**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 
| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                              |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                                |
| ** ** | **For the quarterly period ended September 30, 2005**                                                                                                                                                                                                                     |
| ** ** | ** **                                                                                                                                                                                                                                                                |
| **or**     |
| ** ** |                                                                                                                                                                                                                                                                      |
| **o**      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                             |
| ** ** | ** **                                                                                                                                                                                                                                                                |
| ** ** | **For the transition period  from                   to                   ** |

 

**Commission File Number: 1-4252**

 

**UNITEDINDUSTRIAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                   | ** ** | **95-2081809**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or organization) |       | (I.R.S. Employer Identification No.) |
|                                                           |       |                                 |
| **124 Industry Lane, Hunt Valley, Maryland**                   | ** ** | **21030**                            |
| (Address of principal executive offices)                       |       | (Zip Code)                           |

 

**(410) 628-3500**

(Registrant’s telephone number, includingarea code)

 

**Not Applicable**

(Former name, former address and former fiscal year, if changed sincelast report)

 
| ** ** | Indicate by check mark whether the registrant: (1) has filed all  reports required to be filed by Section 13 or 15(d) of the Securities  Exchange Act of 1934 during the preceding 12 months (or for such shorter  period that the registrant was required to file such reports), and (2) has  been subject to such filing requirements for the past 90 days.  Yes  ý   No  o |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                            |
| ** ** | Indicate by check mark whether the registrant is an accelerated filer  (as defined in Rule 12b-2 of the Exchange Act). Yes  ý   No  o                                                                                                                                                                                                                                              |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                            |
| ** ** | Indicate by check mark whether the registrant is a shell company (as  defined in Rule 12b-2 of the Exchange Act).   Yes  o   No  ý                                                                                                                                                                                                                                            |
| ** ** |                                                                                                                                                                                                                                                                                                                                                                                                                  |
| ** ** | Indicate the number of shares outstanding of each of the issuer’s  classes of common stock, as of the latest practicable date: 11,260,879 shares  of common stock as of October 20, 2005.                                                                                                                                                                                                                        |

 

 

----

 

**UNITED INDUSTRIAL CORPORATION**

 

INDEX

 
| ** **                                                                                           | **Page**                                                                                                           |
|------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------|
| PART I - FINANCIAL INFORMATION                                                                       |                                                                                                               |
|                                                                                                 |                                                                                                               |
| Item 1. Financial Statements                                                                         |                                                                                                               |
|                                                                                                 |                                                                                                               |   |
|                                                                                                 | Consolidated Condensed Balance Sheets -  September 30, 2005 and December 31, 2004                                  | 2 |
|                                                                                                 |                                                                                                               |   |
|                                                                                                 | Consolidated Condensed Statements of  Operations -  Three Months and Nine Months Ended September 30, 2005 and 2004 | 3 |
|                                                                                                 |                                                                                                               |   |
|                                                                                                 | Consolidated Condensed Statements of Cash  Flows -  Nine Months Ended September 30, 2005 and 2004                  | 4 |
|                                                                                                 |                                                                                                               |   |
|                                                                                                 | Notes to Consolidated Condensed Financial  Statements                                                              | 5 |
|                                                                                                 |                                                                                                               |   |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 29                                                                                                                 |
|                                                                                                 |                                                                                                               |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                  | 41                                                                                                                 |
|                                                                                                 |                                                                                                               |
| Item 4.  Controls and Procedures                                                                     | 41                                                                                                                 |
|                                                                                                 |                                                                                                               |
| PART II - OTHER INFORMATION                                                                          |                                                                                                               |
|                                                                                                 |                                                                                                               |
| Item 1. Legal Proceedings                                                                            | 42                                                                                                                 |
|                                                                                                 |                                                                                                               |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                 | 42                                                                                                                 |
|                                                                                                 |                                                                                                               |
| Item 6. Exhibits                                                                                     | 42                                                                                                                 |
|                                                                                                 |                                                                                                               |
| SIGNATURES                                                                                           | 43                                                                                                                 |

 

1

----

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1. - Financial Statements**

 

UNITED INDUSTRIAL CORPORATION ANDSUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS

*(Dollars in thousands)*

 
| ** **                                                                                                                                                                                                   | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| ASSETS                                                                                                                                                                                                       |       |                    |       |                   |       |
| Current assets:                                                                                                                                                                                              |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                    |       | $                       | 66,150     |                   | $          | 80,679 |   |
| Marketable equity securities                                                                                                                                                                                 |       | 13,109                  |       | —                 |       |
| Securities pledged to creditors                                                                                                                                                                              |       | —                  |       | 124,626                |       |
| Restricted cash                                                                                                                                                                                              |       | 4,812                   |       | 33,845                 |       |
| Trade receivables, net                                                                                                                                                                                       |       | 60,960                  |       | 46,658                 |       |
| Inventories                                                                                                                                                                                                  |       | 33,073                  |       | 34,639                 |       |
| Prepaid expenses and other current assets                                                                                                                                                                    |       | 10,095                  |       | 12,465                 |       |
| Assets of discontinued operations                                                                                                                                                                            |       | 11,878                  |       | 13,545                 |       |
| Total  current assets                                                                                                                                                                                        |       | 200,077                 |       | 346,457                |       |
| Deferred income taxes                                                                                                                                                                                        |       | 11,455                  |       | 13,930                 |       |
| Goodwill                                                                                                                                                                                                     |       | 4,833                   |       | —                 |       |
| Other assets                                                                                                                                                                                                 |       | 14,021                  |       | 11,953                 |       |
| Insurance receivable - asbestos litigation                                                                                                                                                                   |       | 20,343                  |       | 20,343                 |       |
| Property and equipment - less accumulated  depreciation (2005-$78,794; 2004-$85,762)                                                                                                                         |       | 40,204                  |       | 27,645                 |       |
|                                                                                                                                                                                                         |       | $                       | 290,933    |                   | $          | 420,328 |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                    |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                                                                         |       |                    |       |                   |       |
| Current portion of long-term debt                                                                                                                                                                            |       | $                       | 964        |                   | $          | 958 |   |
| Payable under securities loan agreement                                                                                                                                                                      |       | —                  |       | 124,619                |       |
| Accounts payable                                                                                                                                                                                             |       | 22,390                  |       | 21,664                 |       |
| Accrued employee compensation and taxes                                                                                                                                                                      |       | 18,163                  |       | 13,706                 |       |
| Other current liabilities                                                                                                                                                                                    |       | 15,387                  |       | 14,942                 |       |
| Liabilities of discontinued operations                                                                                                                                                                       |       | 13,177                  |       | 18,566                 |       |
| Total current liabilities                                                                                                                                                                                    |       | 70,081                  |       | 194,455                |       |
| Long-term debt                                                                                                                                                                                               |       | 121,053                 |       | 122,000                |       |
| Post-retirement benefit obligation other  than pension, and other long-term liabilities                                                                                                                      |       | 21,192                  |       | 22,942                 |       |
| Minimum  pension liability                                                                                                                                                                                   |       | 21,193                  |       | 17,513                 |       |
| Asbestos litigation liability                                                                                                                                                                                |       | 31,852                  |       | 31,852                 |       |
| Total liabilities                                                                                                                                                                                            |       | 265,371                 |       | 388,762                |       |
| Shareholders’ equity:                                                                                                                                                                                   |       |                    |       |                   |       |
| Preferred stock, par value $1.00 per share;  1,000,000 shares authorized;  none issued and outstanding                                                                                                       |       | —                  |       | —                 |       |
| Common stock, par value $1.00 per share;  30,000,000 shares authorized;  11,423,728 and 12,291,951 shares outstanding at September 30, 2005 and  December 31, 2004, respectively (net of shares in treasury) |       | 14,374                  |       | 14,374                 |       |
| Additional capital                                                                                                                                                                                           |       | 83,123                  |       | 84,296                 |       |
| Retained earnings                                                                                                                                                                                            |       | 30,331                  |       | 3,499                  |       |
| Treasury stock, at cost; 2,950,420 and  2,082,197 shares at  September 30, 2005 and December 31, 2004, respectively                                                                                          |       | (71,598                 | )          | (40,019                | )          |
| Accumulated other comprehensive loss, net  of tax                                                                                                                                                            |       | (30,668                 | )          | (30,584                | )          |
| Total shareholders’ equity                                                                                                                                                                              |       | 25,562                  |       | 31,566                 |       |
| Total liabilities and shareholders’ equity                                                                                                                                                              |       | $                       | 290,933    |                   | $          | 420,328 |   |

 

See accompanying notes to the consolidatedcondensed financial statements.

 

2

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UNITED INDUSTRIAL CORPORATION ANDSUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OFOPERATIONS

*(Dollars in thousands, except per shareamounts)*

(Unaudited)

* *
| ** **                                                                                                                                                                                                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                                                                                                                               | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                                                                                                                                                                                                                |       | $                                     | 126,402    |                                 | $          | 98,719 |   | $ | 353,878 |   | $ | 289,927 |   |
| Cost of sales                                                                                                                                                                                                                                            |       | 96,768                                |       | 73,958                               |       | 267,916 |   | 219,629 |   |
|                                                                                                                                                                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Gross profit                                                                                                                                                                                                                                             |       | 29,634                                |       | 24,761                               |       | 85,962 |   | 70,298 |   |
| Selling and administrative expenses                                                                                                                                                                                                                      |       | 14,318                                |       | 12,648                               |       | 45,268 |   | 34,846 |   |
| Other operating expenses, net                                                                                                                                                                                                                            |       | 280                                   |       | 87                                   |       | 804 |   | 273 |   |
| Operating income                                                                                                                                                                                                                                         |       | 15,036                                |       | 12,026                               |       | 39,890 |   | 35,179 |   |
| Non-operating income and (expense):                                                                                                                                                                                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Interest income                                                                                                                                                                                                                                          |       | 730                                   |       | 151                                  |       | 2,479 |   | 281 |   |
| Interest expense                                                                                                                                                                                                                                         |       | (1,424                                | )          | (254                                 | )          | (4,642 | ) | (280 | ) |
| Gain on sale of property                                                                                                                                                                                                                                 |       | —                                |       | —                               |       | 7,152 |   | — |   |
| Equity in net income of joint venture                                                                                                                                                                                                                    |       | 114                                   |       | 15                                   |       | 166 |   | 75 |   |
| Other income (loss), net                                                                                                                                                                                                                                 |       | (41                                   | )          | 72                                   |       | 796 |   | 160 |   |
|                                                                                                                                                                                                                                                     |       | (621                                  | )          | (16                                  | )          | 5,951 |   | 236 |   |
| Income from continuing operations before income  taxes                                                                                                                                                                                                   |       | 14,415                                |       | 12,010                               |       | 45,841 |   | 35,415 |   |
| Provision for income taxes                                                                                                                                                                                                                               |       | 5,101                                 |       | 4,266                                |       | 15,602 |   | 12,626 |   |
| Income from continuing operations                                                                                                                                                                                                                        |       | 9,314                                 |       | 7,744                                |       | 30,239 |   | 22,789 |   |
| Income (loss) from discontinued operations,  net of income tax provision of $330 and $736 for the three and nine months ended  September 30, 2005 and tax benefit of $147 and $505 for the three and nine  months ended September 30, 2004, respectively |       | 112                                   |       | (274                                 | )          | 305 |   | (939 | ) |
| Net income                                                                                                                                                                                                                                               |       | $                                     | 9,426      |                                 | $          | 7,470 |   | $ | 30,544 |   | $ | 21,850 |   |
|                                                                                                                                                                                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Basic earnings per share:                                                                                                                                                                                                                                |       |                                  |       |                                 |       |   |   |   |   |
| Income from continuing operations                                                                                                                                                                                                                        |       | $                                     | 0.80       |                                 | $          | 0.60 |   | $ | 2.52 |   | $ | 1.76 |   |
| Income (loss) from discontinued operations                                                                                                                                                                                                               |       | 0.01                                  |       | (0.02                                | )          | 0.02 |   | (0.07 | ) |
| Net income                                                                                                                                                                                                                                               |       | $                                     | 0.81       |                                 | $          | 0.58 |   | $ | 2.54 |   | $ | 1.69 |   |
| Diluted earnings per share:                                                                                                                                                                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Income from continuing operations                                                                                                                                                                                                                        |       | $                                     | 0.68       |                                 | $          | 0.57 |   | $ | 2.13 |   | $ | 1.70 |   |
| Income (loss) from discontinued operations                                                                                                                                                                                                               |       | 0.01                                  |       | (0.02                                | )          | 0.02 |   | (0.07 | ) |
| Net income                                                                                                                                                                                                                                               |       | $                                     | 0.69       |                                 | $          | 0.55 |   | $ | 2.15 |   | $ | 1.63 |   |

 

See accompanying notes to the consolidated condensed financialstatements.

 

3

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UNITED INDUSTRIAL CORPORATION ANDSUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

*(Dollars in thousands)*

(Unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 30,544     |   | $ | 21,850 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                |       |   |   |
| (Income) loss from discontinued operations,  net of taxes                          |       | (305                                | )          | 939 |   |
| Depreciation and amortization                                                      |       | 6,268                               |       | 4,149 |   |
| Gain on sale of property                                                           |       | (7,152                              | )          | — |   |
| Pension expense                                                                    |       | 3,680                               |       | 3,318 |   |
| Deferred income taxes                                                              |       | 2,664                               |       | 407 |   |
| Income from equity investment in joint  venture                                    |       | (166                                | )          | (75 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                |       |   |   |
| Increase in trade receivables                                                      |       | (11,930                             | )          | (22,030 | ) |
| Decrease (increase) in inventories                                                 |       | 2,247                               |       | (19,501 | ) |
| Decrease (increase) in prepaid expenses and  other current assets                  |       | 1,779                               |       | (754 | ) |
| Increase in customer advances                                                      |       | 398                                 |       | 3,897 |   |
| Increase in accounts payable, accruals and  other current liabilities              |       | 3,504                               |       | 13,204 |   |
| Decrease in long-term liabilities                                                  |       | (1,752                              | )          | (625 | ) |
| Other – net                                                                   |       | 859                                 |       | 138 |   |
| Net cash provided by operating activities  from continuing operations              |       | 30,638                              |       | 4,917 |   |
| Net cash used in discontinued operations                                           |       | (3,418                              | )          | (4,051 | ) |
| Net cash provided by operating activities                                          |       | 27,220                              |       | 866 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |                                |       |   |   |
| Purchases of property and equipment                                                |       | (18,278                             | )          | (2,864 | ) |
| Proceeds from sale of available-for-sale  securities                               |       | 124,626                             |       | — |   |
| Purchase of marketable equity securities                                           |       | (12,780                             | )          | — |   |
| Business acquisition, net of cash acquired                                         |       | (9,883                              | )          | — |   |
| Proceeds from sale of property                                                     |       | 7,555                               |       | — |   |
| Net cash provided by (used in) investing  activities                               |       | 91,240                              |       | (2,864 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |                                |       |   |   |
| Proceeds from issuance of long-term debt                                           |       | —                              |       | 120,000 |   |
| Debt issuance fees paid                                                            |       | —                              |       | (3,600 | ) |
| Repayment of long-term debt                                                        |       | (947                                | )          | (668 | ) |
| Repayment of collateral received from  securities lending transaction              |       | (124,619                            | )          | — |   |
| Decrease in restricted cash                                                        |       | 29,033                              |       | — |   |
| Proceeds from exercise of stock options                                            |       | 1,474                               |       | 3,352 |   |
| Dividends paid                                                                     |       | (3,705                              | )          | (3,881 | ) |
| Purchase of treasury shares                                                        |       | (34,225                             | )          | (34,842 | ) |
| Net cash (used in) provided by financing  activities                               |       | (132,989                            | )          | 80,361 |   |
| (Decrease) increase in cash and cash  equivalents                                  |       | (14,529                             | )          | 78,363 |   |
| Cash and cash equivalents at beginning of  year                                    |       | 80,679                              |       | 24,138 |   |
| Cash and cash equivalents at end of period                                         |       | $                                   | 66,150     |   | $ | 102,501 |   |

 

See accompanying notes to the consolidatedcondensed financial statements.

 

4

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UNITED INDUSTRIAL CORPORATION ANDSUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

**Note A - Basis of Presentation and Nature ofOperations**

 

The accompanying unaudited Consolidated Condensed Financial Statementsof United Industrial Corporation (“United Industrial”) and its subsidiaries(collectively, the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Rule 10-01 of RegulationS-X.  Accordingly, they do not includeall of the information and notes required by accounting principles generallyaccepted in the United States of America (GAAP) for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring items) considerednecessary for a fair presentation have been included.  Operating results for the three-month andnine-month periods ended September 30, 2005 are not necessarily indicative ofthe results that may be expected for the year ending December 31, 2005.  These unaudited Consolidated CondensedFinancial Statements should be read in conjunction with the ConsolidatedFinancial Statements and notes thereto included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2004.

 

On April 4, 2005, the Company acquired ESL Defence Limited (“ESL”), anelectronic warfare systems company based in the United Kingdom. The operatingresults of ESL have been included in the consolidated financial statements ofthe Company since April 4, 2005.

 

The Company conducts a significant amount of business with the U.S.Government.  No single customer otherthan the U.S. Government accounted for ten percent or more of consolidated netsales in any year.

 

The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements as well as reported amountsof revenues and expenses during the reporting period.  Actual results could differ from these estimatesand those differences could be material.

 

**Note B - Segment Information - ContinuingOperations**

 

The Company has two reportable segments: Defense and Energy.  The operations of the Defense and Energysegments are conducted principally through two wholly-owned subsidiaries, AAICorporation and its subsidiaries (“AAI”) and Detroit Stoker Company (“DetroitStoker”), respectively.  The Companymeasures its segment performance based on income (loss) before incometaxes.  Costs related to the continuing operationsthat are not identified with the two business segments primarily relate tofinancing costs and are grouped under the heading Other.  The Company has a transportation operationthat is accounted for as discontinued operations in the accompanying ConsolidatedCondensed Financial Statements.

 
| **(Dollars  in thousands)**                    | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Three Months Ended September 30, 2005          |       |        |       |       |       |      |       |       |       |
| Net sales                                      |       | $           | 116,815    |       | $          | 9,587     |       | $          | —     |   | $ | 126,402 |   |
| Gross profit                                   |       | 25,832      |       | 3,802      |       | —    |       | 29,634     |       |
| Income from equity investment in joint venture |       | 114         |       | —     |       | —    |       | 114        |       |
| Interest income (expense), net                 |       | 104         |       | 63         |       | (861      | )          | (694       | )          |
| Depreciation and amortization expense          |       | 2,185       |       | 73         |       |      |       | 2,258      |       |
| Income (loss) before income taxes              |       | 13,794      |       | 1,388      |       | (767      | )          | 14,415     |       |
|                                           |       |        |       |       |       |      |       |       |       |
| Nine Months Ended September 30, 2005           |       |        |       |       |       |      |       |       |       |
| Net sales                                      |       | $           | 328,586    |       | $          | 25,292    |       | $          | —     |   | $ | 353,878 |   |
| Gross profit                                   |       | 76,569      |       | 9,393      |       | —    |       | 85,962     |       |
| Income from equity investment in joint venture |       | 166         |       | —     |       | —    |       | 166        |       |
| Interest income (expense), net                 |       | 220         |       | 150        |       | (2,533    | )          | (2,163     | )          |
| Depreciation and amortization expense          |       | 6,045       |       | 223        |       |      |       | 6,268      |       |
| Income (loss) before income taxes              |       | 45,453      |       | 2,478      |       | (2,090    | )          | 45,841     |       |

 

5

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| **(Dollars in thousands)**                      | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|-------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Three Months Ended September 30, 2004           |       |        |       |       |       |      |       |       |       |
| Net sales                                       |       | $           | 90,143     |       | $          | 8,576     |       | $          | —     |   | $ | 98,719 |   |
| Gross profit                                    |       | 21,461      |       | 3,300      |       | —    |       | 24,761     |       |
| Income from equity investment in joint  venture |       | 15          |       | —     |       | —    |       | 15         |       |
| Interest income (expense), net                  |       | 49          |       | 5          |       | (157      | )          | (103       | )          |
| Depreciation and amortization expense           |       | 1,299       |       | 88         |       | —    |       | 1,387      |       |
| Income (loss) before income taxes               |       | 10,957      |       | 1,185      |       | (132      | )          | 12,010     |       |
|                                            |       |        |       |       |       |      |       |       |       |
| Nine Months Ended September 30, 2004            |       |        |       |       |       |      |       |       |       |
| Net sales                                       |       | $           | 266,510    |       | $          | 23,417    |       | $          | —     |   | $ | 289,927 |   |
| Gross profit                                    |       | 61,285      |       | 9,013      |       | —    |       | 70,298     |       |
| Income from equity investment in joint  venture |       | 75          |       | —     |       | —    |       | 75         |       |
| Interest income (expense), net                  |       | 482         |       | 21         |       | (502      | )          | 1          |       |
| Depreciation and amortization expense           |       | 3,889       |       | 260        |       | —    |       | 4,149      |       |
| Income (loss) before income taxes               |       | 33,192      |       | 2,648      |       | (425      | )          | 35,415     |       |

 

##### **Note C - Earnings Per Share**

 

Basic earnings per share for all periodspresented were computed by dividing net earnings for the respective period bythe weighted-average number of shares of the Company’s common stock outstandingduring the period.  Diluted earnings pershare was computed by dividing (i) net earnings during the period, adjusted toadd back the after-tax interest charges incurred on the Company’s $120,000,000aggregate principal amount of 3.75% Convertible Senior Notes due September 15,2024, by (ii) the weighted-average number of shares of Common Stock outstandingduring the period, adjusted to add the weighted-average number of potentialdilutive common shares that would have been outstanding upon the assumedexercise of stock options and conversion of the 3.75% Convertible Senior Notesfor Common Stock.

 

Options to purchase 189,000 shares of theCompany’s Common Stock for the nine months ended September 30, 2005 and optionsto purchase 25,000 shares of the Company’s Common Stock for the three and ninemonths ended September 30, 2004 were not included in the computation of dilutedearnings per share because their impact would be anti-dilutive.

Basic and diluted earnings per share amountswere computed as follows:

** **
| ** **                                         | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| **(Dollars in thousands, except  per share data)** | ** ** | **Earnings**                         | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** |
|                                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Basic Earnings Per Share                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                  |       | $                                    | 9,314      |   | 11,652,025 |   | $ | 0.80 |   | $ | 7,744 |   | 12,810,916 |   | $ | 0.60 |   |
|                                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities                      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Stock Options                                      |       | —                               |       | 286,421 |   |   |   | — |   | 487,288 |   |   |   |
| 3.75% Convertible Senior Notes                     |       | 855                                  |       | 3,058,356 |   |   |   | 148 |   | 498,645 |   |   |   |
| Diluted Earnings Per Share                         |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                  |       | $                                    | 10,169     |   | 14,996,802 |   | $ | 0.68 |   | $ | 7,892 |   | 13,796,849 |   | $ | 0.57 |   |

 

6

----

 
| ** **                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **(Dollars in thousands, except  per share data)** | ** ** | **Earnings**                        | ** ** | **Shares** | ** ** | **Per  Share** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Per  Share** | ** ** |
|                                               |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Basic Earnings Per Share                           |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                  |       | $                                   | 30,239     |   | 12,012,831 |   | $ | 2.52 |   | $ | 22,789 |   | 12,958,288 |   | $ | 1.76 |   |
|                                               |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities                      |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Stock Options                                      |       | —                              |       | 272,127 |   |   |   | — |   | 363,841 |   |   |   |
| 3.75% Convertible Senior Notes                     |       | 2,449                               |       | 3,058,356 |   |   |   | 148 |   | 167,428 |   |   |   |
| Diluted Earnings Per Share                         |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                  |       | $                                   | 32,688     |   | 15,343,314 |   | $ | 2.13 |   | $ | 22,937 |   | 13,489,557 |   | $ | 1.70 |   |

#####  

##### **Note D - Stock-Based Compensation**

 

For each of the three and nine month periods ended September 30, 2005and 2004, the Company accounted for its stock-based compensation plans inaccordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB No. 25”), and its related implementationguidance, whereby compensation cost for stock options is recognized in earningsbased on the excess, if any, of the quoted market price of the stock at thegrant date of the award or other measurement date over the amount an employeemust pay to acquire the stock.  Hadcompensation cost been determined consistent with the fair value method setforth under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accountingfor Stock-Based Compensation” (“SFAS No. 123”), as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation – Transition and Disclosure” (“SFAS No. 148”), forall awards under the plans, income and earnings per share from continuingoperations would have decreased to the pro forma amounts indicated below:

 
| ** **                                                                                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands, except per share data)**                                                                     | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income from continuing operations:                                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| As reported                                                                                                            |       | $                                     | 9,314      |                                 | $          | 7,744 |   | $ | 30,239 |   | $ | 22,789 |   |
| Deduct: Total employee stock-based compensation  expense determined under fair value method for all awards, net of tax |       | (198                                  | )          | (152                                 | )          | (665 | ) | (404 | ) |
| Pro forma                                                                                                              |       | $                                     | 9,116      |                                 | $          | 7,592 |   | $ | 29,574 |   | $ | 22,385 |   |
| Earnings per share from continuing  operations:                                                                        |       |                                  |       |                                 |       |   |   |   |   |
| As reported:                                                                                                           |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                                  |       | $                                     | 0.80       |                                 | $          | 0.60 |   | $ | 2.52 |   | $ | 1.76 |   |
| Diluted                                                                                                                |       | 0.68                                  |       | 0.57                                 |       | 2.13 |   | 1.70 |   |
| Pro forma:                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                                                                  |       | $                                     | 0.78       |                                 | $          | 0.59 |   | $ | 2.46 |   | $ | 1.73 |   |
| Diluted                                                                                                                |       | 0.66                                  |       | 0.56                                 |       | 2.09 |   | 1.67 |   |

 

7

----

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-BasedPayment” (“SFAS No. 123R”), which replaced SFAS No. 123 and superseded SFAS No.148 and APB No. 25 and its related implementation guidance.  SFAS No. 123R requires entities to recognizein their financial statements the cost of employee services received inexchange for awards of equity instruments based on the grant-date fair value ofthose awards (with limited exceptions). SFAS No. 123R is effective for the Company as of the interim period thatbegins January 1, 2006.  The Company hasnot yet determined which method of adoption it will select.  Any impact recognized in the fair value ofawards is not an allowable cost and will impact our net income.

#####  

##### **Note E – Marketable Equity Securities**

 

##### **Available-for-salesecurities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, onavailable-for-sale securities are excluded from earnings and are reported as aseparate component of other comprehensive income until realized.  Realized gains and losses from the sale ofavailable-for-sale securities are determined on a specific-identificationbasis.  Marketable equity securities atSeptember 30, 2005, represent common stock of one entity.  Management expects that these securities willbe sold within one year.  An unrealizedgain of $334,000 was recorded in other comprehensive income at September 30,2005.**

#####  

##### **Note F - Supplemental Balance Sheet and CashFlow Information**

 

Inventories consisted of the following components:

 
| **(Dollars in thousands)**         | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Finished goods and work-in-process |       | $                       | 31,071     |                   | $          | 33,384 |   |
| Materials and supplies             |       | 2,002                   |       | 1,255                  |       |
| Total inventories                  |       | $                       | 33,073     |                   | $          | 34,639 |   |

 

Other assets consisted of the following components:

 
| **(Dollars in thousands)**  | ** ** | **September 30,  2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------|------------|-------------------------|------------|-----------------------|------------|
| Intangibles, net            |       | $                       | 6,063      |                  | $          | 4,060 |   |
| Debt issuance costs, net    |       | 3,884                   |       | 4,620                 |       |
| Investment in joint venture |       | 1,782                   |       | 1,616                 |       |
| Other                       |       | 2,292                   |       | 1,657                 |       |
| Total other assets          |       | $                       | 14,021     |                  | $          | 11,953 |   |

 

Other current liabilities consisted of the following components:

 
| **(Dollars in thousands)**      | ** ** | **September 30,  2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------|------------|-------------------------|------------|-----------------------|------------|
| Customer advances               |       | $                       | 5,974      |                  | $          | 5,576 |   |
| Accrual for contract losses     |       | 2,486                   |       | 1,680                 |       |
| Accrued interest expense        |       | 224                     |       | 1,364                 |       |
| Accrued liabilities             |       | 4,070                   |       | 2,864                 |       |
| Other                           |       | 2,633                   |       | 3,458                 |       |
| Total other current liabilities |       | $                       | 15,387     |                  | $          | 14,942 |   |

 

Cash paid for Federal income taxes during thenine months ended September 30, 2005 and 2004 was $10,100,000 and $6,680,000respectively.  Cash paid for interestduring the nine months ended September 30, 2005 and 2004 was $4,550,000 and$53,000 respectively.

 

8

----

 

##### **Note G – Revolving Credit Facility**

#####  

On July 18, 2005, the Company and AAI Corporation, a wholly ownedsubsidiary of the Company (“AAI”), entered into a $100,000,000 four-yearrevolving credit agreement (the “Credit Agreement”) with a syndicate of sixbanks, consisting of SunTrust Bank, as administrative agent and issuing bank,Citibank, F.S.B., Key Bank, PNC Bank, Commerce Bank and Provident Bank.  The Credit Agreement provides for a creditfacility (the “Credit Facility”) consisting of a $100,000,000 Senior SecuredRevolving Credit Facility with a $5,000,000 Swing Line and a $100,000,000Letter of Credit sub-facility. The interest rate for loans made under thisfacility is thirty-day London Interbank Offered Rate (“LIBOR”) plus anapplicable margin between 1.25% and 2.00% based upon the Company’s leverageratio.  As of September 30, 2005 theCompany had $2,939,000 outstanding under the Letter of Credit sub-facility.

 

Pursuant to the terms of the Credit Agreement and the parent guarantyagreement dated as of July 18, 2005 (the “Parent Guaranty”), the Company has guarantiedAAI’s obligations.  In addition, certainof AAI’s subsidiaries entered into a subsidiary guaranty agreement, dated as ofJuly 18, 2005, whereby they guarantied the payment of AAI’s obligation underthe Credit Agreement (the “Subsidiary Guaranty”).  The proceeds of the Credit Facility will beused to fund future acquisitions, finance capital expenditures, provide workingcapital, fund letters of credit, and for other general corporate purposes.  The Credit Agreement contains affirmative,negative and financial covenants customary for facilities of this type,including, among other things, maintenance of certain leverage and fixed chargecoverage ratios, as well as minimum consolidated tangible net worth ratios,limits on the incurrence of debt and preferred equity, limits on the incurrenceof liens, a limit on the making of dividends or distributions, limits on salesof assets and a limit on capital expenditures.

 

In connection with the Credit Agreement, United Industrial, AAI andcertain of AAI’s subsidiaries entered into a security agreement, dated as ofJuly 18, 2005, whereby they granted the lenders under the Credit Agreement, afirst priority security interest in all of their assets.  The security interest was granted, withrespect to AAI, to secure its obligations under the Credit Agreement and otherloan documents to which it is a party, with respect to United Industrial, tosecure its obligations under the Parent Guaranty and other loan documents towhich it is a party, and with respect to AAI’s subsidiaries, to secure theirobligations under the Subsidiary Guaranty and other loan documents to whichthey are a party.

 

In connection with the Credit Agreement, United Industrial entered intoa parent pledge agreement, dated as of July 18, 2005, pursuant to which itpledged the capital stock of AAI to secure its obligations under the ParentGuaranty, the Credit Agreement, and other loan documents to which it is aparty.  In addition, AAI and certain ofits subsidiaries entered into a borrower pledge agreement, dated as of July 18,2005, pursuant to which they pledged the capital stock of their subsidiaries,with respect to AAI, to secure its obligations under the Credit Agreement andother loan documents to which it is a party, and with respect to itssubsidiaries, to secure their obligations under the Subsidiary Guaranty andother loan documents to which they are a party.

 

In connection with the Credit Agreement, AAI and certain of itssubsidiaries entered into an environmental indemnity agreement, dated as ofJuly 18, 2005, pursuant to which they agreed to indemnify the lenders under theCredit Agreement with respect to certain hazardous materials or environmentalconditions that may affect certain property that the lenders encumbered inconnection with the Credit Agreement.

 

9

----

 

##### **Note H – Secured Borrowing**

 

On December 29, 2004, the Company purchased $125,000,000 aggregateprincipal amount at maturity of U.S. treasury bills for $124,619,000, whichmatured on February 24, 2005.  TheCompany classified this investment as available-for-sale, which required it tobe reported at estimated fair value, with unrealized gains and losses, net oftax, reported as a separate component of Accumulated Other Comprehensive Lossin Shareholders’ Equity until realized. Concurrently with the purchase of the U.S. treasury bills on December29, 2004, the Company entered into a securities lending transaction with itsbroker-dealer, which matured on February 23, 2005 and was accounted for as asecured borrowing.  In exchange forlending the U.S. treasury bills to its broker-dealer, the Company received cashcollateral from its broker-dealer in an amount equal to 100% of the fair valueof the securities loaned, net of a $25,000,000 refundable deposit that remainedat its broker-dealer in a segregated, interest-bearing account.  At maturity on February 23, 2005, the Companyrepaid the cash collateral received, together with approximately $444,000 ofrelated interest charges.  Also atmaturity, the Company collected its $25,000,000 refundable deposit, togetherwith approximately $86,000 of related interest income earned.  During the first quarter of 2005, the Companyrealized a $7,500 loss on this investment, excluding approximately $373,000 ofinterest income received.

 

**Note I - Pension and Other Post-retirementBenefits**

 

The following table provides the components of net periodic pensionbenefit cost for the three and nine months ended September 30, 2005 and 2004:
| ** **                         | ** ** | **Pension Benefits  Three Months Ended  September 30,** | ** ** | **Pension Benefits  Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|
| **(Dollars  in thousands)**        | ** ** | **2005**                                                | ** ** | **2004**                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost                       |       | $                                                       | 819        |                                                   | $          | 736 |   | $ | 2,437 |   | $ | 2,236 |   |
| Interest cost                      |       | 2,576                                                   |       | 2,651                                                  |       | 7,733 |   | 7,794 |   |
| Expected return on plan assets     |       | (3,213                                                  | )          | (3,146                                                 | )          | (9,632 | ) | (9,460 | ) |
| Net amortization and deferral:     |       |                                                    |       |                                                   |       |   |   |   |   |
| Amortization of prior service cost |       | 69                                                      |       | 46                                                     |       | 207 |   | 136 |   |
| Amortization of actuarial loss     |       | 1,019                                                   |       | 1,200                                                  |       | 3,128 |   | 2,887 |   |
| Net periodic pension benefit cost  |       | $                                                       | 1,270      |                                                   | $          | 1,487 |   | $ | 3,873 |   | $ | 3,593 |   |

 

The following table provides the components of other post-retirementbenefit cost for the three and nine months ended September 30, 2005 and 2004:

 
| ** **                         | ** ** | **Other Post-retirement  Benefits  Three Months Ended  September 30,** | ** ** | **Other Post-retirement  Benefits  Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**        | ** ** | **2005**                                                               | ** ** | **2004**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost                       |       | $                                                                      | 48         |                                                                  | $          | 37 |   | $ | 143 |   | $ | 130 |   |
| Interest cost                      |       | 297                                                                    |       | 327                                                                   |       | 890 |   | 952 |   |
| Net amortization and deferral:     |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Amortization of prior service cost |       | (5                                                                     | )          | (11                                                                   | )          | (14 | ) | (31 | ) |
| Amortization of actuarial loss     |       | 3                                                                      |       | 41                                                                    |       | 9 |   | — |   |
| Other post-retirement benefit cost |       | $                                                                      | 343        |                                                                  | $          | 394 |   | $ | 1,028 |   | $ | 1,051 |   |

 

10

----

 

The following table provides the Company’s contributions to andbenefits paid under pension and other post-retirement benefit plans:

 
| ** **                                                                 | ** ** | **Pension Benefits  Nine Months Ended  September 30,** | ** ** | **Other Post-retirement  Benefits  Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**                                                | ** ** | **2005**                                               | ** ** | **2004**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                       |       |                                                   |       |                                                                  |       |   |   |   |   |
| Expected fiscal year contributions reported  at the end of the prior year: |       |                                                   |       |                                                                  |       |   |   |   |   |
| Employer                                                                   |       | $                                                      | 244        |                                                                  | $          | 259 |   | $ | 3,007 |   | $ | 2,572 |   |
| Employee                                                                   |       | —                                                 |       | —                                                                |       | — |   | 172 |   |
|                                                                       |       | 244                                                    |       | 259                                                                   |       | 3,007 |   | 2,744 |   |
|                                                                       |       |                                                   |       |                                                                  |       |   |   |   |   |
| Actual contributions made in the current  year                             |       | 193                                                    |       | 223                                                                   |       | 2,347 |   | 2,058 |   |
| Remaining contributions expected to be made  in the current year           |       | 51                                                     |       | 36                                                                    |       | 752 |   | 686 |   |
| Total expected current year contributions                                  |       | 244                                                    |       | 259                                                                   |       | 3,099 |   | 2,744 |   |
| Difference from expectations at end of the  prior year                     |       | $                                                      | —     |                                                                  | $          | — |   | $ | 92 |   | $ | — |   |

 

Effective July 1, 2004, the Company adopted FSP No. FAS 106-2 andincludes the effects of the Medicare Act of 2003 in its measurement of netperiodic post-retirement benefit cost and accumulated post-retirement benefit obligations(“APBO”).

 

**Note J - Other Operating Expenses, Net andOther Non-Operating Income, Net**

** **
| ** **                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands)**                                                       | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Other operating expenses, net                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Amortization of intangible assets                                                 |       | $                                     | 55         |                                 | $          | 55 |   | $ | 166 |   | $ | 166 |   |
| Amortization of facility consolidation  costs                                     |       | 47                                    |       | 64                                   |       | 136 |   | 210 |   |
| Amortization of deferred compensation  liability                                  |       | (16                                   | )          | (25                                  | )          | (48 | ) | (81 | ) |
| Asbestos litigation expense                                                       |       | 208                                   |       | —                               |       | 422 |   | — |   |
| Other (income) expense, net                                                       |       | (14                                   | )          | (7                                   | )          | 128 |   | (22 | ) |
| Total other operating expenses, net                                               |       | $                                     | 280        |                                 | $          | 87 |   | $ | 804 |   | $ | 273 |   |
|                                                                              |       |                                  |       |                                 |       |   |   |   |   |
| Other non-operating income (expense), net                                         |       |                                  |       |                                 |       |   |   |   |   |
| Royalties and commissions                                                         |       | $                                     | 23         |                                 | $          | 14 |   | $ | 41 |   | $ | 70 |   |
| Rental income                                                                     |       | 14                                    |       | 14                                   |       | 44 |   | 42 |   |
| Gain from change in fair value of embedded  derivatives underlying long-term debt |       | 81                                    |       | —                               |       | 382 |   | — |   |
| Other income (expense), net                                                       |       | (159                                  | )          | 44                                   |       | 329 |   | 48 |   |
| Total other non-operating income (expense),  net                                  |       | $                                     | (41        | )                                    | $          | 72 |   | $ | 796 |   | $ | 160 |   |

 

11

----

 

##### **Note K - Comprehensive Income**

 

The following table sets forth the componentsof other comprehensive income and total comprehensive income:

 
| ** **                                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands)**                            | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                             |       | $                                     | 9,426      |                                 | $          | 7,470 |   | $ | 30,544 |   | $ | 21,850 |   |
| Other comprehensive income (loss), net of  tax:        |       |                                  |       |                                 |       |   |   |   |   |
| Minimum pension liability, net of tax of  $627 in 2004 |       | —                                |       | —                               |       | — |   | 627 |   |
| Unrealized gain on marketable securities               |       | 179                                   |       | —                               |       | 334 |   | — |   |
| Loss on foreign currency translation                   |       | (176                                  | )          | —                               |       | (418 | ) | — |   |
| Total comprehensive income                             |       | $                                     | 9,429      |                                 | $          | 7,470 |   | $ | 30,460 |   | $ | 22,477 |   |

 

**Note L – Acquisitions**

 

On April 4, 2005, the Company acquired ESL, an electronic warfaresystems company based in the United Kingdom. The net purchase price was $10,363,000 in cash.  The operating results of ESL have beenincluded in the consolidated financial statements of the Company since April 4,2005.  The purchase price of thisbusiness has been preliminarily allocated to the estimated fair value of nettangible and intangible assets acquired, with any excess recorded as goodwill.  The estimates related to the acquired assetsand liabilities have not been finalized at September 30, 2005, specifically,the Company is awaiting the completion of the identification and valuation ofintangible assets acquired.  The Companyexpects these analyses to be completed by December 2005.

The following table summarizes the preliminary estimated fair value ofthe assets and liabilities assumed at April 4, 2005.

 

| **(Dollars in thousands)** | ** ** | **At April 4, 2005** | ** ** |
|----------------------------|------------|----------------------|------------|
|                       |       |                 |       |
| Cash and equivalents       |       | $                    | 479        |   |
| Current assets             |       | 3,054                |       |
| Property and equipment     |       | 384                  |       |
| Intangible assets          |       | 2,486                |       |
| Goodwill                   |       | 5,684                |       |
| Total assets acquired      |       | 12,087               |       |
|                       |       |                 |       |
| Current liabilities        |       | 1,724                |       |
| Total liabilities assumed  |       | 1,724                |       |
| Net assets acquired        |       | $                    | 10,363     |   |

 

The acquired intangible assets, all of which are being amortized andrelate primarily to contract related intangibles, have an estimated weightedaverage useful life of approximately seven years.  The goodwill is expected to be fullydeductible for U.S. tax purposes. Aggregate amortization expense for amortizingintangible assets was $173,010 at September 30, 2005.  Estimated amortization expense for the nextfive years is $258,691 in 2005, $342,724 in 2006, $342,724 in 2007, $342,724,in 2008, and $342,724 in 2009.  Thisacquisition is not considered to be material, so, pro-forma information is notpresented.

 

12

----

 

##### **Note M - Discontinued Operations**

 

Assets and liabilities of the discontinuedtransportation operations, which have been reclassified to Assets ofdiscontinued operations and Liabilities of discontinued operations andsummarized in the accompanying Consolidated Condensed Balance Sheets,respectively, were as follows:

 
| **(Dollars  in thousands)**               | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Current assets:                           |       |                    |       |                   |       |
| Trade receivables from affiliate          |       | $                       | 39,322     |                   | $          | 39,322 |   |
| Less allowances                           |       | (39,322                 | )          | (39,322                | )          |
| Prepaid expenses and other current assets |       | 51                      |       | 51                     |       |
| Deferred taxes                            |       | 11,827                  |       | 13,494                 |       |
| Other receivables from affiliate          |       | 12,957                  |       | 11,278                 |       |
| Less allowances                           |       | (12,957                 | )          | (11,278                | )          |
| Total current assets                      |       | $                       | 11,878     |                   | $          | 13,545 |   |
| Current liabilities:                      |       |                    |       |                   |       |
| Accounts payable                          |       | $                       | 174        |                   | $          | 937 |   |
| Accrued employee compensation and taxes   |       | 141                     |       | 164                    |       |
| Other current liabilities                 |       | 11,270                  |       | 11,270                 |       |
| Accrual for contract losses               |       | 1,592                   |       | 6,164                  |       |
| Other                                     |       | —                  |       | 31                     |       |
| Total current liabilities                 |       | $                       | 13,177     |                   | $          | 18,566 |   |

 

Summary results of the transportationoperations, which have been classified separately as discontinued operations,were as follows:

 
| ** **                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands)**                                                     | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                         |       | $                                     | —     |                                 | $          | — |   | $ | — |   | $ | — |   |
| Income (loss) before income taxes                                               |       | 442                                   |       | (421                                 | )          | 1,041 |   | (1,444 | ) |
| (Provision for) benefit from income taxes                                       |       | (330                                  | )          | 147                                  |       | (736 | ) | 505 |   |
| Income (loss) from discontinued  transportation operations, net of income taxes |       | $                                     | 112        |                                 | $          | (274 | ) | $ | 305 |   | $ | (939 | ) |

 
| ** **                                               | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|
| **(Dollars in thousands)**                               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Net cash provided by (used in) discontinued  operations: |       |                                  |       |   |   |
| Net income (loss)                                        |       | $                                     | 305        |   | $ | (939 | ) |
| Changes in operating assets and liabilities              |       | (787                                  | )          | (397 | ) |
| Increase in deferred income tax assets                   |       | 1,667                                 |       | 819 |   |
| Decrease in accrual for contract losses and  other       |       | (4,603                                | )          | (3,534 | ) |
| Net cash used in discontinued  transportation operations |       | $                                     | (3,418     | ) | $ | (4,051 | ) |

 

13

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**Note N - Commitments and Contingencies**

 

In the normal course of its continuing and discontinued business,various lawsuits, claims and legal proceedings have been or may be institutedor asserted against or by the Company. Based on currently available facts, the Company believes, except asotherwise set forth below, that the disposition of matters pending or assertedagainst the Company will not have a material adverse effect on the Company’sfinancial position, results of operations or liquidity.

 

ASBESTOS

 

History

 

United Industrial and Detroit Stoker, have been named as defendants inasbestos-related personal injury litigation. Neither United Industrial norDetroit Stoker fabricated, milled, mined, manufactured or marketed asbestos,and neither United Industrial nor Detroit Stoker made or sold insulationproducts or other construction materials that have been identified as theprimary cause of asbestos-related disease in the vast majority of claimants.Rather, United Industrial and Detroit Stoker made several products, some of theparts and components of which used asbestos-containing material fabricated andprovided by third parties. The use of asbestos-containing materials ceased inapproximately 1981.

 

Cases involving United Industrial and Detroit Stoker typically name 80to 120 defendants, although some cases have as few as 6 and as many as 250defendants. As of this date, United Industrial and Detroit Stoker have not goneto trial with respect to any asbestos-related personal injury claims, althoughthere is no assurance that trials may not occur in the future. Accordingly, asof this date, neither United Industrial nor Detroit Stoker have been requiredto pay any punitive damage awards, although there can be no assurance thismight not occur in the future. In addition, as of this date, some previouslypending claims have been settled or dismissed (with or without prejudice).  There is no assurance, however, thatdismissals and settlements will occur at the same rate, if at all, or thatclaims that have been dismissed without prejudice will not be re-filed.

 

Defenses

 

Management continues to believe that a majority of the claimants inpending cases will not be able to demonstrate that they have been exposed toUnited Industrial’s or Detroit Stoker’s asbestos-containing products orsuffered any compensable loss as a result of any such exposure. This belief isbased in large part on two factors: the limited number of asbestos-containingproducts and betterments sold by United Industrial and Detroit Stoker andUnited Industrial’s and Detroit Stoker’s access to sales, service, and otherhistorical business records going back over 100 years, which allow UnitedIndustrial and Detroit Stoker to determine to whom products were sold, the dateof sale, the installation site and, in some instances, the date products wereremoved from service. In addition, because of the limited and restrictedplacement of the asbestos-containing products, even at sites where a claimantcan verify his or her presence during the same period those products wereinstalled, liability cannot be presumed because, even if an individualcontracted an asbestos-related disease, not everyone who was employed at a sitewas exposed to United Industrial’s or Detroit Stoker’s asbestos-containingproducts.

 

These factors have allowed United Industrial and Detroit Stoker toeffectively manage their asbestos-related claims.

 

Settlements

 

To date, settlements of claims against United Industrial and/or DetroitStoker have been made without any admission of liability by United Industrialand/or Detroit Stoker. Settlement amounts may vary depending upon a number offactors, including the jurisdiction where the action was brought, the natureand extent of the disease alleged and the associated medical evidence, the ageand occupation of the claimant, the existence or absence of other possiblecauses of the claimant’s alleged illness, and the availability of legaldefenses, as well as whether the action is brought alone or as part of a groupof claimants. Before paying any settlement amount, United Industrial and/orDetroit Stoker require proof of exposure to their asbestos-containing productsand proof of injury to the plaintiff. In addition, the claimant is required toexecute a release of United Industrial, Detroit Stoker and associated parties,from any liability for asbestos-related injuries or claims.

 

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Insurance Coverage

 

The insurance coverage potentially available to United Industrial andDetroit Stoker is substantial. Following the institution of asbestoslitigation, an effort was made to identify all of United Industrial’s andDetroit Stoker’s primary and excess insurance carriers from 1940 through 1990.There were approximately 40 such carriers, all of which were put on notice ofthe litigation. In November of 1999, a Participation Agreement was entered intoamong United Industrial, Detroit Stoker and their primary insurance carriers.The Participation Agreement is an advance understanding that supplements all ofthe contracts of insurance, without altering the coverage of those contracts,that creates an administrative framework within which the insurers and UnitedIndustrial and Detroit Stoker can more efficiently and effectively manage thelarge quantity of on-going litigation.

 

Any party may terminate the Participation Agreement, without cause, bygiving the other parties 60 days prior written notice. Termination of the ParticipationAgreement does not affect any rights or obligations of the parties that haveaccrued under the Participation Agreement on or before the effective date ofthe termination, nor does it affect any rights outside of the ParticipationAgreement.

 

Although the carriers can opt out of the Participation Agreement on 60days notice, management does not believe that this will occur in the immediateor near term. For example, unless a carrier professes to have met the limits ofits liability, it would have to consider the potentially greater costs ofpermitting United Industrial and Detroit Stoker to handle their own cases.Further, opting out of the Participation Agreement does not exculpate liabilityon the part of the carrier.

 

United Industrial’s counsel retained a consulting firm with expertisein the field of evaluating insurance coverage and the likelihood of recoveryfor claims, such as costs incurred in connection with asbestos-related injuryclaims. In 2002, that firm worked with United Industrial to project theinsurance coverage of United Industrial and Detroit Stoker for asbestos-relatedclaims. The insurance consultant’s conclusions were based primarily on a reviewof United Industrial’s and Detroit Stoker’s coverage history, application ofreasonable assumptions on the allocation of coverage consistent with industrystandards, an assessment of the creditworthiness of the insurance carriers, andthe experience of and a review of the report of the asbestos liabilityconsultant described below. The insurance consultant also considered theParticipation Agreement.

 

Based on the assumptions employed by and the report prepared by theinsurance consultant, other variables, and the report prepared by the asbestosliability consultant, which is discussed below, the Company recorded anestimated insurance recovery as of December 31, 2002, of $20,343,000 reflectingthe estimate determined to be probable of being available to mitigate UnitedIndustrial’s and Detroit Stoker’s potential asbestos liability through2012.  The Company continuously evaluatesthis insurance receivable and believes it is appropriately valued at September30, 2005.

 

Quantitative Claims Information

 

As of September 30, 2005, United Industrial and/or Detroit Stoker werenamed in asbestos litigation pending in Arkansas, California, Louisiana,Michigan, Minnesota, Mississippi, New Jersey, New York and North Dakota. As ofSeptember 30, 2005, there were approximately 12,897 pending claims, compared toapproximately 21,123 pending claims as of December 31, 2004 and approximately21,114 pending claims as of September 30, 2004. During 2004, Detroit Stoker was named as a defendant in two cases inArkansas alleging personal injuries to one and approximately 199 plaintiffs,respectively, as a result of silica and/or refractory ceramic fiber exposure inaddition to asbestos exposure.  Thepleadings in these two cases name approximately 32 and 68 defendants,respectively, and include no allegations specific to Detroit Stoker.  Because claims are often filed and disposedof by dismissal or settlement in large numbers, the amount and timing ofsettlements and the number of open claims during a particular period canfluctuate from period to period and may not be indicative of the trend infuture claims, settlements or dismissals. In addition, most of these lawsuitsdo not include specific dollar claims for damages, and many include a number ofplaintiffs and multiple defendants. Therefore, the Company cannot provide anymeaningful disclosure about the total amount of the damages sought. Inaddition, the direct asbestos-related expenses of United Industrial and DetroitStoker for defense and indemnity for the past five years were not material.

 

A significant increase in the volume of asbestos-related bodily injurycases arose in Mississippi beginning in 2002 and extended through mid-year2003. Management believes this peak in the volume of claims in Mississippi wasdue to the passage of tort reform legislation (applicable to asbestos-relatedinjuries), which became effective at the end of 2002 and which resulted in alarge number of claims being filed in Mississippi by plaintiffs seeking toensure their claims would be governed by the law in effect prior to the passageof tort reform.

 

15

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In 2002, United Industrial’s counsel engaged a consulting firm withexpertise in the field of evaluating asbestos bodily-injury claims to assistUnited Industrial in projecting the future asbestos-related liabilities anddefense costs of United Industrial and Detroit Stoker. The methodology used bythis asbestos liability consultant to project future asbestos-related costs isbased primarily on estimates of the labor force exposed to asbestos in UnitedIndustrial’s and Detroit Stoker’s products, epidemiological modeling ofasbestos-related disease manifestation, and estimates of claim filings andsettlement and defense costs that may occur in the future. Using thisinformation, the asbestos liability consultant estimated the number of futureclaims that would be filed, as well as the related costs that would be incurredin resolving those claims. United Industrial’s and Detroit Stoker’s claimshistory prior to 2002 was not a significant variable in developing theestimates because such history was not significant as compared to the number ofclaims filed in 2002.

 

Projecting future asbestos costs is subject to numerous variables thatare extremely difficult to predict. In addition to the significantuncertainties surrounding the number of claims that might be received, othervariables include the type and severity of the disease alleged by eachclaimant, the long latency period associated with asbestos exposure, dismissalrates, costs of medical treatment, the impact of bankruptcies of othercompanies that are co-defendants in claims, uncertainties surrounding thelitigation process from jurisdiction to jurisdiction and from case to case, andthe impact of potential changes in legislative or judicial standards.Furthermore, any predictions with respect to these variables are subject toeven greater uncertainty as the projection period lengthens. In light of theseinherent uncertainties, United Industrial’s and Detroit Stoker’s limited claimshistory prior to 2002 and consultation with the asbestos and insuranceconsultants, the Company believes that ten years is the most reasonable periodfor recognizing a reserve for future costs, and that costs that might beincurred after that period were not reasonably estimable.  As a result, the Company also believes thatits ultimate net asbestos-related contingent liability (i.e. its indemnity orother claim disposition costs plus related legal fees less insurancerecoveries) cannot be estimated with certainty.

 

Based on the assumptions employed by and the report prepared by theasbestos liability consultant and other variables, the Company recorded anundiscounted liability for its best estimate of bodily injury liabilities forasbestos-related matters in the amount of $31,852,000 as of December 31, 2002,including damages and defense costs.

 

Given the inherent uncertainty in making future projections and thatUnited Industrial and Detroit Stoker periodically receive potentially materialnew information from claimants and their counsel that relates to the factualbasis of their asserted and unasserted claims, United Industrial and DetroitStoker plan on a periodic basis, to have either (1) the key assumptions used inprojecting the future asbestos-related liabilities and defense costs of UnitedIndustrial and Detroit Stoker validated or (2) the projections of current andfuture asbestos claims re-examined, and United Industrial and Detroit Stokerwill update them if needed based on the experience of United Industrial andDetroit Stoker and other relevant factors, such as changes in the tort systemand the resolution of bankruptcies of various asbestos defendants.

 

In connection with the preparation of its annual report on Form 10-Kfor the year ended December 31, 2004, United Industrial provided the asbestosconsulting firm with updated information regarding asbestos cases filed againstUnited Industrial and/or Detroit Stoker, and asked the consulting firm toperform a validation of its 2002 report. In particular, the consulting firm was asked if it would use the samemethodology to calculate future asbestos liability and if the assumptions usedin 2002 are still valid.  The consultingfirm reported that nothing had come to their attention in the intervening periodthat would call into question the central assumptions underlying the report, orthe report’s ten-year estimate of United Industrial’s and Detroit Stoker’sfuture potential liability.  The Company’sasbestos liability was $31,852,000 and $31,334,000 at September 30, 2005 and2004, respectively, and its insurance receivables for asbestos-relatedliabilities were $20,343,000 and $20,236,000 at September 2005 and 2004,respectively.  These figures reflect theCompany’s policy of maintaining a ten-year estimate of future liability, theperiod in which such costs are deemed to be reasonably estimable.

 

In light of the asbestos liability consultant’s reports and based uponthe facts as now known, including the reasonable possibility that claims willbe received and paid over the next 50 year period, the Company believes thatalthough asbestos claims could have a material adverse effect on the Company’sfinancial condition or results of operations in a particular reporting period,asbestos claims should not have a material adverse effect on the Company’s longterm financial condition, liquidity or results of operations. No assurances canbe given, however, as to the actual amount of United Industrial’s and DetroitStoker’s liability for such present and future claims or the amount ofinsurance recoveries (including any recoveries from liquidating excessinsurance carriers), and the differences from estimated amounts could bematerial.

 

16

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Reform Legislation

 

The outlook for federal legislation to provide national asbestoslitigation reform continues to be uncertain. Also uncertain is whether, and towhat extent, United Industrial and Detroit Stoker would be required to makecontributions to a prospective national asbestos trust pursuant to suchlegislation. No assurances can be given that a proposed trust or any otherasbestos legislation will ultimately become law, or when such action mightoccur.

 

STATE OF ARIZONA DEPARTMENT OF ENVIRONMENTAL QUALITY V. UIC, ET AL.

 

On May 19, 1993, United Industrial was named as one of three defendantsin a civil action brought pursuant to the Comprehensive Environmental ResponseCompensation and Liability Act (“CERCLA”) by the Arizona Department ofEnvironmental Quality (“ADEQ”) in the United States District Court for the Districtof Arizona. ADEQ sought remediation of a manufacturing site in the State ofArizona operated by U.S. Semiconductor Products, Inc. (“U.S. Semiconductor”), amanufacturer of semiconductors formerly owned by United Industrial. ADEQalleged that from 1959 until United Industrial sold U.S. Semiconductor in 1961,U.S. Semiconductor disposed of tricholoroethylene, a “hazardous substance,” andother hazardous substances under CERCLA, onto the ground and into various pitsand drains located on the site.

 

In 1996, United Industrial entered into a consent decree with ADEQ.Pursuant to the consent decree, United Industrial is required to complete aRemedial Investigation/Feasibility Study (“RI/FS”), pay $125,000 for pastresponse costs, pay quarterly Arizona oversight costs (averaging less than$10,000 annually) and pay $125,000 for future response costs plus a graduatedpercentage of the cleanup costs for the site if those costs are in excess of$10,000,000 but less than $40,000,000. United Industrial’s liability for futureresponse costs under the consent decree is capped at $1,780,000 in addition tothe $125,000 that United Industrial has already paid. In connection with theRI/FS, United Industrial has retained and is paying for an environmentalconsultant.  The Remedial Investigationwas submitted to ADEQ for approval on March 31, 2004 and was approved by ADEQon August 9, 2004.  In March 2005, ADEQissued its Proposed Remedial Objectives Report for public comment.  ADEQ received no substantive comments regardingthe report, and in May 2005, ADEQ issued is final Remedial ObjectivesReport.  United Industrial is required tosubmit to ADEQ a Feasibility Study and Proposed Remedies to meet ADEQ’s May2005 Remedial Objectives.  Managementbelieves that it will reach closure with ADEQ on all RI/FS issues on anacceptable basis to United Industrial following approval of the FeasibilityStudy.  No assurances can be given,however, as to the actual extent to which United Industrial may be determinedto have further liability, if at all.

 

MICHIGAN DEPARTMENT OF NATURAL RESOURCES

 

Detroit Stoker was notified in March 1992 by the Michigan Department ofNatural Resources (“MDNR”) that it is a potentially responsible party inconnection with the cleanup of a former industrial landfill located in Port ofMonroe, Michigan. MDNR is treating the Port of Monroe landfill site as acontaminated facility within the meaning of the Michigan Environmental ResponseAct (“MERA”). Under MERA, if a release or potential release of a discardedhazardous substance is or may be injurious to the environment or to the publichealth, safety or welfare, MDNR is empowered to undertake or compelinvestigation and response activities in order to alleviate any contaminationthreat.  Management believes DetroitStoker would be considered a de minimis potentially responsible party and doesnot believe that the resolution of this matter will have a materially adverseeffect on United Industrial’s or Detroit Stoker’s financial condition orresults of operations. No assurances can be given, however, as to the actualextent to which Detroit Stoker may be determined to be liable, if at all.

 

OTHER LEGAL MATTERS

 

Departments and agencies of the U.S. Government have the authority atmany levels to investigate transactions and operations of the Company, and theresults of such investigations may lead to administrative, civil, or criminalproceedings, the ultimate outcome of which could be fines, penalties,repayments or compensatory or treble damages. Agencies that oversee contractperformance include: the Defense Contract Audit Agency, the Department ofDefense Inspector General, the General Accounting Office, the Department ofJustice, the Department of State, and Congressional Committees.  U.S. Government regulations provide thatcertain findings against a contractor may lead to suspension or debarment fromfuture U.S. Government contracts or the loss of export privileges for a companyor an operating division or subdivision.

 

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The Company has in place international and domestic compliance policiesand procedures, including training of employees. From time to time, the Companyreceives allegations of improper conduct relating to its operations, includingoperations subject to the U.S. Foreign Corrupt Practices Act and other U.S.domestic and international laws. When the Company receives any suchallegations, it conducts internal (and if necessary, external) investigationsto determine whether there is support for any such allegations.  An investigation is ongoing in response toallegations provided to Company management of improper payments to foreigngovernment officials and improper invoicing. External counsel has been retainedby the Audit Committee of the Company’s Board of Directors to determine ifthere is support for any such allegations, and to review the Company’scompliance policies and procedures, and the Company is cooperating fully withcounsel.  In addition, appropriategovernment agencies have been advised of this investigation.  The Company is cooperating with theirrequests for information. The investigation by external counsel, which iscontinuing, has thus far not revealed any prior involvement or knowledge regardingthe allegations by any officer or director of United Industrial. At the currentstage of this investigation, any ultimate liability is not presentlydeterminable.

 

PERFORMANCE GUARANTIES

 

In connection with certain contracts, United Industrial’s operatingsubsidiaries have committed to certain performance guaranties existing atSeptember 30, 2005. The ability to perform under these guaranties may, in part,be dependent on the performance of other parties, including partners andsubcontractors. If United Industrial’s operating subsidiaries are unable tomeet these performance obligations, the performance guaranties could have amaterial adverse effect on profit margins and the Company’s results ofoperations, liquidity or financial position. United Industrial’s operatingsubsidiaries monitor the progress of their partners and subcontractors, andUnited Industrial and its operating subsidiaries do not believe that theperformance of these partners and subcontractors will adversely affect thesecontracts.  No assurances can be given,however, as to the liability of United Industrial’s operating subsidiaries ifpartners or subcontractors are unable to perform their obligations.

 

DISCONTINUED TRANSPORTATION OPERATION

 

## MUNI Contract

 

In connection with the discontinued Transportation operations, AAI owns35% of Electric Transit, Inc. (“ETI”). Skoda a.s. (“Skoda”), a Czech company, owns the remaining 65% ofETI.  ETI’s one remaining productioncontract with the San Francisco Municipal Railway (“MUNI”) involves the designand manufacture of 273 electric trolley buses (“ETBs”). In executing itscontract with MUNI, ETI entered into subcontracts with AAI, certain Skodaoperating affiliates and others. AAI and the Skoda operating affiliates havecompleted delivery of their respective scopes of work to support the deliveryof the ETB’s to MUNI and the Skoda operating affiliates are now subject towarranty requirements. Skoda’s operating affiliates have continued to deliverproducts and services under their subcontracts with ETI through September 2005.

 

Following Skoda’s bankruptcy declaration in 2001 in the Czech Republic,effective as of 2002, AAI began recording 100%, instead of 35%, of ETI’s lossesand income in accordance with the equity method of accounting applicable tominority shareholders.  Although AAI hascompleted performance on its subcontract with ETI on the MUNI contract, AAI hascontinued to provide ETI with personnel and other financial support in order toenable ETI to satisfy certain of its remaining commitments to MUNI.

 

As of April 22, 2004, ETI and MUNI finalized an agreement to modify theoriginal MUNI contract (“Modification No. 6”) under which ETI assigned itsremaining subcontractor obligations to MUNI and MUNI relieved ETI of itswarranty, performance and certain related bonding obligations, as well as otherobligations under its ETB contract with MUNI, except for the performance of adefined scope of work related to modifications of ETB hardware, which have beencompleted.

 

In conjunction with Modification No. 6, AAI executed a guarantyagreement with MUNI as of April 22, 2004 (the “Guaranty Agreement”) thatassures performance of certain of ETI’s obligations under Modification No. 6.In conjunction with the Guaranty Agreement, AAI obtained a release from itssubcontrctor warranty and all further obligations under its subcontract inexchange for a cash payment to MUNI of $500,000 and other consideration.  AAI’s sole remaining

 

18

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obligation under the Guaranty Agreement is to provide the services ofthree engineers and one purchasing expediter through April 2006.  The Company believes that it has adequatelyprovided for its obligations under the Guaranty Agreement in its existing lossreserves.

 

As required by MUNI, ETI obtained a surety bond to guaranty payment toall those providing labor and materials to ETI in furtherance of itsperformance under the MUNI contract.  AAIagreed to indemnify the surety, if necessary, for up to $14,800,000 on thislabor and materials bond, representing 35% of the original face value of thebond (in proportion to AAI’s equity interest in ETI). On November 18, 2003, AAIprovided the surety with notice of its claim against the labor and materialsbond for unpaid receivables in connection with AAI’s MUNI subcontract from ETI,totaling in excess of $47,000,000, the maximum penal sum of the labor andmaterials bond. AAI’s payment rights under the labor and materials bond (amongother claims) are currently at issue in a case before the Federal court in theNorthern District of California.  Priorto final adjudication of this case, there can be no assurances as to the amountor timing of a recovery by AAI, if any, on its claim on the labor and materialsbond.  To date no amount of recovery hasbeen recorded by AAI.

 

##### **Note O – Dividends**

 

The Company’s Board of Directors declared a dividend of $0.10 per shareon its common stock for each quarter for the nine months ended September 30,2005 and 2004.

 

| **For the quarter ended** | ** ** | **Total amount dividends paid** | ** **      | **Date dividends were paid** | ** **      |
|---------------------------|------------|---------------------------------|-----------------|------------------------------|-----------------|
| March 31, 2005            |       | $                               |  1,230,089 |                         | March 31, 2005  |   |
| June 30, 2005             |       | $                               |  1,234,479 |                         | May 30, 2005    |   |
| September 30, 2005        |       | $                               |  1,239,459 |                         | August 31, 2005 |   |
| March 31, 2004            |       | $                               |  1,313,236 |                         | March 31, 2004  |   |
| June 30, 2004             |       | $                               |  1,292,646 |                         | May 28, 2004    |   |
| September 30, 2004        |       | $                               |  1,305,109 |                         | August 17, 2004 |   |

 

**Note P – Issuer Purchases of EquitySecurities**

 

On September 7, 2005, the Board of Directorsof the Company authorized a stock purchase plan for up to $15,000,000.  The Company repurchased a total of 262,578shares with an average price of $35.22 during the three months ended September30, 2005.  As of September 30, 2005,there remained $5,744,000 available under the subject authorization for futurepurchases.  During October 2005, anadditional 163,049 shares were purchased with an average purchase price of$35.16, utilizing the remaining funds under the plan.

 

On March 10, 2005, the Company’s Board ofDirectors of the Company authorized a stock purchase plan for up to$25,000,000.  During the first six monthsof 2005, a total of 735,345 shares were repurchased under the plan for anaggregate amount of $25,000,000, or an average price of $33.97 per share,utilizing all funds available under the March 10, 2005 stock purchase plan.

 

In September 2004, the Company purchased850,400 shares of its Common Stock for approximately $24,356,000, or $28.64 pershare, using a portion of the net proceeds from the issuance and sale inSeptember 2004 of the 3.75% Convertible Senior Notes.  These shares were purchased concurrently withthe sale of the 3.75% Convertible Senior Notes in privately negotiatedtransactions.

 

In November 2003, the Board of Directors of the Company authorized thepurchase of up to $10,000,000 of the Company’s Common Stock.  On March 10, 2004, the Company’s Board ofDirectors extended the plan for one additional year through March 15, 2005, andauthorized the purchase of up to an additional $10,000,000 of CommonStock.  From inception of this plan inNovember 2003 to its expiration on March 15, 2005, the Company had purchased atotal of 917,700 shares for $16,522,000, or an average of $18.00 pershare.  The remaining $3,478,000 was notused and expired on March 15, 2005.

 

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**Note Q - Restructuring Charges**

** **
| **(Dollars in thousands)**            | ** ** | **Severance** | ** ** | **Employee  Relocation** | ** ** | **Facility  Relocation** | ** ** | **Facility  Closing  Costs** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|---------------|------------|--------------------------|------------|--------------------------|------------|------------------------------|------------|-----------|------------|
|                                  |       |          |       |                     |       |                     |       |                         |       |      |       |
| **Defense  segment**                  |       |          |       |                     |       |                     |       |                         |       |      |       |
| Reserve balance at December 31, 2004  |       | $             | 160        |                     | $          | 169                      |       | $                            | 74         |      | $          | — |   | $ | 403 |   |
| Restructuring charges                 |       | 349           |       | 418                      |       | —                   |       | 1,161                        |       | 1,928     |       |
| Paid or otherwise settled             |       | (436          | )          | (587                     | )          | (74                      | )          | (1,161                       | )          | (2,258    | )          |
| Reserve balance at September 30, 2005 |       | $             | 73         |                     | $          | —                   |       | $                            | —     |      | $          | — |   | $ | 73 |   |
|                                  |       |          |       |                     |       |                     |       |                         |       |      |       |
| **Energy  segment**                   |       |          |       |                     |       |                     |       |                         |       |      |       |
| Reserve balance at December 31, 2004  |       | $             | —     |                     | $          | —                   |       | $                            | —     |      | $          | — |   | $ | — |   |
| Restructuring charges                 |       | 88            |       | —                   |       | 61                       |       | 84                           |       | 233       |       |
| Paid or otherwise settled             |       | (88           | )          | —                   |       | (61                      | )          | (84                          | )          | (233      | )     |
| Reserve balance at September 30, 2005 |       | $             | —     |                     | $          | —                   |       | $                            | —     |      | $          | — |   | $ | — |   |

 

**Note R - Supplemental Guarantor Information**

 

In September 2004, United Industrial issuedand sold $120,000,000 aggregate principal amount of 3.75% Convertible SeniorNotes, which are fully and unconditionally guarantied by AAI, the Company’swholly-owned subsidiary that constitutes the Defense segment.  The 3.75% Convertible Senior Notes are notguarantied by Detroit Stoker, the Company’s wholly-owned subsidiary thatconstitutes the Energy segment.  Thefollowing condensed consolidating financial information sets forth supplementalinformation for United Industrial, the parent company, AAI, the guarantorsubsidiary, and Detroit Stoker, the non-guarantor subsidiary, as of September30, 2005 and December 31, 2004, and for the three-month and nine-month periodsended September 30, 2005 and 2004.

 

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CONDENSED CONSOLIDATING FINANCIAL INFORMATION

 

CONDENSED CONSOLIDATING BALANCE SHEETS

As of September 30, 2005

(Dollars in thousands)

(Unaudited)

 
| ** **                                 | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| ASSETS                                     |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current Assets                             |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Cash and cash equivalents                  |       | $                                             | 52,335     |                                                 | $          | 3,272                                           |       | $                | 10,543     |                                                   | $          | — |   | $ | 66,150 |   |
| Marketable equity securities               |       | 13,109                                        |       | —                                               |       | —                                          |       | —           |       | 13,109                                                 |       |
| Securities pledged to creditors            |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Restricted cash                            |       | —                                        |       | 4,812                                                |       | —                                          |       | —           |       | 4,812                                                  |       |
| Trade receivables, net                     |       | 459                                           |       | 56,331                                               |       | 4,170                                           |       | —           |       | 60,960                                                 |       |
| Inventories                                |       | (516                                          | )          | 30,616                                               |       | 2,973                                           |       | —           |       | 33,073                                                 |       |
| Other current assets                       |       | 991                                           |       | 8,488                                                |       | 815                                             |       | (199             | )          | 10,095                                                 |       |
| Assets of discontinued operations          |       | —                                        |       | 11,878                                               |       | —                                          |       | —           |       | 11,878                                                 |       |
| Total  current assets                      |       | 66,378                                        |       | 115,397                                              |       | 18,501                                          |       | (199             | )          | 200,077                                                |       |
| Insurance receivable - asbestos litigation |       | —                                        |       | —                                               |       | 20,343                                          |       | —           |       | 20,343                                                 |       |
| Property and equipment, net                |       | —                                        |       | 38,390                                               |       | 1,814                                           |       |             |       | 40,204                                                 |       |
| Other assets                               |       | 11,520                                        |       | 33,406                                               |       | 2,493                                           |       | (17,110          | )          | 30,309                                                 |       |
| Intercompany receivables                   |       | —                                        |       | 293                                                  |       | —                                          |       | (293             | )          | —                                                 |       |
| Investment in consolidated subsidiaries    |       | 76,806                                        |       | —                                               |       | —                                          |       | (76,806          | )          | —                                                 |       |
|                                       |       | $                                             | 154,704    |                                                 | $          | 187,486                                         |       | $                | 43,151     |                                                   | $          | (94,408 | ) | $ | 290,933 |   |
|                                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| LIABILITIES AND SHAREHOLDERS’EQUITY   |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current portion of long-term debt          |       | $                                             | —     |                                                 | $          | 964                                             |       | $                | —     |                                                   | $          | — |   | $ | 964 |   |
| Other current liabilities                  |       | 3,869                                         |       | 62,021                                               |       | 5,606                                           |       | (15,556          | )          | 55,940                                                 |       |
| Liabilities of discontinued operations     |       | —                                        |       | 13,177                                               |       | —                                          |       | —           |       | 13,177                                                 |       |
| Total current liabilities                  |       | 3,869                                         |       | 76,162                                               |       | 5,606                                           |       | (15,556          | )          | 70,081                                                 |       |
| Long-term debt                             |       | 120,000                                       |       | 1,053                                                |       | —                                          |       | —           |       | 121,053                                                |       |
| Asbestos litigation liability              |       | —                                        |       | —                                               |       | 31,852                                          |       | —           |       | 31,852                                                 |       |
| Other long-term liabilities                |       | 2,809                                         |       | 44,835                                               |       | 11,851                                          |       | (17,110          | )          | 42,385                                                 |       |
| Intercompany (receivables) payables        |       | 35,199                                        |       | (50,633                                              | )          | 345                                             |       | 15,089           |       | —                                                 |       |
| Shareholders’ equity (deficit)        |       | (7,173                                        | )          | 116,069                                              |       | (6,503                                          | )          | (76,831          | )          | 25,562                                                 |       |
|                                       |       | $                                             | 154,704    |                                                 | $          | 187,486                                         |       | $                | 43,151     |                                                   | $          | (94,408 | ) | $ | 290,933 |   |

 

21

----

 

CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2004

(Dollars in thousands)

 
| ** **                                 | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| ASSETS                                     |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current  assets:                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Cash and cash equivalents                  |       | $                                             | 129        |                                                 | $          | 72,269                                          |       | $                | 8,281      |                                                   | $          | — |   | $ | 80,679 |   |
| Securities pledged to creditors            |       | 124,626                                       |       | —                                               |       | —                                          |       | —           |       | 124,626                                                |       |
| Restricted cash                            |       | 25,000                                        |       | 8,845                                                |       | —                                          |       | —           |       | 33,845                                                 |       |
| Trade receivables, net                     |       | 17                                            |       | 44,152                                               |       | 2,489                                           |       | —           |       | 46,658                                                 |       |
| Inventories                                |       | —                                        |       | 31,957                                               |       | 2,682                                           |       | —           |       | 34,639                                                 |       |
| Other current assets                       |       | 3,295                                         |       | 8,283                                                |       | 909                                             |       | (22              | )          | 12,465                                                 |       |
| Assets of discontinued operations          |       | —                                        |       | 13,545                                               |       | —                                          |       | —           |       | 13,545                                                 |       |
| Total  current assets                      |       | 153,067                                       |       | 179,051                                              |       | 14,361                                          |       | (22              | )          | 346,457                                                |       |
| Insurance receivable - asbestos litigation |       | —                                        |       | —                                               |       | 20,343                                          |       | —           |       | 20,343                                                 |       |
| Property and equipment, net                |       | —                                        |       | 25,643                                               |       | 2,002                                           |       | —           |       | 27,645                                                 |       |
| Other assets                               |       | 12,258                                        |       | 25,844                                               |       | 2,499                                           |       | (14,718          | )          | 25,883                                                 |       |
| Intercompany receivables                   |       | —                                        |       | 141                                                  |       | —                                          |       | (141             | )          | —                                                 |       |
| Investment in consolidated subsidiaries    |       | 78,050                                        |       | —                                               |       | —                                          |       | (78,050          | )          | —                                                 |       |
|                                       |       | $                                             | 243,375    |                                                 | $          | 230,679                                         |       | $                | 39,205     |                                                   | $          | (92,931 | ) | $ | 420,328 |   |
|                                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY  |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current liabilities:                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current portion of long-term debt          |       | $                                             | —     |                                                 | $          | 958                                             |       | $                | —     |                                                   | $          | — |   | $ | 958 |   |
| Payable under securities loan agreement    |       | 124,619                                       |       | —                                               |       | —                                          |       | —           |       | 124,619                                                |       |
| Other current liabilities                  |       | 5,466                                         |       | 41,179                                               |       | 3,689                                           |       | (22              | )          | 50,312                                                 |       |
| Liabilities of discontinued operations     |       | —                                        |       | 18,566                                               |       | —                                          |       | —           |       | 18,566                                                 |       |
| Total current liabilities                  |       | 130,085                                       |       | 60,703                                               |       | 3,689                                           |       | (22              | )          | 194,455                                                |       |
| Long-term debt                             |       | 120,000                                       |       | 2,000                                                |       | —                                          |       | —           |       | 122,000                                                |       |
| Asbestos litigation liability              |       | —                                        |       | —                                               |       | 31,852                                          |       | —           |       | 31,852                                                 |       |
| Other long-term liabilities                |       | 2,152                                         |       | 41,253                                               |       | 11,768                                          |       | (14,718          | )          | 40,455                                                 |       |
| Intercompany (receivables) payables        |       | (40,428                                       | )          | 40,528                                               |       | 41                                              |       | (141             | )          | —                                                 |       |
| Shareholders’ equity (deficit)        |       | 31,566                                        |       | 86,195                                               |       | (8,145                                          | )          | (78,050          | )          | 31,566                                                 |       |
|                                       |       | $                                             | 243,375    |                                                 | $          | 230,679                                         |       | $                | 39,205     |                                                   | $          | (92,931 | ) | $ | 420,328 |   |

 

22

----

 

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2005

(Dollars in thousands)

(Unaudited)

 
| ** **                                                            | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                                  |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                             |       | $                                             | —     |                                                 | $          | 116,815                                         |       | $                | 9,587      |                                                   | $          | — |   | $ | 126,402 |   |
| Cost of sales                                                         |       | —                                        |       | 90,983                                               |       | 5,785                                           |       | —           |       | 96,768                                                 |       |
| Gross profit                                                          |       | —                                        |       | 25,832                                               |       | 3,802                                           |       | —           |       | 29,634                                                 |       |
| Selling and administrative expenses                                   |       | —                                        |       | 11,994                                               |       | 2,324                                           |       | —           |       | 14,318                                                 |       |
| Other operating income (expense) - net                                |       | 16                                            |       | (103                                                 | )          | (193                                            | )          | —           |       | (280                                                   | )          |
| Total operating income                                                |       | 16                                            |       | 13,735                                               |       | 1,285                                           |       | —           |       | 15,036                                                 |       |
| Non-operating income and (expense):                                   |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                                       |       | 510                                           |       | 156                                                  |       | 64                                              |       | —           |       | 730                                                    |       |
| Interest expense                                                      |       | (1,371                                        | )          | (52                                                  | )          | (1                                              | )          | —           |       | (1,424                                                 | )          |
| Equity in net income of joint venture                                 |       |                                          |       | 114                                                  |       |                                            |       |             |       | 114                                                    |       |
| Intercompany interest income (expense)                                |       | 1                                             |       | —                                               |       | (1                                              | )          | —           |       | —                                                 |       |
| Other income (expense) - net                                          |       | 78                                            |       | (159                                                 | )          | 40                                              |       | —           |       | (41                                                    | )          |
|                                                                  |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
|                                                                  |       | (782                                          | )          | 59                                                   |       | 102                                             |       | —           |       | (621                                                   | )          |
| (Loss) income from continuing operations  before income taxes         |       | (766                                          | )          | 13,794                                               |       | 1,387                                           |       | —           |       | 14,415                                                 |       |
| Benefit from (provision for) income taxes                             |       | 255                                           |       | (4,891                                               | )          | (465                                            | )          | —           |       | (5,101                                                 | )          |
| (Loss) income from continuing operations                              |       | (511                                          | )          | 8,903                                                |       | 922                                             |       | —           |       | 9,314                                                  |       |
| Income from discontinued operations – net  of income tax benefit |       | —                                        |       | 112                                                  |       | —                                          |       | —           |       | 112                                                    |       |
| Income from investment in subsidiaries                                |       | 9,937                                         |       | —                                               |       | —                                          |       | (9,937           | )          | —                                                 |       |
| Net income (loss)                                                     |       | $                                             | 9,426      |                                                 | $          | 9,015                                           |       | $                | 922        |                                                   | $          | (9,937 | ) | $ | 9,426 |   |

 

23

----

 

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Three Months Ended September 30, 2004

(Dollars in thousands)

(Unaudited)

 
| ** **                                                          | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                                |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                           |       | $                                             | —     |                                                 | $          | 90,143                                          |       | $                | 8,576      |                                                   | $          | — |   | $ | 98,719 |   |
| Cost of sales                                                       |       | —                                        |       | 68,682                                               |       | 5,276                                           |       | —           |       | 73,958                                                 |       |
| Gross profit                                                        |       | —                                        |       | 21,461                                               |       | 3,300                                           |       | —           |       | 24,761                                                 |       |
| Selling and administrative expenses                                 |       | —                                        |       | 10,492                                               |       | 2,156                                           |       | —           |       | 12,648                                                 |       |
| Other operating income (expense)- net                               |       | 25                                            |       | (120                                                 | )          | 8                                               |       | —           |       | (87                                                    | )          |
| Total operating income                                              |       | 25                                            |       | 10,849                                               |       | 1,152                                           |       | —           |       | 12,026                                                 |       |
| Non-operating income and (expense):                                 |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                                     |       | 63                                            |       | 68                                                   |       | 20                                              |       | —           |       | 151                                                    |       |
| Interest expense                                                    |       | (235                                          | )          | (19                                                  | )          | —                                          |       | —           |       | (254                                                   | )          |
| Intercompany interest income (expense)                              |       | 15                                            |       | —                                               |       | (15                                             | )          | —           |       | —                                                 |       |
| Other income - net                                                  |       |                                          |       | 59                                                   |       | 28                                              |       | —           |       | 87                                                     |       |
|                                                                |       | (157                                          | )          | 108                                                  |       | 33                                              |       | —           |       | (16                                                    | )          |
| (Loss) income from continuing operations  before income taxes       |       | (132                                          | )          | 10,957                                               |       | 1,185                                           |       | —           |       | 12,010                                                 |       |
| Benefit from (provision for) income taxes                           |       | 37                                            |       | (3,852                                               | )          | (451                                            | )          | —           |       | (4,266                                                 | )          |
| (Loss) income from continuing operations                            |       | (95                                           | )          | 7,105                                                |       | 734                                             |       | —           |       | 7,744                                                  |       |
| Loss from discontinued operations – net of  income tax benefit |       | —                                        |       | (274                                                 | )          | —                                          |       | —           |       | (274                                                   | )          |
| Income from investment in subsidiaries                              |       | 7,565                                         |       | —                                               |       | —                                          |       | (7,565           | )          | —                                                 |       |
| Net income (loss)                                                   |       | $                                             | 7,470      |                                                 | $          | 6,831                                           |       | $                | 734        |                                                   | $          | (7,565 | ) | $ | 7,470 |   |

 

24

----

 

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2005

(Dollars in thousands)

(Unaudited)

 
| ** **                                                        | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                              |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                         |       | $                                             | —     |                                                 | $          | 328,586                                         |       | $                | 25,292     |                                                   | $          | — |   | $ | 353,878 |   |
| Cost of sales                                                     |       | —                                        |       | 252,017                                              |       | 15,899                                          |       | —           |       | 267,916                                                |       |
| Gross profit                                                      |       | —                                        |       | 76,569                                               |       | 9,393                                           |       | —           |       | 85,962                                                 |       |
| Selling and administrative expenses                               |       | —                                        |       | 38,555                                               |       | 6,713                                           |       | —           |       | 45,268                                                 |       |
| Other operating income (expense), net                             |       | 48                                            |       | (460                                                 | )          | (392                                            | )          | —           |       | (804                                                   | )          |
| Total operating income                                            |       | 48                                            |       | 37,554                                               |       | 2,288                                           |       | —           |       | 39,890                                                 |       |
| Non-operating income and (expense):                               |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                                   |       | 1,946                                         |       | 382                                                  |       | 151                                             |       | —           |       | 2,479                                                  |       |
| Interest expense                                                  |       | (4,479                                        | )          | (162                                                 | )          | (1                                              | )          | —           |       | (4,642                                                 | )          |
| Intercompany interest income (expense)                            |       | 4                                             |       | —                                               |       | (4                                              | )          | —           |       | —                                                 |       |
| Other income, net                                                 |       | 395                                           |       | 7,679                                                |       | 40                                              |       | —           |       | 8,114                                                  |       |
|                                                              |       | (2,134                                        | )          | 7,899                                                |       | 186                                             |       | —           |       | 5,951                                                  |       |
| (Loss) income from continuing operations  before income taxes     |       | (2,086                                        | )          | 45,453                                               |       | 2,474                                           |       | —           |       | 45,841                                                 |       |
| Benefit from (provision for) income taxes                         |       | 697                                           |       | (15,466                                              | )          | (833                                            | )          | —           |       | (15,602                                                | )          |
| (Loss) income from continuing operations                          |       | (1,389                                        | )          | 29,987                                               |       | 1,641                                           |       | —           |       | 30,239                                                 |       |
| Income from discontinued operations, net of  income tax provision |       | —                                        |       | 305                                                  |       | —                                          |       | —           |       | 305                                                    |       |
| Income from investment in subsidiaries                            |       | 31,933                                        |       | —                                               |       | —                                          |       | (31,933          | )          | —                                                 |       |
| Net income (loss)                                                 |       | $                                             | 30,544     |                                                 | $          | 30,292                                          |       | $                | 1,641      |                                                   | $          | (31,933 | ) | $ | 30,544 |   |

 

25

----

 

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS

Nine Months Ended September 30, 2004

(Dollars in thousands)

(Unaudited)

 
| ** **                                                    | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                          |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                     |       | $                                             | —     |                                                 | $          | 266,510                                         |       | $                | 23,417     |                                                   | $          | — |   | $ | 289,927 |   |
| Cost of sales                                                 |       | —                                        |       | 205,225                                              |       | 14,404                                          |       | —           |       | 219,629                                                |       |
| Gross profit                                                  |       | —                                        |       | 61,285                                               |       | 9,013                                           |       | —           |       | 70,298                                                 |       |
| Selling and administrative expenses                           |       | —                                        |       | 28,326                                               |       | 6,520                                           |       | —           |       | 34,846                                                 |       |
| Other operating income (expense), net                         |       | 81                                            |       | (376                                                 | )          | 22                                              |       | —           |       | (273                                                   | )          |
| Total operating income                                        |       | 81                                            |       | 32,583                                               |       | 2,515                                           |       | —           |       | 35,179                                                 |       |
| Non-operating income and (expense):                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                               |       | 63                                            |       | 170                                                  |       | 48                                              |       | —           |       | 281                                                    |       |
| Interest expense                                              |       | (235                                          | )          | (45                                                  | )          | —                                          |       | —           |       | (280                                                   | )          |
| Intercompany interest (expense) income                        |       | (330                                          | )          | 357                                                  |       | (27                                             | )          | —           |       | —                                                 |       |
| Other (expense) income, net                                   |       | (4                                            | )          | 127                                                  |       | 112                                             |       | —           |       | 235                                                    |       |
|                                                          |       | (506                                          | )          | 609                                                  |       | 133                                             |       | —           |       | 236                                                    |       |
| (Loss) income from continuing operations  before income taxes |       | (425                                          | )          | 33,192                                               |       | 2,648                                           |       | —           |       | 35,415                                                 |       |
| Benefit from (provision for) income taxes                     |       | 140                                           |       | (11,752                                              | )          | (1,014                                          | )          | —           |       | (12,626                                                | )          |
| (Loss) income from continuing operations                      |       | (285                                          | )          | 21,440                                               |       | 1,634                                           |       | —           |       | 22,789                                                 |       |
| Loss from discontinued operations, net of  income tax benefit |       | —                                        |       | (939                                                 | )          | —                                          |       | —           |       | (939                                                   | )          |
| Income from investment in subsidiaries                        |       | 22,135                                        |       | —                                               |       | —                                          |       | (22,135          | )          | —                                                 |       |
| Net income (loss)                                             |       | $                                             | 21,850     |                                                 | $          | 20,501                                          |       | $                | 1,634      |                                                   | $          | (22,135 | ) | $ | 21,850 |   |

 

26

----

 

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2005

(Dollars in thousands)

(Unaudited)

 
| ** **                                                            | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                                  |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| OPERATING ACTIVITIES:                                                 |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Cash flows (used in) provided by continuing  operations               |       | $                                             | (11,637    | )                                                    | $          | 39,920                                          |       | $                | 2,355      |                                                   | $          | — |   | $ | 30,638 |   |
| Cash flows used in discontinued operations                            |       | —                                        |       | (3,418                                               | )          | —                                          |       | —           |       | (3,418                                                 | )          |
| Net cash (used in) provided by operating  activities                  |       | (11,637                                       | )          | 36,502                                               |       | 2,355                                           |       | —           |       | 27,220                                                 |       |
| INVESTING ACTIVITIES:                                                 |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Purchase of property and equipment                                    |       | —                                        |       | (18,185                                              | )          | (93                                             | )          | —           |       | (18,278                                                | )          |
| Proceeds from sale of available-for-sale  securities                  |       | 124,626                                       |       | —                                               |       | —                                          |       | —           |       | 124,626                                                |       |
| Investments in marketable equity securities                           |       | (12,780                                       | )          | —                                               |       | —                                          |       |             |       | (12,780                                                | )          |
| Business acquisition, net of cash acquired                            |       | —                                        |       | (9,883                                               | )          | —                                          |       | —           |       | (9,883                                                 | )          |
| Proceeds from sale of property                                        |       | —                                        |       | 7,555                                                |       | —                                          |       | —           |       | 7,555                                                  |       |
| Net cash provided by (used in) investing  activities                  |       | 111,846                                       |       | (20,513                                              | )          | (93                                             | )          |             |       | 91,240                                                 |       |
| FINANCING ACTIVITIES:                                                 |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Repayment of collateral received from  securities lending transaction |       | (124,619                                      | )          | —                                               |       | —                                          |       | —           |       | (124,619                                               | )          |
| Repayment of long-term debt                                           |       | —                                        |       | (947                                                 | )          | —                                          |       | —           |       | (947                                                   | )          |
| Proceeds from exercise of stock options                               |       | 1,474                                         |       | —                                               |       | —                                          |       | —           |       | 1,474                                                  |       |
| Dividends paid                                                        |       | (3,705                                        | )          | —                                               |       | —                                          |       | —           |       | (3,705                                                 | )          |
| Decrease in restricted cash                                           |       | 25,000                                        |       | 4,033                                                |       | —                                          |       | —           |       | 29,033                                                 |       |
| Purchase of treasury shares                                           |       | (34,225                                       | )          | —                                               |       | —                                          |       | —           |       | (34,225                                                | )          |
| Intercompany                                                          |       | 88,072                                        |       | (88,072                                              | )          | —                                          |       | —           |       | —                                                 |       |
| Net cash (used in) provided by financing  activities                  |       | (48,003                                       | )          | (84,986                                              | )          | —                                          |       | —           |       | (132,989                                               | )          |
| Increase (decrease) in cash and cash  equivalents                     |       | 52,206                                        |       | (68,997                                              | )          | 2,262                                           |       | —           |       | (14,529                                                | )          |
| Cash and cash equivalents at beginning of  year                       |       | 129                                           |       | 72,269                                               |       | 8,281                                           |       | —           |       | 80,679                                                 |       |
| Cash and cash equivalents at end of period                            |       | $                                             | 52,335     |                                                 | $          | 3,272                                           |       | $                | 10,543     |                                                   | $          | — |   | $ | 66,150 |   |

 

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CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

Nine Months Ended September 30, 2004

(Dollars in the thousands)

(Unaudited)

 
| ** **                                              | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                    |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| OPERATING ACTIVITIES:                                   |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Cash flows provided by (used in) continuing  operations |       | $                                             | 2,976      |                                                 | $          | 653                                             |       | $                | 1,288      |                                                   | $          | — |   | $ | 4,917 |   |
| Cash flows used in discontinued operations              |       | —                                        |       | (4,051                                               | )          | —                                          |       | —           |       | (4,051                                                 | )          |
| Net cash provided by (used in) operating  activities    |       | 2,976                                         |       | (3,398                                               | )          | 1,288                                           |       | —           |       | 866                                                    |       |
| INVESTING ACTIVITIES:                                   |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Purchase of property and equipment                      |       | —                                        |       | (2,661                                               | )          | (203                                            | )          | —           |       | (2,864                                                 | )          |
| Net cash used in investing activities                   |       | —                                        |       | (2,661                                               | )          | (203                                            | )          | —           |       | (2,864                                                 | )          |
| FINANCING ACTIVITIES:                                   |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Proceeds from issuance of long-term debt                |       | 120,000                                       |       | —                                               |       | —                                          |       | —           |       | 120,000                                                |       |
| Debt issuance fees paid                                 |       | (3,600                                        | )          | —                                               |       | —                                          |       | —           |       | (3,600                                                 | )          |
| Repayment of long-term debt                             |       | —                                        |       | (668                                                 | )          | —                                          |       | —           |       | (668                                                   | )          |
| Proceeds from exercise of stock options                 |       | 3,352                                         |       | —                                               |       | —                                          |       | —           |       | 3,352                                                  |       |
| Dividends paid                                          |       | (3,881                                        | )          | —                                               |       | —                                          |       | —           |       | (3,881                                                 | )          |
| Purchase of treasury shares                             |       | (34,842                                       | )          | —                                               |       | —                                          |       | —           |       | (34,842                                                | )          |
| Intercompany                                            |       | (84,348                                       | )          | 82,740                                               |       | 1,608                                           |       | —           |       | —                                                 |       |
| Net cash (used in) provided by financing  activities    |       | (3,319                                        | )          | 82,072                                               |       | 1,608                                           |       | —           |       | 80,361                                                 |       |
| (Decrease) increase in cash and cash  equivalents       |       | (343                                          | )          | 76,013                                               |       | 2,693                                           |       | —           |       | 78,363                                                 |       |
| Cash and cash equivalents at beginning of  year         |       | 648                                           |       | 17,482                                               |       | 6,008                                           |       | —           |       | 24,138                                                 |       |
| Cash and cash equivalents at end of period              |       | $                                             | 305        |                                                 | $          | 93,495                                          |       | $                | 8,701      |                                                   | $          | — |   | $ | 102,501 |   |

 

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**Item 2. - Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

###### **Forward-LookingInformation**

 

This Quarterly Report on Form 10-Q contains “forward-looking statements”within the meaning of the Private Securities Litigation Reform Act of1995.  Such forward-looking statementsare based on management’s expectations, estimates, projections andassumptions.  Words such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “estimates,” and variations of such words andsimilar expressions are intended to identify such forward-looking statementswhich include, but are not limited to, projections of revenues, earnings,segment performance, cash flows and contract awards.  These forward-looking statements are subjectto risks and uncertainties, which could cause the actual results or performanceof United Industrial Corporation and its subsidiaries (collectively, the “Company”)to differ materially from those expressed or implied in such statements.  These risks and uncertainties include, butare not limited to, the following:

•                  theCompany’s successful execution of internal performance plans;

•                  performanceissues with key suppliers, subcontractors and business partners;

•                  theability to negotiate financing arrangements with lenders;

•                  theoutcome of current and future litigation, proceedings and investigations;

•                  theaccuracy of the Company’s analysis of its potential asbestos-related exposureand insurance coverage;

•                  productdemand and market acceptance risks;

•                  theeffect of economic conditions;

•                  theimpact of competitive products and pricing;

•                  productdevelopment, commercialization and technological difficulties;

•                  capacityand supply constraints or difficulties;

•                  theintegration of acquisitions;

•                  legislativeor regulatory actions impacting the Company’s Defense segment, Energy segmentand discontinued transportation operation;

•                  changingpriorities or reductions in the U.S. Government’s defense budget;

•                  contractcontinuation and future contract awards; and

•                  U.S.and foreign military budget constraints and determinations.

 

The Company intends that all forward-looking statements it makes willbe subject to the safe harbor protection of the Federal securities laws foundin Section 27A of the Securities Act of 1933, as amended, and Section 21E ofthe Securities Exchange Act of 1934, as amended.

 

These statements speak only as to the date when they are made.  The Company makes no commitment to update anyforward-looking statement or to disclose any facts, events, or circumstancesafter the date hereof that may affect the accuracy of any forward-lookingstatements.  See “Risk Factors” underItem 7 of the Company’s Annual Report on Form 10-K for the year ended December31, 2004, for important factors that could cause the Company’s actual resultsto differ materially from those suggested by the Company’s forward-lookingstatements contained in this Quarterly Report on Form 10-Q.

 

###### **Management Overview**

 

The Company designs, develops, manufacturesand supports defense systems and training and test systems.  The Company is committed to creatinginnovative solutions, disciplined program management and continuous operationalimprovements. Its products and services include unmanned aerial vehicle (“UAV”)systems, training and simulation systems, automated aircraft test andmaintenance equipment, armament systems, logistical and engineering services,and other leading-edge technology solutions for defense needs.  The Company also manufactures combustionequipment for biomass and refuse fuels.

 

29

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The continuing operations of the Companyconsist of two business segments: Defense and Energy.  Costs related to the continuing operationsthat are not identified with the two business segments primarily relate tofinancing costs and are grouped under the heading Other.  The operations of the Defense and Energysegments are conducted principally through its two wholly-owned subsidiaries,AAI and Detroit Stoker, respectively. The following information primarily relates to the continuing operationsof the Company and its consolidated subsidiaries.  The Company has a transportation operationthat is accounted for as discontinued operations, and is discussed separatelyin the information that follows.

 

The Company’s net sales increased to$126,402,000 in the third quarter of 2005 from $98,179,000 during the sameperiod in 2004.  In addition, the Companycontinued to focus on its core Defense segment, which accounted forapproximately 92.4% and 91.3% of total consolidated net sales from continuingoperations during the third quarter of 2005 and 2004, respectively.  In the third quarter of 2005, the Defensesegment reported a 29.6% increase in net sales compared to the same period of2004 primarily due to greater logistical support related to an increasingnumber of fielded Shadow® 200 Tactical Unmanned Aerial Vehicle (“TUAV”) Systemsin 2005.  In addition, growth in thevolume of the Advanced Boresight Equipment (“ABE”) Systems, the addition of theBiological Detection Systems program awarded in the third quarter of 2004, andsales by ESL Defence (“ESL”), an electronic warfare systems company acquired inthe second quarter of 2005, contributed to the higher sales in 2005.

 

**Revolving Credit Facility**

 

On July 18, 2005, the Company and AAI entered into a $100,000,000four-year revolving credit agreement (the “Credit Agreement”) with a syndicateof six banks, consisting of SunTrust Bank, as administrative agent and issuingbank, Citibank, F.S.B., Key Bank, PNC Bank, Commerce Bank and ProvidentBank.  The Credit Agreement provides fora credit facility (the “Credit Facility”) consisting of a $100,000,000 SeniorSecured Revolving Credit Facility with a $5,000,000 Swing Line and a$100,000,000 Letter of Credit sub-facility.

 

Pursuant to the terms of the Credit Agreementand the parent guaranty agreement dated as of July 18, 2005 (the “ParentGuaranty”), the Company has guarantied AAI’s obligations.  The proceeds of the Credit Facility will beused to fund future acquisitions, finance capital expenditures, provide workingcapital, fund letters of credit, and for other general corporate purposes.

 

**Gain on Sale of Property**

 

In January 2005, the Company soldapproximately 26 acres of undeveloped property adjacent to its Hunt Valley,Maryland facility for $8,105,000, which yielded proceeds of $7,555,000, net ofselling expenses and closing costs.  TheCompany recognized a pre-tax gain on the sale of this property in the firstquarter of 2005 of approximately $7,152,000. On March 4, the Company purchased a new facility for $5,085,000 in SouthCarolina for AAI Services Corporation (“AAI Services”), a wholly-ownedsubsidiary of AAI, to support the growth in their operations.  Substantially all the remaining net proceedswere disbursed from a qualified intermediary account by July 11, 2005, and wereused for improvements to the facility. As a result, the Company expects that it will be able to defer payingsubstantially all of the income tax obligation incurred in connection with thegain on the sale of the property in Hunt Valley, in accordance with Section1031(b) of the Internal Revenue Code.

 

30

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**Restructuring Activities**

 

During the fourth quarter of 2004, themanagements of both AAI and Detroit Stoker developed plans to maximizeefficiencies by streamlining certain of their operations, in accordance withthe Company’s previously disclosed strategic initiatives.

 

AAI began reorganizing the operations of itsfluid test systems product area in the Defense segment in order to realizecertain operating efficiencies.  Theseactivities are expected to result in total cash charges of approximately$2,700,000, of which approximately $600,000 was expensed and $200,000 was paidin 2004.  In the third quarter of 2005,an additional $39,000 was expensed and $215,000 was paid or otherwise settled.  For the nine months ended September 30, 2005,$1,928,000 was expensed and $2,258,000 was paid or otherwise settled.  The remaining expenses of approximately$172,000 and cash charges of approximately $242,000 are expected to berecognized in, and paid by, the Defense segment’s operations during theremainder of 2005 as the obligations are incurred and paid, respectively.

 

As a result of the planned reduction in itswork force, Detroit Stoker recognized a curtailment charge of approximately$1,959,000 to accelerate the amortization of prior service cost and recognizeenhanced benefits for one of its pension benefit plans in the fourth quarter of2004.  In the first quarter of 2005,Detroit Stoker reduced its employee base as contemplated under this plan.  Most of the manufacturing operationspreviously performed at Detroit Stoker’s facilities have been outsourced tolower-cost producers.  As a result of thereduction in Detroit Stoker’s workforce, the Company recognized severancecharges in the Energy segment of approximately $17,000 in the third quarter of2005.  The Company also recognized$47,000 in facility relocation cost and other restructuring activities in thethird quarter of 2005. For the nine months ended September 30, 2005, the Energysegment recognized severance charges of $88,000 and facility relocation costand facility closure cost of $145,000. Additional costs associated with Detroit Stoker’s restructuring planwill be paid and charged to operations in 2005 as the liabilities are incurred,which are estimated to be approximately $59,000.

 

**Acquisition of ESL**

 

On April 4, 2005, the Company acquired ESLDefence Limited (“ESL”), an electronic warfare (“EW”) systems company based inthe United Kingdom.  The net purchaseprice was $10,363,000 in cash.  ESL is adesigner and producer of electro optical (“EO”) test and simulation productsfor use on flight lines and in aircraft maintenance facilities.  The simulators are used to assess theoperational readiness of sophisticated missile warning and countermeasuresself-protection systems used on military aircraft.  ESL’s EO simulators are also used at militarytest, evaluation, and training ranges to evaluate the effectiveness of newself- protection systems and to train pilots for combat readiness.  In addition, ESL specializes in EW relatedresearch, study, and in-service support activity for U.K. government agenciesand prime contractors both in the United Kingdom and the United States.  For the three and nine months ended September30, 2005, ESL contributed net sales of $2,646,000 and $4,705,000, respectively.

 

**Resultsof Operations**

 

The following discussion should be read inconjunction with the Company’s Consolidated Financial Statements and relatednotes thereto contained in this Quarterly Report on Form 10-Q for the quarterlyperiod ended September 30, 2005, and the discussion included in its AnnualReport on Form 10-K for the year ended December 31, 2004.

 

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**Overview of Consolidated Results**

#### *** ***

#### ***Threeand Nine Months Ended September 30, 2005 Compared to the Three and Nine MonthsEnded September 30, 2004***

 
| ** **                                              | ** ** | **Three Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|--------------------------|------------|
| **(Dollars  in thousands)**                             | ** ** | **2005**                             | ** ** | **2004**                 | ** ** | **$**                               | ** ** | **%**                    | ** ** | **2005** | ** ** | **2004** | ** ** | **$** | ** ** | **%** | ** ** |
|                                                    |       |                                 |       |                     |       |                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net  sales                                              |       | $                                    | 126,402    |                     | $          | 98,719                              |       | $                        | 27,683     |   | 28.0 | % | $ | 353,878 |   | $ | 289,927 |   | $ | 63,951 |   | 22.1 | % |
| Gross  profit                                           |       | 29,634                               |       | 24,761                   |       | 4,873                               |       | 19.7                     | %          | 85,962 |   | 70,298 |   | 15,664 |   | 22.3 | % |
| Selling  and administrative expenses                    |       | 14,318                               |       | 12,648                   |       | 1,670                               |       | 13.2                     | %          | 45,268 |   | 34,846 |   | 10,422 |   | 29.9 | % |
| Operating  income                                       |       | 15,036                               |       | 12,026                   |       | 3,010                               |       | 25.0                     | %          | 39,890 |   | 35,179 |   | 4,711 |   | 13.4 | % |
| Non-operating  income (expense)                         |       | (621                                 | )          | (16                      | )          | 605                                 |       | 3781.3                   | %          | 5,951 |   | 236 |   | 5,715 |   | 2421.6 | % |
| Income  from continuing operations, net of income taxes |       | 9,314                                |       | 7,744                    |       | 1,570                               |       | 20.3                     | %          | 30,329 |   | 22,789 |   | 7,450 |   | 32.7 | % |
|                                                         |            |                                      |            |                          |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Defense Segment***

#### ** **

| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|--------------------------|------------|
| **(Dollars  in thousands)**          | ** ** | **2005**                             | ** ** | **2004**                 | ** ** | **$**                               | ** ** | **%**                    | ** ** | **2005** | ** ** | **2004** | ** ** | **$** | ** ** | **%** | ** ** |
|                                 |       |                                 |       |                     |       |                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net  sales                           |       | $                                    | 116,815    |                     | $          | 90,143                              |       | $                        | 26,672     |   | 29.6 | % | $ | 328,586 |   | $ | 266,510 |   | $ | 62,076 |   | 23.3 | % |
| Gross  profit                        |       | 25,832                               |       | 21,461                   |       | 4,371                               |       | 20.4                     | %          | 76,569 |   | 61,285 |   | 15,284 |   | 24.9 | % |
| Selling  and administrative expenses |       | 11,994                               |       | 10,492                   |       | 1,502                               |       | 14.3                     | %          | 38,555 |   | 28,326 |   | 10,229 |   | 36.1 | % |
| Operating  income                    |       | 13,735                               |       | 10,849                   |       | 2,886                               |       | 26.6                     | %          | 37,554 |   | 32,583 |   | 4,971 |   | 15.3 | % |
| Income  before income taxes          |       | 13,794                               |       | 10,957                   |       | 2,837                               |       | 25.9                     | %          | 45,453 |   | 33,192 |   | 12,261 |   | 36.9 | % |
|                                      |            |                                      |            |                          |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Energy Segment***

#### *** ***

| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|--------------------------|------------|
| **(Dollars  in thousands)**          | ** ** | **2005**                             | ** ** | **2004**                 | ** ** | **$**                               | ** ** | **%**                    | ** ** | **2005** | ** ** | **2004** | ** ** | **$** | ** ** | **%** | ** ** |
|                                 |       |                                 |       |                     |       |                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net  sales                           |       | $                                    | 9,587      |                     | $          | 8,576                               |       | $                        | 1,011      |   | 11.8 | % | $ | 25,292 |   | $ | 23,417 |   | $ | 1,875 |   | 8.0 | % |
| Gross  profit                        |       | 3,802                                |       | 3,300                    |       | 502                                 |       | 15.2                     | %          | 9,393 |   | 9,013 |   | 380 |   | 4.2 | % |
| Selling  and administrative expenses |       | 2,324                                |       | 2,156                    |       | 168                                 |       | 7.8                      | %          | 6,713 |   | 6,520 |   | 193 |   | 3.0 | % |
| Income  before income taxes          |       | 1,388                                |       | 1,185                    |       | 203                                 |       | 17.1                     | %          | 2,478 |   | 2,648 |   | (170 | ) | (6.4 | )% |
|                                      |            |                                      |            |                          |            |                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Three Months EndedSeptember 30, 2005 compared to the Three Months Ended September 30, 2004***

 

The Company’s net sales increased 28.0% for the three months endedSeptember 30, 2005 compared to the three months ended September 30, 2004,including $26,672,000 and $1,011,000 higher net sales for the Defense andEnergy segments, respectively.  Net salesfor the Defense segment for the three months ended September 30, 2005 increased29.6% to $116,815,000 from $90,143,000 for the three months ended September 30,2004.  The increase was primarily due togreater logistical support related to an increasing number of fielded Shadow200 TUAV Systems in 2005, growth in the volume of ABE Systems, the BiologicalDetection Systems program awarded in the third quarter of 2004 and theacquisition of ESL in the second quarter of 2005.

 

The gross margin percentage for continuing operations decreased to 23.4%in the third quarter of 2005 from 25.1% during the same period in 2004. TheDefense segment’s gross margin percentage was 22.1% in the third quarter 2005compared to 23.8% during the same period in 2004.  Increased sales generated by increased Shadow200 TUAV logistical support and Services’ business, that generate lower grossmargin percentages than other sales realized by AAI, primarily caused thedecreased margin.

 

Selling and administrative expense increased to $14,318,000, in thethird quarter of 2005 compared to $12,648,000 during the same period in2004.  However, as a percentage of sales,selling and administrative expenses decreased to 11.3% in the third quarter of2005 compared to 12.8% during the same period in 2004.  Selling and administrative expense in theDefense segment increased to $11,994,000, or 10.3% of sales, in the thirdquarter of 2005 from $10,492,000, or 11.6% of sales, during the same period in2004. The $1,502,000 increase was primarily due to $1,273,000 higher researchand development expense and bid and proposal costs to support the Defensesegment’s growth, $1,062,000 of general and administrative expenses incurred bythe recently acquired ESL, $620,000 of increased legal expenses, partiallyoffset by expense reductions of $1,453,000 in lower costs mostly related to thereorganization of the Defense segment’s fluid test system product area.

 

Operating income for the Company increased to $15,036,000, or 11.9% ofsales, in the third quarter of 2005 from $12,026,000, or 12.2% of sales, duringthe same period in 2004.  Operatingincome in the Defense segment increased to $13,735,000, or 11.8% of sales, inthe third quarter of 2005 from $10,849,000, or 12.0% of sales, during the sameperiod in 2004.  The decrease inoperating income as a percentage of sales is primarily due to the decrease inthe gross profit percentage.

 

Net interest expense increased $591,000 to$694,000 in the third quarter of 2005 from net interest expense of $103,000during the same period in 2004 primarily as a result of the payment of interestto the holders of the Company’s $120,000,000 3.75% Convertible Senior Notesissued in September 2004.

 

Net income from continuing operations net ofincome taxes in the third quarter of 2005 increased to $9,314,000, or $0.68 perdiluted share, compared to $7,744,000, or $0.57 per diluted share, during thesame period in 2004.

 

Net income that includes the results of bothcontinuing and discontinued operations in the third quarter of 2005 increasedto $9,426,000, or $0.69 per diluted share, compared to $7,470,000, or $0.55 perdiluted share, during the same period in 2004.

 

***Nine Months EndedSeptember 30, 2005 compared to the Nine Months Ended September 30, 2004***

 

Net sales from continuing operations for the nine months ended September30, 2005 increased 22.1% to $353,878,000 compared to $289,927,000 for the ninemonths ended September 30, 2004.  Netsales for the Defense segment for the nine months ended September 30, 2005increased 23.3% to $328,586,000 from $266,510,000 for the nine months endedSeptember 30, 2004.  The increase wasprimarily due to higher production and logistical support related to anincreasing number of fielded Shadow 200 TUAV Systems in 2005, increased demandfor ABE Systems, the Biological Detection System Program that was awarded inthe third quarter of 2004, and the acquisition of ESL in the second quarter of2005.

 

The gross margin percentage for continuing operations increased to24.3% in the nine months ended September 30, 2005 from 24.2% during the sameperiod in 2004.  The gross marginpercentage for the Defense segment increased to 23.3% in the nine months endedSeptember 30, 2005 from 23.0% in the nine months ended September 30, 2004.

 

33

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Selling and administrative expenses in the nine months ended September30, 2005 increased to $45,268,000, or 12.8% of sales, from $34,846,000, or12.0% of sales, during the same period in 2004. Selling and administrative expenses in the Defense segment in the ninemonths ended September 30, 2005 increased to $38,555,000 or 11.7% of sales,from $28,326,000, or 10.6% of sales, during the same period in 2004.  The $10,299,000 increase was primarily due to$4,671,000 for higher research and development expenses and bid and proposalcosts to support the Defense segment’s growth, $1,928,000 of restructuringcharges to reorganize the Defense segment’s fluid test systems productarea,  $1,748,000 of general andadministrative expenses incurred by the recently acquired ESL, $1,400,000 ofhigher legal expenses, and other expenses reduction of $552,000.

 

Operating income increased to $39,890,000, or 11.3% of sales, in thenine months ended September 30, 2005 from $35,179,000, or 12.1% of sales,during the same period in 2004. Operating income in the Defense segmentincreased to $37,544,000, or 11.4% of sales, in the nine months ended September30, 2005, from $32,583,000, or 12.2% of sales, during the same period in 2004.

 

Net interest expense was $2,163,000 for the nine months ended September30, 2005 an increase of $2,162,000 from the nine months ended September 30,2004 primarily as a result of the payment of interest to the holders of theCompany’s $120,000,000 3.75% Convertible Senior Notes issued in September2004.  Included in the interest expensefor 2005 is approximately $4,100,000 related to the $120,000,000 3.75%Convertible Senior Notes issued in September 2004.

 

Income from continuing operations before income taxes increased 29.4%,to $45,841,000 in the nine months ended September 30, 2005 from $35,415,000during the same period in 2004.  Thisincrease included a $7,152,000 gain from the sale of undeveloped propertyrecorded during the first quarter of 2005.

 

Net income from continuing operations, net of taxes in the nine monthsended September 30, 2005 increased $7,450,000 to $30,239,000, or $2.13 perdiluted share, compared to $22,789,000, or $1.70 per diluted share, during thesame period in 2004.

 

Net income that includes the results of both continuing and discontinuedoperations in the nine months ended September 30, 2005 increased to$30,544,000, or $2.15 per diluted share, compared to $21,850,000, or $1.63 perdiluted share, during the same period in 2004.

 

**Discontinued Transportation Operations**

 

Income from the Company’s discontinuedtransportation operations for the third quarter of 2005 was $112,000, or $0.01per diluted share, compared to a loss of ($274,000), or ($0.02) per dilutedshare during the same period in 2004.

 

Income from the Company’s discontinued transportationoperations for the nine months ended September 30, 2005 was $305,000, or $0.02per diluted share, as compared to a loss of ($939,000), or ($0.07) per dilutedshare, during the same period in 2004.

 

Electric Transit, Inc. (“ETI”), an entity owned 35% by AAI and 65% bySkoda a.s. (“Skoda”), a Czech company, sold its remaining inventory of spareparts and continued to favorably resolve certain operational challengesassociated with its last remaining program during the nine months endedSeptember 30, 2005, which contributed to the favorable results from thediscontinued transportation operations in 2005.

 

For additional information regarding the discontinued transportationoperations, see Note M to the Consolidated Condensed Financial Statements includedin this Quarterly Report on Form 10-Q.

 

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**Funded Backlog**

** **
| **(Dollars in thousands)** | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------|------------|-------------------------|------------|------------------------|------------|
| Defense segment            |       | $                       | 508,633    |                   | $          | 380,622 |   |
| Energy segment             |       | 11,230                  |       | 7,296                  |       |
| Total                      |       | $                       | 519,863    |                   | $          | 387,918 |   |

 

The Company’s funded backlog for continuing operations, defined asorders placed for which funds have been appropriated or purchase ordersreceived, was $519,863,000 at September 30, 2005, an increase of $131,945,000,or 34.0%, from December 31, 2004.

 

The Company received $163,618,000 of funded new orders for products andservices during the third quarter of 2005, an increase of $38,812,000, or31.1%, compared to $124,806,000 the third quarter of 2004. Included in thethird quarter 2005 were funded new orders of $153,128,000 in the Defensesegment and $10,490,000 in the Energy segment.

 

For the nine months ended September 30, 2005, the Company received$484,009,000 in funded new orders compared to $297,360,000 for the nine monthsended September 30, 2004, an increase of $186,649,000, or 62.8%.  The funded new orders for the nine monthsended September 30, 2005 included $453,977,000 of funded new orders in theDefense segment and $30,032,000 of funded new orders in the Energy segment.

 

The increase in the funded backlog for the Defense segment includedadditional funding for existing contracts and funding for new contracts, fornew Shadow 200 TUAV systems, logistical support for fielded Shadow 200 TUAVsystems and development of ground control stations.  Further, we received additional funding forthe Biological Detection Systems program.

 

The increase in the Energy segment’s fundedbacklog was primarily due to an increase in orders received during the thirdquarter of 2005.

 

**Liquidityand Capital Resources**

 

**Overview**

 

The Company’s principal source of liquidityis cash on hand and cash generated from operations.  On September 30, 2005, the Company had cashand cash equivalents of $66,150,000. Effective December 23, 2004, the Company terminated its Loan andSecurity Agreement dated June 28, 2001, as amended, with Bank of AmericaBusiness Capital (formerly Fleet Capital Corporation).  On July 18, 2005, the Company and AAI,entered into a $100,000,000 four-year revolving Credit Agreement with asyndicate of six banks, consisting of SunTrust Bank, as administrative agentand issuing bank, Citibank, F.S.B., Key Bank, PNC Bank, Commerce Bank andProvident Bank.  The Credit Agreementprovides for a Credit Facility consisting of a $100,000,000 Senior SecuredRevolving Credit Facility with a $5,000,000 Swing Line and a $100,000,000Letter of Credit sub-facility. The interest rate for loans made under thisfacility is thirty-day LIBOR plus an applicable margin between 1.25% and 2.00%based upon the Company’s leverage ratio. As of September 30, 2005, the Company had $2,939,000 outstanding underthe Letter of Credit sub-facility. Pursuant to the terms of the Credit Agreement and the Parent Guaranty,the Company has guarantied AAI’s obligations. The proceeds of the Credit Facility will be used to fund futureacquisitions, finance capital expenditures, provide working capital, fundletters of credit, and for other general corporate purposes. Based on cash onhand, future cash expected to be generated from operations, and the new CreditFacility, the Company expects to have sufficient cash to meet its requirementsfor at least the next twelve months.

 

On December 29, 2004, the Company invested $124,619,000 in U.S.treasury bills maturing on February 24, 2005. The U.S. treasury bills were concurrently loaned to the Company’sbroker-dealer in a securities lending transaction in exchange for cashcollateral in an amount equal to 100% of the fair value of the securitieslent.  The securities lending transactionterminated on February 23, 2005, at which time the Company redeemed the U.S.treasury bills and received approximately $373,000 of interest thereon, repaidthe cash collateral to its broker-dealer together with $444,000 of relatedinterest charges, and collected the $25,000,000 deposit plus $86,000 of accruedinterest thereon.

 

35

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As discussed under the subheading “*Gainon Sale of Property*” in the “*ManagementOverview*” section above, in January 2005, the Company soldapproximately 26 acres of undeveloped property adjacent to its Hunt Valley,Maryland facility for $8,105,000, which yielded proceeds of $7,555,000, net ofselling expenses and closing costs.  The Companyreinvested approximately $5,085,000 of the net proceeds from this sale in a newfacility in South Carolina for AAI Services to support the growth in theiroperations.  The remaining net proceedswere disbursed from a qualified intermediary account by July 11, 2005, and wereused primarily for improvements to the facility.  As a result, the Company expects that it willbe able to defer paying substantially all of the income tax obligation incurredin connection with the gain on the sale of the property in Hunt Valley, inaccordance with Section 1031 (b) of the Internal Revenue Code.

 

Inaccordance with its strategic initiatives to enhance shareholder value, theCompany is continuing to focus its efforts on the profitability and growth ofits core Defense product areas, seeking to maximize operating efficiencies, andexploring the sale of non-core assets.

 

TheCompany intends to complement its growth strategy for its Defense segmentthrough select acquisitions that broaden its product and service offerings,deepen its capabilities, and allow entry into new markets.  Acquisition candidates may include public andprivate companies and divisions, subsidiaries and product lines of suchcompanies.  In accordance with thisinitiative on April 4, 2005, the Company acquired ESL, an electronic warfare systemscompany based in the United Kingdom, as more fully discussed in the “ManagementOverview” section above.

 

Duringthe fourth quarter of 2003, as part of the Company’s strategy to explore thesale of non-core assets, the Company engaged Imperial Capital, LLC, aninvestment-banking firm, to act as exclusive financial advisor to assist inexploring strategic alternatives for Detroit Stoker, including a possible sale(the “Transaction”).  The Company andImperial Capital are continuing to explore potential Transactions involvingDetroit Stoker.  From time to time, theCompany and potential buyers may (i) have discussions regarding a potentialTransaction, (ii) negotiate the preliminary terms of a potential Transaction,and (iii) enter into customary non-binding agreements in order to facilitateany such discussions and negotiations. No assurances can be given regarding whether a Transaction involvingDetroit Stoker will occur or the timing or proceeds from any such Transaction.

 

**Sources and Uses of Cash**

 

The following is a discussion of the Company’s major operating,investing, and financing activities for each of the nine-month periods endedSeptember 30, 2005 and 2004.  Thefinancial information presented in the table below is summarized from theCompany’s Consolidated Condensed Statements of Cash Flows.

 
| ** **                                           | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands)**                          | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Operating activities:                                |       |                                 |       |   |   |
| Net cash provided by continuing operations           |       | $                                    | 30,638     |   | $ | 4,917 |   |
| Net cash used in discontinued operations             |       | (3,418                               | )          | (4,051 | ) |
| Net cash provided by operating activities            |       | 27,220                               |       | 866 |   |
| Net cash provided by (used in) investing  activities |       | 91,240                               |       | (2,864 | ) |
| Net cash (used in) provided by financing  activities |       | (132,989                             | )          | 80,361 |   |
| (Decrease) increase in cash and cash  equivalents    |       | $                                    | (14,529    | ) | $ | 78,363 |   |

 

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***Operating Activities***

 

Net cash provided by continuing operations in the nine months endedSeptember 30, 2005 increased $25,721,000 to $30,638,000 compared to $4,917,000for the nine months ended September 30, 2004 due to a decrease of $20,776,000in cash used in operations for changes in operating assets and liabilities andan increase in cash provided of $4,945,000 due to higher income from continuingoperations before non-cash depreciation and other charges. Cash provided byincome from continuing operations before non-cash depreciation and othercharges was $35,533,000 for the nine months ended September 30, 2005.  Changes in operating assets and liabilitiesin the nine months ended September 30, 2005 used cash of $4,895,000, whichincluded an increase in accounts receivable of $11,930,000 due to the timing ofmilestone invoicing and payments, offset by a decrease in inventory of$2,247,000, a decrease in prepaid expenses and other current assets of$2,638,000 and a net increase in other operating liabilities of$2,150,000.  Cash provided by income fromcontinuing operations before non-cash depreciation and other charges was$30,588,000 for the nine months ended September 30, 2004.  Changes in operating assets and liabilitiesin the nine months ended September 30, 2004 used cash of $25,671,000 whichincluded an increase in accounts receivable of $22,030,000 due to significantbillings at the end of the quarter, an increase in inventory of $19,501,000 dueto higher production levels as well as temporary deferral in certain billingmilestones, and an increase in prepaid expenses and other current assets of$616,000, offset by increases in operating liabilities of $16,476,000.  Inventory was lower and accounts receivablehigher at September 30, 2005 than at September 30, 2004 primarily due to theachievement of certain billing milestones in the Defense segment.

 

TheCompany’s cash flows from operations are dependent on the timing of receiptsfrom various government payment offices and, as a result, may differ fromperiod to period and such differences could be significant.

 

Net cash used by the discontinued transportation operations in the ninemonths ended September 30, 2005 primarily related to unreimbursed services andother financial support provided to ETI in connection with the MUNI contractguaranty agreement as discussed in Note N.

 

***Investing Activities***

 

On December 29, 2004, the Company invested $124,619,000 of cash in U.S.treasury bills, which matured on February 24, 2005.  The U.S. treasury bills were concurrentlyloaned to the Company’s broker-dealer in a securities lending transaction,which is discussed in the “*LiquidityOverview*” section above.

 

During the nine months ended September 30, 2005, the Company invested$12,780,000 in marketable common stock securities that are available for sale.

 

Cash used for the purchase of property and equipment was $18,278,000,including $7,470,000 for the purchase and improvement of a building in SouthCarolina, $3,616,000 for implementation of AAI’s new Enterprise ResourcePlanning (“ERP”) system, and $4,990,000 for Defense facility improvementsincluding $2,016,000 for enhancements to the UAV Production Facilities for thenine months ended September 30, 2005. Capital expenditures were $2,864,000 for the same period of the prioryear and was the only investing activity for the nine months ended September30, 2004.  The Company anticipates thatfuture requirements for expenditures will include completing the facilitiesimprovement and the ERP system implementation as well as expenditures incurredduring the ordinary course of business. See “*Capital Expenditures*”below.

 

On April 4, 2005, the Company purchased ESL for $9,883,000, net of cashacquired.

 

Net cash provided by investing activities in 2005 included proceeds of$7,555,000 from the sale of certain undeveloped property at the Company’s HuntValley, MD corporate headquarters.

 

***Financing Activities***

 

The Company’s financing activities for the nine months ended September30, 2005 used $132,989,000 of cash, including approximately $124,619,000 forthe repayment of collateral received from a securities lending transaction ofU.S. treasury bills that were sold concurrently.  In connection with this securities lendingtransaction, which is discussed more fully in the “*Liquidity Overview*” section above, the Company also receivedthe $25,000,000 refundable deposit from its broker-dealer.

 

37

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This deposit, together with a decrease of $4,033,000 in collateral theCompany was required to post in connection with outstanding letters of creditand a cash management security arrangement with Bank of America BusinessCapital, is presented as a $29,033,000 decrease in restricted cash in theaccompanying Consolidated Statements of Cash Flows for the period endingSeptember 30, 2005.

 

Financing activities in 2005 also included $34,225,000 for the purchaseof the Company’s common stock, $3,705,000 of cash used for the payment ofdividends, $1,474,000 of cash receipts from the exercise of stock options, and$947,000 used for the repayment of long-term debt, primarily related to thefinancing of the ERP System.

 

Net cash provided by the Company’s financing activities for the ninemonths ended September 30, 2004 was $80,361,000, including approximately$92,044,000 of net proceeds from the issuance and sale of the 3.75% ConvertibleSenior Notes after the concurrent repurchase of 850,400 shares of Common Stockfor $24,356,000 and deducting $3,600,000 of investment banking fees associatedwith the sale.  Financing activities alsoinclude $3,352,000 of cash receipts from the exercise of stock options, partiallyoffset by $10,486,000 of cash used for the repurchase of the Company’s CommonStock under its previously announced repurchase programs, $3,881,000 of cashused for the payment of dividends, and $668,000 used for the repayment oflong-term debt related to the financing of AAI’s new ERP System.

** **

**Debt and Related Covenants**

 

The Credit Facility entered into on July 18,2005 by the Company and AAI contains affirmative, negative and financialcovenants customary for facilities of this type, including, among other things,maintenance of certain leverage and fixed charge coverage ratios, as well asminimum consolidated tangible net worth ratios, limits on the incurrence ofdebt and preferred equity, limits on the incurrence of liens, a limit on themaking of dividends or distributions, limits on sales of assets and a limit oncapital expenditures.

 

For a complete description of the Company’s long-term debt, includingthe terms and conditions of each debt instrument, please see Note 6 to theConsolidated Financial Statements included in Part II, Item 8 of the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004 and Note G tothe Consolidated Condensed Financial Statements included in part I, Item 1 ofthis Quarterly Report on Form 10-Q. There are no covenant violations as of September 30, 2005.

** **

**Cash Requirements**

 

***Capital Expenditures***

 

The Company expects that capital expenditures in 2005 will besignificantly higher than in 2004 primarily due to (i) the purchase of the$5,085,000 new facility in South Carolina, and approximately $3,500,000 ofimprovements to be made to that facility, (ii) approximately $3,200,000 ofenhancements to the Company’s UAV production facilities, including the purchaseof new manufacturing equipment to increase production output and efficiency and(iii) $4,800,000 related to the continuing implementation of the Company’s ERPSystem.

 

As of September 30, 2005, the Company had no significant commitmentsfor capital expenditures except for the continuing implementation of its newERP System. The Company expects to incur approximately $2,000,000 related tothe implementation of its ERP System, which exclude ongoing annual maintenancefees of approximately $400,000 per year. As of September 30, 2005, the Company had capitalized a total ofapproximately $6,920,000 related to the implementation of the ERP System,$2,385,000 for improvements to the new facility in South Carolina and$2,016,000 for enhancements to the Company’s UAV production facilities as wellas $2,974,000 in general facility improvements for the year.

 

***Other CashRequirements***

 

On September 7, 2005, the Board of Directorsof the Company authorized a stock purchase plan for up to $15,000,000.  The Company repurchased a total of 262,578shares with an average price of $35.22 during the three months ended September30, 2005.  As of September 30, 2005,there remained $5,744,000 available under the subject authorization for futurepurchases.  During October 2005, anadditional 163,049 shares were purchased with an average purchase price of$35.16, utilizing the remaining funds under the plan.

 

38

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For the nine months ended September 30, 2005, the Company paid cashdividends of $0.10 per share on March 31, 2005, on May 30, 2005 and on August31, 2005, for an aggregate amount of $3,704,027.  The payment of any future dividends will beat the discretion of the Board of Directors and will depend upon, among otherthings, the Company’s corporate strategy, future earnings, operations, capitalrequirements, and the Company’s financial condition and general businessconditions.  Should the Companydistribute a cash dividend in any quarterly period in excess of $0.10 pershare, the conversion rate provided for in the Indenture governing the 3.75%Convertible Senior Notes would be adjusted. In addition, the Company’s lenders may impose restrictions on thepayment of dividends.

 

As discussed more fully under “*ManagementOverview*” above, during the remainder of 2005 the Company’smanagement will continue to implement its restructuring plans to reduce costsand streamline operations in the Defense segment’s fluid test systems productarea and at Detroit Stoker.  The Companyexpects that it will continue to incur and pay costs during the remainder of2005 as these plans are fully implemented, which will primarily be charged toearnings as the related obligations are incurred.  For the reorganization activities in theDefense segment’s fluid test systems product line, the Company estimates thatit will incur total cash charges of approximately $2,700,000, of whichapproximately $600,000 was expensed and $200,000 was paid in 2004.  For the nine months ended September 30, 2005,an additional $1,928,000 was expensed and $2,258,000 was paid or otherwisesettled.  The remaining expenses ofapproximately $172,000 are expected to be charged to the Defense segment’soperations, and paid during the remainder of 2005 as the obligations areincurred.  The Energy segment recognizedexpense of $233,000 for restructuring activities during 2005.  The Company estimates Detroit Stoker willrecognize additional expense of approximately $59,000 for the restructuringactivities for the remainder of 2005.

 

The cash required to completely exit the discontinued transportationoperation subsequent to September 30, 2005 is expected to be approximately$2,000,000 through 2006, of which $1,000,000 is expected to be paid during theremainder of 2005.  These amounts excludelegal fees expected to be incurred related to claims made by AAI in pursuit ofpayment under a surety bond (see Note N to the Consolidated CondensedFinancial Statements included in this Quarterly Report on Form 10-Q for adiscussion of AAI’s claims).

 

For additional information regarding theCompany’s contingencies, please see the discussion under the heading “*Contingent Matters*” below.

 

The Company does not anticipate having tocontribute cash to the UIC Retirement Pension Plan, but does expect tocontribute $244,000 to the union pension plan in the Energy segment during2005, of which $193,000 was funded in the nine months ended September 30,2005.  Further, the Company expects topay other post-retirement benefits of approximately $3,099,000 in 2005, ofwhich $2,347,000 was funded during the nine months ended September 30, 2005.

 

39

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**Contingent Matters**

 

**Off-Balance Sheet Arrangements**

 

In connection with certain contracts, UnitedIndustrial’s operating subsidiaries have committed to certain performanceguaranties. The ability to perform under these guaranties may, in part, bedependent on the performance of other parties, including partners andsubcontractors. If United Industrial’s operating subsidiaries are unable tomeet these performance obligations, the performance guaranties could have a materialadverse effect on product margins and the Company’s results of operations,liquidity or financial position. United Industrial’s operating subsidiariesmonitor the progress of their partners and subcontractors, and UnitedIndustrial does not believe that the performance of these partners andsubcontractors will adversely affect these contracts as of September 30, 2005.No assurances can be given, however, as to the liability of United Industrial’soperating subsidiaries if partners or subcontractors are unable to performtheir obligations.

 

**Other Contingent Matters**

 

The Company is involved in various lawsuits and claims, includingasbestos-related litigation and environmental matters.  Except as set forth in Note N to theConsolidated Condensed Financial Statements included in this Quarterly Reporton Form 10-Q, there have been no material changes in any legal proceedingssince the Company filed its Annual Report on Form 10-K for the year endedDecember 31, 2004.  For furtherinformation, refer to the Consolidated Financial Statements and Notes theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2004 and to Note N to the Consolidated Condensed FinancialStatements included in this Quarterly Report on Form 10-Q.

 

**Critical Accounting Policies**

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions.  These estimates and assumptions affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements, as well as reportedamounts of revenues and expenses during the reporting period.  Judgments and assessments of uncertainties arerequired in applying the Company’s accounting policies in many areas.  Actual results could differ from theseestimates.

 

There have been no revisions to the CriticalAccounting Policies as filed in the Company’s Annual Report on Form 10-K forthe year ended December 31, 2004.

 

**NewAccounting Pronouncements**

 

In May 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB opinion No. 20and FASB Statement No. 3 (“SFAS No. 154”). SFAS No. 154 requires retrospective application to prior periodfinancial statements of a voluntary change in accounting principle, and iseffective in the first quarter of 2006. The Company does not expect the adoption of SFAS No. 154 to have a materialeffect on its results of operations, financial conditions or cash flows.

 

For further information, refer to the NewAccounting Pronouncements as filed in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

40

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**Item 3. - Quantitative and QualitativeDisclosures about Market Risk**

 

**Interest Rate**

 

On September 15, 2004, the Company issued andsold $120,000,000 of 3.75% Convertible Senior Notes.  Several features contained in the indenturegoverning the 3.75% Convertible Senior Notes are considered embedded derivativeinstruments and are being accounted for as derivative instruments separate fromthe host contract (the 3.75% Convertible Senior Notes). The Company will recordgains or losses in its Consolidated Condensed Statements of Operations forchanges in the fair value of these embedded derivatives.  The aggregate fair value assigned to theseembedded derivatives at December 31, 2004 was approximately $742,000, and wasapproximately $361,000 at September 30, 2005. Accordingly, the Company recognized a gain of $381,000 for the ninemonths ended September 30, 2005 as the result of the change in fair value ofthe embedded derivatives.

 

Each of the embedded derivatives may result in certain payments to theholders of the 3.75% Convertible Senior Notes.

 

There has been no material change in the interest rate risk orcontingent payment features from December 31, 2004 (see Item 7A in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004).

 

**Foreign Currency**

 

A portion of the Company’s operationsconsists of manufacturing and sales activities in foreign jurisdictions, andsome of these transactions are denominated in foreign currencies.  As a result, the Company’s financial resultscould be affected by changes in foreign exchange rates.  To mitigate the effect of changes in theserates, the Company, from time to time, enters into foreign exchange forwardcontracts.  There has been no materialchange in the firmly committed sales exposures and related derivative contractsfrom December 31, 2004 (see Item 7A in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004).

 

**Item 4. - Controls and Procedures**

 

(a)                TheCompany’s management evaluated, with the participation of the Company’s principalexecutive and principal financial officers, the effectiveness of the Company’sdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), asof September 30, 2005.  Based on theirevaluation, the Company’s principal executive and principal financial officersconcluded that the Company’s disclosure controls and procedures were effectiveas of September 30, 2005.

 

(b)               Therehas been no change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) thatoccurred during the Company’s fiscal quarter ended September 30, 2005, that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal control over financial reporting.

 

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**PART II - OTHER INFORMATION**

 

##### **Item 1. - Legal Proceedings**

 

Reference is made to the information containedin the section entitled “*Management’sDiscussion and Analysis of Financial Condition and Results of Operations*”set forth above in Item 2 of Part I and to Note N to the Consolidated CondensedFinancial Statements included herein, which information is incorporated hereinby reference.

** **

**Item 2. – Unregistered Sales of EquitySecurities and Use of Proceeds**

 

For information regarding the Company’s purchases of its equitysecurities, please reference Note P to the Consolidated Condensed FinancialStatements included herein, which information is incorporated herein byreference.

 
| **Period**            | ** ** | **Total Number of  Shares Purchased** | ** ** | **Average Price Paid per  Share** | ** ** | **Total Number of  Shares Purchased as a  Part of Publicly  Announced Programs** | ** ** | **Approximate Dollar  Value of Shares That  May Yet Be Purchased  Under The Program** | ** ** |
|-----------------------|------------|---------------------------------------|------------|-----------------------------------|------------|----------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **            | ** ** | ** **                            | ** ** | ** **                        | ** ** | ** **                                                                       | ** ** | **(in millions)**                                                                     | ** ** |
| 7/1/05 – 7/31/05 |       | —                                |       | —                            |       | —                                                                           |       | $                                                                                     | —     |   |
| 8/1/05 – 8/31/05 |       | —                                |       | —                            |       | —                                                                           |       | $                                                                                     | —     |   |
| 9/1/05 – 9/30/05 |       | 262,578                               |       | $                                 | 35.22      |                                                                             | 262,578    |                                                                                  | $          | 5.7 |   |
|                       |            |                                       |            |                                   |            |                                                                                  |            |                                                                                       |            |  |  |

 

**Item6. - Exhibits**

 

31.1                           Rule 13a-14(a)/15d-14(a)Certification by the Chief Executive Officer of the Company.

 

31.2                           Rule 13a-14(a)/15d-14(a)Certification by the Chief Financial Officer of the Company.

 

32.1                           Section 1350 Certificationby the Chief Executive Officer of the Company.

 

32.2                           Section 1350 Certificationby the Chief Financial Officer of the Company.

 

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SIGNATURE

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|   |              | UNITED  INDUSTRIAL CORPORATION |
|--------|-------------------|--------------------------------|
|   |              |                           |
|   |              |                           |
| Date:  | November 8,  2005 |                           | By: | /s/ James H. Perry |   |
|   |              |                           | James H. Perry  Vice President, and  Chief Financial Officer  (as duly authorized officer  and principal accounting  officer) |
|        |                   |                                |  |  |  |  |

 

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INDEX OF EXHIBITS FILED HEREWITH

 
| **Exhibit No.** |   |                                                                                    |
|-----------------|--------|-----------------------------------------------------------------------------------------|
|            |   |                                                                                    |
| 31.1            |   | Rule  13a-14(a)/15d-14(a) Certification by the Chief Executive Officer of the  Company. |
|            |   |                                                                                    |
| 31.2            |   | Rule  13a-14(a)/15d-14(a) Certification of the Chief Financial Officer of the Company.  |
|            |   |                                                                                    |
| 32.1            |   | Section 1350  Certification of the Chief Executive Officer of the Company.              |
|            |   |                                                                                    |
| 32.2            |   | Section 1350  Certification of the Chief Financial Officer of the Company.              |

 

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