UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

Commission file number 1-15885

 

 

 

BRUSH ENGINEERED MATERIALS INC.

(Exact name of Registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code 216-486-4200

 

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

 

 

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

None

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

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

 

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

 

 

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

 

The aggregate market value of Common Stock, no par value, held by non-affiliates of the registrant (based upon the closing sale price on the New York Stock Exchange) on June 29, 2007 was $855,877,425.

 

As of February 15, 2008, there were 20,389,418 shares of Common Stock, no par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the proxy statement for the annual meeting of shareholders to be held on May 7, 2008 are incorporated by reference into Part III.

 

 

BRUSH ENGINEERED MATERIALS INC.

 

Index to Annual Report
On Form 10-K for
Year Ended December 31, 2007

 

 

 

Forward-Looking Statements

 

Portions of the narrative set forth in this document that are not statements of historical or current facts are forward-looking statements. Our actual future performance may materially differ from that contemplated by the forward-looking statements as a result of a variety of factors. These factors include, in addition to those mentioned elsewhere herein:

 

 

 

Brush Engineered Materials Inc., through its wholly owned subsidiaries, is a manufacturer of high performance advanced enabling engineered materials serving the global telecommunications and computer, data storage, aerospace and defense, automotive electronics, industrial components, appliance and medical markets. As of December 31, 2007, we had 2,201 employees.

 

Our businesses are organized under four reportable segments: Advanced Material Technologies and Services, Specialty Engineered Alloys, Beryllium and Beryllium Composites and Engineered Material Systems. Advanced Material Technologies and Services includes Williams Advanced Materials Inc. (WAM). The Specialty Engineered Alloys segment consists of Alloy Products, which includes bulk and strip form products, and beryllium hydroxide produced by Brush Resources Inc. (BRI). The Beryllium and Beryllium Composites segment consists of Beryllium Products and Brush Ceramic Products Inc. while the Engineered Material Systems segment includes Technical Materials, Inc. (TMI).

Our parent company, Brush Engineered Materials Inc., and other corporate expenses, as well as the operating results from BEM Services, Inc., Zentrix Technologies Inc. and Circuits Processing Technology, Inc. (CPT), all wholly owned subsidiaries, are not part of any segment and remain in All Other. BEM Services, Inc. charges a management fee for the services it provides, primarily corporate, administrative and financial oversight, to our other businesses on a cost-plus basis. Zentrix manufactures electronic packages and other components for sale to the telecommunications and computer and automotive electronics markets, and CPT manufactures circuitry for defense and commercial applications. CPT was sold in March of 2007. Corporate employees not covered as part of a reportable segment, including employees of BEM Services, Inc. and Zentrix Technologies Inc., totaled 142 as of December 31, 2007.

 

Our website address is www.beminc.com. Information contained on our website does not constitute part of this Form 10-K. We make available, free of charge through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as amendments to those reports, as soon as reasonably practicable after we file such reports with, or furnish such reports to, the Securities and Exchange Commission.

 

ADVANCED MATERIAL TECHNOLOGIES AND SERVICES

 

Advanced Material Technologies and Services (AMTS) is comprised of WAM. Sales for this segment were $519.9 million or 54% of total sales in 2007; $343.4  million or 45% of total sales in 2006 and $209.5 million or 39% of total sales in 2005. As of December 31, 2007, AMTS had 656 employees.

 

AMTS manufactures and fabricates precious, non-precious and specialty metal products for the data storage, medical and the wireless, semiconductor, photonic and hybrid segments of the microelectronics market. AMTS also has refining capabilities for the reclaim of precious metals from internally or customer-generated scrap. In addition, AMTS provides chamber services for its customers to reclaim precious metals and refurbish reusable components used in its customers’ vapor deposition systems. AMTS’ major product lines include vapor deposition targets, clad and precious metals preforms, high temperature braze materials, ultra fine wire, sealing lids for the semiconductor/hybrid markets and specialty inorganic materials.

 

AMTS’ products are sold directly from its facilities in Buffalo, New York; Brewster, New York; Wheatfield, New York; Buellton, California; Milwaukee, Wisconsin; Ireland; Singapore; Taiwan; Japan; Korea; the Philippines; China and the Czech Republic, as well as through direct sales offices and independent sales representatives throughout the world. Principal competition includes companies such as Sumitomo Metals, Heraeus Inc., Praxair, Inc., Honeywell International Inc., Solar Applied Materials Technology Corp. and a number of smaller regional and national suppliers.

 

Advanced Material Technologies and Services — Sales and Backlog

 

The backlog of unshipped orders for AMTS as of December 31, 2007, 2006, and 2005 was $23.8 million, $28.7 million and $16.0 million, respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. We expect that substantially all of our backlog of orders for this segment at December 31, 2007 will be filled during 2008. The increase in backlog from 2005 to 2006 is primarily due to the acquisition of CERAC, incorporated in January 2006 and an increase in the demand for vapor deposition targets.

 

Sales are made to over 2,800 customers. Government sales, principally subcontracts, accounted for less than 1% of the sales volume in 2007 and 2006 and 0% in 2005. Sales outside the United States, principally to Europe and Asia, accounted for approximately 30% of sales in 2007, and 18% of sales in 2006 and 2005. Other segment reporting and geographic information is contained in Note M of Notes to Consolidated Financial Statements, which can be found in Part II, Item 8 of this document.

 

Advanced Material Technologies and Services — Research and Development

 

Active research and development programs seek new product compositions and designs as well as process innovations. Expenditures for research and development for AMTS amounted to $1.6 million in 2007, $0.4 million

in 2006 and $0.8 million in 2005. A staff of 15 scientists, engineers and technicians was employed in this effort as of year-end 2007.

 

SPECIALTY ENGINEERED ALLOYS

 

Specialty Engineered Alloys (SEA) sells strip products, bulk products and beryllium hydroxide (BRI). Sales for this segment were $290.0 million or 30% of total sales in 2007; $275.6 million or 36% of total sales in 2006 and $213.8 million or 39% of total sales in 2005. As of December 31, 2007, Specialty Engineered Alloys had 925 employees.

 

SEA manufactures beryllium-containing and other high performance-based materials including copper-nickel-tin alloys that are metallurgically tailored to meet specific customer performance requirements. These products exhibit high electrical and thermal conductivities, high strength and hardness, good formability, lubricity, and excellent resistance to corrosion, wear and fatigue. These alloys, sold in strip and bulk form, are ideal choices for demanding applications in the telecommunications and computer, aerospace, industrial components (including oil and gas, heavy equipment and plastic mold tooling) and appliance markets. These products are sold domestically through SEA and independent distribution centers and internationally through Company-owned and independent distribution centers and independent sales representatives.

 

SEA’s primary direct competitor in strip form beryllium alloys is NGK Insulators, Ltd. of Nagoya, Japan, with subsidiaries in the U.S. and Europe. SEA also competes with alloy systems manufactured by Global Brass and Copper, Inc., Wieland Electric, Inc., Stolberger Metallwerke GmbH, Nippon Mining, PMX Industries, Inc. and also with other generally less expensive materials, including phosphor bronze, stainless steel and other specialty copper and nickel alloys which are produced by a variety of companies around the world. In the area of bulk products (bar, plate, tube and rod), in addition to NGK Insulators, SEA competes with several smaller regional producers such as Freedom Alloys in the U.S., LaBronze Industriel in Europe and Young II in Asia.

 

SEA, through BRI, manages our mine and milling operations. The milling operations produce beryllium hydroxide from mined bertrandite ore and purchased beryl ore. The beryllium hydroxide is used primarily as a raw material input by the other businesses within the company. BRI also sells beryllium hydroxide externally to SEA’s primary competitor in beryllium alloys, NGK Insulators, Ltd.

 

Specialty Engineered Alloys — Sales and Backlog

 

The backlog of unshipped orders for SEA as of December 31, 2007, 2006 and 2005 was $71.5 million, $62.1 million and $49.6 million, respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. We expect that substantially all the backlog of orders for this segment as of December 31, 2007 will be filled during 2008.

 

Sales are made to over 2,000 customers. Government sales, principally subcontracts, accounted for less than 1% of sales in 2007, 2006 and 2005. Sales outside the United States, principally to Europe and Asia, accounted for approximately 55% of sales in 2007 and 2006 and 51% of sales in 2005. Other segment reporting and geographic information is contained in Note M of Notes to Consolidated Financial Statements, which can be found in Part II, Item 8 of this document.

 

Specialty Engineered Alloys — Research and Development

 

Active research and development programs seek new product compositions and designs as well as process innovations. Expenditures for research and development amounted to $1.9 million in 2007, $2.1 million in 2006 and $2.6 million in 2005. A staff of 10 scientists, engineers and technicians was employed in this effort as of year-end 2007.

 

BERYLLIUM AND BERYLLIUM COMPOSITES

 

Beryllium and Beryllium Composites includes Beryllium Products and Brush Ceramic Products Inc. Sales for this segment were $60.5 million or 6% of total sales in 2007; $57.6 million or 8% of total sales in 2006 and $53.1

million or 10% of total sales in 2005. As of December 31, 2007, Beryllium and Beryllium Composites had 276 employees.

 

Beryllium and Beryllium Composites manufactures products that include beryllium, AlBeMet^® and E-materials. Beryllium is a lightweight metal possessing unique mechanical and thermal properties. Its specific stiffness is much greater than other engineered structural materials such as aluminum, titanium and steel. Beryllium is extracted from both bertrandite and imported beryl ore. Beryllium products are used in a variety of high performance applications in the defense, space, industrial, scientific equipment, electronics (including acoustics), medical, automotive electronics and optical scanning markets. Beryllium-containing products are sold throughout the world through a direct sales organization and through Company-owned and independent distribution centers. While Beryllium and Beryllium Composites is the only domestic producer of metallic beryllium, it competes with other fabricators as well as with designs utilizing other materials.

 

Beryllium and Beryllium Composites also manufactures beryllia ceramics for electronic packaging and electro-optical applications including lasers. Electronic components utilizing beryllia are used in the telecommunications, medical, industrial, automotive and defense markets. These products are distributed through direct sales and independent sales agents. Direct competitors include American Beryllia Inc. and CBL Ceramics Limited.

 

Beryllium and Beryllium Composites — Sales and Backlog

 

The backlog of unshipped orders for Beryllium and Beryllium Composites as of December 31, 2007, 2006 and 2005 was $23.9 million, $18.4 million and $16.5 million, respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. We expect that substantially all of our backlog of orders for this segment at December 31, 2007 will be filled during 2008.

 

Sales are made to over 400 customers. Government sales, principally subcontracts, accounted for 1% of Beryllium and Beryllium Composites’ sales in 2007, 2006 and 2005. Sales outside the United States, principally to Europe and Asia, accounted for approximately 16% of sales in 2007, 29% of sales in 2006 and 16% of sales in 2005. Other segment reporting and geographic information is contained in Note M of Notes to Consolidated Financial Statements, which can be found in Part II, Item 8 of this document.

 

Beryllium and Beryllium Composites — Research and Development

 

Active research and development programs seek new product compositions and designs as well as process innovations. Expenditures for research and development amounted to $1.0 million in 2007 and $1.1 million in 2006 and in 2005. A staff of 9 scientists, engineers and technicians was employed in this effort as of year-end 2007. Some research and development projects, expenditures for which are not material, were externally sponsored and funded.

 

ENGINEERED MATERIAL SYSTEMS

 

Engineered Material Systems is comprised of TMI. Sales for this segment were $70.9 million or 7% of total sales in 2007; $68.7 million or 9% of total sales in 2006 and $50.0 million or 9% of total sales in 2005. As of December 31, 2007, Engineered Material Systems had 202 employees.

 

Engineered Material Systems manufactures engineered material systems, which include clad inlay and overlay metals, precious and base metal electroplated systems, electron beam welded systems, contour profiled systems and solder-coated metals systems. These products are used in telecommunications and computer systems, data storage, automotive electronics, semi-conductors, energy, defense and medical applications. Engineered Material Systems’ products are sold directly and through its sales representatives. Engineered Material Systems has limited competition in the United States and several European manufacturers are competitors for the sale of inlay strip.

 

Engineered Material Systems — Sales and Backlog

 

The backlog of unshipped orders for Engineered Material Systems as of December 31, 2007, 2006 and 2005 was $12.4 million, $16.1 million and $16.3 million respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. We expect that substantially all of our backlog of orders for this segment at December 31, 2007 will be filled during 2008.

Sales are made to approximately 300 customers. Engineered Material Systems did not have any sales to the government for 2007, 2006 or 2005. Sales outside the United States, principally to Europe and Asia, accounted for approximately 12% of Engineered Material Systems’ sales in 2007, 9% of sales in 2006 and 6% of sales in 2005. Other segment reporting and geographic information is contained in Note M of Notes to Consolidated Financial Statements, which can be found in Part II, Item 8 of this document.

 

Engineered Material Systems — Research and Development

 

Active research and development programs seek new product compositions and designs as well as process innovations. Expenditures for research and development for Engineered Material Systems were nominal in 2007, 2006 and 2005.

 

GENERAL

 

Availability of Raw Materials

 

The principal raw materials we use are beryllium (extracted from both imported beryl ore and bertrandite mined from our Utah properties), copper, gold, silver, nickel, platinum, palladium, aluminum and ruthenium. We will be developing a new bertrandite pit at our Utah mine site, targeting early 2008 to begin extracting ore. Ore reserve data can be found in Part II, Item 7 of this document. We have a long-term supply arrangement with Ulba/Kazatomprom of the Republic of Kazakhstan and its marketing representative, Nukem, Inc. of New York, to purchase quantities of copper beryllium master alloy and beryllium vacuum cast billet. The availability of these raw materials, as well as other materials used by us, is adequate and generally not dependent on any one supplier.

 

Patents and Licenses

 

We own patents, patent applications and licenses relating to certain of our products and processes. While our rights under the patents and licenses are of some importance to our operations, our business is not materially dependent on any one patent or license or on all of our patents and licenses as a group.

 

Regulatory Matters

 

We are subject to a variety of laws which regulate the manufacture, processing, use, handling, storage, transport, treatment, emission, release and disposal of substances and wastes used or generated in manufacturing. For decades we have operated our facilities under applicable standards of inplant and outplant emissions and releases. The inhalation of airborne beryllium particulate may present a health hazard to certain individuals. Standards for exposure to beryllium are under review by the United States Occupational Safety and Health Administration and by other governmental and private standard-setting organizations. One result of these reviews will likely be more stringent worker safety standards. The development, proposal or adoption of more stringent standards may affect buying decisions by the users of beryllium-containing products. If the standards are made more stringent and/or our customers or other downstream users decide to reduce their use of beryllium-containing products, our operating results, liquidity and capital resources could be materially adversely affected. The impact of this potential adverse effect would depend on the nature and extent of the changes to the standards, the cost and ability to meet the new standards, the extent of any reduction in customer use and other factors. The magnitude of this potential adverse effect cannot be estimated.

Executive Officers of the Registrant

 

 

 

Our business, financial condition, results of operations and cash flows can be affected by a number of factors, including but not limited to those set forth below and elsewhere in the Annual Report on Form 10-K, any one of which could cause our actual results to vary materially from recent results or from our anticipated future results. Therefore, an investment in us involves some risks, including the risks described below. The risks discussed below are not the only risks that we may experience. If any of the following risks occur, our business, results of operations or financial condition could be negatively impacted.

 

Health issues, litigation and government regulation relating to machining and manufacturing of beryllium-containing products could significantly reduce demand for our products, limit our ability to operate and adversely affect our profitability.

 

If exposed to respirable beryllium fumes, dusts or powder, some individuals may demonstrate an allergic reaction to beryllium and may later develop a chronic lung disease known as chronic beryllium disease, or CBD. Some people who are diagnosed with CBD do not develop clinical symptoms at all. In others, the disease can lead to scarring and damage of lung tissue, causing clinical symptoms that include shortness of breath, wheezing and coughing. Severe cases of CBD can cause disability or death.

 

Further, some scientists claim there is evidence of an association between beryllium exposure and lung cancer, and certain standard-setting organizations have classified beryllium and beryllium compounds as human carcinogens.

The health risks relating to exposure to beryllium have been, and will continue to be, a significant issue confronting the beryllium-containing products industry. The health risks associated with beryllium have resulted in product liability claims, employee and third-party lawsuits and increased levels of scrutiny by federal, state, foreign and international regulatory authorities. Concerns over CBD and other potential adverse health effects relating to beryllium, as well as concerns regarding potential liability from the use of beryllium, may discourage our customers’ use of our beryllium-containing products and significantly reduce demand for our products. In addition, continued or increased adverse media coverage relating to our beryllium-containing products could damage our reputation or cause a decrease in demand for beryllium-containing products, which could adversely affect our profitability.

 

We are presently uninsured for beryllium-related claims where the claimants’ first exposure to beryllium occurred on or after January 1, 2008, and we have not undertaken to estimate the impact of such claims, which have yet to be asserted. In addition, some jurisdictions preclude insurance coverage for punitive damages awards. Accordingly, our profitability could be adversely affected if any current or future claimants obtain judgments for any uninsured compensatory or punitive damages. Further, an unfavorable outcome or settlement of a pending beryllium case or additional adverse media coverage could encourage the commencement of additional similar litigation.

 

Our bertrandite ore mining and beryllium-related manufacturing operations and our customers’ businesses are subject to extensive health and safety regulations that impose, and will continue to impose, significant costs and liabilities, and future regulation could increase those costs and liabilities or effectively prohibit production or use of beryllium-containing products.

 

Our customers and we are subject to laws regulating worker exposure to beryllium. Standards for exposure to beryllium are under review by the United States Occupational Safety and Health Administration and by other governmental and private standard-setting organizations. One result of these reviews will likely be more stringent worker safety standards. The development, proposal or adoption of more stringent standards may affect buying decisions by the users of beryllium-containing products. If the standards are made more stringent and/or our customers or other downstream users decide to reduce their use of beryllium-containing products, our operating results, liquidity and capital resources could be materially adversely affected. The impact of this potential adverse effect would depend on the nature and extent of the changes to the standards, the cost and ability to meet the new standards, the extent of any reduction in customer use and other factors. The magnitude of this potential adverse effect cannot be estimated.

 

Our bertrandite ore mining and manufacturing operations are subject to extensive environmental regulations that impose, and will continue to impose, significant costs and liabilities on us, and future regulation could increase these costs and liabilities or prevent production of beryllium-containing products.

 

We are subject to a variety of governmental regulations relating to the environment, including those relating to our handling of hazardous materials and air and wastewater emissions. Some environmental laws impose substantial penalties for noncompliance. Others, such as the federal Comprehensive Environmental Response, Compensation, and Liability Act, impose strict, retroactive and joint and several liability upon entities responsible for releases of hazardous substances. Bertrandite ore mining is also subject to extensive governmental regulation on matters such as permitting and licensing requirements, plant and wildlife protection, reclamation and restoration of mining properties, the discharge of materials into the environment and the effects that mining has on groundwater quality and availability. If we fail to comply with present and future environmental laws and regulations, we could be subject to liabilities or our operations could be interrupted. In addition, future environmental laws and regulations could restrict our ability to expand our facilities or extract our bertrandite ore deposits. They could also require us to acquire costly equipment or to incur other significant expenses in connection with our business, which would increase our costs of production.

The availability of competitive substitute materials for beryllium-containing products may reduce our customers’ demand for these products and reduce our sales.

 

In certain product applications, we compete with manufacturers of non-beryllium-containing products, including organic composites, metal alloys or composites, titanium and aluminum. Our customers may choose to use substitutes for beryllium-containing products in their products for a variety of reasons, including, among other things, the lower costs of those substitutes, the health and safety concerns relating to these products and the risk of litigation relating to beryllium-containing products. If our customers use substitutes for beryllium-containing products in their products, the demand for our beryllium-containing products may decrease, which could reduce our sales.

 

The markets for our beryllium-containing and non-beryllium-containing products are experiencing rapid changes in technology.

 

We operate in markets characterized by rapidly changing technology and evolving customer specifications and industry standards. New products may quickly render an existing product obsolete and unmarketable. For example, at one time we produced beryllium-copper alloys that were used in the production of some golf club heads, however, these beryllium-copper alloy club heads are no longer produced by any of our customers. Our growth and future results of operations depend in part upon our ability to enhance existing products and introduce newly developed products on a timely basis that conform to prevailing and evolving industry standards, meet or exceed technological advances in the marketplace, meet changing customer specifications, achieve market acceptance and respond to our competitors’ products.

 

The process of developing new products can be technologically challenging and requires the accurate anticipation of technological and market trends. We may not be able to introduce new products successfully or do so on a timely basis. If we fail to develop new products that are appealing to our customers or fail to develop products on time and within budgeted amounts, we may be unable to recover our significant research and development costs, which could adversely affect our margins and profitability.

 

Our beryllium-containing and non-beryllium-containing products are deployed in complex applications and may have errors or defects that we find only after deployment.

 

Our products are highly complex, designed to be deployed in complicated applications and may contain undetected defects, errors or failures. Although our products are generally tested during manufacturing, prior to deployment, they can only be fully tested when deployed in specific applications. For example, we sell beryllium-copper alloy strip products in a coil form to some customers, who then stamp the alloy for its specific purpose. On occasion, it is not until such customer stamps the alloy that a defect in the alloy is detected. In addition, the Company has experienced on one occasion, a quality issue during the manufacturing ramp up of a new product. Consequently, our customers may discover errors after the products have been deployed. The occurrence of any defects, errors, or failures could result in installation delays, product returns, termination of contracts with our customers, diversion of our resources, increased service and warranty costs and other losses to our customers, end users or to us. Any of these occurrences could also result in the loss of or delay in market acceptance of our products and could damage our reputation, which could reduce our sales.

 

Our customers are subject to significant fluctuations as a result of the cyclical nature of their industries and their sensitivity to general economic conditions, which could adversely affect their demand for our products and reduce our sales.

 

A substantial number of our customers are in the telecommunications and computer, data storage, aerospace and defense, automotive electronics, industrial components, appliance and medical industries. Each of these industries is cyclical in nature, influenced by a combination of factors which could have a negative impact on our business, including, among other things, periods of economic growth or recession, strength or weakness of the United States dollar, the strength of the consumer electronics, automotive electronics and computer industries and the rate of construction of telecommunications infrastructure equipment and government spending on defense.

Also, in times when growth rates in our markets slow down, there may be temporary inventory adjustments by our customers that may negatively affect our business.

 

The demand for our products is generally affected by macroeconomic fluctuations in the global economies in which we sell our products. Future economic downturns, stagnant economies or global currency fluctuations could also negatively affect our financial performance.

 

Our business is dependent on continued capital spending by the global telecommunications and computer industries, and a decrease in capital spending for infrastructure and equipment could affect our revenue from these markets. Our business could be exposed to unexpected or extended downturns in capital spending, which could adversely affect our sales. In addition, a decrease in military, aerospace or defense-related spending could adversely reduce demand for our products.

 

We may not be able to complete our acquisition strategy or successfully integrate acquired businesses.

 

We have been active over the last three years in pursuing niche acquisitions for one of our subsidiaries, Williams Advanced Materials Inc. We intend to continue to consider further growth opportunities through the acquisition of assets or companies and routinely review acquisition opportunities. We cannot predict whether we will be successful in pursuing any acquisition opportunities or what the consequences of any acquisition would be. Future acquisitions may involve the expenditure of significant funds and management time. Depending upon the nature, size and timing of future acquisitions, we may be required to raise additional financing, which may not be available to us on acceptable terms. Further, we may not be able to successfully integrate any acquired business with our existing businesses or recognize any expected advantages from any completed acquisition.

 

The terms of our indebtedness may restrict our ability to pursue our growth and acquisition strategies.

 

The terms of our credit facilities restrict our ability to, among other things, borrow and make investments and acquire other businesses. In addition, the terms of our indebtedness require us to satisfy specified financial covenants. Our ability to comply with these provisions depends, in part, on factors over which we may have no control. These restrictions could adversely affect our ability to pursue our growth and acquisition strategies. If we breach any of our financial covenants or fail to make scheduled payments, our creditors could declare all amounts owed to them to be immediately due and payable, and we may not have sufficient available funds to repay the amounts due, in which case we may be required to seek legal protection from our creditors.

 

We conduct our sales and distribution operations on a worldwide basis and are subject to the risks associated with doing business outside the United States.

 

We sell to customers outside of the United States from our United States and international operations. We have been and are continuing to expand our geographic reach in Europe and Asia. Shipments to customers outside of the United States accounted for approximately 43% of our sales in 2007, 35% in 2006 and 33% in 2005. We anticipate that international shipments will account for a significant portion of our sales for the foreseeable future. Revenue from non-U.S. operations (principally Europe and Asia) amounted to approximately 23% of our sales in 2007, 23% in 2006 and 25% in 2005. There are a number of risks associated with international business activities, including:

 

 

Fluctuations in currency exchange rates, particularly for the euro and the yen, have impacted our sales, margins and profitability in the past. The fair value of our net liability relating to outstanding foreign currency contracts

was $1.5 million at December 31, 2007, indicating that the average hedge rates were unfavorable compared to the actual year-end market exchange rates. Additionally, foreign and international regulations have also impacted our sales, margins and profitability in the past. See also “— Health issues, litigation and government regulation relating to machining and manufacturing of beryllium-containing products could significantly reduce demand for our products, limit our ability to operate and adversely affect our profitability”, found on page 6 and “— Our bertrandite ore mining and beryllium-related manufacturing operations and our customers’ businesses are subject to extensive health and safety regulations that impose, and will continue to impose, significant costs and liabilities, and future regulation could increase those costs and liabilities or effectively prohibit production or use of beryllium-containing products”, found on page 7. Further, any of these risks could continue in the future.

 

A major portion of our bank debt consists of variable-rate obligations, which subjects us to interest rate fluctuations.

 

Our credit facilities are secured by substantially all of our assets (other than non-mining real property and certain other assets). Our working capital line-of-credit includes variable-rate obligations, which expose us to interest rate risks. If interest rates increase, our debt service obligations on our variable-rate indebtedness would increase even if the amount borrowed remained the same, resulting in a decrease in our net income. We have developed a hedging program to manage the risks associated with interest rate fluctuations, but our program may not effectively eliminate all of the financial exposure associated with interest rate fluctuations. We currently have an instrument in place that has the effect of fixing the interest rate on a portion of our outstanding debt through December 2008. Additional information regarding our market risks is contained in Part II, Item 7A of this document.

 

The availability and prices of some raw materials we use in our manufacturing operations fluctuate, and increases in raw material costs can increase our operating costs.

 

We manufacture engineered materials using various precious and non-precious metals, including gold, silver, palladium, platinum, ruthenium, copper and nickel. The availability of and prices for these raw materials are subject to volatility and are influenced by worldwide economic conditions, speculative action, world supply and demand balances, inventory levels, availability of substitute metals, the United States dollar exchange rate, production costs of United States and foreign competitors, anticipated or perceived shortages and other factors. Decreased availability and fluctuating prices of precious and non-precious metals that we use in our manufacturing can increase our operating costs. For example, prices for copper have recently reached an all-time high due to, among other things, smelting capacity and increased demand from China. Further, we maintain some precious metals on a consigned inventory basis. The owners of the precious metals charge a fee that fluctuates based on the market price of those metals and other factors. A significant increase in the market price of precious metals or the consignment fee could increase our financing costs, which could increase our operating costs. We use ruthenium for the manufacture of perpendicular magnetic recording technology products for the data storage market. Ruthenium is not widely used or traded on a public market and therefore there is no established market for hedging price exposure. Although our selling price is generally based on our cost to purchase ruthenium, the inventory carrying value may be exposed to market fluctuations.

 

Because we experience seasonal fluctuations in our sales, our quarterly results will fluctuate, and our annual performance will be affected by the fluctuations.

 

Because many of our European and automotive electronics customers slow or cease operations during the summer months, we sometimes experience weaker demand in the quarters ending in September compared to the quarters ending in March, June and December. We expect this seasonal pattern to continue, which causes our quarterly results to fluctuate. If our revenue during any quarter were to fall below the expectations of investors or securities analysts, our share price could decline, perhaps significantly. Unfavorable economic conditions, lower than normal levels of demand and other occurrences in any of the other quarters could also harm our operating results.

Natural disasters, equipment failures, work stoppages, bankruptcies and other unexpected events may lead our customers to curtail production or shut down their operations.

 

Our customers’ manufacturing operations are subject to conditions beyond their control, including raw material shortages, natural disasters, interruptions in electrical power or other energy services, equipment failures, bankruptcies, work stoppages due to strikes or lockouts, including those affecting the automotive industry, one of our major markets, and other unexpected events. For example, in 2005, Delphi Corporation, a customer of three of our business units and the largest U.S. supplier of automotive parts, filed for bankruptcy protection. Any of those events could also affect other suppliers to our customers. In either case, those events could cause our customers to curtail production or to shut down a portion or all of their operations, which could reduce their demand for our products and reduce our sales.

 

Unexpected events and natural disasters at our mine could increase the cost of operating our business.

 

A portion of our production costs at our mine are fixed regardless of current operating levels. Our operating levels are subject to conditions beyond our control that may increase the cost of mining for varying lengths of time.

 

These conditions include, among other things, fire, natural disasters, pit wall failures and ore processing changes. Our mining operations also involve the handling and production of potentially explosive materials. It is possible that an explosion could result in death and injuries to employees and others and material property damage to third parties and us. Any explosion could expose us to adverse publicity or liability for damages and materially adversely affect our operations. Any of these events could increase our cost of operations.

 

Equipment failures and other unexpected events at our facilities may lead to manufacturing curtailments or shutdowns.

 

The manufacturing processes that take place in our mining operation, as well as in our manufacturing facilities, depend on critical pieces of equipment. This equipment may, on occasion, be out of service because of unanticipated failure, and some equipment is not readily available or replaceable. In addition to equipment failures, our facilities are also subject to the risk of loss due to unanticipated events such as fires, explosions or other disasters. Material plant shutdowns or reductions in operations could harm our ability to fulfill our customers’ demands, which could harm our sales and cause our customers to find other suppliers. Further, remediation of any interruption in production capability may require us to make large capital expenditures, which may have a negative effect on our profitability and cash flows. Our business interruption insurance may not cover all of the lost revenues associated with interruptions in our manufacturing capabilities.

 

Many of our manufacturing facilities are dependent on single source energy suppliers, and interruption in energy services may cause manufacturing curtailments or shutdowns.

 

Many of our manufacturing facilities depend on one source for electric power and for natural gas. For example, Utah Power is the sole supplier of electric power to the processing facility for our mining operations in Utah. A significant interruption in service from our energy suppliers due to equipment failures, terrorism or any other cause may result in substantial losses that are not fully covered by our business interruption insurance. Any substantial unmitigated interruption of our operations due to these conditions could harm our ability to meet our customers’ demands and reduce our sales.

 

If the price of electrical power, fuel or other energy sources increases, our operating expenses could increase significantly.

 

We have numerous milling and manufacturing facilities and a mining operation, which depend on electrical power, fuel or other energy sources. See “Item 2. — Properties,” found on page 15. Our operating expenses are sensitive to changes in electricity prices and fuel prices, including natural gas prices. Prices for electricity and natural gas have continued to increase and can fluctuate widely with availability and demand levels from other users. During periods of peak usage, supplies of energy may be curtailed, and we may not be able to purchase energy at historical market rates. While we have some long-term contracts with energy suppliers, we are exposed to fluctuations in energy costs that can affect our production costs. Although we enter into forward fixed price supply

contracts for natural gas and electricity for use in our operations, those contracts are of limited duration and do not cover all of our fuel or electricity needs. Price increases in fuel and electricity costs will continue to increase our cost of operations.

 

We have a limited number of manufacturing facilities, and damage to those facilities could interrupt our operations, increase our costs of doing business and impair our ability to deliver our products on a timely basis.

 

Some of our facilities are interdependent. For instance, our manufacturing facility, in Elmore, Ohio relies on our mining operation for its supply of beryllium hydroxide used in production of most of its beryllium-containing materials. Additionally, our Shoemakersville, Pennsylvania, Fremont, California and Tucson, Arizona manufacturing facilities are dependent on materials produced by our Elmore, Ohio manufacturing facility and our Wheatfield, New York manufacturing facility is dependent on our Buffalo, New York manufacturing facility. See “Item 2 — Properties”, found on page 15. The destruction or closure of any of our manufacturing facilities or our mine for a significant period of time as a result of fire, explosion, act of war or terrorism or other natural disaster or unexpected event may interrupt our manufacturing capabilities, increase our capital expenditures and our costs of doing business and impair our ability to deliver our products on a timely basis. In such an event, we may need to resort to an alternative source of manufacturing or to delay production, which could increase our costs of doing business. Our property damage and business interruption insurance may not cover all of our potential losses and may not continue to be available to us on acceptable terms, if at all.

 

Our lengthy and variable sales and development cycle makes it difficult for us to predict if and when a new product will be sold to customers.

 

Our sales and development cycle, which is the period from the generation of a sales lead or new product idea through the development of the product and the recording of sales, may typically take up to two or three years, making it very difficult to forecast sales and results of operations. Our inability to accurately predict the timing and magnitude of sales of our products, especially newly introduced products, could affect our ability to meet our customers’ product delivery requirements or cause our results of operations to suffer if we incur expenses in a particular period that do not translate into sales during that period, or at all. In addition, these failures would make it difficult to plan future capital expenditure needs and could cause us to fail to meet our cash flow requirements.

 

Future terrorist attacks and other acts of violence or war may directly harm our operations.

 

Future terrorist attacks or other acts of violence or war may directly impact our physical facilities. For example, our Elmore, Ohio facility is located near and derives power from a nuclear power plant, which could be a target for a terrorist attack. In addition, future terrorist attacks, related armed conflicts or prolonged or increased tensions in the Middle East or other regions of the world could cause consumer confidence and spending to decrease, decreasing demand for consumer goods that contain our products. Further, when the United States armed forces are involved in active hostilities or large-scale deployments, defense spending tends to focus more on meeting the physical needs of the troops, and planned expenditures on weapons and other systems incorporating our products may be reduced or deferred. Any of these occurrences could also increase volatility in the United States and worldwide financial markets, which could negatively impact our sales.

 

We may be unable to access the financial markets on favorable terms.

 

The inability to raise capital on favorable terms, particularly during times of uncertainty in the financial markets, could impact our ability to sustain and grow our business and would increase our capital costs. We rely on access to financial markets as a significant source of liquidity for capital requirements not satisfied by cash on hand or operating cash flow. Our access to the financial markets could be adversely impacted by various factors, including:

 

 

 

All of these factors, except a material breakdown in our risk management procedures, have adversely impacted our access to the financial markets at various times over the last five years.

 

Low investment performance by our domestic pension plan assets may require us to increase our pension liability and expense, which may require us to fund a portion of our pension obligations and divert funds from other potential uses.

 

We provide defined benefit pension plans to eligible employees. Our pension expense and our required contributions to our pension plans are directly affected by the value of plan assets, the projected rate of return on plan assets, the actual rate of return on plan assets and the actuarial assumptions we use to measure our defined benefit pension plan obligations, including the rate at which future obligations are discounted to a present value, or the discount rate. As of December 31, 2007, for pension accounting purposes, we assumed an 8.25% rate of return on pension assets.

 

Lower investment performance of our pension plan assets resulting from a decline in the stock market could significantly increase the deficit position of our plans. Should the assets earn an average return less than 8.25% over time, it is likely that future pension expenses would increase. The actual return on our plan assets for the twelve months ending December 31, 2007 was 5.8% and the ten-year average annualized return as of year-end 2007 was 6.5%.

 

We establish the discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year based upon the available market rates for high quality, fixed income investments. An increase in the discount rate would reduce the future pension expense and, conversely, a lower discount rate would raise the future pension expense.

 

Based on current guidelines, assumptions and estimates, including stock market prices and interest rates, we anticipate that we will be required to make a cash contribution of approximately $4.5 million to our pension plan in 2008. If our current assumptions and estimates are not correct, a contribution in years beyond 2008 may be greater than the projected 2008 contribution required.

 

We cannot predict whether changing market or economic conditions, regulatory changes or other factors will further increase our pension expenses or funding obligations, diverting funds we would otherwise apply to other uses.

 

Our expenditures for post-retirement health benefits could be materially higher than we have predicted if our underlying assumptions prove to be incorrect.

 

We also provide post-retirement health benefits to eligible employees. Our retiree health expense is directly affected by the assumptions we use to measure our retiree health plan obligations, including the assumed rate at which health care costs will increase and the discount rate used to calculate future obligations. For retiree health accounting purposes, we increased the assumed rate at which health care costs will increase for the next year to 9% at December 31, 2007 from 8% at December 31, 2006. In addition, we have assumed that this health care cost increase trend rate will decline to 5% by 2012. We have used the same discount rates for our retiree health plans that we use for our pension plan accounting.

 

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A 1.0% increase in assumed health care cost trend rates would have increased the post-employment benefits included among the liabilities in our balance sheet by $0.9 million at December 31, 2007.

We cannot predict whether changing market or economic conditions, regulatory changes or other factors will further increase our retiree health care expenses or obligations, diverting funds we would otherwise apply to other uses.

 

We are subject to fluctuations in currency exchange rates, which may negatively affect our financial performance.

 

A significant portion of our sales is conducted in international markets and priced in currencies other than the United States dollar. Revenues from customers outside of the United States (principally Europe and Asia) amount to 43% of sales for 2007, 35% of sales for 2006 and 33% of sales for 2005. A significant part of these international sales are priced in currencies other than the U.S. dollar. Significant fluctuations in currency values relative to the United States dollar may negatively affect our financial performance. While we may hedge our currency transactions to mitigate the impact of currency price volatility on our earnings, any hedging activities may not be successful.

 

Our holding company structure causes us to rely on funds from our subsidiaries.

 

We are a holding company and conduct substantially all our operations through our subsidiaries. As a holding company, we are dependent upon dividends or other intercompany transfers of funds from our subsidiaries. The payment of dividends and other payments to us by our subsidiaries may be restricted by, among other things, applicable corporate and other laws and regulations, agreements of the subsidiaries and the terms of our current and future indebtedness.

 

 

None.

 

We operate manufacturing plants, service and other facilities throughout the world. Information as of December 31, 2007, with respect to our significant facilities that are owned or leased, and the respective segments in which they are included, is set forth below.

 

 

 

 

In addition to the above, there are 7,500 acres in Juab County, Utah with respective mineral rights from which the beryllium-bearing ore, bertrandite, is mined by the open pit method. A portion of the mineral rights is held under lease. Ore reserve data can be found in Part II, Item 7 of this document.

 

Our subsidiaries and our holding company are subject, from time to time, to a variety of civil and administrative proceedings arising out of our normal operations, including, without limitation, product liability claims, health, safety and environmental claims and employment-related actions. Among such proceedings are the cases described below.

 

Beryllium Claims

 

As of December 31, 2007, our subsidiary, Brush Wellman Inc., was a defendant in nine proceedings in various state and federal courts brought by plaintiffs alleging that they have contracted, or have been placed at risk of contracting, chronic beryllium disease or other lung conditions as a result of exposure to beryllium. Plaintiffs in beryllium cases seek recovery under negligence and various other legal theories and seek compensatory and punitive damages, in many cases of an unspecified sum. Spouses of some plaintiffs claim loss of consortium.

 

During 2007, the number of beryllium cases decreased from 13 cases (involving 54 plaintiffs) as of December 31, 2006 to nine cases (involving 31 plaintiffs) as of December 31, 2007:

 

 

In addition, three plaintiffs were dismissed from a purported class action (involving eight named plaintiffs) and the case was remanded to the trial court for further proceedings as to the remaining five individual plaintiffs only. Summary judgment was granted in the Company’s favor in two cases (involving 12 plaintiffs), though the plaintiffs have filed appeals in both cases. No cases were filed in 2007.

 

The nine pending beryllium cases as of December 31, 2007 fall into two categories: Seven cases involving third-party individual plaintiffs, with 15 individuals (and four spouses who have filed claims as part of their spouse’s case and two children who have filed claims as part of their parent’s case); and two purported class actions, involving ten named plaintiffs, as discussed more fully below. Claims brought by third-party plaintiffs (typically employees of our customers or contractors) are generally covered by varying levels of insurance.

 

The first purported class action is Manuel Marin, et al. v. Brush Wellman Inc., filed in Superior Court of California, Los Angeles County, case number BC299055, on July 15, 2003. The named plaintiffs are Manuel Marin, Lisa Marin, Garfield Perry and Susan Perry. The defendants are Brush Wellman, Appanaitis Enterprises, Inc., and Doe Defendants 1 through 100. A First Amended Complaint was filed on September 15, 2004, naming five additional plaintiffs. The five additional named plaintiffs are Robert Thomas, Darnell White, Leonard Joffrion, James Jones and John Kesselring. The plaintiffs allege that they have been sensitized to beryllium while employed at the Boeing Company. The plaintiffs’ wives claim loss of consortium. The plaintiffs purport to represent two classes of approximately 250 members each, one consisting of workers who worked at Boeing or its predecessors and are beryllium sensitized and the other consisting of their spouses. They have brought claims for negligence, strict liability — design defect, strict liability — failure to warn, fraudulent concealment, breach of implied warranties, and unfair business practices. The plaintiffs seek injunctive relief, medical monitoring, medical and health care provider reimbursement, attorneys’ fees and costs, revocation of business license, and compensatory and punitive damages. Messrs. Marin, Perry, Thomas, White, Joffrion, Jones and Kesselring represent current and past employees of Boeing in California; and Ms. Marin and Ms. Perry are spouses. Defendant Appanaitis Enterprises, Inc. was dismissed on May 5, 2005. This case is set for trial on June 17, 2008.

 

The second purported class action is Gary Anthony v. Small Tube Manufacturing Corporation d/b/a Small Tube Products Corporation, Inc., et al., filed in the Court of Common Pleas of Philadelphia County, Pennsylvania, case number 000525, on September 7, 2006. The case was removed to the U.S. District Court for the Eastern District of Pennsylvania, case number 06-CV-4419, on October 4, 2006. The only named plaintiff is Gary Anthony. The defendants are Small Tube Manufacturing Corporation, d/b/a Small Tube Products Corporation, Inc.; Admiral Metals Inc.; Tube Methods, Inc.; and Cabot Corporation. The plaintiff purports to sue on behalf of a class of current

and former employees of the U.S. Gauge facility in Sellersville, Pennsylvania who have ever been exposed to beryllium for a period of at least one month while employed at U.S. Gauge. The plaintiff has brought claims for negligence. Plaintiff seeks the establishment of a medical monitoring trust fund, cost of publication of approved guidelines and procedures for medical screening and monitoring of the class, attorneys’ fees and expenses. Defendant Tube Methods, Inc. filed a third-party complaint against Brush Wellman Inc. in that action on November 15, 2006. Tube Methods alleges that Brush supplied beryllium-containing products to U.S. Gauge, and that Tube Methods worked on those products, but that Brush is liable to Tube Methods for indemnification and contribution. Brush moved to dismiss the Tube Methods complaint on December 22, 2006. On January 12, 2007, Tube Methods filed an amended third-party complaint, which Brush moved to dismiss on January 26, 2007; however, the Court denied the motion on September 28, 2007. Brush filed its answer to the amended third-party complaint on October 19, 2007.

 

As previously reported and noted above, one purported class action has been remanded to the trial court for proceedings as to the five individuals who allege beryllium sensitization following the appellate court’s affirming of the trial court’s grant of summary judgment in the Company’s favor. Neal Parker, et al. v. Brush Wellman Inc., was filed in the Superior Court of Fulton County, State of Georgia, case number 2004CV80827, on January 29, 2004. The case was removed to the U.S. District Court for the Northern District of Georgia, case number 04-CV-606, on May 4, 2004. The named plaintiffs were Neal Parker, Wilbert Carlton, Stephen King, Ray Burns, Deborah Watkins, Leonard Ponder, Barbara King and Patricia Burns. The defendants were Brush Wellman; Schmiede Machine and Tool Corporation; ThyssenKrupp Materials NA Inc., d/b/a Copper and Brass Sales; Axsys Technologies Inc.; Alcoa, Inc.; McCann Aerospace Machining Corporation; Cobb Tool, Inc.; and Lockheed Martin Corporation. Messrs. Parker, Carlton, King and Burns and Ms. Watkins were current employees of Lockheed. Mr. Ponder was a retired employee; and Ms. King and Ms. Burns were family members. The plaintiffs brought claims for negligence, strict liability, fraudulent concealment, civil conspiracy and punitive damages. The plaintiffs sought a permanent injunction requiring the defendants to fund a court-supervised medical monitoring program, attorneys’ fees and punitive damages. On March 29, 2005, the Court entered an order (1) directing plaintiffs to amend their pleading to segregate out those plaintiffs who endured only subclinical, cellular and subcellular effects from those who sustained actionable tort injuries, and stating that following such amendment, the Court would enter an order dismissing the claims asserted by the former subset of claimants; (2) dismissing Count I of the Complaint, which sought the creation of a medical monitoring fund; and (3) dismissing the claims against Axsys Technologies Inc. On April 20, 2005, the plaintiffs filed a Substituted Amended Complaint for Damages, contending that each of the eight named plaintiffs and the individuals listed on the attachment to the original Complaint, and each of the putative class members sustained personal injuries; however, they alleged that they identified five individuals whose injuries manifested themselves such that they had been detected by physical examination and/or laboratory test. On May 23, 2005, the defendants filed a Motion to Enforce the March 29, 2005 Order, which argued that the five plaintiffs identified in the Amended Complaint had only beryllium sensitization, which is not an actionable tort injury as defined in the March 29, 2005 Order. On March 10, 2006, the Court entered an order construing this motion as a Motion for Summary Judgment and granted summary judgment in the Company’s favor; however, the plaintiffs filed an appeal. On April 18, 2007, the Eleventh Circuit Court of Appeals affirmed in part and reversed in part the trial court’s grant of summary judgment, holding that Georgia tort law requires a current physical injury and that allegations of subclinical and cellular damage do not satisfy the physical injury requirement. However, with respect to the five named individuals with alleged beryllium sensitization, there was a genuine issue of material fact that precluded summary judgment, and the case has been remanded to the district court for further proceedings. Those five individuals are Messrs. Parker, Carlton, Brown, Griffin and Walker. Defendants and plaintiffs filed motions for reconsideration, which the Eleventh Circuit denied on June 6, 2007.

 

As previously reported and noted above, one purported class action has been finally decided. George Paz, et al. v. Brush Engineered Materials Inc., et al., was filed in the U.S. District Court for the Southern District of Mississippi, case number 1:04CV597, on June 30, 2004. The named plaintiffs were George Paz, Barbara Faciane, Joe Lewis, Donald Jones, Ernest Bryan, Gregory Condiff, Karla Condiff, Odie Ladner, Henry Polk, Roy Tootle, William Stewart, Margaret Ann Harris, Judith Lemon, Theresa Ladner and Yolanda Paz. The defendants were Brush Engineered Materials Inc., Brush Wellman Inc., Wess-Del Inc. and the Boeing Company. Plaintiffs sought the establishment of a medical monitoring trust fund as a result of their alleged exposure to products containing beryllium, attorneys’ fees and expenses, and general and equitable relief. The plaintiffs purported to sue on behalf of

a class of present or former Defense Contract Management Administration (DCMA) employees who conducted quality assurance work at Stennis Space Center and the Boeing Company at its facility in Canoga Park, California; present and former employees of Boeing at Stennis; and spouses and children of those individuals. Messrs. Paz and Lewis and Ms. Faciane represented current and former DCMA employees at Stennis. Mr. Jones represented DCMA employees at Canoga Park. Messrs. Bryan, Condiff, Ladner, Polk, Tootle and Stewart and Ms. Condiff represented Boeing employees at Stennis. Ms. Harris, Ms. Lemon, Ms. Ladner and Ms. Paz were family members. We filed a Motion to Dismiss on September 28, 2004, which was granted and judgment was entered on January 11, 2005; however, the plaintiffs filed an appeal. Brush Engineered Materials Inc. was dismissed for lack of personal jurisdiction on the same date, which plaintiffs did not appeal. On April 7, 2006, the U.S. Court of Appeals for the Fifth Circuit, in case number 05-60157, certified the question regarding whether Mississippi has a medical monitoring cause of action to the Mississippi Supreme Court. In case number 2006-FC-007712-SCT, the Mississippi Supreme Court issued an opinion that the laws of Mississippi do not allow for a medical monitoring cause of action without an accompanying physical injury on January 4, 2007. Plaintiffs filed a motion for rehearing, which was denied by the Mississippi Supreme Court on March 1, 2007. On March 29, 2007, the Fifth Circuit entered and filed its judgment affirming the District Court’s granting of the Company’s Motion to Dismiss. On April 6, 2007, plaintiffs filed a Petition for Panel Rehearing, which was denied by the Fifth Circuit on June 18, 2007, and the case is now closed.

 

Subsequent Events

 

From January 1, 2008 to February 15, 2008, there were no material developments in any of the cases. No new cases were filed during the period.

 

Other Claims

 

One of our subsidiaries, Williams Advanced Materials Inc. (“WAM”), is a party to two patent litigations in the U.S. involving Target Technology Company, LLC of Irvine, California (“Target”). Both actions involve patents directed to technology used in the production of DVD-9s, which are high storage capacity DVDs. The patents at issue concern certain silver alloys used to make the semi-reflective layer in DVD-9s, a thin metal film that is applied to a DVD-9 through a process known as sputtering. The raw material used in the sputtering process is called a target. Target alleges that WAM manufactures and sells infringing sputtering targets to DVD manufacturers.

 

In the first action, filed in April 2003 by WAM against Target in the U.S. District Court, Western District of New York (case no. 03-CV-0276A (SR)) (the “NY Action”), WAM has asked the Court for a judgment declaring certain Target patents invalid and/or unenforceable and awarding WAM damages. Target counterclaimed alleging infringement of those patents and seeking a judgment for infringement, an injunction against further infringement and damages for past infringement. Following certain proceedings in which WAM was denied an injunction to prevent Target from suing and threatening to sue WAM’s customers, Target filed an amended counterclaim and a third-party complaint naming certain of WAM’s customers and other entities as parties to the case and adding related other patents to the NY Action. The action is stayed pending resolution of the ownership issue in the CA Action, discussed more fully below.

 

In the second litigation, Target in September 2004 filed in the U.S. District Court, Central District of California (case no. SAC04-1083 DOC (MLGx)) a separate action for infringement of one of the same patents named in the NY Action (the “CA Action”), naming as defendants WAM and certain of WAM’s customers who purchase certain WAM sputtering targets. Target seeks a judgment that the patent is valid and infringed by the defendants, a permanent injunction, damages adequate to compensate Target for the infringement, treble damages and attorneys’ fees and costs. In April 2007, Sony DADC U.S., Inc. (“Sony”) intervened in the CA Action claiming ownership of that patent and others of the patents that Target is seeking to enforce in the NY Action. Sony’s claim is based on its prior employment of the patentee and Target’s founder, Hanphire H. Nee, and includes a demand for damages against both Target and Nee. WAM on behalf of itself and its customers has a paid-up license from Sony under any rights that Sony has in those patents. Trial of the CA Action is currently scheduled for August 2008.

 

On April 17, 2003, the Company filed a complaint in the Court of Common Pleas for Ottawa County, Ohio, case number 03-CVH-089, seeking a declaration of certain rights under insurance policies issued by Lloyds of

London, certain London Market companies and certain domestic insurers, and damages and breach of contract. On August 30, 2006, the court granted Brush’s motion for partial summary judgment in its entirety. The parties then stipulated to the amount of damages and prejudgment interest resulting from those breaches of contract of approximately $7.3 million, subject to reduction if an appellate court modified or amended the grant of partial summary judgment. The defendants’ attempt to appeal on an interlocutory basis was denied. The parties agreed separately to approximately $0.5 million in damages related to claims not covered by the partial summary judgment order. Trial of the bad faith claim had been set for December 2007, but was adjourned to January 2008. The damage award was subsequently increased to $8.8 million as a result of the defendants’ stipulating to the attorneys’ fees incurred in pursuing this action. On December 21, 2007, the parties reached an agreement to settle the litigation. The settlement includes a pre-tax cash payment to the Company of approximately $17.5 million and provision by the London Market Insurers of a new insurance policy. A portion of the cash proceeds will be used to reimburse other costs related to past claims, offset certain receivables due from the insurers and pay attorneys’ fees as well as taxes. During the next 15 years, the new insurance policy will cover, subject to an annual $1.0 million self-insured retention, reasonable defense and indemnity costs incurred by the Company in connection with beryllium claims where the actual or alleged first exposure to beryllium occurred prior to January 1, 2008. The new insurance policy will cover beryllium claims for which the Company previously did not have insurance.

 

 

No matters were submitted to a vote of security holders during the fiscal fourth quarter of 2007.

 

 

Market Information and Dividends

 

(a) The Company’s common shares are listed on the New York Stock Exchange under the symbol “BW”. As of February 15, 2008 there were approximately 1,468 shareholders of record. The table below is a summary of the range of market prices with respect to common shares, during each quarter of fiscal years 2007 and 2006. We did not pay any dividends in 2007 or 2006. We have no current intention to declare dividends on our common shares in the near term. Our current policy is to retain all funds and earnings for the use in the operation and expansion of our business.

 

 

We did not purchase any of our shares of common stock or other securities during the year ended December 31, 2007.

Peformance Graph

 

The following graph sets forth the cumulative shareholder return on our common stock as compared to the cumulative total return of the S&P Small-cap 600 Index and the Russell 2000 Index. Brush Engineered Materials Inc. is a component company of the S&P Small-cap 600 Index and the Russell 2000 Index.

 

 

 

The above graph assumes that the value of our common stock and each index was $100 on December 31, 2002 and that all dividends, if paid, were reinvested.

 

 

Brush Engineered Materials Inc. and Subsidiaries

 

 

Minority interest of $45,000 decreased the net loss for 2003.

 

In addition to the capital expenditures shown above, the Company purchased $0.4 million of assets in 2005, $0.9 million of assets in 2004 and $51.8 million of assets in 2003 that were previously held under operating leases and used by the Company.

 

Changes in deferred tax valuation allowances decreased income tax expense by $21.8 million, $8.1 million and $9.3 million in 2006, 2005 and 2004, respectively, and increased income tax expense by $5.3 million in 2003.

 

See Notes to Consolidated Financial Statements.

 

OVERVIEW

 

We are an integrated producer of high performance specialty engineered materials used in a variety of electrical, electronic, thermal and structural applications. Our products are sold into numerous markets, including telecommunications and computer, data storage, aerospace and defense, automotive electronics, industrial components, appliance and medical.

 

Sales and earnings improved once again in 2007. Sales of $955.7 million in 2007 established a record high, surpassing the previous record of $763.1 million set last year by 25%. Sales have grown in each of the last five years and the compound annual growth rate is 21% over this time period.

 

The sales growth in 2007 was across all four of our business segments. The majority of the growth came from the data storage market as new technologies increased the demand for our materials for disk drive applications. Demand from other markets, including defense, oil and gas, medical and portions of the telecommunications and computer market, also improved in 2007. Sales from new products contributed to the current year sales growth as did higher metal prices.

 

Operating profit totaled $84.5 million in 2007, an improvement of $40.7 million, or 93%, over 2006. In addition to the incremental margin generated by the additional sales and other operating factors, profit in 2007 was significantly affected by changes in ruthenium prices and a favorable legal settlement.

 

Movements in the market price of ruthenium resulted in both large gains and charges against margins. A sudden upward movement in the market price of ruthenium late in 2006 and early 2007 allowed us to generate $22.9 million in additional margin from the sale of low cost inventory purchased in 2006 at higher market prices in 2007. We do not anticipate having similar margin gains in the future due to changes in our pricing policies early in 2007. Reductions in the market price of ruthenium later in 2007 required us to record lower of cost or market charges of $4.5 million to write down a portion of the inventory.

 

The settlement of a lawsuit against our former insurers resulted in a net $8.7 million gain. In addition, the settlement provided enhanced insurance coverage for our beryllium products related exposures.

 

Our balance sheet position strengthened during 2007. While the accounts receivable and inventory balances increased, utilization ratios, measured by the days sales outstanding and inventory turnover, improved over the prior year. Cash flow from operations of $54.4 million in 2007 allowed us to reduce debt by $13.5 million and fund capital expenditures and mine development costs of $33.6 million, which was the highest level of spending since 1998. With the lower debt and an increase to shareholders’ equity during 2007, the debt-to-debt-plus-equity ratio improved once again from 15% in 2006 to 9% in 2007. The cash balance grew $16.1 million during the year. In the fourth quarter 2007, we negotiated a new revolving credit agreement that increases our borrowing capacity with less restrictive covenants, reduces borrowing costs and improves financing flexibility.

 

RESULTS OF OPERATIONS

 

 

Sales of $955.7 million in 2007 were 25% higher than sales of $763.1 million in 2006 while sales in 2006 were 41% higher than sales of $541.3 million in 2005. Sales have grown over the comparable quarter in the prior year for twenty consecutive quarters.

 

International sales grew 57% in 2007 over 2006 after growing 47% in 2006 over 2005. Sales in Asia accounted for the majority of the growth in international sales in both years. International sales to other regions, primarily

Western Europe, also improved in 2007 and 2006 over the respective prior years. International sales accounted for 43% of total sales in 2007. Domestic sales increased a more modest 9% in 2007 over 2006 after growing 38% in 2006 over 2005.

 

The majority of the sales growth in 2007 was in ruthenium-based and other products for media applications in the data storage market. Sales to this market in 2007 were more than double the sales from 2006 while sales in 2006 increased 40% over 2005. Sales to the telecommunications and computer market also grew approximately 19% in 2007 following a 49% growth rate in 2006. Portions of the improvement in these two markets were due to the increasing demand for consumer electronic products, including cell phones, MP3 players and gaming systems. Changes in technologies, including the drive toward higher power, improved functionality and increased miniaturization in these and other devices, may result in the increased demand for our higher performing materials.

 

Sales for defense applications improved in the second half of 2006 and remained strong throughout 2007. Automotive electronics market sales decreased slightly in 2007 compared to 2006 after growing 37% in 2006 over 2005. Demand from the oil and gas market also improved in 2007. Sales into various smaller markets, including medical, grew in each of the last two years as well.

 

We acquired three small businesses between the second quarter 2005 and the first quarter 2006. These operations offer complementary products and services that have helped create additional market opportunities for our existing materials. The sharing of technology among the acquired and existing operations has also helped to develop additional applications across the organization. The acquired businesses themselves contributed $8.2 million of the sales increase in 2007 over 2006 and $29.5 million to the sales increase in 2006 over 2005.

 

The development of new products and applications into existing and/or emerging markets has also been a key part of the sales growth in each of the last two years. A portion of the sales growth in each of our main businesses was due to new products or applications.

 

Sales are affected by metal prices as changes in precious metal and a portion of the changes in base metal prices, primarily copper, are passed on to our customers. Average metal prices in 2007 and 2006 were higher than average prices in the respective prior year. Copper prices increased significantly in the first half of 2006 and on average remained high through year-end 2007 despite periods of significant fluctuations. Precious metal prices, and gold and platinum prices in particular, increased in value throughout 2006 and 2007. We estimate that the higher metal prices accounted for $36.8 million, or 19% of the $192.6 million growth in 2007 sales and $72.0 million, or 32%, of the $221.8 million growth in 2006 sales.

 

Gross margin was $196.7 million, or 21% of sales, in 2007, $162.2 million, or 21% of sales, in 2006 and $110.2 million, or 20% of sales, in 2005. The gross margin improved $34.5 million in 2007 over 2006. The increased sales volume in 2007 generated an estimated additional $23.7 million in margin; the incremental margin earned on the sales growth was less than the prior year margin rate as the majority of the sales increase was in ruthenium products that had a very high metal content and cost. We made improvements to the pricing for our copper-based alloy products in the fourth quarter of 2006 that allowed for an increase in the percentage of copper-based sales subject to the copper cost pass-through. However, the full year benefit of that improved pricing in 2007 was more than offset by an unfavorable change in product mix, manufacturing inefficiencies and other factors. Gross margin in 2007 was also affected by the following issues associated with the production and sale of ruthenium products:

 

 

 

The gross margin in 2006 was $51.9 million higher than in 2005. The increased sales volumes generated an estimated $58.2 million of additional margin in 2006 over 2005. The change in product mix was favorable in that sales of products that generate higher margins increased more than sales of lower margin products. Margins were reduced in the first three quarters of 2006 by the increased cost of raw materials, primarily copper and nickel, which could not be passed through to the customer. Improvements in our pricing structure helped to mitigate the impact of the higher metal costs in the fourth quarter 2006. Manufacturing yields and performance also improved at various facilities. Manufacturing overhead costs increased $10.0 million in 2006, with the acquisitions accounting for $8.5 million of this increase.

 

Selling, general and administrative expenses (SG&A) were $110.1 million in 2007 (12% of sales), $111.0 million in 2006 (15% of sales) and $78.5 million in 2005 (14% of sales). Expenses declined 1% in 2007 from 2006 after increasing 41% in 2006 over 2005. The slight decline in expenses in 2007 resulted primarily from lower incentive compensation accruals, retirement plan costs and corporate administrative expenses offset in part by higher selling and marketing costs, primarily overseas. The increase in 2006 over 2005 was due to a higher investment in marketing and sales development programs, increased incentive compensation and retirement costs, the impact of the acquisitions and other factors.

 

International expenses, excluding incentive compensation, increased $2.9 million in 2007 over 2006 and $2.0 million in 2006 over 2005 due to the expansion of our overseas operations and increased sales and marketing support efforts.

 

Incentive compensation expense declined $2.1 million in 2007 from 2006 after growing $15.5 million in 2006 over 2005. The changes in the annual expense were caused by the performance of the individual businesses relative to their plans’ objectives. The higher cost in 2006 resulted from the significant improvement in the operating profit from that year as well as from the increase in the price of our common shares as the payouts under certain employee compensation plans are share based. The increase in the share price was less in 2007 than in 2006 and therefore had less of an impact on the incentive compensation expense.

 

Stock-based compensation costs associated with stock options and stock appreciation rights totaled $0.8 million in 2007 and $0.6 million in 2006 and were included within SG&A expenses. We adopted Statement No. 123 (Revised 2004), “Share-Based Payments”, which requires that all share-based payments be measured at fair value and charged to income over the vesting period effective January 1, 2006. In previous periods, we had adopted the disclosure only provisions of Statement No. 123 and therefore, there was no comparable recorded expense in 2005. See Note K to the Consolidated Financial Statements for further information on the share-based compensation plans. Total stock-based compensation expense, including performance shares (which are part of the incentive compensation expense totals noted above) and restricted stock, was $3.9 million in 2007, $1.7 million in 2006 and $0.1 million in 2005.

 

Expenses for the U.S. defined benefit pension plan and certain other domestic retirement plans were $1.3 million lower in 2007 than in 2006 due to changes in plan valuation assumptions, changes in participant data and other factors. In 2006, these expenses were $2.6 million higher than in 2005. The major causes for the difference in expense between years included the plan valuation assumptions for each year, the actual performance of the plan and other factors. The 2006 expense was also higher than 2005 due to the impact of a remeasurement of the defined benefit plan in 2005 resulting from a plan amendment. The majority of these retirement costs were charged to SG&A expense, although a portion of the cost was included in cost of sales and a much smaller portion in research and development expenses.

Domestic selling and marketing costs also grew in 2007 and 2006 in order to support the sales growth and market development efforts. This was offset in part by savings from the closure of the New Jersey service center late in 2006. One-time closure costs totaled $1.1 million in 2006.

 

Other corporate administrative expenses declined $0.7 million in 2007 from 2006 after increasing $1.9 million in 2006 over 2005. Various legal and other administrative costs were lower in 2007 while the increase in 2006 was due to higher environmental, health and safety expenses, information technology costs and legal costs.

 

The three businesses acquired in 2006 and 2005 added $4.9 million to SG&A expense in 2006 compared to 2005. The change in expenses in 2007 versus 2006 was more modest since the operations were owned for essentially all of both years.

 

The litigation settlement gain of $8.7 million resulted from the settlement of a lawsuit against our former insurers in the fourth quarter 2007. We originally filed the lawsuit in order to resolve a dispute over how insurance coverage should be applied to incurred indemnity losses and defense costs. The court previously had issued a summary judgment in our favor in the third quarter 2006 and awarded us damages of $7.8 million. The defendants did not pay the award at that time and, due to the uncertainty of the appeal process, we did not record the benefits of that award in our Consolidated Financial Statements. Under the terms of the settlement, the insurers agreed to pay us $17.5 million and to provide enhanced insurance coverage. This enhanced insurance includes occurrence based coverage for years up to the date of the settlement, including years when we did not have any beryllium-related product liability insurance. We agreed to dismiss our bad faith claim against the insurers, which was scheduled to go to trial in the first quarter 2008, as well as the prior damage award of $7.8 million.

 

We applied $1.1 million of the settlement against amounts recorded on our Consolidated Balance Sheet as recoverable amounts for previously incurred indemnity and defense costs. The remaining $16.4 million was credited to income on the Consolidated Statement of Income. We incurred $7.7 million of legal fees pursuing the lawsuit and negotiating the settlement agreement in 2007, yielding a net pre-tax benefit to income of $8.7 million.

 

One of the insurers paid $6.2 million, which represented their share of the settlement, directly to our attorneys prior to December 31, 2007 in partial settlement of our fees, reducing our receivable from the insurers and the payable to our attorneys by the same amount. The remaining $11.3 million due to us was recorded in other receivables on the Consolidated Balance Sheet as of December 31, 2007 and was subsequently paid in full in the first quarter 2008.

 

Research and development expenses (R&D) were $5.0 million in 2007, $4.2 million in 2006 and $5.0 million in 2005. R&D expenses were below 1% of sales in each of the last three years, although we did increase our R&D spending rate in 2007. In the fourth quarter 2006, the Specialty Engineered Alloys segment consolidated its R&D laboratory that was in Cleveland, Ohio into the existing laboratory in Elmore, Ohio in order to improve efficiencies and response times. R&D efforts are focused on developing new products and applications as well as continuing improvements in our existing products.

 

Other-net expense for each of the last three years is summarized in the following table:

 

 

Foreign currency exchange gains and losses result from movements in value of the U.S. dollar against the euro, yen and sterling and the maturity of hedge contracts. The income or expense on the directors’ deferred

compensation plan is a function of the outstanding shares in the plan and movements in the market price of our stock. In 2007 and 2006, the share price increased, which increased our liability to the plan and created a higher expense. In 2005, the share price declined, which reduced our liability to the plan and generated income. Metal financing fees are a function of the quantity and market price of precious metals held on consignment. Derivative ineffectiveness represents changes in the fair value of a derivative financial instrument that does not qualify for the favorable hedge accounting treatment. The debt prepayment cost of $4.4 million in 2005 included the penalty and write-off of associated deferred financing costs as a result of the prepayment of $30.0 million of subordinated debt in the fourth quarter and $18.6 million of term notes in the first quarter 2005.

 

In the first quarter of 2007, we sold substantially all of the operating assets and liabilities of Circuits Processing Technology, Inc. (CPT), a wholly owned subsidiary that manufactures thick film circuits, for $2.2 million. CPT, which was acquired in 1996, was a small operation with limited growth opportunities. The loss on the sale was approximately $0.3 million.

 

Other-net expense also includes bad debt expense, cash discounts, gains and losses on the sale of fixed assets and other non-operating items.

 

Operating profit of $84.5 million was an improvement of $40.7 million, or 93%, over the operating profit of $43.8 million generated in 2006. The operating profit in 2007 established a record high. The profit margin on the sale of the 2006 ruthenium inventory due to the sudden market price escalation, the lower of cost or market charges from the subsequent ruthenium price decline and the litigation settlement gain accounted for $27.1 million of the profit improvement in 2007. All other factors combined to improve operating profit $13.6 million, or 31%, over 2006. Operating profit was 9% of sales in 2007, 6% of sales in 2006 and 4% of sales in 2005.

 

Operating profit in 2006 was $24.3 million higher than the $19.5 million of profit earned in 2005. The improved profit resulted from the margin earned on the higher sales volume and from an improved product mix reduced in part by higher manufacturing overhead and SG&A expenses.

 

Interest expense was $1.8 million in 2007, $4.1 million in 2006 and $6.4 million in 2005. The reduced expense in 2007 was primarily due to lower outstanding debt while the lower expense in 2006 as compared to 2005 was largely due to a lower effective borrowing rate. The high rate $30.0 million subordinated debt was paid off in December 2005 with a combination of excess cash and borrowings under the lower rate revolving credit agreement. The declining interest expense also resulted from lower amortization of deferred financing costs each year. The amortization expense was $0.4 million in 2007, $0.5 million in 2006 and $1.1 million in 2005.

 

Income before income taxes was $82.7 million, an improvement of $43.0 million over income before income taxes of $39.7 million in 2006. Income before income taxes in 2006 was more than triple the income before income taxes of $13.1 million in 2005.

 

The income tax expense (benefit) for 2007, 2006 and 2005, including the movement in the deferred tax valuation allowance, is summarized as follows:

 

 

In calculating the tax expense prior to movements in the valuation allowance, the effects of foreign source income and percentage depletion were major causes of the differences between the effective and statutory rates for all three years. The production deduction and executive compensation were also major causes for the difference between the effective and statutory rates in 2007. See Note P to the Consolidated Financial Statements for a reconciliation of the statutory and effective tax rates.

 

The deferred tax valuation allowance was initially recorded in 2002 in accordance with Statement No. 109, “Accounting for Income Taxes”, which requires a company to evaluate its deferred tax assets for impairment in the event of recent operating losses. This evaluation process is not based upon the specific expiration date of the individual deferrals but rather on the company’s ability to demonstrate that future taxable income will result in

utilization of those assets. As a result of a review in the fourth quarter 2002, we determined that it was more likely than not that the majority of our deferred tax assets were impaired and a valuation allowance was recorded accordingly.

 

In subsequent periods, the valuation allowance was either increased to offset the creation of additional deferred tax assets or reduced for the use of deferred tax assets. In 2005, in addition to reducing the valuation allowance by $2.2 million for the use of net operating losses, we also reduced the valuation allowance by $5.9 million as, based upon the earnings trend at that time, as well as various projections, we determined that it was more likely than not that we would utilize this additional portion of our deferred tax assets in future periods.

 

In the fourth quarter 2006, as a result of the improved actual and projected earnings and the actual and projected use of deferred tax assets, we determined it was more likely than not that substantially all of the deferred tax assets would be utilized and we reversed $21.8 million of the valuation allowance back to income. An immaterial valuation allowance associated with our U.K. subsidiary was not reversed and remained on the balance sheet.

 

In 2007, we recorded a $1.1 million benefit of a deferred tax asset associated with certain state tax carryforwards as a reduction to the tax expense. Due to the uncertainty of realizing this asset, a valuation allowance of the same amount was recorded as well. These items offset and had no net impact on the income tax expense in 2007.

 

The valuation allowance did not affect any tax payments or refunds in the three years presented.

 

Net income was $53.3 million, or $2.59 per share diluted, in 2007, $49.6 million, or $2.45 per share diluted, in 2006 and $17.8 million, or $0.92 per share diluted, in 2005. Net income and earnings per share did not grow proportionately with income before income taxes in 2007 as compared to 2006 due to the favorable reversal of the $21.8 million valuation allowance in 2006.

 

Segment Disclosures

 

The Company has four reporting segements. Williams Advanced Materials Inc. (WAM) and its subsidiaries are reported as Advanced Material Technologies and Services. Alloy Products, including Brush Resources Inc., is reported as Specialty Engineered Alloys. Beryllium Products is reported as Beryllium and Beryllium Composites while Technical Materials, Inc. (TMI) is reported as Engineered Material Systems.

 

The All Other column includes our parent company expenses, other corporate charges, the operating results of BEM Services, Inc., a wholly owned subsidiary that provides administrative and financial oversight services to our other businesses on a cost-plus basis, and Zentrix Technologies Inc., a wholly owned subsidiary that manufactures electronic packages and other products. The All Other column shows a profit of $5.0 million in 2007 compared to a loss of $4.8 million in 2006. This improvement was due to the $8.7 million legal settlement gain, the $1.0 million lower expense on the directors’ deferred compensation plan, improved operating performance from Zentrix and other factors. See Note M to the Consolidated Financial Statements.

 

Advanced Material Technologies and Services

 

 

Advanced Material Technologies and Services manufactures precious, non-precious and specialty metal products, including vapor deposition targets, frame lid assemblies, clad and precious metal preforms, high temperature braze materials, ultra-fine wire, specialty inorganic materials, optics and performance coatings. Major markets for these products include data storage, medical and the wireless, semiconductor, photonic and hybrid sectors of the microelectronics market. An in-house refinery and metal cleaning operations allow for the reclaim of precious metals from internally generated or customers’ scrap. Due to the high cost of precious metal products, we emphasize quality, delivery performance and customer service in order to attract and maintain applications. This

segment has domestic facilities in New York, California and Wisconsin and international facilities in Asia and Europe.

 

Sales from Advanced Material Technologies and Services grew significantly in 2007 and 2006 over the respective prior years. Sales of $519.9 million in 2007 were $176.5 million, or 51%, higher than sales of $343.4 million in 2006 while sales in 2006 were 64% higher than in 2005.

 

We adjust our selling prices daily to reflect the current cost of the precious and various non-precious metals sold. The cost of the metal is generally a pass-through to the customer and we generate a margin on our fabrication efforts irrespective of the type or cost of the metal used in a given application. Therefore, the cost and mix of metals sold will affect sales but not necessarily the margin dollars generated by those sales. Metal prices increased on average in each of the last two years and the metal content increased as a percent of sales in both years as well, meaning that the underlying volume growth was less than the growth in the dollar value of sales. The higher metal prices accounted for $29.7 million of the sales increase in 2007 over 2006 and $44.2 million of the sales increase in 2006 over 2005.

 

The majority of the sales growth in 2007 was generated by sales of ruthenium products for media applications to customers in the data storage market. A large portion of this growth was driven by the market’s conversion to the perpendicular magnetic recording technology, which allows for a significant increase in the amount of data that can be stored on the same sized disk. Our product development efforts in recent years have allowed us to capture a share of this growing market. However, the aforementioned quality issue and the change in specifications slowed the rate of growth of our sales to this market, particularly in the second half of 2007.

 

The sales growth in each of the last two years was also due to higher sales of vapor deposition targets. Sales of targets, wire and other products into the wireless and photonic sectors improved in 2007 and 2006 over the respective prior years while demand from other sectors of the microelectronics market softened in 2007. Demand for giant magnetic resistance film applications remained strong during the last two years as well.

 

In the first quarter 2006, we acquired CERAC, incorporated, a manufacturer of physical vapor deposition materials that serves a variety of industries. This acquisition followed two smaller ones in 2005. In the second quarter 2005, we acquired OMC Scientific Limited (OMC), which provides physical vapor deposition material cleaning and reconditioning services to customers in Europe. In the fourth quarter 2005, we acquired Thin Film Technology, Inc. (TFT), which manufactures precision optical coatings, thin film circuits and coatings and other products. These acquisitions serve to expand our capabilities and add further breadth to the existing product offerings. Prior to the acquisitions, we had a supplier or customer relationship with each of these businesses. The three acquired businesses accounted for approximately 22 percentage points of Advanced Material Technologies and Services’ sales growth in 2006 and 5 percentage points of the 2007 sales growth.

 

A portion of the sales growth for this segment in each of the last two years is due to new product development and geographic expansion of the business. The technologies from the three acquisitions are being used in conjunction with the existing technologies and market development staff to develop new applications in a variety of markets. We opened a new facility in the Czech Republic in 2007 that provides shield kit cleaning and target bonding services. We also are in the process of constructing a new facility in China that initially will produce specialty inorganic materials and will offer an additional marketing base to augment our offices in Singapore, Taiwan and Korea.

 

Gross margins generated by Advanced Material Technologies and Services totaled $100.7 million (19% of sales) in 2007, $65.8 million (19% of sales) in 2006 and $41.6 million (20% of sales) in 2005. The higher metal prices and content in sales without a commensurate flow through to margins has the effect of lowering the margin as a percent of sales in both 2007 and 2006.

 

Gross margin grew $34.9 million in 2007 over 2006. The previously discussed $22.9 million benefit from the sale of the low cost ruthenium inventory at higher market prices, the $4.5 million lower of cost or market charges and the $5.7 million quality charge flowed through the gross margin of the Advanced Material Technologies and Services segment. The remaining $22.2 million improvement in the gross margin in 2007 over 2006 was primarily due to the benefits of the higher sales volumes partially offset by a $2.9 million increase in manufacturing overhead. The change in product mix effect was slightly favorable as well.

The higher sales volumes generated approximately $31.3 million in additional margins in 2006 over 2005, while the change in product mix had an immaterial impact on the segment’s gross margin in 2006. Manufacturing overhead costs increased $6.4 million in 2006 mainly as a result of the acquisitions.

 

SG&A, R&D and other-net expenses from Advanced Material Technologies and Services were $41.3 million in 2007, $35.3 million in 2006 and $21.2 million in 2005. Expenses were 8% of sales in 2007, 10% of sales in 2006 and 10% of sales in 2005. Expenses incurred at the Brewster and Buffalo, New York facilities increased in each of the last two years in order to support the growth in the business and to further develop new applications and markets. International expenses increased $1.7 million in 2007 over 2006 as a result of increased activity and in order to support the growth in sales overseas, including the creation of new overseas operations. Incentive compensation expense was $0.8 million higher in 2007 than 2006 and $1.8 million higher in 2006 than 2005 due to the growth in profitability relative to the incentive plan targets. Metal financing fees were unchanged in 2007 as compared to 2006 after growing $0.7 million in 2006 over 2005 due to a combination of higher metal prices and an increased quantity of metal on hand. The incremental expense incurred by the three acquisitions totaled $4.9 million in 2006 as compared to 2005, while the amortization expense, primarily on intangible assets from these acquisitions, was $0.1 million higher in 2007 than 2006 and $0.8 million higher in 2006 than 2005. Domestic administrative costs also increased in 2007 and 2006 over the respective prior year in order to support the larger organization.

 

Operating profit from Advanced Material Technologies and Services improved $28.9 million, growing from $30.5 million in 2006 to $59.4 million in 2007. The operating profit in 2006 was an improvement of $10.1 million over the operating profit of $20.4 million in 2005. Operating profit was 11% of sales in 2007, 9% in 2006 and 10% in 2005.

 

Specialty Engineered Alloys

 

 

Specialty Engineered Alloys manufactures and sells three main product families:

 

Strip products, the larger of the product families, include thin gauge precision strip and thin diameter rod and wire. These copper and nickel beryllium alloys provide a combination of high conductivity, high reliability and formability for use as connectors, contacts, switches, relays and shielding. Major markets for strip products include telecommunications and computer, automotive electronics, appliance and medical;

 

Bulk products are copper and nickel-based alloys manufactured in plate, rod, bar, tube and other customized forms that, depending upon the application, may provide superior strength, corrosion or wear resistance, thermal conductivity or lubricity. While the majority of bulk products contain beryllium, a growing portion of bulk products sales is from non-beryllium-containing alloys as a result of product diversification efforts. Applications for bulk products include plastic mold tooling, bearings, bushings, welding rods, oil and gas drilling components and telecommunications housing equipment; and,

 

Beryllium hydroxide is produced by Brush Resources Inc., a wholly owned subsidiary, at its milling operations in Utah from its bertrandite mine and purchased beryl ore. The hydroxide is used primarily as a raw material input for strip and bulk products as well as by the Beryllium and Beryllium Composites segment. External sales of hydroxide from the Utah operations were less than 3% of Specialty Engineered Alloys’ total sales in each of the three most recent years.

 

Strip and bulk products are manufactured at facilities in Ohio and Pennsylvania and are distributed worldwide through a network of company-owned service centers and outside distributors and agents.

 

Sales from Specialty Engineered Alloys were $290.0 million in 2007, which was $14.4 million, or 5%, greater than sales of $275.6 million in 2006. Sales in 2006 were 29% higher than sales of $213.8 million in 2005. Sales of bulk products increased in 2007 while strip product sales declined. In 2006, sales of both strip and bulk products were higher than in 2005. The change in total volumes shipped between years was less than the growth in sales value

due to the impact of the higher metal prices and the pass-through effect on sales in both 2007 and 2006 as compared to the respective prior year.

 

Strip product shipment volumes declined 11% in 2007 after growing 6% in 2006. Shipments of both the higher beryllium-containing and lower beryllium-containing strip products were down in 2007. Demand from the telecommunications and computer market for these products, including hand set applications, softened in 2007. Demand from the automotive market was relatively flat. Shipments of the higher beryllium-containing alloys had grown in 2006 over 2005 while shipments of the lower beryllium-containing alloys declined. Volumes of thin diameter rod and wire products increased in each of the last two years.

 

Bulk product shipment volumes grew 3% in 2007 over 2006 and 16% in 2006 over 2005. Demand from the aerospace market continued to be strong in 2007 after growing significantly in 2006. Sales of bulk products into this market in 2007 were approximately twice the sales level in 2005. Sales into the industrial components market also increased in each of the last two years. The higher energy prices have helped spur demand for our products from the oil and gas sector of this market while the continued development of applications utilizing non-beryllium-containing alloys in the heavy equipment sector have contributed to the growth as well. The plastic tooling sector of the industrial components market remained weak in 2007.

 

Sales of new products contributed to the growth in Specialty Engineered Alloy sales, including products for undersea telecommunications and homeland security.

 

Specialty Engineered Alloys generated a gross margin of $58.2 million in 2007 compared to $65.9 million in 2006. The gross margin in 2006 was an increase of $22.8 million over the gross margin of $43.1 million in 2005. Gross margin was 20% of sales in 2007, 24% of sales in 2006 and 20% of sales in 2005.

 

The reduced gross margin in 2007 was caused partially by the lower sales volumes as a large portion of the sales increase was due to the pass-through of higher metal prices that did not generate any additional margin. In addition, production volumes were lower than the sales volumes as inventory levels were reduced in 2007, which has an adverse effect on cost of sales.

 

The cost of raw materials used by Specialty Engineered Alloys increased significantly in 2007 and 2006. The average price of copper in 2007 was approximately twice the price in 2005, while nickel prices in 2007 were more than double the prices from two years ago. In the second half of 2006, we increased the proportion of sales subject to a metal price pass-through and the improved pricing helped to offset these higher costs. However, the full year margin benefit of the improved pricing in 2007 was more than offset by yield and performance and other manufacturing issues, primarily at the Elmore facility, an unfavorable change in product mix and other factors.

 

The higher sales volume in 2006 generated an estimated $18.2 million of margin over 2005 while the change in product mix also improved margins in 2006, primarily due to the growth in higher beryllium-containing strip and thin diameter rod and wire sales. An improvement in manufacturing yields also contributed to the margin growth in 2006. The higher copper cost that could not be passed through to customers reduced margins by an estimated $1.8 million in 2006 as compared to 2005.

 

Total SG&A, R&D and net-other expenses were $50.7 million in 2007, a decline of $7.2 million from the $57.9 million expense in 2006. Expenses in 2006 were $9.5 million higher than in 2005. Incentive compensation expenses were $3.7 million lower in 2007 than 2006 after increasing $5.5 million in 2006 over 2005. One-time costs associated with the closure of the New Jersey service center added $1.1 million to SG&A expenses in 2006. Corporate charges were also lower in 2007 than 2006 after increasing in 2006 over 2005.

 

Operating profit from Specialty Engineered Alloys was $7.6 million in 2007, a decline of $0.3 million from the profit of $7.9 million in 2006. In 2005, Specialty Engineered Alloys recorded an operating loss of $5.4 million.

 

Beryllium and Beryllium Composites

 

Beryllium and Beryllium Composites manufactures beryllium-based metals and metal matrix composites in rod, sheet, foil and a variety of customized forms at the Elmore, Ohio and Fremont, California facilities. These materials are used in applications that require high stiffness and/or low density and they tend to be premium priced due to their unique combination of properties. This segment also manufactures beryllia ceramics through our wholly owned subsidiary Brush Ceramic Products in Tucson, Arizona. Defense and government-related applications, including aerospace, is the largest market for Beryllium and Beryllium Composites, while other markets served include medical, telecommunications and computer, electronics (including acoustics), optical scanning and automotive electronics.

 

Sales from Beryllium and Beryllium Composites during the 2005 to 2007 timeframe included shipments under two distinct, non-repeating programs — the James Webb Space Telescope (JWST) for NASA and the Joint European Torus (JET), a nuclear fusion reactor. A summary of the segment sales for these two projects and all other customers is as follows:

 

 

Both the JWST and JET projects were substantially complete as of December 31, 2007 and we do not anticipate significant sales for either project in 2008.

 

While total Beryllium and Beryllium Composites sales grew 5% in 2007 and 9% in 2006 over the respective prior year, sales to all customers excluding the JWST and JET grew 17% in 2007 and 19% in 2006. This growth was primarily due to increased demand from the defense market. Sales for defense platforms, mainly aerospace and missile systems, improved in the second half of 2006 and remained strong throughout 2007 after slowing down in 2005 and early 2006 due to government budget revisions that had diverted funds away from these types of applications. Sales for medical and industrial x-ray applications from the Fremont facility increased each of the last two years. Sales of new products, including applications using near net shape technologies also contributed to the sales growth in 2007. Sales of ceramics declined in 2007 compared to 2006 and were approximately equal to the sales in 2005.

 

The gross margin on sales of Beryllium and Beryllium Composites was $20.1 million (33% of sales) in 2007, $18.7 million (32% of sales) in 2006 and $19.0 million (36% of sales) in 2005. The margin growth in 2007 was due to the incremental margin generated by the higher sales volumes partially offset by an unfavorable change in the product mix. This mix shift was a combination of the declining volumes of the JET and JWST programs and the increased sales for the new applications that tend to carry lower margins. An unfavorable product mix shift in 2006 more than offset the margin benefit from the increased sales in that year compared to 2005.

 

SG&A, R&D and other net expenses were $12.2 million in 2007 (20% of sales) in 2007, $11.3 million (20% of sales) in 2006 and $9.1 million (17% of sales) in 2005. The growth in SG&A expenses in 2007 was partially due to additional costs to support the sales growth. Expenses also increased in 2007 and 2006 due to implementing a program to invest in people and processes that is designed to improve the timing, coordination and efficiency of the entire order fulfillment process, from application design to order placement to shipment and billing. Incentive compensation costs were unchanged between 2007 and 2006 but were higher in 2006 than 2005. Legal costs were also higher in 2006 than 2005.

 

Operating profit from Beryllium and Beryllium Composites was $7.8 million in 2007, an improvement of $0.4 million over profit of $7.4 million in 2006. In 2005, this segment earned a profit of $9.8 million. The growth in profitability in 2007 was generated by the higher margin earned on the increased sales offset in part by higher expenses. The decline in profitability in 2006 from 2005 was primarily due to the margin impact caused by the mix shift, mainly the lower JWST sales. Profit as a percent of sales was 13% in both 2007 and 2006 and 19% in 2005.

Engineered Material Systems

 

 

Engineered Material Systems include clad inlay and overlay metals, precious and base metal electroplated systems, electron beam welded systems, contour profiled systems and solder-coated metal systems. These specialty strip metal products provide a variety of thermal, electrical or mechanical properties from a surface area or particular section of the material. Our cladding and plating capabilities allow for a precious metal or brazing alloy to be applied to a base metal only where it is needed, reducing the material cost to the customer as well as providing design flexibility. Major applications for these products include connectors, contacts and semiconductors. The largest markets for Engineered Material Systems are automotive electronics, telecommunications and computer electronics and data storage, while the energy and defense and medical electronic markets offer further growth opportunities. Engineered Material Systems are manufactured at our Lincoln, Rhode Island facility.

 

Engineered Material Systems’ sales of $70.9 million improved $2.2 million, or 3%, over sales of $68.7 million in 2006, while sales in 2006 improved $18.7 million, or 38%, over sales of $50.0 million in 2005.

 

The sales growth in each of the last two years was largely due to new products. Sales of materials for disk drive arm applications in computer equipment, in particular, have been a significant contributor to the sales growth. Sales of these and other new products, including fuses and switches, and sales for new applications in the energy and medical markets helped to offset softness in portions of Engineered Material Systems’ traditional markets and applications.

 

The domestic automotive electronics market demand, which had improved in 2006 over 2005, began to weaken in the fourth quarter 2006 and remained weak until late in the third quarter 2007 when the order entry rate began to strengthen. We also continued our efforts to develop programs and implement marketing strategies overseas in order to capture transplant automotive business and further develop other applications in the Asian market.

 

Gross margin on Engineered Material Systems’ sales in 2007 was $13.0 million, a 14% improvement over the gross margin of $11.3 million in 2006, while the 2006 gross margin was an improvement of $4.7 million (or 71%) over 2005. As a percent of sales, gross margin improved in each of the last two years, growing from 13% in 2005 to 17% in 2006 and 18% in 2007.

 

The major cause for the improvement in gross margin in both years was the increase in sales. Yields and other manufacturing efficiencies improved in 2007, particularly in the fourth quarter. A portion of this improvement was due to recent capital investments. Improved yields on the manufacturing of disk drive arms beginning early in 2006 contributed to the margin gains in 2006 over 2005. The change in product mix effect was favorable in both years as well. Manufacturing overhead costs were relatively unchanged in 2007 compared to 2006 after increasing $1.9 million in 2006 due to higher manpower and utility costs.

 

SG&A, R&D and other-net expenses from Engineered Material Systems were $0.3 million lower in 2007 than in 2006 while these expenses were $2.6 million higher in 2006 than in 2005. Legal and administrative costs were lower in 2007 than in 2006. In 2006, these costs were higher due to efforts to develop a joint venture in China; we decided not to pursue this effort any further early in the first quarter 2007. Incentive compensation costs were higher in 2007 than 2006 but this increase was largely offset by lower corporate charges. Incentive compensation accounted for approximately $1.0 million of the increased expense in 2006 while cost allocations from the corporate office were $0.5 million higher. The balance of the higher expense in 2006 was due to increased costs to support the higher level of sales, additional marketing costs and the aforementioned legal and administrative costs for the China joint venture.

 

Operating profit generated by Engineered Material Systems was $4.7 million (7% of sales) in 2007, $2.7 million (4% of sales) in 2006 and $0.7 million (1% of sales) in 2005.

International Sales and Operations

 

We operate in worldwide markets and our international customer base continues to expand due to the development of various foreign nations’ economies and the relocation of U.S. businesses overseas. Our international operations are designed to provide a cost-effective method of capturing the growing overseas demand for our products.

 

Advanced Material Technologies and Services has operations in Singapore, Taiwan, the Philippines and Ireland. In 2007, Advanced Material Technologies and Services constructed new facilities in China and the Czech Republic.

 

Brush International has service centers in Germany, England, Japan and Singapore that primarily focus on the distribution of Specialty Engineered Alloys while also providing additional local support to portions of our other businesses.

 

We also have branch sales offices and other operations in various countries, including China, Japan, Korea and Taiwan, and we utilize an established network of independent distributors and agents throughout the world.

 

Total international sales, including sales from international operations as well as direct exports from the U.S., were as follows:

 

 

The international sales presented in the above table are included in individual segment sales figures previously discussed. The majority of international sales are to the Pacific Rim, Europe and Canada.

 

The increase in international sales in both 2007 and 2006 was primarily in Asia, although sales to Europe grew both years as well. Asian sales grew 73% in 2007 over 2006 and 51% in 2006 over 2005. A large portion of the Asian sales growth was due to increased sales to the data storage market. It also resulted from additional penetration of other markets and the relocation of U.S. production to overseas locations.

 

Data storage, telecommunications and computer and automotive electronics are the largest international markets for our products. The appliance market for Specialty Engineered Alloys is a more significant market, primarily in Europe, than it is domestically while government and defense applications are not as prevalent overseas as they are in the U.S. Our market share is smaller in the overseas markets than it is domestically and, given the macro-economic growth potential for the international economies, including the continued transfer of U.S. business to overseas locations, the international markets may present greater long-term growth opportunities. We believe that a large portion of the long-term international growth will come from Asia and we continue to expand our marketing presence, distributor arrangements and customer relationships there.

 

Sales from the European and certain Asian operations are denominated in the local currency. Exports from the U.S. and the balance of the sales from the Asian operations are denominated in U.S. dollars. In 2007, the dollar weakened on average against the currencies in which we sell and the currency effect on the translation of foreign currency sales was a favorable $4.1 million as compared to 2006. In 2006, the dollar strengthened on average and the currency translation effect on sales was an unfavorable $1.3 million as compared to 2005. Local competition limits our ability to adjust selling prices upwards to compensate for short-term unfavorable exchange rate movements. We have a hedge program with the objective of minimizing the impact of fluctuating currency values on our reported results.

 

Legal Proceedings

 

One of our subsidiaries, Brush Wellman Inc., is a defendant in proceedings in various state and federal courts brought by plaintiffs alleging that they have contracted chronic beryllium disease or other lung conditions as a result of exposure to beryllium. Plaintiffs in beryllium cases seek recovery under negligence and various other legal

theories and seek compensatory and punitive damages, in many cases of an unspecified sum. Spouses, if any, claim loss of consortium.

 

The following table summarizes the associated activity with beryllium cases.

 

 

Settlement payment and dismissal for a single case may not occur in the same period.

 

Additional beryllium claims may arise. Management believes that we have substantial defenses in these cases and intends to contest the suits vigorously. Employee cases, in which plaintiffs have a high burden of proof, have historically involved relatively small losses to us. Third-party plaintiffs (typically employees of customers or contractors) face a lower burden of proof than do employees or former employees, but these cases are generally covered by varying levels of insurance.

 

Although it is not possible to predict the outcome of the litigation pending against our subsidiaries and us, we provide for costs related to these matters when a loss is probable and the amount is reasonably estimable. Litigation is subject to many uncertainties, and it is possible that some of these actions could be decided unfavorably in amounts exceeding our reserves. An unfavorable outcome or settlement of a pending beryllium case or additional adverse media coverage could encourage the commencement of additional similar litigation. We are unable to estimate our potential exposure to unasserted claims.

 

Based upon currently known facts and assuming collectibility of insurance, we do not believe that resolution of the current beryllium proceedings will have a material adverse effect on our financial condition or cash flow. However, our results of operations could be materially affected by unfavorable results in one or more of these cases. As of December 31, 2007, two purported class actions were pending.

 

The balances recorded on the Consolidated Balance Sheets associated with beryllium litigation were as follows:

 

 

Both the reserve and the recoverable declined in 2007 as a result of changes in outstanding cases. The recoverable account, which represents amounts due on outstanding as well as previously paid claims, also declined as a result of the legal settlement with our insurers in the fourth quarter 2007.

 

Regulatory Matters.  Standards for exposure to beryllium are under review by the United States Occupational Safety and Health Administration and by other governmental and private standard-setting organizations. One result of these reviews will likely be more stringent worker safety standards. The development, proposal or adoption of more stringent standards may affect buying decisions by the users of beryllium-containing products. If the standards are made more stringent and/or our customers or other downstream users decide to reduce their use of beryllium-containing products, our operating results, liquidity and capital resources could be materially adversely affected. The impact of this potential adverse effect would depend on the nature and extent of the changes to the standards, the cost and ability to meet the new standards, the extent of any reduction in customer use and other factors. The magnitude of this potential adverse effect cannot be estimated.

FINANCIAL POSITION

 

Working Capital

 

Cash flow from operations totaled $54.4 million in 2007 compared to $38.8 million in 2006. Cash flow from operations strengthened in the second half of 2007, totaling $42.9 million for the six month period. The cash balance was $31.7 million at December 31, 2007, an increase of $16.1 million from the balance of $15.6 million at December 31, 2006 as the cash flow from operations coupled with the proceeds from the exercise of stock options were more than enough to fund capital expenditures and reduce debt.

 

Accounts receivable totaled $97.4 million at year-end 2007 and was $10.9 million, or 13% higher than the receivable balance of $86.5 million at year-end 2006. The growth in receivables was due to the higher sales volumes in the fourth quarter 2007 as compared to the fourth quarter 2006. Receivables grew at a slightly slower pace than sales due to an improvement in the average collection period. The year-end days sales outstanding (DSO), a measure of how quickly receivables are collected, after adjusting for the unearned revenue effect, improved by approximately one day from year-end 2006. Accounts receivable grew $16.6 million in 2006 over the prior year-end as a result of higher sales volumes net of an improved DSO in that period. Accounts written off to bad debt expense remained relatively minor in 2007 and 2006.

 

Inventories of $165.2 million at December 31, 2007 were $13.2 million, or 9% higher than inventories of $152.0 million at December 31, 2006. Despite the growth in the inventory balance, inventory turns, a measure of how efficiently inventory is utilized, improved in 2007. The majority of the growth in inventories was in Advanced Material Technologies and Services. This segment maintains the majority of its precious metals on off-balance sheet arrangements. However, a significant portion of its sales growth in both 2007 and 2006 was in products that use other metals that are owned and not held on consignment, including ruthenium. Inventories of these materials increased in both 2007 and 2006 in order to support the growth in those sales.

 

Inventories grew $47.9 million (or 46%) in 2006 and turns declined slightly. In addition to the increase in Advanced Material Technologies and Services’ inventory, Specialty Engineered Alloys’ inventory level increased as of December 31, 2006 in part to support the higher anticipated sales volume in the first quarter 2007.

 

The higher cost of certain metals, including copper, nickel, gold and other precious metals, increased the value of the inventory on a first-in, first-out (FIFO) basis in each of the last two years; however, this impact was partially offset by the use of the last-in, first-out (LIFO) valuation method for these metals, limiting the impact on the increase in inventory value on the balance sheet. The FIFO inventory value, LIFO reserve and LIFO inventory value of inventory as of year-end 2007, 2006 and 2005 and the annual change in those balances were as follows:

 

 

In 2007, approximately $8.2 million of the $23.9 million increase in the FIFO value was due to higher metal prices that, in turn, was offset by an increase in the LIFO reserve. In 2006, approximately $24.0 million of the increase in the FIFO value was due to higher metal prices that were offset by the LIFO reserve increase.

 

Prepaid expenses, including insurance, property taxes, rent and other items, totaled $17.7 million as of December 31, 2007 and were $3.7 million higher than the $14.0 million balance as of December 31, 2006. The prepaid expense balance declined $0.4 million in 2006 from the year-end 2005 balance. Prepaid expenses also include the short-term fair value of derivative instruments that are in a gain position. Fair values of derivatives included in prepaid expenses were $0.1 million in 2007, $0.6 million in 2006 and $3.4 million in 2005.

Other assets totaled $11.8 million at year-end 2007 compared to $13.6 million at year-end 2006. This decline was primarily due to the amortization of intangible assets totaling $1.6 million. The insurance recoverable account was also reduced as a result of the legal settlement in the fourth quarter and other changes to the individual outstanding cases during the year. Other assets increased $5.3 million during 2006 primarily due to the net change in the value of intangible assets. During 2006, we acquired $6.8 million of intangible assets, the majority of which were part of the purchase of CERAC, while the amortization of intangible assets totaled $1.5 million.

 

Accounts payable of $27.1 million as of December 31, 2007 was a $3.6 million decrease over the prior year-end balance of $30.7 million while the 2006 balance was $9.9 million higher than 2005 year-end. The change in balances between years was primarily due to the timing of payments.

 

Accrued salaries and wages grew $2.1 million in 2007 over 2006 after growing $19.7 million in 2006 over year-end 2005. The changes in the accrued salaries and wages balance in both years were due to changes in the incentive compensation accruals, manpower levels and other related factors.

 

Unearned revenue, which is a liability representing billings to customers in advance of the shipment of product, was $2.6 million as of year-end 2007 and $0.3 million as of year-end 2006.

 

Other long-term liabilities were $11.6 million at year-end 2007, unchanged from the prior year-end. Long-term unearned income increased $3.5 million in 2007 for reimbursements under a government funded capital expenditure program. See Critical Accounting Policies. This increase was offset by reductions in the long-term management incentive plan accrual, due to a portion of the accrual becoming a current liability, and the legal reserve. The legal reserve declined in 2007 as a result of cases being dismissed and the payment of $0.1 million for settlements. Other long-term liabilities grew $3.4 million during 2006 largely due to higher accruals under long-term management incentive plans offset in part by a decrease in the fair value of the outstanding interest rate swap derivative. Legal settlements paid in 2006 were less than $0.1 million.

 

Depreciation and Amortization

 

Depreciation, amortization and depletion was $23.9 million in 2007, $24.6 million in 2006 and $21.7 million in 2005. The $2.9 million increase in expense in 2006 was due in part to the impact of the three acquisitions.

 

Capital Expenditures

 

Capital expenditures for property, plant and equipment and mine development totaled $33.6 million in 2007, $15.5 million in 2006 and $13.8 million in 2005. Capital spending exceeded the level of depreciation in 2007 for the first time since 2001 as we increased the level of capital investment in order to meet our customers’ growing demand, expand our operations, improve efficiencies and upgrade older equipment.

 

Spending within Advanced Material Technologies and Services totaled $10.3 million in 2007 and included the expansion of the Brewster, New York facility to accommodate the growth in the production of targets for media applications and the expansion of the Wheatfield, New York facility. We also constructed a small facility in the Czech Republic while another facility was partially completed in China. Capital spending within this segment totaled $6.3 million in 2006.

 

Capital spending by Specialty Engineered Alloys was $12.5 million in 2007 and $4.5 million in 2006. The spending in 2007 included mine development costs of $7.1 million; we anticipate that we will begin producing ore from the new pit in 2008. The balance of the spending in 2007 and the majority of the spending in 2006 was on small infrastructure projects, equipment upgrades and discreet pieces of equipment. The 2006 spending included purchases of mining equipment in Utah in anticipation of increased mining activity in 2007.

 

Engineered Material Systems’ capital spending totaled $3.0 million in 2007 and $1.8 million in 2006. In 2007, we began installing new equipment and rearranging the existing equipment in order to create a new efficient high technology work center at the Lincoln, Rhode Island facility.

 

Included in the capital expenditure total for 2007 is $3.5 million that was part of a $9.0 million award received under the U.S. Department of Defense’s (DOD) Defense Production Act, Title III program for the design of a new facility for the production of primary beryllium, the feedstock material used to manufacture beryllium metal

products. Reimbursements from the DOD for these capital expenditures are recorded as unearned income and included in other long-term liabilities on the Consolidated Balance Sheet. It is anticipated that the design phase of this project will be completed in 2008. The design phase will determine the total cost of the facility, which we currently estimate will be between $70.0 and $90.0 million. A portion of the total cost of the facility, which we will own, will be borne by us. We anticipate that construction will begin in 2008 and will take two to three years to complete. Additional Title III approval is still required. Since 2000, all of our metallic beryllium requirements have been supplied from materials purchased from the National Defense Stockpile and international vendors. Successful completion of this project will allow for the creation of the only domestic facility capable of producing primary beryllium.

 

In addition to the above capital expenditure total, we acquired the stock of CERAC in the first quarter 2006 for $25.7 million, net of cash received.

 

While certain pieces of equipment may have been capacity-constrained or operated near their capacity, in general, we had sufficient production capacity to meet the level of demand throughout 2007.

 

Retirement and Post-employment Benefits

 

The liability for the domestic defined benefit pension plan is included in retirement and post-employment obligations on the Consolidated Balance Sheet and is calculated in accordance with Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an Amendment of FASB Statements 87, 88, 106 and 132(R)” which we adopted in the fourth quarter 2006.

 

The projected benefit obligation for this plan was $124.2 million at year-end 2007, an increase of $0.4 million from year-end 2006. The market value of the plan assets, however, increased $4.6 million in 2007, from $102.6 million in 2006 to $107.2 million in 2007 as a result of investment returns and a plan contribution net of benefits and expenses paid. The plan was 86% funded as of December 31, 2007.

 

The domestic pension liability on the Consolidated Balance Sheets totaled $17.0 million as of December 31, 2007 and $21.0 million as of December 31, 2006. In the fourth quarter 2007, we reduced the minimum pension liability and recorded a pre-tax benefit to other comprehensive income (OCI), a component of shareholders’ equity, of $4.0 million as a result of the plan performance and changes in plan assumptions. In the fourth quarter of 2006, we recorded a pre-tax benefit to OCI of $9.3 million as a result of those factors in that year plus the impact of adopting Statement No. 158.

 

Brush International’s subsidiary in Germany has an unfunded retirement plan for its employees while its subsidiary in England has a funded retirement plan. See Note I to the Consolidated Financial Statements for additional details.

 

A portion of our retirees and current employees are eligible to participate in a retiree medical benefit plan. The liability for this plan, which is unfunded, was $34.2 million at December 31, 2007 and $31.4 million at December 31, 2006. The plan expense was $2.2 million in 2007 and 2006. In the fourth quarter 2007, the liability was increased and a pre-tax charge of $3.1 million was recorded against OCI. In 2006, the liability was reduced and a pre-tax benefit of $2.2 million was recorded against OCI as a result of the adoption of Statement No. 158 and other factors.

 

Shareholders’ Equity

 

Shareholders’ equity totaled $353.7 million at December 31, 2007, an increase of $62.7 million over equity of $291.0 million at December 31, 2006. Equity increased $79.6 million in 2006. The main cause for the increase in both years was comprehensive income, which totaled $52.0 million in 2007 and $58.7 million in 2006. See Note L to the Consolidated Financial Statements. We received $5.0 million for the exercise of approximately 296,000 stock options in 2007 compared to $13.6 million for the exercise of approximately 841,000 stock options in 2006. Equity was also affected by the tax benefits on the exercise of options and other factors in both years.

 

We adopted FASB Interpretation No. 48, “Accounting for Uncertainties in Income Taxes, an interpretation of FASB Statement No. 109” (FIN 48) as of January 1, 2007. FIN 48 provides guidance on the financial statement

recognition, measurement, treatment and disclosure of a tax position taken or expected to be taken on a tax return as well as the associated interest and penalties. As a result of adopting FIN 48, we increased our accrued income tax payable by $1.4 million with the offset recorded as a charge against retained earnings as of January 1, 2007. Prior year results were not restated for the adoption of FIN 48. Charges to the income statement in 2007 as a result of FIN 48 were immaterial.

 

Debt and Off-balance Sheet Obligations

 

In the fourth quarter 2007, we negotiated a new $240.0 million revolving credit agreement replacing the prior $125.0 million revolving credit agreement. The new agreement matures in the fourth quarter 2012 and is comprised of sub-facilities for revolving loans, swing line loans, letters of credit and foreign currency denominated borrowings. The agreement also provides for an uncommitted incremental facility whereby, under certain circumstances, we may be able to borrow an additional $50.0 million. The covenants and other terms in the new agreement are less restrictive than the prior agreement and the borrowing costs are lower.

 

Outstanding debt totaled $35.5 million as of December 31, 2007, a decrease of $13.5 million from the $49.0 million balance at the prior year-end. Short-term debt of $24.9 million declined $3.2 million during 2007 and included $19.8 million of gold-denominated debt and $5.1 million of foreign currency denominated debt designed as hedges against assets similarly denominated. The gold-denominated loan’s value increased due to the higher price of gold at year-end 2007. Long-term debt stood at $10.6 million as of year-end 2007 with $0.6 million classified as currently payable. Long-term debt declined $10.3 million during 2007 as a result of the pay down of borrowings under the revolving credit agreement and the pay-off of the $0.8 million Utah variable rate promissory note. We were in compliance with our debt covenants as of December 31, 2007.

 

Total debt declined $8.2 million in 2006, despite borrowing $26.2 million to purchase CERAC in January 2006. Short-term debt totaled $28.1 million as of December 31, 2006 and included $15.0 million of gold-denominated debt and $5.2 million of foreign currency denominated debt. Short-term borrowings under the revolving credit agreement totaled $7.9 million. Total short-term debt increased $4.4 million during 2006. Long-term debt of $20.9 million declined $12.6 million during 2006 and included borrowings under the revolving credit agreement and three other variable rate instruments.

 

We maintain the majority of our precious metal inventories on a consignment basis in order to reduce our metal price exposure. See the Quantitative and Qualitative Disclosures About Market Risk in Part II, Item 7A. In 2007, we renegotiated our metal financing lines and increased the available capacity under these lines by $96.0 million. The notional value of the off-balance sheet inventory was $71.2 million at December 31, 2007 compared to $62.2 million at December 31, 2006. This increase in value was due to higher metal prices as of year-end 2007 than at year-end 2006, offset in part by lower quantities on hand.

 

Contractual Obligations

 

A summary of payments to be made under long-term debt agreements and operating leases, pension plan contributions and material purchase commitments by year is as follows:

 

 

We anticipate that a new debt agreement will be negotiated prior to the maturation of the current revolving credit agreement in 2012. Outstanding borrowings under the revolving credit agreement totaled $1.1 million as of December 31, 2007. See Note F to the Consolidated Financial Statements for additional debt information. The lease payments represent payments under non-cancelable leases with initial lease terms in excess of one year as of December 31, 2007. See Note G to the Consolidated Financial Statements for further leasing details.

The pension plan contribution in the above table refers to the domestic defined benefit plan. Contributions to the plan are based upon the plan’s funded ratio, which is affected by actuarial assumptions, plan performance, amendments and other factors. Therefore, it is not practical to estimate contributions to the plan beyond one year. However, we anticipate that additional contributions will be required in years subsequent to 2008 in order to comply with government funding requirements. The amount shown in the table represents our best estimate of the 2008 contribution as of early in 2008.

 

The purchase commitments include $3.2 million for capital equipment to be acquired in 2008 and $7.7 million for raw materials to be acquired under long-term supply agreements. See Note J to the Consolidated Financial Statements.

 

Other

 

We believe that cash flow from operations plus the available borrowing capacity and the current cash balance are adequate to support operating requirements, capital expenditures, projected pension plan contributions, environmental remediation projects and strategic acquisitions. Cash flow from operations was positive in 2007 and 2006. During 2006 and 2007, debt declined a total of $21.7 million while the cash balance increased $21.1 million despite an increase in the capital spending rate and the completion of a $25.7 million acquisition. The new revolving line of credit has increased our borrowing capacity and provides more flexible covenants and terms. The debt-to-debt-plus-equity ratio, a measure of leverage, improved in each of the last two years. In addition to the $31.7 million cash balance, available borrowings under existing unused lines of credit totaled $217.0 million as of December 31, 2007.

 

Portions of the cash balances may be invested in high quality, highly liquid investments with maturities of three months or less.

 

ENVIRONMENTAL

 

We have an active program of environmental compliance. We estimate the probable cost of identified environmental remediation projects and establish reserves accordingly. The environmental remediation reserve balance was $5.2 million at December 31, 2007 and $5.1 million at December 31, 2006. There were no new significant remediation projects identified during either 2007 or 2006. Payments against the reserve totaled $0.1 million in both 2007 and in 2006. See Note J to the Consolidated Financial Statements.

 

ORE RESERVES

 

Brush Resources’ reserves of beryllium-bearing bertrandite ore are located in Juab County, Utah. An ongoing drilling program has generally added to proven reserves. Proven reserves are the measured quantities of ore commercially recoverable through the open-pit method. Probable reserves are the estimated quantities of ore known to exist, principally at greater depths, but prospects for commercial recovery are indeterminable. Ore dilution that occurs during mining is approximately seven percent. Approximately 87% of beryllium in ore is recovered in the extraction process. We augment our proven reserves of bertrandite ore through the purchase of imported beryl ore. This ore, which is approximately 4% beryllium, is also processed at Brush Resources’ Utah extraction facility.

 

We use computer models to estimate ore reserves, which are subject to economic and physical evaluation. Development drilling can also affect the total ore reserves to some degree, although there was no development drilling activity in 2007 or 2006. The requirement that reserves pass an economic test causes open-pit mineable ore to be found in both proven and probable geologic settings. Proven reserves have decreased slightly in each of the last four years while probable reserves have remained unchanged over the same time period. We own approximately 95% of the proven reserves, with the remaining reserves leased. Based upon average production levels in recent

years, proven reserves would last in excess of one hundred years. Ore reserves classified as possible are excluded from the following table.

 

 

CRITICAL ACCOUNTING POLICIES

 

The preparation of financial statements requires the inherent use of estimates and management’s judgment in establishing those estimates. The following are the most significant accounting policies we use that rely upon management’s judgment.

 

Accrued Liabilities.  We have various accruals on our balance sheet that are based in part upon management’s judgment, including accruals for litigation, environmental remediation and workers’ compensation costs. We establish accrual balances at the best estimate determined by a review of the available facts and trends by management and independent advisors and specialists as appropriate. Absent a best estimate, the accrual is established at the low end of the estimated reasonable range in accordance with Statement No. 5, “Accounting for Contingencies”. Litigation and environmental accruals are only established for identified and/or asserted claims; future claims, therefore, could give rise to increases to the accruals. The accruals are adjusted as facts and circumstances change. The accruals may also be adjusted for changes in our strategies or regulatory requirements. Since these accruals are estimates, the ultimate resolution may be greater or less than the established accrual balance for a variety of reasons, including court decisions, additional discovery, inflation levels, cost control efforts and resolution of similar cases. Changes to the accruals would then result in an additional charge or credit to income. See Note J to the Consolidated Financial Statements.

 

Certain legal claims are subject to partial or complete insurance recovery. The accrued liability is recorded at the gross amount of the estimated cost and the insurance recoverable, if any, is recorded as a separate asset and is not netted against the liability. The accrued legal liability includes the estimated indemnity cost only, if any, to resolve the claim through a settlement or court verdict. The legal defense costs are not included in the accrual and are expensed in the period incurred, with the level of expense in a given year affected by the number and types of claims we are actively defending.

 

The enhanced insurance coverage included in the litigation settlement with our insurers in the fourth quarter 2007 provides for coverage of non-employee claims for beryllium disease made prior to year-end 2022 where any portion of the alleged exposure period is prior to January 1, 2008. This occurrence-based coverage now insures claims from various prior years where we previously had little or sometimes no coverage. The insurance covers defense costs and indemnity payments and is subject to a $1.0 million annual deductible. There was no deductible associated with the prior coverage.

 

Pensions.  We have a defined benefit pension plan that covers a large portion of our current and former domestic employees. We account for this plan in accordance with Statement No. 158. Under this statement, the carrying values of the associated assets and liabilities are determined on an actuarial basis using numerous actuarial and financial assumptions. Differences between the assumptions and current period actual results may be deferred into the net pension asset or liability value and amortized against future income under established guidelines. The deferral process generally reduces the volatility of the recognized net pension asset or liability and current period income or expense. Unrealized gains or losses are recorded in OCI. The actuaries adjust certain assumptions to reflect changes in demographics and other factors, including mortality rates and employee turnover, as warranted. Management annually reviews other key assumptions, including the expected return on plan assets, the discount rate

and the average wage rate increase, against actual results, trends and industry standards and makes adjustments accordingly. These adjustments may then lead to a higher or lower expense in a future period.

 

Our pension plan investment strategies are governed by a policy adopted by the Retirement Plan Review Committee of the Board of Directors. The future return on pension assets is dependent upon the plan’s asset allocation, which changes from time to time, and the performance of the underlying investments. As a result of our review of various factors, including the short and long-term trends of actual returns, we reduced the expected rate of return on plan asset assumption for our domestic defined benefit pension plan to 8.25% as of December 31, 2007. The rate of return assumption had been 8.50% as of December 31, 2006. We believe that an 8.25% return over the long term is reasonable. Should the assets earn an average return less than 8.25% over time, in all likelihood the future pension expense would increase. Investment earnings in excess of 8.25% would tend to reduce the future expense.

 

We establish the discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year based upon the available market rates for high quality, fixed income investments. An increase to the discount rate would reduce the present value of the projected benefit obligation and future pension expense and, conversely, a lower discount rate would raise the benefit obligation and future pension expense. We elected to use a discount rate of 6.50% as of December 31, 2007, an increase from the discount rate of 6.125% as of December 31, 2006.

 

We anticipate that the net expense from the domestic defined benefit pension plan will be higher in 2008 than 2007 as a result of the actual plan performance and expenses offset in part by a benefit from a higher discount rate.

 

If the expected rate of return assumption was changed by 25 basis points (0.25%) and all other pension assumptions remained constant, the 2008 projected pension expense would change by approximately $0.3 million. If the December 31, 2007 discount rate were reduced by 25 basis points and all other pension assumptions remained constant, then the 2008 projected pension expense would increase by approximately $0.4 million.

 

Cash contributions and funding requirements are governed by ERISA and IRS guidelines and not by Statement No. 158. Based upon these guidelines, current assumptions and estimates and our pension plan objectives, we estimate a cash contribution to the domestic plan of approximately $4.5 million will be made in 2008.

 

The minimum pension liability under Statement No. 158 will be recalculated at the measurement date (December 31 of each year) and any adjustments to this account and other comprehensive income within shareholders’ equity will be recorded at that time accordingly. See Note I to the Consolidated Financial Statements for additional details on our pension and other retirement plans.

 

LIFO Inventory.  The prices of certain major raw materials that we use, including copper, nickel, gold, silver and other precious metals, fluctuate during a given year. As noted, copper and nickel prices increased significantly in each of the last two years. Gold, silver and platinum prices also increased in 2007 and 2006. Where possible, such changes in costs are generally reflected in selling price adjustments. The prices of labor and other factors of production, including supplies and utilities, generally increase with inflation. Additions to capacity, while more expensive over time, usually result in greater productivity or improved yields. However, market factors, alternative materials and competitive pricing may limit our ability to offset cost increases with higher prices.

 

We use the last-in, first-out (LIFO) method for costing the majority of our domestic inventories. Under the LIFO method, inflationary cost increases are charged against the current cost of goods sold in order to more closely match the cost with the associated revenue. The carrying value of the inventory is based upon older costs and as a result, the LIFO cost of the inventory on the balance sheet is typically lower than it would be under most alternative costing methods. The LIFO cost may also be lower than the current replacement cost of the inventory. The LIFO inventory value tends to be less volatile during years of fluctuating costs than the value would be using other costing methods. The LIFO impact on the income statement in a given year is dependent upon the inflation rate effect on raw material purchases and manufacturing conversion costs, the level of purchases in a given year and changes in the inventory mix and quantities.

 

Assuming no change in the quantity or mix of inventory from the December 31, 2007 level, a 1% change in the annual inflation rate would cause a $0.5 million change in the LIFO inventory value.

 

Deferred Tax Assets.  We record deferred tax assets and liabilities in accordance with Statement No. 109, “Accounting For Income Taxes”. The deferrals are determined based upon the temporary difference between the

financial reporting and tax bases of assets and liabilities. We review the expiration dates of the deferrals against projected income levels to determine if the deferral will or can be realized. If it is determined that it is more likely than not that a deferral will not be realized, a valuation allowance would be established for that item. Certain deferrals, including the alternative minimum tax credit, do not have an expiration date. See Note P to the Consolidated Financial Statements for additional deferred tax details.

 

In addition to reviewing the deferred tax assets against their expiration dates, we evaluated our deferred tax assets for impairment and, due to the operating losses in 2001 and 2002 we recorded a valuation allowance in December 2002. The valuation allowance was adjusted in each subsequent year, with amounts being charged or credited to income, including the use of net operating loss carryforwards, or OCI as appropriate. Based upon current and projected earnings and analyses of our deferred tax assets in the fourth quarter 2005 and 2006 that indicated it was more likely than not that we would utilize substantially all of our deferred tax assets, we reversed out substantially all of the valuation allowance in those two years with only an immaterial amount associated with one of our international operations remaining on the balance sheet as of December 31, 2007.

 

The reversal of the valuation allowance in 2005 and 2006 resulted in a tax benefit rather than a tax expense being recorded against income before income taxes in each of those years. Tax expense was recorded in 2007 at the effective tax rate without a net adjustment for any material movement in a valuation allowance.

 

Unearned revenue.  Billings under long-term sales contracts in advance of the shipment of the goods are recorded as unearned revenue, which is a liability on the balance sheet. Revenue and the related cost of sales and gross margin are only recognized for these transactions when the goods are shipped, title passes to the customer and all other revenue recognition criteria are met. The unearned revenue liability is reversed when the revenue is recognized. The related inventory also remains on our balance sheet until these criteria are met. Billings in advance of the shipments allow us to collect cash earlier than billing at the time of the shipment and, therefore, the collected cash can be used to help finance the underlying inventory.

 

Long-term unearned income.  Expenditures for capital equipment to be reimbursed under government contracts are recorded in construction in process. Reimbursements for those expenditures are recorded in unearned income, a liability on the balance sheet. The total cost of the assets to be constructed may include costs reimbursed by the government as well as costs borne by us. When the assets are placed in service and capitalized, this total cost will be depreciated over the useful life of the assets. The unearned income liability will be reduced and credited to income ratably with the annual depreciation expense. This benefit in effect reduces the net expense charged to the income statement to an amount equal to the depreciation on the portion of the cost of the assets borne by us.

 

Capital expenditures subject to reimbursement from the government under the current Title III project and the related unearned income balance totaled $3.5 million as of December 31, 2007. This total could rise to between $70.0 and $90.0 million over the next two to three years depending upon the actual cost of the facility to be constructed, government approval of the project funding, the timing of the construction of the facility and the portion of the cost to be retained by us.

 

Through December 31, 2007, we also incurred $4.0 million of costs for expense items under the current government contract that could not be capitalized into the cost of the assets to be constructed, including expenses for development of a business plan and related activities. These costs were charged to a prepaid expense on the balance sheet, which was subsequently reduced for the reimbursement from the government.

 

Derivatives.  We may use derivative financial instruments to hedge our foreign currency, commodity price and interest rate exposures. We apply hedge accounting when an effective hedge relationship can be documented and maintained. If a hedge is deemed effective, changes in its fair value are recorded in OCI until the underlying hedged item matures. If a hedge does not qualify as effective, changes in its fair value are recorded against income in the current period. We secure derivatives with the intention of hedging existing or forecasted transactions only and do not engage in speculative trading or holding derivatives for investment purposes. Our annual budget, quarterly forecasts and other analyses serve as the basis for determining forecasted transactions. The use of derivatives is governed by policies approved by the Board of Directors. The level of derivatives outstanding may be limited by the availability of credit from financial institutions.

During 2006, changes in the pricing of our copper-based products resulted in a reduction of the previously estimated copper price exposure, reducing the need to hedge the exposure with derivative contracts. Therefore, we terminated contracts in 2006 that were initially scheduled to mature in 2007. The deferred gain in OCI on these contracts and other contracts that matured in the second half of 2006 totaled $5.7 million as of December 31, 2006. Gains totaling $5.5 million were amortized to cost of sales in 2007 in accordance with the original maturity schedules in the contracts. Only $0.2 million of deferred gains remained in OCI as of December 31, 2007, which will be amortized in 2008.

 

OUTLOOK

 

We enter 2008 with mixed economic signals. Various economists are indicating that the U.S. economy may be heading towards a recession as there are concerns over the high energy and raw material costs, the uncertainties in the banking industry caused by the sub-prime loan defaults and other factors. However, portions of the Asian economy, in general, continue to perform well.

 

Some of our markets, however, continue to be strong in early 2008, including portions of the telecommunications and computer, oil and gas, defense, medical and heavy equipment markets. The data storage market also continues to grow at a fast pace due to changes in technology. While our sales to this market grew significantly in 2007, that growth was less than the growth in the potential applications for our materials in this market. Our product development efforts have also enabled us to expand our sales beyond our traditional applications and markets while our marketing investments have allowed our sales in Asia to grow significantly over the last two years. We believe that the Asian markets will continue to offer growth opportunities for our products.

 

Early in the first quarter 2008, we acquired the operating assets of Techni-Met, Inc. for $87.4 million in cash. Techni-Met, at its operations in Connecticut, produces precision precious metal coated polymeric films that are sold into the medical market for diabetes testing strips and other applications. Techni-Met sources its precious metal requirements from our Advanced Material Technologies and Services segment and has complementary technologies to our existing operations. Immediately after the acquisition, we sold the precious metal content of Techni-Met’s inventory for its fair value of $24.3 million in cash to a financial institution, while we continue to hold the inventory under our existing metal consignment lines. We anticipate that Techni-Met will be accretive in 2008.

 

Manufacturing issues hampered the profitability of our Advanced Material Technologies and Services and Specialty Engineered Alloys segments in 2007. A key to maintaining and increasing our profitability will be our ability to implement the necessary processes in order to improve our manufacturing yields and the quality of our products on a consistent basis in 2008.

 

We entered 2008 with a stronger balance sheet than a year ago. Our net cash/debt position improved in 2007 and our borrowing costs declined. We used a combination of available cash and borrowings under our new, expanded credit facility to finance the Techni-Met acquisition. We anticipate that cash flow from operations in 2008 will enable us to reduce a portion of this additional debt by the end of the year. The litigation settlement provides us with enhanced insurance coverage and reduces our risks of exposures for liability claims for beryllium-containing products.

 

As of early in the first quarter 2008, we are projecting diluted earnings per share to be in the range of $1.80 to $2.30 for the year.

 

 

We are exposed to precious metal and commodity price, interest rate and foreign exchange rate differences. While the degree of exposure varies from year to year, our methods and policies designed to manage these exposures have remained fairly consistent. We attempt to minimize the effects of these exposures through the use of natural hedges, which include pricing strategies, borrowings denominated in the same terms as the exposed asset, off-balance arrangements and other methods. Where we cannot use a natural hedge, we may use derivative financial instruments to minimize the effects of these exposures when practical and efficient.

We use gold and other precious metals in manufacturing various products. To reduce the exposure to market price changes, precious metals are maintained on a consigned inventory basis. We purchase the metal out of consignment from our suppliers when it is ready to ship to a customer as a finished product. Our purchase price forms the basis for the price charged to the customer for the precious metal content and, therefore, the current cost is matched to the selling price and the price exposure is minimized. The use of precious metal consignment arrangements is governed by a policy approved by the Board of Directors.

 

We are charged a consignment fee by the financial institutions that actually own the precious metals. This fee is partially a function of the market price of the metal. Because of market forces and competition, the fee can only be charged to customers on a case-by-case basis. To further limit price and financing rate exposures, under some circumstances we will require customers to furnish their own metal for processing. This practice is used more frequently when the rates are high and/or more volatile. Should the market price of precious metals that we use increase by 20% from the prices on December 31, 2007, the additional pre-tax cost to us on an annual basis would be approximately $0.4 million. This calculation assumes no changes in the quantity of inventory or the underlying fee and that none of the additional fees are charged to customers.

 

The available capacity of our existing credit lines to consign precious metals is a function of the quantity and price of the metals on hand. As prices increase, a given quantity of metal will use a larger proportion of the credit line. A significant prolonged increase in metal prices could result in our credit lines being fully utilized, and, absent securing additional credit line capacity from a financial institution, could require us to purchase precious metals rather than consign them, require customers to supply their own metal and/or force us to turn down additional business opportunities. The financial statement impact of this risk cannot be estimated at the present time.

 

We also use base metals, including copper, in our production processes. When possible, fluctuations in the purchase price of copper are passed on to customers in the form of price adders or reductions. In prior periods, we entered into derivative contracts to hedge portions of this price exposure and gains on the matured contracts helped to mitigate the negative margin impact of the higher copper prices. There were no copper price derivative contracts outstanding as of December 31, 2007.

 

We use ruthenium in the manufacture of one of our new family of products. Sales of ruthenium-based products increased significantly in 2007 and the inventory on hand to support those sales increased as well. Ruthenium is not a widely used or traded metal and, therefore, there is no established efficient market for derivative financial instruments that could be used to effectively hedge the ruthenium price exposure. We changed our pricing practices with respect to ruthenium products in 2007 so that the selling price would generally be based upon our cost to purchase the material, limiting our price exposure. However, the inventory carrying value may be exposed to market fluctuations. The inventory value is maintained at the lower of cost or market and if the market value were to drop below the carrying value, the inventory would have to be reduced accordingly and a charge taken against cost of sales. This risk is mainly associated with sludges and scrap materials, which generally have longer processing times to be refined into a usable form for further manufacturing. The market price for ruthenium fluctuated throughout 2007 and in the second and fourth quarters of 2007 we recorded lower of cost or market charges totaling $4.5 million on portions of the inventory. Assuming no changes to the inventory quantities, costs or make-up, should the market price of ruthenium decline 10% from the December 31, 2007 price, we would have to record a charge of $2.4 million to write down the exposed portion of the inventory. This calculation assumes no change in the inventory cost or make-up or in the outstanding sales orders with firm pricing from customers.

 

We are exposed to changes in interest rates on our debt and cash balances. This interest rate exposure is managed by maintaining a combination of short-term and long-term debt and variable and fixed rate instruments. We may also use interest rate swaps to fix the interest rate on variable rate obligations, as we deem appropriate. Excess cash is typically invested in high quality instruments that mature in ninety days or less. Investments are made in compliance with policies approved by the Board of Directors. We had $35.5 million in variable rate debt and a variable-to-fixed interest rate swap with a notional value of $23.2 million outstanding at December 31, 2007. If interest rates were to increase 200 basis points (2.0%) from the December 31, 2007 rates and assuming no changes in debt from the December 31, 2007 levels, the net interest expense would increase by $0.2 million (net of the impact of the swap). This calculation does not include the impact of any changes in interest income earned on portions of the December 31, 2007 cash balance of $31.7 million.

Portions of our international operations sell products priced in foreign currencies, mainly the euro, yen and sterling, while the majority of these products’ costs are incurred in U.S. dollars. We are exposed to currency movements in that if the U.S. dollar strengthens, the translated value of the foreign currency sale and the resulting margin on that sale will be reduced. We typically cannot increase the price of our products for short-term exchange rate movements because of local competition. To minimize this exposure, we may purchase foreign currency forward contracts, options and collars in compliance with approved policies. Should the dollar strengthen, the decline in the translated value of the margins should be offset by a gain on the hedge contract. A decrease in the value of the dollar would result in larger margins but potentially a loss on the contract, depending upon the method used to hedge the exposure. The notional value of the outstanding currency contracts was $49.8 million as of December 31, 2007. If the dollar weakened 10% against the currencies we have hedged from the December 31, 2007 exchange rates, the reduced gain and/or increased loss on the outstanding contracts as of December 31, 2007 would reduce pre-tax profits by approximately $4.8 million in 2008. This calculation does not take into account the increase in margins as a result of translating foreign currency sales at the more favorable exchange rates, any changes in margins from potential volume fluctuations caused by currency movements or the translation effects on any other foreign currency denominated income statement or balance sheet item.

 

The fair values of derivatives, which are determined by financial institutions and represent the market price for the instrument between two willing parties, are recorded on the balance sheet as assets or liabilities. Changes in the fair value of outstanding derivatives are recorded in equity or against income as appropriate under the applicable guidelines. The fair value of the outstanding foreign currency contracts was a net liability of $1.5 million at December 31, 2007, indicating that the average hedge rates were unfavorable compared to the actual year-end market exchange rates. The year-end 2007 fair value of the interest rate swap was a loss of $0.4 million as the available interest rates were lower than the rate fixed under the swap contract. The net derivative loss recorded in OCI, including the deferred copper swap gains, was $1.3 million before taxes as of December 31, 2007 compared to a net gain of $4.9 million before taxes as of December 31, 2006.

 

We are also exposed to the risk of fluctuating utility costs. Our total utility cost in 2007 was approximately $20.6 million, down $0.6 million from 2006. However, utility costs increased 12% in 2006 over 2005. This cost may fluctuate in future periods based upon changes in rates as well as consumption levels, with the consumption level in a given year dependent upon the level of production activity as well as the climate.

 

Management’s Report on Internal Control over Financial Reporting

 

The management of Brush Engineered Materials Inc. and subsidiaries is responsible for establishing and maintaining adequate internal controls over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Brush Engineered Materials Inc. and subsidiaries’ internal control system was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

 

Brush Engineered Materials Inc. and subsidiaries’ management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. In making this assessment, it used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria) in Internal Control-Integrated Framework. Based on our assessment, we believe that, as of December 31, 2007, the Company’s internal control over financial reporting is effective.

 

The effectiveness of our internal control over financial reporting as of December 31, 2007 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report herein.

 

Richard J. Hipple

Chairman, President and Chief Executive Officer

 

John D. Grampa

Senior Vice President Finance and Chief Financial Officer

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders of Brush Engineered Materials Inc.

 

We have audited Brush Engineered Materials Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Brush Engineered Materials Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

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

 

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

 

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

 

In our opinion, Brush Engineered Materials Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007 of Brush Engineered Materials Inc. and subsidiaries and our report dated February 27, 2008 expressed an unqualified opinion thereon.

 

 

Cleveland, Ohio

February 27, 2008

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders of Brush Engineered Materials Inc.

 

We have audited the accompanying consolidated balance sheets of Brush Engineered Materials Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15 (a) 2. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

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

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Brush Engineered Materials Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note K to the financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment. Also, as discussed in Note I to the financial statements, effective December 31, 2006, the Company adopted Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pensions and Other Postretirement Plans. Also, as discussed in Notes A and P to the financial statements, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, effective January 1, 2007.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Brush Engineered Materials Inc.’s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2008 expressed an unqualified opinion thereon.

 

 

Cleveland, Ohio

February 27, 2008

Brush Engineered Materials Inc. and Subsidiaries

Years ended December 31, 2007, 2006 and 2005

 

Consolidated Statements of Income

 

 

See Notes to Consolidated Financial Statements.

Brush Engineered Materials Inc. and Subsidiaries
Years ended December 31, 2007, 2006 and 2005

 

Consolidated Statements of Cash Flows

 

 

See Notes to Consolidated Financial Statements.

Brush Engineered Materials Inc. and Subsidiaries
As of December 31, 2007 and 2006

 

Consolidated Balance Sheets

 

 

See Notes to Consolidated Financial Statements.

Brush Engineered Materials Inc. and Subsidiaries
Years ended December 31, 2007, 2006 and 2005

 

Consolidated Statements of Shareholders’ Equity