of future events and circumstances that could result in impairment charges. When we review Asset Groups for recoverability, we also consider depreciation estimates and methods or the amortization period, in each case as required by applicable accounting standards. Any revision to the remaining useful life of a long-lived asset resulting from that review also is considered in developing estimates of future cash flows used to test the Asset Group for recoverability. GOODWILL. Goodwill is not amortized. We test goodwill for impairment at the reporting unit level on an annual basis, as of September 30, or more frequently if an event occurs or circumstances change that indicate that the fair value of a reporting unit could be below its carrying amount. The impairment test consists of comparing the fair value of a reporting unit with its carrying amount including goodwill, and, if the carrying amount of the reporting unit exceeds its fair value, comparing the implied fair value of goodwill with its carrying amount. An impairment loss would be recognized for the carrying amount of goodwill in excess of its implied fair value. ENVIRONMENTAL COSTS. We are subject to environmental regulations that relate to our past and current operations. We record liabilities for environmental remediation costs when our assessments indicate that remediation efforts are probable and the costs can be reasonably estimated. On a quarterly basis, we review our estimates of future costs that could be incurred for remediation activities. In some cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used; otherwise, we accrue the minimum amount of the range. Estimates of - 38 --------------------------------------------------------------------------------- Table of Contents liabilities are based on currently available facts, existing technologies and presently enacted laws and regulations. These estimates are subject to revision in future periods based on actual costs or new circumstances. Accrued environmental remediation costs include the undiscounted cost of equipment, operating and maintenance costs, and fees to outside law firms and consultants, for the estimated duration of the remediation activity. Estimating environmental cost requires us to exercise substantial judgment regarding the cost, effectiveness and duration of our remediation activities. Actual future expenditures could differ materially from our current estimates. We evaluate potential claims for recoveries from other parties separately from our estimated liabilities. We record an asset for expected recoveries when recoveries of the amounts are probable. INCOME TAXES. We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured, separately for each tax-paying entity in each tax jurisdiction, using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. When measuring deferred tax assets, we assess whether a valuation allowance should be established by evaluating both positive and negative factors. This evaluation requires that we exercise judgment in determining the relative significance of each factor. A valuation allowance is established if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The assessment of valuation allowance requirements, if any, involves significant estimates regarding the timing and amount of reversal of taxable temporary differences, future taxable income and the implementation of tax planning strategies. We rely on deferred tax liabilities in our assessment of the realizability of deferred tax assets if the temporary timing difference is anticipated to reverse in the same period and jurisdiction and the deferred tax liabilities are of the same character as the temporary differences giving rise to the deferred tax assets. We weigh both positive and negative evidence in determining whether it is more likely than not that a valuation allowance is required. As of September 30, 2010, recovery of our U.S. jurisdiction deferred tax assets, net of applicable deferred tax liabilities, required that we generate approximately $75,000 in taxable income in periods ranging from one to at least 12 years in the future. To determine whether a valuation allowance is required, we project our future taxable income. The projections require us to make assumptions regarding our product revenues, gross margins and operating expenses. For our U.S. tax jurisdictions, negative evidence includes, but is not limited to, our reported book losses before income taxes in recent periods. In contemplating this evidence we have taken into consideration that a significant portion of such losses occur from environmental remediation charges. Significant positive evidence includes, but is not limited to, our historical longer-term trend of profitable operations, our forecast of future taxable income, the very long term nature of our significant deferred tax assets which are primarily associated with inventory, pension and remediation deductions, the lack of significant net operating loss carryforwards, and the lack of reliance on success in implementing tax planning strategies, utilization of short carry-back periods or appreciated asset values. Further, we do not have a history of tax credits expiring unused. For foreign tax jurisdictions, the most compelling negative evidence is a history of unprofitable operations. Accordingly, we have fully reserved our foreign deferred tax assets. We account for uncertain tax positions in accordance with an accounting standard which creates a single model to address uncertainty in income tax positions and prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. The standard also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. - 39 --------------------------------------------------------------------------------- Table of Contents Under this standard, we may recognize tax benefits from an uncertain position only if it is more likely than not that the position will be sustained upon examination by taxing authorities based on the technical merits of the issue. The amount recognized is the largest benefit that we believe has greater than a 50% likelihood of being realized upon settlement. Actual income taxes paid may vary from estimates depending upon changes in income tax laws, actual results of operations, and the final audit of tax returns by taxing authorities. Tax assessments may arise several years after tax returns have been filed. PENSION BENEFITS. We sponsor four defined benefit pension plans in various forms for employees who meet eligibility requirements. Applicable accounting standards require that we make assumptions and use statistical variables in actuarial models to calculate our pension obligations and the related periodic pension expense. The most significant assumptions are the discount rate and the expected rate of return on plan assets. Additional assumptions include the future rate of compensation increases, which is based on historical plan data and assumptions on demographic factors such as retirement, mortality and turnover. Depending on the assumptions selected, pension expense could vary significantly and could have a material effect on reported earnings. The assumptions used can also materially affect the measurement of benefit obligations. The discount rate is used to estimate the present value of projected future pension payments to all participants. The discount rate is generally based on the yield on AAA/AA-rated corporate long-term bonds. At September 30 of each year, the discount rate is determined using bond yield curve models matched with the timing of expected retirement plan payments. Our discount rate assumption was 5.80 percent as of September 30, 2010. Holding all other assumptions constant, a hypothetical increase or decrease of 25 basis points in the discount rate assumption would increase or decrease annual pension expense by approximately $400. The expected long-term rate of return on plan assets represents the average rate of earnings expected on the plan funds invested in a specific target asset allocation. The expected long-term rate of return assumption on pension plan assets was 8.00 percent in Fiscal 2010. Holding all other assumptions constant, a hypothetical 25 basis point increase or decrease in the assumed long-term rate of return would increase or decrease annual pension expense by approximately $100. RECENTLY ISSUED OR ADOPTED ACCOUNTING STANDARDS. In April 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2010-17, which provides guidance on defining a milestone under Topic 605 and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and nonsubstantive milestones that should be evaluated individually. This standard became effective for us beginning on October 1, 2010. The adoption of this standard did not have a material impact on our results of operations, financial position or cash flows. In December 2010, the FASB issued ASU No. 2010-28 that affects entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. The amendments in the ASU modify Step 1 so that for those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with existing guidance, which requires that goodwill of a reporting unit be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. This standard is effective for us beginning on October 1, 2011. The adoption of this standard is not expected to have a material impact on our results of operations, financial position or cash flows. - 40 --------------------------------------------------------------------------------- Table of Contents In June 2011, the FASB issued ASU No. 2011-05 which amends Topic 220, Comprehensive Income. The amendment allows an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements, and eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This standard is effective for us beginning on October 1, 2012. The adoption of this standard is not expected to have a material impact on our results of operations, financial position or cash flows. [ Back To TMCnet.com's Homepage ]