**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

**FORM 10-K**

**(Mark One)**

| **x**                               | ** ** | **Annual Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**     |
|-------------------------------------|------------|----------------------------------------------------------------------------------------------------|
| ** **                          | ** ** | ** **                                                                                         |
| ** **                          | ** ** | **For the  fiscal year ended December 31, 2006**                                              |
| ** **                          | ** ** | ** **                                                                                         |
| **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**

(Address ofprincipal executive offices)

 

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

SecuritiesRegistered Pursuant to Section 12(b) of the Act:
| **Title of each class**                  | ** ** | **Names of each exchange on which registered** |
|------------------------------------------|------------|------------------------------------------------|
| Common Stock,  par value $0.01 per share | ** ** | The NASDAQ Stock  Market, LLC                  |

 

Securities registered pursuant tosection 12(g) of the Act:
| **None**         |
|------------------|
| (Title of Class) |

 

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

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

Indicate by check markwhether the registrant(1) has filed all reports required to be filed by Section13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.     Yes x No o

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

Indicateby check mark whether the Registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2of the Exchange Act. (Check one):
| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|---------------------------|--------|----------------------|--------|--------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act).  Yes o  Nox

Aggregate market value of voting stock held bynon-affiliates as of June 30, 2006 was - $135.8 million.

Commonshares outstanding as of March 9, 2007 was — 5,524,250

DOCUMENTSINCORPORATED BY REFERENCE

Portions of the followingdocuments are incorporated into this report by reference:

Part III, Items 10, 11, 12, 13 and 14. The Registrant’s definitive Proxy Statement for the 2007 Annual Meetingof Stockholders to be filed with the Commission within 120 days after the closeof the fiscal year.

 

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**ALDILA, INC.**

**Report on Form 10-K****For the Fiscal Year Ended December 31, 2006**

**INDEX**
| Part I         |   |      |   |                                                                                                                |   |
|----------------|--------|-----------|--------|---------------------------------------------------------------------------------------------------------------------|--------|
|           |   |      |   |                                                                                                                |   |
|           |   | Item  1.  |   | Business                                                                                                            |   |
|           |   | Item  1A. |   | Risk  Factors                                                                                                       |   |
|           |   | Item 1B.  |   | Unresolved Staff  Comments                                                                                          |   |
|           |   | 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, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   |
|           |   | 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                                                                                            |   |
|           |   | Item 9B.  |   | Other Information                                                                                                   |   |
|           |   |      |   |                                                                                                                |   |
| 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 and Related Stockholder  Matters                    |   |
|           |   | Item 13.  |   | Certain  Relationships and Related Transactions, and Director Independence                                          |   |
|           |   | 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-looking statementswithin the meaning of the federal securities laws.  These forward-looking statements arenecessarily based on certain assumptions and are subject to significant risksand uncertainties.  These forward-lookingstatements are based on management’s expectations as of the date hereof, andthe Company does not undertake any responsibility to update any of thesestatements in the future.  Actual futureperformance and results could differ from that contained in or suggested bythese forward-looking statements as a result of factors set forth in this Form10-K (including those sections hereof incorporated by reference from otherfilings with the Securities and Exchange Commission), in particular as set forthin “Business Risks” under Item 1 and set forth in the “Management’s Discussionand Analysis of Financial Condition and Results of Operations” under Item 7.*

**Item 1. Business**

**General**

Aldila, Inc. (“Aldila” or the “Company”) is a leadingdesigner and manufacturer of high-quality innovative graphite (carbonfiber-based composite) golf shafts in the United States today.  Aldila conducts its operations through itssubsidiaries, Aldila Golf Corp. (“Aldila Golf”) and Aldila Materials TechnologyCorp.  Aldila enjoys strong relationshipswith most major domestic and many foreign golf club manufacturers includingCallaway Golf, TaylorMade-adidas Golf, Ping and Acushnet Company.  Aldila believes that it is one of the fewindependent shaft manufacturers with the technical and production expertiserequired to produce high-quality graphite shafts in quantities sufficient tomeet demand.  The Company’s current golfshaft product lines consist of Aldila branded and co-branded products designedfor its major customers and custom club makers, as well as custom shaftsdeveloped in conjunction with its major customers. These product lines aredesigned to improve the performance of any level of golfer from novice to tourprofessional.

In 1994, the Company started production of itsprincipal raw material for shafts, graphite prepreg, which consists of carbonfibers combined with epoxy resin in sheet form. See “Manufacturing—Raw Materials.” The Company now produces substantially all of its graphite prepregrequirements internally and also sells prepreg externally.

In 1998, the Company established a manufacturingfacility in Evanston, Wyoming for the production of carbon fiber, in an effortto further vertically integrate its manufacturing operations.  On October 29, 1999, SGL Carbon Fibersand Composites, Inc. (“SGL”) purchased a 50% interest in the Company’s carbonfiber manufacturing operation.  TheCompany and SGL entered into an agreement to operate the facility through alimited liability company with equal ownership interests between the jointventure members.  The Company and SGLalso entered into supply agreements with the new entity, Carbon FiberTechnology LLC (“CFT”), for the purchase of carbon fiber at cost plus anagreed-upon mark-up.  Profits and lossesof CFT are shared equally by the partners.

**GraphiteGolf Shafts**

The Company was founded in San Diego, California in1972 and was an early leader in the design and production of graphite golfshafts.  The Company believes it is wellpositioned to remain a leader in the market for graphite shafts due to itsinnovative and high-quality products, strong customer relationships, design andcomposite 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.

Unlike steel shafts, the design of graphite shafts iseasier to alter with respect to weight, flex, flex location and torque toproduce greater distance, increased accuracy and reduced club vibrationresulting in improved “feel” to the golfer. The improvements in the design and manufacture of graphite shafts andthe growing recognition of their superior performance characteristics for manygolfers compared to steel have resulted in increased demand for graphite shaftsby golfers of all skill levels. The initial acceptance of graphite shafts wasprimarily for use in woods.  According tothe 2006 U.S. National Consumer Survey conducted by The Darrell Survey Company,graphite continues to dominate the professional and consumer wood club market,with over 98**%** of new drivers purchased in 2006including graphite shafts.   In Hybridclubs, 76% of the new clubs purchased had graphite shafts up from 65% theprevious year.  The acceptance ofgraphite shafts

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inirons has not achieved the same success as in woods.  While acceptance in irons did increase in2006, it still lags well behind with only 26% of new irons purchased havinggraphite shafts. However, with the introduction of Hybrid clubs into themarket, players golf bags do not have the traditional amount of irons in theirbags as the Hybrid clubs typically replace the harder to hit long irons,usually the lower numbered irons in a golfers bag.  This results in players having more graphiteshafted clubs in their bags now than prior to the introduction of Hybrid clubs.

**Products**

*GolfShafts*

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

The Company’s shafts, which constituted approximately85% of net sales in the year ended December 31, 2006, are designed inpartnership with its customers (principally golf club manufacturers) toaccommodate specific golf club designs. In addition, the Company researches new and innovative shaft designs onan independent basis, which has enabled the Company to produce a variety of newbranded shafts as well as generate design ideas for customized shafts.  The Company’s branded and co-branded modelsare typically sold to golf club manufacturers, distributors and golf pro andrepair shops and are used either to assemble a new custom club from selectedcomponents or as an after market re-shaft of existing clubs.  The Company also helps develop cosmeticdesigns to give the customer’s golf clubs a distinctive look, even when thecustomer does not require a shaft with customized performancecharacteristics.  The prices of Aldilashafts typically range from $6 to $199.

The Company introduced the NVPrototype at the 2003 PGAMerchandise Show in January 2003 and subsequently changed it to the NVTM.   The NVTM went on to becomethe most successful new product launch in the Company’s history and returnedAldila to the forefront of the composite shaft industry.  The NVTM features the Company’s exclusive Micro LaminateTechnology TM (“MLT”). The Company followed up the NVTMwith the introduction of the NVS, NV ProtoPypeTM, NVTM Hybrid, NVS Hybrid family of shafts and the GamerTM shaft in 2004. The NVS shaft is geared toward the player who requires a shaft thatpromotes a higher initial launch angle, and one that makes it easier to turnthe ball right to left.  The NV ProtoPypeTM promotes a lower, more controlled launchangle, with reduced spin, along with very low torque to provide extremely tightdispersion.  Hybrid clubs (also known asutility clubs and driving irons) are currently the fastest growing segment ofthe golf industry.  They are designed toreplace long irons by providing a club that is easier to hit and much moreforgiving for average as well as very skilled players.  The Company offers a full range of shafts tofit hybrid clubs, including the VS ProtoTM Hybrid, NVTM Hybrid, NVS Hybrid and GamerTM. In the spring of 2006, Aldila began shipments of our two newest shaftofferings – the VS ProtoTM and the VS ProtoTM Hybrid. The VS Proto has quickly become one of Aldila’s single most popularshaft models on Tour.  Both are high-end,high performance shafts featuring carbon nanotubes as well as aerospace carbonfibers and Aldila’s exclusive high performance resin system.  The Company believes that it will continue tobe successful in the branded segment for the foreseeable future and has focusedits engineering, marketing and advertising effort in support of this business.

*Other Products*

Since 1994, the Companyhas manufactured prepreg material for its production of golf shafts.  In 1998, the Company began selling prepregmanufactured in its Poway, California manufacturing facility to thirdparties.  Net sales of prepreg were approximately12% of the Company’s net sales in 2006.  The Company began the manufacture ofcomposite hockey sticks in 2000.  Themanufacture of composite hockey sticks is similar to that of graphite golfshafts and uses similar raw materials. Revenues from the sale of hockey sticks were approximately 3% of netsales in 2006 and are not expected to be significant to the Company.

The Company offers carbonfiber for sale through its joint venture, CFT, however, the Company does notanticipate outside sales of carbon fiber to be significant for the foreseeablefuture.  Carbon fiber composite materialsare suited for a diverse range of applications based on their distinctivecombination of physical and chemical properties.  See “Manufacturing – Carbon FiberManufacturing Process.”  Carbon fibersare used as reinforcements in composite materials that combine fibers withepoxy resins or other matrix materials to form a substance with high strength,low weight, stiffness, resistance to corrosion, resistance to fatigue andcapacity to dissipate heat and electrical conductivity.  Carbon fiber materials produced by

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the Company or CFT are used in a variety ofapplications such as molding compounds for the manufacture of electroniccomponents, masts and spars for the marine industry, hockey sticks, fishingrods, industrial products, as well as golf shafts.

**ProductDesign and Development**

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

Graphite shaft designs and modifications 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 as generatedesign ideas for customized shafts.  Toimprove and advance product designs as they relate to composite technology andshaft process manufacturing, the Company’s engineers have experience withexisting materials, such as boron, kevlar, fiberglass, ceramic, thermoplasticand carbon fiber.  The Company’sengineers also look to newer, more advanced materials such as carbonnanotubes.  Nanotechnology is a fastgrowing field of research that has good potential for structures such ascomposite golf shafts.  The Companybelieves it is the first major shaft company to employ carbon nanotubes inshaft design, and is at the forefront of utilizing this emerging technology ingolf shaft development.  The Company’sdesign research also focuses on improvements in graphite shaft aesthetics sincecosmetic appearance has become increasingly important to customers.  The Company’s research and developmentefforts have resulted in the Aldila “One” shaft, Aldila NVTM, NVS, NV ProtoPypeTM, NVTM Xtreme, NVTM Hybrid, NVSHybrid, GamerTM shafts, and the VS Proto and VS ProtoHybrid.  All of the NVTM family of shafts feature the Company’sexclusive MLT.  Although the Companyemphasizes these research and development activities, there can be no assurancethat Aldila will continue to develop competitive products or that the Companywill be able to utilize new composite material technology on a timely orcompetitive basis, or otherwise respond to emerging market trends.

The Company has been one of the leaders in developingthe market for lower cost large bundle carbon fiber by successfully convertingto this fiber type in some of its products from a more expensive carbon fibermaterial for the manufacture of certain of its graphite golf shafts.  The Company has had some success in providinglarge bundle carbon fiber to other manufacturing applications outside of golfshafts.

The Company has applied its composite materialsexpertise on a limited basis to other products in recent years, producinghockey sticks as well as graphite tubing and other molded parts on a specialorder basis.

**Customersand 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.  The Company’spartnership relationship with its customers continues after the development ofclubs containing Aldila’s shafts. Following the design process, the Company continues to provide highlevels of customer support and service in areas such as quality control andassurance, timely and responsive manufacturing, delivery schedules andeducation.  The Company believes thephysical proximity of its headquarter facilities to many of its customers hasfacilitated a high degree of customer interaction and responsiveness tocustomer needs.  While the Company hashad long-established relationships with most of its customers, it is not theexclusive supplier of graphite shafts to most of them and generally does nothave long-term supply agreements with its customers.

Forfiscal year 2006, the Company had approximately 670 golf shaft customers, whichincluded approximately 120 golf club manufacturers and more than 150distributors, with the balance principally consisting of custom clubassemblers, pro shops and repair shops. However, the majority of the Company’s sales has been and may continueto be concentrated among a relatively small number of customers.  Sales to the Company’s top five customersrepresented approximately 62%, 62% and 57% of net sales in 2006, 2005 and 2004,respectively.

Historically, Aldila’s principal customers have variedas a result of general market trends in the golf industry, in

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particularthe 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, and Ping.  While theCompany believes its relationship with each of these major customers is good,the Company is not the exclusive supplier to any of them.  The Company’s sales to its principalcustomers have varied substantially from year to year.
| Customer         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|
| Ping             |       | 18       | %          | 19       | %          | 9        | %          |
| Acushnet Company |       | 17       | %          | 19       | %          | 22       | %          |
| Callaway Golf    |       | 15       | %          | 18       | %          | 17       | %          |
|             |       |     |       |     |       |     |       |

 

Becauseof the historic volatility of consumer demand for specific clubs, as well ascontinued competition from alternative shaft suppliers, sales to a givencustomer in a prior period may not necessarily be indicative of future salesand it is often difficult to project the Company’s sales to a given customer inadvance.

Althoughthe Company believes that its relationships with its customers are good, theloss of a significant customer or a substantial decrease in sales to asignificant customer (whether as a result of diminished sales by that customeror a shaft sourced from other suppliers) could have a material adverse effecton the Company’s business or operating results.

**Marketing,Advertising and Promotion**

TheCompany’s marketing strategy is designed to encourage golf club manufacturersto select and promote Aldila shafts and to increase overall market acceptanceand use of graphite golf shafts.  TheCompany utilizes a variety of marketing and promotional channels to increasesales of Aldila brand name shafts through its network of distributors and tosupport Aldila’s brand name recognition and reputation among consumers foroffering consistently high quality products designed for a wide range ofgolfers. Although the Company has very limited sales directly to the end usersof its products, the Company believes that its brand name recognitioncontributes to the marketability of its customers’ products.  In addition, Nick Price, Gary McCord andPaula Creamer serve on the Company’s advisory staff and assist in its marketingefforts. Aldila’s marketing and promotion expenditures were approximately $3.2million, $2.3 million and $2.2 million in 2006, 2005 and 2004,respectively.  The Company does notcurrently incur significant marketing expenses for its products other than golfshafts.

**Sales andDistribution**

Within the golf club industry, most companies do notmanufacture the three principal components of the golf club — the grip, theshaft and the clubhead — but rather source these components from independentsuppliers that design and manufacture components to the club manufacturers’specifications.  As a result, Aldilasells its graphite shafts primarily to golf club manufacturers and, to a lesserextent, distributors, custom club shops, pro shops and repair shops.  Distributors typically resell the Company’sproducts to custom club assemblers, pro and custom club shops, andindividuals.  The Company uses itsinternal sales force in the marketing and sale of its shafts to golf clubmanufacturers and distributors.  Sales togolf club manufacturers accounted for approximately 77% of net sales for theyear ended December 31, 2006 as compared to 81% for the previous year.

Prepreg sales, which represented 12% of the Company’s2006 net sales, and carbon fiber sales (through the Company’s joint venture,CFT) are made primarily to manufacturers of composite products.  The Company predominantly has utilized itsinternal sales force in the marketing and sale of these products to itscustomers in the past and will continue to utilize its internal sales force forthe sales of prepreg in the future.

International sales represented 28%, 23%, and 18% ofnet sales for the years ended December 31, 2006, 2005 and 2004,respectively.  The Company’sinternational sales have increased from 18% in 2004 to 28% in 2006.  A large portion of the increase was attributedto increased sales to customers in China. The majority of the customers are assemblers in China, with the endproduct usually being shipped back to the United States or Europe.  See Note 12 in the Notes to ConsolidatedFinancial Statements for further breakdown of our international sales andlong-lived assets.

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**Manufacturing**

The Companybelieves that its manufacturing expertise and production capacity differentiateit from many of its competitors and enable Aldila to respond quickly to itscustomers’ orders and provide sufficient quantities on a timely basis.  The Company today operates three golf shaftmanufacturing facilities, one prepreg manufacturing facility (in conjunctionwith one of its shaft manufacturing facilities) and through its 50% ownershipinterest in CFT, one carbon fiber manufacturing facility.  The Company is constructing another shaftmanufacturing facility, which will be operational and producing shafts duringthe first quarter of 2007.  During its 34years of operation, the Company has improved its manufacturing processes andbelieves it has established a reputation as the industry’s leading volumemanufacturer 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 processand the materials used.  In traditionalshaft designs, treated graphite known as “prepreg” (See Prepreg ManufacturingProcess) is rolled onto metal rods known as mandrels.   The graphite is then baked at hightemperatures to harden the material into a golf shaft.  At the end of the manufacturing process, theshafts are painted and stylized using a variety of colors, patterns anddesigns, including logos and other custom identification.  Through each phase of this process, theCompany performs quality control reviews to ensure continuing high standards ofquality and uniformity to meet exacting customer specifications.  The Company’s shaft manufacturing facilitiesare located in Poway, California, Tijuana, Mexico, and Zhuhai, China, with anincreasing percentage of its shafts being manufactured in China, in recentyears.  The Company is currentlyconstructing a facility in Ho Chi Minh City, Vietnam, which will be operationaland producing shafts in the first quarter of 2007.

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

*Prepreg Manufacturing Process. *In October 1994, theCompany initiated the internal production of prepreg in its Poway, Californiafacility.  The Company believes that byproducing a major portion of its prepreg requirements internally, it may bettercontrol the supply of raw material for shafts and may reduce the impact ofpotential future price increases.  TheCompany now produces substantially all of its prepreg requirements internallyand is dependent on its own prepreg production operation to support its shaftmanufacturing requirements and for its outside sales of prepreg material.  The Company is, however, somewhat dependentupon certain domestic prepreg suppliers for types of prepreg that it does notproduce and, therefore, the Company expects to occasionally purchase someprepreg products from outside suppliers in the future.  Although the Company believes that there willcontinue to be alternative third party suppliers of prepreg, there can be noassurance that unforeseen difficulties which could lead to an interruption inthe Company’s internal prepreg production will not occur, which would result inproduction delays.

The Company’s prepreg operation is dependent oncertain suppliers for carbon fibers, which along with epoxy resins and releasepaper constitute the primary components used to manufacture prepreg.  Through 1997, the Company purchased all ofits carbon fibers from outside vendors. Beginning in 1998, the Company manufactured carbon fiber at its 50%owned Evanston, Wyoming facility, CFT, to provide fiber for its prepregmanufacturing process for consumption by its golf shaft productionoperation.  Because several differentforms of carbon fiber are required for golf shaft products, including some notmanufactured at the CFT facility, the Company will continue to depend onoutside suppliers for a portion of its ongoing carbon fiber needs.  In 2006, the Company obtained a large portionof its carbon fiber from CFT but also purchased carbon fiber from other carbonfiber manufacturers.  The prices paid bythe Company for carbon fiber not produced at CFT began to increase at the endof 2003 and throughout 2005, due to rising manufacturing costs and capacityconstraints in the carbon fiber industry. However, after an initial price increase in early 2006, the prices remainedlevel with no apparent changes in capacity constraints.  If the Company is unable to purchase carbonfiber from suppliers, other than that produced at CFT, it could result inproduction delays of composite prepreg and golf shafts.

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

Typically, the composite structure will weigh 25 to 50percent 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’s,into one which produced approximately 50 million pounds of carbon fiber in2005.

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Carbon fiber usage has grown primarily for consumptionby 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 production ofprepreg, which is used in the manufacture of graphite golf shafts.  In 1998 the Company completed construction ofa 50,000 square foot carbon fiber manufacturing facility in Evanston, Wyoming,which subsequently became CFT.  CFTproduces large bundle carbon fiber material from acrylic fiber through a seriesof stretching, stabilizing and carbonizing sequences in this facility.  Carbon fiber that has more than 24,000 (24K)filaments is considered to be large tow carbon fiber.  During 2004, CFT began producing a smallertow (24K), which yields better properties and can be used in more applications.  CFT now produces two different tow sizes ofcarbon fibers.  These materials aresignificant raw materials used in the Company’s prepreg manufacturing operationto support the manufacture of graphite golf shafts, although the Company stillprocures certain types of fibers from outside vendors for the manufacture ofgolf shafts.  The Company believes it canpurchase the type of fibers produced by CFT from at least two outside sources.

CFT purchased substantially all of its raw acrylicfibers for the carbon fiber operation from one supplier for the years 2000through 2006.  Previous to 2000, theCompany purchased raw acrylic fibers from another supplier who in May 2005,filed bankruptcy and announced its intention to cease producing acrylic fibers,which left CFT in a true sole source position. The assets of this previous supplier are now owned by China Bluestar whocontinues to operate the business.  Thereis no certainty that China Bluestar will be successful.  CFT is continuing to pursue alternate sourcesof supply for this material and has run several trials with results that areencouraging.  However, if the currentsupplier is unable to deliver and CFT cannot qualify and source material from anew supplier prior to this event, it could have a material adverse effect onthe Company’s business.

**EnvironmentalMatters**

The Company is subject to various federal, state,local and foreign environmental laws and regulations, including those governingthe use, discharge and disposal of hazardous materials as the Company useshazardous substances and generates hazardous waste in the ordinary course ofits manufacturing of graphite golf shafts, other composites, graphite prepregand carbon fiber.  The Company believesit is in substantial compliance with applicable laws and regulations and hasnot to date incurred any material liabilities under environmental laws andregulations; however, there can be no assurance that environmental liabilitieswill not arise in the future which may affect the Company’s business.

**Competition**

Aldila operates in a highly competitive environment inboth the United States and international markets for the sale of its graphitegolf club shafts.  The Company believesthat it competes on the basis of its ability to provide a broad range of highquality, performance graphite shafts, its ability to deliver customizedproducts in large quantities and on a timely basis to its customers, theacceptance of graphite shafts in general, and Aldila shafts in particular, byprofessional and other golfers, whose preferences are to some extentsubjective, and finally, price.  Untilrecently, the United States market for graphite shafts was dominated by arelatively small number of United States based shaft manufacturers whichcompeted predominantly for the business of larger original equipmentmanufacturers (“OEMs”).  However, theCompany now competes against United States and foreign-based shaftmanufacturers for the OEM shaft market. This competition has made it moredifficult to retain existing customers, attract new customers and has placedincreasing pressure on prices for OEM shafts. The Company believes that it is the largest supplier of graphite shaftsto the United States club market, which results from its ability to establish apremium brand image and reputation among golf club companies as a value-addedsupplier with competitive prices.  Aldilacompetes against other shaft manufacturers, both graphite and steel, and in thepast also against golf club companies that produced their own shaftsinternally, some of which may have or had greater resources than Aldila.  The Company also faces potential competitionfrom those golf club manufacturers that currently purchase golf shaftcomponents from outside suppliers but that may have, develop or acquire theability to manufacture all or a portion of its graphite shafts internally.  Should any of the Company’s significantcustomers decide to meet any of its shaft needs internally, it could have anadverse effect on the Company.  TheCompany also competes against companies who manufacture one or more of threeprincipal components of the golf club, the grip, the shaft and the club head,and assemble completed golf clubs for delivery to club companies.  Should any of the Company’s significantcustomers decide to source their golf clubs in this manner where an Aldilashaft is not included, it could have an adverse effect on the Company.  Presently, there exists substantial excessgraphite shaft manufacturing capacity both in the United States and in othercountries, however, this excess manufacturing capacity has somewhat beenmitigated by carbon fiber supply constraints.

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The Company also competes for sales of prepreg fromits prepreg facility and carbon fiber through its 50% interest in CFT withother producers of prepreg and carbon fibers, many of which have substantiallygreater research and development, managerial and financial resources than theCompany.  Some producers have beenproducing prepreg and carbon fiber for substantially longer periods of timethan the Company has, and represent significant competition to theCompany.  The Company’s ability tocompete in the sale of prepreg and carbon fiber is dependent to some extent onthe Company’s ability to cause manufacturers and consumers of carbonfiber-based products to utilize the types of carbon fiber manufactured by CFT,which is a significant portion of the carbon fiber used in Aldila’s graphiteprepreg.  In addition, the ability topurchase fiber from an outside source when required in today’s fiber market,limits the Company’s ability to compete in prepreg sales.

**IntellectualProperty**

Aldila utilizes a number of trademarks and logos inconnection 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, 2006 the Company had approximately 55 UnitedStates and foreign registered trademarks.

**Employees**

As of December 31, 2006, Aldila employed 1,366persons on a full-time basis, including 11 in sales and marketing, 18 inresearch, development and engineering and 1,143 in production. The balance ofemployees are administrative and support staff. The number of full-time employees includes 467 persons who are employedin the Company’s Mexico facility, 692 who are employed in the Company’s Chinafacility and nine persons who are employed in the Company’s Vietnamfacility.  Because of seasonal demands,the Company hires a significant number of temporary employees.  As of December 31, 2006, the Companyalso employed 32 temporary employees. Aldila considers its employee relationsto be good.

**Seasonality**

Because the Company’s customers have historicallybuilt inventory in anticipation of purchases by golfers in the spring andsummer, 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, 2006, the Company had a salesbacklog of approximately $12.5 million compared to approximately $11.4 millionas of December 31, 2005.  TheCompany believes that the dollar volume of its current backlog will be shippedover the next three months.  Orders cantypically be cancelled without penalty up to 30 days prior to shipment.  Historically, the Company’s backlog generallyhas been highest in the first and fourth quarters, due in large part toseasonal factors.  Due to the timing andreceipt of customer orders, backlog is not necessarily indicative of futureoperating results.

**Item 1A. Risk Factors**

**CustomerConcentration**

The Company’s sales have been, and very likely willcontinue to be, concentrated among a small number of customers.  In 2006, sales to the Company’s top fivecustomers represented approximately 62% of net sales.  Aldila’s principal customers havehistorically varied depending largely on the prevailing popularity of thevarious clubs that contain Aldila shafts. In 2006, Ping accounted for 18% of net sales, Acushnet Company accountedfor 17% of net sales and Callaway Golf accounted for 15% 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, Ping, Acushnet Company andCallaway Golf, who collectively represent approximately 51%

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of theCompany’s net sales in 2006, each purchased from at least two other graphiteshaft suppliers.  In the event Ping,Acushnet Company and Callaway Golf or any other significant customer increasespurchases from its other suppliers or adds additional suppliers, the Companycould be adversely affected.  Althoughthe Company believes that its relationships with its customers are good, theloss of a significant customer or a substantial decrease in sales to asignificant customer could have a material adverse effect on the Company’sbusiness and operating results.  In addition,sales by the Company’s major customers are likely to vary dramatically fromtime to time due to fluctuating public demand for golf equipment generally andfor their specific products.

**Competition**

Aldila operates ina highly competitive environment for golf equipment sales.  The Company believes that it competesprincipally on the basis of its ability to provide a broad range of highquality, performance graphite shafts, its ability to deliver customized productsin large quantities and on a timely basis, the acceptance of graphite shafts ingeneral, and Aldila shafts in particular, by professionals and other golfers,whose preferences are to some extent subjective, and finally, price.

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

As the Companyfurther enters into the manufacture and sale of prepreg products, it competeswith other producers of prepregs, many of which have substantially greaterresearch and development, managerial and financial resources than the Companyand represent significant competition for the Company.

**New Product Introduction**

The Companybelieves that the introduction of new, innovative golf shafts using graphite orother composite materials will be critical to its future success.  While the Company emphasizes research anddevelopment activities in connection with carbon fiber and other compositematerial technology, there can be no assurance that the Company will continueto develop competitive products or that the Company will be able to develop orutilize new composite material technology on a timely or competitive basis orotherwise respond to emerging market trends.

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

**Reliance on Offshore Manufacturing Facilities**

* *The Company operatesmanufacturing facilities in Tijuana, Mexico and Zhuhai, People’s Republic ofChina and is currently constructing a plant in Ho Chi Minh City, Vietnam.  The Company pays certain expenses of thesefacilities in Mexican pesos, Chinese renminbis and Vietnam dong, respectively,which are subject to fluctuations in currency value and exchange rates.  The facility in Tijuana, Mexico operatespursuant to the “maquiladora” duty-free program established by the Mexican andUnited States governments.  Such programenables the Company to take advantage of generally lower costs in Mexico,without paying duty on inventory shipped into or out of Mexico.  The Company also operates in the People’sRepublic of China in a special economic zone, which affords special advantagesto companies with regards to income taxes. The operation in Vietnam also will enjoy advantages in regards to incometaxes.  There can be no assurance thatthe governments of Mexico, the People’s Republic of China or Vietnam willcontinue the programs currently in place or that the Company will continue tobe able to benefit from these programs. The loss of these benefits could have an adverse effect on the Company’sbusiness.  The Company is also subject toother customary risks of doing business outside the United States, includingpolitical instability, other import/export regulations and culturaldifferences.

**Raw Material Cost/Availability**

The Company’sgross profit margins, in part, are dependent on the price paid for carbon fiberpurchased from outside vendors, and more substantially starting in the latterpart of 1998, the cost of production of carbon fiber at the Evanston, Wyomingfacility, CFT, including the price paid for the acrylic fiber used for themanufacture of carbon fiber and the other costs associated with the operationof the carbon fiber plant.

The Companyexperienced an increase in carbon fiber prices in 1996 and 1997 due to thegrowth experienced in the use of carbon fiber coupled with relatively littleexcess capacity.  The prices paid by theCompany for carbon fiber leveled in

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1998 and decreased during1999 through 2002, due to excess capacity in the carbon fiber manufacturingindustry.  However, that trend reverseditself in the later part of 2003.  TheCompany experienced carbon fiber price increases in certain grades of carbonfiber prices during the later part of 2003 and through 2005, however, priceshave not changed since early 2006. Management is not able to predict the timing or extent of any futureprice changes for carbon fiber; however, the Company could be negativelyimpacted if carbon fiber prices continue to increase and the Company is notable to pass along these increases to its customers due to competition.

The Company also has relationships with other outsidevendors for its additional carbon fiber needs through 2006 and beyond.  Depending on market conditions prevailing atthe time and extent to which production at CFT meets expectations, the Companymay face difficulties in obtaining adequate supplies of carbon fiber fromexternal sources to provide for any carbon fiber needs not met internally.  If it appears that CFT is not likely tosatisfy a significant portion of the Company’s needs or if it appears thatthere will not be adequate availability in the market, the Company may not havemade arrangements in advance for the purchase of material amounts of carbonfiber from alternative sources.

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

**Joint Venture Operating Carbon Fiber Facility**

The Company started producing carbon fiber at itsEvanston, Wyoming facility in 1998. Since October 1999, this facility has been operated as 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 bestinterests of both joint venture partners.

**Reliance on Carbon Fiber Manufacturing Facility**

Until recently, during the period in which the Companyor the joint venture has operated the Evanston, Wyoming facility, the marketfor carbon fiber products has been soft, which has limited the Company’sability to take full advantage of the opportunity offered by the verticalintegration of its carbon fiber raw material usage in graphite golfshafts.  If the facility does not producehigh quality fiber at the anticipated volumes, either because of productionshortfalls or limited demand for the facility’s carbon fiber, the per poundcost of the fiber produced will likely be higher due to the substantial fixedcosts involved in operating a carbon fiber production facility.  In addition, if the facility is not capableof producing carbon fiber at sufficient volumes to satisfy the demands of bothventure partners, the Company would be required to purchase additional fiberfrom third party suppliers, which may not be available in sufficient quantitiesto satisfy its demands and could result in higher marginal costs to the Companythan fiber acquired from the joint venture. In addition, if CFT is unable to obtain precursor, the significant rawmaterial consumed in the carbon fiber manufacturing process, it could have amaterial adverse effect on the Company’s business.

**Potential Cash Flow Shortages**

The Company has cash, cash equivalents and marketablesecurities totaling $15.2 million as of December 31, 2006.  Management anticipates that these sources offunds, when combined with cash flow generated from operations, will besufficient to finance its business operations at least through 2007.  If the Company is not able to generate theexpected cash flows from operations, the Company could be adversely affected.

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

Another factor that could have a negative impact inthe future on the Company’s sales to golf club manufacturers would be adecision by one of its customers to manufacture all or a portion of theirgraphite shaft requirements, or to have an increased amount of theirrequirements filled from one-stop shops (where main components, shaft or head,of the golf club could be purchased and assembled). While the Company has notto date experienced any material decline in its sales for these

11

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reasons,should any of the Company’s major customers decide to meet any significantportion of their shaft needs either internally or through one-stop shops, itcould have a material adverse impact on the Company and its financial results.

**Utilization of Certain Hazardous Materials**

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

**Dependence on Discretionary Consumer Spending**

Sales of golf equipment have historically beendependent 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 upon itssenior management team, as well as its ability to attract and retain qualifiedpersonnel.  There is competition forqualified personnel in the golf shaft industry as well as the carbon fiberbusiness.  There is no assurance that theCompany will be able to retain its existing senior management personnel or toattract additional qualified personnel.

**Justice Department Investigation**

During 1999 the Company received a subpoena fordocuments 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 1B. Unresolved Staff Comments**

None.

**Item 2. Properties**

The Company’s principal executive offices are locatedin Poway, California (in the San Diego metropolitan area).  The Company’s golf shafts are manufactured atfour separate facilities; one located in Poway, California, one located inTijuana, Mexico, one in the Zhuhai economic development zone of the People’sRepublic of China and one that is currently being built in Ho Chi Minh City,Vietnam.  The Company leases a 73,000 squarefoot facility in Poway, California for shaft manufacturing operations, graphiteprepreg production and for its executive offices.  The Company also has leased an additional52,000 square foot facility in Poway, California and plans to move its golf operations,executive offices and warehouse into this facility in 2007.  This would leave the graphite prepregproduction at the original Poway facility and provide room for expansion.  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 Vietnam facility wasbuilt by the Company and operates under a 54 year land lease. The land isapproximately 10,000 square meters and the building is comprised ofapproximately 64,000 square feet. The Company also may lease warehousing spacewhen needed.  Currently, the Companyleases warehousing space in the United States and in China. ** **Inaddition, the Company’s 50% joint venture, CFT, owns 14 acres of land inEvanston, Wyoming on which it operates a 50,000 square foot carbon fibermanufacturing plant.

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**Item 3. Legal Proceedings**

None.

**Item 4. Submission of Matters to a Vote of Security Holders**

Therewere no matters submitted to a vote of security holders during the fourthquarter of fiscal 2006.

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**PART II**

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

**COMMONSTOCK PERFORMANCE**
|                | ** ** | **2006**      | ** ** | **2005**   | ** ** |
|----------------|------------|---------------|------------|------------|------------|
| ** **     | ** ** | **Dividends** | ** ** | ** ** | ** ** | ** ** | ** ** | **Dividends** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **     | ** ** | **Declared**  | ** ** | **High**   | ** ** | **Low** | ** ** | **Declared** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $             | 0.15       |       | $          | 33.20 |   | $ | 25.80 |   | $ | 0.05 |   | $ | 18.71 |   | $ | 13.16 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Second Quarter |       | $             | 0.15       |       | $          | 35.16 |   | $ | 25.25 |   | $ | 1.10 |   | $ | 24.06 |   | $ | 17.52 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Third Quarter  |       | $             | 0.15       |       | $          | 25.49 |   | $ | 13.79 |   | $ | 0.15 |   | $ | 27.83 |   | $ | 19.79 |   |
|           |       |          |       |       |       |   |   |   |   |   |   |   |   |
| Fourth Quarter |       | $             | 0.15       |       | $          | 16.48 |   | $ | 14.31 |   | $ | 1.15 |   | $ | 25.50 |   | $ | 21.21 |   |

 

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.  OnMarch 9, 2007, the closing common stock price was **$**16.15**,**and there were approximately 167****commonstockholders of record.  The companybelieves a significant number of beneficial owners also own Aldila stock in “streetname.”

Aldila,Inc. common stock is traded on the NASDAQ Global Market, symbol:  ALDA.

TheCompany intends to retain earnings for use in operations and payments of cashdividends on its common stock.  Cashdividends are discussed by the Company’s Board of Directors and management ateach quarterly Board Meeting, and if approved, cash dividends areannounced.  Aldila, Inc. is a holdingcompany whose ability to pay dividends depends on the receipt of dividends orother payments from its two principal subsidiaries, Aldila Golf and AldilaMaterials Technology Corp.

TheCompany announced on July 28, 2006 that its Board of Directors authorized therepurchase of up to $5.0 million of the Company’s common stock.  Theshares will be repurchased from time to time in open market transactions at theCompany’s discretion, subject to market conditions and other factors,including  imposed “black-out periods” during which the Company and itsinsiders are prohibited from trading in the Company’s common stock.  During the year, the Company used cash ofapproximately $1.2 million purchasing 75,596 shares of its common stock, withan average price paid of $16.11; however, the Company did not repurchase anyshares during the fourth quarter of 2006.  The Company has approximately $3.8 million remaining under its currentstock repurchase plan.

**TOTALRETURN GRAPH**

The graph below matchesthe cumulative 5-year total return of holders of Aldila, Inc.’s common stockwith the cumulative total returns of the NASDAQ Composite index, and a peergroup of seventeen NASDAQ listed companies in SIC Codes 3940-3949 listed infootnote 1 below. The graph assumes that the value of the investment in theCompany’s common stock, in the peer group, and the index (including reinvestmentof dividends) was $100 on 12/31/2001 and tracks it through 12/31/2006. Theinformation was provided by the Research Data Group, Inc.

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**COMPARISON OF 5 YEAR CUMULATIVETOTAL RETURN***

Among Aldila,Inc., The NASDAQ Composite IndexAnd A Peer Group

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*$100 invested on12/31/01 in stock or index-including reinvestment of dividends.

Fiscal year ending December 31.
|                      | ** ** | **12/01**  | ** ** | **12/02**  | ** ** | **12/03**  | ** ** | **12/04**  | ** ** | **12/05**  | ** ** | **12/06**  | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Aldila, Inc.**     | ** ** | **100.00** | ** ** | **48.29**  | ** ** | **113.05** | ** ** | **489.48** | ** ** | **904.75** | ** ** | **545.56** | ** ** |
| **NASDAQ Composite** | ** ** | **100.00** | ** ** | **69.66**  | ** ** | **99.71**  | ** ** | **113.79** | ** ** | **114.47** | ** ** | **124.20** | ** ** |
| **Peer Group**       | ** ** | **100.00** | ** ** | **85.19**  | ** ** | **112.70** | ** ** | **167.17** | ** ** | **163.51** | ** ** | **189.68** | ** ** |

 

*The stockprice performance included in this graph is not necessarily indicative offuture stock price performance*

(1.)The seventeen companies included in the peer group (SIC Codes 3940-3949) are:Action Products International Inc, Aldila, American Sports Development GroupInc, BP International Inc, Ecom Ecom.com Inc, Escalade Inc, Gametech InternationalInc, Gaming Partners International Corp., Golfgear International Inc, Jakks PacificInc, LEW Corp., Marx Toys & Entertainment Corp., Natural Golf Corp., RC2Corp., Simon Worldwide Inc, Sport-Haley Inc and Sports Arenas Inc.

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**EQUITYCOMPENSATION PLAN INFORMATION**

The following table provides information regardingsecurities authorized for issuance under the Company’s equity compensationplans as of December 31, 2006 (all numbers of securities reflect theCompany’s one-for-three reverse stock split on June 3, 2002):
| Plan Category                                                                             | ** ** | **Number of  securities to be  issued upon  exercise of  outstanding  options** | ** ** | **Weighted-  average exercise  price of  outstanding  options** | ** ** | **Number of  securities to  be issued  upon vesting  of restricted  stock** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                           |       |                                                                                                     |       |                                                                      |       |                                                                                                 |       |                                                                                                                                    |       |
| Equity  compensation plans approved by security holders – 1994 Stock Incentive Plan       |       | 161,630                                                                                                  |       | $                                                                         | 13.41      |                                                                                                 | 28,473     |                                                                                                                                    | 439,446    |   |
|                                                                                           |       |                                                                                                     |       |                                                                      |       |                                                                                                 |       |                                                                                                                                    |       |
| Equity  compensation plans not approved by security holders – 1992 Stock Option Plan  (1) |       | —                                                                                                   |       |                                                                      |       | —                                                                                               |       | 20,167                                                                                                                                  |       |
| Total                                                                                          |       | 161,630                                                                                                  |       |                                                                      |       | 28,473                                                                                               |       | 459,613                                                                                                                                 |       |
|                                                                                                |            |                                                                                                          |            |                                                                           |            |                                                                                                      |            |                                                                                                                                         |            |  |

 

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(1)****In1992, the Company adopted the 1992 Stock Option Plan to provide equityincentives for the management and directors of the Company.  The Company has reserved 175,431 shares forissuance under this Plan.  The Companydoes not expect to issue additional options under the 1992 Plan.

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**Item 6.   SelectedFinancial Data**

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

**ALDILA,INC.**

**SELECTEDFINANCIAL DATA**

**(Inthousands, except per share amounts)**
| ** **                                              | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Operating Results (Year  ended December 31):            |       |       |       |       |       |       |       |       |       |       |       |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Net sales                                               |       | $          | 72,370     |       | $          | 76,978     |       | $          | 52,762     |       | $          | 37,807 |   | $ | 37,462 |   |
| Cost of sales                                           |       | 48,087     |       | 47,368     |       | 34,786     |       | 30,586     |       | 32,828     |       |
| Gross profit                                            |       | 24,283     |       | 29,610     |       | 17,976     |       | 7,221      |       | 4,634      |       |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Selling, general and  administrative                    |       | 10,731     |       | 9,741      |       | 8,237      |       | 6,989      |       | 7,334      |       |
| Plant consolidation                                     |       | —     |       | —     |       | —     |       | —     |       | 300        |       |
| Operating income (loss)                                 |       | 13,552     |       | 19,869     |       | 9,739      |       | 232        |       | (3,000     | )          |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Interest (expense)                                      |       | —     |       | —     |       | —     |       | (23        | )          | (94        | )          |
| Interest income                                         |       | 714        |       | 639        |       | 148        |       | 46         |       | 22         |       |
| Other income (expense),  net                            |       | 2,148      |       | (53        | )          | (88        | )          | (94        | )          | (84        | )          |
| Impairment of  investment in joint venture              |       | —     |       | —     |       | —     |       | (2,220     | )          | —     |       |
| Equity in earnings of  joint venture                    |       | 407        |       | 236        |       | 246        |       | 150        |       | 269        |       |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Income (loss) before  income taxes                      |       | 16,821     |       | 20,691     |       | 10,045     |       | (1,909     | )          | (2,887     | )          |
| Provision (benefit) for  income taxes                   |       | 5,585      |       | 7,287      |       | 725        |       | (183       | )          | (43        | )          |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Net income (loss)                                       |       | $          | 11,236     |       | $          | 13,404     |       | $          | 9,320      |       | $          | (1,726 | ) | $ | (2,844 | ) |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Net income (loss) per  common share-basic:              |       | $          | 2.04       |       | $          | 2.54       |       | $          | 1.85       |       | $          | (0.35 | ) | $ | (0.57 | ) |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Net income (loss) per  common share, assuming dilution: |       | $          | 2.01       |       | $          | 2.46       |       | $          | 1.77       |       | $          | (0.35 | ) | $ | (0.57 | ) |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Selected Operating  Results                             |       |       |       |       |       |       |       |       |       |       |       |
| As a Percentage of Net  Sales:                          |       |       |       |       |       |       |       |       |       |       |       |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Gross profit                                            |       | 33.6       | %          | 38.5       | %          | 34.1       | %          | 19.1       | %          | 12.4       | %          |
| Selling, general and  administrative                    |       | 14.8       | %          | 12.7       | %          | 15.6       | %          | 18.5       | %          | 19.6       | %          |
| Operating income                                        |       | 18.7       | %          | 25.8       | %          | 18.5       | %          | 0.6        | %          | 8.0        | %          |
| Net income (loss)                                       |       | 15.5       | %          | 17.4       | %          | 17.7       | %          | (4.6       | )%         | (7.6       | )%         |
| ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Financial Position (at  December 31):                   |       |       |       |       |       |       |       |       |       |       |       |
|                                                    |       |       |       |       |       |       |       |       |       |       |       |
| Working capital                                         |       | $          | 36,050     |       | $          | 28,805     |       | $          | 25,977     |       | $          | 15,181 |   | $ | 13,162 |   |
| Total assets                                            |       | 55,896     |       | 48,089     |       | 42,075     |       | 29,013     |       | 31,159     |       |
| Total stockholders’ equity                         |       | 49,326     |       | 38,551     |       | 35,061     |       | 24,446     |       | 26,353     |       |

 

17

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**Item7.    Management’s Discussion and Analysisof Financial Condition and Results of Operations (“MD&A”)**

The Company’s MD&A is comprised of significantaccounting estimates made in the normal course of its operations, overview ofthe Company’s business conditions, results of operations, liquidity and capitalresources and contractual obligations. The Company did not have any off balance sheet arrangements as ofDecember 31, 2006 and 2005.  The Company’ssignificant accounting estimates identified are, revenue recognition, accountsreceivables and inventory valuation.  TheCompany is disclosing segment information for two segments.  The Company has historically considered itsoperations to be comprised of one business segment. However, due to thesignificance of its external sales of prepreg in the first quarter of 2006, atrend which management believes will continue, the Company believes itsbusiness to be comprised of two operating segments, Composite Products andComposite Materials.  The Company began reportingtwo segments for the first quarter of 2006. Composite Products is comprised sales of golf shafts, hockey sticks andother composite products. Composite Materials is comprised of external sales ofprepreg products in the forms of uni-tapes, fabrics and film adhesives alongwith contributions from its interest in CFT.

**SignificantAccounting Estimates**

The consolidatedfinancial statements of the Company are prepared in conformity with accountingprinciples generally accepted in the United States of America.  As such, the Company is required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information available. These estimates and assumptions affect the reported amounts of assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the periods presented.  The significant accounting policies, whichthe Company believes are the most critical to aid in fully understanding andevaluating our reported financial results, include the following:

*Revenue Recognition*

The Company recognizes revenue from product sales at the time of shipment and passage of title. We also offer certain of our customers the right to return shafts for breakage within a limited time after delivery.  We track such shaft returns, and we record a provision for the estimated amount of such future returns, based on historical experience and any notification we receive of pending returns at the time sales are made.  The Company believes that any shafts returned for breakage will be returned within three years of the initial sale of the shaft.  The Company estimates in regards to total actual returns, that 50% will be returned in the first year after sale, 30% in the second year after sale and the remaining 20% in the third year after sale, assuming a mid-year convention.  The Company’s breakage return rate has been between .17% and 1.09% (breakage returns divided by sales dollars) for the past ten years.  The Company has historically utilized a four-year moving average of the breakage return rate to record its estimated liability.  The four-year average utilized in the accrual estimate as of December 31, 2006 is .24%.   The Company’s breakage return rate has declined over the past years.  The highest four-year average over the past ten years has been 1.01%.  If the Company were to use 1.01% in estimating its liability as of December 31, 2006, it would have the effect of increasing the liability by approximately $1.2 million, which would be recorded in cost of goods sold.  While such returns have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same return rates that we have in the past. Any significant increase in product failure rates and the resulting returns could have a material adverse impact on our operating results for the period or periods in which such returns materialize.

*Accounts Receivable*

We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history and the customer’s current credit worthiness, as determined by our review of their current credit information.  We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified.  While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.  Since our accounts receivable are concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of any one of these customers could have a material adverse impact on the collectability of our accounts receivable and our future operating results.  The Company estimates its allowance for doubtful accounts on a monthly basis, by reviewing all amounts owed to the Company and focusing on those amounts that are greater than 60 days past due.  The Company reviews the customers that have amounts greater than 60 days past due and where appropriate reserves for the receivable amount.  As of December 31, 2006, the Company estimated this amount to be approximately $36,000.  If the Company were to reserve for the total amount greater than 60 days past due, it would increase the allowance by approximately $161,000, which would be recorded in administrative expense.

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*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.

The Company’s reserve methodology consists of the following: reviewing on hand inventories of our top customers and comparing inventories to historical sales trends and anticipated sales forecasts.  A 100% reserve is established for all shafts that are deemed to be obsolete.  Raw materials are reviewed based upon estimated future production and when appropriate, reserves are established.  Shafts that are designated for rework (parts that need additional work) are reviewed and when appropriate reserves are established.  The final analysis is to review inactive inventory, and apply reserves to parts that were not included in the other analyses and have been inactive in the system for a period of twelve months.  The Company’s average reserve percentage compared to gross inventory has been approximately 16% for the past five years.  In the past five years, the highest reserve percentage was approximately 30% and the lowest reserve percentage was approximately 8%.  The Company’s reserve percentage as of December 31, 2006 is 9%.   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 12/31/06  |       | $           | 15,061     |        | $          | 15,061     |       | $ | 15,061 |   |
| Reserve rate                     |       | 30          | %(a)       | 16          | %          | 8          | %          |
| Estimated  reserve               |       | 4,568       |       | 2,410       |       | 1,161      |       |
| Recorded Reserve  as of 12/31/06 |       | 1,370       |       | 1,370       |       | 1,370      |       |
| Impact to costs of  goods sold   |       | $           | 3,198      |        | $          | 1,040      |       | $ | (209 | ) |

 

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(a) This was the Company’s highest rate; the second highestrate in the past five years was 21%.

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 increase in inventory in the current year was attributed to an increase in finished goods, with the majority of that increase being Aldila branded shafts.  However, the Company’s reserve percentage as compared to gross inventories has remained consistent with prior year.  The Company continues to look at ways of minimizing its inventory levels and to be more efficient.  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**

*Composite Products*

The Composite Products segment is mainly comprised ofgraphite golf shafts and, to a lesser extent, hockey sticks.  The graphite shaft market consists ofcustomized OEM production shafts, both premium and value and Aldila branded andco-branded shafts.  The Company sellscustomized OEM production and co-branded shafts directly to its OEM customersand sells Aldila branded shafts through the OEM custom stock and custom fitprograms and to distributors.  TheCompany has re-emerged over the past couple of years as an innovator in thebranded segment of the business, in which shafts tend to sell at higher pricesand gross margins than the customized OEM production shafts sold to clubmanufacturers.  The Company introducedthe Aldila NVTM in 2003, featuring the Company’s exclusiveMicro Laminate Technologyä.  The NVTM has had numerousTour victories.  The Company introducedNVäline extensions in 2004, including the NVSä,NV ProtoPypeä, Pink NVä,NVäIrons and NVä Hybrid shafts. The Company began shipping its newest shaft offering – the VS ProtoTM and the VS ProtoTM Hybrid in 2006.  The VS ProtoTM was used by the winner of the 2006 U.S. Openand is

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quicklybecoming Aldila’s single most popular shaft model on Tour.  As with the NV ProtoPypeTM, the VS ProtoTM isa high performance shaft featuring carbon nanotubes as well as aerospace carbonfibers and Aldila’s exclusive high performance resin system.  In addition, the Company unveiled the new VSProtoTM Hybrid shaft for high-end hybrid clubs.  The Company’s sales of the VS ProtoTM shaft line have exceeded the first year salesof our NVTM shaft line over a comparable period oftime.   In 2006, PGA Tour, LPGA Tour andNationwide Tour professionals using Aldila NVTM orVS ProtoTM shafts in their clubs have won a total of 32Tour events.  The Aldila VS ProtoTM and NVTM Hybrid shaftscombined have been the number one hybrid shafts at every event this year on thePGA Tour, according to the Darrell Survey Company.  In addition, Aldila Hybrid shafts won theAnnual Golf Magazine Club Test for 2006. Forty club testers evaluated hybrid clubs for Golf Magazine and clubsfeaturing Aldila Hybrid shafts received the highest rating in every categoryfor hybrid clubs. Overall the Aldila shafts helped give the testers the bestfeel, playability, forgiveness and distance with their hybrids compared to thecompetition.  As the 2007 PGA Tour hasbegan, Aldila was once again the leading shaft manufacturer represented at theMercedes Championship, winning both the wood and hybrid shaft count.  The Company also recorded its first win ofthe year at the recent Sony Open with the winner using an Aldila NVTM shafted driver.  Paula Creamer, who is a member of the Aldilaadvisory staff, won the SBS Open playing her customary pink NVTM. The Company believes that it will continue to be successful in thebranded segment and has focused its marketing and advertising effort in supportof this business.

The Company continues to maintain a broad customerbase in both the OEM production shaft and branded shaft market segments andcompetes aggressively with both United States and foreign-based shaftmanufacturers for OEM production shafts and branded shafts.  However, the Company’s sales have tended tobe concentrated among a limited number of major club companies, thus making theCompany’s results of operations dependent on those customers, their continuedwillingness to purchase a significant portion of their shafts from the Company,and their success in selling clubs containing the Company’s shafts to theircustomers.  In 2006, net sales to Ping,Acushnet Company and Callaway Golf represented 18%, 17% and 15% of the Company’snet sales, respectively, and the Company anticipates that these companies willcontinue, collectively, to represent the largest portion of its sales in2007.  Although it is generally difficultto predict in advance the success of any particular club or of any particularmanufacturer, the Company believes that it is protected to some extent fromnormal periodic fluctuations in sales among the various golf club companies byvirtue of the broad range of its club manufacturer customers.  Golf club companies regularly introduce new clubs,frequently containing innovations in design. Sometimes these new clubs achieve dramatic success in the marketplace,thus increasing the overall volatility of club sales among the major companies.  While the Company seeks to have its shaftsrepresented on as many major product introductions as possible, it can provideno assurance that its shafts will be included in any particular “hot” club orthat sales of a “hot” club that does not include the Company’s shafts will nothave a negative impact on the sales of those clubs that do.  The Company’s sales could also suffer asignificant drop-off from period to period to the extent that they may bedependent in any period on sales of one or more “hot” clubs, which then tailoff in subsequent periods when no other club offers a high level of new salesto replace the lost sales.

During the 1990’s, the graphite golf shaft industrybecame increasingly competitive, placing extraordinary pressure on the sellingprices of the Company’s golf shafts and adversely affecting its gross profitmargins and level of profitability.  TheCompany’s average selling price decreased by 64% from December 31, 1990 throughDecember 31, 2002.  The pressure wasmainly attributed to the increased competition for OEM production shafts, and ashift of our customers away from branded shafts to customized OEM productionshafts.  Beginning in 2003, the Companywas able to achieve higher average selling prices as it enjoyed increasingsuccess in the branded segment of the business. In late 2004, the Company began to see its OEM customers chooseco-branded shafts for their stock offerings. The introduction of co-branded shafts and the continued success in thebranded segment had the effect of increasing the Company’s average sellingprices over the last few years.  TheCompany’s average selling price increased by approximately 70% for the yearended December 31, 2006 as compared to the comparable period in 2002.  However, the Company’s average selling pricedecreased by 6% for the year ended December 31, 2006 as compared to thecomparable period in 2005.  Thepercentage of the total branded and co-branded shaft revenue to total CompositeProducts revenue decreased to 46% for the year ended December 31, 2006 ascompared to 58% for the year ended December 31, 2005.  As the Company’s branded and co-brandedshafts typically sell at higher selling prices than OEM production shafts, asignificant change in product mix in any one period will have the effect ofincreasing or decreasing the average selling price of shafts sold.  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’sresponse to the pricing pressure it faced during the 1990’s, and continues toface in the OEM production shaft segment, has been to vertically integrate,reduce its cost structure and to focus on continued penetration of the brandedand co-branded shaft segments.  Thevertical integration began in 1994 when the Company started manufacturingprepreg, the principal raw material in the manufacture of graphite golf shafts,at its facility in Poway, California. See Composite Materials.  In additionto the Company’s efforts to reduce its costs through vertical integration, theCompany also reduced its cost structure by shifting more of its shaftproduction to lower cost labor markets, such as Mexico, China and in 2007,Vietnam.

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In addition to golf shafts, the Company alsomanufactures hockey sticks for one customer. The Company began manufacturing and selling hockey sticks in 2002.  The Company has not seen a significantincrease in sales of hockey sticks and is not satisfied with current status ofits hockey business.  The Company doesnot see the hockey business as being material to the Company in thefuture.  The percentage of hockey shaftrevenue to total Composite Products revenue was 3% for the year ended December31, 2006 as compared to 2% for the year ended December 31, 2005.

*Composite Materials*

The Composite Materials segment is comprised ofexternal sales of prepreg, film adhesives, fabrics and other materials and thecontribution provided by the Company’s 50% owned interest in CFT.  The Company has never tracked inter-segmentsales and has always looked at the contribution provided by Composite Materialsbased upon the external sales of materials. The Company records all shared cost to Composite Products and allocatescertain costs for segment reporting, such as shipping, purchasing and otheradministrative costs based upon the net revenues of each segment.  Costs that are specific to one segment arecharged directly to the respective segment.

The Company began the manufacture of compositematerials in 1994.  Initially, theprepreg produced was mainly consumed by the Composite Products segment.  The Company’s external sales of prepreg andother materials have increased over the past several years.  Sales of prepreg as a percentage of net saleswere 12% year ended December 31, 2006 as compared to 10% for 2005.  In the second half of 2005, the Companypurchased a second resin filmer.  Theaddition of a second resin filmer provides additional supply of resin film,which is one of the key raw materials in the production of prepreg.  The increase in resin film capacity enablesthe Company to add additional capacity to the Company’s prepreg compositemanufacturing operations as well as provide increased capacity for filmproducts.  In addition, it providescapacity protection should the Company encounter problems with its other resinfilmer.  The Company has completed theinstallation of its sixth prepreg tape line, which enables it to supportanticipated growth for shaft and prepreg sales.   In addition, an additional wide prepreg tapeline will be installed late this year to add further capacity to supportanticipated growth in this business segment.

The Company continues to look for opportunities tosell its prepreg and film adhesive products to other fabricators of productsmanufactured from composite materials. The Company has achieved some success in these areas and managementbelieves that growth opportunities in these areas will continue to exist. Inaddition, management believes that vertical integration through its prepregoperation has been successful to date and is allowing the Company to maintain,or in some cases enhance, its competitive position with respect to the majorUnited States golf club companies that are its principal customers.

In addition to vertical integration through prepreg,the Company established a manufacturing facility in Evanston, Wyoming for theproduction of carbon fiber in 1998, which is a significant raw material used inthe prepreg production process.  During1998 and through the first ten months of 1999, the Company used the materialfrom this facility to satisfy a significant portion of its internal demand forcarbon fiber in the manufacturing of prepreg used for graphite shaftproduction. During 1999, the Company also produced and sold carbon fiber fromthis facility to other unrelated entities for the manufacture of othercarbon-based products.  On October 29,1999, SGL purchased a 50% interest in the Company’s carbon fiber manufacturingoperation.

The Company and SGL entered into an agreement tooperate 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-upon mark-up.  The Company and SGL are each responsible tobear 50% of the fixed costs to operate the facility as a term of this supplyagreement.  The partners share profitsand losses of CFT equally.  The jointventure partners primarily consume the carbon fiber manufactured from thisfacility.

If the carbon fiber facility is not operated at highproduction levels, either because of production difficulties or because thereis not enough demand by the joint venture owners to justify that level ofproduction, the cost per unit of carbon fiber consumed by the Company (and thusthe cost of producing the Company’s golf shafts and other products) isincreased due to spreading the fixed costs of production over smallervolumes.  If demand is lower thanproduction capacity, CFT also runs the risk of building up excessinventory.  Given the relatively lowcosts historically in the market for carbon fiber and the highly competitivemarket for graphite golf shafts, the failure to operate at high levels couldadversely affect the Company’s gross margins or its ability to maintainprofitable competitive prices for its products. Although selling prices of carbon fiber had been depressed for the 1998through mid 2003 period based on a surplus of supply in the market for carbon

21

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fiber,in the second half of 2003 the Company began to see increases in carbon fiberprices and a constriction of supply of all types of carbon fiber notmanufactured at CFT.  If the pricescontinue to increase or if the company cannot obtain an adequate supply at areasonable price, it could have an adverse effect on the Company’sbusiness.  The Company does not expectthird party sales at CFT to have a significant effect on either the Company’sprofitability.

CFT purchased substantially all of its raw acrylicfibers for the carbon fiber operation from one supplier for the years 2000through 2006.  Previous to 2000, theCompany purchased raw acrylic fibers from another supplier who in May 2005,filed bankruptcy and announced its intention to cease producing acrylic fibers,which left CFT in a true sole source position. The assets of this previous supplier are now owned by China Bluestar whocontinues to operate the business.  Thereis no certainty that China Bluestar will be successful.  CFT is continuing to pursue alternate sourcesof supply for this material and has run several trials with results that areencouraging.  The current supplier ofprecursor has recently notified CFT that it does not intend to continue tosupply precursor beyond late October 2007. CFT management projects that precursor in inventory when supply endsfrom the current supplier should carry the operation through the first half of2008.  However, if the current supplieris unable to deliver and CFT cannot qualify and source material from a newsupplier prior to this event, it could have a material adverse effect on theCompany’s business.

Until recently, the Company believed that the costsaving benefits of its efforts to vertically integrate through the manufactureof carbon fiber had not benefited the Company.  Market prices for golf shaft raw materials, which are primarily based oncarbon fiber costs, have been historically low with carbon fiber readilyavailable at attractive prices when compared to the Company’s cost to purchaseit from CFT.  The Company’s gross marginsand profitability were adversely affected when the market prices of carbonfiber were low.  However, in the secondhalf of 2003, the availability of carbon fiber began to tighten and pricesbegan to increase. The shortage of carbon fiber in the world markets today isreal and appears to be long term. The Company believes that CFT is now avaluable strategic asset.

**Results of Operations**

***2006 Compared to 2005***

*Net Sales*
|                     | ** ** | **2006** | ** ** | **2005** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|---------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Composite Products  |       | $        | 63,479     |     | $          | 69,561  |       | $              | (6,082     | ) | (9 | )% |
| Composite Materials |       | 8,891    |       | 7,417    |       | 1,474   |       | 20             | %          |
| Total Net Sales     |       | $        | 72,370     |     | $          | 76,978  |       | $              | (4,608     | ) | (6 | )% |

 

Net sales decreased by $4.6 million for 2006 from2005.  The decrease in sales wasattributed to a decrease in Composite Product sales, which were partiallyoffset by an increase in Composite Materials sales.  The decrease in the Composite Product salesis mainly attributed to a change in product mix in 2006 as compared to 2005.  The Company’s average selling price of golfshaft sales decreased by 6% for the year and overall units declined by 4%.There were decreases in sales of branded and co-branded products, which werepartially offset by increases in OEM products. Branded golf shaft sales declined by 19% and co-branded golf shaft salesdeclined by 44%, which were partially offset by an increase in OEM stock typeshaft sales of 16%.  Branded and co-brandedgolf shaft sales declined to 46% of Composite Products sales in 2006 from 58%in 2005.  The decreases in branded andco-branded were attributed to a relatively weak demand of driver club units,which represent the best opportunities for branded and co-brandedproducts.  Composite Materials salesincreased by $1.5 million, or a 20% increase. Composite Materials have increased to approximately 12% of the Company’sconsolidated net revenues.  The Companybelieves that these sales will continue to increase and is installing anadditional wide prepreg tape line at the end of 2007 to support thisanticipated growth.

*GrossProfit*
|                     | ** ** | **2006** | ** ** | **2005** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|---------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Composite Products  |       | $        | 20,577     |     | $          | 27,271  |       | $              | (6,694     | ) | (25 | )% |
| Composite Materials |       | 3,706    |       | 2,339    |       | 1,367   |       | 58             | %          |
| Total Gross Profit  |       | $        | 24,283     |     | $          | 29,610  |       | $              | (5,327     | ) | (18 | )% |

 

Total gross profit decreased by approximately $5.3million, or 18% in 2006 as compared to 2005. The decrease in gross profit was primarily attributed to a decrease ingross profit of Composite Products, which was partially offset by an increasein gross profit of Composite Materials. The decrease in Composite Products gross profit was mainly attributed to

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thedecrease in branded and co-branded sales in 2006 as compared to 2005.  Composite Products gross margin decreased to32% for 2006 as compared to 39% for 2005. The Composite Materials gross profit increased by approximately $1.4million, or 58%, in 2006 as compared to 2005. The increase is mainly attributed to an increase in contributionprovided by the operations of CFT and the increase in gross profit provided bythe sales of external materials.  TheCompany’s gross profit was negatively affected by additional inventory reservesof $811,000 in 2006 as compared to $710,000 in 2005.  The increase in reserves in 2006 and 2005were offset by the sales of product that was fully reserved for of $22,000 in2006 and $147,000 in 2005.  The neteffect of the inventory reserve adjustments was a decrease in gross profit of$789,000 in 2006 and a decrease in gross profit of $563,000 in 2005.

*OperatingIncome*
|                                                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Gross profit                                                    |       | $        | 24,283     |     | $          | 29,610  |       | $              | (5,327     | ) | (18 | )% |
|                                                            |       |     |       |     |       |    |       |           |       |
| Selling, General &  Administrative (“SG&A) Expense |       |     |       |     |       |    |       |           |       |
| Composite Products                                              |       | 10,104   |       | 9,127    |       | 977     |       | 11             | %          |
| Composite Materials                                             |       | 627      |       | 614      |       | 13      |       | 2              | %          |
| Total SG&A                                                  |       | 10,731   |       | 9,741    |       | 990     |       | 10             | %          |
|                                                            |       |     |       |     |       |    |       |           |       |
| Operating Income                                                |       |     |       |     |       |    |       |           |       |
| Composite Products                                              |       | 10,474   |       | 18,144   |       | (7,671  | )          | (42            | )%         |
| Composite Materials                                             |       | 3,078    |       | 1,725    |       | 1,354   |       | 78             | %          |
| Operating Income                                                |       | $        | 13,552     |     | $          | 19,869  |       | $              | (6,317     | ) | (32 | )% |
| Operating Margin                                                |       | 19       | %          | 26       | %          | (7      | )%         |           |       |

 

Operating income decreased by approximately $6.3million, or 32%, in 2006 as compared to 2005. The decrease was attributed to a decrease in gross profit and anincrease in SG&A.  The Company’sSG&A expenses increased by approximately $990,000 in 2006 as compared to2005.  SG&A increased as a percentageof revenues to 15% in 2006 as compared to 13% for 2005.  The increase was primarily attributed to theincreased costs in selling, advertising, marketing and tour support of theCompany’s branded and co-branded product. Such costs increased by 35% in 2006 as compared to 2005.  The Company anticipates that this spendingwill remain flat in 2007.  In addition,other administrative expense increased by 14% in 2006 as compared to 2005.  The Company anticipates these costs mayincrease slightly in 2007 due to having a full years worth of operations inVietnam.  These increases in SG&Awere partially offset by a decrease in the Company’s incentive expenses, whichis comprised of bonuses, employee benefits and stock-based compensation expense.Incentive expenses decreased by approximately 65% in 2006 as compared to2005.  The Company’s stock-basedcompensation expense was $255,000 in 2006 as compared to $0 in 2005.  Although incentive expenses decreased in2006, the Company anticipates that stock-based compensation expense willincrease in the future to the extent that the Company’s Board of Directorsapproves additional grants of equity awards to employees and directors of theCompany.  In addition, each May there isan automatic grant of options to the external directors of the Company.  The Company’s corporate costs increased by21% in the current year, although the Company’s Sarbanes-Oxley section 404 (“SOX”)compliance work decreased slightly in the year. The Company spent $498,000 on SOX in 2006 as compared to $603,000 in2005.  The Company has established aninternal audit department in 2006 and hopes to use more internal resources in2007 to complete the SOX compliance work. Such compliance costs are ongoing and the Company anticipates spendingbetween $300,000 to $400,000 in 2007 for its SOX compliance efforts.

*OtherIncome*
|                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
|                                 |       |     |       |     |       |    |       |           |       |
| Operating income                     |       | $        | 13,552     |     | $          | 19,869  |       | $              | (6,317     | ) | (32 | )% |
|                                 |       |     |       |     |       |    |       |           |       |
| Interest income                      |       | 714      |       | 639      |       | 75      |       | 12             | %          |
| Other, net                           |       | 2,148    |       | (53      | )          | 2,201   |       | 4,153          | %          |
| Equity in earnings of  joint venture |       | 407      |       | 236      |       | 171     |       | 72             | %          |
| Total other  income                  |       | 3,269    |       | 822      |       | 2,447   |       | 298            | %          |
| Income before income  taxes          |       | $        | 16,821     |     | $          | 20,691  |       | $              | (3,870     | ) | 19 | % |

 

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Other Income increased by approximately $2.5 millionfor 2006, or 298%, as compared to 2005. The Company benefited from a settlement as a class member in a civilsuit against certain carbon fiber producers in the amount of $2.2 million,which is recorded in other, net.  Inaddition, the Company benefited from an increase in earnings from its equityinvestment in CFT.

*IncomeTaxes*
|                             | ** ** | **2006** | ** ** | **2005** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Income before income  taxes |       | $        | 16,821     |     | $          | 20,691  |       | $              | (3,870     | ) | 19 | % |
| Provision for income  taxes |       | 5,585    |       | 7,287    |       | (1,702  | )          | (23            | )%         |
| Net income                  |       | $        | 11,236     |     | $          | 13,404  |       | $              | (2,168     | ) | (16 | )% |
| Effective tax rate          |       | 33       | %          | 35       | %          | 2       | %          |           |       |
| Profit margin               |       | 16       | %          | 17       | %          | (1      | )%         |           |       |

 

TheCompany recorded a provision for income taxes in the amount of $5.6 million in2006 as compared to $7.3 for 2005.  TheCompany’s effective tax rate was 33% in 2006 as compared to 35% in 2005.  The Company’s decrease in its effective taxrate was primarily attributed to research and developmental (“R&D”) taxcredits that were taken in the fourth quarter. The Company undertook a project, with the assistance of consultants whospecialize in R&D tax credits, during the year to review the past creditstaken and the methodology used to compute them. The Company in recent years has increased its R&D efforts inmaterial, resin and graphite shaft technology. The increase in efforts has had the effect of increasing the Company’sR&D tax credits.  The benefit to theeffective tax rate was approximately 2% in the current year.  The Company does not anticipate this benefitto be as significant going forward. The Company estimates that its effectivetax rate going forward will be between 35% and 38%.

***2005 Compared to 2004***

*Net Sales*
|                     | ** ** | **2005** | ** ** | **2004** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|---------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Composite Products  |       | $        | 69,561     |     | $          | 48,312  |       | $              | 21,249     |   | 44 | % |
| Composite Materials |       | 7,417    |       | 4,450    |       | 2,967   |       | 67             | %          |
| Total Net Sales     |       | $        | 76,978     |     | $          | 52,762  |       | $              | 24,216     |   | 46 | % |

 

* *Netsales increased by $24.2 million for 2005 from 2004.  The increase was mainly attributed to a $21.2million increase in Composite Products sales, and to a lesser extent anincrease in Composite Materials sales of $3.0 million.  The increase in Composite Products sales wasattributed to increases in sales of branded and co-branded golf shafts.  Branded golf shaft sales increased 73% in2005 as compared to 2004, which was mainly attributed to the success of theCompany’s NVTM family of shafts.  Co-branded golf shaft sales increased 1,387%in 2005 as compared to 2004.  Theincreased branded and co-branded sales are mainly attributed to demand fromfirst and second tier club companies to these shafts in their driver, fairwayand hybrid club models.  Total golf shaftunit sales increased by approximately 13% for 2005 from 2004.  The average selling price of shafts soldincreased by approximately 33% for 2005 from 2004, which was attributed to theincreased branded and co-branded shaft sales in the product mix.  Composite Material sales increased byapproximately 67% in 2005 from 2004 and represented 10% of the Company’s netsales for 2005.  The Company added a newresin filmer, which was operational in the first quarter of 2006.

*GrossProfit*
|                     | ** ** | **2005** | ** ** | **2004** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|---------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Composite Products  |       | $        | 27,271     |     | $          | 17,505  |       | $              | 9,766      |   | 56 | % |
| Composite Materials |       | 2,339    |       | 471      |       | 1,868   |       | 397            | %          |
| Total Gross Profit  |       | $        | 29,610     |     | $          | 17,976  |       | $              | 11,634     |   | 65 | % |

 

Gross profit increased by approximately $11.6 millionfor 2005 from 2004.  The Company’s grossprofit margin

24

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increasedto 38% in 2005 from 34% in 2004.  Theincrease in gross profit was mainly attributed to the increased gross profitcontributed by Composite Products and to a lesser extent a gross profitincreased provided by Composite Materials. The increase in sales of the Company’s branded and co-branded products,which typically have higher gross margins than that of the Company’s otherComposite Products, were the reason for the increased gross profit in CompositeProducts.  In addition, the Company’sgross profit was negatively affected by additional inventory related reservesof approximately $710,000 in 2005, versus an increase of  $97,000 in 2004.  The increase in reserves in 2005 and 2004were offset by the sales of product that was fully reserved for of $147,000 in2005 and $285,000 in 2004.  The neteffect of the inventory reserve adjustments was a decrease in gross profit of$563,000 in 2005 and an increase in gross profit of $186,000 in 2004.

*OperatingIncome*
|                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Gross profit                                                    |       | $        | 29,610     |     | $          | 17,976  |       | $              | 11,634     |   | 65 | % |
|                                                            |       |     |       |     |       |    |       |           |       |
| Selling, General &  Administrative (“SG&A) Expense |       |     |       |     |       |    |       |           |       |
| Composite Products                                              |       | 9,127    |       | 7,796    |       | 1,331   |       | 17             | %          |
| Composite Materials                                             |       | 614      |       | 441      |       | 173     |       | 39             | %          |
| Total SG&A                                                  |       | 9,741    |       | 8,237    |       | 1,504   |       | 18             | %          |
|                                                            |       |     |       |     |       |    |       |           |       |
| Operating Income                                                |       |     |       |     |       |    |       |           |       |
| Composite Products                                              |       | 18,144   |       | 9,709    |       | 8,435   |       | 87             | %          |
| Composite Materials                                             |       | 1,725    |       | 30       |       | 1,695   |       | 5662           | %          |
| Operating Income                                                |       | $        | 19,869     |     | $          | 9,739   |       | $              | 10,130     |   | 104 | % |
| Operating Margin                                                |       | 26       | %          | 18       | %          | 8       | %          |           |       |

 

Operating income increased by approximately $10.1million for 2005 from 2004.  The increasewas primarily attributed to the increase in gross profit.  The Company’s selling, general andadministrative (“SG&A”) expenses increased by approximately $1.5 million in2005 as compared to 2004.  The increasewas primarily attributed to the increased costs associated with being apublicly traded company.  The Company’scorporate costs increased by 130%, with the majority of the increase attributedto Sarbanes-Oxley section 404 (“SOX”) compliance work, which was beingperformed with the assistance of outside consultants.  The Company spent approximately $603,000 in2005 for its SOX compliance efforts.  Inaddition to the increase in corporate expenses, the Company had higher SG&Acosts related to incentive expenses and sales and marketing expenses.  SG&A decreased as a percentage of netsales to 13% in 2005, from 16% in 2004.

*OtherIncome*
|                                      | ** ** | **2005** | ** ** | **2004** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
|                                 |       |     |       |     |       |    |       |           |       |
| Operating income                     |       | $        | 19,869     |     | $          | 9,739   |       | $              | 10,130     |   | 104 | % |
|                                 |       |     |       |     |       |    |       |           |       |
| Interest income                      |       | 586      |       | 60       |       | 526     |       | 877            | %          |
| Equity in earnings of  joint venture |       | 236      |       | 246      |       | (10     | )          | (4             | )%         |
| Total other  income                  |       | 822      |       | 306      |       | 516     |       | 169            | %          |
| Income before  income taxes          |       | $        | 20,691     |     | $          | 10,045  |       | $              | 10,646     |   | 106 | % |

 

OtherIncome increased by approximately $516,000 for 2005 from 2004.  The increase was attributed to the interestincome the Company realized on its invested cash balances.

*IncomeTaxes*
|                             | ** ** | **2005** | ** ** | **2004** | ** ** | **Chg** | ** ** | **% Chg** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|---------|------------|----------------|------------|
| Income before income  taxes |       | $        | 20,691     |     | $          | 10,045  |       | $              | 10,646     |   | 106 | % |
| Provision for income  taxes |       | 7,287    |       | 725      |       | 6,562   |       | 905            | %          |
| Net income                  |       | $        | 13,404     |     | $          | 9,320   |       | $              | 4,084      |   | 44 | % |
| Effective tax rate          |       | 35       | %          | 7        | %          | 28      | %          |           |       |
| Profit margin               |       | 17       | %          | 18       | %          | (1      | )%         |           |       |

 

25

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TheCompany recorded a provision for income taxes in the amount of $7.3 million in2005 as compared to approximately $725,000 for 2004.  The Company’s effective tax rate was 35% in 2005as compared to 7% in 2004.  Thedifference in the effective tax rates was related to a change in the Company’svaluation allowance during 2004.

AtDecember 31, 2004, the Company had a net deferred tax asset ofapproximately $2.2 million.  This deferredtax asset represented net operating loss carryforwards, tax creditcarryforwards and other basis differences, which give rise to future taxdeductions in excess of book deductions. Realization of these tax benefits is dependent upon the generation of futuretaxable income. During the fourth quarter of 2002, management determined thatbased on its then current outlook and existing circumstances that it was notlikely that the tax benefits associated with its deferred tax assets would berealized.  Accordingly, the Companyplaced a full valuation allowance against its net deferred tax asset as ofDecember 31, 2002.  Based upon theCompany’s results in 2004, the Company re-addressed the appropriateness of itsvaluation allowance and the circumstances that led to the establishment of itsvaluation allowance.  The Companydetermined that there had been a change in circumstances, and that its deferredtax assets would be realized in future years and accordingly reduced itsvaluation allowance against the related deferred tax assets to zero as ofDecember 31, 2004.

**Liquidityand Capital Resources**

Cash, cash equivalents and marketable securities (“cash”)decreased by approximately $639,000 for 2006 as compared to 2005.  The decrease in cash was attributed to changesin working capital, capital spending, dividend payments and repurchases ofcommon stock, which were partially offset by net income, issuance of commonstock, depreciation and amortization and benefit from the exercise of stockoptions.  The majority of the cash usedfor working capital was attributed to an increase in restricted cash of $1.4million, increases in accounts receivable of $1.6 million and inventories of$1.3 million and decreases in accounts payable and accrued expenses of $3.0million.

The restricted cash is associated with cash on depositin China for customs duties and taxes based upon raw materials imported.  The Company’s custom status was downgradedduring 2006.  The Company anticipatesthat it will regain its previous status in the second half of 2007, however,their can be no guarantee the Company will regain its previous customsstatus.  The Company’s average daysoutstanding of its accounts receivable increased to 45 days in 2006 as comparedto 36 in 2005.  The increase is mainlyattributed to the timing of sales in 2006 as compared to 2005 and to a slowerpaying customer mix in 2006 as compared to 2005.  The Company does not anticipate any problemsin collecting its accounts receivable balance as of December 31, 2006.  The increase in inventories was mainlyattributed to increases of the Company’s branded products in finishedgoods.  Cash provided by operatingactivities in 2006 was approximately $4.5 million, compared to approximately$10.4 million in 2005.

The Company used $4.6 million for capital expendituresduring 2006.  Composite Products capitalexpenditures were $3.2 million in 2006, with the majority of that beingattributed to the expansion in Vietnam. Composite Materials capital expenditures were $1.4 million in 2006.  The capital expenditures in CompositeMaterials was attributed to the remaining payments on the resin filmerinstalled in the first quarter of 2006 and sixth prepreg tape line installed atthe end of 2006.  The capital expendituresof the Composite Materials segment also support the Composite Products segment.Management anticipates capital expenditures will approximate between $4.0million and $6.0 million for 2007.  Theincrease in capital spending will be used to support the Company’s growth inthe Composite Materials business, finish the expansion in Vietnam and relocatethe Company’s corporate offices, warehousing and other departments into onebuilding.  The Company received incometax distributions from CFT totaling $169,000 in 2006 compared to $400,000 in2005.  Future distributions from CFT mustbe agreed upon by both joint venture partners prior to any distribution beingmade.

The Company paid $3.3 million in dividend payments in2006 as compared to $13.1 million in 2005. The Company declared and paid four $0.15 per share quarterly dividendsin 2006.  The Company declared and paidtwo special $1.00 per-share dividends in 2005, which were not paid in2006.  In addition, the Companyrepurchased 75,596 shares of its common stock in the open market during 2006,which resulted in a use of cash of $1.2 million.  The Company’s dividend policy and stockrepurchase policy are discussed quarterly during the Company’s board ofdirectors meetings and subject to board approval.  The Company has $3.8 million remaining thatcan be repurchased against its current approved stock buyback plan.

26

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**ContractualObligations**
|                      | ** ** | **Payments Due by Period (thousands)** | ** ** |
|----------------------|------------|------------------------------------------------------------|------------|
| ** **           | ** ** | **Less Than  1 Year**                            | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than  5 Years** | ** ** | **Total** | ** ** |
| Operating leases (a) |       | $                                                          | 1,348      |   | $ | 3,015 |   | $ | 1,116 |   | $ | 180 |   | $ | 5,659 |   |
| CFT Fixed Costs (b)  |       | 1,600                                                      |       | 3,200 |   | 3,200 |   | — |   | 8,000 |   |
| Total                |       | $                                                          | 2,948      |   | $ | 6,215 |   | $ | 4,316 |   | $ | 180 |   | $ | 13,659 |   |

 

----

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

(b)         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 2005.   As the Company isresponsible for the fixed costs until CFT is dissolved, the Company has estimatedthe amount through year 5.  If CFT wereto still be in existence past year 5, the Company is still responsible for 50%of their fixed costs.  The Company doesnot currently have a fixed or minimum quantity of carbon fiber that it isrequired to purchase from CFT.

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

**Seasonality**

Becausethe Company’s customers have historically built inventory in anticipation ofpurchases by golfers in the spring and summer, the principal selling season forgolf equipment, the Company’s operating results have been affected by seasonaldemand for golf clubs, which has generally resulted in highest sales occurringin the second quarter.  The timing ofcustomers’ new product introductions has frequently mitigated the impact ofseasonality in recent years.

**“SafeHarbor” Statement Under the Private Securities Litigation Reform Act of 1995**

This Annual Report on Form 10-K and certaininformation incorporated herein by reference contain forward-looking statementswithin the “safe harbor” provisions of the Private Securities Litigation ReformAct of 1995.  All statements included orincorporated by reference in this Annual Report on Form 10-K, other thanstatements that are purely historical, are forward-looking statements.

Words such as “anticipates,” “expects,” “intends,” “plans,”“believes,” “seeks,” “estimates,” and similar expressions also identifyforward-looking statements. Forward-looking statements are not guarantees of future performance andare subject to risks and uncertainties that could cause actual results to differmaterially 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 theseforward-looking statements as a result of the factors set forth in thisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, the Business Risks described in Item 1 of this Report on Form 10-Kand elsewhere in the Company’s filings with the Securities and ExchangeCommission.

**Item 7a. Quantitative and Qualitative Disclosures about Market Risk**

The Company believes that its exposure to market riskrelating to interest rate risk is not material. The Company is exposed to foreign exchange risk to the extent of adversefluctuations in the Mexican peso, the Chinese renminbi and the Vietnamesedong.  Based on historical movements ofthese 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.

**Item 8. Financial Statements and Supplementary Data**

Theinformation required as to this Item is incorporated by reference from theconsolidated financial statements and supplementary data listed in Item 15 ofPart IV of this report.

27

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**Item 9. Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure**

None.

**Item 9A. Controls and Procedures**

As of the end of theperiod covered by this report, Aldila management, including the Chief ExecutiveOfficer and Chief Financial Officer, conducted an evaluation of theeffectiveness of our disclosure controls and procedures pursuant to ExchangeAct Rule 13a-15(e).  Based upon thatevaluation, the Chief Executive Officer and the Chief Financial Officerconcluded that such disclosure controls and procedures are effective inalerting them on a timely basis to material information relating to Aldilarequired to be included in Aldila’s periodic filings under the Exchange Act.

**Management’sReport on Internal Control Over Financial Reporting**

The Company’s managementis responsible for establishing and maintaining effective internal control overfinancial reporting (as defined in Rule 13a-15(f) of the Securities ExchangeAct).  Management assessed theeffectiveness of the Company’s internal control over financial reporting as ofDecember 31, 2006.  In making thisassessment, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) in its reportentitled *Internal Control – IntegratedFramework. *Based on theassessment, management believes that, as of December 31, 2006, the Company’sinternal control over financial reporting is effective based on those criteria.

Because of the inherentlimitations of internal control over financial reporting, including thepossibility of collusion or improper management override of controls, materialmisstatements due to error or fraud may not be prevented or detected on atimely basis.  Also, projections of anyevaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

Management’s assessmentof the effectiveness of the Company’s internal control over financial reportingas of December 31, 2006 has been audited by Squar, Milner, Peterson, Miranda& Williamson, LLP, an independent registered public accounting firm, asstated in its report which is included herein.

28

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING

To the Board of Directors andStockholders of

Aldila, Inc.

Poway,California

Wehave audited management’s assessment, included in the accompanying Management’sReport on Internal Control over Financial Reporting, that Aldila, Inc.maintained effective internal control over financial reporting as of December31, 2006, based on criteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).  Aldila, Inc.’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

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

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

Inour opinion, management’s assessment that Aldila, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2006 is fairlystated, in all material respects, based on criteria established in *Internal Control—Integrated Framework* issued by the COSO.Also in our opinion, Aldila, Inc. maintained, in all material respects,effective internal control over financial reporting as of December 31, 2006,based on criteria established in *Internal Control—IntegratedFramework* issued by the COSO.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the balance sheets and the relatedstatements of income, stockholders’ equity, and cash flows of Aldila, Inc., andour report dated March 9, 2007 expressed an unqualified opinion thereon.

SQUAR,MILNER, PETERSON, MIRANDA & WILLIAMSON, LLP

San Diego, California

March 9, 2007

*Changesin internal control. *Therehave been no significant changes in internal controls or in factors that couldsignificantly affect internal controls, including any corrective actions withregard to significant deficiencies and material weaknesses, subsequent to thedate the Chief Executive Officer and Chief Financial Officer completed theirevaluation.

**Item 9B. Other Information**

None.

29

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##### **PART III**

**Item 10. Directors and Executive Officers of the Registrant**

The information required as to this Item isincorporated by reference from the section headed “Election of Directors” inthe Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders forthe year ended December 31, 2006, which will be filed with the Commissionwithin 120 days of the end of the fiscal year covered by this report (“2007Proxy Statement”).

The Company adopted a Code of Business Conduct andEthics on December 31, 2002 governing its officers, directors andemployees, including our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions.  A copy of the Code ofEthics is available at the Company’s website, www.aldila.com. See the Code ofBusiness Conduct and Ethics included herein as Exhibit 14.0 to this Report.

**Item 11. Executive Compensation**

Theinformation required as to this Item is incorporated herein by reference fromthe data under the caption “Executive Compensation” in the 2007 ProxyStatement.

**Item 12. Security Ownership of Certain Beneficial Owners and Management**

Theinformation required as to this Item is incorporated herein by reference fromthe data under the caption “Security Ownership of Certain Beneficial Owners andManagement” in the 2007 Proxy Statement.

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

Theinformation required as to this Item as it pertains to Director Independence isincorporated by reference from the section headed “Election of Directors”in the 2007 Company’s Proxy Statement.

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

The informationrequired as to this Item is incorporated herein by reference from the dataunder the caption “Independent Accountant Fees” in the 2007 Proxy Statement.

30

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**PART IV**

**Item15.  Exhibits, Financial StatementSchedules, and Reports on Form 8-K**

(a)          Documentsincluded as part of this report:

1.                                       Theconsolidated financial statements for the Registrant are included in thisreport.
|        | Consolidated  Balance Sheets at                           |   |
|--------|-----------------------------------------------------------|--------|
|   | December 31, 2006 and 2005;                               |   |
|   |                                                      |   |
|   | Consolidated  Statements of Operations for                |   |
|   | the years ended December 31,                              |   |
|   | 2006, 2005 and 2004;                                      |   |
|   |                                                      |   |
|   | Consolidated  Statements of Stockholders’ Equity     |   |
|   | for the years ended December  31, 2006,                   |   |
|   | 2005 and 2004;                                            |   |
|   |                                                      |   |
|   | Consolidated  Statements of Cash Flows                    |   |
|   | for the years ended December  31,                         |   |
|   | 2006, 2005 and 2004;                                      |   |
|   |                                                      |   |
|   | Notes  to Consolidated Financial Statements               |   |
|   |                                                      |   |
|   | Reports of  Independent Registered Public Accounting Firm |   |

 

2.                                       ScheduleIIC Valuation and Qualifying Accounts for the years ended December 31, 2006, 2005and 2004.

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

3.                                       Seethe Index to Exhibits on page 52 of this Form 10-K.  Financial statements of subsidiaries notconsolidated and fifty percent or less owned persons, management contracts orcompensatory plans or arrangements required to be filed as exhibits to thisreport are identified on the Index to Exhibits.

(b)         Exhibitsrequired by Item 601 of Regulation S-K.

See item (a) 3above.

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

See item (a) 3above.

31

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**ALDILA,INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands, except share data)**
| ** **                                                                                                                                                                 | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **            | ** ** | ** **            | ** ** |
|                                                                                                                                                                       |       |                  |       |                  |       |
| CURRENT ASSETS:                                                                                                                                                            |       |                  |       |                  |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                     | 15,182     |                  | $          | 15,821 |   |
| Restricted cash                                                                                                                                                            |       | 1,444                 |       | —                |       |
| Accounts receivable                                                                                                                                                        |       | 8,862                 |       | 7,233                 |       |
| Income taxes receivable                                                                                                                                                    |       | 1,237                 |       | 895                   |       |
| Inventories                                                                                                                                                                |       | 13,691                |       | 12,387                |       |
| Deferred tax assets                                                                                                                                                        |       | 1,360                 |       | 1,352                 |       |
| Prepaid expenses and other current assets                                                                                                                                  |       | 795                   |       | 625                   |       |
| Total current assets                                                                                                                                                       |       | 42,571                |       | 38,313                |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| PROPERTY, PLANT  AND EQUIPMENT                                                                                                                                             |       | 8,794                 |       | 5,570                 |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| INVESTMENT IN  JOINT VENTURE                                                                                                                                               |       | 3,091                 |       | 2,895                 |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| DEFERRED TAXES                                                                                                                                                             |       | 1,144                 |       | 1,051                 |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| OTHER  NON-CURRENT ASSETS                                                                                                                                                  |       | 296                   |       | 260                   |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| TOTAL ASSETS                                                                                                                                                               |       | $                     | 55,896     |                  | $          | 48,089 |   |
|                                                                                                                                                                       |       |                  |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                             | ** ** | ** **            | ** ** | ** **            | ** ** |
|                                                                                                                                                                       |       |                  |       |                  |       |
| CURRENT  LIABILITIES:                                                                                                                                                      |       |                  |       |                  |       |
| Accounts payable                                                                                                                                                           |       | $                     | 4,479      |                  | $          | 6,294 |   |
| Accrued expenses                                                                                                                                                           |       | 2,042                 |       | 3,214                 |       |
| Total current liabilities                                                                                                                                                  |       | 6,521                 |       | 9,508                 |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| LONG-TERM  LIABILITIES:                                                                                                                                                    |       |                  |       |                  |       |
| Deferred rent and other long-term liabilities                                                                                                                              |       | 49                    |       | 30                    |       |
| Total liabilities                                                                                                                                                          |       | 6,570                 |       | 9,538                 |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                             |       |                  |       |                  |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| 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 5,524,250 shares as of December 31, 2006 and  5,395,523 shares as of December 31, 2005 |       | 55                    |       | 54                    |       |
| Additional paid-in capital                                                                                                                                                 |       | 49,903                |       | 47,041                |       |
| Accumulated deficit                                                                                                                                                        |       | (632                  | )          | (8,544                | )          |
| Total stockholders’ equity                                                                                                                                            |       | 49,326                |       | 38,551                |       |
|                                                                                                                                                                       |       |                  |       |                  |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                           |       | $                     | 55,896     |                  | $          | 48,089 |   |

 

See notes to consolidatedfinancial statements.

32

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**ALDILA,INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**
| ** **                                                      | ** ** | **Year ended**   | ** ** |
|-----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **December 31,** | ** ** |
| ** **                                                      | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| NET SALES                                                       |       | $                     | 72,370     |   | $ | 76,978 |   | $ | 52,762 |   |
| COST OF SALES                                                   |       | 48,087                |       | 47,368 |   | 34,786 |   |
| Gross profit                                                    |       | 24,283                |       | 29,610 |   | 17,976 |   |
|                                                            |       |                  |       |   |   |   |   |
| SELLING, GENERAL  AND ADMINISTRATIVE                            |       | 10,731                |       | 9,741 |   | 8,237 |   |
| Operating income                                                |       | 13,552                |       | 19,869 |   | 9,739 |   |
|                                                            |       |                  |       |   |   |   |   |
| OTHER INCOME  (EXPENSE):                                        |       |                  |       |   |   |   |   |
| Interest income                                                 |       | 714                   |       | 639 |   | 148 |   |
| Other, net                                                      |       | 2,148                 |       | (53 | ) | (88 | ) |
| Equity in earnings of joint venture                             |       | 407                   |       | 236 |   | 246 |   |
|                                                            |       |                  |       |   |   |   |   |
| INCOME BEFORE  INCOME TAXES                                     |       | 16,821                |       | 20,691 |   | 10,045 |   |
| PROVISION FOR  INCOME TAXES                                     |       | 5,585                 |       | 7,287 |   | 725 |   |
|                                                            |       |                  |       |   |   |   |   |
| NET INCOME                                                      |       | $                     | 11,236     |   | $ | 13,404 |   | $ | 9,320 |   |
|                                                            |       |                  |       |   |   |   |   |
| NET INCOME PER  COMMON SHARE, BASIC                             |       | $                     | 2.04       |   | $ | 2.54 |   | $ | 1.85 |   |
|                                                            |       |                  |       |   |   |   |   |
| NET INCOME PER  COMMON SHARE, ASSUMING DILUTION                 |       | $                     | 2.01       |   | $ | 2.46 |   | $ | 1.77 |   |
|                                                            |       |                  |       |   |   |   |   |
| WEIGHTED AVERAGE  NUMBER OF COMMON SHARES OUTSTANDING           |       | 5,518                 |       | 5,273 |   | 5,027 |   |
|                                                            |       |                  |       |   |   |   |   |
| WEIGHTED AVERAGE NUMBER  OF COMMON AND COMMON EQUIVALENT SHARES |       | 5,591                 |       | 5,457 |   | 5,255 |   |

 

See notes to consolidatedfinancial statements.

33

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**ALDILA,INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

**(Inthousands)**
| ** **                                                                                | ** ** | ** **            | ** ** | **Additional** | ** ** | ** **  | ** ** | ** **                   | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|-------------|------------|------------------------------|------------|
| ** **                                                                                | ** ** | **Common Stock** | ** ** | **Paid-in**    | ** ** | ** **  | ** ** | ** **                   | ** ** |
| ** **                                                                                | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Capital** | ** ** | **Accumulated Deficit** | ** ** | **Total** | ** ** |
| Balance at  January 1, 2004                                                               |       | 4,885                 |       | $              | 48         |        | $          | 41,803                       |       | $ | (17,405 | ) | $ | 24,446 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Repurchases of  common stock                                                              |       | (55                   | )          | —         |       | (295        | )          |                         |       | (295 | ) |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Common stock  issued upon stock option exercises, including income tax benefits of $917   |       | 297                   |       | 3              |       | 2,356       |       |                         |       | 2,359 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Dividend  payments                                                                        |       |                  |       |           |       |        |       | (769                         | )          | (769 | ) |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Net income                                                                                |       |                  |       |           |       |        |       | 9,320                        |       | 9,320 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Balance at  Deccember 31, 2004                                                            |       | 5,127                 |       | 51             |       | 43,864      |       | (8,854                       | )          | 35,061 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Common stock  issued upon stock option exercises, including income tax benefits of $1,799 |       | 268                   |       | 3              |       | 3,177       |       |                         |       | 3,180 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Dividend  payments                                                                        |       |                  |       |           |       |        |       | (13,094                      | )          | (13,094 | ) |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Net income                                                                                |       |                  |       |           |       |        |       | 13,404                       |       | 13,404 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Balance at  December 31, 2005                                                             |       | 5,395                 |       | 54             |       | 47,041      |       | (8,544                       | )          | 38,551 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Repurchases of  common stock                                                              |       | (75                   | )          | (1             | )          | (1,210      | )          |                         |       | (1,211 | ) |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Stock-based  compensation                                                                 |       |                  |       |           |       | 255         |       |                         |       | 255 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Common stock  issued upon stock option exercises, including income tax benefits of $1,549 |       | 204                   |       | 2              |       | 3,817       |       |                         |       | 3,819 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Dividend  payments                                                                        |       |                  |       |           |       |        |       | (3,324                       | )          | (3,324 | ) |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Net income                                                                                |       |                  |       |           |       |        |       | 11,236                       |       | 11,236 |   |
|                                                                                      |       |                  |       |           |       |        |       |                         |       |   |   |
| Balance at December 31,  2006                                                             |       | 5,524                 |       | $              | 55         |        | $          | 49,903                       |       | $ | (632 | ) | $ | 49,326 |   |

 

See notes to consolidatedfinancial statements.

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**ALDILA,INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**
| ** **                                                                         | ** ** | **Year ended**   | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **December 31,** | ** ** |
| ** **                                                                         | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                             |       |                  |       |   |   |   |   |
| Net income                                                                         |       | $                     | 11,236     |   | $ | 13,404 |   | $ | 9,320 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                  |       |   |   |   |   |
| Depreciation and amortization                                                      |       | 1,322                 |       | 1,275 |   | 1,422 |   |
| Stock-based compensation                                                           |       | 255                   |       | — |   | — |   |
| Loss (gain) on disposal of fixed assets                                            |       | 43                    |       | (5 | ) | 32 |   |
| Undistributed income of joint venture, net                                         |       | (365                  | )          | (223 | ) | (285 | ) |
| Changes in assets and liabilities:                                                 |       |                  |       |   |   |   |   |
| Restricted cash                                                                    |       | (1,444                | )          | — |   | — |   |
| Accounts receivable                                                                |       | (1,629                | )          | (2,019 | ) | (601 | ) |
| Inventories                                                                        |       | (1,304                | )          | (4,095 | ) | (514 | ) |
| Deferred tax assets                                                                |       | (101                  | )          | (199 | ) | (2,204 | ) |
| Prepaid expenses and other assets                                                  |       | (227                  | )          | (392 | ) | 52 |   |
| Accounts payable                                                                   |       | (1,815                | )          | 2,081 |   | 1,146 |   |
| Accrued expenses                                                                   |       | (1,172                | )          | 433 |   | 1,320 |   |
| Income taxes payable/receivable                                                    |       | (342                  | )          | 118 |   | (1,013 | ) |
| Deferred rent and other long-term liabilities                                      |       | 19                    |       | 10 |   | (19 | ) |
| Net cash provided by operating activities                                          |       | 4,476                 |       | 10,388 |   | 8,656 |   |
|                                                                               |       |                  |       |   |   |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |                  |       |   |   |   |   |
| Purchases of property, plant and equipment                                         |       | (4,570                | )          | (1,565 | ) | (1,871 | ) |
| Proceeds from sales of property, plant and equipment                               |       | 2                     |       | 10 |   | 3 |   |
| Investment in marketable securities                                                |       | —                |       | — |   | (4,971 | ) |
| Proceeds from sales of marketable securities                                       |       | —                |       | 4,971 |   | — |   |
| Distributions from joint venture                                                   |       | 169                   |       | 400 |   | 1,500 |   |
| Net cash (used for) provided by investing activities                               |       | (4,399                | )          | 3,816 |   | (5,339 | ) |
|                                                                               |       |                  |       |   |   |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |                  |       |   |   |   |   |
| Repurchases of common stock                                                        |       | (1,211                | )          | — |   | (295 | ) |
| Benefit from exercise of stock options                                             |       | 1,549                 |       | 1,799 |   | 917 |   |
| Proceeds from issuance of common stock                                             |       | 2,270                 |       | 1,381 |   | 1,442 |   |
| Dividend payments                                                                  |       | (3,324                | )          | (13,094 | ) | (769 | ) |
| Net cash (used for) provided by financing activities                               |       | (716                  | )          | (9,914 | ) | 1,295 |   |
|                                                                               |       |                  |       |   |   |   |   |
| NET (DECREASE)  INCREASE IN CASH AND CASH EQUIVALENTS                              |       | (639                  | )          | 4,290 |   | 4,612 |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                      |       | 15,821                |       | 11,531 |   | 6,919 |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                            |       | $                     | 15,182     |   | $ | 15,821 |   | $ | 11,531 |   |
|                                                                               |       |                  |       |   |   |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                |       |                  |       |   |   |   |   |
| Cash paid during the year for:                                                     |       |                  |       |   |   |   |   |
| Income taxes                                                                       |       | $                     | 4,480      |   | $ | 5,813 |   | $ | 3,095 |   |

 

See notes to consolidatedfinancial statements.

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**ALDILA, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.****              SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

*The Company**–***Aldila,Inc. (a Delaware Corporation) (the “Company”) designs, manufacturers andmarkets graphite golf club shafts for sale principally in the UnitedStates.  In addition, the Company sellscomposite prepregs and other related materials and a limited amount of hockeysticks.

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

*Use of Estimates* – Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses, as well as the disclosure of contingenciesaffected by such estimates and assumptions. Actual results could differ from these estimates.

*Revenue Recognition* – The Companyrecognizes revenues from product sales upon transfer of title to the customerat the time of shipment.  The Companyalso offers discounts to certain customers based on early payment.  Sales to these customers are recognized on a grossbasis, and sales discounts are recorded at the time the discount is taken bythe customer.  Recording revenue net ofdiscounts would not have a significant effect on net sales or on the netrealizable value of accounts receivable. Sales discounts for the years ended December 31, 2006, 2005 and 2004were $303,000, $554,000 and $328,000, respectively, representing less than 1%of gross revenues.  The Company monitorsthe significance of these amounts.

*CashEquivalents* – The Company considers all highly liquidinvestments purchased with an original maturity of three months or less to becash equivalents.  The Company has nothistorically experienced losses on such investments.

*Restricted Cash *–* *The Company had restricted cash inthe amount of $1.4 million as of December 31, 2006, all of which is classifiedas current.  The $1.4 million is foreignrestricted currency maintained in a separate bank account at the Bank of China,under the name of its Chinese subsidiary to support the import and export activitiesin China.  The restriction requirementoccurred due to customs infractions during inspections carried out by the localcustoms office in Zhuhai that resulted in the Company’s custom import statusbeing downgraded during the second quarter of 2006.  The downgrade is not necessarily permanentand the Company believes that it will be able to apply for a status reviewduring the second quarter of 2007.

*MarketableSecurities* – Management determines the appropriateclassification of marketable debt and equity securities at the time of purchaseand reevaluates such designation as of 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 fair value of investments is determinedusing quoted market prices for those securities.

*Accounts Receivable* – The Companysells graphite golf club shafts primarily to golf club manufacturers anddistributors on credit terms.  TheCompany also sells hockey sticks to one customer and composite prepregs tomanufacturers of other composite based products on credit terms.  The Company provides an allowance fordoubtful accounts equal to the estimated uncollectible amounts.  The Company’s estimate is based on historicalcollection experience and a monthly review of the current status of outstandingcustomer balances.  Historically, creditlosses have been minimal in relation to the credit extended.

*Inventories* – Inventories arestated at the lower of first-in, first-out (FIFO) cost or market value.  The inventory balance, which includesmaterial, labor and manufacturing overhead costs, is recorded net of anestimated allowance for obsolete or unmarketable inventory. The estimatedallowance for obsolete or unmarketable inventory is based upon management’sunderstanding of market conditions and forecasts of future product demand, allof which are subject to change. If actual

36

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charges forobsolescence or unmarketable inventory significantly exceed the estimatedallowance, the Company’s operating results would be significantly adverselyaffected.

*Property, Plant and Equipment* –Property and equipment are stated at cost. Repairs and maintenance are charged 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      |       |

 

Leaseholdimprovements are amortized over the shorter of the asset life or the remainingterm of the related lease.

*JointVenture –* The Company’s 50% investment in CFT is accountedfor under the equity method. (See Note 5).

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

WarrantyReserve *–*The Company provides a warranty to itscustomers for shaft breakage in the normal course of business.  The Company accrues for the estimatedwarranty based on historical experience at time of sale.  The estimated warranty is calculated basedupon a rolling four-year ratio of breakage returns to sales applied to currentyear sales. (See Note 6).

*Advertising**–* The Company advertises primarily throughprint media. The Company’s policy is to expense advertising costs, includingproduction costs, as incurred. Advertising expenses for 2006, 2005 and 2004were $1.4 million, $1.2 million and $1.2 million, respectively.

*Shipping and Handling Costs -*Shippingand handling costs are classified as cost of sales.

*Research& Development (“R&D”)**–*The Company performs internal research and development efforts. Research anddevelopment expenses were approximately $2.5 million, $2.4 million and $1.7million for 2006, 2005 and 2004, respectively.

*Foreign Currency Translation –*The Company’s foreign subsidiaries are adirect and integral component or extension of the parent company’soperation.  The daily operations offoreign subsidiaries are dependent on the economic environment of the parent’scurrency.  In addition, the changes inthe foreign subsidiary’s individual assets and liabilities directly affect thecash flow of the parent company.  Thefunctional currency of foreign subsidiaries is the US dollar.  During the years ended December 31,2006, 2005 and 2004, net foreign currency transaction gains and losses includedin the Company’s Statements of Operations were insignificant.

*Common Stock and Earnings Per Share (“EPS”)**–* Earnings per share - basic iscalculated based upon the weighted average number of shares outstanding duringthe year, while diluted also gives effect to all potential dilutive commonshares outstanding during each year such as options, restricted stock, warrantsand other contingently issuable shares.

*IncomeTaxes* - Incometaxes are provided utilizing the asset and liability method.  The assetand 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 –*AtDecember 31, 2006, the Company has two stock-based compensation plans, whichare described more fully in Note 8. Beginning in fiscal year 2006, the Companyaccounts for share-based compensation arrangements in accordance with theprovisions of Statement of Financial Accounting Standards No. 123R (“SFAS123R”) “Share-Based Payment,” which requires the measurement and recognition ofcompensation expense for all

37

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share-basedpayment awards to employees and directors based on estimated fair values. TheCompany uses the Black-Scholes option valuation model to estimate the fairvalue of its stock options at the date of grant. The Black-Scholes optionvaluation model requires the input of subjective assumptions to calculate thevalue of stock options. The Company uses historical data among otherinformation to estimate the expected price volatility, the expected option lifeand the expected forfeiture rate.  Inaccordance with SFAS 123R, the Company records compensation expense forRestricted Stock Awards based on the estimated fair value of the award on thedate of grant. The estimated fair value is determined based on the closing price of the Company’sCommon Stock on the award date multiplied by the number of awards expected tovest. The number of awards expected to vest is based on the number of awardsgranted adjusted by estimated forfeiture rates. The total compensation cost isthen recognized ratably over the vesting period.

*Concentration Risk -* The Companymaintains some of its cash in bank deposit accounts which may be uninsured orexceed the federally insured limits.  No losses have been experiencedrelated to such accounts.  The Company believes it places its cash withquality financial institutions and is not exposed to any significantconcentration of credit risk on cash.

*Recently Issued Accounting Pronouncements - *In September 2006, theSecurities and Exchange Commission issued Staff Accounting Bulletin No.108, “Financial Statements *–* Consideringthe Effects of Prior Year Misstatements When Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”). This new guidance addresses howa registrant should quantify the effect of errors on the financial statementsbased on their impact to both the balance sheet and the income statement inorder to determine materiality. The interpretations in this SAB 108 are beingissued to address diversity in practice in quantifying financial statementmisstatements and the potential under current practice for the build up ofimproper amounts on the balance sheet. The guidance provides for a one-time cumulative effect adjustment tocorrect for misstatements and errors that were not deemed material under aprior approach but are material under the SAB 108 approach. Theapplication of SAB 108 did not have an effect on the Company’sconsolidated financial position or results of operations.

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issued SFASNo. 157, “Fair Value Measurements” (“SFAS 157”). This new standardprovides guidance for using fair value to measure assets and liabilities andinformation about the extent to which companies measure assets and liabilitiesat fair value, the information used to measure fair value, and the effect offair value measurements on earnings. This framework is intended to provideincreased consistency in how fair value determinations are made under variousexisting accounting standards which permit, or in some cases require, estimatesof fair market value. SFAS 157 also expands financial statement disclosurerequirements about a company’s use of fair value measurements, including theeffect of such measures on earnings. The provisions of SFAS 157 are effectivefor financial statements issued for fiscal years beginning afterNovember 15, 2007. The Company has not assessed the impact on itsconsolidated financial statements, if any.

In July 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes” (“FIN 48”) which clarifies the accounting for uncertainty inincome taxes recognized in the financial statements in accordance with FASBStatement No. 109, “Accounting for Income Taxes”. This pronouncementprescribes a recognition threshold and measurement process for recording in thefinancial statements uncertain tax positions taken or expected to be taken inthe Company’s tax return. FIN 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods anddisclosure requirements for uncertain tax positions. The accounting provisionsof FIN 48 are effective for the Company beginning January 1, 2007. Thecumulative effect of initially adopting FIN 48 will be recorded as anadjustment to opening retained earnings in the year of adoption and will bepresented separately. The Company is in the process of evaluating the effect,if any, the adoption of FIN 48 will have on its financial statements.

*Reclassifications**–*Certain reclassifications have been made to prior years’ disclosures to conformto current year classifications.

**2.****              ACCOUNTSRECEIVABLE**

Accountsreceivable at December 31 consist of the following (in thousands):
|                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
|                                   |       |     |       |     |       |
| Trade accounts  receivable             |       | $        | 8,898      |     | $          | 7,251 |   |
| Less: allowance  for doubtful accounts |       | (36      | )          | (18      | )          |
| Accounts  receivable                   |       | $        | 8,862      |     | $          | 7,233 |   |

 

38

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**3.****              INVENTORIES**

Inventories atDecember 31 consist of the following (in thousands):
|                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
|            |       |     |       |     |       |
| Raw materials   |       | $        | 8,364      |     | $          | 8,447 |   |
| Work-in-process |       | 1,204    |       | 1,279    |       |
| Finished goods  |       | 4,123    |       | 2,661    |       |
| Inventories     |       | $        | 13,691     |     | $          | 12,387 |   |

 

**4.  PROPERTY, PLANT AND EQUIPMENT**

Property, plantand equipment at December 31 consists of the following (in thousands):
|                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
|                                             |       |     |       |     |       |
| Machinery and equipment                          |       | $        | 17,712     |     | $          | 15,437 |   |
| Office furniture and  equipment                  |       | 1,730    |       | 1,655    |       |
| Leasehold improvements                           |       | 9,362    |       | 8,881    |       |
| Property and equipment  not yet in service       |       | 2,431    |       | 954      |       |
|                                             |       | 31,235   |       | 26,927   |       |
| Less: accumulated  depreciation and amortization |       | (22,441  | )          | (21,357  | )          |
| Property, plant and  equipment                   |       | $        | 8,794      |     | $          | 5,570 |   |

 

Depreciation and amortization expense were $1.3 million, $1.3 millionand $1.4 million in 2006, 2005 and 2004, respectively.

**5.     INVESTMENT IN JOINT VENTURE**

TheCompany and SGL Carbon and Composites, Inc. (“SGL”) each own 50% of CFT in ajoint venture to produce carbon fiber. CFT, which was previously a wholly owned subsidiary of AMTC, was formedon October 29, 1999.  AMTC contributednet assets with a book value of approximately $13.3 million to CFT.  SGL purchased a 50% interest in AMTC’s carbonfiber manufacturing operations for approximately $7.0 million in cash.  The Amended and Restated Limited LiabilityCompany Agreement provides that CFT is to continue until December 31, 2099unless it is dissolved earlier, its affairs are wound up and final liquidatingdistributions are made pursuant to the agreement.

TheCompany’s 50% investment in CFT is accounted for 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 for50% of the fixed costs of the facility regardless on the amount of fiber thatis purchased from the joint venture.  In2006, CFT’s sales to the Company and its partner were $6.9 million and $6.6million, respectively.  The amount ofconsolidated retained earnings of the Company represented by undistributedearnings of CFT was an accumulated deficit of approximately $4.1 million as ofDecember 31, 2006.  The Company’s equityin earnings from the joint venture for the years ended December 31, 2006, 2005and 2004 was approximately $407,000, $236,000 and $246,000, respectively.  The Company’s investment includes theunamortized excess of the Company’s original investment over its equity in thejoint venture net assets.  The excess wasapproximately $25,000 and $45,000 at December 31, 2006 and 2005, respectively,and is being amortized on a straight-line basis over an initial estimatedeconomic useful life of approximately 101 months.

**6.     ACCRUED EXPENSES**

Accrued expensesat December 31 consist of the following (in thousands):
|                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
|                           |       |     |       |     |       |
| Payroll and employee  benefits |       | $        | 1,490      |     | $          | 2,653 |   |
| Warranty reserve [1]           |       | 157      |       | 180      |       |
| Legal and professional  fees   |       | 12       |       | 67       |       |
| Plant consolidation            |       | 81       |       | —-  |       |
| Other                          |       | 302      |       | 314      |       |
| Accrued expenses               |       | $        | 2,042      |     | $          | 3,214 |   |

 

39

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| [1] Warranty Reserve | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Beginning Balance              |       | $        | 180        |     | $          | 176 |   |
| Settlement of Warranty         |       | (119     | )          | (106     | )          |
| Adjustments to Warranty        |       | 96       |       | 110      |       |
| Ending Balance                 |       | $        | 157        |     | $          | 180 |   |

 

**7.    STOCKHOLDERS’ EQUITY**

TheCompany announced on July 28, 2006 that its Board of Directors authorized therepurchase of up to $5.0 million of the Company’s common stock.  Theshares will be repurchased from time to time in open market transactions at theCompany’s discretion, subject to market conditions and other factors,including  imposed “black-out periods” during which the Company and itsinsiders are prohibited from trading in the Company’s common stock.  Whilethe Company typically allows insiders to trade in its stock for thirty daysbeginning the third day after its quarterly earnings announcement, the Companymay impose a black-out period at any time without advance public notice. During the year, the Company used cash of approximately $1.2 million purchasing75,596 shares of its common stock, with an average price paid of $16.11.  The Company has approximately $3.8 millionremaining under its current stock repurchase plan.  The Company also announced that all priorstock repurchase plans have been cancelled. Prior to the announcement, the Company had adopted previous stockrepurchase plans, but had not repurchased any shares under those plans sinceAugust 2004.  The Company repurchased54,989 shares in 2004 at an approximate cost of $295,000.  The Board of Directors discusses stockbuyback levels at each of the Company’s quarterly board meetings.  All shares that have been repurchased underthe Company’s stock buyback programs have been retired.

TheCompany declared and paid four quarterly dividends in the amount of $0.15 pershare to holders of its common stock during 2006, which resulted in dividendpayments totaling $3.3 million.  TheCompany declared and paid dividends during 2005, including two $1.00 specialdividends.  The Company paid dividendstotaling $2.45 per share in 2005, which resulted in dividend payments of $13.0million to holders of the Company’s common stock.  The Company also paid approximately $769,000in dividends during 2004, which was the first year the Company began payingdividends to holders of its common stock.

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

OnJanuary 1, 2006 the Company adopted Statement of Financial Accounting Standards(“SFAS”) No.123R (Revised 2004), “Share Based Payment,” (“SFAS 123R”), usingthe modified prospective method.  Inaccordance with SFAS No. 123R, the Company measures the cost of employeeservices received in exchange for an award of equity instruments based on thegrant-date fair value of the award.  Thatcost is recognized over the period during which an employee is required toprovide service in exchange for the award — the requisite service period.  The Company determines the grant-date fairvalue of employee share options using the Black-Scholes option-pricing model.On December 19, 2005 the Compensation Committee of the Company’s Board ofDirectors approved a plan to accelerate the vesting of approximately 150,000stock options granted to employees in 2004 and 2005, including options held byexecutive officers of the Company.  TheBoard took this action with the belief that it was in the best interests of thestockholders, as it will reduce the Company’s reported compensation expenseassociated with those options in future periods compared to the expense thatotherwise would have been recorded in connection with the implementation ofSFAS No.123R.

In1992, the Company adopted a Stock Option Plan for management.  The Company has reserved 175,431 shares forissuance under this Plan.  Options aregranted at the fair market value of the shares at the date of grant, generallybecome fully vested three years after grant, and expire ten years from the dateof grant.  In May of 1994, thestockholders adopted the 1994 Stock Incentive Plan (“Plan”) for employees,directors and consultants of the Company. The Company has reserved 1,366,667 shares for issuance under thisPlan.  Equity incentive programs coveredunder the Plan, include incentive stock options, non-qualified stock optionsand restricted stock awards.  Stockoptions and restricted stock awards are granted at the fair market value of theshares at the date of grant, generally become fully vested over three yearsafter grant, and expire ten years from the date of grant.

Therewere no capitalized stock-based compensation costs at December 31, 2006.  There were no modifications to stock optionsawards during 2006.  The Companyrecognizes stock-based compensation expense using the straight line attributionmethod.  The remaining unrecognizedcompensation cost related to unvested awards at December 31, 2006 is approximately

40

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$675,000, which isexpected to be recognized over a weighted average period of 7.5 years.  This amount does not include the cost of anyadditional options or restricted stock awards that may be awarded in futureperiods nor any changes in the Company’s forfeiture rate.

Inaccordance with the modified prospective method, the Company’s ConsolidatedFinancial Statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS No. 123R. The following table summarizes compensation costs related to the Company’sstock-based compensation plans for the twelve month period ended December 31,2006 (in thousands):
|                                           | ** ** | **Twelve month  period ended  December  31, 2006** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------------------|------------|
| Cost of sales                             |       | $                                                                 | —     |   |
| Selling, general and  administrative      |       | 255                                                               |       |
| Pre-tax stock-based  compensation expense |       | 255                                                               |       |
| Income tax benefit                        |       | 85                                                                |       |
|                                      |       |                                                              |       |
| Net stock-based compensation expense      |       | $                                                                 | 170        |   |

 

***Stock Option Activity***

SFASNo.123R requires the Company to reflect income tax benefits resulting from taxdeductions in excess of expense as a financing cash flow in its ConsolidatedStatement of Cash Flow rather than as an operating cash flow as in priorperiods.  Cash proceeds, tax benefits andintrinsic value of related total stock options exercised during the twelvemonth period ended December 31, 2006 are as follows (in thousands):
|                                                 | ** ** | **Twelve month  period ended  December  31, 2006** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| Proceeds from stock  options exercised          |       | $                                                                 | 2,270      |   |
| Tax benefit related to  stock options exercised |       | $                                                                 | 1,549      |   |
| Intrinsic value of stock options exercised      |       | $                                                                 | 4,347      |   |

 

Thefair value of stock options at date of grant was estimated using theBlack-Scholes model.  The expected lifeof employee stock options is determined using historical data of employeeexercises and represents the period of time that stock options are expected tobe outstanding.  The risk free interestrate is based on the U.S. Treasury constant maturity for the expected life ofthe stock option.  Expected volatility isbased on the historical volatilities of the Company’s common stock.  Below is the information for the grantsissued for 2006, 2005 and 2004.
|                                                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (years)                          |       | 6        |       | 5        |       | 5        |       |
| Risk-free interest rate                        |       | 5.0      | %          | 3.8      | %          | 3.5      | %          |
| Expected volatility                            |       | 72.3     | %          | 54.5     | %          | 59.0     | %          |
| Expected dividend yield                        |       | 1.9      | %          | 1.5      | %          | 1.0      | %          |
| Weighted average fair value of options granted |       | $        | 18.84      |     | $          | 11.28    |       | $ | 5.06 |   |
|                                                |            |          |            |          |            |          |            |  |  |  |

 

Thefollowing table summarizes the stock option transactions during the twelvemonth period ended December 31, 2006:
|                                 | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**        | ** ** | ** **    | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|---------------------|------------|---------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** **   | ** ** | **average**         | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **remaining**       | ** ** | ** **    | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **average**  | ** ** | **contractual**     | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **exercise** | ** ** | **life**            | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **price**    | ** ** | **(in years)** | ** ** | **Value**     | ** ** |
| Options outstanding  1/1/2006   |       | 353,311    |       | $            | 11.36      |                |       |          |       |   |
| Options granted                 |       | 13,336     |       | 32.01        |       |                |       |          |       |
| Options exercised               |       | 204,323    |       | 11.11        |       |                |       |          |       |
| Options terminated              |       | 694        |       | 17.11        |       |                |       |          |       |
| Options outstanding  12/31/2006 |       | 161,630    |       | $            | 13.41      |                | 7.5        |          | $          | 6.48 |   |
| Options exercisable 12/31/2006  |       | 133,142    |       | $            | 10.86      |                | 7.2        |          | $          | 4.95 |   |

 

41

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Thetotal intrinsic value of options exercised during the twelve month periodsended December 31, 2006, 2005 and 2004 was approximately $4.3, $4.0 million and$2.4 million, respectively.  The totalfair value of shares vested during the period ended December 31, 2006 wasapproximately $388,000.  A summary of thestatus of the Company’s nonvested shares as of December 31, 2006 and changesduring the twelve month period ended December 31, 2006 is presented below.
| Nonvested Shares   | ** ** | **Shares (000)** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|-------------------------|------------|-----------------------|------------|----------------------------------------------------|------------|
| Nonvested at 1/1/2006   |       | 56                    |       | $                                                  | 4.81       |   |
| Granted                 |       | 13                    |       | 18.84                                              |       |
| Vested                  |       | 41                    |       | 3.24                                               |       |
| Forfeited               |       | —                |       | —                                             |       |
| Nonvested at 12/31/2006 |       | 28                    |       | $                                                  | 13.63      |   |

 

***RestrictedStock Activity***

Restrictedstock awards were issued to employees under the Company’s Plan.  Restricted stock awards vest over three yearsand are subject to the employees’ continuing service to the Company. The costof restricted stock awards is determined using the fair value of the Company’scommon stock on the date of the grant. The compensation expense is recognizedratably over the vesting period.    A summary of the status of andchanges in restricted stock units granted under the Company’s Plan as of andduring the twelve months ended December 31, 2006 is presented below:
|                                         | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | ** **                      | ** ** | **Weighted** | ** ** |
| ** **                              | ** ** | ** **                      | ** ** | **average** | ** ** |
| ** **                              | ** ** | ** **                      | ** ** | **exercise** | ** ** |
| ** **                              | ** ** | **Shares**                      | ** ** | **price** | ** ** |
| Restricted stock  outstanding 1/1/2006  |       | —                          |       | — |   |
| Restricted stock  awarded               |       | 28,473                          |       | $ | 15.70 |   |
| Restricted stock  terminated            |       | —                          |       | — |   |
| Restricted stock outstanding 12/31/2006 |       | 28,473                          |       | $ | 15.70 |   |

 

***Pro forma Information for PeriodsPrior to the Adoption of FAS 123R***

Ifcompensation cost for the Company’s stock-based compensation plans had beenrecognized in the twelve month periods ended December 31, 2005 and 2004 underthe provisions of FAS No. 123R, the Company’s net income and EPS would havebeen reduced to the following pro forma amounts:
|                                                                                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income as  reported                                                                                                                       |       | $        | 13,404     |     | $          | 9,320 |   |
|                                                                                                                                          |       |     |       |     |       |
| Add back:                                                                                                                                     |       |     |       |     |       |
| Option charge  from accelerated vesting of options                                                                                            |       | 19       |       |     |       |
|                                                                                                                                          |       |     |       |     |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (1,378   | )          | (202     | )          |
| Pro forma net  income                                                                                                                         |       | $        | 12,045     |     | $          | 9,118 |   |
|                                                                                                                                          |       |     |       |     |       |
| Earnings per  share:                                                                                                                          |       |     |       |     |       |
| Basic – as  reported                                                                                                                     |       | $        | 2.54       |     | $          | 1.85 |   |
| Basic – pro  forma                                                                                                                       |       | $        | 2.28       |     | $          | 1.81 |   |
|                                                                                                                                          |       |     |       |     |       |
| Diluted – as  reported                                                                                                                   |       | $        | 2.46       |     | $          | 1.77 |   |
| Diluted – pro forma                                                                                                                      |       | $        | 2.21       |     | $          | 1.74 |   |

 

42

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**9.  INCOME TAXES**

During the year endedDecember 31, 2006, the Company completed an R&D project, which resulted inthe Company benefiting from increased R&D credits in the current year.  Where appropriate, the Company amended pastincome tax returns.  The R&D creditshad the effect of reducing the Company’s income tax expense in the current yearfor Federal and State income taxes by approximately $289,000 and $444,000,respectively.

During the year endedDecember 31, 2004, the Company addressed the appropriateness of its valuationallowance and the circumstances that led to the establishment of its valuationallowance in accordance with SFAS 109. The Company believed there had been a change in circumstances, and thatits deferred tax assets would be realized in future years and accordinglyreduced its valuation allowance against the related deferred tax assets to zeroas of December 31, 2004.  The recordedamount of the valuation allowance as of December 31, 2003 was $2.5 million,which was reduced to zero during 2004.

*Income tax provision for the years ended Decembers31, is as follows (in thousands):*
|                             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                    |       |     |       |     |       |     |       |
| Federal                     |       | $        | 4,706      |     | $          | 6,273    |       | $ | 2,256 |   |
| State                       |       | 627      |       | 1,101    |       | 455      |       |
| Foreign                     |       | 356      |       | 114      |       | 217      |       |
| Total                       |       | 5,689    |       | 7,487    |       | 2,928    |       |
| Deferred:                   |       |     |       |     |       |     |       |
| Federal                     |       | (99      | )          | 202      |       | 2,352    |       |
| State                       |       | (5       | )          | (2       | )          | (149     | )          |
| Total                       |       | (104     | )          | 200      |       | 2,203    |       |
| Provision for  income taxes |       | $        | 5,585      |     | $          | 7,287    |       | $ | 725 |   |

 

*Ratereconciliations for the years ended December 31, are as follows:*
|                                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory rate                                  |       | 35.0     | %          | 35.0     | %          | 34.0     | %          |
| State income  taxes, net of Federal tax benefit |       | 2.4      |       | 3.5      |       | 4.0      |       |
| Valuation  allowance                            |       | —   |       | —   |       | (26.9    | )          |
| R&D tax  credits                            |       | (2.1     | )          | —   |       | —   |       |
| Foreign earnings  taxed at different rates      |       | (1.8     | )          | (2.3     | )          | (4.0     | )          |
| Other items                                     |       | (.3      | )          | (1.0     | )          | .1       |       |
| Effective rate                                  |       | 33.2     | %          | 35.2     | %          | 7.2      | %          |

 

*Netdeferred income taxes  as of December 31,are as follows (in thousands):*

Net deferredincome taxes included in current and long-term assets in the balance sheet atDecember 31, consist of the tax effects of temporary differences related to thefollowing:
| Deferred tax assets-net, current | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Inventories                                     |       | $        | 1,056      |     | $          | 943 |   |
| Accrued expenses                                |       | 322      |       | 258      |       |
| Allowance for  doubtful accounts                |       | 15       |       | 7        |       |
| Deferred  expenses (capital losses)             |       | 20       |       | 4        |       |
| Prepaid expenses                                |       | —   |       | —   |       |
| State income  taxes                             |       | 25       |       | 140      |       |
| Other                                           |       | (78      | )          | —   |       |
| Deferred tax  assets – current             |       | $        | 1,360      |     | $          | 1,352 |   |

 

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| Deferred tax assets-net, long-term | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------|------------|----------|------------|----------|------------|
| Property and  equipment                           |       | $        | 488        |     | $          | 543 |   |
| Basis in joint  venture (CFT)                     |       | (341     | )          | (418     | )          |
|                                              |       |     |       |     |       |
| CFT impairment  charge                            |       | 898      |       | 904      |       |
| Other                                             |       | 99       |       | 22       |       |
| Deferred tax  assets – long term             |       | $        | 1,144      |     | $          | 1,051 |   |

 
| Reconciliation of deferred tax assets | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets – current                       |       | $        | 1,360      |     | $          | 1,352 |   |
| Deferred tax  assets – long term                     |       | 1,144    |       | 1,051    |       |
| Total net  deferred tax asset before valuation allowance  |       | 2,504    |       | 2,403    |       |
| Valuation  allowance                                      |       |     |       |     |       |
| Total deferred tax  asset                                 |       | $        | 2,504      |     | $          | 2,403 |   |

 

TheCompany has adopted the position under APB 23 that earnings of its foreignsubsidiaries will be permanently reinvested outside of the United States.  As such, United States deferred taxes havenot been provided for on these earnings.

**10.  EMPLOYEE BENEFIT PLAN**

In1994, the Company adopted the Aldila, Inc. 401(k) Savings Plan (the “Plan”) foremployees of the Company and its subsidiaries. This defined contribution plan allows employees who satisfy the age andservice requirements of the Plan to contribute up to 19% of pre-tax wages,limited to the maximum amount permitted under federal law.  The Company matches the first 4% of wagescontributed by employees at a rate of $0.50 for every $1.00.  The Company’s matching contributions vestover four years based on years of service. The Company’s contributions amounted to approximately $137,000, $58,000and $48,000 in 2006, 2005 and 2004, respectively.

**11.  COMMITMENTS AND CONTINGENCIES**

TheCompany leases building space and certain equipment under operatingleases.  The Company’s leases for officeand manufacturing space contain rental escalation clauses and renewaloptions.  Rental expense for the Companywas $1.1 million, $1.1 million and $900,000 for 2006, 2005 and 2004,respectively.  As of December 31, 2006,future minimum lease payments for all operating leases are as follows (inthousands):

| 2007       |   | $     | 1,348  |   |
|------------|--------|-------|--------|--------|
| 2008       |   | 1,522 |   |
| 2009       |   | 1,493 |   |
| 2010       |   | 583   |   |
| 2011       |   | 533   |   |
| Thereafter |   | 180   |   |
|       |   | $     | 5,659  |   |

 

**12.  SEGMENT INFORMATION**

TheCompany classifies its business into two segments based on products offered;Composite Products and Composite Materials. The Composite Products segment is primarily comprised of sales ofgraphite golf shafts and hockey sticks. The Composite Materials segment is comprised of external sales ofprepreg uni-tapes, fabrics, film adhesives and the Company’s 50% interest inCFT.  The Company reported one segment inits Annual Report filed on Form 10-K for the year ended December 31, 2005.  Historically, the Company’s external sales ofComposite Materials have not been significant; however, they have increased asa percentage of net sales in the last couple of years although never exceeding10% of consolidated net sales prior to 2006. Composite Materials net sales was 12% of consolidated net sales for thetwelve month period ended December 31, 2006, and the Company believes that thistrend will continue for the foreseeable future. The Company evaluates performance based on profit or loss fromoperations.  The Company does notevaluate inter-segment sales and has never tracked such sales.  The Composite Materials segment produces themajority of its materials for the Composite Products segment.  Certain SG&A costs and other sharedsupport costs are recorded initially in the Composite Products segment andallocated for segment reporting.

44

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*SegmentOperating Results*
|                                   | ** ** | **Twelve months ended December 31, 2006** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Composite**                                                      | ** ** | **Composite** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Products**                                                       | ** ** | **Materials** | ** ** | **Total** | ** ** |
| Revenues from external  customers |       | $                                                                  | 63,479     |   | $ | 8,891 |   | $ | 72,370 |   |
| Operating income                  |       | $                                                                  | 10,474     |   | $ | 3,078 |   | $ | 13,552 |   |
| Income before income taxes        | ** ** | $                                                                  | 12,686     |   | $ | 4,135 |   | $ | 16,821 |   |

 
|                                   | ** ** | **Twelve months ended December 31, 2005** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Composite**                                                      | ** ** | **Composite** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Products**                                                       | ** ** | **Materials** | ** ** | **Total** | ** ** |
| Revenues from external  customers |       | $                                                                  | 69,561     |   | $ | 7,417 |   | $ | 76,978 |   |
| Operating income                  |       | $                                                                  | 18,144     |   | $ | 1,725 |   | $ | 19,869 |   |
| Income before income taxes        |       | $                                                                  | 18,680     |   | $ | 2,011 |   | $ | 20,691 |   |

 
|                                   | ** ** | **Twelve months ended December 31, 2004** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                        | ** ** | **Composite**                                                      | ** ** | **Composite** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Products**                                                       | ** ** | **Materials** | ** ** | **Total** | ** ** |
| Revenues from external  customers |       | $                                                                  | 48,312     |   | $ | 4,450 |   | $ | 52,762 |   |
| Operating income                  |       | $                                                                  | 9,709      |   | $ | 30 |   | $ | 9,739 |   |
| Income before income taxes        |       | $                                                                  | 9,769      |   | $ | 276 |   | $ | 10,045 |   |

 

*SegmentLong-Lived Assets*
|                                      | ** ** | **As of December 31,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|
| ** **                           | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Property, Plant and  Equipment       |       |                                  |       |   |   |
| Composite Products                   |       | $                                     | 5,082      |   | $ | 2,979 |   |
| Composite Materials (1)              |       | $                                     | 3,712      |   | $ | 2,591 |   |
| Total Property, Plant  and Equipment |       | $                                     | 8,794      |   | $ | 5,570 |   |
|                                 |       |                                  |       |   |   |
| Investment in Joint  Venture         |       |                                  |       |   |   |
| Composite Products                   |       | $                                     | —     |   | $ | — |   |
| Composite Materials                  |       | $                                     | 3,091      |   | $ | 2,895 |   |
| Total Investment in  Joint Venture   |       | $                                     | 3,091      |   | $ | 2,895 |   |
|                                 |       |                                  |       |   |   |
| Total Long-Lived Assets              |       |                                  |       |   |   |
| Composite Products                   |       | $                                     | 5,082      |   | $ | 2,979 |   |
| Composite Materials                  |       | $                                     | 6,803      |   | $ | 5,486 |   |
| Total Long-Lived Assets              |       | $                                     | 11,885     |   | $ | 8,465 |   |

 

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Notes

(1) These assetsalso support the Composite Products segment as the Composite Materials segmentmanufactures the majority of the materials consumed by the Composite Productssegment.

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*Informationabout Geographic Areas*

TheCompany markets its products domestically and internationally, with itsprincipal international market being Europe. The table below contains information about the geographical areas inwhich the Company operates.  Revenues areattributed to countries based on location in which the sale is settled.  Long-lived assets are based on the country ofdomicile.  Although sales to China haveincreased over the years, the majority of those shafts being sold in China arebeing assembled and sent either back to the United States or to Europe.  The majority of the international sales areattributed to the Composite Products segment. Composite Materials international sales are immaterial.
| (in thousands)          | ** ** | ** ** | ** ** | ** **                 | ** ** |
|-------------------------|------------|------------|------------|----------------------------|------------|
| 2006                    | ** ** | **Sales**  | ** ** | **Long-Lived Assets** | ** ** |
| United States           |       | $          | 51,928     |                       | $          | 8,329 |   |
| England                 |       | 7,453      |       | —                     |       |
| China                   |       | 9,006      |       | 1,553                      |       |
| Canada                  |       | 2,461      |       | —                     |       |
| Australia               |       | 570        |       | —                     |       |
| Mexico                  |       | —     |       | 482                        |       |
| Vietnam                 |       | —     |       | 1,521                      |       |
| Other Foreign Countries |       | 952        |       | —                     |       |
| Total                   |       | $          | 72,370     |                       | $          | 11,885 |   |

 
| 2005                    | ** ** | **Sales** | ** ** | **Long-Lived Assets** | ** ** |
|-------------------------|------------|-----------|------------|----------------------------|------------|
| United States           |       | $         | 59,523     |                       | $          | 6,415 |   |
| England                 |       | 7,524     |       | —                     |       |
| China                   |       | 6,908     |       | 1,813                      |       |
| Canada                  |       | 959       |       | —                     |       |
| Australia               |       | 800       |       | —                     |       |
| Mexico                  |       | —    |       | 237                        |       |
| Other Foreign Countries |       | 1,264     |       | —                     |       |
| Total                   |       | $         | 76,978     |                       | $          | 8,465 |   |

 
| 2004                    | ** ** | **Sales** | ** ** | **Long-Lived Assets** | ** ** |
|-------------------------|------------|-----------|------------|----------------------------|------------|
| United States           |       | $         | 43,277     |                       | $          | 6,134 |   |
| Scotland                |       | —    |       | —                     |       |
| England                 |       | 3,510     |       | —                     |       |
| China                   |       | 4,356     |       | 1,887                      |       |
| Mexico                  |       | —    |       | 296                        |       |
| Other Foreign Countries |       | 1,619     |       | —                     |       |
| Total                   |       | $         | 52,762     |                       | $          | 8,317 |   |

 

*Informationabout Major Customers*

Historically, Aldila’s principal customers have variedas a result of general market trends in the golf industry, in particular theprevailing popularity of the various clubs that contain Aldila’s shafts.  As a result, there typically are changes inthe composition of the list of the Company’s ten most significant customersfrom year to year.  Due to the substantialmarketplace success of their clubs in recent periods, for the last severalyears the Company’s largest customers have been Acushnet Company, CallawayGolf, and Ping.
| Major Customers | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| Ping                 |       | 18       | %          | 19       | %          | 9        | %          |
| Acushnet Company     |       | 17       | %          | 19       | %          | 22       | %          |
| Callaway Golf        |       | 15       | %          | 18       | %          | 17       | %          |

 

46

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

The following is asummary of the quarterly results of operations for the two years in the periodended December 31, 2006 (in thousands, except per share data):
|                                             | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **March 31,**     | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                  | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **2006:**                                   |       |                   |       |   |   |   |   |   |   |
| Net sales                                   |       | $                      | 20,770     |   | $ | 17,397 |   | $ | 16,329 |   | $ | 17,874 |   |
| Gross profit                                |       | 9,668                  |       | 6,186 |   | 4,113 |   | 4,316 |   |
| Net income                                  |       | 4,342                  |       | 2,685 |   | 2,861 |   | 1,348 |   |
|                                        |       |                   |       |   |   |   |   |   |   |
| Net income per  common share-basic          |       | $                      | 0.80       |   | $ | 0.48 |   | $ | 0.51 |   | $ | 0.24 |   |
| Net income per  common share-diluted        |       | $                      | 0.78       |   | $ | 0.47 |   | $ | 0.51 |   | $ | 0.24 |   |
|                                        |       |                   |       |   |   |   |   |   |   |
| **2005:**                                   |       |                   |       |   |   |   |   |   |   |
| Net sales                                   |       | $                      | 17,808     |   | $ | 21,821 |   | $ | 19,327 |   | $ | 18,022 |   |
| Gross profit                                |       | 7,435                  |       | 8,118 |   | 7,866 |   | 6,191 |   |
| Net income  (loss)                          |       | 3,309                  |       | 3,644 |   | 3,761 |   | 2,690 |   |
|                                        |       |                   |       |   |   |   |   |   |   |
| Net income  (loss) per common share-basic   |       | $                      | 0.64       |   | $ | 0.70 |   | $ | 0.71 |   | $ | 0.50 |   |
| Net income (loss) per  common share-diluted |       | $                      | 0.61       |   | $ | 0.66 |   | $ | 0.68 |   | $ | 0.48 |   |

 

Earnings(loss) per share are computed independently for each of the quarters presentedand therefore may not sum to the annual amount for the year.  The Company benefited from a $2.2 millionpre-tax settlement of a class action lawsuit that it was a party to during thethird quarter ended September 30, 2006.

**14.  RELATED PARTY TRANSACTIONS**

Thedollar amount of transactions with related parties, primarily attributed topurchases of carbon fiber from CFT, was approximately $6.9, $4.8 and $4.7million for the years ended December 31, 2006, 2005 and 2004,respectively.  Amounts owed to CFT as ofDecember 31, 2006 and 2005 were approximately $156,000 and $255,000,respectively.

47

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**ALDILA INC. AND SUBSIDIARIES**

**SCHEDULEIIC VALUATION AND QUALIFYING ACCOUNTS**

**Forthe years ended December 31, 2006, 2005 and 2004**
| ** **                            | ** ** | **Balance at beginning** | ** ** | **Charged to costs and** | ** ** | ** **     | ** ** | **Balance at end** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|-----------------------------------------|------------|----------------|------------|------------------------------|------------|
| ** **                            | ** ** | **of year**                   | ** ** | **expenses**                            | ** ** | **Deductions** | ** ** | **of year**             | ** ** |
| Year ended December 31,  2004         |       |                               |       |                                    |       |           |       |                         |       |
| Allowance for  uncollectible accounts |       | $                                  | 34,000     |                                    | $          | 60,000         |       | $                            | (69,000    | ) | $ | 25,000 |   |
| Inventory Reserves                    |       | $                                  | 2,007,000  |                                    | $          | 97,000         |       | $                            | (1,143,000 | ) | $ | 961,000 |   |
| Warranty reserve                      |       | $                                  | 184,000    |                                    | $          | 69,000         |       | $                            | (77,000    | ) | $ | 176,000 |   |
|                                  |       |                               |       |                                    |       |           |       |                         |       |
| Year ended December 31,  2005         |       |                               |       |                                    |       |           |       |                         |       |
| Allowance for  uncollectible accounts |       | $                                  | 25,000     |                                    | $          | 2,000          |       | $                            | (9,000     | ) | $ | 18,000 |   |
| Inventory Reserves                    |       | $                                  | 961,000    |                                    | $          | 710,000        |       | $                            | (636,000   | ) | $ | 1,035,000 |   |
| Warranty reserve                      |       | $                                  | 176,000    |                                    | $          | 110,000        |       | $                            | (106,000   | ) | $ | 180,000 |   |
|                                  |       |                               |       |                                    |       |           |       |                         |       |
| Year ended December 31,  2006         |       |                               |       |                                    |       |           |       |                         |       |
| Allowance for  uncollectible accounts |       | $                                  | 18,000     |                                    | $          | 34,000         |       | $                            | (16,000    | ) | $ | 36,000 |   |
| Inventory Reserves                    |       | $                                  | 1,035,000  |                                    | $          | 811,000        |       | $                            | (476,000   | ) | $ | 1,370,000 |   |
| Warranty reserve                      |       | $                                  | 180,000    |                                    | $          | 96,000         |       | $                            | (119,000   | ) | $ | 157,000 |   |

 

48

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REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholdersof

Aldila,Inc.

Poway,California

Wehave audited the accompanying consolidated balance sheets of Aldila, Inc. as ofDecember 31, 2006 and 2005, andthe related statements of income, stockholders’ equity and cash flows for eachof the years in the three-year period ended December 31, 2006.  In connection with our audit of theconsolidated financial statements, we have also audited the accompanyingfinancial statement schedule listed in Item 15(a) 2 for the year ended December31, 2006.   These consolidated financialstatements and the financial statement schedule are the responsibility of thecompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audits.

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

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Aldila, Inc.  as of December 31, 2006  and 2005, and the results of its operationsand its cash flows for each of the years in the three-year period endedDecember 31, 2006 in conformity with accounting principles generally acceptedin the United States of America.  Also,in our opinion, the related financial statement schedule for the year endedDecember 31, 2006, when considered in relation to the basic financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

Asdiscussed in Note 1 to the consolidated financial statements, the Companychanged its method of accounting for stock based compensation, effectiveJanuary 1, 2006, as a result of the adoption of Statement of FinancialAccounting Standards No. 123R, *Share-BasedPayments*.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Aldila, Inc.’sinternal control over financial reporting as of December 31, 2006, based oncriteria established in *InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO), and our report dated March 9,2007 expressed an unqualified opinion on management’s assessment of theeffectiveness of internal control over financial reporting and an unqualifiedopinion on the effectiveness of internal control over financial reporting.
| Squar, Milner, Peterson, Miranda &  Williamson, LLP |   |
|---------------------------------------------------------|--------|
|                                                    |
| San Diego, California                                   |
| March 9, 2007                                           |

 

49

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
|        |   | ALDILA, INC. |
|--------|--------|--------------|
|   |   |         |   |
|   |   | By:          | /s/ Peter R.  Mathewson |   |
|   |   |         | Peter R.  Mathewson |   |
|   |   |         | Chairman of the  Board, |   |
|   |   |         | **Chief Executive Officer** |   |

 
| Signature                 | ** ** | **Title**                          | ** ** | **Date**       |
|---------------------------|------------|------------------------------------|------------|----------------|
|                      |       |                               |       |           |
| /s/ Peter R. Mathewson    |       | Chief Executive Officer            |       | March 14, 2007 |
| Peter R. Mathewson        |       | and Director  (Principal           |       |           |
|                      |       | Executive  Officer)                |       |           |
|                      |       |                               |       |           |
| /s/ Robert J. Cierzan     |       | Vice President, Finance            |       | March 14, 2007 |
| Robert J. Cierzan         |       | (Principal  Financial Officer      |       |           |
|                      |       | and Principal  Accounting Officer) |       |           |
|                      |       |                               |       |           |
| /s/ Lloyd I. Miller,  III |       | Director                           |       | March 14, 2007 |
| Lloyd I. Miller, III      |       |                               |       |           |
|                      |       |                               |       |           |
| /s/ Thomas A. Brand       |       | Director                           |       | March 14, 2007 |
| Thomas A. Brand           |       |                               |       |           |
|                      |       |                               |       |           |
| /s/ Andrew M. Leitch      |       | Director                           |       | March 14, 2007 |
| Andrew M. Leitch          |       |                               |       |           |
|                      |       |                               |       |           |
| /s/ Bryant R. Riley       |       | Director                           |       | March 14, 2007 |
| Bryant R. Riley           |       |                               |       |           |
|                      |       |                               |       |           |

 

50

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**EXHIBIT INDEX**
| Exhibit  Number | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 2.1             |       | Agreement of  Purchase and Sale, dated as of December 14, 1991, by and among Aldila  Acquisition Corp., Aldila, Inc. and all of the Shareholders of Aldila, Inc.,  as amended by the First Amendment dated January 9, 1992 by and among Aldila  Acquisition Corp., Aldila, Inc. and all the Shareholders of Aldila, Inc.  (Filed as Exhibit 2.1 to the Company’s Registration Statement on Form S-1  (Registration No. 33-61560) and incorporated herein by reference). |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 3.1             |       | Restated  Certificate of Incorporation. (Filed as Exhibit 3.1 to the Company’s  Registration Statement on Form S-1 (Registration No. 33-70010) and  incorporated herein by reference).                                                                                                                                                                                                                                                                                  |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 3.2             |       | Restated By-Laws  of the Company. (Filed as Exhibit 3.2 to the Company’s Registration Statement  on Form S-1 (Registration No. 33-61560) and incorporated herein by  reference).                                                                                                                                                                                                                                                                                        |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 4.1             |       | Specimen form of  Company’s Common Stock Certificate. (Filed as Exhibit 4.1 to the Company’s  Registration Statement on Form S-1 (Registration No. 33-61560) and  incorporated herein by reference).                                                                                                                                                                                                                                                               |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| * 10.1          |       | 1992 Stock  Option Plan of the Company, as amended. (Filed as Exhibit 10.6 to the  Company’s Registration Statement on Form S-1 (Registration No. 33-61560) and  incorporated herein by reference).                                                                                                                                                                                                                                                                     |   |
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   |
| * 10.2          |       | Form of Stock  Option Agreement in connection with Stock Option Plan. (Filed as Exhibit 10.7  to the Company’s Registration Statement on Form S-1 (Registration No.  33-61560) and incorporated herein by reference).                                                                                                                                                                                                                                                   |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| * 10.3          |       | Executive Bonus  Plan of the Company. (Filed as Exhibit 10.2 to the Company’s Report on Form  10-Q for the quarterly period ended September 30, 1994 and incorporated  herein by reference).                                                                                                                                                                                                                                                                            |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 10.4            |       | Form of  Indemnification Agreement between the Company and its directors and executive  officers. (Filed as Exhibit 10.13 to the Company’s Registration Statement on  Form S-1 (Registration No. 33-61560) and incorporated herein by reference).                                                                                                                                                                                                                       |   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   |
| 10.5            |       | Lease Agreement dated  as of October 15, 1990, between the Company and Baja del Mar, S.A. de C.V.  (Filed as Exhibit 10.16 to the Company’s Registration Statement on Form S-1  Registration No. 33-61560) and incorporated herein by reference).                                                                                                                                                                                                                       |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.6            |       | Lease Agreement  dated as of August 30, 1993, between the Company and T.M. Cobb Company.  (Filed as Exhibit 10.16 to the Company’s Registration Statement on Form S-1  (Registration No. 33-70010) and incorporated herein by reference).                                                                                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.7            |       | First Amendment  to Lease Agreement dated as of August 30, 1993, between the Company and T.M.  Cobb Company. (Filed as Exhibit 10.14 to the Company’s Report on Form 10-K  for the year ended December 31, 1993 and incorporated herein by reference).                                                                                                                                                                                                                  |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8            |       | Lease Agreement  dated as of November 30, 1993, between the Company and T.M. Cobb Company.  (Filed as Exhibit 10.15 to the Company’s Report on Form 10-K for the year  ended December 31, 1993 and incorporated herein by reference).                                                                                                                                                                                                                                   |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.9            |       | 1994 Stock  Incentive Plan of the Company, as amended. (Filed as Exhibit A to the  Company’s 1997 Proxy Statement dated March 26, 1997 and incorporated herein  by reference).                                                                                                                                                                                                                                                                                          |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.10           |       | Form of Stock  Option Agreement in connection with the 1994 Stock Incentive Plan. (Filed as  Exhibit 10.1 to the Report on Form 10-Q for the quarterly period ended  September 30, 1994 and incorporated herein by reference).                                                                                                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.11           |       | Lease Agreement  dated May 15, 1995 between the Company and Desarrollo Industrial de Tijuana,  S.A. de                                                                                                                                                                                                                                                                                                                                                                       |

 

51

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|         |   | C.V.(Filed as Exhibit  10.1 to the Company’s Report on Form 10-Q for the quarterly period ended June  30, 1995 and incorporated herein by reference).                                                                                                                                                                           |   |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|    |   |                                                                                                                                                                                                                                                                                                                                 |   |
| 10.12   |   | Member Interest  Purchase Agreement dated as of October 20, 1999 among SGL Carbon Fibers and  Composites, Inc., SGL Technik GmbH, Aldila Materials Technology Corp. and the  Company. (Filed as Exhibit 10.17 to the Company’s Report on Form 10-K for the  year ended December 31, 1999 and incorporated herein by reference). |   |
|    |   |                                                                                                                                                                                                                                                                                                                                 |   |
| * 10.13 |   | Severance Protection  Agreement dated March 11, 1999 between the Company and Peter R. Mathewson.  (Filed as Exhibit 10.3 to the Company’s Report on Form 10-Q for the quarterly  period ended June 30, 1999 and incorporated herein by reference).                                                                              |   |
|    |   |                                                                                                                                                                                                                                                                                                                                 |   |
| * 10.14 |   | Severance  Protection Agreement dated March 11, 1999 between the Company and Robert J.  Cierzan. (Filed as Exhibit 10.4 to the Company’s Report on Form 10-Q for the  quarterly period ended June 30, 1999 and incorporated herein by reference).                                                                               |   |
|    |   |                                                                                                                                                                                                                                                                                                                                 |   |
| * 10.15 |   | Severance  Protection Agreement dated March 11, 1999 between the Company and Michael J.  Rossi. (Filed as Exhibit 10.5 to the Company’s Report on Form 10-Q for the  quarterly period ended June 30, 1999 and incorporated herein by reference).                                                                                |   |
|    |   |                                                                                                                                                                                                                                                                                                                                 |   |
| 10.16   |   | 1994 Stock  Option Plan of the Company, as amended. (Filed as attachment A-1 in the  Company’s 2000 Proxy Statement and registered on the Company’s Form S-8  (Registration No. 333-57754) and incorporated herein by reference).                                                                                          |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 10.17   |   | Aldila, Inc.  Audit Committee Charter included as Exhibit A in the Company’s 2001 Proxy  dated April 4, 2001 and incorporated herein by reference.                                                                                                                                                                              |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 10.18   |   | Aldila, Inc.’s  Code of Business Conduct and Ethics adopted on December 31, 2002 (Filed as  Exhibit 14.0 in the Company’s Report on Form 10-K for the year ended December  31, 2003)                                                                                                                                       |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 11.1    |   | Statement re: Computation of Net Income (Loss) per  Common Share.                                                                                                                                                                                                                                                                    |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 21.1    |   | Subsidiaries of the Company.                                                                                                                                                                                                                                                                                                         |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 23.1    |   | Consent of  Independent Registered Public Accounting Firm – Squar, Milner, Peterson,  Miranda & Williamson, LLP                                                                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 31.1    |   | Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 31.2    |   | Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 32.1    |   | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                            |
|    |   |                                                                                                                                                                                                                                                                                                                                 |
| 99.1    |   | Carbon Fiber  Technology, LLC financial statements as of and for the years ended December  31, 2004 and 2003 (filed as Exhibit 99.1 in the Company’s Report on Form 10-K  for the year ended December 31, 2004 and incorporated herein by reference)                                                                            |
|         |        |                                                                                                                                                                                                                                                                                                                                      |        |  |  |

 

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*Indicates managementcontracts or compensatory plans or arrangements required to be filed asexhibits to this Report on Form 10-K.

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