**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

| **(Mark One)**                                       |
|------------------------------------------------------|
| **ý**                                           | ** ** | **Annual  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934** |
|                                                 |   |   |
| **For the fiscal year ended December 31, 2005** |
| ** **                                           |
| **or**                                               |
|                                                 |   |   |
| **o**                                                | ** ** | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of  1934** |
|                                                 |   |   |
| **Commission File Number 0-21872**                   |

 

**ALDILA, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                   | ** ** | **13-3645590**                           |
|----------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction ofincorporation or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                           |       |                                     |
| **13450 STOWE  DRIVE, POWAY, CALIFORNIA 92064**                |
| (Address of principal  executive offices)                      |

 

Registrant’s telephone number, including area code – **858-513-1801**

 

Securities Registered Pursuant to Section 12(b) of the Act:

 
| **Title  of each class** | ** ** | **Names of each exchange on which  registered** |
|--------------------------|------------|-------------------------------------------------|
| None                     |       | None                                            |

 

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

 
| **Common Stock, par value $0.01 per share** |
|---------------------------------------------|
| (Title of Class)                            |

 

Indicateby check mark if the registrant is well-known seasoned issuer, as defined inRule 405 of the Securities Act.       Yes  o    No  ý

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes  o    No  ý

 

Indicateby check mark whether the registrant(1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes  ý    No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis form 10-K.  o

 

Indicateby check mark whether the Registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2ofthe Exchange Act. (Check one):

 
| Large accelerated filer o | Accelerated filer ý | Non-accelerated filer o |
|--------------------------------|-------------------------------|------------------------------|

 

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

 

Aggregatemarket value of voting stock held by non-affiliates as of June 30, 2005—  $77.1 million.

 

Commonshares outstanding as of March 10, 2006 was — 5,398,857

 
| DOCUMENTS  INCORPORATED BY REFERENCE |
|--------------------------------------|

 

Portionsof the following documents are incorporated into this report by reference:

 

PartIII, Items 10, 11, 12, 13 and 14.  TheRegistrant’s definitive Proxy Statement for the 2006 Annual Meeting ofStockholders to be filed with the Commission within 120 days after the close ofthe fiscal year.

 

 

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**ALDILA, INC.**

 

**Report on Form 10-K**

**For the Fiscal Year Ended December 31,2005**

 

**INDEX**

 
| Part I        |      |
|---------------|-----------|
|          |      |   |   |
|          | Item 1.   | Business | 3 |
|          | Item  1A. | Risk  Factors | 9 |
|          | Item 1B.  | Unresolved Staff Comments | 12 |
|          | Item  2.  | Properties | 12 |
|          | Item  3.  | Legal  Proceedings | 12 |
|          | Item 4.   | Submission of Matters to a Vote of Security Holders | 12 |
|          |      |   |   |
| Part II       |      |
|          |      |   |   |
|          | Item 5.   | Market for Registrant’s Common Equity, Related Stockholder Matters  and Issuer Purchases of Equity Securities | 13 |
|          | Item 6.   | Selected Financial Data | 14 |
|          | Item 7.   | Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 15 |
|          | Item 7a.  | Quantitative and Qualitative Disclosures about Market Risk | 22 |
|          | Item 8.   | Financial Statements and Supplementary Data | 22 |
|          | Item 9.   | Changes in and Disagreements with Accountants on Accounting and  Financial Disclosure | 22 |
|          | Item 9A.  | Controls and Procedures | 22 |
|          | Item 9B.  | Other Information | 24 |
|          |      |   |   |
| Part  III     |      |
|          |      |   |   |
|          | Item 10.  | Directors and Executive Officers of the  Registrant | 24 |
|          | Item 11.  | Executive Compensation | 24 |
|          | Item 12.  | Security Ownership of Certain Beneficial  Owners and Management | 24 |
|          | Item 13.  | Certain Relationships and Related Transactions | 24 |
|          | Item 14.  | Principal and Accounting Fees and Services | 24 |
|          |      |   |   |
| Part  IV      |      |
|          |      |   |   |
|          | Item 15.  | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K | 25 |
|          |      |   |   |
| Signatures    |      |
| Exhibit Index |      |

 

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**PART I**

 

*This Form 10-K contains forward-lookingstatements within the meaning of the federal securities laws.  These forward-looking statements arenecessarily based on certain assumptions and are subject to significant risksand uncertainties.  These forward-lookingstatements are based on management’s expectations as of the date hereof, andthe Company does not undertake any responsibility to update any of thesestatements in the future.  Actual futureperformance and results could differ from that contained in or suggested bythese forward-looking statements as a result of factors set forth in this Form10-K (including those sections hereof incorporated by reference from otherfilings with the Securities and Exchange Commission), in particular as setforth in “Business Risks” under Item 1 and set forth in the “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” underItem 7.*

 

**Item1.  Business**

 

**General**

 

Aldila, Inc. (“Aldila” or the “Company”) is a leading designer andmanufacturer of high-quality innovative graphite (carbon fiber-based composite)golf shafts in the United States today. Aldila conducts its operations through its subsidiaries, Aldila GolfCorp. (“Aldila Golf”) and Aldila Materials Technology Corp. Aldila enjoysstrong relationships with most major domestic and many foreign golf clubmanufacturers including Callaway Golf, TaylorMade-addidas Golf, Ping andAcushnet Company.  Aldila believes thatit is one of the few independent shaft manufacturers with the technical andproduction expertise required to produce high-quality graphite shafts inquantities sufficient to meet demand. The Company’s current golf shaft product lines consist of Aldila brandedand co-branded products designed for its major customers and custom clubmakers, as well as custom shafts developed in conjunction with its majorcustomers. These product lines are designed to improve the performance of anylevel of golfer from novice to tour professional.  

 

In 1994, the Company started production of its principal raw material forshafts, graphite prepreg, which consists of sheets of carbon fibers combinedwith epoxy resin.  See “Manufacturing—RawMaterials.”  The Company now producessubstantially all of its graphite prepreg requirements internally and alsosells prepreg externally.

 

In 1998, the Company established a manufacturing facility in Evanston,Wyoming for the production of carbon fiber, in an effort to further verticallyintegrate its manufacturing operations. On October 29, 1999, SGL Carbon Fibers and Composites, Inc. (“SGL”)purchased a 50% interest in the Company’s carbon fiber manufacturingoperation.  The Company and SGL enteredinto an agreement to operate the facility through a limited liability companywith equal ownership interests between the joint venture members.  The Company and SGL also entered into supplyagreements with the new entity, Carbon Fiber Technology LLC (“CFT”), for thepurchase of carbon fiber at cost plus an agreed-upon mark-up.  Profits and losses of CFT are shared equallyby the partners.  

 

**Graphite Golf Shafts**

 

The Company was founded in San Diego, California in 1972 and was anearly leader in the design and production of graphite golf shafts.  The Company believes it is well positioned toremain a leader in the market for graphite shafts due to its innovative andhigh-quality products, strong customer relationships, design and compositeexpertise and significant manufacturing capabilities.

 

Most golf clubs being sold today have shafts constructed from steel orgraphite, although limited numbers are also manufactured from othermaterials.  Graphite shafts wereintroduced in the early 1970’s as the first major improvement in golf shafttechnology since steel replaced wood in the 1930’s.  The first graphite shafts had significanttorque (twisting force) and appealed primarily to weaker-swinging playersdesiring greater distance.  Graphiteshaft technology has subsequently improved so that shafts can now be designedfor golfers at all skill levels.  

 

Unlike steel shafts, the design of graphite shafts is easier to alterwith respect to weight, flex, flex location and torque to produce greaterdistance, increased accuracy and reduced club vibration resulting in improved “feel”to the golfer.  The improvements in thedesign and manufacture of graphite shafts and the growing recognition of theirsuperior performance characteristics for many golfers compared to steel haveresulted in increased demand for graphite shafts by golfers of all skilllevels. The initial acceptance of graphite shafts was primarily for use inwoods.  Graphite continues to dominatethe professional and consumer wood club market, with over 97% of new woodspurchased in 2005 including graphite shafts.  The acceptance of graphite shafts in irons has not achieved the samesuccess as in woods, and acceptance in irons has declined somewhat in recentyears.  In 2005, approximately 24% of newirons purchased were graphite shafted.

 

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Since many golfers consider professionals to be “opinion leaders,”increased acceptance and use of graphite shafts in irons by professionals helpbroaden the overall graphite market.

 

**Products**

 

*GolfShafts*

 

Aldila offers a broadrange of innovative and high-quality graphite golf shafts designed to maximizethe performance of golfers of every skill level.  The Company manufactures hundreds of uniquegraphite shafts featuring various combinations of performance characteristicssuch as weight, flex, flex point and torque. All of the Company’s shafts are composite structures consistingprincipally of carbon fiber and epoxy resins. The Company’s shafts may also include boron (added to increase shaftstrength) or fiberglass.  The Companyregularly evaluates new composite materials for inclusion in the Company’sshafts and new refinements on designs using current materials.

 

The Company’s shafts, which constituted approximately 88.3% of netsales in the year ended December 31, 2005, are designed in partnershipwith its customers (principally golf club manufacturers) to accommodatespecific golf club designs.  In addition,the Company researches new and innovative shaft designs on an independentbasis, which has enabled the Company to produce a variety of new branded shaftsas well as generate design ideas for customized shafts.  The Company’s branded and co-branded modelsare typically sold to golf club manufacturers, distributors and golf pro andrepair shops and are used either to assemble a new custom club from selectedcomponents or as an after market re-shaft of existing clubs.  The Company also helps develop cosmeticdesigns to give the customer’s golf clubs a distinctive look, even when thecustomer does not require a shaft with customized performancecharacteristics.  The prices of Aldilashafts typically range from $6 to $199.

 

The Company introduced the NVPrototype at the 2003 PGAMerchandise Show in January 2003 and subsequently changed it to the NVTM.   The NVTM features the Company’sexclusive Micro Laminate Technology TM (“MLT”).  The Company followed up the NVTM withthe introduction of the NVS, NV ProtoPypeTM, NVTM Xtreme,NVTM Hybrid, NVS Hybrid family of shafts and the GamerTMshaft in 2004.  The NVS shaft is gearedtoward the player who requires a shaft that promotes a higher initial launchangle, and one that makes it easier to turn the ball right to left.  The NV ProtoPypeTM promotes alower, more controlled launch angle, with reduced spin, along with very lowtorque to provide extremely tight dispersion. The NVTM Xtreme features a combination of the Company’s MLTwith ribbons of a hypoeutectic steel alloy precisely wound around the exteriorof the shaft structure, which provides additional cross-sectional stability andminimizes energy loss during the loading and unloading of the shaft in the golfswing.  The Hybrid family of shafts (NVTMHybrid, NVS Hybrid and GamerTM) service the rapidly growing Hybridsegment of the golf industry.  Hybridclubs (also known as utility clubs and driving irons) are designed to replacelong irons by providing a club that is easier to hit and much more forgivingfor average as well as very skilled players. In the spring of 2006, Aldila will begin shipments of our two newestshaft offerings – the NV ProtoPypeTM and the VS Proto.  The VS Proto has quickly become Aldila’s singlemost poplar shaft model on Tour.  Bothare high-end, high performance shafts featuring carbon nanotubes as well asaerospace carbon fibers and Aldila’s exclusive high performance resinsystem.  In addition, we unveiled the newVS Proto Hybrid shaft for high-end hybrid clubs and a new GamerTMwood and iron shaft to match the GamerTM Hybrid shaft previouslyintroduced.  The Company believes that itwill continue to be successful in the branded segment for the foreseeablefuture and has focused its marketing and advertising effort in support of thisbusiness.    

 

*Other Products*

 

Since 1994, the Company has manufactured prepregmaterial for its production of golf shafts. In 1998, the Company began selling prepreg manufactured in its Poway,California manufacturing facility to third parties.  Revenues from the sale of prepreg wereapproximately 9.6% of net sales in 2005. The Companybegan the manufacture of composite hockey sticks in 2000.  The manufacture of composite hockey sticks issimilar to that of graphite golf shafts and uses similar raw materials.  Revenues from the sale of hockey sticks wereapproximately 1.9% of net sales in 2005 and are not expected to be significantto the Company for several years.  

 

The Company offers carbon fiber for sale through itsjoint venture, CFT, however, the Company does not anticipate outside sales ofcarbon fiber to be significant for the foreseeable future.  Carbon fiber composite materials are suitedfor a diverse range of applications based on their distinctive combination ofphysical and chemical properties.  See “Manufacturing– Carbon Fiber Manufacturing Process.” Carbon fibers are used as reinforcements in composite materials thatcombine fibers with epoxy resins or other matrix materials to form a substancewith high strength, low weight, stiffness, resistance to corrosion, resistanceto fatigue and capacity to dissipate heat and electrical conductivity.  Carbon fiber materials produced by theCompany or CFT are used in a variety of applications such as molding compoundsfor the manufacture of electronic

 

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components, masts and spars for the marine industry,hockey sticks, fishing rods, industrial products, as well as golf shafts.

 

**Product Design and Development**

 

Aldila is committed to maintaining its reputation as a leader ininnovative shaft design and composite materials technology.  The Company believes that the enhancement andexpansion of its existing product lines and the development of new products arenecessary for the Company’s growth and success. However, while the Company believes that it has generally achievedsuccess in the introduction of its graphite golf shafts, no assurance can begiven that the Company will be able to continue to design and manufactureproducts that meet with market acceptance.

 

Graphite shaft designs and modifications are frequently the directresult of the combined efforts and expertise of the Company and its customersto develop an exclusive shaft for each customer’s clubs.  New golf shaft designs are developed andtested using a CAD/CAE golf shaft analysis program, which evaluates a new shaftdesign with respect to weight, torque, flex point, tip and butt flexibility,swing weight and other critical shaft design criteria.  In addition, the Company researches new andinnovative shaft designs on an independent basis, which has enabled the Companyto produce a variety of new branded shafts as well as generate design ideas forcustomized shafts.  To improve andadvance product designs as they relate to composite technology and shaftprocess manufacturing, the Company’s engineers have experience with existingmaterials, such as boron, kevlar, fiberglass, ceramic, thermoplastic and carbonfiber.  The Company’s engineers also lookto newer, more advanced materials such as Single Walled Carbon Nanotubes (“SWNT”).  Nanotechnology is a fast growing field ofresearch that has good potential for structures such as composite golfshafts.  The Company believes it is thefirst major shaft company to employ SWNT in shaft design, and is at theforefront of utilizing this emerging technology in golf shaft development.  The Company’s design research also focuses onimprovements in graphite shaft aesthetics since cosmetic appearance has becomeincreasingly important to customers.  TheCompany’s research and development efforts have resulted in the Aldila “One”shaft, Aldila NVTM, NVS, NV ProtoPypeTM, NVTMXtreme, NVTM Hybrid, NVS Hybrid, GamerTM shafts, and theVS Proto and VS Proto Hybrid.  All of theNVTM family of shafts feature the Company’s exclusive MLT.  Although the Company emphasizes theseresearch and development activities, there can be no assurance that Aldila willcontinue to develop competitive products or that the Company will be able toutilize new composite material technology on a timely or competitive basis, orotherwise respond to emerging market trends.

 

The Company has been one of the leaders in developing the market forlower cost large bundle carbon fiber by successfully converting to this fibertype in some of its products from a more expensive carbon fiber material forthe manufacture of certain of its graphite golf shafts.  The Company has had some success in providinglarge bundle carbon fiber to other manufacturing applications outside of golfshafts.

 

The Company has applied its composite materials expertise on a limitedbasis to other products in recent years, producing hockey sticks as well asgraphite tubing and other molded parts on a special order basis.

 

**Customers and Customer Relations**

 

The Company believes that its close customer relationships andresponsive service have been significant elements of its success to date,establishing it as a premier graphite shaft company.  Aldila’s golf club manufacturer customers oftenwork together with the Company’s engineers when developing a new golf club inorder to design a club that maximizes the performance features of the principalcomponent parts:  the grip, the clubheadand the Aldila shaft.  The Company’spartnership relationship with its customers continues after the development ofclubs containing Aldila’s shafts. Following the design process, the Company continues to provide highlevels of customer support and service in areas such as quality control andassurance, timely and responsive manufacturing, delivery schedules andeducation.  The Company believes thephysical proximity of its headquarter facilities to many of its customers hasfacilitated a high degree of customer interaction and responsiveness tocustomer needs.  While the Company hashad long-established relationships with most of its customers, it is not theexclusive supplier of graphite shafts to most of them and generally does nothave long-term supply agreements with its customers.

 

For fiscal year 2005, theCompany had approximately 670 golf shaft customers, which includedapproximately 120 golf club manufacturers and more than 80 distributors, withthe balance principally consisting of custom club assemblers, pro shops andrepair shops.  However, the majority ofthe Company’s sales has been and may continue to be concentrated among arelatively small number of customers. Sales to the Company’s top five customers represented approximately 62%,57% and 70% of net sales in 2005, 2004 and 2003, respectively.

 

Historically, Aldila’s principal customers have varied as a result ofgeneral market trends in the golf industry, in particular the prevailingpopularity of the various clubs that contain Aldila’s shafts.  As a result, there typically are changes in

 

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the composition of the list of the Company’s ten most significantcustomers from year to year.  Due to thesubstantial marketplace success of their clubs in recent periods, for the lastseveral years the Company’s largest customers have been Acushnet Company,Callaway Golf, and Ping.  While theCompany believes its relationship with each of these major customers is good,the Company is not the exclusive supplier to any of them.  The Company’s sales to its principalcustomers have varied substantially from year to year.

 
| **Customer**      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|----------|------------|
| Acushnet  Company |       | 19       | %          | 22       | %          | 27       | %          |
| Callaway  Golf    |       | 18       | %          | 17       | %          | 21       | %          |
| Ping              |       | 19       | %          | 9        | %          | 10       | %          |

 

Because of the historic volatility of consumer demand for specificclubs, as well as continued competition from alternative shaft suppliers, salesto a given customer in a prior period may not necessarily be indicative offuture sales and it is often difficult to project the Company’s sales to agiven customer in advance.

 

Although the Company believes that its relationships with its customersare good, the loss of a significant customer or a substantial decrease in salesto a significant customer (whether as a result of diminished sales by thatcustomer or a shaft sourced from other suppliers) could have a material adverseeffect on the Company’s business or operating results.

 

**Marketing, Advertising and Promotion**

 

The Company’s marketing strategy is designed to encourage golf clubmanufacturers to select and promote Aldila shafts and to increase overallmarket acceptance and use of graphite golf shafts.  The Company utilizes a variety of marketingand promotional channels to increase sales of Aldila brand name shafts throughits network of distributors and to support Aldila’s brand name recognition andreputation among consumers for offering consistently high quality productsdesigned for a wide range of golfers. Although the Company has very limitedsales directly to the end users of its products, the Company believes that itsbrand name recognition contributes to the marketability of its customers’products.  In addition, Nick Price, GaryMcCord, Rich Beem and Paula Creamer serve on the Company’s advisory staff andassist in its marketing efforts. Aldila’s marketing and promotion expenditureswere approximately $2.3 million, $2.2 million and $1.9 million in 2005, 2004and 2003, respectively.  The Company doesnot currently incur significant marketing expenses for its products other thangolf shafts.

 

**Sales and Distribution**

 

Within the golf club industry, most companies do not manufacture thethree principal components of the golf club — the grip, the shaft and theclubhead — but, rather, source these components from independent suppliers thatdesign and manufacture components to the club manufacturers’specifications.  As a result, Aldilasells its graphite shafts primarily to golf club manufacturers and, to a lesserextent, distributors, custom club shops, pro shops and repair shops.  Distributors typically resell the Company’sproducts to custom club assemblers, pro and custom club shops, andindividuals.  The Company uses itsinternal sales force in the marketing and sale of its shafts to golf clubmanufacturers and distributors.  Sales togolf club manufacturers accounted for approximately 79% of net sales for theyear ended December 31, 2005.

 

Prepreg sales, which represented 9.6% of the Company’s net sales, andcarbon fiber sales (through the Company’s joint venture, CFT) are madeprimarily to manufacturers of composite products.  The Company predominantly has utilized itsinternal sales force in the marketing and sale of these products to itscustomers in the past and will continue to utilize its internal sales force forthe sales of prepreg in the future.

 

International sales represented 23%, 18%, and 15% of net sales for theyears ended December 31, 2005, 2004 and 2003, respectively.  The Company’s international sales haveincreased from 15% in 2003 to 23% in 2005. A large portion of the increase was attributed to increased sales tocustomers in China.  The majority of thecustomers are assemblers in China, with the end product usually being shippedback to the United States or Europe.  SeeNote 13 in the Notes to Consolidated Financial Statements for further breakdownof our international sales and long-lived assets.

 

**Manufacturing**

 

The Company believes that its manufacturing expertise and productioncapacity differentiate it from many of its competitors and enable Aldila torespond quickly to its customers’ orders and provide sufficient quantities on atimely basis.  The Company today operatesthree golf shaft manufacturing facilities, one prepreg manufacturing facility(in conjunction with one of its shaft manufacturing facilities) and through its50% ownership interest in CFT, one carbon fiber manufacturing

 

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facility.  During its 34 years ofoperation, the Company has improved its manufacturing processes and believes ithas established a reputation as the industry’s leading volume manufacturer ofhigh performance graphite shafts.

 

*Shaft Manufacturing Process*.  The process of manufacturing a graphite shafthas several distinct phases.  Differentdesigns of Aldila shafts require variations in both the manufacturing processand the materials used.  In traditionalshaft designs, treated graphite known as “prepreg” (See Prepreg ManufacturingProcess) is rolled onto metal rods known as mandrels.   The graphite is then baked at hightemperatures to harden the material into a golf shaft.  At the end of the manufacturing process, theshafts are painted and stylized using a variety of colors, patterns anddesigns, including logos and other custom identification.  Through each phase of this process, theCompany performs quality control reviews to ensure continuing high standards ofquality and uniformity to meet exacting customer specifications.  The Company’s shaft manufacturing facilitiesare located in Poway, California, Tijuana, Mexico, and Zhuhai, China, with anincreasing percentage of its shafts being manufactured in China, in recentyears.

 

*Shaft Manufacturing Raw Materials*.  The primary materials currently used in theCompany’s graphite shafts are prepreg, paints, inks and heat transfer decals.

 

*Prepreg Manufacturing Process. *In October 1994,the Company initiated the internal production of prepreg in its Poway,California facility.  The Companybelieves that by producing a major portion of its prepreg requirementsinternally, it may better control the supply of raw material for shafts and mayreduce the impact of potential future price increases.  The Company now produces substantially all ofits prepreg requirements internally and is dependent on its own prepregproduction operation to support its shaft manufacturing requirements and forits outside sales of prepreg material. The Company is, however, somewhat dependent upon certain domesticprepreg suppliers for types of prepreg that it does not produce and, therefore,the Company expects to occasionally purchase some prepreg products from outsidesuppliers in the future.  Although theCompany believes that there will continue to be alternative third partysuppliers of prepreg, there can be no assurance that unforeseen difficultieswhich could lead to an interruption in the Company’s internal prepregproduction will not occur, which would result in production delays.

 

The Company’s prepreg operation is dependent on certain suppliers forcarbon fibers, which along with epoxy resins and release paper constitute theprimary components used to manufacture prepreg. Through 1997, the Company purchased all of its carbon fibers fromoutside vendors.  Beginning in 1998, theCompany manufactured carbon fiber at its 50% owned Evanston, Wyoming facility,CFT, to manufacture prepreg for consumption by its golf shaft productionoperation.  Because several differentforms of carbon fiber are required for golf shaft products, including some notmanufactured at the CFT facility, the Company will continue to depend onoutside suppliers for a portion of its ongoing carbon fiber needs.  In 2005, the Company obtained a large portionof its carbon fiber from CFT but also purchased carbon fiber from other carbonfiber manufacturers.  The prices paid bythe Company for carbon fiber not produced at CFT began to increase at the endof 2003 and throughout 2005, due to rising manufacturing costs and capacityconstraints in the carbon fiber industry. If the Company is unable to purchase carbon fiber from suppliers, otherthan that produced at CFT, it could result in production delays of compositepregreg and golf shafts.

 

*Carbon Fiber Manufacturing Process.* Carbon fiber is produced by processing acrylicfiber through a series of stretching, stabilizing and carbonizing sequencesconverting it into essentially a pure carbon chain fiber exhibiting stiffnessand strength characteristics when made into a composite part similar to steelat significantly less weight.  The degreeof the heating and stretching of the graphite fibers determines the tensilestrength and modulus (stiffness) of the fiber. These carbon fibers combined with various resins are then converted tocomposite structures, which have replaced metals in a number of weight criticalaerospace, sporting and industrial applications.  

 

Typically, the composite structure will weigh 25 to 50 percent lessthan the metal structure it has replaced. Carbon fiber composite structures also provide toughness, resistance tocorrosion, resistance to fatigue, capacity to dissipate heat and electricalconductivity.  The carbon fiber industryhas grown from its inception in the late 1950’s into one, which producedapproximately 50 million pounds of carbon fiber in 2005.

 

Carbon fiber usage has grown primarily for consumption by the aerospaceindustry and for sporting goods and industrial applications.  Aerospace grade carbon fibers continue to beutilized for production of commercial and military aerostructures.  The higher cost, aerospace grade carbonfibers were first used in sporting goods and industrial applications until alower cost, large bundle carbon fiber was developed as an alternative for usein many sporting goods and industrial applications.  Aldila was a leader in utilizing large bundlecarbon fibers initially purchased from outside vendors, for the manufacture ofgraphite golf shafts.  In 1998 theCompany completed construction of a 50,000 square foot carbon fibermanufacturing facility in Evanston, Wyoming, which subsequently becameCFT.  CFT produces large bundle carbonfiber material from acrylic fiber through a series of stretching, stabilizingand carbonizing sequences in this facility. Carbon fiber

 

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that has more than 24,000 (24K) filaments is considered to be large towcarbon fiber.  During 2004, CFT began producinga smaller tow (24K), which yields better properties and can be used in moreapplications.  CFT now produces twodifferent tow sizes of carbon fibers. These materials are now significant raw materials used in the Company’sprepreg manufacturing operation to support the manufacture of graphite golfshafts, although the Company still procures certain types of fibers fromoutside vendors for the manufacture of golf shafts.  The Company believes it can purchase the typeof fibers produced by CFT from at least two outside sources.

 

CFT purchased substantially all of its raw acrylic fibers for thecarbon fiber operation from one supplier for the years 2000 through 2005.  Previous to 2000, the Company purchased rawacrylic fibers from another supplier who in May 2005, filed bankruptcy andannounced its intention to cease producing acrylic fibers, which left CFT in atrue sole source position.  It wasannounced on October 28, 2005 that the precursor production assets of the CFT’sformer supplier were sold to a third party whose intention is to continue theproduction of precursor for sale to unrelated parties.  There is no certainty that the new owner ofthese assets will be successful.  CFTwill continue to pursue alternate sources of supply for this material.  However, if the current supplier is unable todeliver and CFT cannot find a new supplier, it could have a material adverseeffect on the Company’s business.

 

**Environmental Matters**

 

The Company is subject to various federal, state, local and foreign environmentallaws and regulations, including those governing the use, discharge and disposalof hazardous materials as the Company uses hazardous substances and generateshazardous waste in the ordinary course of its manufacturing of graphite golfshafts, other composites, graphite prepreg and carbon fiber.  The Company believes it is in substantialcompliance with applicable laws and regulations and has not to date incurredany material liabilities under environmental laws and regulations; however,there can be no assurance that environmental liabilities will not arise in thefuture which may affect the Company’s business.

 

**Competition**

 

Aldila operates in a highly competitive environment in both the UnitedStates and international markets for the sale of its graphite golf clubshafts.  The Company believes that itcompetes on the basis of its ability to provide a broad range of high quality,performance graphite shafts, its ability to deliver customized products in largequantities and on a timely basis to its customers, the acceptance of graphiteshafts in general, and Aldila shafts in particular, by professional and othergolfers, whose preferences are to some extent subjective, and, finally,price.  Until recently, the United Statesmarket for graphite shafts was dominated by a relatively small number of UnitedStates based shaft manufacturers which competed predominantly for the businessof larger original equipment manufacturers (“OEMs”).  However, the Company now competes againstUnited States and foreign-based shaft manufacturers for the OEM shaft market.This competition has made it more difficult to retain existing customers,attract new customers and has placed increasing pressure on prices for OEMshafts.  The Company believes that it isthe largest supplier of graphite shafts to the United States club market, whichresults from its ability to establish a premium brand image and reputationamong golf club companies as a value-added supplier with competitiveprices.  Aldila competes against othershaft manufacturers, both graphite and steel, and in the past also against golfclub companies that produced their own shafts internally, some of which mayhave or had greater resources than Aldila. The Company also faces potential competition from those golf clubmanufacturers that currently purchase golf shaft components from outsidesuppliers but that may have, develop or acquire the ability to manufacture allor a portion of its graphite shafts internally. Should any of the Company’s significant customers decide to meet any ofits shaft needs internally, it could have an adverse effect on theCompany.  The Company also competesagainst companies who manufacture one or more of three principal components ofthe golf club, the grip, the shaft and the club head, and assemble completedgolf clubs for delivery to club companies. Should any of the Company’s significant customers decide to source theirgolf clubs in this manner where an Aldila shaft is not included, it could havean adverse effect on the Company.  Presently,there exists substantial excess graphite shaft manufacturing capacity both inthe United States and in other countries, however, this excess manufacturingcapacity has somewhat been mitigated by carbon fiber supply constraints.  

 

The Company also competes for sales of prepreg from its prepregfacility and carbon fiber through its 50% interest in CFT with other producersof prepreg and carbon fibers, many of which have substantially greater researchand development, managerial and financial resources than the Company.  Some producers have been producing prepregand carbon fiber for substantially longer periods of time than the Company has,and represent significant competition to the Company.  The Company’s ability to compete in the saleof prepreg and carbon fiber is dependent to some extent on the Company’sability to cause manufacturers and consumers of carbon fiber-based products toutilize the types of carbon fiber manufactured by CFT, which is a significantportion of the carbon fiber used in Aldila’s graphite prepreg.  In addition, the ability to purchase fiberfrom an outside source when required in today’s fiber market, limits theCompany’s ability to compete in prepreg sales.

 

8

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**Intellectual Property**

 

Aldila utilizes a number of trademarks and logos in connection with thesale and advertising of its products. The Company takes all reasonable measures to ensure that any productbearing an Aldila trademark reflects the consistency and quality associatedwith the Company’s products and intends to continue to protect them to thefullest extent practicable.  As ofDecember 31, 2005 the Company had approximately 59 United States andforeign registered trademarks.

 

**Employees**

 

As of December 31, 2005, Aldila employed 1,253 persons on afull-time basis, including nine in sales and marketing, 23 in research,development and engineering and 1,039 in production. The balance of employeesare administrative and support staff. The number of full-time employees includes 438 persons who are employedin the Company’s Mexico facility and 640 who are employed in the Company’sChina facility.  Because of seasonaldemands, the Company hires a significant number of temporary employees.  As of December 31, 2005, the Companyalso employed an additional 21 temporary employees. Aldila considers itsemployee relations to be good.

 

**Seasonality**

 

Because the Company’s customers have historically built inventory inanticipation of purchases by golfers in the spring and summer, the principalselling season for golf equipment, the Company’s operating results have beenaffected by seasonal demand for golf clubs, which has generally resulted inhighest sales occurring in the first and second quarter.  The timing of customers’ new productintroductions has frequently mitigated the impact of seasonality in recentyears.

 

**Backlog**

 

As of December 31, 2005, the Company had a sales backlog ofapproximately $11.4 million compared to approximately $9.9 million as ofDecember 31, 2004.  The Companybelieves that the dollar volume of its current backlog will be shipped over thenext three months.  Orders can typicallybe cancelled without penalty up to 30 days prior to shipment.  Historically, the Company’s backlog generallyhas been highest in the first and fourth quarters, due in large part toseasonal factors.  Due to the timing andreceipt of customer orders, backlog is not necessarily indicative of futureoperating results.

 

**Item1A.  Risk Factors**

 

**Customer Concentration**

 

The Company’s sales have been, and very likely will continue to be,concentrated among a small number of customers. In 2005, sales to the Company’s top five customers representedapproximately 62% of net sales.  Aldila’sprincipal customers have historically varied depending largely on theprevailing popularity of the various clubs that contain Aldila shafts.  In 2005, Acushnet Company accounted for 19%of net sales, Ping accounted for 19% of net sales and Callaway Golf accountedfor 18% of net sales.  The Company cannotpredict the impact that general market trends in the golf industry, includingthe fluctuation in popularity of specific clubs manufactured by customers, willhave on its future business or operating results.

 

While the Company has had long-establishedrelationships with most of its customers, it is not the exclusive supplier ofgraphite shafts to most of them, and consistent with the industry practice,generally does not have long-term contracts with its customers.  In this regard, Acushnet Company, Ping andCallaway Golf, who collectively represent approximately of 56% of the Company’snet sales in 2005, each purchased from at least two other graphite shaftsuppliers.  In the event AcushnetCompany, Ping, and Callaway Golf or any other significant customer increasespurchases from its other suppliers or adds additional suppliers, the Companycould be adversely affected.  Althoughthe Company believes that its relationships with its customers are good, theloss of a significant customer or a substantial decrease in sales to asignificant customer could have a material adverse effect on the Company’sbusiness and operating results.  Inaddition, sales by the Company’s major customers are likely to varydramatically from time to time due to fluctuating public demand for golfequipment generally and for their specific products.

 

**Competition**

 

Aldila operates in a highly competitive environment for golf equipmentsales.  The Company believes that it

 

9

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competes principally on the basis of its ability to provide a broadrange of high quality, performance graphite shafts, its ability to delivercustomized products in large quantities and on a timely basis, the acceptanceof graphite shafts in general, and Aldila shafts in particular, byprofessionals and other golfers, whose preferences are to some extentsubjective, and finally, price.

 

Aldila competes against both domestic and foreign shaftmanufacturers.  Some of the Company’scurrent and potential competitors may have greater resources than Aldila.  The Company also faces potential competitionfrom those golf club manufacturers that currently purchase golf shaftcomponents from outside suppliers but that may have, develop or acquire, theability to manufacture shafts internally.

 

As the Company further enters into the manufacture and sale of prepregproducts, it competes with other producers of prepregs, many of which havesubstantially greater research and development, managerial and financialresources than the Company and represent significant competition for theCompany.

 

**New Product Introduction**

 

The Company believes that the introduction of new, innovative golfshafts using graphite or other composite materials will be critical to itsfuture success.  While the Companyemphasizes research and development activities in connection with carbon fiberand other composite material technology, there can be no assurance that theCompany will continue to develop competitive products or that the Company willbe able to develop or utilize new composite material technology on a timely orcompetitive basis or otherwise respond to emerging market trends.

 

Although the Company believes that it has generally achieved success inthe introduction of its customized graphite golf shafts, specifically, theAldila NVTM line of golf shafts, no assurance can be given that theCompany will be able to continue to design and manufacture products that meetwith market acceptance, either on the part of club manufacturers orgolfers.  The design of new graphite golfshafts is also influenced by rules and interpretations of the United StatesGolf Association (“USGA”).  There can beno assurance that any new products will receive USGA approval or that existingUSGA standards will not be altered in ways that adversely affect the sales ofthe Company’s products.

 

**Reliance on Offshore Manufacturing Facilities**

 

* *TheCompany operates manufacturing facilities in Tijuana, Mexico and Zhuhai, People’sRepublic of China.  The Company payscertain expenses of these facilities in Mexican pesos and Chinese renminbis,respectively, which are subject to fluctuations in currency value and exchangerates.  The facility in Tijuana, Mexicooperates pursuant to the “maquiladora” duty-free program established by theMexican and United States governments. Such program enables the Company to take advantage of generally lowercosts in Mexico, without paying duty on inventory shipped into or out ofMexico.  The Company also operates in thePeople’s Republic of China in a special economic zone, which affords specialadvantages to companies with regards to income taxes, import and export dutiesand value added taxes.  There can be noassurance that the governments of Mexico or the People’s Republic of China willcontinue the programs currently in place or that the Company will continue tobe able to benefit from these programs. The loss of these benefits could have an adverse effect on the Company’sbusiness.  The Company is also subject toother customary risks of doing business outside the United States, includingpolitical instability, other import/export regulations and culturaldifferences.

 

**Raw Material Cost/Availability**

 

The Company’s gross profit margins, in part, are dependent on the pricepaid for carbon fiber purchased from outside vendors, and more substantiallystarting in the latter part of 1998, the cost of production of carbon fiber atthe Evanston, Wyoming facility, CFT, including the price paid for the acrylicfiber used for the manufacture of carbon fiber and the other costs associatedwith the operation of the carbon fiber plant.

 

The Company experienced an increase in carbon fiber prices in 1996 and1997 due to the growth experienced in the use of carbon fiber coupled withrelatively little excess capacity.  The pricespaid by the Company for carbon fiber leveled in 1998 and decreased during 1999through 2002, due to excess capacity in the carbon fiber manufacturingindustry.  However, that trend reverseditself in the later part of 2003.  TheCompany experienced carbon fiber price increases in certain grades of carbonfiber prices during the later part of 2003 and through 2005.  Management is not able to predict the timingor extent of any future price changes for carbon fiber; however, the Companycould be negatively impacted if carbon fiber prices continue to increase andthe Company is not able to pass along these increases to its customers due tocompetition.

 

The Company also has relationships with other outside vendors for itsadditional carbon fiber needs through 2005 and beyond.  Depending on market conditions prevailing atthe time and extent to which production at CFT meets expectations, the Companymay face difficulties in obtaining adequate supplies of carbon fiber fromexternal sources to provide for any carbon fiber needs not met internally.  If it appears that CFT is not likely tosatisfy a significant portion of the Company’s needs or if it appears thatthere will not be adequate availability in the market, the Company may not havemade arrangements in advance for the purchase of material amounts of carbonfiber from alternative sources.

 

10

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In addition, the Company is dependent on its internal production ofgraphite prepreg to support its shaft manufacturing operations and has notsecured adequate additional sources of supply should its production of prepregbe interrupted for any reason.  Theexposure to the Company resulting from its increasing reliance on its owninternal production of the raw materials for its golf shaft business isenhanced because the Company currently operates only one prepreg facility andhas an interest in only one carbon fiber manufacturing facility.  Until recently, there has been excess-capacityin these industries.  In the past,significant market shortages of both carbon fiber and graphite prepreg haveoccurred and if they re-occur, it could have a negative impact on the Company’sfinancial statements.

 

**Joint Venture Operating Carbon Fiber Facility**

 

The Company started producing carbon fiber at its Evanston, Wyomingfacility in 1998.  SinceOctober 1999, this facility has been operated by a joint venture, 50%owned by each of the Company and SGL.  Asa result of the operation of this facility through the joint venture, the Companyis subject to business and financial risks, such as the risks that SGL will beunable to meet its obligations to the joint venture, that there will beoperational difficulties resulting from the split ownership, raw materialsupply problems, changes in demand for carbon fiber based products, or thatthere will be differences of opinion between the joint venture partners as tofuture operations leading to an inability to make decisions when required or tothe making of decisions not in the best interests of both joint venturepartners.

 

**Reliance on Carbon Fiber Manufacturing Facility**

 

Until recently, during the period in which the Company or the jointventure has operated the Evanston, Wyoming facility, the market for carbonfiber products has been soft, which has limited the Company’s ability to takefull advantage of the opportunity offered by the vertical integration of itscarbon fiber raw material usage in graphite golf shafts.  If the facility does not produce high qualityfiber at the anticipated volumes, either because of production shortfalls orlimited demand for the facility’s carbon fiber, the per pound cost of the fiberproduced will likely be higher due to the substantial fixed costs involved inoperating a carbon fiber production facility. In addition, if the facility is not capable of producing carbon fiber atsufficient volumes to satisfy the demands of both venture partners, the Companywould be required to purchase additional fiber from third party suppliers,which may not be available in sufficient quantities to satisfy its demands andcould result in higher marginal costs to the Company than fiber acquired fromthe joint venture.  In addition, if CFTis unable to obtain precursor, the significant raw material consumed in thecarbon fiber manufacturing process, it could have a material adverse effect onthe Company’s business.

 

**Potential Cash Flow Shortages**

 

The Company has cash, cash equivalents and marketable securitiestotaling $15.8 million as of December 31, 2005.  Management anticipates that these sources offunds, when combined with cash flow generated from operations, will besufficient to finance its business operations at least through 2006.  If the Company is not able to generate theexpected cash flows from operations, the Company could be adversely affected.

 

**Shaft Manufacturing by Club Companies and One-StopShops**

 

Another factor that could have a negative impact in the future on theCompany’s sales to golf club manufacturers would be a decision by one of itscustomers to manufacture all or a portion of their graphite shaft requirements,or to have an increased amount of their requirements filled from one-stop shops(where main components, shaft or head, of the golf club could be purchased andassembled). While the Company has not to date experienced any material declinein its sales for these reasons, should any of the Company’s major customersdecide to meet any significant portion of their shaft needs either internallyor through one-stop shops, it could have a material adverse impact on theCompany and its financial results.

 

**Utilization of Certain Hazardous Materials**

 

In the ordinary course of its manufacturing processes, the Company useshazardous substances and generates hazardous waste.  The Company has not to date incurred anymaterial liabilities under environmental laws and regulations and believes thatit is in substantial compliance with applicable laws and regulations.  Nevertheless, no assurance can be given thatthe Company will not encounter environmental problems or incur environmentalliabilities in the future, which could adversely affect its business.

 

11

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**Dependence on Discretionary Consumer Spending**

 

Sales of golf equipment have historically been dependent on discretionaryspending by consumers, which may be adversely affected by general economicconditions.  The Company believes thatgolf equipment sales have remained flat in recent periods and may continue tobe so in the future.  A decrease inconsumer spending on golf equipment or, in particular, a decrease in demand forgolf clubs with graphite shafts could have an adverse effect on the Company’sbusiness and operating results.

 

**Reliance on Key Personnel**

 

The success of the Company is dependent upon its senior managementteam, as well as its ability to attract and retain qualified personnel.  There is competition for qualified personnelin the golf shaft industry as well as the carbon fiber business.  There is no assurance that the Company willbe able to retain its existing senior management personnel or to attractadditional qualified personnel.

 

**Justice Department Investigation**

 

During 1999 the Company received a subpoena for documents from theAntitrust Division of the U.S. Department of Justice in connection with theon-going investigation of an alleged price fixing conspiracy in the carbonfiber and graphite prepreg industries. The Department of Justice has informed the Company that it is notcurrently a target of the investigation, although it has indicated that it hasnot cleared the Company of any involvement in the alleged conspiracy.  The Company is cooperating with theDepartment of Justice’s investigation.

 

**Item 1B. Unresolved Staff Comments**

 

None.

 

**Item 2.Properties**

 

The Company’s principal executive offices are located in Poway,California (in the San Diego metropolitan area).  The Company’s golf shafts are manufactured atthree separate facilities, one located in Poway, California, one located inTijuana, Mexico and one in the Zhuhai economic development zone of the People’sRepublic of China.  The Company leases a73,000 square foot facility in Poway, California for shaft manufacturingoperations, graphite prepreg production and for its executive offices.  The Mexico facility is also leased and comprisesapproximately 31,000 square feet.  TheChina facility is also leased and comprises approximately 88,000 squarefeet.  The Company also may leasewarehousing space when needed. Currently, the Company leases warehousing space in the United States andin China. ** **In addition, the Company’s 50%joint venture, CFT, owns 14 acres of land in Evanston, Wyoming on which itoperates a 50,000 square foot carbon fiber manufacturing plant.

 

**Item3.  Legal Proceedings**

 

None.

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

 

There were no matters submitted to a vote of security holders duringthe fourth quarter of fiscal 2005.

 

12

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**PART II**

 

**Item 5.  Market for Registrant’sCommon Equity and Related Stockholder Matters**

 

**COMMON STOCK PERFORMANCE**

 
| ** **     | ** ** | **2005**      | ** ** | **2004**   | ** ** |
|----------------|------------|---------------|------------|------------|------------|
| ** **     | ** ** | **Dividends** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dividends** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **     | ** ** | **Declared**  | ** ** | **High**   | ** ** | **Low** | ** ** | **Declared** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $             | 0.05       |       | $          | 18.71 |   | $ | 13.16 |   |   |   | $ | 5.92 |   | $ | 3.57 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Second Quarter |       | $             | 1.10       |       | $          | 24.06 |   | $ | 17.52 |   | $ | 0.05 |   | $ | 17.78 |   | $ | 5.75 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Third Quarter  |       | $             | 0.15       |       | $          | 27.83 |   | $ | 19.79 |   | $ | 0.05 |   | $ | 13.60 |   | $ | 9.30 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Fourth Quarter |       | $             | 1.15       |       | $          | 25.50 |   | $ | 21.21 |   | $ | 0.05 |   | $ | 15.49 |   | $ | 10.99 |   |

 

All the prices above reflect the Company’s one-for-three reverse stocksplit, for shareholders of record at the close of business on June 3,2002.  On March 10, 2006, theclosing common stock price was **$**30.85**,** and there were approximately 236****common stockholders of record.  The company believes a significant number ofbeneficial owners also own Aldila stock in “street name.”

 

Aldila, Inc. common stock is traded on the NASDAQ national market,symbol:  ALDA.

 

The Company intends to retain earnings for use in operations andpayments of cash dividends on its common stock. Cash dividends are discussed by the Company’s Board of Directors andmanagement at each quarterly board meeting, and if approved, cash dividends areannounced.  Aldila, Inc. is a holdingcompany whose ability to pay dividends depends on the receipt of dividends orother payments from its two principal subsidiaries, Aldila Golf and AldilaMaterials Technology Corp.

 

**EQUITY COMPENSATION PLAN INFORMATION**

 

The following table provides informationregarding securities authorized for issuance under the Company’s equitycompensation plans as of December 31, 2005 (all numbers of securitiesreflect the Company’s one-for-three reverse stock split on June 3, 2002):

 
| **Plan Category**                                                                             | ** ** | **Number of securities to be  issued upon exercise of  outstanding options** | ** ** | **Weighted-average exercise  price of outstanding  options** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
|                                                                                          |       |                                                                         |       |                                                         |       |                                                                                                |       |
| Equity compensation plans approved by  security holders – 1994 Stock Incentive Plan      |       | 353,311                                                                      |       | $                                                            | 11.36      |                                                                                                | 480,561    |   |
|                                                                                          |       |                                                                         |       |                                                         |       |                                                                                                |       |
| Equity compensation plans not approved by  security holders – 1992 Stock Option Plan (1) |       | —                                                                       |       |                                                         |       | 20,167                                                                                              |       |
| Total                                                                                         |       | 353,311                                                                      |       |                                                         |       | 500,728                                                                                             |       |
|                                                                                               |            |                                                                              |            |                                                              |            |                                                                                                     |            |  |

 

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(1) In 1992, the Companyadopted the 1992 Stock Option Plan to provide equity incentives for themanagement and directors of the Company. The Company has reserved 175,431 shares for issuance under thisPlan.  The Company does not expect toissue additional options under the 1992 Plan.

 

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**Item 6.   SelectedFinancial Data**

 

The information required as to this Item is contained in the followingtable.

 

**ALDILA, INC.**

**SELECTED FINANCIAL DATA**

**(In thousands, except per share amounts)**

 
| ** **                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Operating Results (Year ended December 31):             |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net sales                                               |       | $        | 76,978     |     | $          | 52,762   |       | $        | 37,807     |     | $          | 37,462 |   | $ | 39,561 |   |
| Cost of sales                                           |       | 47,368   |       | 34,786   |       | 30,586   |       | 32,828   |       | 33,304   |       |
| Gross profit                                            |       | 29,610   |       | 17,976   |       | 7,221    |       | 4,634    |       | 6,257    |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Selling, general and administrative                     |       | 9,741    |       | 8,237    |       | 6,989    |       | 7,334    |       | 6,851    |       |
| Impairment of goodwill                                  |       | —   |       | —   |       | —   |       | —   |       | 41,932   |       |
| Impairment of trademarks & patents                  |       | —   |       | —   |       | —   |       | —   |       | 12,963   |       |
| Amortization of goodwill                                |       | —   |       | —   |       | —   |       | —   |       | 1,410    |       |
| Plant consolidation                                     |       | —   |       | —   |       | —   |       | 300      |       | 593      |       |
| Operating income (loss)                                 |       | 19,869   |       | 9,739    |       | 232      |       | (3,000   | )          | (57,492  | )          |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Other expense (income)                                  |       |     |       |     |       |     |       |     |       |     |       |
| Interest expense                                        |       | —   |       | —   |       | 23       |       | 94       |       | 375      |       |
| Interest and other (income) expense, net                |       | (586     | )          | (60      | )          | 48       |       | 62       |       | 65       |       |
| Impairment of investment in joint venture               |       | —   |       | —   |       | 2,220    |       | —   |       | —   |       |
| Equity in earnings of joint venture                     |       | (236     | )          | (246     | )          | (150     | )          | (269     | )          | (231     | )          |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Income (loss) before income taxes                       |       | 20,691   |       | 10,045   |       | (1,909   | )          | (2,887   | )          | (57,701  | )          |
| Provision (benefit) for income taxes                    |       | 7,287    |       | 725      |       | (183     | )          | (43      | )          | (6,282   | )          |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income (loss)                                       |       | $        | 13,404     |     | $          | 9,320    |       | $        | (1,726     | )        | $          | (2,844 | ) | $ | (51,419 | ) |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income (loss) per common share-basic:               |       | $        | 2.54       |     | $          | 1.85     |       | $        | (0.35      | )        | $          | (0.57 | ) | $ | (10.10 | ) |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income (loss) per common share,  assuming dilution: |       | $        | 2.46       |     | $          | 1.77     |       | $        | (0.35      | )        | $          | (0.57 | ) | $ | (10.10 | ) |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Selected Operating Results                              |       |     |       |     |       |     |       |     |       |     |       |
| As a Percentage of Net Sales:                           |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Gross profit                                            |       | 38.5     | %          | 34.1     | %          | 19.1     | %          | 12.4     | %          | 15.8     | %          |
| Selling, general and administrative                     |       | 12.7     | %          | 15.6     | %          | 18.5     | %          | 19.6     | %          | 17.3     | %          |
| Operating income (loss)                                 |       | 25.8     | %          | 18.5     | %          | 0.6      | %          | (8.0     | )%         | (145.3   | )%         |
| Net income (loss)                                       |       | 17.4     | %          | 17.7     | %          | (4.6     | )%         | (7.6     | )%         | (130.0   | )%         |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Financial Position (at December 31):                    |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Working capital                                         |       | $        | 28,805     |     | $          | 25,977   |       | $        | 15,181     |     | $          | 13,162 |   | $ | 13,851 |   |
| Total assets                                            |       | $        | 48,089     |     | $          | 42,075   |       | $        | 29,013     |     | $          | 31,159 |   | $ | 34,886 |   |
| Total stockholders’ equity                         |       | $        | 38,551     |     | $          | 35,061   |       | $        | 24,446     |     | $          | 26,353 |   | $ | 29,197 |   |

 

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**Item 7.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Significant Accounting Estimates**

 

We prepared the consolidated financial statements of the Company inconformity with accounting principles generally accepted in the United Statesof America.  As such, we are required tomake certain estimates, judgments and assumptions that we believe arereasonable based upon the information available.  These estimates and assumptions affect thereported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the periodspresented.  The significant accountingpolicies, which we believe are the most critical to aid in fully understandingand evaluating our reported financial results include the following:

 

*Revenue Recognition*

 

The Company recognizes revenue from product sales at the time of shipment and passage of title. We also offer certain of our customers the right to return shafts for breakage within a limited time after delivery.  We track such shaft returns, and we record a provision for the estimated amount of such future returns, based on historical experience and any notification we receive of pending returns at the time sales are made.  The Company believes that any shafts returned for breakage will be returned within three years of the initial sale of the shaft.  The Company estimates in regards to total actual returns, that 50% will be returned in the first year after sale, 30% in the second year after sale and the remaining 20% in the third year after sale, assuming a mid-year convention.  The Company’s breakage return rate has been between .17% and 1.09% (breakage returns divided by sales dollars) for the past ten years.  The Company has historically utilized a four-year moving average of the breakage return rate to record its estimated liability.  The four-year average utilized in the accrual estimate as of December 31, 2005 is .29%.  The Company’s breakage return rate has declined over the past years.  The highest four-year average over the past ten years has been 1.01%.  If the Company were to use 1.01% in estimating its liability as of December 31, 2005, it would have the effect of increasing the liability by approximately $900,000, which would be recorded in cost of goods sold.  While such returns have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same return rates that we have in the past. Any significant increase in product failure rates and the resulting returns could have a material adverse impact on our operating results for the period or periods in which such returns materialize.

 

*Accounts Receivable*

 

We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s current credit worthiness, as determined by our review of their current credit information.  We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified.  While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.  Since our accounts receivable are concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of any one of these customers could have a material adverse impact on the collectability of our accounts receivable and our future operating results.  The Company estimates its allowance for doubtful accounts on a monthly basis, by reviewing all amounts owed to the Company and focusing on those amounts that are greater than 60 days past due.  The Company reviews the customers that have amounts greater than 60 days past due and where appropriate reserves for the receivable amount.  As of December 31, 2005, the Company estimated this amount to be approximately $18,000.  If the Company were to reserve for the total amount greater than 60 days past due, it would increase the allowance by approximately $29,000, which would be recorded in administrative expense.

 

*Inventories*

 

We value our inventory at the lower of the actual cost to purchase and/or manufacture the inventory or the current estimated market value of the inventory.  We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the next twelve months.  A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand.   Management of the Company, including but not limited to, representatives from manufacturing, sales, accounting and officers review the inventory reserve methodology quarterly and when appropriate, establish additional reserves or reduce existing reserves.  

 

15

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The Company’s reserve methodology consists of the following: reviewing on hand inventories of our top customers and comparing inventories to historical sales trends and anticipated sales forecasts.  A 100% reserve is established for all shafts that are deemed to be obsolete.  Raw materials are reviewed based upon estimated future production and when appropriate, reserves are established.  Shafts that are designated for rework (parts that need additional work) are reviewed and when appropriate reserves are established.  The final analysis is to review inactive inventory, and apply reserves to parts that were not included in the other analyses and have been inactive in the system for a period of twelve months.  The Company’s average reserve percentage compared to gross inventory has been approximately 18% for the past five years.  In the past five years, the highest reserve percentage was approximately 30% and the lowest reserve percentage was approximately 8%.  The Company’s reserve percentage as of December 31, 2005 is 8%.   See the estimated impact below to cost of goods sold, utilizing the different reserve rates above:

 

(Amounts below in thousands)

 
| ** **                       | ** ** | **Highest** | ** ** | **Average** | ** ** | **Lowest** | ** ** |
|----------------------------------|------------|-------------|------------|-------------|------------|------------|------------|
| Gross  inventory as of 12/31/05  |       | $           | 13,422     |        | $          | 13,422     |       | $ | 13,422 |   |
| Reserve rate                     |       | 30          | %(a)       | 18          | %          | 8          | %          |
| Estimated  reserve               |       | 4,071       |       | 2,416       |       | 1,035      |       |
| Recorded  Reserve as of 12/31/05 |       | 1,035       |       | 1,035       |       | 1,035      |       |
| Impact to  costs of goods sold   |       | $           | 3,036      |        | $          | 1,381      |       | $ | — |   |

 

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(a) This was theCompany’s highest rate; the second highest rate in the past five years was 22%.

 

In the future, if our inventory were determined to be overvalued, we would be required to recognize such costs in our cost of goods sold at the time of such determination. Likewise, if our inventory is determined to be undervalued, we may have over-reported our costs of goods sold in previous periods and would be required to recognize such additional operating income at the time of sale. Therefore, although we make every effort to ensure that our forecasts of future product demands are reasonable, any significant unanticipated changes in demand could have a significant impact on the value of our inventory and our reported operating results. The Company has reduced its gross inventories by 9% from December 31, 2001 through December 31, 2005.  In addition, the Company has reduced its gross work-in-process and gross finished goods inventory collectively by approximately 52% since 2001.  This is the major contributing factor to the decrease of the Company’s reserves in the past few years.  Part of the 52% decrease is attributed to the disposal of a significant amount of fully reserved inventories over the past two years.  This has had the effect of reducing the Company’s reserve percentage against gross inventories.  As such, the Company’s related inventory reserves have decreased over that same period.  As the Company continues to try and reduce its carrying levels of its work-in-process and finished goods inventory, it should have the effect of further reducing the amount of its inventory reserves.

 

**Overview - Business Conditions**

 

The Company is principally engaged in the business of designing,manufacturing and marketing graphite (carbon fiber based composite) golf clubshafts, with approximately 79% of its net sales resulting from sales to golfclub manufacturers for inclusion in their clubs.  As a result, the Company’s operating resultsare substantially dependent not only on demand by its customers for the Company’sshafts, but also on demand by consumers for clubs including graphite shaftssuch as the Company’s.

 

The graphite shaft market consists of customized OEM production shafts,both premium and value and branded and co-branded shafts.  The Company sells customized OEM productionand co-branded shafts directly to its OEM customers and sells Aldila brandedshafts through the OEM custom stock and custom fit programs anddistributors.  The Company has re-emergedover the past couple of years as an innovator in the branded segment of thebusiness, in which shafts tend to sell at higher prices and gross margins thanthe customized OEM production shafts sold to club manufacturers.  The Company introduced the Aldila NVTMin 2003, featuring the Company’s exclusive Micro Laminate Technologyä.  The NVTM has had numerous Tourvictories, and was in the winner’s bag for the 2003 British Open, the 2005 U.S.Open and is currently the number one shaft model on Tour.  The Company continues to develop otherpremium branded custom shafts and introduced NVäline extensions in 2004, including the NVS, NV ProtoPypeä,NVäExtreme and the NVä Hybrid shafts. In 2005, PGA Tour and NationwideTour professionals using Aldila NVTM shafted drivers have won morethan $23 million in Tour earnings.  Inaddition, the Company introduced the GamerTM shaft at the end of2004 and the first part of 2005.  In thespring of 2006, Aldila will begin shipments of our two newest shaft offerings –the NV ProtoPypeTM and the VS Proto. The VS Proto is quickly becoming Aldila’s single most popular shaftmodel on Tour.  Both are high-end, highperformance shafts featuring carbon nanotubes as well as aerospace carbonfibers and Aldila’s exclusive high performance resin system.  In addition, we unveiled the new VS ProtoHybrid shaft for high-end hybrid clubs and a new GamerTM wood shaftand iron shaft

 

16

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to match the GamerTM Hybrid shaft previouslyintroduced.  The Company believes that itwill continue to be successful in the branded segment and has focused itsmarketing and advertising effort in support of this business.    

 

The Company continues to maintain a broad customer base in both the OEMproduction shaft and branded shaft market segments and competes aggressivelywith both United States and foreign-based shaft manufacturers for OEMproduction shafts.  However, the Company’ssales have tended to be concentrated among a limited number of major clubcompanies, thus making the Company’s results of operations dependent on thosecustomers, their continued willingness to purchase a significant portion oftheir shafts from the Company, and their success in selling clubs containingthe Company’s shafts to their customers. In 2005, net sales to Acushnet Company, Ping and Callaway Golfrepresented 19%, 19% and 18% of the Company’s net sales, respectively, and theCompany anticipates that these companies will continue, collectively, torepresent the largest portion of its sales in 2006.  Although it is generally difficult to predictin advance the success of any particular club or of any particularmanufacturer, the Company believes that it is protected to some extent fromnormal periodic fluctuations in sales among the various golf club companies byvirtue of the broad range of its club manufacturer customers.  Golf club companies regularly introduce newclubs, frequently containing innovations in design.  Sometimes these new clubs achieve dramaticsuccess in the marketplace, thus increasing the overall volatility of clubsales among the major companies.  Whilethe Company seeks to have its shafts represented on as many major productintroductions as possible, it can provide no assurance that its shafts will beincluded in any particular “hot” club or that sales of a “hot” club that doesnot include the Company’s shafts will not have a negative impact on the salesof those clubs that do.  The Company’ssales could also suffer a significant drop-off from period to period to theextent that they may be dependent in any period on sales of one or more “hot”clubs, which then tail off in subsequent periods when no other club offers ahigh level of new sales to replace the lost sales.

 

During the 1990’s, the graphite golf shaft industry became increasinglycompetitive, placing extraordinary pressure on the selling prices of theCompany’s golf shafts and adversely affecting its gross profit margins andlevel of profitability.  The Company’saverage selling price decreased by 64% from December 31, 1990 through December31, 2002.  The pressure was mainlyattributed to the increased competition for OEM production shafts, and a shiftof our customers away from branded shafts to customized OEM productionshafts.  Beginning in 2003, the Companywas able to achieve higher average selling prices as it enjoyed success in thebranded segment of the business. Beginning in late 2004, the Company began to see its OEM customerschoose co-branded shafts in their stock offerings.  The introduction of co-branded shafts and thecontinued success in the branded segment has had the affect of increasing theCompany’s average selling prices over the last few years.  The Company’s average selling price increasedby approximately 36% during the quarter ended December 31, 2005 and hasincreased by approximately 33% for the year ended December 31, 2005 as comparedto the comparable periods in 2004.  TheCompany believes that its average selling price will further increase if itcontinues to be successful in the branded and co-branded segments of the golfshaft market.  In addition, increases incarbon fiber prices passed on to its customers will also have the effect ofincreasing average selling prices in the future.

 

  The Company’s response to thepricing pressure it faced during the 1990’s, and continues to face in the OEMproduction shaft segment, has been to vertically integrate, reduce its coststructure and to focus on continued penetration of the branded and co-brandedshaft segments.  The vertical integrationbegan in 1994 when the Company started manufacturing prepreg, the principal rawmaterial in the manufacture of graphite golf shafts, at its facility in Poway,CA.  The Company uses most of itsproduction of prepreg internally, with the remainder sold to other fabricatorsof products manufactured from composite materials.  Sales of prepreg as a percentage of netrevenues were 9.6% and 8.4% for the years ended December 31, 2005 and2004.  The Company previously announcedthat it intends to purchase a second resin filmer, which the Companyanticipates will be installed and operational in the first quarter of2006.  The addition of a second resinfilmer will provide additional supply of resin film, which is one of the keyraw materials in the production of prepreg. The increase in resin film capacity will enable the Company to addadditional capacity to the Company’s prepreg composite manufacturing operationsas well as provide increase capacity for film products.  In addition, it will provide capacityprotection should the Company encounter problems with its other resinfilmer.  The Company also has placed onorder its sixth prepreg tape line, which will enable it to support anticipatedgrowth for shaft and prepreg sales.

 

The Company continues to look for opportunities to sell its prepreg andfilm adhesive products to other fabricators of products manufactured fromcomposite materials and to manufacture other non-golf composite materialsproducts, such as hockey sticks.  TheCompany has achieved some success in these areas and management believes thatthe growth opportunities in these areas will exist. Management believes thatvertical integration through its prepreg operation has been successful to dateand is allowing the Company to maintain, or in some cases enhance, itscompetitive position with respect to the major United States golf clubcompanies that are its principal customers.

 

In addition to vertical integration through prepreg, the Companyestablished a manufacturing facility in Evanston, Wyoming for the production ofcarbon fiber in 1998.  During 1998 and throughthe first ten months of 1999, the Company

 

17

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used the material from this facility to satisfy a significant portionof its internal demand for carbon fiber in the manufacturing of prepreg usedfor graphite shafts.  During 1999, theCompany also produced and sold carbon fiber from this facility to otherunrelated entities for the manufacture of other carbon-based products.  On October 29, 1999, SGL Carbon Fibers andComposites, Inc. (“SGL”) purchased a 50% interest in the Company’s carbon fibermanufacturing operation.

 

The Company and SGL entered into an agreement to operate the facilityas a limited liability company with equal ownership interests between theventure members.  The Company and SGLalso entered into supply agreements with the new entity, CFT, for the purchaseof carbon fiber at cost plus an agreed-upon mark-up.  The Company and SGL are each responsible tobear 50% of the fixed costs to operate the facility as a term of this supplyagreement.  The partners share profitsand losses of CFT equally.  The jointventure partners primarily consume the carbon fiber manufactured from thisfacility.

 

If the carbon fiber facility is not operated at high production levels,either because of production difficulties or because there is not enough demandby the joint venture owners to justify that level of production, the cost perunit of carbon fiber consumed by the Company (and thus the cost of producingthe Company’s golf shafts and other products) is increased due to spreading thefixed costs of production over smaller volumes. If demand is lower than production capacity, CFT also runs the risk ofbuilding up excess inventory.  Given therelatively low costs historically in the market for carbon fiber and the highlycompetitive market for graphite golf shafts, the failure to operate at highlevels could adversely affect the Company’s gross margins or its ability tomaintain profitable competitive prices for its products.  Although selling prices of carbon fiber hadbeen depressed for the 1998 through mid 2003 period based on a surplus ofsupply in the market for carbon fiber, the Company began to see increases incarbon fiber prices and a constriction of supply of all types of carbon fiber,which are not manufactured at CFT in the second half of 2003.  If the prices continue to increase or if thecompany cannot obtain an adequate supply at a reasonable price, it could havean adverse affect on the Company’s business. The Company does not expect third party sales at CFT to have asignificant effect on either its sales or profitability.

 

Over the past several years, CFT haspurchased its carbon fiber raw material known as precursor (an acrylic fiber)from a single source.  During that timeperiod it had considered its previous supplier a viable backup materialsource.  In May 2005, CFT’s previoussupplier filed bankruptcy and announced its intention to cease producingacrylic fibers, which left CFT in a true sole source position.  It was announced on October 28, 2005 that theprecursor production assets of CFT’s previous supplier were sold to a thirdparty whose intention is to continue the production of precursor for sale tounrelated parties.  There is no certaintythat the new owner of these assets will be successful.  CFT is pursuing alternate sources of supplyfor this raw material. However, if the current supplier is unable to deliverand CFT cannot find a new supplier, it could have an adverse effect on theCompany’s business.

 

Until recently, the Company believed that the cost saving benefits ofits efforts to vertically integrate through the manufacture of carbon fiber hadnot benefited the Company in the last several years.  Market prices for golf shaft raw materials,which are primarily based on carbon fiber costs, have been historically lowwith carbon fiber readily available at attractive prices when compared to theCompany’s cost to purchase it from CFT. The Company’s gross margins and profitability were adversely affectedwhen the market prices of carbon fiber were low.  In the second half of 2003, the availabilityof carbon fiber began to tighten and prices began to increase. The shortage ofcarbon fiber in the world markets today is real and appears to be long term.The Company believes that CFT is now a valuable strategic asset. 

 

In addition to the Company’s efforts to reduce its costs throughvertical integration, the Company also reduced its cost structure by shiftingmore of its shaft production to lower cost labor markets, such as Mexico andChina.  In a further effort to reducecosts, the Company consolidated its executive offices with its manufacturingfacilities in Poway, California in 2002. 

 

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**Results of Operations**

 

The following table sets forth the operating results for the yearsindicated:

 
| ** **                                        | ** ** | **For the years ended****December 31,** | ** ** | **Period Change** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|
| ** **                                        | ** ** | **2005**                                     | ** ** | **2004**          | ** ** | **2003** | ** ** | **2005 vs.  2004** | ** ** | **2004 vs.  2003** | ** ** |
| **Results of Operations**                         | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Sales                                         |       | $                                            | 76,978     |              | $          | 52,762 |   | $ | 37,807 |   | 46 | % | 40 | % |
| Cost Of Sales                                     |       | 47,368                                       |       | 34,786            |       | 30,586 |   | 36 | % | 14 | % |
| Gross Profit                                      |       | 29,610                                       |       | 17,976            |       | 7,221 |   | 65 | % | 149 | % |
| Gross Margin                                      |       | 38                                           | %          | 34                | %          | 19 | % |   |   |   |   |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| Selling, General And Administrative               |       | 9,741                                        |       | 8,237             |       | 6,989 |   | 18 | % | 18 | % |
| Operating Income                                  |       | 19,869                                       |       | 9,739             |       | 232 |   | 104 | % | 4,098 | % |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| Other Expense (Income):                           |       |                                         |       |              |       |   |   |   |   |   |   |
| Interest Expense                                  |       | —                                       |       | —            |       | 23 |   | — |   | 100 | % |
| Interest and other (income) expense, net          |       | (586                                         | )          | (60               | )          | 48 |   | 877 | % | 225 | % |
| Impairment Of Investment In Joint Venture         |       | —                                       |       | —            |       | 2,220 |   | — |   | 100 | % |
| Equity In Earnings Of Joint Venture               |       | (236                                         | )          | (246              | )          | (150 | ) | -4 | % | 64 | % |
| Income (Loss) Before Income Taxes                 |       | 20,691                                       |       | 10,045            |       | (1,909 | ) | 106 | % | 626 | % |
| Provision (Benefit) For Income Taxes              |       | 7,287                                        |       | 725               |       | (183 | ) | 905 | % | 496 | % |
| Net Income (Loss)                                 |       | $                                            | 13,404     |              | $          | 9,320 |   | $ | (1,726 | ) | 44 | % | 640 | % |
| Net Income (Loss) Per Common Share-Basic          |       | $                                            | 2.54       |              | $          | 1.85 |   | $ | (0.35 | ) | 37 | % | 629 | % |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| **Cash Flow Data**                                |       |                                         |       |              |       |   |   |   |   |   |   |
| Cash provided by operating activities             |       | $                                            | 12,187     |              | $          | 9,573 |   | $ | 3,997 |   | 27 | % | 140 | % |
| Cash (used for) provided by investing  activities |       | $                                            | 3,816      |              | $          | (5,339 | ) | $ | (183 | ) | 171 | % | -2,817 | % |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| Cash provided by (used for) financing  activities |       | $                                            | (11,713    | )                 | $          | 378 |   | $ | (181 | ) | -3,199 | % | 309 | % |

 

***2005 Compared to 2004***

** **

*Net Sales. *Net sales increased by $24.2 million for 2005from 2004.  The majority of the increasein sales was attributed to an increase in sales of branded and co-branded golfshafts and to a lesser extent the increase in sales of prepreg material.  Branded golf shaft sales increased 73% in2005 as compared to 2004, which was mainly attributed to the success of theCompany’s NVTM family of shafts. Co-branded golf shaft sales increased 1,387% in 2005 as compared to2004.  The increase branded andco-branded sales are mainly attributed to the move of first and second tierclub companies to these shafts in their driver, fairway and hybrid clubmodels.  The Company believes thesetrends will continue as the club companies introduce new models.  The Company believes its success in the brandedand co-branded shaft segments will continue for the foreseeable future,however, it does not anticipate it will achieve the same year over year growthrate. Total golf shaft unit sales increased by approximately 13% for 2005 from2004.  The average selling price ofshafts sold increased by approximately 33% for 2005 from 2004, which wasattributed to the increased branded and co-branded shaft sales in the productmix.  Prepreg material sales increased byapproximately 67% in 2005 from 2004 and represented 9.6% of the Company’s netsales for 2005.  The Company has added anew resin filmer, which the Company believes will be operational in the firstquarter of 2006 and plans to add a sixth prepreg line to support its golf andprepreg business.  Hockey sticks salesdecreased by 43% in 2005 from 2004 and represented 1.9% of the Company’s netsales for 2005.  The Company’s hockeystick sales were impacted by the NHL players strike.  The Company believes that it will have abetter year in 2006; however, the Company does not expect hockey stick sales tobe material to the Company’s net sales for 2006.  

 

*Gross Profit.*  Gross profit increased by approximately $11.6million for 2005 from 2004.  The Company’sgross profit margin increased to 38% in 2005 from 34% in 2004.  The increase in gross profit was mainlyattributed to an increase in sales of the Company’s branded and co-brandedproducts, which typically have higher gross margins than that of the Company’sother products.  In addition, the Company’sgross profit was negatively affected by additional inventory related reservesof approximately $710,000 in 2005, versus an increase of $97,000 in 2004.  The increase in reserves in 2005 and 2004were offset by the sales of product that were fully reserved for of $147,000 in2005 and $285,000 in 2004.  The neteffect of the inventory reserve adjustments was a decrease in gross profit of$563,000 in 2005 and an increase in gross profit of $186,000 in 2004. 

 

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*Operating Income (Loss)*.  Operating income increased by approximately$10.1 million for 2005 from 2004.  Theincrease was primarily attributed to the increase in gross profit.  The Company’s selling, general andadministrative (“SG&A”) expenses increased by approximately $1.5 million in2005 as compared to 2004.  The increasewas primarily attributed to the increased costs associated with being apublicly traded company.  The Company’scorporate costs increased by 130%, with the majority of the increase attributedto Sarbanes-Oxley Section 404 (“SOX”) compliance work, which was beingperformed with the assistance of outside consultants.  The Company spent approximately $591,000 in2005 for its SOX compliance efforts. Such compliance costs are ongoing and theCompany anticipates spending between $250,000 to $400,000 in 2006 for its SOXcompliance efforts.  In addition to theincrease in corporate expenses, the Company had higher SG&A costs relatedto incentive expenses and sales and marketing expenses.  The Company anticipates that it will spendapproximately the same amount on advertising and promotion in support of itsbranded and co-branded product in 2006 that it spent in 2005.  SG&A decreased as a percentage of netsales to 13% in 2005, from 16% in 2004.

 

*Other Expense (Income)*.  Other Income increased by approximately$526,000 for 2005 from 2004.  Theincrease was attributed to the interest income the Company realized on itsinvested cash balances.

 

*IncomeTaxes.*  TheCompany recorded a provision for income taxes in the amount of $7.3 million in2005 as compared to approximately $725,000 for 2004.  The Company’s effective tax rate was 35% in2005 as compared to 7% in 2004.  Thedifference in the effective tax rates was related to a change in the Company’svaluation allowance during 2004.

 

At December 31, 2004, the Company had anet deferred tax asset of approximately $2.2 million.  This deferred tax asset represented netoperating loss carryforwards, tax credit carryforwards and other basis differences,which give rise to future tax deductions in excess of book deductions.  Realization of these tax benefits isdependent upon the generation of future taxable income. During the fourthquarter of 2002, management determined that based on its then current outlookand existing circumstances that it was not likely that the tax benefitsassociated with its deferred tax assets would be realized.  Accordingly, the Company placed a fullvaluation allowance against its net deferred tax asset as of December 31,2002.  Based upon the Company’s resultsin 2004, the Company re-addressed the appropriateness of its valuationallowance and the circumstances that led to the establishment of its valuationallowance.  The Company determined thatthere had been a change in circumstances, and that its deferred tax assetswould be realized in future years and accordingly reduced its valuationallowance against the related deferred tax assets to zero as of December 31,2004.  The Company anticipates that itseffective tax rate will be between 35% and 40% for 2006.

 

***2004 Compared to 2003***

** **

*Net Sales. *Net sales increased by $15.0 million for 2004from 2003.  The majority of the increasein sales was attributed to an increase in sales of branded golf shafts and to alesser extent the increase in sales of prepreg material.  Branded golf shaft sales increased 271% in2004 as compared to 2003, which was mainly attributed to the success of theCompany’s NVTM family of shafts. Total golf shaft sales increased by approximately 35% for 2004 from2003.  The average selling price ofshafts sold increased by approximately 22% for 2004 from 2003, which wasattributed to the increased branded shaft sales.  Prepreg material sales increased byapproximately 141% in 2004 from 2003 and represented 8% of the Company’s netsales for 2004.  Hockey sticks salesincreased by 13% in 2004 from 2003 and represent 5% of the Company’s net salesfor 2004.  

 

*Gross Profit.*  Gross profit increased by approximately $10.8million for 2004 from 2003.  The Company’sgross profit margin increased to 34% in 2004 from 19% in 2003.  The increase in gross profit was mainlyattributed to an increase in sales of the Company’s branded product, whichtypically has higher gross margins than that of the Company’s otherproducts.  In addition, the Company’sgross profit was negatively affected by additional inventory related reservesof approximately $97,000 in 2004, versus an increase of $669,000 in 2003.  The increase in reserves in 2004 and 2003were offset by the sales of product that was fully reserved for of $284,000 in2004 and $745,000 in 2003.  The neteffect of the inventory adjustments was an increase in gross profit of $186,000in 2004 and $76,000 in 2003.

 

*Operating Income (Loss)*.  Operating income increased by approximately$9.5 million for 2004 from 2003.  Theincrease was primarily attributed to the increase in gross profit.  The Company’s selling, general andadministrative (“SG&A”) expenses increased by approximately $1.2 million in2004 as compared to 2003.  The increasein SG&A was primarily attributed to increased incentive expenses andincreases in advertising and marketing spending.  Incentive related expense andadvertising/marketing expense represented approximately 42% of SG&A in 2004.  Other SG&A decreased by 5% in 2004 ascompared to 2003.  SG&A decreased asa percentage of net sales to 16% in 2004, from 18% in 2003.

 

*Other Expense (Income)*.  The Company recorded an impairment charge ofapproximately $2.2 million in 2003

 

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related to its investment in its joint venture (CFT).  See - “Notes to Consolidated FinancialStatements,” Note 5. Interest expense decreased to $0 in 2004 from $23,000 in2003.  

 

*Income Taxes.*  The Company recorded a provision for incometaxes in the amount of $725,000 in 2004. The Company’s effective tax rate was 7% in 2004.  At December 31, 2004, the Company had anet deferred tax asset of approximately $2.2 million.  See discussion above regarding the Company’svaluation allowance and the subsequent change in its valuation allowance. 

 

**Liquidity and Capital Resources**

 

Cash, cash equivalents and marketable securities (“cash”) decreased byapproximately $681,000 from 2004.  Themajority of the decrease was attributed to dividend payments during the yeartotaling $13.1 million.  The Company paid$0.45 per share in quarterly dividends during the year and $2.00 per share inspecial dividends during the year. The Company’s current quarterly dividend pershare is $0.15, subject to continued financial success and approval by theCompany’s Board of Directors.  Inaddition, the Company increased its inventory, mainly attributed to rawmaterials, during the year.  The increasein inventory used approximately $4.1 million in cash during the year.  The uses of cash for dividends and inventorywere partially offset by increases in net income of approximately $4.1 millionand accounts payable of $2.1 million. Cash provided by operating activities in 2005 was approximately $12.2 million,compared to approximately $9.6 million in 2004. 

 

The Company used $1.6 million for capital expenditures during 2005,with the majority of it applicable to the tenant improvements placed in serviceat its manufacturing location and added prepreg manufacturing capacity.  Management anticipates capital expenditureswill approximate between $3.0 million and $6.0 million for 2006.  The increase in capital spending will be usedto support the Company’s growth in its golf and prepreg businesses.  The Company received distributions from CFTtotaling $400,000 in 2005 compared to $1.5 million in 2004.  Future distributions from CFT must be agreedupon by both joint venture partners prior to any distribution being made.  

 

Until 2003, the Company had in place a $12.0 million revolving creditfacility from a financial institution, which was secured by substantially allthe assets of Aldila Golf and guaranteed by the Company.  The Company terminated the line of creditduring 2003 and does not anticipate establishing a new line of credit tosupport operations.

 

**Off Balance Sheet Arrangements**

 

As of December 31, 2005 and 2004, the Company did not have any OffBalance Sheet Arrangements.

 

**Contractual Obligations**

 
| ** **            | ** ** | **Payments Due by Period (thousands)** | ** ** |
|-----------------------|------------|----------------------------------------|------------|
| ** **            | ** ** | **Less Than  1 Year**                  | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than  5 Years** | ** ** | **Total** | ** ** |
| Operating  leases (a) |       | $                                      | 988        |   | $ | 1,660 |   | $ | 967 |   | $ | 457 |   | $ | 4,071 |   |
| CFT Fixed  Costs (b)  |       | 1,400                                  |       | 2,800 |   | 2,800 |   | — |   | 7,000 |   |
| Total                 |       | $                                      | 2,388      |   | $ | 4,460 |   | $ | 3,767 |   | $ | 457 |   | $ | 11,071 |   |

 

----

(a)   Weenter into operating leases in the normal course of business.  All lease agreements have fixed payment termsbased on the passage of time.  Some leaseagreements provide us with the option to renew the lease.  Our future operating lease obligations wouldchange if we exercised these renewal options and if we entered into additionaloperating lease agreements.

 

(b)   TheCompany is responsible for 50% of the fixed costs of CFT.  The amounts estimated above are based uponthe amount of fixed costs for CFT in 2005.  As the Company is responsible for the fixed costs until CFT isdissolved, the Company has estimated the amount through year 5.  If CFT were to still be in existence pastyear 5, the Company is still responsible for 50% of their fixed costs.  The Company does not currently have a fixedor minimum quantity of carbon fiber that it is required to purchase from CFT.

 

The Company may from time to time consider the acquisition ofbusinesses complementary to the Company’s business.  The Company could require additional debtfinancing if it were to engage in a material acquisition in the future.

 

21

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**Seasonality**

 

Because the Company’s customers have historically built inventory inanticipation of purchases by golfers in the spring and summer, the principalselling season for golf equipment, the Company’s operating results have beenaffected by seasonal demand for golf clubs, which has generally resulted inhighest sales occurring in the second quarter. The timing of customers’ new product introductions has frequentlymitigated the impact of seasonality in recent years.

 

**“Safe Harbor” Statement Under the Private Securities Litigation ReformAct of 1995**

 

This Annual Report on Form 10-K and certain information incorporatedherein by reference contain forward-looking statements within the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995.  All statements included or incorporated byreference in this Annual Report on Form 10-K, other than statements that arepurely historical, are forward-looking statements.  

 

Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,”“seeks,” “estimates,” and similar expressions also identify forward-lookingstatements.  Forward-looking statementsare not guarantees of future performance and are subject to risks anduncertainties that could cause actual results to differ materially from theresults contemplated by the forward-looking statements.  These forward-looking statements are based onmanagement’s expectations as of the date hereof, that necessarily containcertain assumptions and are subject to certain risks and uncertainties.  The Company does not undertake anyresponsibility to update these statements in the future.  The Company’s actual future performance andresults could differ from that contained in or suggested by theseforward-looking statements as a result of the factors set forth in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, the Business Risks described in Item 1 of this Report on Form 10-Kand elsewhere in the Company’s filings with the Securities and ExchangeCommission.

 

**Item 7a.  Quantitative andQualitative Disclosures about Market Risk**

 

The Company believes that its exposure to market risk relating tointerest rate risk is not material.  TheCompany is exposed to foreign exchange risk to the extent of adversefluctuations in the Mexican peso and the Chinese renminbi.  Based on historical movements of thesecurrencies, the Company does not believe that reasonably possible near-termchanges in these currencies will have a material adverse effect on the Company’sfinancial position or results of operations. In addition, the Company does not engage in hedging activities toprotect from this potential risk.  TheCompany believes that its business operations are not exposed to market riskrelating to commodity price risk or equity price risk.

 

**Item 8.  Financial Statements andSupplementary Data**

 

The information required as to this Item is incorporated by referencefrom the consolidated financial statements and supplementary data listed inItem 15 of Part IV of this report.

 

**Item 9.  Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

 

None.

 

**Item 9A. Controls and Procedures**

 

*Evaluationof disclosure controls and procedures.*As of the end of theperiod covered by this report, Aldila management, including the Chief ExecutiveOfficer and Chief Financial Officer, conducted an evaluation of theeffectiveness of our disclosure controls and procedures pursuant to ExchangeAct Rule 13a-14.  Based upon thatevaluation, the Chief Executive Officer and the Chief Financial Officerconcluded that such disclosure controls and procedures are effective inalerting them on a timely basis to material information relating to Aldilarequired to be included in Aldila’s periodic filings under the Exchange Act.

 

**Management’s Report on Internal Control OverFinancial Reporting**

** **

The Company’s management is responsible forestablishing and maintaining effective internal control over financialreporting (as defined in Rule 13a-15(f) of the Securities Exchange Act).  Management assessed the effectiveness of theCompany’s internal control over financial reporting as of December 31,2005.  In making this assessment,management used the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission (“COSO”) in its report entitled *Internal Control – Integrated Framework. *Based on the assessment,management believes that, as of December 31, 2005, the Company’s internalcontrol over financial reporting is effective based on those criteria.

 

22

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Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of theeffectiveness of the internal control over financial reporting to futureperiods are subject to the risk that the controls may become inadequate becauseof changes in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

 

Management’s assessment of the effectiveness of theCompany’s internal control over financial reporting as of December 31, 2005 hasbeen audited by Peterson & Co., LLP, an independent registered publicaccounting firm, as stated in its report which is included herein.

 

**Report of Independent Registered Public AccountingFirm on Internal Control OverFinancial Reporting**

** **

Tothe Board of Directors and Stockholders of

Aldila,Inc.

Poway,California

 

We have audited management’sassessment, included in the accompanying Management’s Report on InternalControl over Financial Reporting appearing under Item 9A, that Aldila, Inc.maintained effective internal control over financial reporting as of December31, 2005, based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).  Aldila, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

 

Weconducted our audit in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal controlover financial reporting, evaluating management’s assessment, testing andevaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

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

 

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Inour opinion, management’s assessment that Aldila, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2005 is fairlystated, in all material respects, based on criteria established in *Internal Control—Integrated Framework* issued by the COSO.Also in our opinion, Aldila, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31, 2005,based on criteria established in *InternalControl—Integrated Framework* issued by the COSO.

 

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the balance sheets and the relatedstatements of income, stockholders’ equity and comprehensive income, and cashflows of Aldila, Inc., and our report dated March 15, 2006 expressed anunqualified opinion.

 

PETERSON & CO., LLP

 

San Diego, California

March 15, 2006

 

23

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*Changesin internal control.*There have been no significant changesin internal controls or in factors that could significantly affect internalcontrols, including any corrective actions with regard to significantdeficiencies and material weaknesses, subsequent to the date the ChiefExecutive Officer and Chief Financial Officer completed their evaluation.

 

**Item 9B. Other Information**

 

None.

 

##### **PART III**

##### ** **

**Item 10. Directors and Executive Officers ofthe Registrant**

 

The information required as to this Item is incorporatedby reference from the section headed “Election of Directors” in theCompany’s Proxy Statement for the 2006 Annual Meeting of Stockholders for theyear ended December 31, 2005, which will be filed with the Commissionwithin 120 days of the end of the fiscal year covered by this report (“2006Proxy Statement”).

 

The Company adopted a Code of BusinessConduct and Ethics on December 31, 2002 governing its officers, directorsand employees, including our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions. A copy of the Code of Ethics is available at the Company’swebsite, www.aldila.com. See the Code of Business Conduct and Ethics includedherein as Exhibit 14.0 to this Report.

 

**Item 11. Executive Compensation**

 

The information required as to this Item isincorporated herein by reference from the data under the caption “ExecutiveCompensation” in the 2006 Proxy Statement.

 

**Item 12. Security Ownership of Certain BeneficialOwners and Management**

 

The information required as to this Item isincorporated herein by reference from the data under the caption “SecurityOwnership of Certain Beneficial Owners and Management” in the 2006 ProxyStatement.

 

**Item 13. Certain Relationships and RelatedTransactions**

 

There is no information required to besubmitted by the Company under this Item.

 

**Item 14. Principal Accounting Fees andServices**

 

The information required as to this Item is incorporated herein byreference from the data under the caption “Independent Accountant Fees” in the2006 Proxy Statement.

 

24

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**PART IV**

 

**Item 15. Exhibits, Financial Statement Schedules, and Reports on Form8-K**

 

(a)          Documents included as part of this report:

 

1.                                       The consolidatedfinancial statements for the Registrant are included in this report.

 
|   | Consolidated Balance Sheets at  December 31, 2005 and 2004;                                                  | 26     |
|--------|--------------------------------------------------------------------------------------------------------------|--------|
|   |                                                                                                         |   |
|   | Consolidated Statements of Operations for  the years ended December 31,  2005, 2004 and 2003;                | 27     |
|   |                                                                                                         |   |
|   | Consolidated Statements of Stockholders’ Equity  for the years ended December 31, 2005,  2004 and 2003; | 28     |
|   |                                                                                                         |   |
|   | Consolidated Statements of Cash Flows  for the years ended December 31,  2005, 2004 and 2003;                | 29     |
|   |                                                                                                         |   |
|   | Notes to Consolidated Financial Statements                                                                   | 30     |
|   |                                                                                                         |   |
|   | Report of Independent Registered Public Accounting Firm                                                      | 41     |

 

2.                                       Schedule IICValuation and Qualifying Accounts for the years ended December 31, 2005, 2004and 2003.

 

All other schedules are omitted because they are not applicable or therequired information is shown in the consolidated financial statements or thenotes thereto.

 

3.                                       See the Index toExhibits on page 43 of this Form 10-K. Financial statements of subsidiaries notconsolidated and fifty percent or less owned persons, management contracts or compensatoryplans or arrangements required to be filed as exhibits to this report areidentified on the Index to Exhibits.

 

(b)         Exhibits required by Item 601 of RegulationS-K.

 

See item (a) 3 above.

 

(c)          Financial statements required by RegulationS-X which are excluded from the annual report to shareholders by Rule 14a-3,which include separate financial statements of subsidiaries not consolidatedand fifty percent or less owned persons.

 

See item (a) 3 above.

 

25

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**ALDILA, INC. AND SUBSIDIARIES****CONSOLIDATED BALANCE SHEETS****(In thousands, except share data)**

 
| ** **                                                                                                                                                                               | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                               |       |                        |       |                        |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                          |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                |       | $                           | 15,821     |                        | $          | 11,531 |   |
| Marketable securities                                                                                                                                                                    |       | —                      |       | 4,971                       |       |
| Accounts receivable                                                                                                                                                                      |       | 7,233                       |       | 5,214                       |       |
| Income taxes receivable                                                                                                                                                                  |       | 895                         |       | 1,013                       |       |
| Inventories                                                                                                                                                                              |       | 12,387                      |       | 8,292                       |       |
| Deferred tax assets                                                                                                                                                                      |       | 1,352                       |       | 1,570                       |       |
| Prepaid expenses and other current assets                                                                                                                                                |       | 625                         |       | 380                         |       |
| Total current assets                                                                                                                                                                     |       | 38,313                      |       | 32,971                      |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| PROPERTY, PLANT AND EQUIPMENT                                                                                                                                                            |       | 5,570                       |       | 5,245                       |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| INVESTMENT IN JOINT VENTURE                                                                                                                                                              |       | 2,895                       |       | 3,072                       |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| DEFERRED TAXES                                                                                                                                                                           |       | 1,051                       |       | 634                         |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| OTHER ASSETS                                                                                                                                                                             |       | 260                         |       | 153                         |       |
| TOTAL ASSETS                                                                                                                                                                             |       | $                           | 48,089     |                        | $          | 42,075 |   |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                            |       |                        |       |                        |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                     |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                         |       | $                           | 6,294      |                        | $          | 4,213 |   |
| Accrued expenses                                                                                                                                                                         |       | 3,214                       |       | 2,781                       |       |
| Total current liabilities                                                                                                                                                                |       | 9,508                       |       | 6,994                       |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| LONG-TERM LIABILITIES:                                                                                                                                                                   |       |                        |       |                        |       |
| Deferred rent and other long-term liabilities                                                                                                                                            |       | 30                          |       | 20                          |       |
| Total liabilities                                                                                                                                                                        |       | 9,538                       |       | 7,014                       |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| COMMITMENTS AND CONTINGENCIES (Note 12)                                                                                                                                                  |       |                        |       |                        |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                               |       |                        |       |                        |       |
| Preferred stock, $.01 par value; authorized 5,000,000 shares;                                                                                                                            |       |                        |       |                        |       |
| no shares issued                                                                                                                                                                         |       |                        |       |                        |       |
| Common stock, $.01 par value; authorized 30,000,000 shares; issued  and outstanding 5,395,523 shares as of December 31, 2005 and 5,127,310 shares  as of December 31, 2004, respectively |       | 54                          |       | 51                          |       |
| Additional paid-in capital                                                                                                                                                               |       | 47,041                      |       | 43,864                      |       |
| Accumulated deficit                                                                                                                                                                      |       | (8,544                      | )          | (8,854                      | )          |
| Total stockholders’ equity                                                                                                                                                          |       | 38,551                      |       | 35,061                      |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                          |       | $                           | 48,089     |                        | $          | 42,075 |   |

 

See notes to consolidated financialstatements.

 

26

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**ALDILA, INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF OPERATIONS****(In thousands, except per share data)**

 
| ** **                                                     | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                     | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| NET SALES                                                      |       | $                                      | 76,978     |   | $ | 52,762 |   | $ | 37,807 |   |
| COST OF SALES                                                  |       | 47,368                                 |       | 34,786 |   | 30,586 |   |
| Gross profit                                                   |       | 29,610                                 |       | 17,976 |   | 7,221 |   |
|                                                           |       |                                   |       |   |   |   |   |
| SELLING, GENERAL AND ADMINISTRATIVE                            |       | 9,741                                  |       | 8,237 |   | 6,989 |   |
| Operating income                                               |       | 19,869                                 |       | 9,739 |   | 232 |   |
|                                                           |       |                                   |       |   |   |   |   |
| OTHER EXPENSE (INCOME):                                        |       |                                   |       |   |   |   |   |
| Interest expense                                               |       | —                                 |       | — |   | 23 |   |
| Interest and other (income) expense, net                       |       | (586                                   | )          | (60 | ) | 48 |   |
| Impairment of investment in joint venture                      |       | —                                 |       | — |   | 2,220 |   |
| Equity in earnings of joint venture                            |       | (236                                   | )          | (246 | ) | (150 | ) |
|                                                           |       |                                   |       |   |   |   |   |
| INCOME (LOSS) BEFORE INCOME TAXES                              |       | 20,691                                 |       | 10,045 |   | (1,909 | ) |
| PROVISION (BENEFIT) FOR INCOME TAXES                           |       | 7,287                                  |       | 725 |   | (183 | ) |
|                                                           |       |                                   |       |   |   |   |   |
| NET INCOME (LOSS)                                              |       | $                                      | 13,404     |   | $ | 9,320 |   | $ | (1,726 | ) |
|                                                           |       |                                   |       |   |   |   |   |
| NET INCOME (LOSS) PER COMMON SHARE-BASIC                       |       | $                                      | 2.54       |   | $ | 1.85 |   | $ | (0.35 | ) |
|                                                           |       |                                   |       |   |   |   |   |
| NET INCOME (LOSS) PER COMMON SHARE, ASSUMING DILUTION          |       | $                                      | 2.46       |   | $ | 1.77 |   | $ | (0.35 | ) |
|                                                           |       |                                   |       |   |   |   |   |
| WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING           |       | 5,273                                  |       | 5,027 |   | 4,934 |   |
|                                                           |       |                                   |       |   |   |   |   |
| WEIGHTED AVERAGE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES |       | 5,457                                  |       | 5,255 |   | 4,934 |   |

 

See notes to consolidated financial statements.

 

27

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**ALDILA, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**

 
| ** **                                                                                | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**             | ** ** | ** **                     | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------------------|------------|--------------------------------|------------|------------|------------|
| ** **                                                                                | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained Earnings** | ** ** | ** **                     | ** ** |
| ** **                                                                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**                | ** ** | **(Accumulated Deficit)** | ** ** | **Total**  | ** ** |
| Balance at January 1, 2003                                                                |       | 4,948                 |       | $           | 49         |                       | $          | 41,983                         |       | $          | (15,679    | ) | $ | 26,353 |   |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Repurchases of common stock                                                               |       | (63                   | )          | (1          | )          | (180                       | )          | —                         |       | (181       | )          |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Net loss                                                                                  |       | —                |       | —      |       | —                     |       | (1,726                         | )          | (1,726     | )          |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Balance at December 31, 2003                                                              |       | 4,885                 |       | 48          |       | 41,803                     |       | (17,405                        | )          | 24,446     |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Repurchases of common stock                                                               |       | (55                   | )          | —      |       | (295                       | )          | —                         |       | (295       | )          |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Common stock issued upon stock option  exercises, including income tax benefits of $917   |       | 297                   |       | 3           |       | 2,356                      |       | —                         |       | 2,359      |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Dividend payments                                                                         |       | —                |       | —      |       | —                     |       | (769                           | )          | (769       | )          |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Net income                                                                                |       | —                |       | —      |       | —                     |       | 9,320                          |       | 9,320      |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Balance at December 31, 2004                                                              |       | 5,127                 |       | 51          |       | 43,864                     |       | (8,854                         | )          | 35,061     |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Common stock issued upon stock option  exercises, including income tax benefits of $1,799 |       | 268                   |       | 3           |       | 3,177                      |       | —                         |       | 3,180      |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Dividend payments                                                                         |       | —                |       | —      |       | —                     |       | (13,094                        | )          | (13,094    | )          |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Net income                                                                                |       | —                |       | —      |       | —                     |       | 13,404                         |       | 13,404     |       |
|                                                                                      |       |                  |       |        |       |                       |       |                           |       |       |       |
| Balance at December 31, 2005                                                              |       | 5,395                 |       | $           | 54         |                       | $          | 47,041                         |       | $          | (8,544     | ) | $ | 38,551 |   |

 

See notes to consolidated financialstatements.

 

28

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**ALDILA, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

 
| ** **                                              | ** ** | **Year ended  December 31,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                   |       |                                   |       |   |   |   |   |
| Net income (loss)                                       |       | $                                      | 13,404     |   | $ | 9,320 |   | $ | (1,726 | ) |
| Adjustments to reconcile net income (loss)  to net cash |       |                                   |       |   |   |   |   |
| provided by operating activities:                       |       |                                   |       |   |   |   |   |
| Depreciation and amortization                           |       | 1,275                                  |       | 1,422 |   | 1,798 |   |
| (Gain) loss on disposal of fixed assets                 |       | (5                                     | )          | 32 |   | 26 |   |
| Impairment of investment in joint venture               |       | —                                 |       | — |   | 2,220 |   |
| Undistributed income of joint venture, net              |       | (223                                   | )          | (285 | ) | (182 | ) |
| Tax benefit from exercise of stock options              |       | 1,799                                  |       | 917 |   | — |   |
| Changes in assets and liabilities:                      |       |                                   |       |   |   |   |   |
| Accounts receivable                                     |       | (2,019                                 | )          | (601 | ) | (220 | ) |
| Inventories                                             |       | (4,095                                 | )          | (514 | ) | 760 |   |
| Deferred tax assets                                     |       | (199                                   | )          | (2,204 | ) | — |   |
| Prepaid expenses and other assets                       |       | (392                                   | )          | 52 |   | 70 |   |
| Accounts payable                                        |       | 2,081                                  |       | 1,146 |   | 155 |   |
| Accrued expenses                                        |       | 433                                    |       | 1,320 |   | (102 | ) |
| Income taxes receivable/payable                         |       | 118                                    |       | (1,013 | ) | 1,185 |   |
| Deferred rent and other long-term  liabilities          |       | 10                                     |       | (19 | ) | 13 |   |
| Net cash provided by operating activities               |       | 12,187                                 |       | 9,573 |   | 3,997 |   |
|                                                    |       |                                   |       |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                   |       |                                   |       |   |   |   |   |
| Purchases of property, plant and equipment              |       | (1,565                                 | )          | (1,871 | ) | (699 | ) |
| Proceeds from sales of property, plant and  equipment   |       | 10                                     |       | 3 |   | 16 |   |
| Investment in marketable securities                     |       | —                                 |       | (4,971 | ) | — |   |
| Proceeds from sales of marketable  securities           |       | 4,971                                  |       | — |   | — |   |
| Distributions from joint venture                        |       | 400                                    |       | 1,500 |   | 500 |   |
| Net cash provided by (used for) investing  activities   |       | 3,816                                  |       | (5,339 | ) | (183 | ) |
|                                                    |       |                                   |       |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                   |       |                                   |       |   |   |   |   |
| Repurchases of common stock                             |       | —                                 |       | (295 | ) | (181 | ) |
| Proceeds from issuance of common stock                  |       | 1,381                                  |       | 1,442 |   | — |   |
| Dividend payments                                       |       | (13,094                                | )          | (769 | ) | — |   |
| Net cash (used for) provided by financing  activities   |       | (11,713                                | )          | 378 |   | (181 | ) |
|                                                    |       |                                   |       |   |   |   |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS               |       | 4,290                                  |       | 4,612 |   | 3,633 |   |
| CASH AND CASH EQUIVALENTS, BEGINNING OF  YEAR           |       | 11,531                                 |       | 6,919 |   | 3,286 |   |
| CASH AND CASH EQUIVALENTS, END OF YEAR                  |       | $                                      | 15,821     |   | $ | 11,531 |   | $ | 6,919 |   |
|                                                    |       |                                   |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:     |       |                                   |       |   |   |   |   |
| Cash paid during the year for:                          |       |                                   |       |   |   |   |   |
| Interest                                                |       | $                                      | —     |   | $ | — |   | $ | 23 |   |
| Income taxes                                            |       | $                                      | 5,813      |   | $ | 3,095 |   | $ | 183 |   |

 

Seenotes to consolidated financial statements.

 

29

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**ALDILA, INC. AND SUBSIDIARIES****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****              SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

*The Company**–***Aldila,Inc. (a Delaware Corporation) (the “Company”) designs, manufacturers and marketsgraphite golf club shafts for sale principally in the United States. Inaddition, the Company sells a limited amount of composite prepregs and hockeysticks.

 

*Principles of Consolidation*– The consolidated financial statements of the Company include the accounts ofthe Company and its wholly owned subsidiaries, Aldila Materials TechnologyCorporation (“AMTC”), Aldila Golf, and Aldila Golf’s subsidiaries, Aldila deMexico and Aldila Carbon Fiber Products Company Ltd. All intercompanytransactions and balances have been eliminated in consolidation. The Companyaccounts for its joint venture investment in Carbon Fiber Technology LLC (“CFT”)under the equity method of accounting.

 

*Use of Estimates* –The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses, as well as the disclosure ofcontingencies affected by such estimates and assumptions. Actual results coulddiffer from these estimates.

 

*Revenue Recognition*– The Company recognizes revenues from product sales upon transfer of title tothe customer at the time of shipment. The Company also offers discounts tocertain customers based on early payment. Sales to these customers arerecognized on a gross basis, and sales discounts are recorded at the time thediscount is taken by the customer. Recording revenue net of discounts would nothave a significant effect on net sales or on the net realizable value ofaccounts receivable. Sales discounts for the years ended December 31, 2005,2004 and 2003 were $554,000, $328,000 and $245,000, respectively, representingless than 1% of gross revenues. The Company monitors the significance of theseamounts.

 

*Cash Equivalents* –The Company considers all highly liquid investments purchased with an originalmaturity of three months or less to be cash equivalents. The Company has nothistorically experienced losses on such investments.

 

*Marketable Securities*– Management determines the appropriate classification of marketable debt andequity securities at the time of purchase and reevaluates such designation asof each balance sheet date.

 

*Fair Value of Financial Instruments -*Thefair value of short-term marketable securities, trade accounts receivable andpayable and certain accrued expenses approximate their carrying amounts in thefinancial statements due to the short maturity of such instruments. The fairvalue of investments is determined using quoted market prices for thosesecurities.

 

*Accounts Receivable*– The Company sells graphite golf club shafts primarily to golf clubmanufacturers and distributors on credit terms. The Company also sells hockeysticks to one customer and composite prepregs to manufacturers of othercomposite based products on credit terms. The Company provides an allowance fordoubtful accounts equal to the estimated uncollectible amounts. The Company’sestimate is based on historical collection experience and a periodic review ofthe current status of outstanding customer balances. Historically, creditlosses have been minimal in relation to the credit extended.

 

*Inventories* –Inventories are stated at the lower of first-in, first-out (FIFO) cost ormarket value. The inventory balance,which includes material, labor and manufacturing overhead costs, is recordednet of an estimated allowance for obsolete or unmarketable inventory. Theestimated allowance for obsolete or unmarketable inventory is based uponmanagement’s understanding of market conditions and forecasts of future productdemand, all of which are subject to change. If actual charges for obsolescenceor unmarketable inventory significantly exceed the estimated allowance, theCompany’s operating results would be significantly adversely affected.

 

*Property, Plant and Equipment*– Property and equipment are stated at cost. Repairs and maintenance arecharged to expense as incurred. The Company depreciates its property andequipment using the straight-line method over the estimated useful lives of theassets, as follows:

 

30

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| ** **                     | ** ** | **Years** | ** ** |
|--------------------------------|------------|-----------|------------|
|                           |       |      |       |
| Machinery and equipment        |       | 5-10      |       |
|                           |       |      |       |
| Office furniture and equipment |       | 3-10      |       |

 

Leasehold improvements are amortized over the shorter of the asset lifeor the remaining term of the related lease.

 

*Joint Venture –* TheCompany’s 50% investment in CFT is accounted for under the equity method. (SeeNote 5).

 

*Evaluation of Long-lived Assets*–The Company’s policy is to assess potential impairments to its long-livedassets when there is evidence that events or changes in circumstances have maderecovery of the assets carrying value unlikely and the carrying amount of theasset exceeds the estimated undiscounted future cash flows. If such evaluationwere to indicate a material impairment of these long-lived assets, suchimpairment would be recognized by a write down of the applicable asset to itsestimated fair value under Statement of Financial Accounting Standards (“SFAS”)No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”. (SeeNote 5).

 

*Warranty Reserve –*The Company provides a warranty to its customers forshaft breakage in the normal course of business. The Company accrues for theestimated warranty based on historical experience at time of sale. Theestimated warranty is calculated based upon a rolling four-year ratio ofbreakage returns to sales applied to current year sales. (See Note 6).

* *

*Advertising*– The Company advertises primarily through print media.The Company’s policy is to expense advertising costs, including productioncosts, as incurred. Advertising expenses for 2005, 2004 and 2003 were $1.2million, $1.2 million and $1.2 million, respectively.

 

*Research & Development* – TheCompany performs internal research and development efforts. Research anddevelopment expense represented less than approximately 1% of net revenues for2005, 2004 and 2003 and is considered immaterial.

 

*Foreign Currency Translation –*The Company’s foreign subsidiaries are adirect and integral component or extension of the parent company’s operation. Thedaily operations of foreign subsidiaries are dependent on the economicenvironment of the parent’s currency. In addition, the changes in the foreignsubsidiary’s individual assets and liabilities directly affect the cash flow ofthe parent company. The functional currency of foreign subsidiaries is the USdollar. During the years ended December 31, 2005, 2004 and 2003, netforeign currency transaction gains and losses included in the Company’sStatements of Operations were insignificant.

 

*Common Stock and Earnings Per Share (EPS)*– Earnings per share - basic is calculated based upon the weighted averagenumber of shares outstanding during the year, while diluted also gives effectto all potential dilutive common shares outstanding during each year such asoptions, warrants and contingently issuable shares. Options to purchase 623,712shares of common stock as of December 31, 2003 at prices ranging from $2.52 to$18.66 per share were not included in the computation of diluted EPS becausethe effect of such options would be anti-dilutive as they were out-of-the-moneyoptions. In addition, options to purchase 88,785 shares of common stock as ofDecember 31, 2003 at prices ranging $1.61 to $1.87 per share, which werein-the-money options, were not included in the computation of diluted EPSbecause the effect of such options would be anti-dilutive as the Companyreported a net loss for 2003.

 

*IncomeTaxes* - Income taxes are provided utilizing the asset and liabilitymethod.  The asset and liability method requires the recognition ofdeferred tax assets and liabilities for the expected future tax consequences oftemporary differences between the carrying amounts and tax bases of assets andliabilities.  Valuation allowances are established when necessary toreduce deferred income tax assets to amounts more likely than not to berealized.

 

*Accounting for Stock BasedCompensation –*At December 31, 2005, the Company has two stock-basedcompensation plans, which are described more fully in Note 10. SFAS No. 123, “Accountingfor Stock-Based Compensation,” encourages but does not require companies torecord compensation cost for stock-based employee compensation plans at fairvalue (See SFAS 123R below under *RecentlyIssued Accounting Pronouncements)*. The Company has chosen tocontinue to account for stock-based compensation using the intrinsic valuemethod prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations. (See Note 8)

 

*Recently Issued AccountingPronouncements*– In May 2005, the FASB issued SFAS No. 154, “Accounting Changes andError Corrections” (“SFAS No. 154”), which replaces APB OpinionNo. 120, “Accounting Changes,” and SFAS No. 3, “Reporting AccountingChanges in Interim Financial Statements.” SFAS No. 154 changes therequirements for accounting

 

31

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and reporting a change in accounting principle, andapplies to all voluntary changes in accounting principles, as well as changesrequired by an accounting pronouncement in the unusual instance it does notinclude specific transition provisions. Specifically, SFAS No. 154requires retrospective application to prior periods’ financial statements,unless it is impracticable to determine the period-specific effects or thecumulative effect of the change. When it is impracticable to determine theeffects of the change, the new accounting principle must be applied to thebalances of assets and liabilities as of the beginning of the earliest periodfor which retrospective application is practicable and a correspondingadjustment must be made to the opening balance of retained earnings for thatperiod rather than being reported in an income statement. When it isimpracticable to determine the cumulative effect of the change, the newprinciple must be applied as if it were adopted prospectively from the earliestdate practicable. SFAS No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. SFAS No. 154 does not change the transition provisions of anyexisting pronouncements. The Company has evaluated the impact of SFASNo. 154 and does not expect the adoption of this statement to have asignificant impact on its consolidated statement of income or financialcondition. The Company will apply SFAS No. 154 in future periods, whenapplicable.

 

In December 2004, the Financial Accounting StandardsBoard issued SFAS No. 123(R), “Share-Based Payment.”  SFAS No. 123(R)replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123(R) requires compensation costs related to share-based paymenttransactions to be recognized in the financial statements over the period thatan employee provides service in exchange for the award.   SFAS No.123(R) is effective for fiscal years beginning after June 15, 2005.  TheCompany plans to adopt SFAS No. 123(R) on January 1, 2006. The Company does notanticipate the adoption of SFAS 123 to have a material impact on its financialstatements. (See Note 8.)

 

In November 2004, the Financial Accounting StandardsBoard issued SFAS No. 151, “Inventory Costs.”  SFAS No. 151 amends theguidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material.  This Statement requires that those items berecognized as current-period charges regardless of whether they meet thecriterion of “so abnormal.”  In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities.  SFAS No. 151 iseffective for fiscal years beginning after June 15, 2005.  The Companyintends to adopt SFAS No. 151 on January 1, 2006, the beginning of its 2006fiscal year.  The adoption of SFAS No. 151 is not expected to have amaterial impact on the Company’s financial statements.

 

*Reclassifications*– Certain reclassifications have been made toprior years’ disclosures to conform to current year classifications

 

**2.****              ACCOUNTS RECEIVABLE**

 

Accounts receivable at December 31 consist of the following (inthousands):

 
| ** **                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
|                                  |       |     |       |     |       |
| Trade accounts receivable             |       | $        | 7,251      |     | $          | 5,239 |   |
| Less: allowance for doubtful accounts |       | (18      | )          | (25      | )          |
| Accounts receivable                   |       | $        | 7,233      |     | $          | 5,214 |   |

 

**3.****              INVENTORIES**

 

Inventories at December 31 consist of the following (in thousands):

 
| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
|            |       |     |       |     |       |
| Raw materials   |       | $        | 8,447      |     | $          | 4,479 |   |
| Work-in-process |       | 1,279    |       | 920      |       |
| Finished goods  |       | 2,661    |       | 2,893    |       |
| Inventories     |       | $        | 12,387     |     | $          | 8,292 |   |

 

**4. PROPERTY, PLANT AND EQUIPMENT**

 

Property, plant and equipment at December 31 consists of the following(in thousands):

 

32

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| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |
| Machinery and equipment                          |       | $        | 15,437     |     | $          | 15,639 |   |
| Office furniture and equipment                   |       | 1,655    |       | 1,615    |       |
| Leasehold improvements                           |       | 8,881    |       | 8,635    |       |
| Property and equipment not yet in service        |       | 954      |       | 253      |       |
|                                             |       | 26,927   |       | 26,142   |       |
| Less: accumulated depreciation and  amortization |       | (21,357  | )          | (20,897  | )          |
| Property, plant and equipment                    |       | $        | 5,570      |     | $          | 5,245 |   |

 

Depreciation and amortization expense were $1.3 million, $1.4 millionand $1.8 million in 2005, 2004 and 2003, respectively.

 

**5.             INVESTMENT IN JOINTVENTURE**

 

The Company and SGL Carbon and Composites, Inc. (“SGL”) each own 50% ofCFT in a joint venture to produce carbon fiber. CFT, which was previously awholly owned subsidiary of AMTC, was formed on October 29, 1999. AMTCcontributed net assets with a book value of approximately $13.3 million. SGLpurchased a 50% interest in AMTC’s carbon fiber manufacturing operations forapproximately $7.0 million in cash, which resulted in a gain of approximately$334,000. The Amended and Restated Limited Liability Company Agreement providesthat CFT is to continue until December 31, 2099 unless it is dissolved earlier,its affairs are wound up and final liquidating distributions are made pursuantto the agreement.

 

The Company’s 50% investment in CFT is accounted for under the equitymethod. Based on the member’s respective ownership interest in the jointventure, profits and losses are allocated equally to each member. Each partneris responsible for 50% of the fixed costs of the facility regardless on theamount of fiber that is purchased from the joint venture. In 2005, CFT’s salesto the Company and its partner were $4.8 million and $6.2 million, respectively.The amount of consolidated retained earnings of the Company represented byundistributed earnings of CFT was an accumulated deficit of approximately $4.3million as of December 31, 2005. The Company’s equity in earnings from thejoint venture for the years ended December 31, 2005, 2004 and 2003 wasapproximately $236,000, $246,000 and $150,000, respectively. The Company’sinvestment includes the unamortized excess of the Company’s original investmentover its equity in the joint venture net assets. The excess was approximately$45,000 and $64,000 at December 31, 2005 and 2004, respectively, and is beingamortized on a straight-line basis over an initial estimated economic usefullife of approximately 101 months.

 

The Company and its joint venture partner entered into a non-bindingletter of interest on September 17, 2003 to sell selected assets, substantiallyall of the manufacturing equipment, building, land and raw materials(substantially all the total operating assets) of CFT to an independent thirdparty. On February 11, 2004, the Company and its joint venture partner enteredinto a non-binding letter of intent with that same party based on theprevailing circumstances preceding such letter and consequent assessments madeduring that relevant period. The letter of intent included an implied fairvalue of the proposed transaction and the Company was willing, at that time, tosell its 50% of CFT based on the implied fair value within the letter of intent.In consideration of the valuation determined during negotiations, the Companybelieved that impairment had occurred. Consequently it was appropriatelyassessed that the previous carrying amount of its investment in CFT as ofDecember 31, 2003 was not recoverable. As such the Company judged that in accordancewith SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”(“SFAS 144”) it was appropriate to record an impairment charge against therecorded value of its investment in CFT as of December 31, 2003 and suchimpairment charge was recorded in the fourth quarter of 2003. The three partiescontinued to negotiate the terms of the proposed transaction for an extendedperiod thereafter and were subsequently unable to reach an agreement on thetransaction, which along with prevailing market conditions at the time,continued to support the Company’s view as to the valuation of the asset inquestion and the appropriateness of the impairment charge recorded.

 

The Company disclosed in its June 30, 2004 Form 10-Q that thenegotiations regarding the sale of the selected assets failed. The Company nowbelieves that the fair value of CFT as of December 31, 2005 is currentlygreater than its carrying value. The increase in fair value is attributed tothe change of market conditions of the carbon fiber industry during 2004 and2005. Carbon fiber prices increased throughout 2004 and 2005, and supply hascontinued to tighten. The Company currently believes that this trend willcontinue into the foreseeable future. The Company will continue to assess thefair value of its investment in CFT going forward in accordance with SFAS 144.

 

33

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**6.     ACCRUEDEXPENSES**

 

Accrued expenses at December 31 consist of the following (inthousands):

 
| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |
| Payroll and employee benefits     |       | $        | 2,653      |     | $          | 2,280 |   |
| Warranty reserve [1]              |       | 180      |       | 176      |       |
| Marketing and promotional expense |       | —   |       | 225      |       |
| Legal and professional fees       |       | 67       |       | 25       |       |
| Other                             |       | 314      |       | 75       |       |
| Accrued expenses                  |       | $        | 3,214      |     | $          | 2,781 |   |

 
| **[1] Warranty Reserve** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Beginning Balance        |       | $        | 176        |     | $          | 184 |   |
| Settlement of Warranty   |       | (106     | )          | (77      | )          |
| Adjustments to Warranty  |       | 110      |       | 69       |       |
| Ending Balance           |       | $        | 180        |     | $          | 176 |   |

 

**7.     STOCKHOLDERS’ EQUITY**

 

The Company announced on January 17, 2001 that its Board of Directorsauthorized the repurchase of up to 333,333 shares of the Company’s common stock(or up to 6.5% of the 5,154,068 shares then issued and outstanding). TheCompany repurchased 206,267 shares on the open market, at an approximate costof $3.63 per share during 2001. The Company announced on January 22, 2002 anincrease in the number of shares authorized for purchase in its current sharebuyback program from 333,333 to 666,667 shares of the Company’s common stock.On June 27, 2003, the Company announced a stock buyback program under whichshares of the Company’s common stock could be repurchased up to a total of $1.5million. The Company repurchased 62,499 shares on the open market  during 2003, costing an approximate $181,000.The Company repurchased 54,989 shares on the open market during 2004, costingan approximate $295,000. The Company did not repurchase any shares during 2005.All shares that have been repurchased under the Company’s stock buybackprograms have been retired.

 

**8.****              ACCOUNTING FOR STOCKBASED COMPENSATION**

 

At December 31, 2005, the Company has two stock-based compensationplans, which are described more fully in Note 10. SFAS No. 123, “Accounting forStock-Based Compensation,” encourages but does not require companies to recordcompensation cost for stock-based employee compensation plans at fair value(See SFAS 123R under *Recently IssuedAccounting Pronouncements)*. The Company has chosen to continue toaccount for stock-based compensation using the intrinsic value methodprescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations. Accordingly,compensation cost for stock options is measured as the excess, if any, of thequoted market price of the Company’s stock at the date of the grant over theamount an employee must pay to acquire the stock.

 

Had compensation cost for the Company’s stock option awards beendetermined based upon the fair value at the grant date for awards from 2001through 2005 and recognized on a straight-line basis over the related vestingperiod, in accordance with the provisions of SFAS No. 123, the Company’s netincome and earnings per share for 2005 and 2004 would have been decreased andthe net loss and loss per share for 2003 would have been increased to the proforma amounts indicated below:

 
| ** **                                                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income (loss) as reported                                                                                                                 |       | $        | 13,404     |     | $          | 9,320    |       | $ | (1,726 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Add back:                                                                                                                                     |       |     |       |     |       |     |       |
| Option charge from accelerated vesting of  options                                                                                            |       | 19       |       |     |       |     |       |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (1,378   | )          | (202     | )          | (208     | )          |
| Pro forma net income (loss)                                                                                                                   |       | $        | 12,045     |     | $          | 9,118    |       | $ | (1,934 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Earnings (loss) per share:                                                                                                                    |       |     |       |     |       |     |       |
| Basic – as reported                                                                                                                      |       | $        | 2.54       |     | $          | 1.85     |       | $ | (0.35 | ) |
| Basic – pro forma                                                                                                                        |       | $        | 2.28       |     | $          | 1.81     |       | $ | (0.39 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Diluted – as reported                                                                                                                    |       | $        | 2.46       |     | $          | 1.77     |       | $ | (0.35 | ) |
| Diluted – pro forma                                                                                                                      |       | $        | 2.21       |     | $          | 1.74     |       | $ | (0.39 | ) |

 

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InDecember 2004, the Financial Accounting Standards Board issued SFAS No. 123(R),“Share-Based Payment.”  SFAS No. 123(R) replaces SFAS No. 123, “Accountingfor Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  SFAS No. 123(R) requires compensationcosts related to share-based payment transactions to be recognized in thefinancial statements over the period that an employee provides service inexchange for the award.   The provisions of SFAS No. 123(R) are effectiveas of the beginning of the first annual reporting period that begins after June15, 2005. The Company will be adopting the provisions of SFAS No. 123(R) in thefirst quarter of 2006. SFAS 123(R) applies to new awards and to awardsmodified, repurchased or cancelled after the required effective date, as wellas to the unvested portion of awards outstanding as of the required effectivedate. SFAS No. 123(R) requires the fair value of all share based paymenttransactions to be recognized in the financial statements. As a result, uponadoption of SFAS No. 123(R) the Company will be required to recognizecompensation expense for the fair value of employee stock options and employeestock purchase grants over the applicable vesting period. The adoption of SFASNo. 123(R) is not expected to have a significant effect on our financialposition or cash flows, but the Company anticipates that the adoption of SFASNo. 123(R) will negatively impact our results of operations for fiscal 2006,due to non-cash compensation expense that will be recorded in connection withvesting of existing employee options and new options, if any, during theperiod.

 

OnDecember 19, 2005 the Compensation Committee of the Company’s Board ofDirectors approved a plan to accelerate the vesting of approximately 150,000stock options granted to employees in 2004 and 2005, including options held byexecutive officers of the Company. The Board took this action with the beliefthat it was in the best interests of the stockholders, as it will reduce theCompany’s reported compensation expense associated with those options in futureperiods compared to the expense that otherwise would have been recorded inconnection with the implementation of SFAS No. 123(R) during 2006. During thefourth quarter of 2005, the Company recorded a pre-tax charge of approximately$19,000 as compensation expense related to the option vesting acceleration.

 

**9. INCOME TAXES**

 

The components of the provision (benefit) for income taxes are asfollows (in thousands):

 
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                             |       |     |       |     |       |     |       |
| Federal                              |       | $        | 6,273      |     | $          | 2,256    |       | $ | (211 | ) |
| State                                |       | 1,101    |       | 455      |       | (58      | )          |
| Foreign                              |       | 114      |       | 217      |       | 86       |       |
| Total                                |       | 7,487    |       | 2,928    |       | (183     | )          |
| Deferred:                            |       |     |       |     |       |     |       |
| Federal                              |       | 202      |       | 2,352    |       | (57      | )          |
| State                                |       | (2       | )     | (149     | )     | 57       |       |
| Total                                |       | 200      |       | 2,203    |       | —   |       |
| Provision (benefit) for income taxes |       | $        | 7,287      |     | $          | 725      |       | $ | (183 | ) |

 

Net deferred income taxes included in current assets in the balancesheet at December 31, consist of the tax effects of temporary differencesrelated to the following (in thousands):

 
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Inventories                        |       | $        | 943        |     | $          | 914 |   |
| Accrued expenses                   |       | 258      |       | 760      |       |
| Allowance for doubtful accounts    |       | 7        |       | 10       |       |
| Deferred expenses (capital losses) |       | 4        |       | 4        |       |
| Prepaid expenses                   |       | —   |       | (86      | )          |
| State income taxes                 |       | 140      |       | (32      | )          |
| Deferred tax assets – current |       | $        | 1,352      |     | $          | 1,570 |   |

 

35

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Net deferred income taxes included in long-term assets in the balancesheet at December 31 consist of the tax effects of temporary differencesrelated to the following (in thousands):

 

 
| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| Property and equipment                              |       | $        | 543        |     | $          | 312 |   |
| Basis in joint venture (CFT)                        |       | (418     | )          | (586     | )          |
| CFT impairment charge                               |       | 904      |       | 882      |       |
| Other                                               |       | 22       |       | 26       |       |
| Deferred tax assets (liabilities) – long  term |       | $        | 1,051      |     | $          | 634 |   |

 

Total reconciliation of the deferred taxassets and liabilities are below.

 
| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets – current                       |       | $        | 1,352      |     | $          | 1,570 |   |
| Deferred tax assets (liabilities) – long  term      |       | 1,051    |       | 634      |       |
| Total net deferred tax asset before  valuation allowance |       | 2,403    |       | 2,204    |       |
| Valuation allowance                                      |       |     |       |     |       |
| Total deferred tax asset                                 |       | $        | 2,403      |     | $          | 2,204 |   |

 

During the fourth quarter of 2002, management determined that based onits then current outlook and existing circumstances that it was not likely thatthe tax benefits associated with its deferred tax assets would be realized. Accordingly,the Company placed a full valuation allowance against its net deferred taxasset as of December 31, 2002 in accordance with SFAS 109.

 

During theyear ended December 31, 2004, the Company addressed the appropriateness of itsvaluation allowance and the circumstances that led to the establishment of itsvaluation allowance in accordance with SFAS 109. The Company believed there hadbeen a change in circumstances, and that its deferred tax assets would berealized in future years and accordingly reduced its valuation allowanceagainst the related deferred tax assets to zero as of December 31, 2004. Therecorded amount of the valuation allowance as of December 31, 2003 was $2.5million, which was reduced to zero during 2004. Differences between thestatutory federal income tax rate and the effective tax rate as a percentage ofincome taxes are summarized below.

 
| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory rate                                  |       | 35.0     | %          | 34.0     | %          | (34.0    | )%         |
| State income taxes, net of Federal tax  benefit |       | 3.5      |       | 4.0      |       | (4.0     | )          |
| Valuation allowance                             |       | —   |       | (26.9    | )     | 44.7     |       |
| Revision of prior years’ tax estimates     |       | —   |       | —   |       | (10.3    | )     |
| Foreign earnings taxed at different rates       |       | (2.3     | )          | (4.0     | )          | (4.5     | )     |
| Other items                                     |       | (1.0     | )          | .1       |       | (1.5     | )          |
| Effective rate                                  |       | 35.2     | %          | 7.2      | %          | (9.6     | )%         |

 

The Company has adopted the position under APB 23 that earnings of itsforeign subsidiaries will be permanently reinvested outside of the UnitedStates. As such, United States deferred taxes have not been provided for onthese earnings.

 

**10. STOCK OPTION PLAN**

 

In 1992, the Company adopted a Stock Option Plan for management. TheCompany has reserved 175,431 shares for issuance under this Plan. Options aregranted at the fair market value of the shares at the date of grant, generallybecome fully vested three years after grant, and expire ten years from the dateof grant.

 

In May of 1994, the stockholders adopted the 1994 Stock Incentive Planfor employees, directors and consultants of the Company. The Company hasreserved 1,366,667 shares for issuance under this Plan. Options are granted atthe fair market value of the shares at the date of grant, generally becomefully vested three years after grant, and expire ten years from the date ofgrant.

 

The pro forma compensation costs presented in Note 8 were determinedusing the weighted average fair values of options granted under the Company’sstock option plans during 2005, 2004 and 2003, which were estimated at $11.28,$5.06 and $1.41, respectively, on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions:

 

36

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| ** **               | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|----------|------------|----------|------------|----------|------------|
| Dividend yield           | 2%       |       | 1%       |       | —%  |       |
| Volatility               | 55%      |       | 59%      |       | 49%      |       |
| Risk free rate of return | 4.1%     |       | 3.5%     |       | 2.7%     |       |
| Expected life            | 5 years  |       | 5 years  |       | 5 years  |       |

 

The estimated fair value of options granted is subject to theassumptions made and if the assumptions changed, the estimated fair valueamounts could be significantly different. A summary of the Company’s fixedstock option plans as of December 31, 2005, 2004 and 2003 and activity duringthe years then ended is presented below:

 
| ** **                 | ** ** | **2005**   | ** ** | **2004**                                   | ** ** | **2003**   | ** ** |
|----------------------------|------------|------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                 | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** |
| ** **                 | ** ** | ** ** | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at January 1   |       | 485,338    |       | $                                          | 5.86       |       | 712,497    |   | $ | 5.21 |   | 729,189 |   | $ | 5.79 |   |
| Granted                    |       | 91,571     |       | $                                          | 25.80      |       | 132,494    |   | $ | 11.37 |   | 90,440 |   | $ | 3.03 |   |
| Exercises                  |       | (218,213   | )          | $                                          | 5.21       |       | (299,025   | ) | 4.82 |   |   |   |   |   |
| Terminated                 |       | (5,385     | )          | $                                          | 9.09       |       | (60,628    | ) | $ | 15.20 |   | (107,132 | ) | $ | 7.30 |   |
| Outstanding at December 31 |       | 353,311    |       | $                                          | 11.36      |       | 485,338    |   | $ | 5.86 |   | 712,497 |   | $ | 5.21 |   |

 

The following table summarizes information about stock optionsoutstanding and exercisable at December 31, 2005:

 
| ** **                         | ** ** | ** **                                     | ** ** | **Options  Outstanding**                                   | ** ** | **Options  Exercisable**               | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------------------|------------|----------------------------------------|------------|
| **Range of****Exercise****Prices** | ** ** | **Number  Outstanding  at December 31,  2005** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Yrs.)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number****Exercisable****at  December 31,  2005** | ** ** | **Weighted****Average****Exercise  Price** | ** ** |
|                               |       |                                           |       |                                                       |       |                                   |       |   |   |   |   |
| $ 1.61 - $3.29                |       | 123,721                                        |       | 7.5                                                        |       | $                                      | 2.51       |   | 93,572 |   | $ | 2.35 |   |
| $ 4.14 - $5.34                |       | 39,659                                         |       | 5.5                                                        |       | $                                      | 4.71       |   | 39,659 |   | $ | 4.71 |   |
| $ 11.47 - $26.25              |       | 189,931                                        |       | 9.1                                                        |       | $                                      | 18.56      |   | 164,078 |   | $ | 18.53 |   |
| $ 1.61 - $26.25               |       | 353,311                                        |       | 8.1                                                        |       | $                                      | 11.39      |   | 297,309 |   | $ | 11.59 |   |

 

As of December 31, 2005, 2004 and 2003, 297,309, 261,853 and 503,420shares were exercisable under the Plans at a weighted average exercise price of$11.59, $4.20 and $6.08 per share, respectively. As of December 31, 2005, anaggregate of 500,728 shares remain available for grant under the Plans.

 

On March 20, 2000, the Company and Nick Price Group entered into astock option agreement. The option agreement allows Nick Price to purchase50,000 shares of Common Stock at a purchase price of $4.89 per share with athree-year vesting period. In return for the shares, the Company has receivedthe services of Nick Price at a guaranteed minimum value of $4.50 per share, ora minimum aggregate consideration of $225,000. The shares are registered undera Form S-3, which was filed with the Securities and Exchange Commission onAugust 2, 2004. Nick Price Group exercised their 50,000 options on March 11,2005.

 

**11. EMPLOYEE BENEFIT PLAN**

 

In 1994, the Company adopted the Aldila, Inc. 401(k) Savings Plan (the “Plan”)for employees of the Company and its subsidiaries. This defined contributionplan allows employees who satisfy the age and service requirements of the Planto contribute up to 19% of pre-tax wages, limited to the maximum amountpermitted under federal law. The Company matches the first 4% of wagescontributed by employees at a rate of $0.25 for every $1.00. The Company’smatching contributions vest over four years based on years of service. TheCompany’s contributions amounted to approximately $58,000, $48,000 and $48,000in 2005, 2004 and 2003, respectively.

 

37

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**12. COMMITMENTS AND CONTINGENCIES**

 

The Company leases building space and certain equipment under operatingleases. The Company’s leases for office and manufacturing space contain rentalescalation clauses and renewal options. Rental expense for the Company was $1.0million, $900,000 and $900,000 for 2005, 2004 and 2003, respectively. As ofDecember 31, 2005, future minimum lease payments for all operating leases areas follows (in thousands):

 
| 2006       |   | $   | 988    |   |
|------------|--------|-----|--------|--------|
| 2007       |   | 826 |   |
| 2008       |   | 834 |   |
| 2009       |   | 788 |   |
| 2010       |   | 179 |   |
| Thereafter |   | 456 |   |
|       |   | $   | 4,071  |   |

 

**13. SEGMENT INFORMATION**

 

The Company designs and manufacturers graphite shafts for golf clubmanufacturers. In doing so, the Company also manufactures carbon fiber andprepreg materials, which are utilized in the manufacture of graphite golfshafts. In accordance with SFAS No. 131 “Disclosures about Segments of anEnterprise and Related Information”, the Company considers its business toconsist of one reportable operating segment.

 

The Company markets its products domestically and internationally, withits principal international market being Europe. The table below containsinformation about the geographical areas in which the Company operates. Revenuesare attributed to countries based on location in which the sale is settled. Long-livedassets are based on the country of domicile. Sales to a major customerrepresented 19%, 22%, and 27% of net sales in 2005, 2004, and 2003, respectively.Sales to a second customer represented 18%, 17% and 21% of net sales in 2005,2004 and 2003, respectively. Sales to a third customer represented 19%, 9% and10% of net sales in 2005, 2004 and 2003, respectively.

 

(in thousands)
| **2005**                | ** ** | **Sales** | ** ** | **Long-Lived  Assets** | ** ** |
|-------------------------|------------|-----------|------------|------------------------|------------|
| United States           |       | $         | 59,523     |                   | $          | 6,415 |   |
| England                 |       | 7,524     |       | —                 |       |
| China                   |       | 6,908     |       | 1,813                  |       |
| Canada                  |       | 959       |       | —                 |       |
| Australia               |       | 800       |       | —                 |       |
| Mexico                  |       | —    |       | 237                    |       |
| Other Foreign Countries |       | 1,264     |       | —                 |       |
| Total                   |       | $         | 76,978     |                   | $          | 8,465 |   |
|                    |       |      |       |                   |       |
| **2004**                | ** ** | **Sales** | ** ** | **Long-Lived  Assets** | ** ** |
| United States           |       | $         | 43,277     |                   | $          | 6,134 |   |
| Scotland                |       | —    |       | —                 |       |
| England                 |       | 3,510     |       | —                 |       |
| China                   |       | 4,356     |       | 1,887                  |       |
| Mexico                  |       | —    |       | 296                    |       |
| Other Foreign Countries |       | 1,619     |       | —                 |       |
| Total                   |       | $         | 52,762     |                   | $          | 8,317 |   |
|                    |       |      |       |                   |       |
| **2003**                | ** ** | **Sales** | ** ** | **Long-Lived  Assets** | ** ** |
| United States           |       | $         | 32,180     |                   | $          | 6,794 |   |
| Scotland                |       | 53        |       | —                 |       |
| England                 |       | 2,855     |       | —                 |       |
| China                   |       | 1,057     |       | 2,013                  |       |
| Mexico                  |       | —    |       | 256                    |       |
| Other Foreign Countries |       | 1,662     |       | —                 |       |
| Total                   |       | $         | 37,462     |                   | $          | 9,063 |   |

 

38

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**14. QUARTERLY RESULTS OF OPERATIONS (Unaudited)**

 

The following is a summary of the quarterly results of operations forthe two years in the period ended December 31, 2005 (in thousands, except pershare data):

 
| ** **                                 | ** ** | **Quarter  Ended** | ** ** |
|--------------------------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **March  31,**     | ** ** | **June 30,** | ** ** | **September  30,** | ** ** | **December  31,** | ** ** |
| ** **                                 | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2005:**                                  |       |               |       |   |   |   |   |   |   |
| Net sales                                  |       | $                  | 17,808     |   | $ | 21,821 |   | $ | 19,327 |   | $ | 18,022 |   |
| Gross profit                               |       | 7,435              |       | 8,118 |   | 7,866 |   | 6,191 |   |
| Net income                                 |       | 3,309              |       | 3,644 |   | 3,761 |   | 2,690 |   |
|                                       |       |               |       |   |   |   |   |   |   |   |   |   |   |
| Net income per common share-basic          |       | $                  | 0.64       |   | $ | 0.70 |   | $ | 0.71 |   | $ | 0.50 |   |
| Net income per common share-diluted        |       | $                  | 0.61       |   | $ | 0.66 |   | $ | 0.68 |   | $ | 0.48 |   |
|                                       |       |               |       |   |   |   |   |   |   |
| **2004:**                                  |       |               |       |   |   |   |   |   |   |
| Net sales                                  |       | $                  | 15,298     |   | $ | 14,260 |   | $ | 10,772 |   | $ | 12,432 |   |
| Gross profit                               |       | 6,124              |       | 5,979 |   | 2,524 |   | 3,349 |   |
| Net income (loss)                          |       | 2,274              |       | 2,173 |   | 3,318 |   | 1,555 |   |
|                                       |       |               |       |   |   |   |   |   |   |
| Net income (loss) per common share-basic   |       | $                  | 0.47       |   | $ | 0.44 |   | $ | 0.65 |   | $ | 0.30 |   |
| Net income (loss) per common share-diluted |       | $                  | 0.46       |   | $ | 0.42 |   | $ | 0.62 |   | $ | 0.29 |   |

 

Earnings (loss) per share are computed independently for each of thequarters presented and therefore may not sum to the annual amount for the year.Included in the Company’s third quarter results ended September 30, 2004 was anadjustment to the Company’s income tax expense. The adjustment to income taxexpense was approximately $2.5 million, which was attributed to the reversal ofthe Company’s valuation allowance against its deferred tax assets. Included inthe Company’s fourth quarter results ended December 31, 2003 was an impairmentcharge of approximately $2.2 million against the carrying value of the Company’sinvestment in CFT.

 

**15. RELATED PARTY TRANSACTIONS**

 

The dollar amount of transactions with related parties, primarilyattributed to purchases of carbon fiber from CFT, was approximately $4.8, $4.7and $3.3 million for the years ended December 31, 2005, 2004 and 2003,respectively. Amounts owed to CFT as of December 31, 2005 and 2004 wereapproximately $255,000 and $414,000, respectively.

 

39

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**ALDILA INC. AND SUBSIDIARIES**

 

**SCHEDULE IIC VALUATION AND QUALIFYING ACCOUNTS**

 

**For the years ended December 31, 2005, 2004 and 2003**

 
| ** **                           | ** ** | **Balance at beginning  of year** | ** ** | **Charged to costs and  expenses** | ** ** | **Deductions** | ** ** | **Balance at end  of year** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Year ended December 31, 2003         |       |                                             |       |                                              |       |           |       |                                       |       |
| Allowance for uncollectible accounts |       | $                                                | 22,336     |                                              | $          | 45,000         |       | $                                          | (33,260    | ) | $ | 34,076 |   |
| Inventory reserves                   |       | $                                                | 3,716,870  |                                              | $          | 669,368        |       | $                                          | (2,378,908 | ) | $ | 2,007,330 |   |
| Warranty reserve                     |       | $                                                | 345,000    |                                              | $          | (51,000        | )          | $                                          | (110,000   | ) | $ | 184,000 |   |
|                                 |       |                                             |       |                                              |       |           |       |                                       |       |
| Year ended December 31, 2004         |       |                                             |       |                                              |       |           |       |                                       |       |
| Allowance for uncollectible accounts |       | $                                                | 34,076     |                                              | $          | 59,878         |       | $                                          | (69,137    | ) | $ | 24,817 |   |
| Inventory reserves                   |       | $                                                | 2,007,330  |                                              | $          | 97,288         |       | $                                          | (1,143,143 | ) | $ | 961,475 |   |
| Warranty reserve                     |       | $                                                | 184,000    |                                              | $          | 69,000         |       | $                                          | (77,000    | ) | $ | 176,000 |   |
|                                 |       |                                             |       |                                              |       |           |       |                                       |       |
| Year ended December 31, 2005         |       |                                             |       |                                              |       |           |       |                                       |       |
| Allowance for uncollectible accounts |       | $                                                | 24,817     |                                              | $          | 1,853          |       | $                                          | (8,662     | ) | $ | 18,008 |   |
| Inventory reserves                   |       | $                                                | 961,475    |                                              | $          | 710,000        |       | $                                          | (636,523   | ) | $ | 1,034,952 |   |
| Warranty reserve                     |       | $                                                | 176,000    |                                              | $          | 110,000        |       | $                                          | (106,000   | ) | $ | 180,000 |   |

 

40

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REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM

 

Tothe Board of Directors and Stockholders ofAldila, Inc.Poway, California

 

We have audited theaccompanying consolidated balance sheetsof Aldila, Inc. as of December 31, 2005 and 2004, and the relatedstatements of income, stockholders’ equity and cash flows for each of the yearsin the three-year period ended December 31, 2005. These financial statementsare the responsibility of the company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Aldila, Inc. as of December 31,2005 and 2004, and the results of its operations and its cash flows for each ofthe years in the three-year period ended December 31, 2005 in conformity withaccounting principles generally accepted in the United States of America.

 

Ouraudit was conducted for the purpose of forming an opinion on the basicconsolidated financial statements taken as a whole. Schedule IIC is presentedfor the purposes of additional analysis and is not a required part of the basicconsolidated financial statements. This schedule has been subjected to theauditing procedures applied in the audit of the basic consolidated financialstatements and, in our opinion, is fairly stated in all material respects inrelation to the basic consolidated financial statements taken as a whole.

 

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Aldila, Inc.’sinternal control over financial reporting as of December 31, 2005, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), and our report dated March 15,2006 expressed an unqualified opinion on management’s assessment of internalcontrol over financial reporting and an unqualified opinion on theeffectiveness of internal control over financial reporting.

 

PETERSON &CO., LLP

 

San Diego, CaliforniaMarch 15, 2006

 

41

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|   | ALDILA, INC. |
|--------|--------------|
|   |         |   |
|   | By:          |   | /s/ Peter R. Mathewson |   |
|   |         |   | Peter R. Mathewson |
|   |         |   | Chairman of the Board, |
|   |         |   | Chief Executive Officer |

 
| **Signature**           | ** ** | **Title** | ** **                                                      | **Date** |
|-------------------------|------------|-----------|-----------------------------------------------------------------|----------|
|                    |       |      |                                                            |     |
| /s/ Peter R. Mathewson  |       |      | Chief Executive Officer                                         |     | March 15, 2006 |
| Peter R. Mathewson      |       |      | and Director (Principal  Executive Officer)                     |     |   |
|                    |       |      |                                                            |     |   |
| /s/ Robert J. Cierzan   |       |      | Vice President, Finance                                         |     | March 15, 2006 |
| Robert J.  Cierzan      |       |      | (Principal Financial Officer  and Principal Accounting Officer) |     |   |
|                    |       |      |                                                            |     |   |
| /s/ Lloyd I Miller, III |       |      | Director                                                        |     | March 15, 2006 |
| Lloyd I. Miller, III    |       |      |                                                            |     |   |
|                    |       |      |                                                            |     |   |
| /s/ Thomas A. Brand     |       |      | Director                                                        |     | March 15, 2006 |
| Thomas A. Brand         |       |      |                                                            |     |   |
|                    |       |      |                                                            |     |   |
| /s/ Andrew M. Leitch    |       |      | Director                                                        |     | March 15, 2006 |
| Andrew Leitch           |       |      |                                                            |     |   |
|                    |       |      |                                                            |     |   |
| /s/ Bryant R. Riley     |       |      | Director                                                        |     | March 15, 2006 |
| Bryant R. Riley         |       |      |                                                            |     |   |
|                    |       |      |                                                            |     |   |

 

42

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit** |
|---------------------|------------|-------------|
|                |       |        |
|                | 2.1        |        | Agreement of Purchase and Sale, dated as of  December 14, 1991, by and among Aldila Acquisition Corp., Aldila, Inc. and  all of the Shareholders of Aldila, Inc., as amended by the First Amendment  dated January 9, 1992 by and among Aldila Acquisition Corp., Aldila, Inc. and  all the Shareholders of Aldila, Inc. (Filed as Exhibit 2.1 to the Company’s  Registration Statement on Form S-1 (Registration No. 33-61560) and  incorporated herein by reference). |
|                |       |        |   |
|                | 3.1        |        | Restated Certificate of Incorporation. (Filed  as Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (Registration  No. 33-70010) and incorporated herein by reference). |
|                |       |        |   |
|                | 3.2        |        | Restated By-Laws of the Company. (Filed as  Exhibit 3.2 to the Company’s Registration Statement on Form S-1 (Registration  No. 33-61560) and incorporated herein by reference). |
|                |       |        |   |
|                | 4.1        |        | Specimen form of Company’s Common Stock  Certificate. (Filed as Exhibit 4.1 to the Company’s Registration Statement on  Form S-1 (Registration No. 33-61560) and incorporated herein by reference). |
|                |       |        |   |
| *                   | 10.1       |        | 1992 Stock Option Plan of the Company, as amended.  (Filed as Exhibit 10.6 to the Company’s Registration Statement on Form S-1  (Registration No. 33-61560) and incorporated herein by reference). |
| ** **          | ** ** | ** **  | ** ** |
| *                   | 10.2       |        | Form of Stock Option Agreement in  connection with Stock Option Plan. (Filed as Exhibit 10.7 to the Company’s  Registration Statement on Form S-1 (Registration No. 33-61560) and  incorporated herein by reference). |
|                |       |        |   |
| *                   | 10.3       |        | Executive Bonus Plan of the Company. (Filed  as Exhibit 10.2 to the Company’s Report on Form 10-Q for the quarterly period  ended September 30, 1994 and incorporated herein by reference). |
|                |       |        |   |
|                | 10.4       |        | Form of Indemnification Agreement between  the Company and its directors and executive officers. (Filed as Exhibit 10.13  to the Company’s Registration Statement on Form S-1 (Registration No.  33-61560) and incorporated herein by reference). |

 
|   | 10.5   |   | Lease Agreement dated as of October 15,  1990, between the Company and Baja del Mar, S.A. de C.V. (Filed as Exhibit  10.16 to the Company’s Registration Statement on Form S-1 Registration No.  33-61560) and incorporated herein by reference).      |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.6   |   | Lease Agreement dated as of August 30,  1993, between the Company and T.M. Cobb Company. (Filed as Exhibit 10.16 to  the Company’s Registration Statement on Form S-1 (Registration No. 33-70010) and  incorporated herein by reference).              |
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.7   |   | First Amendment to Lease Agreement dated as  of August 30, 1993, between the Company and T.M. Cobb Company. (Filed as  Exhibit 10.14 to the Company’s Report on Form 10-K for the year ended  December 31, 1993 and incorporated herein by reference). |
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.8   |   | Lease Agreement dated as of November 30,  1993, between the Company and T.M. Cobb Company. (Filed as Exhibit 10.15 to  the Company’s Report on Form 10-K for the year ended December 31, 1993 and  incorporated herein by reference).                  |
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.9   |   | 1994 Stock Incentive Plan of the Company,  as amended. (Filed as Exhibit A to the Company’s 1997 Proxy Statement dated  March 26, 1997 and incorporated herein by reference).                                                                          |
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.10  |   | Form of Stock Option Agreement in  connection with the 1994 Stock Incentive Plan. (Filed as Exhibit 10.1 to the  Report on Form 10-Q for the quarterly period ended September 30, 1994 and  incorporated herein by reference).                              |
|   |   |   |                                                                                                                                                                                                                                                        |
|   | 10.11  |   | Lease Agreement dated May 15, 1995 between  the Company and Desarrollo Industrial de Tijuana, S.A. de                                                                                                                                                       |

 

43

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|   |   |   | C.V.(Filed  as Exhibit 10.1 to the Company’s Report on Form 10-Q for the quarterly period  ended June 30, 1995 and incorporated herein by reference).                                                                                                                                                                           |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                                 |
|   | 10.12  |   | Member Interest Purchase Agreement dated as  of October 20, 1999 among SGL Carbon Fibers and Composites, Inc., SGL Technik  GmbH, Aldila Materials Technology Corp. and the Company. (Filed as Exhibit  10.17 to the Company’s Report on Form 10-K for the year ended December 31,  1999 and incorporated herein by reference). |
|   |   |   |                                                                                                                                                                                                                                                                                                                                 |
| *      | 10.13  |   | Severance Protection Agreement dated March  11, 1999 between the Company and Peter R. Mathewson. (Filed as Exhibit 10.3  to the Company’s Report on Form 10-Q for the quarterly period ended June 30,  1999 and incorporated herein by reference).                                                                              |
|   |   |   |                                                                                                                                                                                                                                                                                                                                 |
| *      | 10.14  |   | Severance Protection Agreement dated March  11, 1999 between the Company and Robert J. Cierzan. (Filed as Exhibit 10.4 to  the Company’s Report on Form 10-Q for the quarterly period ended June 30,  1999 and incorporated herein by reference).                                                                               |
|   |   |   |                                                                                                                                                                                                                                                                                                                                 |
| *      | 10.15  |   | Severance Protection Agreement dated March  11, 1999 between the Company and Michael J. Rossi. (Filed as Exhibit 10.5 to  the Company’s Report on Form 10-Q for the quarterly period ended June 30,  1999 and incorporated herein by reference).                                                                                |

 
|   | 10.16  |   | 1994 Stock Option Plan of the Company, as  amended. (Filed as attachment A-1 in the Company’s 2000 Proxy Statement and  registered on the Company’s Form S-8 (Registration No. 333-57754) and  incorporated herein by reference).               |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 10.17  |   | Aldila, Inc. Audit Committee Charter  included as Exhibit A in the Company’s 2001 Proxy dated April 4, 2001 and  incorporated herein by reference.                                                                                                   |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 10.18  |   | Aldila, Inc.’s Code of Business Conduct and  Ethics adopted on December 31, 2002 (Filed as Exhibit 14.0 in the Company’s  Report on Form 10-K for the year ended December 31, 2003)                                                             |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 11.1   |   | Statement re: Computation of Net Income  (Loss) per Common Share.                                                                                                                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 21.1   |   | Subsidiaries of the Company.                                                                                                                                                                                                                              |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 23.1   |   | Consent of Independent Registered Public  Accounting Firm – Peterson & Co., LLP                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 31.1   |   | Certification of Chief Executive Officer                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 31.2   |   | Certification of Chief Financial Officer                                                                                                                                                                                                                  |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 32.1   |   | Certification of Principal Executive  Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                  |
|   |   |   |                                                                                                                                                                                                                                                      |
|   | 99.1   |   | Carbon Fiber Technology, LLC financial statements  as of and for the years ended December 31, 2004 and 2003 (filed as Exhibit  99.1 in the Company’s Report on Form 10-K for the year ended December 31,  2004 and incorporated herein by reference) |

 

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*Indicates management contracts or compensatory plans or arrangementsrequired to be filed as exhibits to this Report on Form 10-K.

 

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