##### 



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-Q
 QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 Commission File Number: 1-11376
 
 The Allied Defense Group, Inc.
 (Exact name of Registrant as specified in its charter)
 Delaware
    
    04-2281015(State or other jurisdiction of
    
    (I.R.S Employer Number)incorporation or organization)
 8000 Towers Crescent Drive, Suite 260
Vienna, Virginia 22182  (Address of principal executive offices, including zip code)
 (703) 847-5268  (Registrants telephone number, including area code)
 
  þ o
  þ o
  o þ




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##### 



THE ALLIED DEFENSE GROUP, INC.
INDEX
 PAGENUMBERPART I. FINANCIAL INFORMATION  UNAUDITEDItem 1. Financial Statements (Unaudited)Condensed Consolidated Balance Sheets
September 30, 2006 and December 31, 2005
    
    
    2Condensed Consolidated Statements of Operations
Three and nine months ended September 30, 2006 and 2005
    
    
    3Condensed Consolidated Statements of Stockholders Equity
    
    
    4Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 2006 and 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    22Item 3. Quantitative and Qualitative Market Risk Disclosure
    
    
    38Item 4. Disclosure Controls and Procedures
    
    
    38PART II. OTHER INFORMATIONItem 6. Exhibits
    
    
    40Signatures
    
    
    41




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##### 



The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Thousands of Dollars, except per share data)
 September 30, 2006
    
    
    December 31, 2005(a)ASSETSCURRENT ASSETSCash and cash equivalents
    
    $
    20,024
    
    
    $
    7,803Restricted cash
    
    
    9,526
    
    
    
    7,428Accounts receivable
    
    
    17,328
    
    
    
    18,547Costs and accrued earnings on uncompleted contracts
    
    
    33,209
    
    
    
    35,178Inventories
    
    
    35,520
    
    
    
    34,300Deferred tax asset
    
    
    3,040
    
    
    
    2,696Fair value of foreign exchange contracts
    
    
    
    
    
    
    5Prepaid and other current assets
    
    
    7,936
    
    
    
    8,339Total current assets
    
    
    126,583
    
    
    
    114,296PROPERTY, PLANT AND EQUIPMENT net of accumulated depreciation
    
    
    32,188
    
    
    
    29,826OTHER ASSETSIntangibles, net of accumulated amortization
    
    
    12,267
    
    
    
    13,353Goodwill
    
    
    17,462
    
    
    
    16,698Deferred tax asset, non-current
    
    
    5,058
    
    
    
    5,672Other assets
    
    
    2,146
    
    
    
    1,101Total other assets
    
    
    36,933
    
    
    
    36,824TOTAL ASSETS
    
    $
    195,704
    
    
    $
    180,946LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITIESBank overdraft facility
    
    $
    18,133
    
    
    $
    15,086Current maturities of long-term debt
    
    
    10,611
    
    
    
    4,342Accounts payable
    
    
    16,100
    
    
    
    31,004Accrued liabilities
    
    
    16,994
    
    
    
    15,097Customer deposits
    
    
    19,848
    
    
    
    9,956Fair value of foreign exchange contracts
    
    
    3
    
    
    
    1,161Income taxes
    
    
    936
    
    
    
    1,288Total current liabilities
    
    
    82,625
    
    
    
    77,934LONG-TERM OBLIGATIONSShort-term debt, to be refinanced
    
    
    
    
    
    
    13,539Long-term debt, less current maturities and unamortized discount
    
    
    31,030
    
    
    
    7,820Deferred compensation
    
    
    233
    
    
    
    160Derivative instrument
    
    
    687
    
    
    
    Total long term liabilities
    
    
    31,950
    
    
    
    21,519TOTAL LIABILITIES
    
    
    114,575
    
    
    
    99,453CONTINGENCIES AND COMMITMENTSSTOCKHOLDERS EQUITYPreferred stock, no par value; authorized, 1,000,000 shares; none issued
    
    
    
    
    
    
    Common stock, par value, $.10 per share; authorized 30,000,000 shares;
issued and outstanding 6,034,558 at September 30, 2006 and 5,982,008
at December 31, 2005
    
    
    603
    
    
    
    598Additional paid-in capital
    
    
    36,280
    
    
    
    34,354Retained earnings
    
    
    28,214
    
    
    
    34,466Accumulated other comprehensive income
    
    
    16,032
    
    
    
    12,075Total stockholders equity
    
    
    81,129
    
    
    
    81,493TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    195,704
    
    
    $
    180,946
 
 (a)
    
    Condensed consolidated balance sheet as of December 31, 2005, has been derived from audited
consolidated financial statements. The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 2




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##### 



The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Thousands of Dollars, except per share data)
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005RESTATED
    
    
    
    
    
    
    RESTATEDRevenues
    
    $
    27,212
    
    
    $
    26,819
    
    
    $
    94,676
    
    
    $
    76,995Cost and expensesCost of sales
    
    
    14,485
    
    
    
    26,994
    
    
    
    66,738
    
    
    
    65,165Selling and administrative
    
    
    10,426
    
    
    
    7,232
    
    
    
    29,282
    
    
    
    23,251Research and development
    
    
    2,192
    
    
    
    1,328
    
    
    
    5,916
    
    
    
    4,345Operating income (loss)
    
    
    109
    
    
    
    (8,735
    )
    
    
    (7,260
    )
    
    
    (15,766
    )Other income (expense)Interest income
    
    
    480
    
    
    
    76
    
    
    
    774
    
    
    
    483Interest expense
    
    
    (1,353
    )
    
    
    (404
    )
    
    
    (5,070
    )
    
    
    (1,441
    )Gain on fair value of Senior Convertible notes and warrants
    
    
    4,190
    
    
    
    
    
    
    
    5,204
    
    
    
    Other-net
    
    
    (197
    )
    
    
    (61
    )
    
    
    837
    
    
    
    (50
    )3,120
    
    
    
    (389
    )
    
    
    1,745
    
    
    
    (1,008
    )Earnings (loss) before
income taxes and
cumulative effect
of change in
application of
accounting principle
    
    
    3,229
    
    
    
    (9,124
    )
    
    
    (5,515
    )
    
    
    (16,774
    )Income tax expense (benefit)
    
    
    737
    
    
    
    (2,363
    )
    
    
    737
    
    
    
    (5,547
    )Earnings (loss) before cumulative effect of
change in application of accounting principle
    
    
    2,492
    
    
    
    (6,761
    )
    
    
    (6,252
    )
    
    
    (11,227
    )Cumulative effect of change in application of accounting principle
    
    
    
    
    
    
    95
    
    
    
    
    
    
    
    (5,372
    )NET INCOME (LOSS)
    
    $
    2,492
    
    
    $
    (6,666
    )
    
    $
    (6,252
    )
    
    $
    (16,599
    )Earnings (loss) per share:Income (loss) before cumulative effect of change in
application of accounting principle  basic
    
    $
    0.41
    
    
    $
    (1.17
    )
    
    $
    (1.04
    )
    
    $
    (1.98
    )Cumulative effect of change in application of
accounting principle
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.95
    )Net Income (loss)  basic
    
    $
    0.41
    
    
    $
    (1.15
    )
    
    $
    (1.04
    )
    
    $
    (2.93
    )Earnings (loss) per share:Income (loss) before cumulative effect of change in
application of accounting principle  diluted
    
    $
    0.40
    
    
    $
    (1.17
    )
    
    $
    (1.04
    )
    
    $
    (1.98
    )Cumulative effect of change in application of
accounting principle
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.95
    )Net Income (loss)  diluted
    
    $
    0.40
    
    
    $
    (1.15
    )
    
    $
    (1.04
    )
    
    $
    (2.93
    )Weighted average number of common shares:Basic
    
    
    6,059,989
    
    
    
    5,798,619
    
    
    
    6,039,940
    
    
    
    5,663,856Diluted
    
    
    6,165,446
    
    
    
    5,798,619
    
    
    
    6,039,940
    
    
    
    5,663,856
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 3




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##### 



The Allied Defense Group, Inc.
  CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(Unaudited)
(in thousands of dollars, except per share data)
  For the year ended December 31, 2005 and the nine months ended September 30, 2006AccumulatedPreferred


Common Stock


Capital





other


TotalStock, no





$.10


in excess


Retained


comprehensive


stockholderspar value


Shares


par value


of par value


earnings


(loss) income


equityBalance at January 1, 2005  RESTATED

$




5,601,101


$
560


$
27,910


$
73,386


$
23,697


$
125,553Common stock awards






54,729



5



399











404Common stock issued with acquisition






118,072



11



2,489











2,500Employee stock purchase plan purchases






5,507



1



107











108Exercise of stock options






202,599



21



2,671











2,692Warrants issued














488











488Directors deferred stock














290











290Comprehensive income:


























Net loss for the year


















(38,920
)






Currency translation adjustment






















(11,622
)


Total comprehensive income


























(50,542
)Balance at December 31,
    2005

$




5,982,008


$
598


$
34,354


$
34,466


$
12,075


$
81,493Common stock awards






10,747



1



549











550Employee stock purchase plan
    purchases






5,636



1



110











111Exercise of stock options






36,167



3



398











401Directors deferred stock compensation














128











128Issue of stock options














367











367Warrants issued














374











374Comprehensive income:


























Net loss for the nine months


















(6,252
)






Currency translation adjustment






















3,957



Total comprehensive income


























(2,295
)Balance at September 30, 2006

$




6,034,558


$
603


$
36,280


$
28,214


$
16,032


$
81,129  The accompanying notes are an integral part of these
    unaudited condensed consolidated financial statements.
 4




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##### 



The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Thousands of Dollars)
 Nine Months ended September 30,2006
    
    
    2005 RESTATEDCash flows from operating activitiesNet loss
    
    $
    (6,252
    )
    
    $
    (16,599
    )Adjustments to reconcile net
loss to net cash used in operating activitiesCumulative effect of accounting change
    
    
    
    
    
    
    5,372Depreciation and amortization
    
    
    5,861
    
    
    
    3,724Amortization of debt discount and debt issue costs
    
    
    1,593
    
    
    
    152Unrealized gain on forward contracts
    
    
    (1,212
    )
    
    
    (1,418
    )Loss on sale of fixed assets
    
    
    412
    
    
    
    Gain related to fair value of notes and warrants
    
    
    (5,204
    )
    
    
    Provision for estimated losses on contracts
    
    
    295
    
    
    
    649Tax benefit of stock options exercised
    
    
    (28
    )
    
    
    Deferred taxes
    
    
    1,039
    
    
    
    (2,905
    )Common stock and option awards
    
    
    933
    
    
    
    227Deferred director stock awards
    
    
    128
    
    
    
    (Increase) decrease in operating assets and increase (decrease) in liabilities:Restricted cash
    
    
    (1,644
    )
    
    
    2,314Accounts receivable
    
    
    1,758
    
    
    
    15,675Costs and accrued earnings on uncompleted contracts
    
    
    4,011
    
    
    
    (8,226
    )Inventories
    
    
    (174
    )
    
    
    1,700Prepaid and other current assets
    
    
    2,010
    
    
    
    (3,840
    )Accounts payable, accrued liabilities and customer deposits
    
    
    (6,433
    )
    
    
    (19,143
    )Deferred compensation
    
    
    27
    
    
    
    43Income taxes
    
    
    (457
    )
    
    
    (3,658
    )Net cash used in operating activities
    
    
    (3,337
    )
    
    
    (25,933
    )Cash flows from investing activitiesCapital expenditures
    
    
    (4,503
    )
    
    
    (5,460
    )Acquisitions, final payment
    
    
    (473
    )
    
    
    Net cash used in investing activities
    
    
    (4,976
    )
    
    
    (5,460
    )Cash flows from financing activitiesPrincipal payments on long-term borrowing
    
    
    (14,000
    )
    
    
    (2,250
    )Debt issue costs
    
    
    (1,908
    )
    
    
    Repayment on capital lease obligations
    
    
    (1,324
    )
    
    
    (1,997
    )Proceeds from issuance of long-term debt
    
    
    30,000
    
    
    
    Net increase (decrease) in short-term borrowings
    
    
    4,715
    
    
    
    2,303(Decrease) increase in bank overdraft facility
    
    
    1,934
    
    
    
    12,922Proceeds from employee stock purchases
    
    
    95
    
    
    
    64Proceeds from option exercises
    
    
    429
    
    
    
    2,691Net cash provided by financing activities
    
    
    19,941
    
    
    
    13,733NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    11,628
    
    
    
    (17,660
    )Effects of exchange rate changes on cash
    
    
    593
    
    
    
    (2,310
    )NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    12,221
    
    
    
    (19,970
    )Cash and cash equivalents at beginning of period
    
    
    7,803
    
    
    
    27,940Cash and cash equivalents at end of period
    
    $
    20,024
    
    
    $
    7,970Supplemental
Disclosures of Cash Flow InformationCash paid during the period forInterest
    
    
    3,300
    
    
    
    734Taxes
    
    
    1,343
    
    
    
    3,661Supplemental
Disclosures of Non-cash Investing and Financing activitiesWarrants issued in conjunction with senior secured credit facility
    
    
    2,387
    
    
    
    Capital leases
    
    
    1,281
    
    
    
    1,840
 The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
 5




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##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 NOTE 1  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
     Liquidity and Cash Flows
    6




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##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
  
    
    The Company intends to have in place, and is in the process of negotiating, a domestic
line of credit, or other facility, that will provide $4,000 to $5,000 of immediate
liquidity with a provision to accordion up to $20,000 based on financial performance in
subsequent periods. This will be contingent on successful registration of the March 2006
issue of convertible debentures and warrants. The Company filed the S-1 to register these
securities on November 7, 2006.
    
    The Company is exploring possible asset backed financing from local banks in Marshall,
TX. This will be contingent on successful registration of the March 2006 convertible
debentures and warrants.
    
    The Company is in discussions with the holders of the convertible debentures and other
investors on a potential offering of 5-10M$ of subordinated notes.
    
    The Company is in discussions with the MECAR SA banking group to allow MECAR SA to
repay ADG approximately 5M$ in intercompany loans and 2006 past due management fees.
    
    The Company is evaluating the disposition of certain non strategic assets.
    
    The Company has the option of receiving dividends from excess cash from its VSK Group at year end.
    
    The Company may further consolidate its California operations to continue to reduce
operating expenses.
  NOTE 2  PRINCIPLES OF CONSOLIDATION
  
    
    ARC Europe, S.A. (ARC Europe), a Belgian company,
    
    Allied Research Corporation Limited (Limited), an inactive United Kingdom company,
    
    News/Sports Microwave Rental, Inc. (NSM), a California corporation,
    
    Titan Dynamics Systems, Inc. (Titan), a Texas corporation,
    
    SeaSpace Corporation (SeaSpace), a California corporation,
    
    MECAR USA, Inc. (MECAR USA), a Delaware corporation,
    
    Allied Technology, LLC (Allied Technology), a Maryland limited liability company, and
    
    Global Microwave Systems, Inc (GMS), a California corporation.
   7




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##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 Ammunition & Weapons Effects
 Electronic Security
 Other
  Accounting Change
 Restatements of Financial Results Accounting for Derivative Instruments and Hedging Activities
  8




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##### 



The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006 
(Thousands of Dollars)
 Selected Consolidated Statements of Earnings Data:
 Three months ended September 30, 2005
 Impact FromForeign
    
    
    
    
    
    Impact ofCurrency
    
    Impact from
    
    RevenueTranslation
    
    Compensation
    
    Recognition
    
    As PreviouslyRESTATED
    
    (1)
    
    Expense (2)
    
    (3)
    
    Reported in 10-QRevenues
    
    $
    26,819
    
    
    $
    (78
    )
    
    $
    
    
    
    $
    3,421
    
    
    $
    23,476Cost of Sales
    
    
    26,994
    
    
    
    
    
    
    
    
    
    
    
    6,717
    
    
    
    20,277Operating Income (loss)
    
    
    (8,735
    )
    
    
    (79
    )
    
    
    
    
    
    
    (3,295
    )
    
    
    (5,360
    )Earnings before income
taxes and the cumulative
effect of change in
application of accounting
principle
    
    
    (9,124
    )
    
    
    (353
    )
    
    
    
    
    
    
    (3,295
    )
    
    
    (5,476
    )Income tax expense (benefit)
    
    
    (2,363
    )
    
    
    (59
    )
    
    
    
    
    
    
    (1,120
    )
    
    
    (1,184
    )Cumulative effect of
change in the application
of accounting principle
    
    
    95
    
    
    
    
    
    
    
    
    
    
    
    95
    
    
    
    Net earnings (loss)
    
    $
    (6,666
    )
    
    $
    (294
    )
    
    $
    
    
    
    $
    (2,080
    )
    
    $
    (4,292
    )Earnings (loss) per share
 Basic & Diluted:Loss before cumulative
effect of change in the
application of accounting
principle
    
    $
    (1.17
    )
    
    $
    (0.05
    )
    
    $
    
    
    
    $
    (0.39
    )
    
    $
    (0.74
    )Cumulative effect of
change in the application
of accounting principle
    
    $
    0.02
    
    
    
    
    
    
    $
    
    
    
    $
    0.02
    
    
    
    Net income (loss)
    
    $
    (1.15
    )
    
    $
    (0.05
    )
    
    $
    
    
    
    $
    (0.36
    )
    
    $
    (0.74
    )Weighted Average number of
common shares (4):Basic
    
    
    5,798,619
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,780,911Diluted
    
    
    5,798,619
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,780,911
 
 (1)
    
    Impact of correcting for the failure to comply with the documentation requirements of FAS 133,
hedge accounting, for changing the exchange rates to period end spot rates at the Companys MECAR
subsidiary for its foreign currency transactions and other adjustments related to sales contracts.(2)
    
    Impact of correcting the measurement date for options granted in February 2002 by the
Compensation Committee of the Board of Directors of the Company that were subject to subsequent
stockholder approval that was obtained in September 2002.(3)
    
    Impact of change in accounting principle on revenue recognition at the Companys MECAR
subsidiary.(4)
    
    Shares Outstanding for the period were restated to correct for deferred compensation for the
outside directors that was stock based that had been incorrectly excluded from the earnings per
share calculation in the period. 9




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##### 



The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006 
(Thousands of Dollars)
 Nine months ended September 30, 2005
 Impact FromForeignCurrency
    
    Impact from
    
    Impact of
    
    As PreviouslyTranslation
    
    Compensation
    
    Revenue
    
    Reported inRESTATED
    
    (1)
    
    Expense (2)
    
    Recognition (3)
    
    10-QRevenues
    
    $
    76,995
    
    
    $
    (1,056
    )
    
    $
    
    
    
    $
    12,418
    
    
    $
    65,633Cost of Sales
    
    
    65,165
    
    
    
    (34
    )
    
    
    
    
    
    
    14,246
    
    
    
    50,953Operating Income (loss)
    
    
    (15,766
    )
    
    
    (1,022
    )
    
    
    (36
    )
    
    
    (1,827
    )
    
    
    (12,881
    )Earnings before income
taxes and the cumulative
effect of change in
application of accounting
principle
    
    
    (16,774
    )
    
    
    (1,589
    )
    
    
    (36
    )
    
    
    (1,825
    )
    
    
    (13,324
    )Income tax expense (benefit)
    
    
    (5,547
    )
    
    
    (647
    )
    
    
    (12
    )
    
    
    (621
    )
    
    
    (4,267
    )Cumulative effect of
change in the application
of accounting principle
    
    
    (5,372
    )
    
    
    
    
    
    
    
    
    
    
    (5,372
    )
    
    
    Net loss
    
    $
    (16,599
    )
    
    $
    (942
    )
    
    $
    (24
    )
    
    $
    (6,576
    )
    
    $
    (9,057
    )Earnings (loss) per share
 Basic & Diluted:Loss before cumulative
effect of change in the
application of accounting
principle
    
    $
    (1.98
    )
    
    $
    (0.17
    )
    
    $
    
    
    
    $
    (0.21
    )
    
    $
    (1.60
    )Cumulative effect of
change in the application
of accounting principle
    
    $
    (0.95
    )
    
    $
    
    
    
    $
    
    
    
    $
    (0.95
    )
    
    $
    Net loss
    
    $
    (2.93
    )
    
    $
    (0.17
    )
    
    $
    
    
    
    $
    (1.16
    )
    
    $
    (1.60
    )Weighted Average number of
common shares (4):Basic
    
    
    5,663,856
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,674,740Diluted
    
    
    5,663,856
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,674,740
 
 (1)
    
    Impact of correcting for the failure to comply with the documentation requirements of FAS 133,
hedge accounting, for changing the exchange rates to period end spot rates at the Companys MECAR
subsidiary for its foreign currency transactions and other adjustments related to sales contracts.(2)
    
    Impact of correcting the measurement date for options granted in February 2002 by the
Compensation Committee of the Board of Directors of the Company that were subject to subsequent
stockholder approval that was obtained in September 2002.(3)
    
    Impact of change in accounting principle on revenue recognition at the Companys MECAR
subsidiary.(4)
    
    Shares Outstanding for the period were restated to correct for deferred compensation for the
outside directors that was stock based that had been incorrectly excluded from the earnings per
share calculation in the period. 10




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 Cash Flow Information
  As previouslyRESTATED
    
    ADJUSTMENT
    
    reported in 10-QNine months ended
September 30, 2005Cash flows from operations:Accounts payable,
accrued liabilities
and customer deposits
    
    $
    (19,143
    )
    
    $
    (12,922
    )
    
    $
    (6,221
    )*Cash flows from financing:Borrowings on bank
overdraft
facility
    
    $
    12,922
    
    
    $
    12,922
    
    
    
    
 
 *
    
    The As previously reported in 10-Q amount has been adjusted for the impact of foreign currency
translation and other restatement adjustments of $7,608. NOTE 3  DERIVATIVE FINANCIAL INSTRUMENTS
 Derivatives and hedging
  Fair value hedges
  11




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 Cash flow hedges
  Derivatives not designated as hedges
  Counterparty credit risk
  NOTE 4  ACCOUNTS RECEIVABLE AND COSTS AND ACCRUED EARNINGS ON UNCOMPLETED CONTRACTS
  September 30, 2006
    
    

December 31, 2005Direct and indirect receivables from foreign governments
    
    $
    6,235
    
    
    $
    1,777Commercial and other receivables, less allowance for
doubtful
receivables of $647 in 2006 and $214 in 2005
    
    
    11,093
    
    
    
    16,770$
    17,328
    
    
    $
    18,547
   NOTE 5  INVENTORIES
  12




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 September 30, 2006
    
    
    December 31, 2005Raw materials
    
    $
    16,865
    
    
    $
    14,942Work in process
    
    
    17,474
    
    
    
    19,265Finished goods
    
    
    2,613
    
    
    
    1,755Gross inventory
    
    
    36,952
    
    
    
    35,962Less reserves for obsolescence
    
    
    (1,432
    )
    
    
    (1,662
    )Net inventory
    
    $
    35,520
    
    
    $
    34,300
 NOTE 6  GOODWILL
   NOTE 7  BANK OVERDRAFT CREDIT FACILITY
  NOTE 8  LONG-TERM DEBT
  September 30, 2006
    
    

December 31, 2005Fair value of Senior subordinated convertible notes
    
    $
    24,109
    
    
    $
    Short-term debt expected to be refinanced, less unamortized discount
    
    
    
    
    
    
    13,539Note related to GMS acquisition, less unamortized discount
    
    
    6,387
    
    
    
    6,173Mortgage loan agreements
    
    
    164
    
    
    
    193Loan for CMS Security Systems acquisition
    
    
    100
    
    
    
    200Other notes payable
    
    
    7,309
    
    
    
    618Capital leases and other
    
    
    3,572
    
    
    
    4,978Total long-term debt
    
    
    41,641
    
    
    
    25,701Less current maturities
    
    
    (10,611
    )
    
    
    (4,342
    )Long-term debt, less current maturities and unamortized
discount, including short-term debt to be
refinanced
    
    $
    31,030
    
    
    $
    21,359
 13




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 Senior subordinated convertible notes.
    14




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 Notes payable.
 Loan for Global Microwave Systems acquisition.
 Mortgage Loan Agreements.
 Loan for CMS Security Systems acquisition.
 Other notes payable.
 Capital lease and other.
 15




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 NOTE 9  INCOME (LOSS) PER SHARE
  Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,Restated
    
    
    
    
    
    
    Restated2006
    
    
    2005
    
    
    2006
    
    
    2005Net income/(loss) before Cumulative Effect of
Change in Accounting Principle
    
    $
    2,492
    
    
    $
    (6,761
    )
    
    $
    (6,252
    )
    
    $
    (11,227
    )Cumulative Effect of Change in Accounting Principle
    
    
    
    
    
    
    95
    
    
    
    
    
    
    
    (5,372
    )Net Income/(loss)
    
    $
    2,492
    
    
    $
    (6,666
    )
    
    $
    (6,252
    )
    
    $
    (16,599
    )Weighted average number of basic shares
    
    
    6,059,989
    
    
    
    5,798,619
    
    
    
    6,039,940
    
    
    
    5,663,856Warrants
    
    
    31,983
    
    
    
    
    
    
    
    
    
    
    
    Stock Options
    
    
    73,474
    
    
    
    
    
    
    
    
    
    
    
    Weighted average number of diluted shares
    
    
    6,165,446
    
    
    
    5,798,619
    
    
    
    6,039,940
    
    
    
    5,663,856Basic income/(loss) per share before Cumulative
Effect of Change in Accounting Principle
    
    $
    0.41
    
    
    $
    (1.17
    )
    
    $
    (1.04
    )
    
    $
    (1.98
    )Cumulative Effect of Change in Accounting Principle
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.95
    )Net income/(loss) per share
    
    $
    0.41
    
    
    $
    (1.15
    )
    
    $
    (1.04
    )
    
    $
    (2.93
    )Diluted income/(loss) per share before Cumulative
Effect of Change in Accounting Principle
    
    $
    0.40
    
    
    $
    (1.17
    )
    
    $
    (1.04
    )
    
    $
    (1.98
    )Cumulative Effect of Change in Accounting Principle
    
    
    
    
    
    
    0.02
    
    
    
    
    
    
    
    (0.95
    )Net income/(loss) per share
    
    $
    0.40
    
    
    $
    (1.15
    )
    
    $
    (1.04
    )
    
    $
    (2.93
    )
 16




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
  NOTE 10  COMPREHENSIVE INCOME (LOSS)
  Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 302006
    
    
    2005
    
    
    2006
    
    
    2005Restated
    
    
    
    
    
    
    RestatedNet income/(loss)
    
    $
    2,492
    
    
    $
    (6,666
    )
    
    $
    (6,252
    )
    
    $
    (16,599
    )Currency Translation Adjustment
    
    
    1,097
    
    
    
    (3,281
    )
    
    
    3,957
    
    
    
    (13,895
    )Comprehensive
income/(loss)
    
    $
    3,589
    
    
    $
    (9,947
    )
    
    $
    (2,295
    )
    
    $
    (30,494
    )
  NOTE 11  SHARE- BASED COMPENSATION
    17




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
       Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2005
    
    
    September 30, 2005(Dollars in thousands, except per share amounts)
    
    Restated
    
    
    RestatedReported net loss
    
    $
    (6,666
    )
    
    $
    (16,599
    )Stock-based compensation costs that would have
been included in the determination of reported
net earnings, if the fair value method was
applied to all awards, net of tax
    
    
    (91
    )
    
    
    (248
    )Pro forma net loss
    
    $
    (6,757
    )
    
    $
    (16,847
    )Basic and diluted loss per share:Reported loss per share
    
    $
    (1.15
    )
    
    $
    (2.93
    )Compensation costs, net of tax
    
    
    (0.02
    )
    
    
    (0.04
    )Pro forma basic loss per share
    
    $
    (1.17
    )
    
    $
    (2.97
    )
 18




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
  Three Months Ended September 30,
    
    
    
    
    
    Nine Months Ended September 30,2005
    
    
    
    
    
    2005Risk free interest rate
    
    
    4.08
    %
    
    
    
    
    
    
    4.08
    %Expected volatility rate
    
    
    44.62
    %
    
    
    
    
    
    
    44.62
    %Expected lives  years
    
    
    5
    
    
    
    
    
    
    
    5Dividend yield
    
    
    
    
    
    
    
    
    
    
    
    Weighted
    
    
    Weighted AverageAverage
    
    
    RemainingNumber of
    
    
    Exercise
    
    
    Contractual Term
    
    
    AggregateOptions
    
    
    Price
    
    
    (in years)
    
    
    Intrinsic Value*Outstanding-beginning of year
    
    
    507,667
    
    
    $
    16.94Granted
    
    
    
    
    
    
    Exercised
    
    
    36,167
    
    
    
    11.87Forfeited
    
    
    
    
    
    
    Outstanding at September 30,
2006
    
    
    471,500
    
    
    $
    17.33
    
    
    
    3.74
    
    
    $
    Exercisable at September 30,
2006
    
    
    378,500
    
    
    $
    16.27
    
    
    
    3.83
    
    
    $
    63
 
 *
    
    The intrinsic value of a stock option is the amount by which the market value of the underlying
stock exceeds the exercise price of the option. The market value of our stock was $16.44 at
September 30, 2006. 19




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 The following table summarizes options outstanding at September 30, 2006:
 Weighted Average
    
    
    ExercisableNumber
    
    
    Range of
    
    
    Weighted Average
    
    
    Remaining
    
    
    Number of
    
    
    Weighted AverageOutstanding
    
    
    Exercise Prices
    
    
    Exercise Prices
    
    
    Contractual Term
    
    
    Options
    
    
    Exercise Prices100,000
    
    
    $7.88   to $8.63
    
    $
    8.63
    
    
    4.25 Years
    
    
    100,000
    
    
    $
    8.6340,000
    
    
    $
    9.01 to $14.90
    
    
    $
    14.90
    
    
    1.58 Years
    
    
    32,000
    
    
    $
    14.90331,500
    
    
    $
    16.40 to $25.00
    
    
    $
    20.25
    
    
    3.84 Years
    
    
    246,500
    
    
    $
    20.25471,500
    
    
    $
    7.88 to $25.00
    
    
    $
    17.33
    
    
    
    
    
    
    
    378,500
    
    
    
    
 The following table summarizes restricted stock (nonvested) shares outstanding as of September
30, 2006
 Weighted- Average GrantRestricted Stock
    
    Shares
    
    
    Date Fair ValueRestricted at January 1, 2006
    
    
    51,793
    
    
    $
    22.99Granted
    
    
    8,300
    
    
    $
    21.53Vested
    
    
    (10,997
    )
    
    $
    22.71Forfeited
    
    
    (2,464
    )
    
    $
    22.33Restricted shares at September 30,
2006
    
    
    46,632
    
    
    $
    22.83
   NOTE 12  INDUSTRY SEGMENTS
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 302006
    
    
    2005
    
    
    2006
    
    
    2005Restated
    
    
    
    
    
    
    RestatedRevenues from external customersAmmunitions & weapons effects
    
    $
    14,353
    
    
    $
    16,736
    
    
    $
    56,240
    
    
    $
    44,112Electronic security
    
    
    10,736
    
    
    
    8,071
    
    
    
    33,614
    
    
    
    28,243Other
    
    
    2,123
    
    
    
    2,012
    
    
    
    4,822
    
    
    
    4,640$
    27,212
    
    
    $
    26,819
    
    
    $
    94,676
    
    
    $
    76,995Segment income/(loss) before
provision for income taxes and
cumulative effect of change in
accounting principle:
    
    
    
    
    
    
    Restated
    
    
    
    
    
    
    RestatedAmmunitions & weapons effects
    
    $
    1,335
    
    
    $
    (7,702
    )
    
    $
    (3,027
    )
    
    $
    (14,002
    )Electronic security
    
    
    (294
    )
    
    
    (245
    )
    
    
    (526
    )
    
    
    368Other
    
    
    71
    
    
    
    (345
    )
    
    
    (928
    )
    
    
    (1,528
    )Corporate
    
    
    2,117
    
    
    
    (832
    )
    
    
    (1,034
    )
    
    
    (1,612
    )$
    3,229
    
    
    $
    (9,124
    )
    
    $
    (5,515
    )
    
    $
    (16,774
    )
 20




---



##### 



The Allied Defense Group, Inc .  NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006
(Thousands of Dollars)
 NOTE 13  PROVISION FOR TAXES
    NOTE 14  COMMITMENTS AND CONTINGENCIES
  21




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Overview
  
    
    Ammunition & Weapons Effectssegment consists of MECAR, located in
Belgium, MECAR USA, located in Marshall, TX, and Titan Dynamics,
located in Marshall, TX. MECAR develops and produces medium
caliber tank, mortar and other ammunition. MECAR USA became
operational in late 2005 and is pursuing contracts from U.S. and
foreign governments for ammunition and pyrotechnics devices with a
focus on the 105MM market. Titan designs, manufactures and sells
battlefield effects simulators, minor pyrotechnics and other
training devices.
    
    Electronic Securitysegment consists of the VSK Group, located in
Belgium and California, and NSM and GMS both located in or near
San Diego, California. The VSK Group consists of VSK Electronics
N.V., which manufactures access control, intrusion protection,
fire detection and video systems; Télé Technique Générale S.A.,
which installs security systems; Intelligent Data Capturing
Systems N.V., which manufacturers integrated video systems;
VIGITEC S.A., which installs networked video surveillance systems;
and CMS Security Systems which manufactures access control
systems. NSM designs, manufactures, installs and services
military surveillance products and integrated systems for the law
enforcement community, agencies of the Department of Homeland
Security and the Department of Defense. GMS designs and
manufactures miniature and sub-miniature FM and digital
transmitters, receivers, and related equipment for investigative,
surveillance, and security applications, and live TV
news/sports/entertainment coverage.
    
    Othersegment consists of the formerly named Environmental Safety
& Security segment and provides products in the area of
environmental monitoring and consists solely of SeaSpace.
SeaSpace designs, manufactures, distributes and services weather
and environmental satellite ground reception systems and
manufactures and markets a line of antenna systems.
    22




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Results of Operations for the Three Months Ended September 30, 2006 and 2005
  Three months ended September 302006
    
    2005RestatedRevenue
    
    
    100.0
    %
    
    
    100.0
    %Cost and expensesCost of sales
    
    
    53.2
    
    
    
    100.7Selling and administrative
    
    
    38.3
    
    
    
    27.0Research and development
    
    
    8.1
    
    
    
    4.9Operating
income/(loss)
    
    
    0.4
    
    
    
    (32.6
    )Other income (expense)Interest income
    
    
    1.8
    
    
    
    0.3Interest expense
    
    
    (5.0
    )
    
    
    (1.5
    )Gain (loss) from fair value of notes and warrants
    
    
    15.4
    
    
    
    Other  net
    
    
    (0.7
    )
    
    
    (0.2
    )Income/(loss) before income taxes
    
    
    11.9
    
    
    
    (34.0
    )Income tax expense (benefit)
    
    
    2.7
    
    
    
    (8.8
    )Net income (loss) before cumulative effect of change in
accounting principle
    
    
    9.2
    
    
    
    (25.2
    )Cumulative effect of change in accounting
principle
    
    
    
    
    
    
    0.4Net income/(loss)
    
    
    9.2
    %
    
    
    (24.8
    )%
 Revenue.
 Revenue by SegmentThree Months Ended
    
    
    Three Months EndedSeptember 30, 2006
    
    
    September 30, 2005Percentage
    
    
    
    
    
    
    PercentageAmount
    
    
    of total
    
    
    Amount
    
    
    of totalRestatedAmmunition & Weapons Effects
    
    $
    14,353
    
    
    
    53
    %
    
    $
    16,736
    
    
    
    62
    %Electronic Security
    
    
    10,736
    
    
    
    39
    %
    
    
    8,071
    
    
    
    30
    %Other
    
    
    2,123
    
    
    
    8
    %
    
    
    2,012
    
    
    
    8
    %$
    27,212
    
    
    
    100
    %
    
    $
    26,819
    
    
    
    100
    %
 23




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
   Cost of Sales.
 Cost of Sales as Percentage of Sales by Segment
 Three months endedSeptember 302006
    
    2005RestatedAmmunition & Weapons Effects (AWE)
    
    
    60
    %
    
    
    121
    %Electronic Security (ES)
    
    
    46
    %
    
    
    69
    %Other
    
    
    44
    %
    
    
    61
    %Total
    
    
    53
    %
    
    
    101
    %
  24




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
   Selling and Administrative Expenses.
    Research and Development.
 Gain on fair value of Senior Subordinated Convertible Notes and warrants.
 25




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Other Income (Expense)
 Interest Income.
 Interest Expense.
 Pre-Tax Income (Loss
 Pre-Tax Income (Loss) by Segment Before  the Cumulative Effect of Accounting Change
 Three months endedSeptember 30,2006
    
    
    2005RestatedAmmunition & Weapons Effects
    
    $
    1,335
    
    
    $
    (7,702
    )Electronic Security
    
    
    (294
    )
    
    
    (245
    )Other
    
    
    71
    
    
    
    (345
    )Corporate
    
    
    2,117
    
    
    
    (832
    )$
    3,229
    
    
    $
    (9,124
    )
    26




---



##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
  Income Taxes.
 Net Income (Loss).
 Results of Operations for the Nine Months Ended September 30, 2006 and 2005
  Nine months ended September 302006
    
    2005RestatedRevenue
    
    
    100.0
    %
    
    
    100.0
    %Cost and expensesCost of sales
    
    
    70.5
    
    
    
    84.6Selling and administrative
    
    
    30.9
    
    
    
    30.2Research and development
    
    
    6.2
    
    
    
    5.6Operating loss
    
    
    (7.6
    )
    
    
    (20.4
    )Other income (expense)Interest income
    
    
    0.8
    
    
    
    0.6Interest expense
    
    
    (5.4
    )
    
    
    (1.9
    )Gain (loss) from fair value of notes and warrants
    
    
    5.5
    
    
    
    Other  net
    
    
    0.9
    
    
    
    (0.1
    )Loss before income taxes
    
    
    (5.8
    )
    
    
    (21.8
    )Income tax expense (benefit)
    
    
    0.8
    
    
    
    (7.2
    )Net loss before cumulative effect of change in
accounting principle
    
    
    (6.6
    )
    
    
    (14.6
    )Cumulative effect of change in accounting
principle
    
    
    
    
    
    
    (7.0
    )Net loss
    
    
    (6.6
    )%
    
    
    (21.6
    )%
 27




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Revenue.
 Revenue by SegmentNine Months Ended
    
    
    Nine Months EndedSeptember 30, 2006
    
    
    September 30, 2005Percentage
    
    
    
    
    
    
    PercentageAmount
    
    
    of total
    
    
    Amount
    
    
    of totalRestatedAmmunition & Weapons Effects
    
    $
    56,240
    
    
    
    59
    %
    
    $
    44,112
    
    
    
    57
    %Electronic Security
    
    
    33,614
    
    
    
    36
    %
    
    
    28,243
    
    
    
    37
    %Other
    
    
    4,822
    
    
    
    5
    %
    
    
    4,640
    
    
    
    6
    %$
    94,676
    
    
    
    100
    %
    
    $
    76,995
    
    
    
    100
    %
   Cost of Sales.
 Cost of Sales as Percentage of Sales by Segment
 Nine months endedSeptember 302006
    
    2005RestatedAmmunition & Weapons Effects (AWE)
    
    
    84
    %
    
    
    104
    %Electronic Security (ES)
    
    
    51
    %
    
    
    59
    %Other
    
    
    60
    %
    
    
    56
    %Total
    
    
    71
    %
    
    
    85
    %
  28




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
    Selling and Administrative Expenses.
    Research and Development.
 Gain on fair value of Senior Subordinated Convertible Notes and warrants.
 29




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
  Other Income.
 Interest Income.
 Interest Expense.
 Pre-Tax Loss
 Pre-Tax Income (Loss) by Segment Before  the Cumulative Effect of Accounting Change
 Nine months endedSeptember 30,2006
    
    
    2005RestatedAmmunition & Weapons Effects
    
    $
    (3,027
    )
    
    $
    (14,002
    )Electronic Security
    
    
    (526
    )
    
    
    368Other
    
    
    (928
    )
    
    
    (1,528
    )Corporate
    
    
    (1,034
    )
    
    
    (1,612
    )$
    (5,515
    )
    
    $
    (16,774
    )
   30




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
    Income Taxes.
 Net Loss.
 Backlog.
 Backlog by SegmentSeptember 30, 2006
    
    
    September 30, 2005Percentage
    
    
    
    
    
    
    PercentageAmount
    
    
    of total
    
    
    Amount
    
    
    of totalAmmunition &
Weapons Effects
    
    $
    30,840
    
    
    
    54
    %
    
    $
    78,166
    
    
    
    77
    %Electronic Security
    
    
    23,574
    
    
    
    41
    %
    
    
    20,681
    
    
    
    21
    %Other
    
    
    3,204
    
    
    
    5
    %
    
    
    2,146
    
    
    
    2
    %$
    57,618
    
    
    
    100
    %
    
    $
    100,993
    
    
    
    100
    %
 31




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
  Liquidity and Cash Flows
      
    
    The Company intends to have in place, and is in the process of negotiating, a domestic
line of credit or other financing that will provide $4,000 to $5,000 of immediate liquidity with a provision
to accordion up to $20,000 based on financial performance in subsequent periods. This will
be contingent on successful registration of the March 2006 issue of convertible debentures
and warrants.
    
    The Company is exploring possible asset backed financing from local banks in Marshall,
TX. This will be contingent on successful registration of the March 2006 convertible
debentures and warrants.
 32




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 
    
    The Company is in discussions with the holders of the convertible debentures and other investors on a potential offering of $5,000 - $10,000 of subordinated notes.
    
    The Company is in discussions with the MECAR SA banking group to allow MECAR SA to repay ADG approximately $5,000 in intercompany loans and 2006 past due management fees.
    
    The Company is evaluating the disposition of certain non strategic assets.
    
    The Company has the option of issuing dividends of excess cash from its VSK Group at year end.
    
    The Company may further consolidate its California operations to further reduce operating expenses.
  Balance Sheet
        33




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Cash Flows
  Nine months ended September 302006
    
    2005RestatedNet cash used in operating activities
    
    $
    (3,337
    )
    
    $
    (25,933
    )Net cash used in investing activities
    
    $
    (4,976
    )
    
    $
    (5,460
    )Net cash provided by financing activities
    
    $
    19,941
    
    
    $
    13,733
 Operating Activities.
 Investing Activities.
 Financing Activities.
 Allied.
 MECAR.
 34




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
  VSK Group.
 Other Subsidiaries.
 Stock Repurchases.
 Off-Balance Sheet Arrangements.
 Trends
 
    
    The Company is focusing on solving its liquidity issues in late 2006 and early 2007.
    
    The Company expects a substantial rebound in 2007 operations after losses in the past.
    
    The Company expects a significant MECAR order from a principal customer in late 2006 or
early 2007. It is expected to be part of a multi-year (likely three years) substantial
purchase by the customer.
    
    The Company continues to work hard to expand MECARs market and expects further positive
results in 2007 from new customers.
    
    As weapon systems from U.S. and NATO forces, which utilize MECAR munitions, especially
the M393A3 105mm HEP round, are expected to be deployed to operational areas of conflict
during 2007, management expects meaningful orders for that munition in 2007.
    
    The Company has engaged in substantial business development efforts at the U.S.
subsidiaries (including the parent company, Allied). Various proposals for work have been
submitted and the Company is hopeful of some successes in late 2006 and in 2007.
    
    The Company has taken steps to reduce the operating costs of its U.S. operations, particularly by reducing the break even at the Marshall, Texas facility, and is
taking steps to reduce operating costs in its foreign operations,
    
    Titan is now operational and will continue to attempt to maximize work on its BES
contract.
    
    In summary, the Company expects that MECAR will rebound in 2007. The Company further
believes that it has taken the steps in 2006 to greatly improve operating results at its
U.S.-based operations.
 35




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 Critical Accounting Policies
   
    
    Revenue recognition via the percentage of completion method;
 
    
    Goodwill and intangible asset valuation;
 
    
    Inventory reserves and allowance for doubtful accounts;
 
    
    Derivative instruments;
 
    
    Valuation of deferred income taxes and income tax reserves.
  Recent Accounting Pronouncements
  Forward-Looking Statements
   36




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##### 



The Allied Defense Group, Inc.
MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2006
(Thousands of Dollars)
(Unaudited)
 
    
    substantial reliance on MECARs principal customers to continue to acquire products on a regular basis;
    
    the cyclical nature of the Companys military business;
    
    rapid technological developments and changes and the Companys ability to continue to introduce competitive
new products and services on a timely, cost effective basis;
    
    the ability of the Company to successfully continue to expand its business base;
    
    the ability of the Companys acquired businesses to mature and meet performance expectations;
    
    the mix of products/services;
    
    domestic and foreign governmental fiscal affairs and public policy changes which may affect the level of
purchases made by customers;
    
    changes in environmental and other domestic and foreign governmental regulations;
    
    changes in foreign currency exchange rates and interest rate fluctuation from market conditions;
    
    general risks associated with doing business outside the United States, including, without limitation,
import duties, tariffs, quotas and political and economic instability;
    
    the effects of terrorist actions on business activities, customer orders and cancellations, and the United
States and international governments responses to these terrorist actions;
    
    changes in government regulations;
    
    liability and other claims asserted against the Company;
    
    the ability to attract and retain qualified personnel; and
    
    continued availability of financing, financial instruments and financial resources in the amounts, at the
times, and on the terms required to support the Companys future business.
  37




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##### 



The Allied Defense Group, Inc.
September 30, 2006
 QUANTITATIVE AND QUALITATIVE MARKET RISK DISCLOSURE
    DISCLOSURE CONTROLS AND PROCEDURES
 Evaluation of disclosure controls and procedures
   38




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##### 



The Allied Defense Group, Inc.
September 30, 2006
 Changes in internal controls
  39




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##### 



The Allied Defense Group, Inc.
September 30, 2006
 PART II. OTHER INFORMATION
 Item 6 Exhibits
 Exhibit No.
    
    Description of Exhibits31.1
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.31.2
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.32
    
    Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
 40




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##### 



The Allied Defense Group, Inc.
 SIGNATURE
  THE ALLIED DEFENSE GROUP, INC./s/ Robert P. DowskiDate: November 14, 2006
    
    Robert P. DowskiChief Financial Officer andTreasurer
 41