** **

**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,  2004** |
|                                                  |                                                                                                     |   |
| **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 itscharter)

 
| **Delaware**                                                     | ** ** | **13-3645590**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification Number) |

 

**13450STOWE DRIVE, POWAY, CALIFORNIA 92064**

(Addressof principal executive offices)

 

**(858) 513-1801**

(Registrant’sTelephone No.)www.aldila.com

 

SecuritiesRegistered 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) ofthe Act:

 

**CommonStock, par value $0.01 per share**

(Title of Class)

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements 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 anyamendment to this form 10-K.  o

 

Indicateby check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2of the Act).      Yes  o    No  ý

 

Theaggregate market value of the Company’s voting stock held by non-affiliates ofthe Company as of June 30, 2004 was approximately $44.4 million.

 

Asof March 23, 2005, there were 5,188,560 shares of the Registrant’s commonstock, par value $0.01 per share, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

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

 

Part III,Items 10, 11, 12, 13 and 14.  TheRegistrant’s definitive Proxy Statement for the 2005 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 theFiscal Year Ended December 31, 2004**

 

**INDEX**

 
| Part I        |   |     |   |                                                                                        |   |
|--------------------|--------|----------|--------|---------------------------------------------------------------------------------------------|--------|
|               |   |     |   |                                                                                        |   |
|               |   | Item 1.  |   | Business                                                                                    |   |
|               |   | Item 2.  |   | Properties                                                                                  |   |
|               |   | Item 3.  |   | Legal Proceedings                                                                           |   |
|               |   | Item 4.  |   | Submission of Matters to a Vote of Security  Holders                                        |   |
|               |   |     |   |                                                                                        |   |
| Part II       |   |     |   |                                                                                        |   |
|               |   |     |   |                                                                                        |   |
|               |   | Item 5.  |   | Market for Registrant’s Common Equity and  Related Stockholder Matters                 |   |
|               |   | Item 6.  |   | Selected Financial Data                                                                     |   |
|               |   | Item 7.  |   | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|               |   | Item 7a. |   | Quantitative and Qualitative Disclosures  about Market Risk                                 |   |
|               |   | Item 8.  |   | Financial Statements and Supplementary Data                                                 |   |
|               |   | Item 9.  |   | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure       |   |
|               |   | Item 9A. |   | Controls and Procedures                                                                     |   |
|               |   |     |   |                                                                                        |   |
| Part III      |   |     |   |                                                                                        |   |
|               |   |     |   |                                                                                        |   |
|               |   | Item 10. |   | Directors and Executive Officers of the  Registrant                                         |   |
|               |   | Item 11. |   | Executive Compensation                                                                      |   |
|               |   | Item 12. |   | Security Ownership of Certain Beneficial  Owners and Management                             |   |
|               |   | Item 13. |   | Certain Relationships and Related  Transactions                                             |   |
|               |   | Item 14. |   | Principal and Accounting Fees and Services                                                  |   |
|               |   |     |   |                                                                                        |   |
| Part IV       |   |     |   |                                                                                        |   |
|               |   |     |   |                                                                                        |   |
|               |   | Item 15. |   | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                      |   |
|               |   |     |   |                                                                                        |   |
| 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 Form 10-K(including those sections hereof incorporated by reference from other filingswith the Securities and Exchange Commission), in particular as set forth in “BusinessRisks” under Item 1 and set forth in the “Management’s Discussion and Analysisof Financial Condition and Results of Operations” under Item 7.*

 

**Item1.  Business**

 

**General**

 

Aldila, Inc. (“Aldila” or the “Company”)is a leading designer and manufacturer of high-quality innovative graphite(carbon fiber-based composite) golf shafts in the United States today and hasmaintained this position for over a decade. 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, TaylorMade-addidas Golf, Ping and AcushnetCompany.  Aldila believes that it is oneof the few independent shaft manufacturers with the technical and productionexpertise required to produce high-quality graphite shafts in quantitiessufficient to meet demand.  The Company’scurrent golf shaft product lines consist of Aldila branded products designedfor custom club makers, as well as custom shafts developed in conjunction withits major customers. These product lines are designed to improve theperformance of any level of golfer from novice to tour professional.

 

In 1994, the Company started production ofits principal raw material for shafts, graphite prepreg, which consists ofsheets of carbon fibers combined with epoxy resin.  See “Manufacturing—Raw Materials.”  The Company now produces substantially all ofits graphite prepreg requirements internally.

 

In 1998, the Company established amanufacturing facility in Evanston, Wyoming for the production of carbon fiber,an effort to further vertically integrate its manufacturing operations.  On October 29, 1999, SGL Carbon Fibersand Composites, Inc. (“SGL”) purchased a 50% interest in the Company’scarbon fiber manufacturing operation. The Company and SGL entered into an agreement to operate the facilitythrough a limited liability company with equal ownership interests between thejoint venture members.  The Company andSGL also entered into supply agreements with the new entity, Carbon Fiber TechnologyLLC (“CFT”), for the purchase of carbon fiber at cost plus an agreed-uponmark-up.  Profits and losses of CFT areshared equally by the partners.

 

**Graphite Golf Shafts**

 

The Company was founded in San Diego,California in 1972 and was an early leader in the design and production ofgraphite golf shafts.  The Companybelieves it is well positioned to remain a leader in the market for graphiteshafts due to its innovative and high-quality products, strong customer relationships,design and composite expertise and significant manufacturing capabilities.

 

Most golf clubs being sold today have shaftsconstructed from steel or graphite, although limited numbers are alsomanufactured from other materials. Graphite shafts were introduced in the early 1970’s as the first majorimprovement in golf shaft technology 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.

 

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Unlike steel shafts, the design of graphiteshafts is easier to alter with respect to weight, flex, flex location andtorque to produce greater distance, increased accuracy and reduced clubvibration resulting in improved “feel” to the golfer.  The improvements in the design andmanufacture of graphite shafts and the growing recognition of their superiorperformance characteristics for many golfers compared to steel have resulted inincreased demand for graphite shafts by golfers of all skill levels. Theinitial acceptance of graphite shafts was primarily for use in woods.  Graphite continues to dominate theprofessional and consumer wood club market, with over 97% of new woodspurchased in 2004 including graphite shafts.  The acceptance of graphite shafts in irons has not achieved the samesuccess as woods, and acceptance in irons has declined somewhat in recentyears.  In 2004, approximately 26% of newirons purchased were graphite shafted. Since many golfers consider professionals to be “opinion leaders,”increased acceptance and use of graphite shafts in irons by professionals wouldhelp broaden the overall graphite market.

 

**Products**

 

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 constitutedapproximately 86% of net sales in the year ended December 31, 2004, aredesigned in partnership with its customers (principally golf clubmanufacturers) to accommodate specific golf club designs.  The Company’s branded models are typicallysold to golf club manufacturers, distributors and golf pro and repair shops andare used either to assemble a new custom club from selected components or as anafter market re-shaft of existing clubs. The Company also helps develop cosmetic designs to give the customer’sgolf clubs a distinctive look, even when the customer does not require a shaftwith customized performance characteristics. The prices of Aldila shafts typically range from $4 to $199.

 

The Company introduced an innovativeproprietary design, the Aldila “One” shaft during 2002.  The Company believes that this is the firstshaft design to feature multiple segments, each with separate designcharacteristics, which allows for more precise performance optimization thanthe traditional graphite shaft design, which embodies only one set of designcharacteristics over its entire length. The “One” shaft is offered through distribution to the custom clubmarket and directly to consumers. It can also be included as a custom option bycertain of its golf club manufacturer customers.  The Company introduced the NVPrototypeat the 2003 PGA Merchandise Show in January 2003 and subsequently changedit to the NVTM.   The NVTMfeatures the Company’s exclusive Micro Laminate Technology TM(“MLT”).  The Company followed up the NVTMwith the introduction of the NVS, NV ProtoPype, NV Xtreme, NV Hybrid, NVSHybrid family of shafts and the Gamer shaft in 2004.  The NVS shaft is geared toward the player whorequires a shaft that promotes a higher initial launch angle, and one thatmakes it easier to turn the ball right to left. The NV ProtoPype promotes a lower, more controlled launch angle, withreduced spin, along with very low torque to provide extremely tightdispersion.  The NV Xtreme features acombination of the Company’s MLT with ribbons of a hypoeutectic steel alloyprecisely wound around the exterior of the shaft structure, which providesadditional cross-sectional stability and minimizes energy loss during theloading and unloading of the shaft in the golf swing.  The Hybrid family of shafts (NV Hybrid, NVSHybrid and Gamer) service the rapidly growing Hybrid segment of golfindustry.  Hybrid clubs (also known asutility clubs and driving irons) are designed to replace long irons byproviding a club that is easier to hit and much more forgiving for average aswell as very skilled players.

 

Since 1994, the Company has manufacturedprepreg material for its production of golf shafts.  In 1998, the Company began selling prepregmanufactured in its Poway, California manufacturing facility to thirdparties.  Revenues from the sale ofprepreg were approximately 8% of net sales in 2004.  Beginning in 1999, the Company offered forsale large bundle carbon fiber and chopped fiber from its manufacturingfacility in Evanston, Wyoming.  Sales oflarge bundle carbon fiber by the Company continued in 1999 through October 29,1999, the date that the Company sold a 50% interest in the carbon fibermanufacturing operation.  All subsequentoutside carbon fiber revenues, if any, are attributed to the joint venture.  The Company does not anticipate outside salesof carbon fiber to be significant in 2005.

 

The Company began themanufacture of composite hockey sticks in 2000, following several months ofdevelopmental work.  The manufacture ofcomposite hockey sticks is similar to that of graphite golf shafts and usessimilar raw materials.  Revenues from thesale of hockey sticks were approximately 5% of net sales in 2004 and are notexpected to be significant to the Company for several years.

 

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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 components, masts and spars for the marineindustry, hockey sticks, fishing rods, industrial products, as well as golfshafts.

 

**Product Design and Development**

 

Aldila is committed to maintaining itsreputation as a leader in innovative shaft design and composite materialstechnology.  The Company believes thatthe enhancement and expansion of its existing product lines and the developmentof new products are necessary for the Company’s growth and success.  However, while the Company believes that ithas generally achieved success in the introduction of its graphite golf shafts,no assurance can be given that the Company will be able to continue to designand manufacture products that meet with market acceptance.

 

Graphite shaft designs and modifications arefrequently the direct result of the combined efforts and expertise of theCompany and its customers to develop an exclusive shaft for each customer’sclubs.  New golf shaft designs aredeveloped and tested using a CAD/CAE golf shaft analysis program, whichevaluates a new shaft design with respect to weight, torque, flex point, tipand butt flexibility, swing weight and other critical shaft designcriteria.  In addition, the Companyresearches new and innovative shaft designs on an independent basis, which hasenabled the Company to produce a variety of new branded shafts as well asgenerate design ideas for customized shafts. To improve and advance product designs as they relate to compositetechnology and shaft process manufacturing, the Company’s engineers haveexperience with existing materials, such as boron, kevlar, fiberglass, ceramic,thermoplastic and carbon fiber.  TheCompany’s engineers also look to newer, more advanced materials such as SingleWalled Carbon Nanotubes (“SWNT”). Nanotechnology is a fast growing field of research that has goodpotential for structures such as composite golf shafts.  The Company believes it is the first majorshaft company to employ SWNT in shaft design, and is at the forefront ofutilizing 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 ProtoPype, NV Xtreme, NV Hybrid, NVSHybrid and the Gamer shafts.  All of theNV 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 indeveloping the market for lower cost large bundle carbon fiber by successfullyconverting to this fiber type in some of its products from a more expensivecarbon fiber material for the manufacture of certain of its graphite golfshafts.  The Company has had limitedsuccess in providing large bundle carbon fiber to other manufacturingapplications outside of golf shafts.

 

The Company has applied its compositematerials expertise on a limited basis to other products in recent years,producing hockey sticks as well as graphite tubing and other molded parts on aspecial order basis.

 

**Customers and Customer Relations**

 

The Company believes that its close customerrelationships and responsive service have been significant elements of itssuccess to date, establishing it as a premier graphite shaft company.  Aldila’s golf club manufacturer customersoften work together with the Company’s engineers when developing a new golfclub in order to design a club that maximizes the performance features of theprincipal component parts:  the grip, theclubhead and the Aldila shaft.  TheCompany’s partnership relationship with its customers continues after thedevelopment of clubs containing Aldila’s shafts.  Following the design process, the Companycontinues to provide high levels of customer support and service in areas suchas quality control and assurance, timely and responsive manufacturing, deliveryschedules and education.  The Companybelieves the physical proximity of its headquarter facilities to many of itscustomers has facilitated a high degree of customer interaction andresponsiveness to customer needs.  Whilethe Company has had long-established relationships with most of its customers,it is not the exclusive supplier of graphite shafts to most of them and generallydoes not have long-term supply agreements with its customers.

 

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For fiscal year 2004, 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 57%,70% and 76% of net sales in 2004, 2003 and 2002, respectively.

 

Historically, Aldila’s principal customershave varied as a result of general market trends in the golf industry, inparticular the prevailing popularity of the various clubs that contain Aldila’sshafts.  As a result, there typically arechanges in 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, Ping and TaylorMade-addidas Golf.  While the Company believes its relationshipwith each of these major customers is good, the Company is not the exclusivesupplier to any of them.  The Company’ssales to its principal customers have varied substantially from year to year.

 
| **Customer (1)**         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Acushnet  Company        |       | 22       | %          | 27       | %          | 22       | %          |
| Callaway  Golf           |       | 17       | %          | 21       | %          | 22       | %          |
| Ping                     |       | 9        | %          | 10       | %          | 9        | %          |
| TaylorMade-addidas  Golf |       | 2        | %          | 6        | %          | 13       | %          |

 

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(1) Certain prior year numbers havechanged to conform to current year presentation.

 

Because of the historic volatility ofconsumer demand for specific clubs, as well as continued competition fromalternative shaft suppliers, sales to a given customer in a prior period maynot necessarily be indicative of future sales and it is often difficult toproject the Company’s sales to a given customer in advance.

 

Although the Company believes that itsrelationships with its customers are good, the loss of a significant customeror a substantial decrease in sales to a significant customer (whether as aresult of diminished sales by that customer or a shaft sourced from othersuppliers) could have a material adverse effect on the Company’s business oroperating results.

 

**Marketing and Promotion**

 

The Company’s marketing strategy is designedto encourage golf club manufacturers to select and promote Aldila shafts and toincrease overall market 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 and Rich Beem serve on the Company’s advisory staff and assist in itsmarketing efforts. Aldila’s marketing and promotion expenditures wereapproximately $2.2 million, $1.9 million and $1.3 million in 2004, 2003 and2002, respectively.  The Company does notcurrently incur significant marketing expenses for its products other than golfshafts.

 

**Sales and Distribution**

 

Within the golf club industry, most companiesdo not manufacture the three principal components of the golf club — the grip,the shaft and the clubhead — but, rather, source these components fromindependent suppliers that design and manufacture components to the clubmanufacturers’ specifications.  As aresult, Aldila sells its graphite shafts primarily to golf club manufacturersand, to a lesser extent, distributors, custom club shops, pro shops and repairshops.  Distributors typically resell theCompany’s products 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.  Sales to golf clubmanufacturers accounted for approximately 75% of net sales for the year ended December 31,2004.

 

Prepreg sales and carbon fiber sales 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.

 

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International sales represented 18%, 15%, and14% of net sales for the years ended December 31, 2004, 2003 and 2002,respectively.  See Note 13 in the Notesto Consolidated Financial Statements for further breakdown of our internationalsales and long-lived assets.

 

**Manufacturing**

 

The Company believes that its manufacturingexpertise and production capacity differentiate it from many of its competitorsand enable Aldila to respond quickly to its customers’ orders and providesufficient quantities on a timely basis. The Company today operates three golf shaft manufacturing facilities,one prepreg manufacturing facility (in conjunction with one of its shaftmanufacturing facilities) and through its 50% ownership interest in CFT, onecarbon fiber manufacturing facility. During its 33 years of operation, the Company has improved itsmanufacturing processes and believes it has established a reputation as theindustry’s leading volume manufacturer of high-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 process andthe materials used.  In traditional shaftdesigns, treated graphite known as “prepreg” is rolled onto metal rods known asmandrels.   The graphite is then baked athigh temperatures 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 and 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.

 

*Raw Materials*.  The primary material currently used in all ofthe Company’s graphite shafts is carbon fiber, which is combined with epoxyresin to produce sheets of graphite prepreg. The degree of the heating and stretching the graphite fibers determinesthe tensile strength and modulus (stiffness) of the fiber.  The Company manufacturers graphite prepreg atits Poway, California facility.

 

*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 for itsoutside sales of prepreg material.  TheCompany is, however, somewhat dependent upon certain domestic prepreg suppliersfor types of prepreg that it does not produce and, therefore, the Companyexpects to occasionally purchase some prepreg products from outside suppliersin the future.  Although the Companybelieves that there will continue to be alternative third party suppliers ofprepreg, there can be no assurance that unforeseen difficulties which couldlead to an interruption in the Company’s internal prepreg production will notoccur, which would result in production delays.

 

The Company’s prepreg operation is dependenton certain suppliers for carbon fibers, which along with epoxy resins andrelease paper constitute the primary components used to manufactureprepreg.  Through 1997, the Companypurchased all of its carbon fibers from outside vendors.  Beginning in 1998, the Company manufacturedcarbon fiber at its 50% owned Evanston, Wyoming facility, CFT, for consumptionby its golf shaft production operation. Because several different forms of carbon fiber are required for golfshaft products, including some not manufactured at the CFT facility, theCompany will continue to depend on outside suppliers for a portion of itsongoing carbon fiber needs.  In 2004, theCompany obtained a large portion of its carbon fiber from CFT but alsopurchased carbon fiber from other carbon fiber manufacturers.  The prices paid by the Company for carbonfiber not produced at CFT began to increase at the end of 2003 and throughout2004, due to capacity constraints in the carbon fiber industry.  If the Company is unable to purchase carbonfiber, other than that produced at CFT, from suppliers, it could result inproduction delays of composite pregreg 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.  Thesecarbon fibers combined with various resins are then converted to compositestructures, which have replaced metals in a number of weight criticalaerospace, sporting and industrial applications.

 

Typically, the composite structure will weigh25 to 50 percent less than the metal structure it has replaced.  Carbon fiber composite structures alsoprovide toughness, resistance to corrosion, resistance to fatigue, capacity todissipate heat and electrical conductivity. The carbon fiber industry has grown from its inception in the late 1950’sinto one, which produced

 

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approximately 45 million pounds of carbon fiber in 2004.

 

Carbon fiber usage has grown primarily forconsumption by the aerospace industry and for sporting goods and industrialapplications.  Aerospace grade carbonfibers continue to be utilized for production of commercial and militaryaerostructures.  The higher-cost,aerospace grade carbon fibers were first used in sporting goods and industrialapplications until a lower-cost, large bundle carbon fiber was developed as analternative for use in 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.  As such, 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 that has more than 24,000 (24K) filaments is considered tobe large tow carbon fiber.  During 2004,CFT began producing a smaller tow (24K), which yields better properties and canbe used in more applications.  CFT nowproduces two different tow sizes of carbon fibers.  These materials are now significant rawmaterials used in the Company’s prepreg manufacturing operation to support themanufacture of graphite golf shafts, although the Company still procurescertain types of fibers from outside vendors for the manufacture of golfshafts.  The Company believes it canpurchase the type of fibers produced by CFT from at least two outside sources.

 

CFT purchased substantially all of its rawacrylic fibers for the carbon fiber operation from Toho Carbon Fibers, Inc.for the years 2000 through 2004. Previous to 2000, Courtaulds Fibres, Ltd. was also used as a supplier ofits raw acrylic fibers.  The Companybelieves these two vendors will be able to provide a reliable source of supplyfor raw materials at the anticipated operating level of CFT.  However, CFT will continue to pursuealternate sources of supply for this material.

 

**Environmental Matters**

 

The Company is subject to various federal,state, local and foreign environmental laws and regulations, including thosegoverning the use, discharge and disposal of hazardous materials as the Companyuses hazardous substances and generates hazardous waste in the ordinary courseof its manufacturing of graphite golf shafts, other composites, graphiteprepreg and carbon fiber.  The Companybelieves it is in substantial compliance with applicable laws and regulationsand has not to date incurred any material liabilities under environmental lawsand regulations; however, there can be no assurance that environmentalliabilities will not arise in the future which may affect the Company’sbusiness.

 

**Competition**

 

Aldila operates in a highly competitiveenvironment in both the United States and international markets for the sale ofits graphite golf club shafts.  TheCompany believes that it competes on the basis of its ability to provide abroad range of high quality, performance graphite shafts; its ability todeliver customized products in large quantities and on a timely basis to itscustomers; the acceptance of graphite in general, and Aldila shafts inparticular, by professional and other golfers, whose preferences are to someextent subjective; and, finally, price. Presently, there exists substantial excess graphite shaft manufacturingcapacity both in the United States and in other countries.  This has had the effect of decreasing theselling prices of the Company’s shafts in past years.  Management anticipates that this trend hasended.  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 OEMs.  However, the Company now competes against United Statesand foreign-based shaft manufacturers for the OEM shaft market. Thiscompetition has made it more difficult to retain existing customers, attractnew customers and has placed increasing pressure on prices for OEM shafts.  The Company believes that it is the largestsupplier of graphite shafts to the United States club market, which resultsfrom its ability to establish a premium brand image and reputation among golf clubcompanies as a value-added supplier with competitive prices.  Aldila competes against other shaftmanufacturers, both graphite and steel, and in the past also against golf clubcompanies that produced their own shafts internally, some of which may have orhad greater resources than Aldila.  TheCompany also faces potential competition from those golf club manufacturersthat currently purchase golf shaft components from outside suppliers but thatmay have, develop or acquire the ability to manufacture all or a portion of itsgraphite shafts internally.  Should anyof the Company’s significant customers decide to meet any of its shaft needsinternally, it could have an adverse effect on the Company.  The Company also competes against companieswho manufacture one or more of three principal components of the golf club, thegrip, the shaft and the club head, and assemble completed golf clubs fordelivery to club companies.  Should anyof the Company’s significant customers decide to source their golf clubs inthis manner where an Aldila shaft is not included, it could have an adverseeffect on the Company.

 

The Company also competes for sales ofprepreg from its prepreg facility and carbon fiber through its 50% interest inCFT with other producers of prepreg and carbon fibers, many of which havesubstantially greater research and development, managerial and financialresources than the Company.  Someproducers have been producing prepreg and

 

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carbon fiber for substantially longer periods of time than the Companyhas, 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 and a significant portionof 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.

 

**Intellectual Property**

 

Aldila utilizes a number of trademarks andlogos in connection with the sale and advertising of its products.  The Company takes all reasonable measures toensure that any product bearing an Aldila trademark reflects the consistencyand quality associated with the Company’s products and intends to continue toprotect them to the fullest extent practicable. As of December 31, 2004 the Company had approximately 60 UnitedStates and foreign registered trademarks.

 

**Employees**

 

As of December 31, 2004, Aldila employed1,237 persons on a full-time basis, including nine in sales and marketing, 24in research, development and engineering and 1,042 in production. The balanceis administrative and support staff.  Thenumber of full-time employees includes 489 persons who are employed in theCompany’s Mexico facility and 609 who are employed in the Company’s Chinafacility.  Because of seasonal demands,the Company hires a significant number of temporary employees.  As of December 31, 2004, the Companyalso employed an additional 18 temporary employees. Aldila considers itsemployee relations to be good.

 

**Seasonality**

 

Because the Company’s customers havehistorically built inventory in anticipation of purchases by golfers in thespring and summer, the principal selling season for golf equipment, the Company’soperating results have been affected by seasonal demand for golf clubs, whichhas generally resulted in highest sales occurring in the first and secondquarter.  The timing of customers’ newproduct introductions has frequently mitigated the impact of seasonality inrecent years.

 

**Backlog**

 

As of December 31, 2004, the Company hada sales backlog of approximately $9.9 million compared to approximately $11.0million as of December 31, 2003. The lower backlog as of December 31, 2004 reflects changing orderpatterns by our large OEM customers with reliance on shorter lead times.  Incoming orders through February 28,2005 were $13.3 million as compared to $7.8 million during the same period of2004.  The Company believes that thedollar volume of its current backlog will be shipped over the next threemonths.  Orders can typically becancelled without penalty up to 30 days prior to shipment.  Historically, the Company’s backlog generallyhas been highest in the first and second quarters, due in large part toseasonal factors.  Due to the timing andreceipt of customer orders, backlog is not necessarily indicative of futureoperating results.

 

**Business Risks**

 

*Customer Concentration*.  The Company’s sales have been, and verylikely will continue to be, concentrated among a small number ofcustomers.  In 2004, sales to the Company’stop five customers represented approximately 57% of net sales.  Aldila’s principal customers havehistorically varied depending largely on the prevailing popularity of thevarious clubs that contain Aldila shafts. In 2004, Acushnet Company accounted for 22% of net sales, Callaway Golfaccounted for 17% of net sales and Ping accounted for 9% of net sales.  The Company cannot predict the impact thatgeneral market trends in the golf industry, including the fluctuation inpopularity of specific clubs manufactured by customers, will have on its futurebusiness 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, CallawayGolf and Ping, who collectively represent in excess of 49% of the Company’s netsales in 2004, each purchased from at least two other graphite shaft suppliers.  In the event Callaway Golf,Acushnet Company, Ping or any other significant customer increases purchasesfrom its other suppliers or adds additional suppliers, the Company could beadversely affected.  Although the Companybelieves that its relationships with its customers are good, the loss of asignificant customer or a substantial decrease in sales to a significantcustomer could have a material adverse effect on the Company’s business andoperating results.  In addition, sales bythe Company’s major customers are

 

9

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likely to vary dramatically from time to time due to fluctuating publicdemand for golf equipment generally and for their specific products.

 

*Competition*.  Aldila operates in a highly competitiveenvironment for golf equipment sales. The Company believes that it competes principally on the basis of itsability to provide a broad range of high-quality, performance graphite shafts;its ability to deliver customized products in large quantities and on a timelybasis; the acceptance of graphite shafts in general, and Aldila shafts inparticular, by professionals and other golfers, whose preferences are to someextent subjective; and finally, price.

 

Aldila competes against both domestic andforeign shaft manufacturers.  Some of theCompany’s current and potential competitors may have greater resources thanAldila.  The Company also faces potentialcompetition from those golf club manufacturers that currently purchase golfshaft components from outside suppliers but that may have, develop or acquire,the ability to manufacture shafts internally.

 

As the Company further enters into themanufacture and sale of prepreg products, it competes with other producers ofprepregs, many of which have substantially greater research and development,managerial and financial resources than the Company and represent significantcompetition for the Company.

 

*New Product Introduction*.  The Company believes that the introduction ofnew, innovative golf shafts using graphite or other composite materials will becritical to its future success.  Whilethe Company emphasizes research and development activities in connection withcarbon fiber and other composite material technology, there can be no assurancethat the Company will continue to develop competitive products or that theCompany will be able to develop or utilize new composite material technology ona timely or competitive basis or otherwise respond to emerging market trends.

 

Although the Company believes that it hasgenerally achieved success in the introduction of its customized graphite golfshafts, specifically, the Aldila NVTM line of golf shafts, noassurance can be given that the Company will be able to continue to design andmanufacture products that meet with market acceptance, either on the part ofclub manufacturers or golfers.  Thedesign of new graphite golf shafts is also influenced by rules andinterpretations of the United States Golf Association (“USGA”).  There can be no assurance that any new productswill receive USGA approval or that existing USGA standards will not be alteredin ways that adversely affect the sales of the Company’s products.

 

*Reliance on Offshore Manufacturing Facilities*.  The Company operates manufacturing facilitiesin Tijuana, Mexico and Zhuhai, People’s Republic of China.  The Company pays certain expenses of thesefacilities in Mexican pesos and Chinese renminbis, respectively, which aresubject to fluctuations in currency value and exchange rates.  The Company operates a shaft manufacturingfacility in Tijuana, Mexico pursuant to the “maquiladora” duty-free programestablished by the Mexican and United States governments.  Such program enables the Company to takeadvantage of generally lower costs in Mexico, without paying duty on inventoryshipped into or out of Mexico.  TheCompany also operates in the People’s Republic of China in a special economiczone, which affords special advantages to companies with regards to incometaxes, import and export duties and value added taxes.  There can be no assurance that thegovernments of Mexico or the People’s Republic of China will continue theprograms currently in place or that the Company will continue to be able tobenefit from these programs.  The loss ofthese benefits could have an adverse effect on the Company’s business.  The Company is also subject to othercustomary 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 price paid for carbon fiber purchased from outsidevendors, and more substantially starting in the latter part of 1998, the costof production of carbon fiber at the Evanston, Wyoming facility, including theprice paid for the acrylic fiber used for the manufacture of carbon fiber andthe other costs associated with the operation of the carbon fiber plant.

 

The Company experienced an increase in carbonfiber prices in 1996 and 1997 due to the growth experienced in the use ofcarbon fiber coupled with relatively little excess capacity.  The prices paid by the Company for carbonfiber leveled in 1998 and decreased during 1999 through 2002, due toexcess-capacity in the carbon fiber manufacturing industry.  However, that trend reversed itself in thelater part of 2003.  The Companyexperienced carbon fiber price increases in certain grades of carbon fiberprices during the later part of 2003 and through 2004.  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 to competition.

 

The Company also has relationships with otheroutside vendors for its additional carbon fiber needs through 2004 andbeyond.  Depending on market conditionsprevailing at the time and extent to which production at CFT meetsexpectations, the Company may face difficulties in obtaining adequate suppliesof carbon fiber from external sources to provide for any carbon fiber needs notmet internally.  If it appears that CFTis not likely to satisfy a significant portion of the Company’s needs or if itappears that there will not be adequate availability in the market, the Companymay not have made arrangements in advance for the purchase of material amountsof carbon fiber from alternative sources.

 

10

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In addition, the Company is dependent on itsinternal production of graphite prepreg to support its shaft manufacturingoperations and has not secured adequate additional sources of supply should itsproduction of prepreg be interrupted for any reason.  The exposure to the Company resulting fromits increasing reliance on its own internal production of the raw materials forits golf shaft business is enhanced because the Company currently operates onlyone prepreg facility and has an interest in only one carbon fiber manufacturingfacility.  Until recently, there has beenexcess-capacity in these industries.  Inthe past, significant market shortages of both carbon fiber and graphiteprepreg have occurred and if they re-occur, it could have a negative impact onthe Company’s financial statements.

 

*Joint Venture Operating Carbon FiberFacility. * The Company started producing carbon fiber atits Evanston, Wyoming facility in 1998. Since October 1999, this facility has been operated by a jointventure, 50% owned by each of the Company and SGL.  As a result of the operation of this facilitythrough the joint venture, the Company is subject to business and financialrisks, such as the risks that SGL will be unable to meet its obligations to thejoint venture, that there will be operational difficulties resulting from thesplit ownership, raw material supply problems, changes in demand for carbonfiber based products, or that there will be differences of opinion between thejoint venture partners as to future operations leading to an inability to makedecisions when required or to the making of decisions not in the best interestsof both joint venture partners.

 

*Reliance on CarbonFiber Manufacturing Facility. *Untilrecently, during the period in which the Company or the joint venture hasoperated the Evanston, Wyoming facility, the market for carbon fiber productshas been soft, which has limited the Company’s ability to take full advantageof the opportunity offered by the vertical integration of its carbon fiber rawmaterial usage in graphite golf shafts. If the facility does not produce high quality fiber at the anticipatedvolumes, either because of production shortfalls or limited demand for thefacility’s carbon fiber, the per pound cost of the fiber produced will likelybe higher due to the substantial fixed costs involved in operating a carbonfiber production facility.  In addition,if the facility is not capable of producing carbon fiber at sufficient volumesto satisfy the demands of both venture partners, the Company would be requiredto purchase additional fiber from third party suppliers, which may not beavailable in sufficient quantities to satisfy its demands and could result inhigher marginal costs to the Company than fiber acquired from the jointventure.

 

*Potential Cash Flow Shortages.*  The Company has cash, cash equivalents andmarketable securities totaling $16.5 million as of December 31, 2004.  Management anticipates that these sources offunds when combined with cash flow generated from operations will be sufficientto finance its business operations at least through 2005.  If the Company is not able to generate theexpected cash flows from operations, the Company could be adversely affected.

 

*Shaft Manufacturing by Club Companies andOne-Stop Shops*. 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 manufacturingprocesses, the Company uses hazardous substances and generates hazardouswaste.  The Company has not to dateincurred any material liabilities under environmental laws and regulations andbelieves that it is in substantial compliance with applicable laws andregulations.  Nevertheless, no assurancecan be given that the Company will not encounter environmental problems orincur environmental liabilities in the future, which could adversely affect itsbusiness.

 

*Dependence on Discretionary Consumer Spending*.  Sales of golf equipment have historicallybeen dependent on discretionary spending by consumers, which may be adverselyaffected by general economic conditions. The Company believes that golf equipment sales have remained flat inrecent periods and may continue to be so in the future.  A decrease in consumer spending on golfequipment or, in particular, a decrease in demand for golf clubs with graphiteshafts could have an adverse effect on the Company’s business and operatingresults.

 

*Reliance on Key Personnel*.  The success of the Company is dependent uponits senior management team, as well as its ability to attract and retainqualified personnel.  There iscompetition for qualified personnel in the golf shaft industry as well as thecarbon fiber business.  There is noassurance that the Company will be able to retain its existing seniormanagement personnel or to attract additional qualified personnel.

 

11

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*Justice Department Investigation*.  During 1999 the Company received a subpoenafor documents from the Antitrust Division of the U.S. Department of Justice inconnection with the on-going investigation of an alleged price fixingconspiracy in the carbon fiber and graphite prepreg industries.  The Department of Justice has informed theCompany that it is not currently a target of the investigation, although it hasindicated that it has not cleared the Company of any involvement in the allegedconspiracy.  The Company is cooperatingwith the Department of Justice’s investigation.

 

**Item 2.Properties**

 

The Company’s principal executive offices arelocated 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 andcomprises approximately 31,000 square feet. The China facility is also leased and comprises approximately 88,000square feet.  The Company also may leasewarehousing space in Mexico and China when needed.  Currently, the Company leases warehousingspace in China.  In addition, the Company’s50% joint venture, CFT, owns 14 acres of land in Evanston, Wyoming on which itoperates a 50,000 square foot carbon fiber manufacturing plant.

 

The Company’s principal executive officeswere previously located in a 33,000 square foot leased facility in Poway,California, with a lease term through October 31, 2005.  During March of 2003, the Companyconsolidated its principal executive offices into its manufacturing facility inPoway, California.  The Companynegotiated a sub-lease of its previous executive offices with a tenant through October 31,2005.

 

**Item 3.  Legal Proceedings**

 

None.

 

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

 

There were no matters submitted to a vote ofsecurity holders during the fourth quarter of fiscal 2004.

 

12

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**PART II**

 

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

 

**COMMON STOCK PERFORMANCE**

 
| ** **      | ** ** | **2004**      | ** ** | **2003**   | ** ** |
|-----------------|------------|---------------|------------|------------|------------|
| ** **      | ** ** | **Dividends** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **      | ** ** | **Declared**  | ** ** | **High**   | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First  Quarter  |       |          |       | $          | 5.92       |   | $ | 3.57 |   | $ | 1.76 |   | $ | 1.29 |   |
|            |       |          |       |       |       |   |   |   |   |   |   |
| Second  Quarter |       | $             | 0.05       |       | $          | 17.78 |   | $ | 5.75 |   | $ | 1.95 |   | $ | 1.55 |   |
|            |       |          |       |       |       |   |   |   |   |   |   |
| Third  Quarter  |       | $             | 0.05       |       | $          | 13.60 |   | $ | 9.30 |   | $ | 2.78 |   | $ | 1.70 |   |
|            |       |          |       |       |       |   |   |   |   |   |   |
| Fourth  Quarter |       | $             | 0.05       |       | $          | 15.49 |   | $ | 10.99 |   | $ | 3.73 |   | $ | 2.60 |   |

 

All the prices above reflect the Company’sone-for-three reverse stock split, for shareholders of record at the close ofbusiness on June 3, 2002.  On March 23,2005, the closing common stock price was $17.33, and there were approximately312****common stockholders ofrecord.  The company believes asignificant number of beneficial owners also own Aldila stock in “street name.”

 

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

 

The Company intends to retain earnings foruse in operations and payments of cash dividends on its common stock.  Cash dividends are discussed by the Company’sboard of directors and management at each quarterly board meeting, and ifapproved, cash dividends are announced. Aldila, Inc. is a holding company whose ability to pay dividendsdepends on the receipt of dividends or other payments from its two principalsubsidiaries, Aldila Golf and Aldila Materials Technology Corp.

 

**EQUITY COMPENSATION PLAN INFORMATION**

 

Thefollowing table provides information regarding securities authorized forissuance under the Company’s equity compensation plans as of December 31,2004 (all numbers of securities reflect the Company’s one-for-three reversestock 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       |       | 485,338                                                                      |       | $                                                            | 5.86       |                                                                                                | 566,747    |   |
|                                                                                           |       |                                                                         |       |                                                         |       |                                                                                                |       |
| Equity  compensation plans not approved by security holders – 1992 Stock Option Plan  (1) |       | —                                                                       |       |                                                         |       | 20,167                                                                                              |       |
| Stock Option  Grant (2)                                                                        |       | 50,000                                                                       |       | $                                                            | 4.89       |                                                                                                | —     |   |
| Total                                                                                          |       | 535,338                                                                      |       |                                                         |       | 586,914                                                                                             |       |

 

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(1) In 1992, the Company adopted the 1992Stock Option Plan to provide equity incentives for the management and directorsof the Company.  The Company has reserved175,431 shares for issuance under this Plan. The Company does not expect to issue additional options under the 1992Plan.

(2) On March 20,2000, the Company and Nick Price Group entered into a stock optionagreement.  The option agreement allowsNick Price to purchase 50,000 shares of Common Stock at a purchase price of$4.89.  The shares are registered under aForm S-3, which was filed with the Securities and Exchange Commission on August 2,2004.  In return for the shares, theCompany received promotional and advisory services of Nick Price for aguaranteed minimum value of $4.50 per share, or a minimum aggregateconsideration of $225,000.  Nick PriceGroup exercised their 50,000 options on March 11, 2005.

 

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**Item 6.   SelectedFinancial Data**

 

**ALDILA, INC.**

**SELECTED FINANCIAL DATA**

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

 
| ** **                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Operating  Results (Year ended December 31):       |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net sales                                               |       | $        | 52,762     |     | $          | 37,807   |       | $        | 37,462     |     | $          | 39,561 |   | $ | 55,859 |   |
| Cost of  sales                                          |       | 34,786   |       | 30,586   |       | 32,828   |       | 33,304   |       | 42,257   |       |
| Gross profit                                            |       | 17,976   |       | 7,221    |       | 4,634    |       | 6,257    |       | 13,602   |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Selling,  general and administrative                    |       | 8,237    |       | 6,989    |       | 7,334    |       | 6,851    |       | 7,483    |       |
| Impairment  of goodwill                                 |       | —   |       | —   |       | —   |       | 41,932   |       | —   |       |
| Impairment  of trademarks & patents            |       | —   |       | —   |       | —   |       | 12,963   |       | —   |       |
| Amortization  of goodwill                               |       | —   |       | —   |       | —   |       | 1,410    |       | 1,428    |       |
| Plant  consolidation                                    |       | —   |       | —   |       | 300      |       | 593      |       | (566     | )          |
| Operating  income (loss)                                |       | 9,739    |       | 232      |       | (3,000   | )          | (57,492  | )          | 5,257    |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Interest  expense                                       |       | —   |       | 23       |       | 94       |       | 375      |       | 900      |       |
| Other  expense (income), net                            |       | (60      | )          | 48       |       | 62       |       | 65       |       | (570     | )          |
| Impairment  of investment in joint venture              |       | —   |       | 2,220    |       | —   |       | —   |       | —   |       |
| Equity in  earnings of joint venture                    |       | (246     | )          | (150     | )          | (269     | )          | (231     | )          | (220     | )          |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Income  (loss) before income taxes                      |       | 10,045   |       | (1,909   | )          | (2,887   | )          | (57,701  | )          | 5,147    |       |
| Provision  (benefit) for income taxes                   |       | 725      |       | (183     | )          | (43      | )          | (6,282   | )          | 1,930    |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income  (loss)                                      |       | $        | 9,320      |     | $          | (1,726   | )          | $        | (2,844     | )        | $          | (51,419 | ) | $ | 3,217 |   |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income  (loss) per common share-basic:              |       | $        | 1.85       |     | $          | (0.35    | )          | $        | (0.57      | )        | $          | (10.10 | ) | $ | 0.62 |   |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Net income  (loss) per common share, assuming dilution: |       | $        | 1.77       |     | $          | (0.35    | )          | $        | (0.57      | )        | $          | (10.10 | ) | $ | 0.62 |   |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Selected  Operating Results                             |       |     |       |     |       |     |       |     |       |     |       |
| As a  Percentage of Net Sales:                          |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Gross profit                                            |       | 34.1     | %          | 19.1     | %          | 12.4     | %          | 15.8     | %          | 24.4     | %          |
| Selling,  general and administrative                    |       | 15.6     | %          | 18.5     | %          | 19.6     | %          | 17.3     | %          | 13.4     | %          |
| Operating  income (loss)                                |       | 18.5     | %          | 0.6      | %          | (8.0     | )%         | (145.3   | )%         | 9.4      | %          |
| Net income  (loss)                                      |       | 17.7     | %          | (4.6     | )%         | (7.6     | )%         | (130.0   | )%         | 5.8      | %          |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Financial  Position (at December 31):              |       |     |       |     |       |     |       |     |       |     |       |
|                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Working  capital                                        |       | $        | 25,977     |     | $          | 15,181   |       | $        | 13,162     |     | $          | 13,851 |   | $ | 13,387 |   |
| Total assets                                            |       | 42,075   |       | 29,013   |       | 31,159   |       | 34,886   |       | 105,018  |       |
| Long-term  debt, including current portion              |       | —   |       | —   |       | —   |       | —   |       | 8,000    |       |
| Total  stockholders’ equity                        |       | 35,061   |       | 24,446   |       | 26,353   |       | 29,197   |       | 81,366   |       |

 

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

 

**Significant Accounting Estimates**

 

We prepare the consolidated financialstatements of the Company in conformity with accounting principles generallyaccepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptionsthat we believe are reasonable 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 shafts returned for breakage will be returned within three years of the initial sale of the shaft.  The Company estimates 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 .23% and 1.54% (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, 2004 is .39%.  The Company’s breakage return rate has declined over the past years.  The highest four-year average over the past four years has been 1.16%.  If the Company were to use 1.16% in estimating its liability as of December 31, 2004, it would have the effect of increasing the liability by approximately $714,000, 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 receivables 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, 2004, the Company estimated this amount to be approximately $25,000.  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.

 

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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 their anticipated sales forecast.  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 20% for the past five years.  In the past five years, the highest reserve percentage was approximately 30% and the lowest reserve percentage was approximately 10%.  The Company’s reserve percentage as of December 31, 2004 is 10%.   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 12/31/04    |       | $           | 9,253      |        | $          | 9,253      |       | $ | 9,253 |   |
| Reserve rate                       |       | 30          | %(a)       | 20          | %          | 10         | %          |
| Estimated  reserve                 |       | 2,776       |       | 1,851       |       | 925        |       |
| Recorded  Reserve as of 12/31/2004 |       | 961         |       | 961         |       | 961        |       |
| Impact to  costs of goods sold     |       | $           | 1,815      |        | $          | 889        |       | $ | (36 | ) |

 

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(a) This wasthe Company’s highest rate; the second highest rate in the past five years was22%.

 

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 37% from December 31, 2001 through December 31, 2004.  In addition, the Company has disposed 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 thebusiness of designing, manufacturing and marketing graphite (carbon fiber basedcomposite) golf club shafts, with approximately 75% of its net sales resultingfrom sales to golf club 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 shafts suchas the Company’s.

 

The graphite shaft market consists of OEMproduction shafts, both premium and value, and branded shafts.  The Company sells customized OEM productionshafts directly to its customers and sells Aldila branded shafts through theOEM custom fit programs and distributors. The Company has re-emerged over the past couple of years as an innovatorin the branded segment of the business, in which shafts tend to sell at higherprices and gross margins than the standard shafts sold to club manufacturers.  The Company introduced its new and innovative“One” shaft early in 2002, which has been successful in the branded segment andthe Company introduced the Aldila NVTM, in 2003, featuring theCompany’s exclusive Micro Laminate Technology. The NVTM has had numerous tour victories, including the 2003British Open and is currently the number one new shaft model on tour.   In addition to the “One” and the NVTMshafts, the Company continues to develop other premium branded custom shaftsand has introduced NV line extensions in 2004, including the NVS, NV ProtoPype,NV Extreme and the NV Hybrid shafts. In addition, the Company introduced theGamer shaft in the first part of 2005, which will also service the Hybrid clubsegment at a different price point.  TheCompany believes that it will continue to be successful in the branded segmentand has focused its marketing and advertising effort in support of thisbusiness.  The Company competesaggressively with both United States and foreign-based shaft manufacturers forOEM production shafts.  The Companycontinues to maintain a broad customer base in both the OEM production shaftand branded shaft market segments.

 

During the 1990’s, the graphite golf shaftindustry became increasingly competitive, placing extraordinary pressure on theselling prices of the Company’s golf shafts and adversely affecting its grossprofit margins and level of profitability.

 

16

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The Company’s selling prices decreased through the 1990s and through December 31,2002.  The pressure was mainly attributedto the increased competition for OEM production shafts, and a shift of ourcustomers away from branded shafts to customized OEM production shafts.TheCompany’s average selling price decreased by 64% from December 31, 1990through December 31, 2002.  TheCompany’s average selling price has increased by approximately 36% from 2002through 2004.  The increase in averageselling prices is primarily attributed to the success the Company has achievedin the branded segment of the business. The Company believes that its average selling price will increase if itcontinues to be successful in the branded segment of the golf shaft market.  In addition, increases in carbon fiber pricespassed on to its customers will also have the effect of increasing averageselling prices in the future.

 

The Company’s response to the pricingpressure it has faced and continues to face has been to reduce its coststructure, vertically integrate and to focus on penetration of the brandedshaft segment.   The Company has reducedits cost structure by shifting more and more of its shaft production offshore,and by manufacturing the majority of its prepreg requirements internally.  In a further effort to reduce costs, theCompany consolidated its executive offices with its manufacturing facilities inPoway, California in 2002.  The Companycontinues to look for opportunities to cut costs.  The cost saving benefits of its efforts tovertically integrate its operations, particularly through carbon fibermanufacturing, has not benefited the Company in the last several years.  Until recently market prices for golf shaftraw materials, which are primarily based on carbon fiber costs, have beenhistorically low with carbon fiber readily available at attractive prices whencompared to the Company’s cost to purchase it from CFT.  In the second half of 2003 the availabilityof carbon fiber began to decline and prices began to increase, which trend theCompany believes will continue at least for the foreseeable future.  Although the Company’s gross margins andprofitability have continued to be adversely affected through this perioddespite its efforts, management believes that vertical integration through itsprepreg operation has been successful to date and is allowing the Company tomaintain, or in some cases enhance, its competitive position with respect tothe major United States golf club companies that are its principalcustomers.    In 2002, the Companyrefocused its efforts on the branded shaft segment.  In 2002, the Company introduced the Aldila “One”shaft; in 2003 the Company introduced the NVTM shaft.  In 2004, the Company introduced lineextensions of the NV.  The Company hasincreased its marketing and advertising spending in support of its brandedproducts.  The Company’s sales havetended to be concentrated among a limited number of major club companies, thusmaking the Company’s results of operations dependent on those customers, theircontinued willingness to purchase a significant portion of their shafts fromthe Company, and their success in selling clubs containing the Company’s shaftsto their customers.  In 2004, net salesto Acushnet Company, Callaway Golf and Ping represented 22%, 17% and 9% of theCompany’s net sales, respectively, and the Company anticipates that thesecompanies will continue, collectively, to represent the largest portion of itssales in 2005.  Although it is generallydifficult to predict in advance the success of any particular club or of anyparticular manufacturer, the Company believes that it is protected to someextent from normal periodic fluctuations in sales among the various golf clubcompanies by virtue 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.

 

In 1994, the Company started manufacturingprepreg, the principal raw material in the manufacture of graphite golf shafts,at its facility in Poway, California.  Mostof its production of prepreg is used internally by the Company, with theremainder sold to other composite materials manufacturers.   The Company continues to look foropportunities to sell its prepreg to other composite materials manufacturersand to manufacture other non-golf composite materials products, such as hockeysticks.  Sales of prepreg as a percentageof net revenues increased to 8% in 2004 as compared to 5% in 2003 and sales ofhockey sticks decreased to 5% of net revenues from 6% in 2003.  Although the Company has achieved somesuccess in these areas, management continues to believe that the growthopportunities in these areas will be limited, especially as it pertains toother composite products, such as hockey sticks.  Management believes that it can continue toimprove on its sales of composite prepreg, although it does not anticipate itwill be material to its results of operations for at least several years.

 

In 1998, the Company established amanufacturing facility in Evanston, Wyoming for the production of carbonfiber.  During 1998 and through the firstten months of 1999, the Company used the material from this facility to satisfya significant portion of its internal demand for carbon fiber in themanufacturing of golf club shafts.  During1999, the Company also produced and sold carbon fiber from this facility toother unrelated entities for the manufacture of other carbon-basedproducts.  On October 29, 1999, SGLpurchased a 50% interest in the Company’s carbon fiber manufacturing operation.

 

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The Company and SGL entered into an agreementto operate the facility as a limited liability company with equal ownershipinterests between the venture members. The Company and SGL also entered into supply agreements with the newentity, CFT, for the purchase of carbon fiber at cost plus an agreed-uponmark-up.  The Company and SGL are eachresponsible to bear 50% of the fixed costs to operate the facility as a term ofthis supply agreement.  Profits andlosses of CFT are shared equally by the partners.  The carbon fiber from this facility isprimarily consumed by the joint venture partners.

 

If the carbon fiber facility is not operatedat high production levels, either because of production difficulties or becausethere is not enough demand by the joint venture partners to justify that levelof production, the cost per unit of carbon fiber consumed by the Company (andthus the cost of producing the Company’s golf shafts and other products) is increaseddue to spreading the fixed costs of production over smaller volumes.  If demand is lower than production capacity,CFT also runs the risk of building up excess inventory.  Given the relatively low costs historicallyin the market for carbon fiber and the highly competitive market for graphitegolf shafts, the failure to operate at high levels could adversely affect theCompany’s gross margins or its ability to maintain competitive prices for itsproducts.  Although selling prices ofcarbon fiber have been depressed for the past several years based on a surplusof supply in the market for carbon fiber, the Company has recently seenincreases in carbon fiber prices and a constriction of supply of some types ofcarbon fiber, which are not manufactured at CFT.  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 for several years.

 

**Results of Operations**

 

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

 
| ** **                                        | ** ** | **For the years ended****December 31,** | ** ** | **Period Change** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|-------------------|------------|
| ** **                                        | ** ** | **2004 vs.**                                 | ** ** | **2003 vs.**      |
| **2004**                                          | ** ** | **2003**                                     | ** ** | **2002**          | ** ** | **2003** | ** ** | **2002** |
| **Results  of Operations**                        | ** ** | ** **                                   | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Sales                                         |       | $                                            | 52,762     |              | $          | 37,807 |   | $ | 37,462 |   | 40 | % | 1 | % |
| Cost Of  Sales                                    |       | 34,786                                       |       | 30,586            |       | 32,828 |   | 14 | % | -7 | % |
| Gross Profit                                      |       | 17,976                                       |       | 7,221             |       | 4,634 |   | 149 | % | 56 | % |
| Gross Margin                                      |       | 34                                           | %          | 19                | %          | 12 | % |   |   |   |   |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| Selling,  General And Administrative              |       | 8,237                                        |       | 6,989             |       | 7,334 |   | 18 | % | -5 | % |
| Impairment  Of Goodwill                           |       | —                                       |       | —            |       | — |   | — |   | — | % |
| Impairment  Of Trademarks & Patents      |       | —                                       |       | —            |       | — |   | — |   | — | % |
| Amortization  Of Goodwill                         |       | —                                       |       | —            |       | — |   | — |   | — | % |
| Plant  Consolidation                              |       | —                                       |       | —            |       | 300 |   | — |   | -100 | % |
| Operating  Income (Loss)                          |       | 9,739                                        |       | 232               |       | (3,000 | ) | 4098 | % | -108 | % |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| Other  Expense (Income):                          |       |                                         |       |              |       |   |   |   |   |   |   |
| Interest  Expense                                 |       | —                                       |       | 23                |       | 94 |   | -100 | % | -76 | % |
| Other, Net                                        |       | (60                                          | )          | 48                |       | 62 |   | 225 | % | -23 | % |
| Impairment  Of Investment In Joint Venture        |       | —                                       |       | 2,220             |       | — |   | -100 | % | — | % |
| Equity In  Earnings Of Joint Venture              |       | (246                                         | )          | (150              | )          | (269 | ) | 64 | % | -44 | % |
| Income  (Loss) Before Income Taxes                |       | 10,045                                       |       | (1,909            | )          | (2,887 | ) | 626 | % | -34 | % |
| Provision  (Benefit) For Income Taxes             |       | 725                                          |       | (183              | )          | (43 | ) | 496 | % | 326 | % |
| Net Income  (Loss)                                |       | $                                            | 9,320      |              | $          | (1,726 | ) | $ | (2,844 | ) | 640 | % | -39 | % |
| Net Income  (Loss) Per Common Share-Basic         |       | $                                            | 1.85       |              | $          | (0.35 | ) | $ | (0.57 | ) | 629 | % | -39 | % |
|                                              |       |                                         |       |              |       |   |   |   |   |   |   |
| **Cash  Flow Data**                               |       |                                         |       |              |       |   |   |   |   |   |   |
| Cash  provided by operating activities            |       | $                                            | 9,573      |              | $          | 3,997 |   | $ | 2,473 |   | 117 | % | 62 | % |
| Cash (used  for) provided by investing activities |       | (5,339                                       | )          | (183              | )          | 547 |   | -2,817 | % | -67 | % |
| Cash  provided by (used for) financing activities |       | 378                                          |       | (181              | )          | — |   | 815 | % | 100 | % |

 

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*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 NV family of shafts.  TheCompany believes its success in the branded shaft segment will continue for theforeseeable future, however, it does not anticipate it will achieve the sameyear over year growth rate.  Total golfshaft sales increased by approximately 35% for 2004 from 2003.  The average selling price of shafts soldincreased by approximately 22% for 2004 from 2003, which was attributed to theincreased branded shaft sales.  Prepregmaterial sales increased by approximately 141% in 2004 from 2003 andrepresented 8% of the Company’s net sales for 2004.  The Company has added a fifth prepreg line tosupport it golf and prepreg business. Hockey sticks sales increased by 13% in 2004 from 2003 and represent 5%of the Company’s net sales for 2004.  TheCompany does not anticipate a significant increase in the sales of hockeysticks in 2005 and could be adversely affected by the NHL players strike,mainly as it relates to the NHL pro service business.

 

*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 to gross profit was an increase in gross profit of $186,000 in 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 in2004.  Other SG&A decreased by 5% in2004 as compared to 2003.  The Companyanticipates that it will spend approximately the same amount on advertising andpromotion in support of its branded product in 2005 that it spent in 2004.  SG&A decreased as a percentage of netsales to 16% in 2004, from 18% in 2003.

 

*Other Expense (Income)*.  The Company recorded an impairment charge ofapproximately $2.2 million in 2003 related to its investment in its jointventure (CFT).  See - “Notes toConsolidated Financial Statements,” Note 5. Interest expense decreased to $0 in2004 from $23,000 in 2003.

 

*IncomeTaxes.*  TheCompany recorded a provision for income taxes in the amount of $725,000 in2004.  The Company’s effective tax ratewas 7% in 2004.  At December 31,2004, the Company had a net deferred tax asset of approximately $2.2million.  This deferred tax assetrepresented net operating loss carryforwards, tax credit carryforwards andother basis differences, which give rise to future tax deductions in excess ofbook deductions.  Realization of thesetax benefits is dependent upon the generation of future taxable income. Duringthe fourth quarter of 2002, management determined that based on its thencurrent outlook and existing circumstances that it was not likely that the taxbenefits associated with its deferred tax assets would be realized.  Accordingly, the Company placed a full valuationallowance against its net deferred tax asset as of December 31, 2002.

 

Based upon the Company’s results in thecurrent year, the Company addressed the appropriateness of its valuationallowance and the circumstances that led to the establishment of its valuationallowance.  The Company believes therehas been a change in circumstances, and that its deferred tax assets will berealized in future years and accordingly has reduced its valuation allowanceagainst the related deferred tax assets to zero as of December 31, 2004.

 

*2003 Compared to 2002*

 

*Net Sales. *Net sales increased by $345,000 for 2003 from2002.  Although, sales were relativelyflat year on year, the composition of the Company’s sales changed.  Sales of golf shafts decreased by approximately5%, which was more than offset by increased sales of composite prepreg andother revenues, primarily related to hockey sticks.  The decrease in golf shaft sales wasattributed to decreases in value and OEM premium sales, which were partiallyoffset by increased sales of the Company’s premium branded shafts.  Sales of value shafts and OEM premium shaftsdecreased by 22% and 5%, respectively with sales of the Company’s brandedproduct increasing by 78% as compared to 2002. Shaft unit sales decreased 15% in

 

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2003 compared to 2002 and the average selling price of shafts soldincreased by 11% in 2003, which was primarily attributed to an increase inpremium branded sales in 2003.

 

*Gross Profit.*  Gross profit increased by approximately $2.6million.  The Company’s gross profitmargin increased to 19% in 2003 from 12% in 2002.  The increase in gross profit was attributedto two factors, first, an increase in sales of the Company’s premium brandedproduct, which typically has higher gross margins than that of the Company’sother products and secondly, a decrease in variable costs of productionattributed to fewer units shipped in 2003 when compared to 2002.  In addition, the Company’s gross profit wasnegatively affected by additional inventory related reserves of approximately$669,000 in 2003, which was offset by the sales of product that were reservedfor in the amount of approximately $745,000. The net impact in gross profit related to inventory reserves was anincrease in gross profit of $76,000 in 2003. The Company’s impact on gross profit in 2002 was a negative impact of$456,000.

 

*Operating Income (Loss)*.  Operating income increased by approximately$3.2 million.  The increase was primarilyattributed to the increase in gross profit. In addition to the increase in gross profit, the Company reduced itsselling, general and administrative (“SG&A”) expense by approximately$345,000 in 2003 as compared to 2002. The decrease in SG&A was primarily attributed to decreasedadministrative expenses, attributed to the consolidation of it corporateoffices and the reduction in professional services expenses.  The decrease in SG&A was partially offsetby an increase in spending on advertising and promotion of approximately$553,000.  SG&A decreased as apercentage of net sales to 18% in 2003, from 20% in 2002.

 

*Other Expense (Income)*.  The Company recorded an impairment charge ofapproximately $2.2 million related to its investment in its joint venture(CFT).  See - “Notes to ConsolidatedFinancial Statements,” Note 5.  TheCompany believes that the recorded amount of its investment in CFT approximatesfair market value.  Interest expensedecreased to $23,000 in 2003 from $94,000 in 2002.  The decrease is attributed to the repaymentof the Company’s long-term debt in 2001 and the termination of its Line ofCredit in 2003.  As the Companyterminated its Line of Credit it 2003, it will no longer be subject to anunused line fee.

 

*Income Taxes.*  The Company recorded a benefit for incometaxes in the amount of $183,000 in 2003. The Company’s effective tax rate was 10% in 2003.  At December 31, 2003, the Company had anet deferred tax asset of approximately $2.5 million.  This deferred tax asset represented netoperating loss carryforwards, tax credit carryforwards and other basisdifferences, which give rise to future tax deductions in excess of bookdeductions.  Realization of these taxbenefits is dependent upon the generation of future taxable income.  During the fourth quarter of 2002, managementdetermined that it was no longer more likely than not that the tax benefitsassociated with these deferred tax assets would be realized.  Accordingly, the Company placed a fullvaluation allowance against its net deferred tax asset.

 

**Liquidity and Capital Resources**

 

Cash, cash equivalents and marketablesecurities (“Cash”) increased $9.6 million from 2003.  The majority of the increase was attributedto increased net income, proceeds from the exercise of stock options and increaseddistributions from CFT, which were partially offset by increased capitalspending and payments of dividends to shareholders.  Cash provided by operating activities in 2004was approximately $9.6 million, compared to approximately $4.0 million in 2003.   The Company used $1.9 million forcapital expenditures during 2004, with the majority of it applicable to thetenant improvements placed in service at its manufacturing location and addedprepreg manufacturing capacity. Management anticipates capital expenditures to approximate between $1.5million and $2.8 million for 2005.  TheCompany received distributions from CFT totaling $1.5 million in 2004 comparedto $500,000 in 2003.  Futuredistributions from CFT must be agreed upon by both joint venture partners priorto any distribution being made.  TheCompany repurchased 54,989 shares of its stock during 2004, costingapproximately $295,000.

 

The Company plans to continue to repurchaseits stock in accordance with its stock buyback plan through 2005.   The Company believes that it will haveadequate cash resources, including anticipated cash flow and borrowingavailability, to meet its obligations at least through 2005.

 

The Company had in place a $12.0 millionrevolving credit facility from a financial institution, which was secured bysubstantially all the assets of Aldila Golf and guaranteed by the Company until2003.  The Company terminated the line ofcredit during 2003 and does not anticipate establishing a new line of credit tosupport operations.

 

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**Off Balance Sheet Arrangements**

 

As of December 31, 2004 and 2003, theCompany did not have any Off Balance 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) |       | $                                       | 1,024      |   | $ | 1,504 |   | $ | 654 |   | $ | 1,045 |   | $ | 4,227 |   |
| CFT Fixed  Costs (b)  |       | 1,400                                   |       | 2,800 |   | 2,800 |   | — |   | 7,000 |   |
| Total                 |       | $                                       | 2,424      |   | $ | 4,304 |   | $ | 3,454 |   | $ | 1,045 |   | $ | 11,227 |   |

 

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(a)          We enter into operatingleases in the normal course of business. All lease agreements have fixed payment terms based on the passage oftime.  Some lease agreements provide uswith the option to renew the lease.  Ourfuture operating lease obligations would change if we exercised these renewaloptions and if we entered into additional operating lease agreements.

(b)         The Company isresponsible for 50% of the fixed costs of CFT. The amounts estimated above are based upon the amount of fixed costs forCFT in 2004.   As the Company isresponsible for the fixed costs until CFT is dissolved, the Company hasestimated the amount through year 5.  IfCFT were to still be in existence past year 5, the Company is still responsiblefor 50% of their fixed costs.  TheCompany does not currently have a fixed or minimum quantity of carbon fiberthat 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.

 

**Seasonality**

 

Because the Company’s customers havehistorically built inventory in anticipation of purchases by golfers in thespring and summer, the principal selling season for golf equipment, the Company’soperating results have been affected by seasonal demand for golf clubs, whichhas generally resulted in highest sales occurring in the second quarter.  The timing of customers’ new productintroductions has frequently mitigated the impact of seasonality in recentyears.

 

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

 

The Company believes that its exposure tomarket risk relating to interest rate risk is not material.  The Company is exposed to foreign exchangerisk to the extent of adverse fluctuations in the Mexican peso and the Chineserenminbi.  Based on historical movementsof these currencies, the Company does not believe that reasonably possiblenear-term changes in these currencies will have a material adverse effect onthe Company’s financial position or results of operations.  In addition, the Company does not engage inhedging activities to protect from this potential risk.  The Company believes that its businessoperations are not exposed to market risk relating to commodity price risk orequity price risk.

 

**“Safe Harbor” Statement Under the PrivateSecurities Litigation Reform Act of 1995**

 

This Annual Report on Form 10-K andcertain information incorporated herein by reference contain forward-lookingstatements within the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995.  Allstatements included or incorporated by reference in this Annual Report on Form 10-K,other than statements that are purely historical, are forward-lookingstatements.

 

Words such as “anticipates,” “expects,” “intends,”“plans,” “believes,” “seeks,” “estimates,” and similar expressions alsoidentify forward-looking statements. Forward-looking statements are not guarantees of future performance andare subject to risks and uncertainties that could cause actual results todiffer materially from the results contemplated by the forward-lookingstatements.  These forward-lookingstatements are based on management’s expectations as of the date hereof, thatnecessarily contain certain assumptions and are subject to certain risks anduncertainties.  The Company does notundertake any responsibility to update these statements in the future.  The Company’s actual future performance andresults could differ from that contained in or suggested by these forwardlooking statements as a result of the factors set forth in this Management’sDiscussion and Analysis of Financial Condition and Results of Operations, theBusiness Risks described in Item 1 of this Report on Form 10-K andelsewhere in the Company’s filings with the Securities and Exchange Commission.

 

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**Item 8.  Financial Statements andSupplementary Data**

 

The information required as to this Item isincorporated by reference from the consolidated financial statements andsupplementary data listed in Item 15 of Part IV of this report.

 

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

 

On May 20, 2003 the Company changed itsaccountants from Deloitte & Touche LLP to Peterson & Co.,LLP.  The change in independentaccountants was recommended and approved by the Company’s Audit Committee.  During the Company’s fiscal years ended December 31,2001 and December 31, 2002, and the subsequent interim periods through May 20,2003, there were no disagreements with Deloitte & Touche LLP on anymatter of accounting principles or practices, financial statement disclosure,or auditing scope or procedure, which disagreements, if not resolved to thesatisfaction of Deloitte & Touche LLP, would have caused Deloitte &Touche LLP to make reference thereto in their report on the financialstatements for such years.  See theCompany’s Current Report filed on form 8K and later amended on form 8-K/A datedMay 20, 2003 and filed on May 29, 2003.

 

**Item 9A. Controls and Procedures**

 

(a)          *Evaluation of disclosure controls and procedures.*Asof the end of the period covered by this report, Aldila management, includingthe Chief Executive Officer and Chief Financial Officer, conducted anevaluation of the effectiveness of our disclosure controls and procedurespursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and the ChiefFinancial Officer concluded that such disclosure controls and procedures areeffective in alerting them on a timely basis to material information relatingto Aldila required to be included in Aldila’s periodic filings under theExchange Act.

 

(b)         *Changes in internal control. *There have been no significantchanges in internal controls or in factors that could significantly affectinternal controls, including any corrective actions with regard to significantdeficiencies and material weaknesses, subsequent to the date the Chief ExecutiveOfficer and Chief Financial Officer completed their evaluation.

 

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**PART III**

 

**Item 10.****Directors and Executive Officers of theRegistrant**

 

The information required as to this Item isincorporated by reference from the section headed “Election of Directors”in the Company’s Proxy Statement for the 2005 Annual Meeting of Stockholdersfor the year ended December 31, 2004, which will be filed with theCommission within 120 days of the end of the fiscal year covered by this report(“2005 Proxy 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.****ExecutiveCompensation**

 

The information required as to this Item isincorporated herein by reference from the data under the caption “ExecutiveCompensation” in the 2005 Proxy Statement.

 

**Item 12.****Security Ownership of Certain Beneficial Ownersand 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 2005 ProxyStatement.

 

**Item 13.****Certain Relationships and Related Transactions**

 

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

 

**Item 14.****Principal Accounting Fees and Services**

 

The information required as to this Item isincorporated herein by reference from the data under the caption “IndependentAccountant Fees” in the 2005 Proxy Statement.

 

23

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**PART IV**

 

**Item 15.****Exhibits, Financial Statement Schedules, andReports on Form 8-K**

 

(a)          Documents included aspart of this report:

 

1.                                       Theconsolidated financial statements for the Registrant are included in thisreport.

 
|   | Consolidated Balance Sheets at December 31, 2004 and 2003;                                                  |   |
|--------|------------------------------------------------------------------------------------------------------------------|--------|
|   |                                                                                                             |   |
|   | Consolidated Statements of Operations for the  years ended December 31, 2004, 2003 and 2002;                |   |
|   |                                                                                                             |   |
|   | Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2004, 2003 and 2002; |   |
|   |                                                                                                             |   |
|   | Consolidated Statements of Cash Flows for  the years ended December 31, 2004, 2003 and 2002;                |   |
|   |                                                                                                             |   |
|   | Notes to Consolidated Financial Statements                                                                       |   |
|   |                                                                                                             |   |
|   | Reports of Independent Registered Public  Accounting Firms                                                       |   |

 

2.                                       Schedule IICValuation and Qualifying Accounts for the years ended December 31, 2004,2003 and 2002.

 

All other schedules are omitted because theyare not applicable or the required information is shown in the consolidatedfinancial statements or the notes thereto.

 

3.                                       Seethe Index to Exhibits on page 43 of this Form 10-K. Financial statements ofsubsidiaries not consolidated and fifty percent or less owned persons,management contracts or compensatory plans or arrangements required to be filedas exhibits to this report are identified on the Index to Exhibits.

 

(b)         Exhibits required by Item601 of Regulation S-K.

 

See item (a) 3 above.

 

(c)          Financial statementsrequired by Regulation S-X which are excluded from the annual report toshareholders by Rule 14a-3, which include separate financial statements ofsubsidiaries not consolidated and fifty percent or less owned persons.

 

See item (a) 3 above.

 

24

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**ALDILA, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except share data)**

 
| ** **                                                                                                                                               | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                               |       |                        |       |                        |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| CURRENT  ASSETS:                                                                                                                                         |       |                        |       |                        |       |
| Cash and  cash equivalents                                                                                                                               |       | $                           | 11,531     |                        | $          | 6,919 |   |
| Marketable  securities                                                                                                                                   |       | 4,971                       |       | —                      |       |
| Accounts  receivable                                                                                                                                     |       | 5,214                       |       | 4,613                       |       |
| Income taxes  receivable                                                                                                                                 |       | 1,013                       |       | —                      |       |
| Inventories                                                                                                                                              |       | 8,292                       |       | 7,778                       |       |
| Deferred tax  assets                                                                                                                                     |       | 1,570                       |       | —                      |       |
| Prepaid  expenses and other current assets                                                                                                               |       | 380                         |       | 399                         |       |
| Total  current assets                                                                                                                                    |       | 32,971                      |       | 19,709                      |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| PROPERTY,  PLANT AND EQUIPMENT                                                                                                                           |       | 5,245                       |       | 4,776                       |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| INVESTMENT  IN JOINT VENTURE                                                                                                                             |       | 3,072                       |       | 4,287                       |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| DEFERRED TAX  ASSETS                                                                                                                                     |       | 634                         |       | —                      |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| OTHER ASSETS                                                                                                                                             |       | 153                         |       | 241                         |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| TOTAL ASSETS                                                                                                                                             |       | $                           | 42,075     |                        | $          | 29,013 |   |
|                                                                                                                                                     |       |                        |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                           |       |                        |       |                        |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                    |       |                        |       |                        |       |
| Accounts  payable                                                                                                                                        |       | $                           | 4,213      |                        | $          | 3,067 |   |
| Accrued  expenses                                                                                                                                        |       | 2,781                       |       | 1,461                       |       |
| Total  current liabilities                                                                                                                               |       | 6,994                       |       | 4,528                       |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| LONG-TERM  LIABILITIES:                                                                                                                                  |       |                        |       |                        |       |
| Deferred  rent                                                                                                                                           |       | 20                          |       | 39                          |       |
| Total  liabilities                                                                                                                                       |       | 7,014                       |       | 4,567                       |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| 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  5,127,310 shares in 2004 and 4,885,149 shares in 2003, respectively |       | 51                          |       | 48                          |       |
| Additional  paid-in capital                                                                                                                              |       | 43,864                      |       | 41,803                      |       |
| Accumulated  deficit                                                                                                                                     |       | (8,854                      | )          | (17,405                     | )          |
| Total  stockholders’ equity                                                                                                                         |       | 35,061                      |       | 24,446                      |       |
|                                                                                                                                                     |       |                        |       |                        |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                         |       | $                           | 42,075     |                        | $          | 29,013 |   |

 

See notes to consolidated financialstatements.

 

25

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**ALDILA,INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**

 
| ** **                                                      | ** ** | **Years ended  December 31,** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                      | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| NET SALES                                                       |       | $                                  | 52,762     |   | $ | 37,807 |   | $ | 37,462 |   |
| COST OF  SALES                                                  |       | 34,786                             |       | 30,586 |   | 32,828 |   |
| Gross profit                                                    |       | 17,976                             |       | 7,221 |   | 4,634 |   |
|                                                            |       |                               |       |   |   |   |   |
| SELLING,  GENERAL AND ADMINISTRATIVE                            |       | 8,237                              |       | 6,989 |   | 7,334 |   |
| PLANT  CONSOLIDATION                                            |       | —                             |       | — |   | 300 |   |
| Operating  income (loss)                                        |       | 9,739                              |       | 232 |   | (3,000 | ) |
|                                                            |       |                               |       |   |   |   |   |
| OTHER  EXPENSE (INCOME):                                        |       |                               |       |   |   |   |   |
| Interest  expense                                               |       | —                             |       | 23 |   | 94 |   |
| Other, net                                                      |       | (60                                | )          | 48 |   | 62 |   |
| Impairment  of investment in joint venture                      |       | —                             |       | 2,220 |   | — |   |
| Equity in  earnings of joint venture                            |       | (246                               | )          | (150 | ) | (269 | ) |
|                                                            |       |                               |       |   |   |   |   |
| INCOME  (LOSS) BEFORE INCOME TAXES                              |       | 10,045                             |       | (1,909 | ) | (2,887 | ) |
| PROVISION  (BENEFIT) FOR INCOME TAXES                           |       | 725                                |       | (183 | ) | (43 | ) |
|                                                            |       |                               |       |   |   |   |   |
| NET INCOME  (LOSS)                                              |       | $                                  | 9,320      |   | $ | (1,726 | ) | $ | (2,844 | ) |
|                                                            |       |                               |       |   |   |   |   |
| NET INCOME  (LOSS) PER COMMON SHARE-BASIC                       |       | $                                  | 1.85       |   | $ | (0.35 | ) | $ | (0.57 | ) |
|                                                            |       |                               |       |   |   |   |   |
| NET INCOME  (LOSS) PER COMMON SHARE, ASSUMING DILUTION          |       | $                                  | 1.77       |   | $ | (0.35 | ) | $ | (0.57 | ) |
|                                                            |       |                               |       |   |   |   |   |
| WEIGHTED  AVERAGE NUMBER OF COMMON SHARES OUTSTANDING           |       | 5,027                              |       | 4,934 |   | 4,948 |   |
|                                                            |       |                               |       |   |   |   |   |
| WEIGHTED  AVERAGE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES |       | 5,255                              |       | 4,934 |   | 4,948 |   |

 

See notes to consolidated financialstatements.

 

26

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**ALDILA, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(In thousands)**

 
| ** **                                                                              | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **                | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|---------------------------|------------|------------|------------|
| ** **                                                                              | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | ** **     | ** ** | ** **                | ** ** |
| ** **                                                                              | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **(Accumulated Deficit)** | ** ** | **Total**  | ** ** |
| Balance at January 1,  2002                                                        |       | 4,948            |       | $           | 49         |           | $          | 41,983                    |       | $          | (12,835    | ) | $ | 29,197 |   |
|                                                                                    |       |             |       |        |       |           |       |                      |       |       |       |
| Net loss                                                                                |       |             |       |        |       |           |       | (2,844                    | )          | (2,844     | )          |
|                                                                                    |       |             |       |        |       |           |       |                      |       |       |       |
| Balance at  Deccember 31, 2002                                                          |       | 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  payment                                                                       |       |             |       |        |       |           |       | (769                      | )          | $          | (769       | ) |
|                                                                                    |       |             |       |        |       |           |       |                      |       |       |       |
| Net income                                                                              |       |             |       |        |       |           |       | 9,320                     |       | 9,320      |       |
|                                                                                    |       |             |       |        |       |           |       |                      |       |       |       |
| Balance at December 31,  2004                                                      |       | 5,127            |       | $           | 51         |           | $          | 43,864                    |       | $          | (8,854     | ) | $ | 35,061 |   |

 

See notes to consolidated financialstatements.

 

27

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**ALDILA, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                                | ** ** | **Years ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                    |       |                               |       |   |   |   |   |
| Net income  (loss)                                                                        |       | $                                  | 9,320      |   | $ | (1,726 | ) | $ | (2,844 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                               |       |   |   |   |   |
| Depreciation  and amortization                                                            |       | 1,422                              |       | 1,798 |   | 1,921 |   |
| Loss (gain)  on disposal of fixed assets                                                  |       | 32                                 |       | 26 |   | (11 | ) |
| Impairment  of investment in joint venture                                                |       | —                             |       | 2,220 |   | — |   |
| Undistributed  income of joint venture, net                                               |       | (285                               | )          | (182 | ) | (249 | ) |
| Tax benefit  from exercise of stock options                                               |       | 917                                |       | — |   | — |   |
| Changes in  assets and liabilities:                                                       |       |                               |       |   |   |   |   |
| Accounts  receivable                                                                      |       | (601                               | )          | (220 | ) | (416 | ) |
| Inventories                                                                               |       | (514                               | )          | 760 |   | 2,934 |   |
| Deferred tax  assets                                                                      |       | (2,204                             | )          | — |   | 2,366 |   |
| Prepaid  expenses and other assets                                                        |       | 52                                 |       | 70 |   | 117 |   |
| Accounts  payable                                                                         |       | 1,146                              |       | 155 |   | (9 | ) |
| Accrued  expenses                                                                         |       | 1,320                              |       | (102 | ) | (802 | ) |
| Income taxes  receivable/payable                                                          |       | (1,013                             | )          | 1,185 |   | (462 | ) |
| Deferred tax  liabilities                                                                 |       | —                             |       | — |   | (67 | ) |
| Deferred  rent and other long-term liabilities                                            |       | (19                                | )          | 13 |   | (5 | ) |
| Net cash  provided by operating activities                                                |       | 9,573                              |       | 3,997 |   | 2,473 |   |
|                                                                                      |       |                               |       |   |   |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                    |       |                               |       |   |   |   |   |
| Purchases of  property, plant and equipment                                               |       | (1,871                             | )          | (699 | ) | (362 | ) |
| Proceeds  from sales of property, plant and equipment                                     |       | 3                                  |       | 16 |   | 19 |   |
| Investment  in marketable securities                                                      |       | (4,971                             | )          | — |   | — |   |
| Distributions  from joint venture                                                         |       | 1,500                              |       | 500 |   | 890 |   |
| Net cash  (used for) provided by investing activities                                     |       | (5,339                             | )          | (183 | ) | 547 |   |
|                                                                                      |       |                               |       |   |   |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                    |       |                               |       |   |   |   |   |
| Borrowings  under line of credit                                                          |       | —                             |       | — |   | 887 |   |
| Payments  under line of credit                                                            |       | —                             |       | — |   | (887 | ) |
| Repurchases  of common stock                                                              |       | (295                               | )          | (181 | ) | — |   |
| Proceeds  from issuance of common stock                                                   |       | 1,442                              |       | — |   | — |   |
| Dividend  payments                                                                        |       | (769                               | )          | — |   | — |   |
| Net cash  provided by (used for) financing activities                                     |       | 378                                |       | (181 | ) | — |   |
|                                                                                      |       |                               |       |   |   |   |   |
| NET INCREASE  IN CASH AND CASH EQUIVALENTS                                                |       | 4,612                              |       | 3,633 |   | 3,020 |   |
| CASH AND  CASH EQUIVALENTS, BEGINNING OF YEAR                                             |       | 6,919                              |       | 3,286 |   | 266 |   |
| CASH AND  CASH EQUIVALENTS, END OF YEAR                                                   |       | $                                  | 11,531     |   | $ | 6,919 |   | $ | 3,286 |   |
|                                                                                      |       |                               |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                       |       |                               |       |   |   |   |   |
| Cash paid  during the year for:                                                           |       |                               |       |   |   |   |   |
| Interest                                                                                  |       | $                                  | —     |   | $ | 23 |   | $ | 48 |   |
| Income taxes                                                                              |       | $                                  | 3,095      |   | $ | 183 |   | $ | 251 |   |

 

See notes to consolidated financialstatements.

 

28

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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 andmarkets graphite 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, Aldila Graphite Products (Zhuhai) Company Ltd. and Aldila Foreign SalesCorporation. All intercompany transactions and balances have been eliminated inconsolidation. The Company accounts for its joint venture investment in CarbonFiber Technology (“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, 2004,2003 and 2002 were $327,887, $245,328 and $180,877, 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. Historically, credit losses have beenminimal in relation to the credit extended.

 

*Inventories* –Inventories are stated at the lower of first-in, first-out (FIFO) cost ormarket value.

 

*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:

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

 

Leasehold improvements are amortized over theshorter of the asset life or the remaining term of the related lease.

 

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

 

29

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*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.

 

*WarrantyReserve –*The Companyprovides a warranty to its customers for shaft breakage in the normal course ofbusiness. The Company accrues for the estimated warranty based on historicalexperience at time of sale. The estimated warranty is calculated based upon arolling four-year ratio of breakage returns to sales applied to current yearsales. (See Note 6).

 

*Research & Development*– The Company performs internalresearch and development efforts. Research and development expense representedless than approximately 1% of net revenues for 2004, 2003 and 2002 and isconsidered 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, 2004, 2003 and 2002,net foreign 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 712,497and 737,961 shares of common stock as of December 31, 2003 and December 31,2002, respectively, at prices ranging from $1.61 to $18.66 per share were notincluded in the computation of diluted EPS because the effect of such optionswould be anti-dilutive. Such options expire at various dates through December of2013.

 

On May 15, 2002, the Company’s Board ofDirectors and stockholders approved a 1-for-3 reverse stock split of theCompany’s Class A Common Stock, which became effectiveon June 3, 2002 for stockholders of record at that date. Stockholders’equity has been retroactively restated to reflect the reverse stock split forall periods presented by reclassifying the additional paid-in capital, whichresulted from the reduction in shares due to the reverse split from commonstock to additional paid-in capital.  All share data in the accompanyingconsolidated financial statements and notes to the consolidated financialstatements have been retroactively restated to reflect the stock split for allperiods presented.

 

*Income Taxes* -Income taxes are provided utilizing the asset and liability method.  Theasset and liability method requires the recognition of deferred tax assets andliabilities for the expected future tax consequences of temporary differencesbetween the carrying amounts and tax bases of assets and liabilities. Valuation allowances are established when necessary to reduce deferred incometax assets to amounts more likely than not to be realized.

 

*Accounting for Stock Based Compensation*– At December 31, 2004, 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 below 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 theCompany’s stock option awards been determined based upon the fair value at thegrant date for awards from 2001 through 2004 and recognized on a straight-linebasis over the related vesting period, in accordance with the provisions ofSFAS No. 123, the Company’s net income and earnings per share for 2004 wouldhave been decreased and the net loss and loss per share for 2003 and 2002 wouldhave been increased to the pro forma amounts indicated below:

 

30

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| ** **                                                                                                                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income  (loss) as reported                                                                                                                |       | $        | 9,320      |     | $          | (1,726   | )          | $ | (2,844 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Deduct:  Total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (202     | )          | (208     | )          | (380     | )          |
| Pro forma  net income (loss)                                                                                                                  |       | $        | 9,118      |     | $          | (1,934   | )          | $ | (3,224 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Earnings  (loss) per share:                                                                                                                   |       |     |       |     |       |     |       |
| Basic – as  reported                                                                                                                     |       | $        | 1.85       |     | $          | (0.35    | )          | $ | (0.57 | ) |
| Basic – pro  forma                                                                                                                       |       | $        | 1.81       |     | $          | (0.39    | )          | $ | (0.65 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Diluted – as  reported                                                                                                                   |       | $        | 1.77       |     | $          | (0.35    | )          | $ | (0.57 | ) |
| Diluted –  pro forma                                                                                                                     |       | $        | 1.74       |     | $          | (0.39    | )          | $ | (0.65 | ) |

 

*Recently Issued Accounting Pronouncements*– In December 2004, the FinancialAccounting Standards Board issued SFAS No. 123(R), “Share-Based Payment.” SFAS No. 123(R) replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issuedto Employees.”  SFAS No. 123(R) requires compensation costs related toshare-based payment transactions to be recognized in the financial statementsover the period that an employee provides service in exchange for theaward.   SFAS No. 123(R) is effective for periods beginning after June 15,2005.  The Company plans to adopt SFAS No. 123(R) on July 1, 2005,the beginning of its third fiscal quarter. SFAS123R eliminates the alternativeto use the intrinsic value method of accounting that was provided in SFAS123 asoriginally issued.                  In accordance with SFAS No. 148, the Companyhas been disclosing the impact on net income and earnings per share had thefair value based method been adopted.  If the fair value method had beenadopted, net income for 2004 would have decreased by $202,000 and net loss for2003 and 2002 would have increased by $208,000, and $380,000, respectively,than reported and earnings (loss) per share would have been reducedapproximately $0.03, $0.04, and $0.08 in 2004, 2003, and 2002, respectively.

 

InNovember 2004, the Financial Accounting Standards Board issued SFAS No.151, “Inventory Costs.”  SFAS No. 151 amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material.  ThisStatement requires that those items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal.”  Inaddition, this Statement requires that allocation of fixed production overheadsto the costs of conversion be based on the normal capacity of the productionfacilities.  SFAS No. 151 is effective for fiscal years beginning after June 15,2005.  The Company intends to adopt SFAS No. 151 on January 1, 2006,the beginning of its 2006 fiscal year.  The adoption of SFAS No. 151 isnot expected to have a material impact on the Company’s financial statements.

 

InDecember 2003, the Financial Accounting Standards Board issuedInterpretation 46R (“FIN 46R”), a revision to Interpretation 46 (“FIN 46”), “Consolidationof Variable Interest Entities.” FIN 46R clarifies some of the provisions of FIN46 and exempts certain entities from its requirements.  FIN 46R waseffective at the end of the first interim period ending after March 15,2004.    The Company adopted FIN 46R on April 1, 2004 andit did not have an impact on the Company’s financial statements

 

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

 

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

 
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
|                                   |       |     |       |     |       |
| Trade  accounts receivable             |       | $        | 5,239      |     | $          | 4,647 |   |
| Less:  allowance for doubtful accounts |       | (25      | )          | (34      | )          |
| Accounts  receivable                   |       | $        | 5,214      |     | $          | 4,613 |   |

 

31

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**3.****              INVENTORIES**

 

Inventories at December 31 consist ofthe following (in thousands):

 
| ** **      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
|            |       |     |       |     |       |
| Raw  materials  |       | $        | 4,632      |     | $          | 5,420 |   |
| Work-in-process |       | 742      |       | 774      |       |
| Finished  goods |       | 2,918    |       | 1,584    |       |
| Inventories     |       | $        | 8,292      |     | $          | 7,778 |   |

 

**4.****              PROPERTY, PLANT ANDEQUIPMENT**

 

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

 
| ** **                                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |
| Machinery  and equipment                         |       | $        | 15,639     |     | $          | 14,738 |   |
| Office  furniture and equipment                  |       | 1,615    |       | 1,603    |       |
| Leasehold  improvements                          |       | 8,635    |       | 8,017    |       |
| Property and  equipment not yet in service       |       | 253      |       | 31       |       |
|                                             |       | 26,142   |       | 24,389   |       |
| Less:  accumulated depreciation and amortization |       | (20,897  | )          | (19,613  | )          |
| Property,  plant and equipment                   |       | $        | 5,245      |     | $          | 4,776 |   |

 

Depreciation and amortization expense were $1.4 million, $1.8 millionand $1.7 million in 2004, 2003 and 2002, respectively.

 

**5.****              INVESTMENT IN JOINTVENTURE**

 

The Company and SGL each own 50% of CFT in ajoint venture to produce carbon fiber. CFT, which was previously a wholly ownedsubsidiary of AMTC, was formed on October 29, 1999. AMTC contributed netassets with a book value of approximately $13.3 million. SGL purchased a 50%interest in AMTC’s carbon fiber manufacturing operations for approximately $7.0million in cash, which resulted in a gain of approximately $334,000.     The Amended and RestatedLimited Liability Company Agreement provides that CFT is to continue until December 31,2099 unless it is dissolved earlier, its affairs are wound up and finalliquidating distributions are made pursuant to the Amended and Restated LimitedLiability Company Agreement.

 

The Company’s 50% investment in CFT is accountedfor under the equity method. Based on the member’s respective ownershipinterest in the joint venture, profits and losses are allocated equally to eachmember. Each partner is responsible for 50% of the fixed costs of the facilityregardless on the amount of fiber that is purchased from the joint venture. In2004, CFT’s sales to the Company and its partner was$4.7 million and $7.0 million, respectively. The amount of consolidatedretained earnings of the Company represented by undistributed earnings of CFTwas an accumulated deficit of approximately $4.2 million as of December 31,2004. The Company’s equity in earnings from the joint venture for the yearsended December 31, 2004, 2003 and 2002 were approximately $246,000,$150,000 and $269,000, respectively. The Company’s investment includes theunamortized excess of the Company’s investment over its equity in the jointventure net assets. The excess was approximately $64,000 and $84,000 at December 31,2004 and 2003, respectively, and is being amortized on a straight-line basisover an initial estimated economic useful life of approximately 101 months.

 

The Company and its joint venture partnerentered into a non-binding letter of interest on September 17, 2003 tosell selected assets, substantially all of the manufacturing equipment,building, land and raw materials (substantially all the total operatingassets), of CFT to an independent third party. On February 11, 2004, theCompany and its joint venture partner entered into a non-binding letter of intentwith that same party based on the prevailing circumstances preceding suchletter and consequent assessments made during that relevant period. The letterof intent included an implied fair value of the proposed transaction and theCompany was willing, at that time, to sell its 50% of CFT based on the impliedfair value within the letter of intent. In consideration of the valuationdetermined during negotiations, the Company believed that impairment hadoccurred. Consequently it was appropriately assessed that the previous carryingamount of its investment in CFT as of December 31, 2003 was notrecoverable. As such the Company judged that in accordance with SFAS 144 “Accountingfor the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) it was appropriateto record an impairment charge against

 

32

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the recordedvalue of its investment in CFT as of December 31, 2003 and such impairmentcharge was recorded in the fourth quarter of 2003. The three parties continuedto negotiate the terms of the proposed transaction for an extended periodthereafter 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 the negotiations regarding the sale of the selected assetsfailed. The Company now believes that the fair value of CFT as of December 31,2004 is currently greater than its carrying value. The increase in fair valueis attributed to the change of market conditions of the carbon fiber industryduring 2004. Carbon fiber prices increased throughout 2004 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.

 

**6.****              ACCRUED EXPENSES**

 

Accrued expenses at December 31 consistof the following (in thousands):

 

 
| ** **                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
|                               |       |     |       |     |       |
| Payroll and  employee benefits     |       | $        | 2,280      |     | $          | 904 |   |
| Warranty  reserve (1)              |       | 176      |       | 184      |       |
| Plant  consolidation               |       | —   |       | —   |       |
| Marketing  and promotional expense |       | 225      |       | 225      |       |
| Legal and  professional fees       |       | 25       |       | 28       |       |
| Interest  payable                  |       | —   |       | —   |       |
| Other                              |       | 75       |       | 120      |       |
| Accrued  expenses                  |       | $        | 2,781      |     | $          | 1,461 |   |

 

----

| **(1) Warranty Reserve** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Beginning  Balance       |       | $        | 184        |     | $          | 345 |   |
| Settlement  of Warranty  |       | (77      | )          | (110     | )          |
| Adjustments  to Warranty |       | 69       |       | (51      | )          |
| Ending  Balance          |       | $        | 176        |     | $          | 184 |   |

 

**7.****              STOCKHOLDERS’ EQUITY**

 

The Company announced on January 17,2001 that its Board of Directors authorized the repurchase of up to 333,333shares of the Company’s common stock (or up to 6.5% of the 5,154,068 sharesthen issued and outstanding). The Company repurchased 206,267 shares on theopen market, at an approximate cost of $3.63 per share during 2001. The Companyannounced on January 22, 2002 an increase in the number of sharesauthorized for purchase in its current share buyback program from 333,333 to666,667 shares of the Company’s common stock. On June 27, 2003, theCompany announced a stock buyback program under which shares of the Company’scommon stock could be repurchased up to a total of $1.5 million. The Companyrepurchased 62,499 shares on the open market during 2003, costing anapproximate $181,000. The Company repurchased 54,989 shares on the open marketduring 2004, costing an approximate $295,000.

 

**8.****              PLANT CONSOLIDATION**

 

During the fourth quarter of 2002, managementdeveloped a plan to consolidate its executive offices with its U.S.manufacturing operations in an effort to reduce costs. The Company successfullynegotiated a sub-lease of its executive offices, with the term of the sub-leaseidentical to the term of the Company’s remaining lease obligation through October 31,2005. Accordingly, the Company recorded a plant consolidation charge in theamount of approximately $300,000. The majority of the charge is related to theCompany’s leasehold improvements at its executive offices. The reserve wassettled during 2003 and as of December 31, 2003 there was $0 remaining inthe reserve for future obligations.

 

33

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**9.****              INCOME TAXES**

 

The components of the provision (benefit) forincome taxes are as follows (in thousands):

 

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                              |       |     |       |     |       |     |       |
| Federal                               |       | $        | 2,256      |     | $          | (211     | )          | $ | (2,317 | ) |
| State                                 |       | 455      |       | (58      | )          | (17      | )          |
| Foreign                               |       | 217      |       | 86       |       | (8       | )          |
| Total                                 |       | 2,928    |       | (183     | )          | (2,342   | )          |
| Deferred:                             |       |     |       |     |       |     |       |
| Federal                               |       | 2,352    |       | (57      | )          | 1,698    |       |
| State                                 |       | (149     | )          | 57       |       | 601      |       |
| Total                                 |       | 2,203    |       | —   |       | 2,299    |       |
| Provision  (benefit) for income taxes |       | $        | 725        |     | $          | (183     | )          | $ | (43 | ) |

 

Net deferred income taxes included in currentassets in the balance sheet at December 31, consist of the tax effects oftemporary differences related to the following (in thousands):

 
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Inventories                         |       | $        | 914        |     | $          | 1,458 |   |
| Accrued  expenses                   |       | 760      |       | 306      |       |
| Allowance  for doubtful accounts    |       | 10       |       | 13       |       |
| Deferred  expenses (capital losses) |       | 4        |       | 18       |       |
| Prepaid  expenses                   |       | (86      | )          | —   |       |
| State income  taxes                 |       | (32      | )          | (201     | )          |
| Deferred tax  assets – current |       | $        | 1,570      |     | $          | 1,594 |   |

 

Net deferred income taxes included inlong-term liabilities in the balance sheet at December 31 consist of the taxeffects of temporary differences related to the following (in thousands):

 
| ** **                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| Property and  equipment                             |       | $        | 312        |     | $          | 493 |   |
| Basis in  joint venture (CFT)                       |       | (586     | )          | (634     | )          |
| CFT  Impairment Charge                              |       | 882      |       | 882      |       |
| Other                                               |       | 26       |       | 208      |       |
| Deferred tax  assets (liabilities) – long term |       | $        | 634        |     | $          | 949 |   |

 

Total reconciliation of the deferred taxassets and liabilities are below.

 
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets – current                      |       | $        | 1,570      |     | $          | 1,594 |   |
| Deferred tax  assets (liabilities) – long term      |       | 634      |       | 949      |       |
| Total net  deferred tax asset before valuation allowance |       | 2,204    |       | 2,543    |       |
| Valuation  allowance                                     |       |     |       | (2,543   | )          |
| Total  deferred tax asset                                |       | $        | 2,204      |     | $          | — |   |

 

During the fourth quarter of 2002, managementdetermined that based on its then current outlook and existing circumstancesthat it was not likely that the tax benefits associated with its deferred taxassets would be realized. Accordingly, the Company placed a full valuationallowance against its net deferred tax asset as of December 31, 2002 inaccordance with SFAS 109.

 

Based upon the Company’s results in the current year, the Companyaddressed the appropriateness of its valuation allowance and the circumstancesthat led to the establishment of its valuation allowance in accordance withSFAS 109. The Company believes there has been a change in circumstances, andthat its deferred tax assets will be realized in future years and accordinglyhas reduced its valuation allowance against the related deferred tax assets tozero as of December 31, 2004.  Differences between the statutory federalincome tax rate and the effective tax rate as a percentage of income taxes aresummarized below.

 

34

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At December 31, 2004, the Company had California net operatingloss carryforwards of $1.5 million. The California net operating losscarryforwards will begin to expire in 2013, unless previously utilized. TheCompany also has federal research and development tax credits of approximately$43,000, which will begin to expire in 2021 unless previously utilized. TheCalifornia research and development credit carryforward of approximately$49,000 can be carried over to succeeding years until exhausted.

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory  rate                                 |       | 34.0     | %          | (34.0    | )%         | (34.0    | )%         |
| State income  taxes, net of Federal tax benefit |       | 4.0      |       | (4.0     | )          | 1.7      |       |
| Valuation  allowance                            |       | (26.9    | )          | 44.7     |       | 66.2     |       |
| Goodwill  impairment                            |       | —   |       | —   |       | —   |       |
| Non-deductible  amortization                    |       | —   |       | —   |       | —   |       |
| Revision of  prior years’ tax estimates    |       | —   |       | (10.3    | )          | (23.4    | )          |
| Foreign  earnings taxed at different rates      |       | (4.0     | )          | (4.5     | )          | (12.5    | )          |
| Other items                                     |       | .1       |       | (1.5     | )          | 0.5      |       |
| Effective  rate                                 |       | 7.2      | %          | (9.6     | )%         | (1.5     | )%         |

 

The Company has adopted the position underAPB 23 that earnings of its foreign subsidiaries will be permanently reinvestedoutside of the United States. As such, United States deferred taxes have notbeen provided for on these earnings.

 

**10.****       STOCK OPTION PLAN**

 

In 1992, the Company adopted a Stock OptionPlan for management. The Company has reserved 175,431 shares for issuance underthis Plan. Options are granted at the fair market value of the shares at thedate of grant, generally become fully vested three years after grant, andexpire ten years from the date of grant.

 

In May of 1994, the stockholders adopted the1994 Stock Incentive Plan for employees, directors and consultants of theCompany. The Company has reserved 1,366,667 shares for issuance under thisPlan. Options are granted at the fair market value of the shares at the date ofgrant, generally become fully vested three years after grant, and expire tenyears from the date of grant.

 

The pro forma compensation costs presented inNote 1 were determined using the weighted average fair values of optionsgranted under the Company’s stock option plans during 2004, 2003 and 2002 wereestimated at $5.06, $1.41 and $0.90, respectively, on the date of grant usingthe Black-Scholes option-pricing model with the following weighted-averageassumptions: 1% dividend yield in 2004, volatility of 59% in 2004, 49% in 2003and 50% in 2002, risk free rate of return of 3.5% in 2004, 2.7% in 2003 and3.3% in 2002 and expected lives of five years. The estimated fair value ofoptions granted is subject to the assumptions made and if the assumptionschanged, the estimated fair value amounts could be significantly different. Asummary of the Company’s fixed stock option plans as of December 31, 2004,2003 and 2002 and activity during the years then ended is presented below:

 

 
| ** **                       | ** ** | **2004**   | ** ** | **2003**                                   | ** ** | **2002**   | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                       | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** | **Shares** | ** ** | **Weighted****Average  Exercise****Price** | ** ** |
| ** **                       | ** ** | ** ** | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding  at January 1   |       | 712,497    |       | $                                          | 5.21       |       | 729,189    |   | $ | 5.79 |   | 1,029,323 |   | $ | 10.08 |   |
| Granted                          |       | 132,494    |       | $                                          | 11.37      |       | 90,440     |   | $ | 3.03 |   | 108,899 |   | $ | 1.92 |   |
| Exercises                        |       | (299,025   | )          | $                                          | 4.82       |       |       |   |   |   |   |   |   |   |
| Terminated                       |       | (60,628    | )          | $                                          | 15.20      |       | (107,132   | ) | $ | 7.30 |   | (409,033 | ) | $ | 15.92 |   |
| Outstanding  at December 31 |       | 485,338    |       | $                                          | 5.86       |       | 712,497    |   | $ | 5.21 |   | 729,189 |   | $ | 5.79 |   |

 

35

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The following table summarizes information about stock optionsoutstanding and exercisable at December 31, 2004:

 
| ** **                         | ** ** | ** **                                          | ** ** | **Options Outstanding**                                   | ** ** | **Options Exercisable**                | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------|------------|
| **Range of****Exercise****Prices** | ** ** | **Number  Outstanding  at December 31,  2004** | ** ** | **Weighted  Average  Remaining Contractual  Life (Yrs.)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number****Exercisable****at December 31,  2004** | ** ** | **Weighted****Average****Exercise  Price** | ** ** |
|                               |       |                                                |       |                                                      |       |                                   |       |   |   |   |   |
| $1.61 -  $3.29                     |       | 176,231                                             |       | 8.4                                                       |       | $                                      | 2.42       |   | 85,240 |   | $ | 2.21 |   |
| $4.14 -  $5.91                     |       | 177,841                                             |       | 6.1                                                       |       | $                                      | 4.68       |   | 167,841 |   | $ | 4.64 |   |
| $11.47 -  $15.75                   |       | 131,266                                             |       | 9.2                                                       |       | $                                      | 12.09      |   | 8,772 |   | $ | 15.18 |   |
| $1.61 -  $15.75                    |       | 485,338                                             |       | 7.8                                                       |       | $                                      | 5.86       |   | 261,853 |   | $ | 4.20 |   |

 

As of December 31, 2004, 2003 and 2002,261,853, 503,420 and 457,258 shares were exercisable under the Plans at aweighted average exercise price of $4.20, $6.08 and $7.06 per share,respectively. As of December 31, 2004, an aggregate of 586,914 sharesremain available for grant under the Plans.

 

On March 20, 2000, the Company and NickPrice Group entered into a stock option agreement. The option agreement allowsNick Price to purchase 50,000 shares of Common Stock at a purchase price of$4.89 per share with a three-year vesting period. In return for the shares, theCompany has received the services of Nick Price at a guaranteed minimum valueof $4.50 per share, or a minimum aggregate consideration of $225,000. TheCompany recognized compensation expense and a liability of approximately $0,$16,000 and $37,000 in 2004, 2003 and 2002, respectively. The shares areregistered under a Form S-3, which was filed with the Securities and ExchangeCommission on August 2, 2004. Nick Price Group exercised their 50,000options 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 itssubsidiaries. This defined contribution plan allows employees who satisfy theage and service requirements of the Plan to contribute up to 19% of pre-taxwages, limited to the maximum amount permitted under federal law. The Companymatches the first 4% of wages contributed by employees at a rate of $0.25 forevery $1.00. The Company’s matching contributions vest over four years based onyears of service. The Company’s contributions amounted to approximately$48,000, $48,000 and $48,000 in 2004, 2003 and 2002, respectively.

 

**12.****       COMMITMENTS ANDCONTINGENCIES**

 

The Company leases building space and certainequipment under operating leases. The Company’s leases for office andmanufacturing space contain rental escalation clauses and renewal options. Rentalexpense for the Company was $900,000, $900,000 and $1.1 million for 2004, 2003and 2002, respectively. As of December 31, 2004, future minimum leasepayments for all operating leases are as follows (in thousands):

 
| 2005       |   | $   | 1,024  |   |
|------------|--------|-----|--------|--------|
| 2006       |   | 837 |   |
| 2007       |   | 667 |   |
| 2008       |   | 654 |   |
| 2009       |   | 624 |   |
| Thereafter |   | 421 |   |
|       |   | $   | 4,227  |   |

 

Amounts receivable from future minimum rentalpayments due from a sub-lessee for the year ending December 31, 2005 is$211,000.

 

**13. SEGMENT INFORMATION**

 

The Companydesigns and manufacturers graphite shafts for golf club manufacturers.In doing so, the Company also manufactures carbon fiber and prepreg materials,which are utilized in the manufacture of graphite golf shafts. In accordancewith SFAS No. 131 “Disclosures about Segments of an Enterprise and RelatedInformation”, the Company considers its business to consist of one reportableoperating segment.

 

The Company markets its products domesticallyand internationally, with its principal international market being Europe.

 

36

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The table below contains information about the geographical areas inwhich the Company operates. Revenues are attributed to countries based onlocation in which the sale is settled. Long-lived assets are based on thecountry of domicile. Sales to a major customer represented 22%, 27%, and 22% ofnet sales in 2004, 2003, and 2002, respectively. Sales to a second customerrepresented 2%, 6%, and 13% of net sales in 2004, 2003, and 2002, respectively.Sales to a third customer represented 17%, 21% and 22% of net sales in 2004,2003 and 2002, respectively. Sales to a fourth customer represented 9%, 10% and9% of net sales in 2004, 2003 and 2002, respectively.

 
| **(in  thousands)****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                    |       | $         | 37,807     |                  | $          | 9,063 |   |

 
| **2002**                 | ** ** | **Sales** | ** ** | **Long-Lived Assets** | ** ** |
|--------------------------|------------|-----------|------------|-----------------------|------------|
| United  States           |       | $         | 32,207     |                  | $          | 10,587 |   |
| Scotland                 |       | 189       |       | —                |       |
| England                  |       | 2,165     |       | —                |       |
| China                    |       | 1,023     |       | 2,324                 |       |
| Mexico                   |       | —    |       | 349                   |       |
| Other  Foreign Countries |       | 1,878     |       | —                |       |
| Total                    |       | $         | 37,462     |                  | $          | 13,260 |   |

 

**14.****       QUARTERLY RESULTS OFOPERATIONS (Unaudited)**

 

The following is a summary of the quarterlyresults of operations for the two years in the period ended December 31,2004 (in thousands, except per share data):

 
| ** **                                  | ** ** | **Quarter Ended**  | ** ** |
|---------------------------------------------|------------|--------------------|------------|
| ** **                                  | ** ** | **March 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                  | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2004:**                                   |       |               |       |   |   |   |   |   |   |
| Net sales                                   |       | $                  | 15,298     |   | $ | 14,260 |   | $ | 10,772 |   | $ | 12,432 |   |
| Gross profit                                |       | 6,124              |       | 5,979 |   | 2,524 |   | 3,349 |   |
| Net income                                  |       | 2,274              |       | 2,173 |   | 3,318 |   | 1,555 |   |
| Net income  per common share-basic          |       | $                  | 0.47       |   | $ | 0.44 |   | $ | 0.65 |   | $ | 0.30 |   |
| Net income  per common share-diluted        |       | $                  | 0.46       |   | $ | 0.42 |   | $ | 0.62 |   | $ | 0.29 |   |
|                                        |       |               |       |   |   |   |   |   |   |
| **2003:**                                   |       |               |       |   |   |   |   |   |   |
|                                        |       |               |       |   |   |   |   |   |   |
| Net sales                                   |       | $                  | 10,164     |   | $ | 9,863 |   | $ | 7,995 |   | $ | 9,785 |   |
| Gross profit                                |       | 1,739              |       | 1,513 |   | 1,893 |   | 2,076 |   |
| Net income  (loss)                          |       | (169               | )          | (471 | ) | 189 |   | (1,275 | ) |
|                                        |       |               |       |   |   |   |   |   |   |
| Net income  (loss) per common share-basic   |       | $                  | (0.03      | ) | $ | (0.10 | ) | $ | 0.04 |   | $ | (0.26 | ) |
| Net income  (loss) per common share-diluted |       | $                  | (0.03      | ) | $ | (0.10 | ) | $ | 0.04 |   | $ | (0.26 | ) |

 

37

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Earnings (loss) per share are computedindependently for each of the quarters presented and therefore may not sum to theannual amount for the year. Included in the Company’s third quarter resultsended September 30, 2004 was an adjustment to the Company’s income taxexpense. The adjustment to income tax expense was approximately $2.5 million,which was attributed to the reversal of the Company’s valuation allowanceagainst its deferred tax assets. Included in the Company’s fourth quarterresults ended December 31, 2003 was an impairment charge of approximately$2.2 million against the carrying value of the Company’s investment in CFT.

 

**15.****       RELATED PARTY TRANSACTIONS**

 

The dollar amount of transactions withrelated parties, primarily attributed to purchases of carbon fiber from CFT,was approximately $4.7, $3.3 and $3.4 million for the years ended December 31,2004, 2003 and 2002, respectively.

 

38

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**ALDILA INC. AND SUBSIDIARIES**

 

**SCHEDULE IICVALUATION AND QUALIFYING ACCOUNTS**

 

**For theyears ended December 31, 2004, 2003 and 2002**

 
| ** **                            | ** ** | **Balance at beginning  of year** | ** ** | **Charged to costs and  expenses** | ** ** | **Deductions** | ** ** | **Balance at end  of year** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|----------------|------------|-----------------------------|------------|
| Year ended December 31,  2002    |       |                              |       |                               |       |           |       |                        |       |
| Allowance  for uncollectible accounts |       | $                                 | 151,275    |                               | $          | (21,899        | )          | $                           | (107,040   | ) | $ | 22,336 |   |
| Inventory  Reserves                   |       | $                                 | 3,260,969  |                               | $          | 455,901        |       | $                           | —     |   | $ | 3,716,870 |   |
| Warranty reserve                      |       | $                                 | 485,000    |                               | $          | (3,000         | )          | $                           | (137,000   | ) | $ | 345,000 |   |
|                                  |       |                              |       |                               |       |           |       |                        |       |
| 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 |   |

 

39

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Reportof Independent Registered Public Accounting Firm

 

Board of Directors andStockholders

Aldila, Inc.

 

We have audited theconsolidated balance sheets of Aldila Inc., and subsidiaries (“the Company”) asof December 31, 2004 and 2003 and the related statements of operations,stockholders’ equity, and cash flows for the years then ended December 31,2004 and 2003. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits. The consolidated financial statements ofAldila, Inc. and its subsidiaries as of December 31, 2002, were audited byother auditors whose report dated February 12, 2003, expressed anunqualified opinion on those statements.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Aldila, Inc. and subsidiaries asof December 31, 2004 and 2003, and the results of its operations and itscash flows for the years then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 
|                   | /s/ PETERSON & Co., LLP |   |
|------------------------|-----------------------------|--------|
|                   | PETERSON & Co., LLP     |
|                   |                        |
| San Diego, California  |                        |
| February 18, 2005 |                        |

 

40

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

Board of Directors and Stockholders

Aldila, Inc.

 

We have audited the accompanying consolidated statements of operations,stockholders’ equity, and cash flows of Aldila, Inc. and its subsidiaries (the “Company”)for the year ended December 31, 2002. Our audit also included the 2002financial statement schedule listed at Item 15. These financial statementsand financial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audit.

 

We conducted our audit in accordance with 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 ouraudit provides a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the results of the Company’s operations and its cashflows for the year ended December 31, 2002, in conformity with accountingprinciples generally accepted in the United States of America. Also, in ouropinion, such financial statement schedule, when considered in relation to thebasic consolidated financial statements taken as a whole, presents fairly inall material respects the information set forth therein.

 

/s/ DELOITTE & TOUCHE LLP

 

San Diego, California

February 12, 2003

 

41

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on 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  and Director (Principal  Executive Officer)                     |       | March 30,  2005 |
| Peter R.  Mathewson      |       |                                                                                      |       |
|                     |       |                                                                                      |       |
|                     |       |                                                                                      |       |                 |
| /s/ Robert  J. Cierzan   |       | Vice  President, Finance  (Principal Financial Officer  and Principal Accounting Officer) |       | March 30,  2005 |
| Robert J. Cierzan        |       |                                                                                      |       |
|                     |       |                                                                                      |       |
|                     |       |                                                                                      |       |                 |
| /s/ Lloyd I  Miller, III |       | Director                                                                                  |       | March 30,  2005 |
| Lloyd I.  Miller, III    |       |                                                                                      |       |                 |
|                     |       |                                                                                      |       |                 |
| /s/ Thomas  A. Brand     |       | Director                                                                                  |       | March 30,  2005 |
| Thomas A.  Brand         |       |                                                                                      |       |                 |
|                     |       |                                                                                      |       |                 |
| /s/ Andrew M.  Leitch    |       | Director                                                                                  |       | March 30,  2005 |
| Andrew M. Leitch         |       |                                                                                      |       |                 |
|                     |       |                                                                                      |       |                 |
| /s/ Bryant  R. Riley     |       | Director                                                                                  |       | March 30,  2005 |
| 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             |       | Business Park Net Lease dated as of May 29,1987, between the Company and Kaiser Development Company  as amended by the First Amendment to Lease dated as of January 12, 1992,  between the Company and Bedford Development Company. (Filed as Exhibit 10.15  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 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).                                                                                                                                                                                                                           |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.7             |       | 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).                                                                                                                                                                                                                                    |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.8             |       | 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).                                                                                                                                                                                                                 |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.9             |       | 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).                                                                                                                                                                                                                                  |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.10            |       | 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).                                                                                                                                                                                                                                                                                               |

 

43

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| 10.11             |   | 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).                                                                                                             |
|------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.12             |   | Lease  Agreement dated May 15, 1995 between the Company and Desarrollo Industrial de  Tijuana, S.A. de 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).                                                                          |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.13             |   | Loan  Agreement dated March 27, 1998 between Aldila, Inc. and Union Bank of  California, N.A. (Filed as Exhibit 10.1 to the Company’s Report on Form 10-Q  for the quarterly period ended March 31, 1998 and incorporated herein by  reference).                                                                                 |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.14             |   | First  Amendment to Loan Agreement dated March 22, 1999 between the Company and  Union Bank of California, N.A. (Filed as Exhibit 10.16 to the Company’s  Report on Form 10-K for the year ended December 31, 1998 and  incorporated herein by reference).                                                                       |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.15             |   | 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). |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| *10.16                 |   | Loan and  Security Agreement by and between Aldila Golf Corp. and Foothill Capital  Corporation dated July 9, 1999. (Filed as Exhibit 10.1 to the Company’s  Report on Form 10-Q for the quarterly period ended June 30, 1999 and  incorporated herein by reference).                                                            |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| *10.17                 |   | 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).                                                                               |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| *10.18                 |   | 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).                                                                               |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| *10.19                 |   | 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).                                                                                |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.20             |   | 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).                                                                                                     |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.21             |   | Aldila, Inc.  Audit Committee Charter included as Exhibit A in the Company’s 2001 Proxy  dated April 4, 2001 and incorporated herein by reference.                                                                                                                                                                                    |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 10.22             |   | 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                                                                                                                                                                                                                                                        |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 23.2    |   | Consent of  Independent Registered Public Accounting Firm – Deloitte & Touche LLP                                                                                                                                                                                                                                                      |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 31.1    |   | Certification  of Chief Executive Officer                                                                                                                                                                                                                                                                                                       |
|                   |   |                                                                                                                                                                                                                                                                                                                                            |
| 31.2    |   | Certification  of Chief Financial Officer                                                                                                                                                                                                                                                                                                       |

 

44

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| 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, 2003 and 2002                                                                             |

 

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

 

45

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