** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

** **

**FORM 10-Q**

** **

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**                                               **For the quarterly period ended September30, 2006      

 

**or**

 

**o**                                 TRANSITIONREPORT 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

 

**UNITED INDUSTRIAL 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, including area code)

 

**Not Applicable**

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

 

Indicate by check mark whether the registrant: (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  x No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

Largeaccelerated filer o      Acceleratedfiler x      Non-acceleratedfiler o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o      No  x

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date: 11,240,539 sharesof common stock as of October 27, 2006.

 

 

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** **

**UNITED INDUSTRIALCORPORATION**

INDEX
|                                                                                                                   | ** ** | **Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART  I - FINANCIAL INFORMATION                                                                                   |       |     |       |
|                                                                                                              |       |     |       |
| Item  1. Financial Statements                                                                                     |       |     |       |
|                                                                                                              |       |     |       |
| Consolidated Condensed Balance Sheets -  September 30, 2006 and December 31, 2005                                 |       | 2        |       |
|                                                                                                              |       |     |       |
| Consolidated Condensed Statements of Operations -  Three Months and Nine Months Ended September 30, 2006 and 2005 |       | 3        |       |
|                                                                                                              |       |     |       |
| Consolidated Condensed Statements of Cash Flows -  Nine Months Ended September 30, 2006 and 2005                  |       | 4        |       |
|                                                                                                              |       |     |       |
| Notes to Consolidated Condensed Financial Statements                                                              |       | 5        |       |
|                                                                                                              |       |     |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations               |       | 30       |       |
|                                                                                                              |       |     |       |
| 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 6.  Exhibits                                                                                                 |       | 42       |       |
|                                                                                                              |       |     |       |
| SIGNATURES                                                                                                        |       | 43       |       |

 

1

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** **

**PART I - FINANCIAL INFORMATION**

**Item 1. - Financial Statements**

UNITEDINDUSTRIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED CONDENSED BALANCE SHEETS*(Dollarsin thousands)*
| ** **                                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                                                   | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                              |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                   |       | $                      | 137,722    |                  | $          | 77,496 |   |
| Marketable  equity securities                                                                                                                                                                                |       | —                 |       | 11,617                |       |
| Deposits and  restricted cash                                                                                                                                                                                |       | —                 |       | 4,810                 |       |
| Trade  receivables, net                                                                                                                                                                                      |       | 65,257                 |       | 69,284                |       |
| Inventories                                                                                                                                                                                                  |       | 35,925                 |       | 23,603                |       |
| Prepaid expenses  and other current assets                                                                                                                                                                   |       | 8,265                  |       | 9,244                 |       |
| Assets of  discontinued operations                                                                                                                                                                           |       | 12,386                 |       | 12,428                |       |
| Total current  assets                                                                                                                                                                                        |       | 259,555                |       | 208,482               |       |
| Marketable equity  securities                                                                                                                                                                                |       | 8,711                  |       | —                |       |
| Deferred income taxes                                                                                                                                                                                        |       | 13,527                 |       | 12,835                |       |
| Intangible assets, net                                                                                                                                                                                       |       | 9,623                  |       | 7,946                 |       |
| Goodwill                                                                                                                                                                                                     |       | 8,484                  |       | 3,607                 |       |
| Other assets                                                                                                                                                                                                 |       | 6,039                  |       | 6,602                 |       |
| Insurance receivable -  asbestos litigation                                                                                                                                                                  |       | 20,186                 |       | 20,186                |       |
| Property and equipment -  net                                                                                                                                                                                |       | 42,029                 |       | 44,743                |       |
| Total assets                                                                                                                                                                                                 |       | $                      | 368,154    |                  | $          | 304,401 |   |
|                                                                                                                                                                                                         |       |                   |       |                  |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                                   |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                         |       |                   |       |                  |       |
| Current portion  of long-term debt                                                                                                                                                                           |       | $                      | 675        |                  | $          | 964 |   |
| Accounts payable                                                                                                                                                                                             |       | 28,865                 |       | 25,787                |       |
| Accrued employee  compensation and taxes                                                                                                                                                                     |       | 17,228                 |       | 17,290                |       |
| Customer  advances                                                                                                                                                                                           |       | 43,750                 |       | 9,936                 |       |
| Other current  liabilities                                                                                                                                                                                   |       | 8,261                  |       | 10,211                |       |
| Liabilities of  discontinued operations                                                                                                                                                                      |       | 13,130                 |       | 13,287                |       |
| Total current  liabilities                                                                                                                                                                                   |       | 111,909                |       | 77,475                |       |
| Long-term debt                                                                                                                                                                                               |       | 120,046                |       | 120,723               |       |
| Post-retirement benefit  obligation other than pension                                                                                                                                                       |       | 18,612                 |       | 19,409                |       |
| Minimum pension  liability                                                                                                                                                                                   |       | 33,843                 |       | 28,448                |       |
| Accrual for asbestos  obligations                                                                                                                                                                            |       | 31,450                 |       | 31,450                |       |
| Other liabilities                                                                                                                                                                                            |       | 2,203                  |       | 1,374                 |       |
| Total  liabilities                                                                                                                                                                                           |       | 318,063                |       | 278,879               |       |
| 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; 11,420,539 and  11,279,379 shares outstanding at September 30, 2006 and December 31, 2005,  respectively (net of shares in treasury) |       | 14,374                 |       | 14,374                |       |
| Additional  capital                                                                                                                                                                                          |       | 85,583                 |       | 83,799                |       |
| Retained  earnings                                                                                                                                                                                           |       | 61,380                 |       | 39,724                |       |
| Treasury stock,  at cost; 2,953,609 and 3,094,769 shares at September 30, 2006 and December 31,  2005, respectively                                                                                     |       | (73,362                | )          | (76,868               | )          |
| Accumulated  other comprehensive loss, net of tax                                                                                                                                                            |       | (37,884                | )          | (35,507               | )          |
| Total  shareholders’ equity                                                                                                                                                                             |       | 50,091                 |       | 25,522                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                              |       | $                      | 368,154    |                  | $          | 304,401 |   |

 

See accompanyingnotes to the consolidated condensed financial statements.

2

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** **

UNITED INDUSTRIALCORPORATION AND SUBSIDIARIESCONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS*(Dollars in thousands, except per shareamounts)*(Unaudited)
| ** **                                                                                                                                                                                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                    | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                                                                                                                                                                                                     |       | $                                                    | 141,599    |                                                | $          | 126,402 |   | $ | 428,433 |   | $ | 353,878 |   |
| Operating costs and  expenses                                                                                                                                                                                                                 |       | 129,805                                              |       | 111,366                                             |       | 385,202 |   | 313,988 |   |
| Operating income                                                                                                                                                                                                                              |       | 11,794                                               |       | 15,036                                              |       | 43,231 |   | 39,890 |   |
| Non-operating income  and (expense):                                                                                                                                                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Gain on sale of  property                                                                                                                                                                                                                     |       | —                                               |       | —                                              |       | — |   | 7,152 |   |
| Interest income                                                                                                                                                                                                                               |       | 1,391                                                |       | 730                                                 |       | 3,572 |   | 2,479 |   |
| Interest expense                                                                                                                                                                                                                              |       | (1,578                                               | )          | (1,424                                              | )          | (4,403 | ) | (4,642 | ) |
| Other income  (expense), net                                                                                                                                                                                                                  |       | 187                                                  |       | 73                                                  |       | 385 |   | 962 |   |
|                                                                                                                                                                                                                                          |       | —                                               |       | (621                                                | )          | (446 | ) | 5,951 |   |
| Income from continuing  operations before income taxes                                                                                                                                                                                        |       | 11,794                                               |       | 14,415                                              |       | 42,785 |   | 45,841 |   |
| Provision for income  taxes                                                                                                                                                                                                                   |       | 4,423                                                |       | 5,101                                               |       | 15,986 |   | 15,602 |   |
| Income from continuing  operations                                                                                                                                                                                                            |       | 7,371                                                |       | 9,314                                               |       | 26,799 |   | 30,239 |   |
| (Loss) income from  discontinued operations, net of income tax benefit (provision) of $607 and  ($330) for the three months ended September 30, 2006 and 2005 and $930  and ($736) for the nine months ended September 30, 2006 and 2005 |       | (1,125                                               | )          | 112                                                 |       | (1,726 | ) | 305 |   |
| Net income                                                                                                                                                                                                                                    |       | $                                                    | 6,246      |                                                | $          | 9,426 |   | $ | 25,073 |   | $ | 30,544 |   |
|                                                                                                                                                                                                                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Basic earnings per  share:                                                                                                                                                                                                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                                                                            |       | $                                                    | 0.65       |                                                | $          | 0.80 |   | $ | 2.36 |   | $ | 2.52 |   |
| (Loss) income  from discontinued operations                                                                                                                                                                                                   |       | (0.10                                                | )          | 0.01                                                |       | (0.15 | ) | 0.02 |   |
| Net income                                                                                                                                                                                                                                    |       | $                                                    | 0.55       |                                                | $          | 0.81 |   | $ | 2.21 |   | $ | 2.54 |   |
| Diluted earnings per  share:                                                                                                                                                                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                                                                            |       | $                                                    | 0.56       |                                                | $          | 0.68 |   | $ | 1.99 |   | $ | 2.13 |   |
| (Loss) income  from discontinued operations                                                                                                                                                                                                   |       | (0.08                                                | )          | 0.01                                                |       | (0.12 | ) | 0.02 |   |
| Net income                                                                                                                                                                                                                                    |       | $                                                    | 0.48       |                                                | $          | 0.69 |   | $ | 1.87 |   | $ | 2.15 |   |

 

See accompanying notes tothe consolidated condensed financial statements.

3

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** **

UNITED INDUSTRIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS*(Dollars in thousands)*(Unaudited)
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 25,073     |   | $ | 30,544 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Loss (income)  from discontinued operations, net of taxes                          |       | 1,726                                               |       | (305 | ) |
| Amortization of  debt issuance costs and deferred financing costs                  |       | 949                                                 |       | 1,262 |   |
| Depreciation and  amortization                                                     |       | 8,568                                               |       | 6,268 |   |
| Stock-based  compensation                                                          |       | 1,817                                               |       | — |   |
| Gain on sale of  property                                                          |       | —                                              |       | (7,152 | ) |
| Deferred income  tax (benefit) provision                                           |       | (1,067                                              | )          | 2,664 |   |
| Income from  equity investment in joint venture                                    |       | (222                                                | )          | (166 | ) |
| Excess tax  benefit from stock-based compensation                                  |       | (1,059                                              | )          | — |   |
| Other — net                                                                   |       | 151                                                 |       | (403 | ) |
| Changes in  operating assets and liabilities:                                      |       |                                                |       |   |   |
| Decrease  (increase) in trade receivables                                          |       | 4,027                                               |       | (11,930 | ) |
| (Increase)  decrease in inventories                                                |       | (12,072                                             | )          | 2,247 |   |
| Decrease in  prepaid expenses and other current assets                             |       | 1,559                                               |       | 1,779 |   |
| Increase  (decrease) in accounts payable, accruals and other current liabilities   |       | 1,322                                               |       | (459 | ) |
| Increase in  customer advances                                                     |       | 33,814                                              |       | 4,360 |   |
| Increase in  long-term liabilities                                                 |       | 5,426                                               |       | 1,929 |   |
| Net cash provided by  operating activities from continuing operations              |       | 70,012                                              |       | 30,638 |   |
| Net cash used in  operating activities by discontinued operations                  |       | (1,841                                              | )          | (3,418 | ) |
| Net cash provided by  operating activities                                         |       | 68,171                                              |       | 27,220 |   |
|                                                                               |       |                                                |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         |       |                                                |       |   |   |
| Purchases of property  and equipment                                               |       | (5,152                                              | )          | (18,278 | ) |
| Proceeds from sale of  available-for-sale securities                               |       | —                                              |       | 124,626 |   |
| Purchase of marketable  equity securities                                          |       | —                                              |       | (12,780 | ) |
| Business acquisition,  net of cash acquired                                        |       | (6,701                                              | )          | (9,883 | ) |
| Proceeds from sale of  property                                                    |       | —                                              |       | 7,555 |   |
| Net cash (used in)  provided by investing activities                               |       | (11,853                                             | )          | 91,240 |   |
|                                                                               |       |                                                |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         |       |                                                |       |   |   |
| Repayment of long-term  debt                                                       |       | (966                                                | )          | (947 | ) |
| Repayment of collateral  received from securities lending transaction              |       | —                                              |       | (124,619 | ) |
| Decrease in deposits  and restricted cash                                          |       | 4,810                                               |       | 29,033 |   |
| Proceeds from exercise  of stock options                                           |       | 2,414                                               |       | 1,474 |   |
| Excess tax benefit from  stock-based compensation                                  |       | 1,059                                               |       | — |   |
| Dividends paid                                                                     |       | (3,409                                              | )          | (3,705 | ) |
| Purchase of treasury  shares                                                       |       | —                                              |       | (34,225 | ) |
| Net cash provided by  (used in) financing activities                               |       | 3,908                                               |       | (132,989 | ) |
| Increase (decrease) in  cash and cash equivalents                                  |       | 60,226                                              |       | (14,529 | ) |
| Cash and cash  equivalents at beginning of year                                    |       | 77,496                                              |       | 80,679 |   |
| Cash and cash equivalents at end of period                                         |       | $                                                   | 137,722    |   | $ | 66,150 |   |

 

See accompanyingnotes to the consolidated condensed financial statements.

4

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** **

UNITED INDUSTRIALCORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS(Dollars in thousands, except share and per share amounts, or unless otherwisenoted)

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

Theaccompanying Consolidated Condensed Financial Statements of United IndustrialCorporation (“United Industrial”) and its subsidiaries (collectively, the “Company”)have been prepared in accordance with accounting principles generally acceptedin the United States of America (GAAP) for interim financial information andwith the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of theinformation and notes required by GAAP for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring items) considered necessary for a fairpresentation have been included. Operating results for the three month and nine month periods endedSeptember 30, 2006 are not necessarily indicative of the results that may beexpected for the year ending December 31, 2006. These unaudited Consolidated Condensed Financial Statements should beread in conjunction with the Consolidated Financial Statements and notesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005.

OnApril 4, 2005, the Company acquired ESL Defence Limited (“ESL”), an electronicwarfare systems company based in the United Kingdom. The operating results ofESL have been included in the consolidated financial statements of the Companysince April 4, 2005.  On June 19, 2006,the Company acquired Aerosonde Pty  Ltd,a Victoria, Australia-based manufacturer of Unmanned Aircraft Vehicles (“UAV”)and Aerosonde North America, Inc., which operates the Aerosonde UAV in supportof customer research and development and weather forecasting requirements ofU.S. based customers (collectively “Aerosonde”).  The operating results of Aerosonde have beenincluded in the consolidated financial statements of the Company since June 19,2006.

The Company conducts asignificant amount of business with the U.S. Government.  No single customer other than the U.S.Government accounted for ten percent or more of consolidated net sales in anyyear.

Thepreparation of financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements as well as reported amounts of revenues andexpenses during the reporting period. Actual results could differ from these estimates and those differencescould be material.  Certain prior yearamounts have been reclassified to conform to current year presentation.  Specifically, general and administrativeexpenses have been included in operating costs and expenses.

**Note B -****New Accounting Prouncement**

OnJuly 13, 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty inIncome Taxes — an Interpretation of FASB Statement No. 109 (“FIN 48”) wasissued.  The provisions of FIN 48 areeffective for fiscal years beginning after December 15, 2006.  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, Accounting for Income Taxes.  It also prescribes a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.  The Company is currently evaluating theimpact of FIN 48 on its results of operations, financial condition or cashflows.

InSeptember 2006, Statement of Financial Accounting Standards No. 158, Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans, anamendment of FASB Statements No. 87, 88, 106, and 132(R), (“SFAS No. 158”) wasissued and is effective for the year ended December 31, 2006.  Under SFAS No. 158, the Company will berequired to initially recognize the overfunded or underfunded status of adefined benefit postretirement plan as an asset or liability in its statementof financial position and to recognize changes in that funded status in theyear in which the changes occur as a component of comprehensive income.  Upon adoption of SFAS No. 158, plan assetsand benefit obligations may continue to be measured as of a date not more thanthree months prior to the balance sheet date. The requirement to measure planassets and benefit obligations as of the date of the employer’s fiscal year-endstatement of financial position is effective for fiscal years ending afterDecember 15, 2008. The Company is currently in the process of assessing theimpact the adoption of SFAS 158 will have on its financial condition.

In September 2006, the Securities andExchange Commission issued Staff Accounting Bulletin No. 108, Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements (“SAB No. 108”), which provides interpretive guidanceon the consideration of the effects of prior year misstatements in quantifyingcurrent year misstatements for the purpose of a materiality assessment. SAB No.108 requires registrants to quantify misstatements using both the balance sheetand income statement approaches and to evaluate whether either approach resultsin quantifying an error that is material based on relevant quantitative andqualitative factors. The guidance is effective for the first fiscal periodending after November 15, 2006. Upon adoption the Company does not expect SABNo. 108 to have a material effect on its results of operations, financialcondition or cash flows.

5

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** **

**Note C -Segment Information - Continuing Operations**

The Company consists of two reportable segments:Defense and Energy.  The operations ofthe Defense and Energy segments are conducted principally through two whollyowned subsidiaries, AAI Corporation and its subsidiaries (“AAI”) and Detroit StokerCompany (“Detroit Stoker”), respectively. The Company measures its segment performance based on income (loss)before income taxes.  Costs related tothe continuing operations that are not identified with the two businesssegments primarily relate to financing costs and are grouped under the headingOther.  The Company has a transportationoperation that is accounted for as discontinued operations in the accompanyingConsolidated Condensed Financial Statements.
| ** **                                                    | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Three Months  Ended September 30, 2006                        |       |        |       |       |       |      |       |       |       |
| Net sales                                                     |       | $           | 131,350    |       | $          | 10,249    |       | $          | —     |   | $ | 141,599 |   |
| Operating costs  and expenses                                 |       | 121,308     |       | 7,973      |       | 524       |       | 129,805    |       |
| Operating income  (loss)                                      |       | 10,042      |       | 2,276      |       | (524      | )          | 11,794     |       |
| Income from  equity investment in joint venture               |       | 9           |       | —     |       | —    |       | 9          |       |
| Interest income  (expense), net                               |       | 38          |       | 205        |       | (430      | )          | (187       | )          |
| Depreciation and  amortization expense                        |       | 3,071       |       | 49         |       | —    |       | 3,120      |       |
| Income (loss) from  continuing operations before income taxes |       | 10,207      |       | 2,573      |       | (986      | )          | 11,794     |       |
|                                                               |            |             |            |            |            |           |            |            |            |  |  |  |  |

 
| ** **                                                    | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Three Months  Ended September 30, 2005                        |       |        |       |       |       |      |       |       |       |
| Net sales                                                     |       | $           | 116,815    |       | $          | 9,587     |       | $          | —     |   | $ | 126,402 |   |
| Operating costs  and expenses                                 |       | 103,080     |       | 8,302      |       | (16       | )          | 111,366    |       |
| Operating income                                              |       | 13,735      |       | 1,285      |       | 16        |       | 15,036     |       |
| Income from  equity investment in joint venture               |       | 114         |       | —     |       | —    |       | 114        |       |
| Interest income  (expense), net                               |       | 104         |       | 61         |       | (859      | )          | (694       | )          |
| Depreciation and  amortization expense                        |       | 2,185       |       | 73         |       | —    |       | 2,258      |       |
| Income (loss) from  continuing operations before income taxes |       | 13,794      |       | 1,386      |       | (765      | )          | 14,415     |       |
|                                                               |            |             |            |            |            |           |            |            |            |  |  |  |  |

 
| ** **                                                    | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Nine Months  Ended September 30, 2006                         |       |        |       |       |       |      |       |       |       |
| Net sales                                                     |       | $           | 397,451    |       | $          | 30,982    |       | $          | —     |   | $ | 428,433 |   |
| Operating costs  and expenses                                 |       | 360,267     |       | 23,714     |       | 1,221     |       | 385,202    |       |
| Operating income  (loss)                                      |       | 37,184      |       | 7,268      |       | (1,221    | )          | 43,231     |       |
| Income from  equity investment in joint venture               |       | 222         |       | —     |       | —    |       | 222        |       |
| Interest income  (expense), net                               |       | 530         |       | 528        |       | (1,889    | )          | (831       | )          |
| Depreciation and  amortization expense                        |       | 8,425       |       | 143        |       | —    |       | 8,568      |       |
| Income (loss) from  continuing operations before income taxes |       | 38,039      |       | 7,918      |       | (3,172    | )          | 42,785     |       |
|                                                               |            |             |            |            |            |           |            |            |            |  |  |  |  |

 
| ** **                                                    | ** ** | **Defense** | ** ** | **Energy** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|------------|------------|-----------|------------|------------|------------|
| Nine Months  Ended September 30, 2005                         |       |        |       |       |       |      |       |       |       |
| Net sales                                                     |       | $           | 328,586    |       | $          | 25,292    |       | $          | —     |   | $ | 353,878 |   |
| Operating costs  and expenses                                 |       | 291,032     |       | 23,004     |       | (48       | )          | 313,988    |       |
| Operating income                                              |       | 37,554      |       | 2,288      |       | 48        |       | 39,890     |       |
| Income from  equity investment in joint venture               |       | 166         |       | —     |       | —    |       | 166        |       |
| Interest income  (expense), net                               |       | 220         |       | 146        |       | (2,529    | )          | (2,163     | )          |
| Depreciation and  amortization expense                        |       | 6,045       |       | 223        |       | —    |       | 6,268      |       |
| Income (loss) from  continuing operations before income taxes |       | 45,453      |       | 2,474      |       | (2,086    | )          | 45,841     |       |
|                                                               |            |             |            |            |            |           |            |            |            |  |  |  |  |

 

6

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#####  

##### **Note D - Earnings Per Share**

Basic earnings per sharefor all periods presented was computed by dividing net earnings for therespective period by the weighted average number of shares of the Company’scommon stock outstanding during the period. Diluted earnings per share was computed by dividing (i) net earningsduring the period, adjusted to add back the after-tax interest and other  charges incurred on the Company’s $120,000aggregate 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 using the treasury stock method and conversion of the3.75% Convertible Senior Notes for Common Stock.

Options to purchase131,500 shares of the Company’s Common Stock for both the three and nine monthsended September 30, 2006, and options to purchase 189,000 shares of the Company’sCommon Stock for the nine months ended September 30, 2005 were not included inthe computation of diluted earnings per share because their impact would beanti-dilutive.

Basic and dilutedearnings per share amounts were computed as follows:
| ** **                         | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **Earnings**                                             | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                               |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Basic Earnings  Per Share          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations  |       | $                                                        | 7,371      |   | 11,420,539 |   | $ | 0.65 |   | $ | 9,314 |   | 11,652,025 |   | $ | 0.80 |   |
|                               |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  Dilutive Securities     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Stock Options                      |       | —                                                   |       | 356,646 |   |   |   | — |   | 286,421 |   |   |   |
| 3.75% Convertible Senior Notes     |       | 911                                                      |       | 3,058,356 |   |   |   | 855 |   | 3,058,356 |   |   |   |
| Diluted Earnings  Per Share        |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing  operations |       | $                                                        | 8,282      |   | 14,835,541 |   | $ | 0.56 |   | $ | 10,169 |   | 14,996,802 |   | $ | 0.68 |   |

 
| ** **                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **Earnings**                                            | ** ** | **Shares** | ** ** | **Per Share** | ** ** | **Earnings** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                               |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Basic Earnings  Per Share          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Income from continuing operations  |       | $                                                       | 26,799     |   | 11,370,735 |   | $ | 2.36 |   | $ | 30,239 |   | 12,012,831 |   | $ | 2.52 |   |
|                               |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Effect of  Dilutive Securities     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Stock Options                      |       | —                                                  |       | 396,376 |   |   |   | — |   | 272,127 |   |   |   |
| 3.75% Convertible Senior Notes     |       | 2,713                                                   |       | 3,058,356 |   |   |   | 2,449 |   | 3,058,356 |   |   |   |
| Diluted Earnings  Per Share        |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Income from  continuing operations |       | $                                                       | 29,512     |   | 14,825,467 |   | $ | 1.99 |   | $ | 32,688 |   | 15,343,314 |   | $ | 2.13 |   |

 

7

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** **

**Note E -Stock-Based Compensation**

TheCompany adopted the provisions of Statement of Financial Accounting StandardsNo. 123 Revised, Accounting for Stock-Based Compensation (“SFAS 123R”) onJanuary 1, 2006, using the modified prospective method.  Under that transition method, compensationcost is recognized for all awards granted after the effective date, and to allawards modified, repurchased, or cancelled after that date.  In addition, compensation cost is recognizedon or after the effective date for the portion of outstanding awards for whichthe requisite service has not yet been rendered, based on the grant date fairvalue of those awards previously calculated and reported in the pro formadisclosures under Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation, (“SFAS No. 123”).  Stock-based compensation expense of $674 and$1,817 was recorded in operating costs and expenses included in operatingincome for the three and nine months ended September 31, 2006,respectively.  In accordance with themodified prospective adoption method of SFAS 123R, financial results for theprior periods have not been restated. Based on the number of unvested outstanding awards at September 30,2006, the effect of adopting SFAS No. 123R is the recording of compensationcost for the year ended December 31, 2006, of approximately $2,518 beforetax.  Additional compensation cost willbe recognized as new options are awarded. The Company has not made any material modifications to its stock-basedcompensation plans as the result of the issuance of SFAS No. 123R.  The Company calculated the pool of excess taxbenefits available to absorb tax deficiencies recognized subsequent to theadoption of Statement 123(R) (APIC pool) based on information about the amountsthat would have qualified as excess tax benefits had the Company adoptedStatement 123 for recognition purposes prior to January 1, 2006.  The Company did not elect the alternativetransition method FASB Staff Position FAS 123(R)-3: Transition Election toAccounting for the Tax Effects of Share-Based Payment Awards, to account forthe tax effects of share-based payment awards to employees.

Prior to January 1, 2006, the Company accountedfor its stock-based compensation plans in accordance with Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”),and its related implementation guidance, whereby compensation cost for stockoptions was recognized in earnings based on the excess, if any, of the quotedmarket price of the stock at the grant date of the award or other measurementdate over the amount an employee must pay to acquire the stock.  Had compensation cost been determinedconsistent with the fair value method set forth under SFAS No. 123, for allawards under the plans, income and earnings per share from continuingoperations would have decreased to the pro forma amounts indicated below forthe three and nine months ended September 30, 2005:
| ** **                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                             | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
|                                                                                                                   |       |                             |       |                             |       |
| Income from  continuing operations:                                                                                    |       |                             |       |                             |       |
| As reported                                                                                                            |       | $                                | 9,314      |                             | $          | 30,239 |   |
| Deduct: Total employee stock-based compensation  expense determined under fair value method for all awards, net of tax |       | (198                             | )          | (665                             | )          |
|                                                                                                                   |       |                             |       |                             |       |
| Pro forma income from continuing operations  determined under the fair value based method, net of tax        |       | $                                | 9,116      |                             | $          | 29,574 |   |
|                                                                                                                   |       |                             |       |                             |       |
| Earnings per  share from continuing operations:                                                                        |       |                             |       |                             |       |
|                                                                                                                   |       |                             |       |                             |       |
| As reported:                                                                                                           |       |                             |       |                             |       |
| Basic                                                                                                                  |       | $                                | 0.80       |                             | $          | 2.52 |   |
| Diluted                                                                                                                |       | 0.68                             |       | 2.13                             |       |
| Pro forma:                                                                                                             |       |                             |       |                             |       |
| Basic                                                                                                                  |       | $                                | 0.78       |                             | $          | 2.46 |   |
| Diluted                                                                                                                |       | 0.66                             |       | 2.09                             |       |

 

8

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On May 18, 2006, the Company’s shareholdersapproved the 2006 Long Term Incentive Plan (the “2006 Plan”) at the AnnualMeeting of Shareholders.  The 2006 Planwas approved by the Company’s Board of Directors (the “Board”) onMarch 30, 2006, subject to shareholder approval. The 2006 Plan providesfor the granting of cash and equity-based incentives in the form ofnon-qualified stock options, stock appreciation rights, performance shares,restricted stock, other stock-based awards and performance-based cash awards toall of the Company’s employees, consultants and non-employee directors. Inaddition, employees of the Company’s affiliates that qualify as subsidiaries(as defined under Section 424 of the Internal Revenue Code) are eligible to begranted incentive stock options under the 2006 Plan. The 2006 Plan isadministered by the Compensation and Stock Option Committee of the Board ofDirectors (the “Compensation Committee”).

Awards that were granted on or prior to May 18,2006 (collectively, the “Prior Awards”), under the United IndustrialCorporation 1994 Stock Option Plan, as amended, United Industrial Corporation1996 Stock Option Plan for Non-employee Directors, as amended, and UnitedIndustrial Corporation 2004 Stock Option Plan (collectively the “Prior Plans”),were transferred to and assumed by the 2006 Plan as of May 18, 2006, and aresubject to the 2006 Plan’s share reserves and provisions in respect ofadjustments; provided that the Prior Awards otherwise continue to be governedby the terms of the applicable agreement in effect prior to such assumption andtransfer.  Upon approval of the 2006Plan, no further awards may be made under the Prior Plans.

The aggregate number of shares of common stock which may be issued orused for reference purposes under the 2006 Plan is 1,787,204 shares, of which1,034,704 shares are in respect of the Prior Awards.  Shares issued under the 2006 Plan may beauthorized and unissued shares or previously issued shares acquired or to beacquired by the Company and held in its treasury. As of September 30, 2006, theCompany had not awarded any equity-based compensation under the 2006 Plan otherthan stock options.  Under the 2006 Plan,the exercise price for each share subject to a stock option granted may not beless than 100% of the market value of the common stock on the date the stockoption is granted.

Underthe terms of the 2006 Plan, the term of each stock option granted to anemployee or consultant is fixed by the Compensation Committee, provided that nostock option may be exercisable more than 10 years after the date the stockoption is granted; and provided further that the term of an Incentive StockOption granted to a ten percent shareholder may not exceed five years.

Unlessotherwise determined by the Compensation Committee at the time of grant or in awritten employment agreement, employee and consultant awards subject to vestingand/or restrictions will accelerate and vest, or restrictions will lapse, upona change in control (as defined in the 2006 Plan) of the Company.  In addition, at the discretion of theCompensation Committee, such awards will be (i) assumed and continued orsubstituted in accordance with applicable law, (ii) purchased by the Companyfor an amount equal to the excess of the price of the Company’s common stockpaid in a change in control over the exercise price of the award, or (iii)cancelled if the price of the Company’s common stock paid in a change incontrol is less than the exercise price of the award.  The Compensation Committee may also, in itssole discretion, provide for accelerated vesting or lapse of restrictions of anaward at any time.  All awards under the2006 Plan must be granted subject to a minimum one-year vesting condition,other than in the case of the participant’s death or change in control.

Underthe 2006 Plan, the Compensation Committee may grant nonqualified stock optionsto non-employee directors to purchase up to 5,000 shares of common stock as ofthe date of the annual meeting of the shareholders of the Company at which thedirector is elected or re-elected to service. Stock options granted tonon-employee directors are exercisable at the next annual meeting ofshareholders of the Company that occurs after the date of grant subject to thedirector’s continuous service through that date.  All non-employee director stock optionsbecome fully vested and exercisable in the event of a change in control of theCompany during the director’s period of service, and are exercisable for aperiod of one year following termination of service as a director unless forcause (as defined in the Plan), in which case the stock option will beimmediately cancelled.

Underthe 2004 Plan and the 1994 Plan (collectively, the “Prior Employee Option Plans”),the exercise price for each share subject to a stock option may not be lessthan 100% of the market value of the common stock on the date the stock optionwas granted.  Stock options granted underthe Prior Employee Option Plans are exercisable over a period determined by theBoard of Directors, but no longer than ten years after the date they aregranted under the 1994 Plan and five years for the 2004 Plan.  Stock options granted under the PriorEmployee Option Plans generally vest in three equal installments on the first,second and third anniversaries of the date of grant. Under the Prior EmployeePlans, upon change in control (as defined in the plan) all outstanding stockoptions become immediately exercisable. In addition, at the discretion of the Compensation Committee, such stockoption may be terminated for an amount equal to the excess of the price of theCompany’s common stock paid in a change in control over the exercise price ofthe stock option.

9

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Underthe 1996 Stock Option Plan for Non-Employee Directors, as amended (the “1996Plan”), the exercise price for each share subject to a stock option granted maynot be less than 100% of the market value of the common stock on the date thestock option was granted.  With theexception of two grants, stock options granted under the 1996 Plan areexercisable up to one-third as of the grant date of the stock option, and up toan additional one-third as of the date of each subsequent annual meeting ofshareholders.  Stock options grantedpursuant to the 1996 Plan prior to April 8, 2004 expire and are no longerexercisable after ten years from the date of grant, and, as the result of anamendment to the 1996 Plan during 2004, stock options granted after April 8,2004 expire after five years from the date of grant. Pursuant to the 1996 Plan,Eligible Directors (as defined in the 1996 Plan) were granted a stock option topurchase 15,000 shares of common stock upon initial appointment to the Board ofDirectors.  Thereafter, each EligibleDirector received further automatic grants of a stock option to purchase 15,000shares of common stock on the date of the third annual shareholders’ meetingfollowing the date of the last grant under the 1996 Plan provided the directorcontinued in office following the annual meeting. Upon a change in control (asdefined in the 1996 Plan), all outstanding stock options become immediatelyexercisable, and upon the occurrence of certain change in control events,immediately terminate and entitle the holder to an amount equal to the excessof the price of the Company’s common stock paid in a change in control over theexercise price of the stock option.

Inconnection with the adoption of the 2006 Plan by the Board of Directors inMarch 2006, the Board of Directors amended the 1996 Plan to provide for a finalaward under the 1996 Plan of a fully exercisable stock option to purchase 5,000shares to two directors re-elected at the 2006 annual meeting of shareholderswho otherwise would have received automatic grants for 15,000 sharesexercisable under the old formula described above.

Asummary of stock option activity under all plans is as follows:
| ** **                           | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Remaining  Contractual  Term (Yrs)** | ** ** | **Weighted -  Average  Exercise Price** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|---------------------------------------------------|------------|
|                                 |       |                                            |       |                            |       |                                        |       |                                              |       |
| Balance at  December 31, 2005        |       | 945                                             |       | —                          |       | —                                      |       | $                                                 | 20.73      |   |
| Granted                              |       | 214                                             |       | —                          |       | —                                      |       | $                                                 | 51.90      |   |
| Exercised                            |       | (141                                            | )          | —                          |       | —                                      |       | $                                                 | 17.10      |   |
| Cancelled                            |       | (6                                              | )          | —                          |       | —                                      |       | $                                                 | 37.92      |   |
| Balance at  September 30, 2006       |       | 1,012                                           |       | $                               | 26,280     |                                        | 4.97       |                                              | $          | 27.74 |   |
|                                 |       |                                            |       |                            |       |                                        |       |                                              |       |
| Exercisable at  September 30, 2006   |       | 596                                             |       | $                               | 20,650     |                                        | 5.09       |                                              | $          | 18.84 |   |
| Unexercisable at  September 30, 2006 |       | 416                                             |       | $                               | 5,630      |                                        | 4.80       |                                              | $          | 40.47 |   |
| Available for future  grants         |       | 775                                             |       |                            |       |                                        |       |                                              |       |

 

Asummary of nonvested stock option activity under all plans is as follows:
| ** **                       | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Weighted -  Average Grant  Date  Fair Value** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|----------------------------------------------------------------|------------|
|                             |       |                                            |       |                                                           |       |
| Nonvested at  January 1, 2006    |       | 366                                             |       | $                                                              | 9.29       |   |
| Granted                          |       | 214                                             |       | $                                                              | 18.15      |   |
| Vested                           |       | (158                                            | )          | $                                                              | 9.10       |   |
| Cancelled                        |       | (6                                              | )          | $                                                              | 12.83      |   |
| Nonvested at September  30, 2006 |       | 416                                             |       | $                                                              | 13.87      |   |

 

Asof September 30, 2006, there was $4,411 of total unrecognized compensation costrelated to nonvested share-based compensation arrangements granted under theplans.  That cost is expected to berecognized over a three year period.

10

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Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model to estimate the fair value of employee stockoptions based on the exercise price of the option, the expected term of theoption, the current price of the underlying share, the expected volatility ofthe price of the underlying share over the expected life of the option, theexpected dividends on the underlying share and the risk-free interest rate forthe expected term of the option as of the date of grant using the followingassumptions:
| ** **              | ** ** | **2006 Grants** | ** ** | **2005 Grants** | ** ** |
|-------------------------|------------|----------------------|------------|----------------------|------------|
| * *                | * *   | * *             | * *   | * *             | * *   |
| Risk-free interest rate |       | 4.46% - 4.95%        |       | 3.73% - 4.36%        |       |
| Expected dividend yield |       | 0.68% - 0.90%        |       | 1.00% - 1.30%        |       |
| Expected volatility     |       | 38.42% - 40.61%      |       | 35.79% - 40.31%      |       |
| Expected life           |       | 4.0 years            |       | 5.0 years            |       |

#####  

##### **NoteF****-****Marketable Equity Securities**

TheCompany’s investment in marketable equity securities consists of an investmentin common stock of one company in the Aerospace and Defense industry.Unrealized holding gains and losses deemed temporary on available-for-salesecurities are excluded from earnings and are reported as a separate componentof other comprehensive income until realized. If an unrealized holding loss is deemed to be other-than-temporary, suchunrealized loss is charged to earnings when identified. The Company’s basis inthe investment is $12,602.  An unrealizedgain of $824 in the third quarter was recorded in other comprehensive income atSeptember 30, 2006.  At September 30,2006 the cumulative net unrealized loss recorded in other comprehensive incomewas $3,890.  In June 2006, the investeecompany disclosed the indictment of the investee company and its chairman andsuspension of certain of its plants from receiving U.S. government contracts,and possible delisting of its common stock.  Management believes that thedisclosure by the investee Company caused the significant devaluation of theircommon stock and resulted in the recording at June 30, 2006 of an unrealizedloss of $6,074 in the second quarter in other comprehensive income.  In September 2006, the investee companyannounced that its company stock will not be delisted.  In October 2006, the investee companyannounced that the suspension of certain of its plants from receiving U.S.government contracts had been lifted.  Managementcontinues to evaluate the financial stability of the investee Company inrelation to the severity and duration of the unrealized loss.  Based on that evaluation and the Company’sability and intent to hold the investment for a reasonable period of timesufficient for a forecasted recovery of fair value, the Company does notconsider this investment to be other-than-temporarily impaired at September 30,2006.

##### **NoteG - Supplemental Balance Sheet and Cash Flow Information**

Inventories consisted of the following components:
| ** **                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Finished goods  and work-in-process |       | $                      | 32,528     |                  | $          | 21,601 |   |
| Materials and  supplies             |       | 3,397                  |       | 2,002                 |       |
| Total inventories                   |       | $                      | 35,925     |                  | $          | 23,603 |   |

 

Cashpaid for Federal income taxes during the nine months ended September 30, 2006and 2005 was $14,690 and $10,100, respectively. Cash paid for interest duringthe nine months ended September 30, 2006 and 2005 was $4,776 and $4,550,respectively.

11

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** **

**Note H - Pension and OtherPost-retirement Benefits**

Thefollowing table provides the components of net periodic pension benefit costfor the three and nine months ended September 30, 2006 and 2005:
| ** **                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                               |       |                                                 |       |                                                |       |   |   |   |   |
| Service cost                       |       | $                                                    | 913        |                                                | $          | 819 |   | $ | 3,297 |   | $ | 2,437 |   |
| Interest cost                      |       | 2,697                                                |       | 2,576                                               |       | 7,929 |   | 7,733 |   |
| Expected return  on plan assets    |       | (3,123                                               | )          | (3,213                                              | )          | (9,538 | ) | (9,632 | ) |
| Net amortization  and deferral:    |       |                                                 |       |                                                |       |   |   |   |   |
| Amortization of prior service cost |       | 157                                                  |       | 69                                                  |       | 521 |   | 207 |   |
| Amortization of actuarial loss     |       | 1,440                                                |       | 1,019                                               |       | 3,964 |   | 3,128 |   |
| Net periodic pension  benefit cost |       | $                                                    | 2,084      |                                                | $          | 1,270 |   | $ | 6,173 |   | $ | 3,873 |   |

 

Thefollowing table provides the components of post-retirement benefit obligationcost other than pension for the three and nine months ended September 30, 2006and 2005:
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                |       |                                                 |       |                                                |       |   |   |   |   |
| Service cost                        |       | $                                                    | 43         |                                                | $          | 48 |   | $ | 130 |   | $ | 143 |   |
| Interest cost                       |       | 307                                                  |       | 297                                                 |       | 923 |   | 890 |   |
| Net amortization  and deferral:     |       |                                                 |       |                                                |       |   |   |   |   |
| Amortization of prior service cost  |       | (3                                                   | )          | (5                                                  | )          | (10 | ) | (14 | ) |
| Amortization of actuarial loss      |       | 38                                                   |       | 3                                                   |       | 113 |   | 9 |   |
| Other  post-retirement benefit cost |       | $                                                    | 385        |                                                | $          | 343 |   | $ | 1,156 |   | $ | 1,028 |   |

 

The following tableprovides the Company’s contributions to and benefits paid under pension andpost-retirement benefit plans for the nine months ended September 30, 2006 and2005:
| ** **                                                                 | ** ** | **Pension Benefits  Nine Months Ended  September 30,** | ** ** | **Post-retirement Benefit  Obligation Other Than  Pension  Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                                   | ** ** | **2005**                                                                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                       |       |                                                                       |       |                                                                                                                        |       |   |   |   |   |
| Expected fiscal  year contributions reported at the end of the prior year: |       |                                                                       |       |                                                                                                                        |       |   |   |   |   |
| Employer                                                                   |       | $                                                                          | 935        |                                                                                                                        | $          | 244 |   | $ | 2,689 |   | $ | 3,007 |   |
| Employee                                                                   |       | —                                                                     |       | —                                                                                                                      |       | — |   | — |   |
|                                                                       |       | 935                                                                        |       | 244                                                                                                                         |       | 2,689 |   | 3,007 |   |
|                                                                       |       |                                                                       |       |                                                                                                                        |       |   |   |   |   |
| Actual  contributions made in the current year                             |       | 779                                                                        |       | 193                                                                                                                         |       | 2,210 |   | 2,347 |   |
| Remaining  contributions expected to be made in the current year           |       | 1,326                                                                      |       | 51                                                                                                                          |       | 387 |   | 752 |   |
| Total expected  current year contributions                                 |       | 2,105                                                                      |       | 244                                                                                                                         |       | 2,597 |   | 3,099 |   |
| Difference from  expectations at end of the prior year                     |       | $                                                                          | 1,170      |                                                                                                                        | $          | — |   | $ | (92 | ) | $ | 92 |   |

 

12

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** **

##### **Note I - Comprehensive Income**

The following table sets forth the components of othercomprehensive income and total comprehensive income:
| ** **                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                   |       | $                                                    | 6,246      |                                                | $          | 9,426 |   | $ | 25,073 |   | $ | 30,544 |   |
|                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Other comprehensive  income:                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Unrealized gain (loss)  on marketable securities, net of tax |       | 824                                                  |       | 179                                                 |       | (3,251 | ) | 334 |   |
| Gain (loss) on  foreign currency translation                 |       | 380                                                  |       | (176                                                | )          | 874 |   | (418 | ) |
| Total comprehensive  income                                  |       | $                                                    | 7,450      |                                                | $          | 9,429 |   | $ | 22,696 |   | $ | 30,460 |   |

#####  

##### **Note J - Acquisitions**

On June 19, 2006, the Companyacquired Aerosonde in stock purchase transactions for an aggregate purchaseprice of $6,701 net of cash acquired, with additional consideration payableupon the achievement of certain milestones. The operating results of Aerosonde have been included in theconsolidated financial statements of the Company since June 19, 2006.  The purchase price for the stock of Aerosondehas been allocated to the estimated fair value of net tangible and intangibleassets acquired, with any excess recorded as Goodwill.  The estimates related to the acquisition arestill preliminary at September 30, 2006. The Company is awaiting the completion of the final identification andvaluation of intangible assets acquired.

|                           | ** ** | **At June 19, 2006** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
|                      |       |                                |       |
| Cash and equivalents      |       | 80                                  |       |
| Current assets            |       | 856                                 |       |
| Property and equipment    |       | 179                                 |       |
| Intangible assets         |       | 2,029                               |       |
| Goodwill                  |       | 4,578                               |       |
| Total assets acquired     |       | 7,722                               |       |
|                      |       |                                |       |
| Current liabilities       |       | 1,131                               |       |
| Total liabilities assumed |       | 1,131                               |       |
| Net assets acquired       |       | 6,591                               |       |

#####  

##### **Note K - Discontinued TransportationOperations**

InDecember 2001, a decision was made to discontinue the Transportation business.Further, the Company ceased to accept new transportation business at thattime.  It was decided that AAI would sellall or part of the Transportation business and “runoff” the operations for anyremaining contractual obligations.  As ofSeptember 30, 2006, the Company’s discontinued Transportation operationconsists primarily of its investment in Electric Transit, Inc. (“ETI”).  AAI owns a 35% interest in the shares of ETI,with the remaining 65% owned by a Czech company, Skoda a.s. (“Skoda”).  As of April 22, 2006, AAI’s guarantee ofcertain of ETI’s obligations regarding the last remaining active productioncontract expired, thereby concluding AAI’s commitment to ETI.

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Following Skoda’s bankruptcy declaration in 2001 in theCzech Republic, effective as of 2002, AAI began recording 100%, instead of 35%,of ETI’s losses and income in accordance with the equity method of accountingapplicable to minority shareholders.  TheCompany has determined that ETI is a variable interest entity, for which theCompany is the primary beneficiary, in accordance with the FASB issuedInterpretation No. 46 (revised December 2003), Consolidation of VariableInterest Entities, an Interpretation of Accounting Research Bulletin No. 51** (“FIN 46R”), whichbecame effective for years beginning after December 31, 2002.  The financial statements for ETI have beenconsolidated for all years presented. Prior to the filing of the Company’s Annual Report on Form 10-K for theyear ended December 31, 2005, the Company accounted for its investment in ETI under the equity method.  The Company accounts forits remaining Transportation operations as discontinued operations, includingthe consolidation of ETI as a variable interest entity.

Summaryresults of the discontinued Transportation operations, which have been reportedseparately as (loss) income from discontinued operations in the accompanyingConsolidated Statements of Operations, were as follows:
| ** **                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Sales                                                                           |       | $                                                    | 354        |                                                | $          | 17 |   | $ | 1,193 |   | $ | 1,049 |   |
| Cost of sales                                                                   |       | (144                                                 | )          | 985                                                 |       | (290 | ) | 2,203 |   |
| General and  administrative                                                     |       | (1,930                                               | )          | (540                                                | )          | (3,514 | ) | (2,164 | ) |
| Other expense                                                                   |       | (12                                                  | )          | (20                                                 | )          | (45 | ) | (47 | ) |
| (Loss) income before  income taxes                                              |       | (1,732                                               | )          | 442                                                 |       | (2,656 | ) | 1,041 |   |
| Benefit from (provision  for) income taxes                                      |       | 607                                                  |       | (330                                                | )          | 930 |   | (736 | ) |
| (Loss) income from  discontinued transportation operations, net of income taxes |       | $                                                    | (1,125     | )                                                   | $          | 112 |   | $ | (1,726 | ) | $ | 305 |   |

 

During2005, ETI was able to favorably resolve certain operational risks associatedwith the execution of its last remaining program.  ETI reported net income for the three andnine months ended September 30, 2006 of approximately $21 and $363,respectively, offset by $1,753 and $3,019 of general and administrativeexpenses incurred by the Company’s discontinued Transportation operationsattributable to ongoing litigation involving AAI’s claims under a labor andmaterials bond.  ETI reported net incomefor the three and nine months ended September 30, 2005 of approximately $928and $2,893, respectively offset by $486 and $1,852 of general andadministrative expenses incurred by the Company’s discontinued Transportationoperations, consisting primarily of professional fees related to the bond claimlitigation.

Thefollowing table provides the sources and uses of net cash flows for thediscontinued Transportation operations, which are aggregated and reportedseparately as Net cash used in operating activities by discontinued operationsin the accompanying Consolidated Statements of Cash Flows:
| ** **                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                                                              |       |                                                |       |   |   |
| Net (loss) income                                                 |       | $                                                   | (1,726     | ) | $ | 305 |   |
| Changes in operating  assets and liabilities                      |       | (484                                                | )          | (5,390 | ) |
| Deferred income taxes                                             |       | 369                                                 |       | 1,667 |   |
| Net cash used in  operating activities by discontinued operations |       | $                                                   | (1,841     | ) | $ | (3,418 | ) |

 

Therewere no cash flows from financing or investing activities by the discontinuedTransportation operations in the nine months ended September 30, 2006 and 2005.

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Assetsand liabilities of the discontinued Transportation operation, which have beenreported and summarized in the accompanying Consolidated Balance Sheets asAssets and Liabilities of discontinued operations, respectively, were asfollows:
| ** **                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                                       |       |                   |       |                  |       |
| Current Assets:                            |       |                   |       |                  |       |
| Cash                                       |       | $                      | 785        |                  | $          | 606 |   |
| Trade  receivables                         |       | 339                    |       | 103                   |       |
| Prepaid expenses  and other current assets |       | 62                     |       | 150                   |       |
| Deferred income  taxes                     |       | 11,200                 |       | 11,569                |       |
|                                       |       | $                      | 12,386     |                  | $          | 12,428 |   |
|                                       |       |                   |       |                  |       |
| Current Liabilities:                       |       |                   |       |                  |       |
| Accounts payable                           |       | 691                    |       | 256                   |       |
| Accrued employee  compensation and taxes   |       | 125                    |       | 159                   |       |
| Other current  liabilities                 |       | 12,077                 |       | 11,270                |       |
| Accrual for  contract losses               |       | 237                    |       | 1,602                 |       |
|                                       |       | $                      | 13,130     |                  | $          | 13,287 |   |

 

**Note L - Commitments and Contingencies**

In the normal course of its continuing anddiscontinued business, various lawsuits, claims and legal proceedings have beenor may be instituted or asserted against or by the Company.  Based on currently available facts, theCompany believes, except as otherwise set forth below, that the disposition ofmatters pending or asserted against the Company will not have a materialadverse effect on the Company’s financial position, results of operations orliquidity.

ASBESTOS

History

United Industrial and Detroit Stoker have been named asdefendants in asbestos-related personal injury litigation. Neither UnitedIndustrial nor Detroit Stoker fabricated, milled, mined, manufactured ormarketed asbestos, and neither United Industrial nor Detroit Stoker made orsold insulation products or other construction materials that have beenidentified as the primary cause of asbestos-related disease in the vastmajority of claimants. Rather, United Industrial and Detroit Stoker madeseveral products, some of the parts and components of which usedasbestos-containing material fabricated and provided by third parties. The useof asbestos-containing materials ceased in approximately 1981.

Cases involving United Industrial and Detroit Stokertypically name 80 to 100 defendants. As of September 30, 2006, UnitedIndustrial and Detroit Stoker have not gone to trial with respect to anyasbestos-related personal injury claims, although there is no assurance thattrials may not occur in the future. Accordingly, as of September 30, 2006,neither United Industrial nor Detroit Stoker have been required to pay any punitivedamage awards, although there can be no assurance this might not occur in thefuture. In addition, as of September 30, 2006, some previously pending claimshave 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 theclaimants in pending cases will not be able to demonstrate that they have beenexposed to United Industrial’s or Detroit Stoker’s asbestos-containing productsor suffered any compensable loss as a result of any such exposure. This beliefis based 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 

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Stoker to determine to whom products were sold, the date ofsale, 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 DetroitStoker to effectively manage their asbestos-related claims.

Settlements

To date, settlements of claims against UnitedIndustrial and/or Detroit Stoker have been made without any admission ofliability by United Industrial and/or Detroit Stoker. Settlement amounts mayvary depending upon a number of factors, including the jurisdiction where theaction was brought, the nature and extent of the disease alleged and theassociated medical evidence, the age and occupation of the claimant, theexistence or absence of other possible causes of the claimant’s allegedillness, and the availability of legal defenses, as well as whether the actionis brought alone or as part of a group of claimants. Before paying anysettlement amount, United Industrial and/or Detroit Stoker require proof ofexposure to their asbestos-containing products and proof of injury to the plaintiff.In addition, the claimant is required to execute a release of UnitedIndustrial, Detroit Stoker and associated parties, from any liability forasbestos-related injuries or claims.

Insurance Coverage

The insurance coverage potentially available to UnitedIndustrial and Detroit Stoker is substantial. Following the institution ofasbestos litigation, an effort was made to identify all of United Industrial’sand Detroit Stoker’s primary and excess insurance carriers from 1940 through1990. There were approximately 40 such carriers, all of which were put onnotice of the litigation. In November of 1999, a Participation Agreement wasentered into among United Industrial, Detroit Stoker and three of their primaryinsurance carriers. The Participation Agreement is an advance understandingthat supplements all of the contracts of insurance, without altering thecoverage of those contracts, which creates an administrative framework withinwhich the insurers and United Industrial and Detroit Stoker can more efficientlyand effectively manage the large quantity of on-going litigation.

Any party may terminate the Participation Agreement, withoutcause, by giving the other parties 60 days prior written notice. Termination ofthe Participation Agreement does not affect any rights or obligations of theparties that have accrued under the Participation Agreement on or before theeffective date of the termination, nor does it affect any rights outside of theParticipation Agreement.

Although the carriers can opt out of the ParticipationAgreement on 60 days notice, management does not believe that this will occurin the immediate or near term. For example, unless a carrier professes to havemet the limits of its liability, it would have to consider the potentiallygreater costs of permitting United Industrial and Detroit Stoker to handletheir own cases. Further, opting out of the Participation Agreement does notexculpate liability on the part of the carrier.

United Industrial’s counsel retained a consulting firm withexpertise in the field of evaluating insurance coverage and the likelihood ofrecovery for claims, such as costs incurred in connection with asbestos-relatedinjury claims. In 2002 and 2003, that firm worked with United Industrial toproject the insurance coverage of United Industrial and Detroit Stoker forasbestos-related claims.  In 2005, UnitedIndustrial engaged the same firm to update its insurance analysis andprojection.  In each case, the insuranceconsultant’s conclusions were based primarily on a review of United Industrial’sand Detroit Stoker’s coverage history, application of reasonable assumptions tothe allocation of coverage consistent with industry standards, an assessment ofthe creditworthiness of the insurance carriers, and the knowledge and experienceof the consulting firm in the field of insurance coverage analysis. Theinsurance consultant also considered the Participation Agreement.

Based on the assumptions employed by and the report preparedby the insurance consultant, other variables, and the report prepared by theasbestos liability consultant, which is discussed below, the Company recordedan estimated insurance recovery as of December 31, 2005, of $20,186 reflectingthe estimate determined to be probable of being available to mitigate UnitedIndustrial’s and Detroit Stoker’s potential asbestos liability through 2015,and as of December 31, 2002, of 

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$20,343, reflecting the estimate determined to be probableof being available to mitigate United Industrial’s and Detroit Stoker’s potentialasbestos liability through 2012.  TheCompany continuously evaluates this insurance receivable and believes it isappropriately valued at September 30, 2006.

Quantitative Claims Information

As of September 30, 2006, United Industrial and/or Detroit Stokerwere named in asbestos litigation pending in Arkansas, California, Louisiana,Michigan, Minnesota, Mississippi, New Jersey, New York, North Dakota and RhodeIsland. As of September 30, 2006, there were approximately 6,911 total pendingclaims asserted in law suits, compared to approximately 11,059 pending claimsasserted in lawsuits as of December 31, 2005 and approximately 12,897 pendingclaims as of September 30, 2005.  Thedecrease in claims was primarily attributable to dismissal of cases initiallybrought in Mississippi in 2002-2003.  In2004, Detroit Stoker was named as a defendant in two cases in Arkansas allegingpersonal injuries to one and approximately 199 plaintiffs (subsequently reducedto 37), respectively, as a result of silica and/or refractory ceramic fiberexposure, in addition to asbestos exposure. The pleadings in these two cases name approximately 32 and 68defendants, respectively.  Because claimsare often filed and disposed of by dismissal or settlement in large numbers,the amount and timing of settlements and the number of open claims during aparticular period can fluctuate from period to period and may not be indicativeof the trend in future claims, settlements or dismissals. In addition, most ofthese lawsuits do not include specific dollar claims for damages, and manyinclude a number of plaintiffs and multiple defendants. Therefore, the Companycannot provide any meaningful disclosure about the total amount of the damagessought. In addition, the direct asbestos-related expenses of United Industrialand Detroit Stoker for defense and indemnity for the past five years were notmaterial.

A significant increase in the volume of asbestos-relatedbodily injury cases arose in Mississippi beginning in 2002 and extended throughmid-year 2003. Management believes this peak in the volume of claims inMississippi was due to the passage of tort reform legislation (applicable toasbestos-related injuries), which became effective at the end of 2002 and whichresulted in a large number of claims being filed in Mississippi by plaintiffsseeking to ensure their claims would be governed by the law in effect prior tothe passage of tort reform.

In 2002, United Industrial’s counsel engaged a consultingfirm with expertise in the field of evaluating asbestos bodily-injury claims toassist United Industrial in projecting the future asbestos-related liabilitiesand defense costs of United Industrial and Detroit Stoker. In 2005, UnitedIndustrial’s counsel engaged the same consulting firm to update the report itissued in 2003.  In each case, themethodology used by the asbestos liability consultant to project futureasbestos-related costs is based primarily on estimates of the labor forceexposed to asbestos in United Industrial’s and Detroit Stoker’s products,epidemiological modeling of asbestos-related disease manifestation, andestimates of claim filings and settlement and defense costs that may occur inthe future. Using this information, in each case the asbestos liabilityconsultant estimated the number of future claims that would be filed, as wellas the related costs that would be incurred in resolving those claims. UnitedIndustrial’s and Detroit Stoker’s claims history prior to 2002 was not asignificant variable in developing the estimates because such history wasdetermined by the consulting firm not to be significant as compared to thenumber of claims filed in 2002.

Projecting future asbestos costs is subject to numerousvariables that are extremely difficult to predict. In addition to thesignificant uncertainties surrounding the number of claims that might bereceived, other variables include the type and severity of the disease allegedby each claimant, the long latency period associated with asbestos exposure,dismissal rates, costs of medical treatment, the impact of bankruptcies ofother companies 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 and consultation with the asbestos and insurance consultants, theCompany believes that ten years is the most reasonable period for recognizing areserve for future costs, and that costs that might be incurred after thatperiod were not reasonably estimable.  Asa result, the Company also believes that its ultimate net asbestos-relatedcontingent liability (i.e. its indemnity or other claim disposition costs plusrelated legal fees less insurance recoveries) cannot be estimated withcertainty.

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Based on the assumptions and results reflected in the 2005and 2003 reports prepared by the asbestos liability consultant and othervariables, the Company recorded an undiscounted liability for its best estimateof liabilities for asbestos-related matters in the amount of $31,450 as ofSeptember 30, 2006 and $ 31,852as of September 30, 2005, respectively, includingdamages and defense costs, and its insurance receivables for asbestos-relatedliabilities were $20,186 and $20,343 at September 30, 2006 and 2005,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.

Given the inherent uncertainty in making futureprojections, and the fact that United Industrial and Detroit Stokerperiodically receive potentially material new information from claimants andtheir counsel that relates to the factual basis of their asserted andunasserted claims, United Industrial and Detroit Stoker will periodically,either (1) validate the key assumptions used in projecting the futureasbestos-related liabilities and defense costs of United Industrial and DetroitStoker or; (2) re-examine and if necessary update the projections of currentand future asbestos claims, based on experience and other relevant factors,such as changes in the tort system and the resolution of bankruptcies ofvarious asbestos defendants.

No assurances can be given as to the actual amount of UnitedIndustrial’s and Detroit Stoker’s liability for such present and future claimsor the amount of insurance recoveries (including any recoveries fromliquidating excess insurance carriers), and the differences from estimatedamounts could be material.

FederalAsbestos Legislation

The outlook for federal legislation to provide a nationalasbestos litigation trust fund continues to be uncertain. Also uncertain iswhether, and to what extent, United Industrial and Detroit Stoker would berequired to make contributions to any prospective national asbestos trust. Noassurances can be given that a proposed trust or any other asbestos legislationwill ultimately become law, or when such action might occur.

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

On May 19, 1993, United Industrial was named as one of threedefendants in a civil action brought pursuant to the ComprehensiveEnvironmental Response Compensation and Liability Act (“CERCLA”) by the ArizonaDepartment of Environmental Quality (“ADEQ”) in the United States DistrictCourt for the District of Arizona. ADEQ sought remediation of a manufacturingsite in the State of Arizona operated by U.S. Semiconductor Products, Inc. (“U.S.Semiconductor”), a manufacturer of semiconductors formerly owned by UnitedIndustrial. ADEQ alleged that from 1959 until United Industrial sold U.S.Semiconductor in 1961, U.S. Semiconductor disposed of tricholoroethylene, a “hazardoussubstance,” and other hazardous substances under CERCLA, onto the ground andinto various pits and drains located on the site.

In1996, United Industrial entered into a consentdecree with ADEQ. Pursuant to the consent decree, United Industrial is requiredto complete a Remedial Investigation/Feasibility Study (“RI/FS”), pay $125 forpast response costs, pay quarterly Arizona oversight costs (averaging less than$13 annually) and pay $125 for future response costs plus a graduatedpercentage of the cleanup costs for the site if those costs are in excess of$10,000 but less than $40,000.  UnitedIndustrial’s liability for future response costs under the consent decree iscapped at $1,780 in addition to the $125 that United Industrial has alreadypaid. In connection with the RI/FS, United Industrial has retained and ispaying for an environmental consultant. The Remedial Investigation was submitted to ADEQ for approval on March31, 2004 and was approved by ADEQ on August 9, 2004.  In March 2005, ADEQ issued its ProposedRemedial Objectives Report for public comment. ADEQ received no substantive comments regarding the report, and in May2005, ADEQ issued its final Remedial Objectives Report.  United Industrial is required to submit toADEQ a Feasibility Study and Proposed Remedies to meet ADEQ’s May 2005 RemedialObjectives.   Management believes it willreach closure with ADEQ on all RI/FS issues on an acceptable basis to UnitedIndustrial following approval of the Feasibility Study.  No assurances can be given, however, as tothe actual extent to which United Industrial may be determined to have furtherliability, if at all.  Managementbelieves it is appropriately accrued for this matter.

MICHIGANDEPARTMENT OF NATURAL RESOURCES

Detroit Stoker was notified in March 1992 by theMichigan Department of Natural Resources (“MDNR”) that it is a potentiallyresponsible party in connection with the cleanup of a former industriallandfill located in Port of Monroe, 

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Michigan. MDNR is treating the Port of Monroelandfill site as a contaminated facility within the meaning of the MichiganEnvironmental Response Act (“MERA”). Under MERA, if a release or potentialrelease of a discarded hazardous substance is or may be injurious to theenvironment or to the public health, safety or welfare, MDNR is empowered toundertake or compel investigation and response activities in order to alleviateany contamination threat.  Managementbelieves Detroit Stoker would be considered a de minimus potentiallyresponsible party and does not believe that the resolution of this matter willhave a materially adverse effect on United Industrial’s or Detroit Stoker’sfinancial condition or results of operations. No assurances can be given,however, as to the actual extent to which Detroit Stoker may be determined tobe liable, if at all.

OTHER LEGAL MATTERS

Departments and agencies of the U.S. Government have theauthority at many levels to investigate transactions and operations of theCompany, and the results of such investigations may lead to administrative,civil, or criminal proceedings, the ultimate outcome of which could be fines,penalties, repayments or compensatory or treble damages. Agencies that overseecontract performance include: the Defense Contract Audit Agency, the Departmentof Defense 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.

The Company has in place international and domesticcompliance policies and procedures, including training of employees. From timeto time, the Company receives allegations of improper conduct relating to itsoperations, including operations subject to the U.S. Foreign Corrupt PracticesAct, export control and licensing regulations and other U.S. domestic andinternational laws. When the Company receives any such allegations, it conductsinternal (and if necessary, external) investigations to determine whether thereis support for any such allegations, and takes corrective action whenwarranted.  An investigation is ongoingin response to allegations provided to Company management of improper paymentsto foreign government officials and improper invoicing. External counsel hasbeen retained by the Audit Committee of the Company’s Board of Directors todetermine if there is support for any such allegations, and to review theCompany’s compliance policies and procedures, and the Company is cooperatingfully with counsel.  In addition,appropriate government 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 knowledgeregarding the allegations by any officer or director of United Industrial. Atthe current stage of this investigation, any ultimate liability is notpresently determinable.

PERFORMANCE GUARANTIES

In connection with certain contracts, United Industrial’soperating subsidiaries have committed to certain performance guarantiesexisting at September 30, 2006. The ability to perform under these guarantiesmay, in part, be dependent on the performance of other parties, includingpartners and subcontractors. If United Industrial’s operating subsidiaries areunable to meet these performance obligations, the performance guaranties couldhave a material 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 OPERATIONS

## MUNI Contract

In connection with the discontinued Transportationoperations, AAI owns 35% of ETI.  Skoda,a Czech company, owns the remaining 65% of ETI. One of ETI’s contracts involved the design and manufacture of 273electric trolley buses (“ETBs”) for the San Francisco Municipal Railway (MUNI).In executing its contract with MUNI, ETI entered into subcontracts with AAI,certain Skoda operating affiliates and others.

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As originally required by MUNI, ETI obtained a surety bondto guaranty payment to all those providing labor and materials to ETI infurtherance of its performance under the MUNI contract.  AAI agreed to indemnify the surety, ifnecessary, for up to $14,800 on this labor and materials bond, representing 35%of the original face value of the bond (in proportion to AAI’s equity interestin ETI). On November 18, 2003, AAI made a claim against the labor and materialsbond for unpaid receivables in connection with AAI’s MUNI subcontract from ETI,totaling in excess of $47,000, the maximum penal sum of the labor and materialsbond. AAI’s payment rights under the labor and materials bond (among otherclaims) are currently at issue in a case before the United States DistrictCourt for the Northern District of California. Prior to final adjudication of this case, there can be no assurances asto the amount or timing of a recovery by AAI, if any, on its claim on the laborand materials bond.  To date no amount ofrecovery has been recorded.

##### **Note M - Dividends**

The Company’s Board of Directors declared a dividend of $0.10 per shareon its common stock during each quarter of the nine months ended September 30,2006 and 2005.

| For the quarter ended                                               | ** ** | **Total amount dividends paid** | ** ** | **Date dividends were paid**                        |
|---------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------------------------------------|
|         September  30, 2006 |       | $1,139                          |       |       August 18, 2006 |
|         June  30, 2006      |       | $1,139                          |       |       May 25, 2006    |
|         March  31, 2006     |       | $1,131                          |       |       March 27, 2006  |
|         September  30, 2005 |       | $1,239                          |       |       August 31, 2005 |
|         June  30, 2005      |       | $1,234                          |       |       May 30, 2005    |
|         March  31, 2005     |       | $1,230                          |       |       March 31, 2005  |

 

**Note N - Treasury Stock**

OnMarch 10, 2005, the Company’s Board of Directors authorized a stock purchaseplan for up to $25,000. During the first six months of 2005, a total of 735,345shares were repurchased under the plan, at an average price of $33.97 pershare, utilizing all funds available under the March 10, 2005 stock purchaseplan.

OnSeptember 7, 2005, the Company’s Board of Directors authorized a stock purchaseplan for up to $15,000.  The Companyrepurchased a total of 425,627 shares at an average price of $35.20 during theremainder of 2005 utilizing all funds available under the plan.

**NoteO - 3.75% Convertible Senior Notes**

The holders of the 3.75% Convertible Senior Notes due 2024 (“SeniorNotes”) can convert their Senior Notes into shares of UIC common stock duringthe next calendar quarter from October 1, 2006 through December 31, 2006.  This event was triggered by the Company’sstock price remaining above $47.09 (120% of the initial conversion price) forat least 20 consecutive trading days during the last 30 trading days of thequarter ended September 30, 2006.

**NoteP - Supplemental Guarantor Information**

In September 2004, United Industrialissued and sold $120,000 aggregate principal amount of 3.75% Convertible SeniorNotes, which are fully and unconditionally guarantied by AAI.  The 3.75% Convertible Senior Notes are notguarantied by Detroit Stoker.  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, 2006 and December 31, 2005, and for the three month and nine month periodsended September 30, 2006 and 2005.

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** **

CONDENSED CONSOLIDATINGFINANCIAL INFORMATION

CONDENSEDCONSOLIDATING BALANCE SHEETSAs of September 30, 2006 (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                       |       | $                                             | 95,878     |                                                 | $          | 22,025                                          |       | $                | 19,819     |                                                   | $          | — |   | $ | 137,722 |   |
| Trade  receivables, net                          |       | 624                                           |       | 62,322                                               |       | 2,311                                           |       | —           |       | 65,257                                                 |       |
| Inventories                                      |       | —                                        |       | 32,955                                               |       | 2,970                                           |       | —           |       | 35,925                                                 |       |
| Other current  assets                            |       | 1,010                                         |       | 6,502                                                |       | 819                                             |       | (66              | )          | 8,265                                                  |       |
| Assets of  discontinued operations               |       | —                                        |       | 12,386                                               |       | —                                          |       | —           |       | 12,386                                                 |       |
| Total current  assets                            |       | 97,512                                        |       | 136,190                                              |       | 25,919                                          |       | (66              | )          | 259,555                                                |       |
| Insurance receivable —  asbestos litigation |       | —                                        |       | —                                               |       | 20,186                                          |       | —           |       | 20,186                                                 |       |
| Property and equipment,  net                     |       | —                                        |       | 40,514                                               |       | 1,515                                           |       | —           |       | 42,029                                                 |       |
| Other assets                                     |       | 11,649                                        |       | 41,581                                               |       | 10,775                                          |       | (17,621          | )          | 46,384                                                 |       |
| Intercompany  receivables                        |       | —                                        |       | 210                                                  |       | —                                          |       | (210             | )          | —                                                 |       |
| Investment in  consolidated subsidiaries         |       | 119,842                                       |       | —                                               |       | —                                          |       | (119,842         | )          | —                                                 |       |
|                                             |       | $                                             | 229,003    |                                                 | $          | 218,495                                         |       | $                | 58,395     |                                                   | $          | (137,739 | ) | $ | 368,154 |   |
|                                             |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| LIABILITIES AND  SHAREHOLDERS’EQUITY        |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current portion of  long-term debt               |       | $                                             | —     |                                                 | $          | 675                                             |       | $                | —     |                                                   | $          | — |   | $ | 675 |   |
| Other current  liabilities                       |       | 3,504                                         |       | 123,044                                              |       | 6,133                                           |       | (34, 577)        |       | 98,104                                                 |       |
| Liabilities of  discontinued operations          |       | —                                        |       | 13,130                                               |       | —                                          |       | —           |       | 13,130                                                 |       |
| Total current  liabilities                       |       | 3,504                                         |       | 136,849                                              |       | 6,133                                           |       | (34,577          | )          | 111,909                                                |       |
| Long-term debt                                   |       | 120,000                                       |       | 46                                                   |       | —                                          |       | —           |       | 120,046                                                |       |
| Accrual for asbestos  obligation                 |       | —                                        |       | —                                               |       | 31,450                                          |       | —           |       | 31,450                                                 |       |
| Other long-term  liabilities                     |       | 4,248                                         |       | 56,521                                               |       | 11,509                                          |       | (17,620          | )          | 54,658                                                 |       |
| Intercompany  (receivables) payables             |       | 84,236                                        |       | (118,859                                             | )          | 298                                             |       | 34,325           |       | —                                                 |       |
| Shareholders’ equity  (deficit)             |       | 17,015                                        |       | 143,938                                              |       | 9,005                                           |       | (119,867         | )          | 50,091                                                 |       |
|                                             |       | $                                             | 229,003    |                                                 | $          | 218,495                                         |       | $                | 58,395     |                                                   | $          | (137,739 | ) | $ | 368,154 |   |

 

21

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CONDENSED CONSOLIDATING FINANCIALINFORMATION

CONDENSEDCONSOLIDATING BALANCE SHEETSAs of December 31, 2005
| ** **                                  | ** ** | **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                   |       | $                                             | 54,365     |                                                 | $          | 8,768                                           |       | $                | 14,363     |                                                   | $          | — |   | $ | 77,496 |   |
| Marketable equity securities                |       | 11,617                                        |       | —                                               |       | —                                          |       | —           |       | 11,617                                                 |       |
| Deposits and restricted cash                |       | —                                        |       | 4,810                                                |       | —                                          |       | —           |       | 4,810                                                  |       |
| Trade receivables, net                      |       | 311                                           |       | 64,487                                               |       | 4,486                                           |       | —           |       | 69,284                                                 |       |
| Inventories                                 |       | —                                        |       | 21,186                                               |       | 2,417                                           |       | —           |       | 23,603                                                 |       |
| Other current assets                        |       | 1,151                                         |       | 7,330                                                |       | 828                                             |       | (65              | )          | 9,244                                                  |       |
| Assets of discontinued operations           |       | —                                        |       | 12,428                                               |       | —                                          |       | —           |       | 12,428                                                 |       |
| Total current assets                        |       | 67,444                                        |       | 119,009                                              |       | 22,094                                          |       | (65              | )          | 208,482                                                |       |
| Insurance  receivable - asbestos litigation |       | —                                        |       | —                                               |       | 20,186                                          |       | —           |       | 20,186                                                 |       |
| Property and  equipment, net                |       | —                                        |       | 43,128                                               |       | 1,615                                           |       | —           |       | 44,743                                                 |       |
| Other assets                                |       | 9,309                                         |       | 34,952                                               |       | 4,852                                           |       | (18,123          | )          | 30,990                                                 |       |
| Intercompany  receivables                   |       | —                                        |       | 508                                                  |       | —                                          |       | (508             | )          | —                                                 |       |
| Investment in  consolidated subsidiaries    |       | 118,968                                       |       | —                                               |       | —                                          |       | (118,968         | )          | —                                                 |       |
|                                        |       | $                                             | 195,721    |                                                 | $          | 197,597                                         |       | $                | 48,747     |                                                   | $          | (137,664 | ) | $ | 304,401 |   |
|                                        |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY  |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current  liabilities:                       |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Current portion of long-term debt           |       | $                                             | —     |                                                 | $          | 964                                             |       | $                | —     |                                                   | $          | — |   | $ | 964 |   |
| Other current liabilities                   |       | 5,020                                         |       | 72,582                                               |       | 6,564                                           |       | (20,942          | )          | 63,224                                                 |       |
| Liabilities of discontinued operations      |       | —                                        |       | 13,287                                               |       | —                                          |       | —           |       | 13,287                                                 |       |
| Total current liabilities                   |       | 5,020                                         |       | 86,833                                               |       | 6,564                                           |       | (20,942          | )          | 77,475                                                 |       |
| Long-term debt                              |       | 120,000                                       |       | 723                                                  |       |                                            |       |             |       | 120,723                                                |       |
| Accrual for  asbestos obligation            |       | —                                        |       | —                                               |       | 31,450                                          |       | —           |       | 31,450                                                 |       |
| Other long-term  liabilities                |       | 3,260                                         |       | 52,305                                               |       | 11,789                                          |       | (18,123          | )          | 49,231                                                 |       |
| Intercompany  (receivables) payables        |       | 41,617                                        |       | (62,622                                              | )          | 612                                             |       | 20,393           |       | —                                                 |       |
| Shareholders’  equity (deficit)        |       | 25,824                                        |       | 120,358                                              |       | (1,668                                          | )          | (118,992         | )          | 25,522                                                 |       |
|                                        |       | $                                             | 195,721    |                                                 | $          | 197,597                                         |       | $                | 48,747     |                                                   | $          | (137,664 | ) | $ | 304,401 |   |

 

22

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CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSThree Months Ended September 30, 2006 (Unaudited)
| ** **                                                     | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                      |       | $                                             | —     |                                                 | $          | 131,350                                         |       | $                | 10,249     |                                                   | $          | — |   | $ | 141,599 |   |
| Operating costs  and expenses                                  |       | 524                                           |       | 121,308                                              |       | 7,973                                           |       | —           |       | 129,805                                                |       |
| Total operating  income                                        |       | (524                                          | )          | 10,042                                               |       | 2,276                                           |       | —           |       | 11,794                                                 |       |
|                                                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Non-operating  income and (expense):                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                                |       | 930                                           |       | 245                                                  |       | 216                                             |       | —           |       | 1,391                                                  |       |
| Interest expense                                               |       | (1,371                                        | )          | (207                                                 | )          | —                                          |       | —           |       | (1,578                                                 | )          |
| Intercompany interest income (expense)                         |       | 11                                            |       | —                                               |       | (11                                             | )          | —           |       | —                                                 |       |
| Other income (expense) - net                                   |       | (32                                           | )          | 127                                                  |       | 92                                              |       | —           |       | 187                                                    |       |
|                                                           |       | (462                                          | )          | 165                                                  |       | 297                                             |       | —           |       | —                                                 |       |
| (Loss) income  from continuing operations before income taxes  |       | (986                                          | )          | 10,207                                               |       | 2,573                                           |       | —           |       | 11,794                                                 |       |
| Benefit from  (provision for) income taxes                     |       | 161                                           |       | (3,650                                               | )          | (934                                            | )          | —           |       | (4,423                                                 | )          |
| (Loss) income  from continuing operations                      |       | (825                                          | )          | 6,557                                                |       | 1,639                                           |       | —           |       | 7,371                                                  |       |
| Loss from  discontinued operations - net of income tax benefit |       | —                                        |       | (1,125                                               | )          | —                                          |       | —           |       | (1,125                                                 | )          |
| Income from  investment in subsidiaries                        |       | 7,071                                         |       | —                                               |       | —                                          |       | (7,071           | )          | —                                                 |       |
| Net income  (loss)                                             |       | $                                             | 6,246      |                                                 | $          | 5,432                                           |       | $                | 1,639      |                                                   | $          | (7,071 | ) | $ | 6,246 |   |

 

23

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CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSThree Months Ended September 30, 2005 (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 |   |
| Operating costs  and expenses (income)                           |       | (16                                           | )          | 103,080                                              |       | 8,302                                           |       | —           |       | 111,366                                                |       |
| 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                                                 | )          |
| Intercompany interest income (expense)                           |       | 2                                             |       | —                                               |       | (2                                              | )          | —           |       | —                                                 |       |
| Other income (expense) - net                                     |       | 78                                            |       | (45                                                  | )          | 40                                              |       | —           |       | 73                                                     |       |
|                                                             |       | (781                                          | )          | 59                                                   |       | 101                                             |       | —           |       | (621                                                   | )          |
| (Loss) income  from continuing operations before income taxes    |       | (765                                          | )          | 13,794                                               |       | 1,386                                           |       | —           |       | 14,415                                                 |       |
| Benefit from  (provision for) income taxes                       |       | 255                                           |       | (4,891                                               | )          | (465                                            | )          | —           |       | (5,101                                                 | )          |
| (Loss) income  from continuing operations                        |       | (510                                          | )          | 8,903                                                |       | 921                                             |       | —           |       | 9,314                                                  |       |
| Income from discontinued  operations - net of income tax benefit |       | —                                        |       | 112                                                  |       | —                                          |       | —           |       | 112                                                    |       |
| Income from  investment in subsidiaries                          |       | 9,936                                         |       | —                                               |       | —                                          |       | (9,936           | )          | —                                                 |       |
| Net income (loss)                                                |       | $                                             | 9,426      |                                                 | $          | 9,015                                           |       | $                | 921        |                                                   | $          | (9,936 | ) | $ | 9,426 |   |

 

24

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** **

CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSNine Months Ended September 30, 2006 (Unaudited)
| ** **                                                     | ** ** | **United  Industrial  Corporation  (Parent)** | ** ** | **AAI  Corporation  and  Subsidiaries  (Guarantor)** | ** ** | **Detroit  Stoker  Company  (Non-  Guarantor)** | ** ** | **Eliminations** | ** ** | **United  Industrial  Corporation  and  Subsidiaries** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------|------------|------------------|------------|--------------------------------------------------------|------------|
|                                                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Net sales                                                      |       | $                                             | —     |                                                 | $          | 397,451                                         |       | $                | 30,982     |                                                   | $          | — |   | $ | 428,433 |   |
| Operating costs and  expenses                                  |       | 1,221                                         |       | 360,267                                              |       | 23,714                                          |       | —           |       | 385,202                                                |       |
| Total operating (loss)  income                                 |       | (1,221                                        | )          | 37,184                                               |       | 7,268                                           |       | —           |       | 43,231                                                 |       |
|                                                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Non-operating income  and (expense):                           |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Interest income                                                |       | 2,186                                         |       | 822                                                  |       | 564                                             |       | —           |       | 3,572                                                  |       |
| Interest expense                                               |       | (4,111                                        | )          | (292                                                 | )          | —                                          |       | —           |       | (4,403                                                 | )          |
| Intercompany  interest income (expense)                        |       | 36                                            |       | —                                               |       | (36                                             | )          | —           |       | —                                                 |       |
| Other income  (expense) - net                                  |       | (62                                           | )          | 325                                                  |       | 122                                             |       | —           |       | 385                                                    |       |
|                                                           |       | (1,951                                        | )          | 855                                                  |       | 650                                             |       | —           |       | (446                                                   | )          |
| (Loss) income from  continuing operations before income taxes  |       | (3,172                                        | )          | 38, 039                                              |       | 7,918                                           |       | —           |       | 42,785                                                 |       |
| Benefit from (provision  for) income taxes                     |       | 501                                           |       | (13,607                                              | )          | (2,880                                          | )          | —           |       | (15,986                                                | )          |
| (Loss) income from  continuing operations                      |       | (2,671                                        | )          | 24,432                                               |       | 5,038                                           |       | —           |       | 26,799                                                 |       |
| Loss from discontinued  operations - net of income tax benefit |       | —                                        |       | (1,726                                               | )          | —                                          |       | —           |       | (1,726                                                 | )          |
| Income from investment  in subsidiaries                        |       | 27,744                                        |       | —                                               |       | —                                          |       | (27,744          | )          | —                                                 |       |
| Net income (loss)                                              |       | $                                             | 25,073     |                                                 | $          | 22,706                                          |       | $                | 5,038      |                                                   | $          | (27,744 | ) | $ | 25,073 |   |

 

25

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CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONSNine Months Ended September 30, 2005 (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 |   |
| Operating costs  and expenses (income)                             |       | (48                                           | )          | 291,032                                              |       | 23,004                                          |       | —           |       | 313,988                                                |       |
| 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 |   |

 

26

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CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWSNine Months Ended September 30, 2006 (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 continuing operations                       |       | $                                             | 41,449     |                                                 | $          | 23,065                                          |       | $                | 5,498      |                                                   | $          | — |   | $ | 70,012 |   |
| Cash flows used  in operating activities by discontinued operations |       | —                                        |       | (1,841                                               | )          | —                                          |       | —           |       | (1,841                                                 | )          |
| Net cash provided by operating activities                           |       | 41,449                                        |       | 21,224                                               |       | 5,498                                           |       | —           |       | 68,171                                                 |       |
|                                                                |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| INVESTING  ACTIVITIES:                                              |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Purchase of  property and equipment                                 |       | —                                        |       | (5,110                                               | )          | (42                                             | )          | —           |       | (5,152                                                 | )          |
| Business  acquisition, net of cash acquired                         |       | —                                        |       | (6,701                                               | )          | —                                          |       | —           |       | (6,701                                                 | )          |
| Net cash used in investing activities                               |       | —                                        |       | (11,811                                              | )          | (42                                             | )          | —           |       | (11,853                                                | )          |
|                                                                |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| FINANCING  ACTIVITIES:                                              |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Repayment of  long-term debt                                        |       | —                                        |       | (966                                                 | )          | —                                          |       | —           |       | (966                                                   | )          |
| Proceeds from  exercise of stock options                            |       | 2,414                                         |       | —                                               |       | —                                          |       | —           |       | 2,414                                                  |       |
| Excess benefit  from stock-based compensation                       |       | 1,059                                         |       | —                                               |       | —                                          |       | —           |       | 1,059                                                  |       |
| Dividends paid                                                      |       | (3,409                                        | )          | —                                               |       | —                                          |       | —           |       | (3,409                                                 | )          |
| Decrease in  deposits and restricted cash                           |       | —                                        |       | 4,810                                                |       | —                                          |       | —           |       | 4,810                                                  |       |
| Net cash provided by financing activities                           |       | 64                                            |       | 3,844                                                |       | —                                          |       | —           |       | 3,908                                                  |       |
|                                                                |       |                                          |       |                                                 |       |                                            |       |             |       |                                                   |       |
| Increase in cash  and cash equivalents                              |       | 41,513                                        |       | 13,257                                               |       | 5,456                                           |       | —           |       | 60,226                                                 |       |
| Cash and cash  equivalents at beginning of year                     |       | 54,365                                        |       | 8,768                                                |       | 14,363                                          |       | —           |       | 77,496                                                 |       |
| Cash and cash  equivalents at end of period                         |       | $                                             | 95,878     |                                                 | $          | 22,025                                          |       | $                | 19,819     |                                                   | $          | — |   | $ | 137,722 |   |

 

27

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CONDENSEDCONSOLIDATING FINANCIAL INFORMATION - CONTINUED

CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWSNine Months Ended September 30, 2005 (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 operating activities by 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                                                |       |
| Investment 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  deposits and restricted cash                             |       | 25,000                                        |       | 4,033                                                |       | —                                          |       | —           |       | 29,033                                                 |       |
| Purchase of  treasury shares                                          |       | (34,225                                       | )          |                                                 |       |                                            |       |             |       | (34,225                                                | )          |
| Intercompany  activities                                              |       | 88,072                                        |       | (88,072                                              | )          | —                                          |       | —           |       | —                                                 |       |
| Net cash used in 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 |   |

 

28

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** **

**NoteQ - Subsequent Event**

OnNovember 7, 2006, AAI Services Corporation, a wholly owned subsidiary ofAAI, entered into a definitive agreement to acquire Texas-based McTurbine,Inc., for a cash purchase price of $31,000 subject to increase or decreasebased upon the closing net worth of McTurbine. Ten percent of the closing purchase price will be placed in escrow for aperiod of eighteen months to fulfill indemnification obligations.  The acquisition is subject to customaryconditions, and is expected to close in November.  McTurbine is an aerospace industry leader inthe maintenance, repair, and overhaul of military helicopter engines. McTurbineis an authorized service center for Honeywell and Goodrich Corporation,providing overhauls of T53 and T55 turboshaft helicopter engines, as well asT53 fuel control units and governors. Locatednear the Corpus Christi Army Depot, McTurbine blends commercially licensedairframe and aviation power plant mechanics with experienced former depotpersonnel.

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**Item 2. - Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**(Dollars in thousands, except per share amounts, orunless otherwise noted)**

###### **Forward-Looking Information**

ThisQuarterly Report on Form 10-Q contains “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements are based onmanagement’s expectations, estimates, projections and assumptions.  Words such as “expects,” “anticipates,” “intends,”“plans,” “believes,” “estimates,” and variations of such words and similarexpressions are intended to identify such forward-looking statements whichinclude, but are not limited to, projections of revenues, earnings, segmentperformance, cash flows and contract awards. These forward-looking statements are subject to risks and uncertainties,which could cause the actual results or performance of United IndustrialCorporation and its subsidiaries (collectively, the “Company”) to differmaterially from those expressed or implied in such statements.  These risks and uncertainties include, butare not limited to, the following:

·                  the Company’ssuccessful execution of internal performance plans;

·                  U.S. andforeign military budget constraints and determinations;

·                  performanceissues with key suppliers, subcontractors and business partners;

·                  the abilityto negotiate financing arrangements with lenders;

·                  the outcomeof current and future litigation, proceedings and investigations;

·                  the accuracyof the Company’s analysis of its potential asbestos-related exposure andinsurance coverage;

·                  productdemand and market acceptance risks;

·                  the effectof economic conditions;

·                  the impactof competitive products and pricing;

·                  productdevelopment, commercialization and technological difficulties;

·                  capacity andsupply constraints or difficulties;

·                  theintegration of acquisitions;

·                  legislativeor regulatory actions impacting the Company’s Defense and Energy segments anddiscontinued Transportation operations;

·                  changing prioritiesor reductions in the U.S. Government’s defense budget including those relatedto Operation Iraqi Freedom (“OIF”); and

·                  contractcontinuation and future contract awards.

TheCompany intends that all forward-looking statements it makes will be subject tothe safe harbor protection of the Federal securities laws found in Section 27Aof the Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.

Thesestatements 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 1A of the Company’s Annual Report on Form 10-K for the year ended December31, 2005, 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.

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###### **Business Overview**

The continuing operations of the Company consist of two businesssegments: Defense and Energy.  TheCompany designs, produces and supports defense systems.  Its products and services include unmannedaircraft systems, training and simulation systems, automated aircrafttest and maintenance equipment, armament systems, logistical and engineeringservices, and other leading-edge technology solutions for defense needs.  The primary customers for theCompany’s defense products are the U.S. military and the armed forces of alliednations.  The Company alsomanufactures combustion equipment for biomass and refuse fuels.  It markets and sells these products andservices in North America, Europe, Asia, South America and New Zealand.

Costsrelated to the continuing operations that are not identified with the twobusiness segments primarily relate to financing costs and are grouped under theheading Other.  The operations of theCompany’s Defense and Energy segments are conducted principally through its twowholly owned subsidiaries, AAI and Detroit Stoker, respectively.  The following information primarily relatesto the continuing operations of the Company and its consolidated subsidiaries.  The Company has a Transportation operationthat is accounted for as a discontinued operation, and is discussed separatelyin the information that follows.

The following discussionshould be read in conjunction with the Company’s Consolidated FinancialStatements and related notes thereto contained in this Quarterly Report on Form10-Q for the quarterly period ended September 30, 2006, and the discussionincluded in its Annual Report on Form 10-K for the year ended December 31,2005.

**Acquisitions**

On June 19, 2006, the Companyacquired Aerosonde Pty Ltd. and Aerosonde North America, Inc. in stock purchasetransactions for an aggregate purchase price of $6,701, with additionalconsideration payable upon the achievement of certain milestones.  Aerosonde Pty Ltd. is a Victoria,Australia-based manufacturer and developer of Unmanned Aircraft Vehicles (“UAV”).  Aerosonde North America operates theAerosonde UAV in support of research and development and weather forecastingrequirements of U.S. based customers including the U.S. Air Force, the NationalOceanic and Atmospheric Administration and NASA.  The operating results of Aerosonde have beenincluded in the consolidated financial statements of the Company since June 19,2006.

OnNovember 7, 2006, AAI Services Corporation, a wholly owned subsidiary of AAI,entered into a definitive agreement to acquire Texas-based McTurbine, Inc., fora cash purchase price of $31,000 subject to increase or decrease based upon theclosing net worth of McTurbine.  Tenpercent of the closing purchase price will be placed in escrow for a period ofeighteen months to fulfill indemnification obligations.  The acquisition is subject to customaryconditions, and is expected to close in November.  McTurbine is an aerospace industry leader inthe maintenance, repair, and overhaul of military helicopter engines. McTurbineis an authorized service center for Honeywell and Goodrich Corporation,providing overhauls of T53 and T55 turboshaft helicopter engines, as well asT53 fuel control units and governors. Locatednear the Corpus Christi Army Depot, McTurbine blends commercially licensedairframe and aviation power plant mechanics with experienced former depotpersonnel.

**Results of Operations**

**ConsolidatedOverview**

Net sales for thethird quarter of 2006 were $141,599, an increase of 12.0% over the thirdquarter of 2005.  The increase resultedprimarily from higher production volume of Shadow® 200 Tactical UnmannedAircraft Systems (“TUAS”), engineering activities related to improvements andmodifications to the Shadow 200 TUAS, increased volume on the C-17 and F-22Maintenance Trainer programs, and increased volume on new Unmanned AircraftSystems (“UAS”) product initiatives.

Net sales for thenine months ended September 30, 2006 were $428,433, an increase of 21.1% overthe nine months ended September 30, 2005. The increase resulted primarily from higher volume of Shadow 200 TUASsupport for a growing number of these fielded systems, UAS engineeringactivities related to improvements and modifications of the Shadow 200 TUAS,increased volume on new UAS product initiatives, and increased volume on F-22and C-17 Maintenance Trainer programs.

31

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Operating margin for thethird quarter of 2006 decreased 3.6 percentage points to 8.3% from 11.9% forthe third quarter of 2005.  Operating marginfor the nine months ended September 30, 2006 decreased 1.2 percentage points to10.1% from 11.3% for the nine months ended September 30, 2005.  The decrease in the Company’s operatingmargin was primarily attributable to a 4.2 percentage point decrease and a 2.0percentage point decrease in the operating margin of the Defense segment in thethree months and nine months ended September 30, 2006, respectively. Costoverruns primarily on four fixed price Defense contracts resulted in a loweroperating margin of $2,165 or 1.5 percentage points in the third quarter of2006 and $3,145 or 0.7 percentage points in the nine months ended September 30,2006.  In addition, primarily in theDefense segment, higher non-cash pension expense of $776 and non-cash stock-basedcompensation of $674 in the third quarter of 2006 contributed a combined 1.0percentage point to the decrease in Company operating margin, and highernon-cash pension expense of $2,243 and non-cash stock-based compensation of$1,817 in the nine months ended September 30, 2006 contributed a combined 0.9percentage point to the decrease in Company operating margin.  Stock-based compensation is now required tobe included in earnings under Statement of Financial Accounting Standard No.123 Revised, Accounting for Stock-Based Compensation (“SFAS 123R”), effectiveJanuary 1, 2006.  No stock-basedcompensation was included in 2005.  Also,the Company experienced a higher operating margin of 1.7 percentage points, or$2,190 in operating income, and a higher operating margin of 0.6 percentagepoints, or $2,211 in operating income, in the three and nine months endedSeptember 30, 2005, respectively, due to favorable production efficienciesrealized on certain Defense segment production contracts.  These contracts were substantially completedin 2005.

The cost overrunson the four fixed price Defense contracts related to overcoming significanttechnical challenges under each contract. In one case, the cost overrun arose out of the decision to accelerateproduct development on AAI’s small ducted fan UAS technology in order to fieldthe product ahead of schedule.  A secondUAS-related contract incurred additional costs in upgrading portions of thePioneer UAS. A third contract involved the delivery of an upgraded existingweapons training product that incurred cost overruns due to obsolescence of akey component, and the resulting costs associated with redesigning majorportions of a high performance visual projection system.  Cost overruns on the fourth contract, also aweapons training system, related to unanticipated difficulties in obtainingsufficient operating data on the weapons system, and loss, at a crucial time,of a key technical expert designing the system. Management does not anticipate any significant future cost overruns onthese contracts, some of which have been substantially completed, althoughthere can be no assurance that there will not be additional cost overruns untilthese contracts are completed.

Theresults for the nine months ended September 30, 2005 included a gain on sale ofundeveloped property of $4,649, net of tax, or $0.31 per diluted share.

The Company’seffective tax rate for the nine-month period ended September 30, 2006 was 37.4%compared with 34.0% for the same period in 2005.  This rate increase was primarily related tonon-deductible stock-based compensation expense in 2006 and lower domesticproduction activity deductions in 2006.

The Company’s totalbacklog for continuing operations increased to $640,042 at September 30, 2006compared with $495,865 at December 31, 2005. New orders received in the third quarter were $128,061, including$117,836 in the Defense segment and $10,225 in the Energy segment.

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***Three and Nine Months Ended September 30,2006 Compared to the Three and Nine Months Ended September 30, 2005***
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                                                    | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **$**                                               | ** ** | **%**                    | ** ** | **2006** | ** ** | **2005** | ** ** | **$** | ** ** | **%** | ** ** |
|                                                          |       |                                                 |       |                     |       |                                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net sales                                                     |       | $                                                    | 141,599    |                     | $          | 126,402                                             |       | $                        | 15,197     |   | 12.0 |   | $ | 428,433 |   | $ | 353,878 |   | $ | 74,555 |   | 21.1 |   |
| Operating costs  and expenses                                 |       | 129,805                                              |       | 111,366                  |       | 18,439                                              |       | 16.6                     |       | 385,202 |   | 313,988 |   | 71,214 |   | 22.7 |   |
| Operating income                                              |       | 11,794                                               |       | 15,036                   |       | (3,242                                              | )          | (21.6                    | )          | 43,231 |   | 39,890 |   | 3,341 |   | 8.4 |   |
| Operating margin                                              |       | 8.3                                                  | %          | 11.9                     | %          | —                                              |       | —                   |       | 10.1 | % | 11.3 | % | — |   | — |   |
| Non-operating  income (expense)                               |       | —                                               |       | (621                     | )          | 621                                                 |       | 100.0                    |       | (446 | ) | 5,951 |   | (6,397 | ) | (107.5 | ) |
| Income from  continuing operations, net of income taxes       |       | 7,371                                                |       | 9,314                    |       | (1,943                                              | )          | (20.9                    | )          | 26,799 |   | 30,239 |   | (3,440 | ) | (11.4 | ) |
| (Loss) income  from discontinued operations net of income tax |       | (1,125                                               | )          | 112                      |       | (1,237                                              | )          | (1104.5                  | )          | (1,726 | ) | 305 |   | (2,031 | ) | (665.9 | ) |
| Net income                                                    |       | 6,246                                                |       | 9,426                    |       | (3,180                                              | )          | (33.7                    | )          | 25,073 |   | 30,544 |   | (5,471 | ) | (17.9 | ) |
| Diluted earnings  per share                                   |       |                                                 |       |                     |       |                                                |       |                     |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                             |       | 0.56                                                 |       | 0.68                     |       | —                                              |       | —                   |       | 1.99 |   | 2.13 |   | — |   | — |   |
| Loss from discontinued operations                             |       | (0.08                                                | )          | 0.01                     |       | —                                              |       | —                   |       | (0.12 | ) | 0.02 |   | — |   | — |   |
| Net income                                                    |       | 0.48                                                 |       | 0.69                     |       | —                                              |       | —                   |       | 1.87 |   | 2.15 |   | — |   | — |   |
|                                                               |            |                                                      |            |                          |            |                                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Defense Segment***
| ** **                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **$**                                               | ** ** | **%**                    | ** ** | **2006** | ** ** | **2005** | ** ** | **$** | ** ** | **%** | ** ** |
|                          |       |                                                 |       |                     |       |                                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net sales                     |       | $                                                    | 131,350    |                     | $          | 116,815                                             |       | $                        | 14,535     |   | 12.4 |   | $ | 397,451 |   | $ | 328,586 |   | $ | 68,865 |   | 21.0 |   |
| Operating costs  and expenses |       | 121,308                                              |       | 103,080                  |       | 18,228                                              |       | 17.7                     |       | 360,267 |   | 291,032 |   | 69,235 |   | 23.8 |   |
| Operating income              |       | 10,042                                               |       | 13,735                   |       | (3,693                                              | )          | (26.9                    | )          | 37,184 |   | 37,554 |   | (370 | ) | (1.0 | ) |
| Operating margin              |       | 7.6                                                  | %          | 11.8                     | %          | —                                              |       | —                   |       | 9.4 | % | 11.4 | % | — |   | — |   |
| Income before income  taxes   |       | 10,207                                               |       | 13,794                   |       | (3,587                                              | )          | (26.0                    | )          | 38,039 |   | 45,453 |   | (7,414 | ) | (16.3 | ) |
|                               |            |                                                      |            |                          |            |                                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Energy Segment***
| ****                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                    | ** ** | **2006**                                             | ** ** | **2005**                 | ** ** | **$**                                               | ** ** | **%**                    | ** ** | **2006** | ** ** | **2005** | ** ** | **$** | ** ** | **%** | ** ** |
|                          |       |                                                 |       |                     |       |                                                |       |                     |       |   |   |   |   |   |   |   |   |
| Net sales                     |       | $                                                    | 10,249     |                     | $          | 9,587                                               |       | $                        | 662        |   | 6.9 |   | $ | 30,982 |   | $ | 25,292 |   | $ | 5,690 |   | 22.5 |   |
| Operating costs  and expenses |       | 7,973                                                |       | 8,302                    |       | (329                                                | )          | (4.0                     | )          | 23,714 |   | 23,004 |   | 710 |   | 3.1 |   |
| Operating income              |       | 2,276                                                |       | 1,285                    |       | 991                                                 |       | 77.1                     |       | 7,268 |   | 2,288 |   | 4,980 |   | 217.7 |   |
| Operating margin              |       | 22.2                                                 | %          | 13.4                     | %          | —                                              |       | —                   |       | 23.5 | % | 9.0 | % | — |   | — |   |
| Income before income  taxes   |       | 2,573                                                |       | 1,386                    |       | 1,187                                               |       | 85.6                     |       | 7,918 |   | 2,474 |   | 5,444 |   | 220.0 |   |
|                               |            |                                                      |            |                          |            |                                                     |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Three Months EndedSeptember 30, 2006 compared to the Three Months Ended September 30, 2005***

DefenseSegment

Netsales for the third quarter of 2006 were $131,350, an increase of 12.4% overthe third quarter of 2005.  The growth innet sales was primarily due to a $5,492 increase in Shadow 200 TUAS productionvolume, $5,092 of engineering activities related to improvements andmodifications primarily related to the Extended Range Multi Purpose (ERMP) UASprogram, $2,700 and $2,302 increased volume on the C-17 and F-22 MaintenanceTrainer programs, respectively, and $1,946 increased volume on new UAS productinitiatives, partially offset by a $2,488 decrease in logistical support forfielded Shadow 200 TUAS, and various other items which netted to a decrease of$509. The C-17 Maintenance Trainer program increase was largely due to work onsix new trainers for the U. S. Air Force, awarded in December of 2005. The F-22Maintenance Trainer program increase is due to additional contract awards inthe first quarter of 2006.

IncreasedShadow 200 TUAS production activity for new systems and logistics support in2006 was enabled by management’s decision in the fourth quarter of 2005 toincrease production capacity to address higher order volumes.  In early 2006, in anticipation of increasedrequirements for UAS production, including logistical support, the Companyincreased capacity to approximately two equivalent systems per month, with additionalcapability for surge requirements. This capacity covers all aspects of theShadow 200 TUAS program requirements, including: production of new systems,reset (refurbishment) of existing systems, repair of damaged systems orcomponents, and production of spares. This increase in capacity enabled theCompany to deliver new systems and meet reset, repair and support requirementsat higher levels than in prior years.  Inline with U.S. Army needs, the volume for any one aspect of the program,including production activities, has varied, and is expected to continue tovary from month to month.  The Company’splan is to keep the manufacturing level-loaded for maximum efficiency, makingfrequent decisions, in coordination with the Company’s customer, to deliverequipment, spares, repairs, and reset systems in response to customer demandfor both basic and wartime needs.

Contractcost overruns, as discussed above, resulted in decreased operating margin of$2,165, or 1.6 percentage points, in the third quarter of 2006.  The third quarter of 2006 included higherpension expense of $776, or 0.6 percentage points, resulting from greateremployment and a 0.25% lower discount rate used to calculate the present valueof the pension obligation. Further, the third quarter of 2005 experiencedproduction efficiencies on certain production contracts that contributed 1.9percentage points to operating margin. These contracts were substantially completed in 2005.

EnergySegment

Netsales for the third quarter of 2006 increased 6.9% to $10,249 from $9,587 inthe third quarter of 2005.  The increasein sales in the three months ended September 30, 2006 compared to the sameperiod in 2005 was primarily driven by higher demand for Detroit Stoker’salternative fuel products, such as coal and wood burning stokers, in responseto recent high and volatile prices for oil and natural gas.  Operating income for the third quarter of2006 increased 77.1% to $2,276, or 22.2% of sales, from $1,285, or 13.4% ofsales, during the same period in 2005.

34

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Theoperating margin improved as a result of restructuring activities completed in2005.  The full benefits of therestructuring plan, including its outsourcing strategy for manufacturingactivities, were not fully realized until the fourth quarter of 2005.  Also contributing to the increase inoperating margin were the economies of scale related to the higher sales volumelevels in 2006.

***Nine Months EndedSeptember 30, 2006 compared to the Nine Months Ended September 30, 2005***

DefenseSegment

Netsales for the nine months ended September 30, 2006 increased 21.0% to $397,451from $328,586 during the same period in 2005. The growth in net sales was primarily due to a $25,759 increase inShadow 200 TUAS production volume, a $21,313 increase in logistical support foran increasing number of fielded Shadow 200 TUAS, a $11,329 increase inengineering activities primarily related to the ERMP program, a $6,986 increasein new UAS program initiatives, a $5,503 increased volume on the F-22Maintenance Trainer program, and$5,131 of other various increases, partially offset by a $7,156 decrease in theTraining Systems program.

Theincreased Shadow 200 TUAS production activity for new systems and logistics supportin 2006 was enabled by management’s previously discussed decision in the fourthquarter of 2005 to increase production capacity to address higher ordervolumes. The increased Shadow 200 TUAS logistical support activity was due tothe growing number of flight hours that resulted from an increasing number offielded systems and utility, especially by those fielded by the U.S. Army inOIF.

Contractcost overruns, as discussed above, resulted in decreased operating margin of$3,145 or 0.8 percentage points, in the nine months ended September 30, 2006.  The nine months ended September 30, 2006included higher pension expense of $2,243 or 0.6 percentage points, resultingfrom greater employment and a 0.25% lower discount rate used to calculate thepresent value of the pension obligation. Further, the nine months endedSeptember 30, 2005 experienced production efficiencies on certain productioncontracts that contributed 0.7 percentage points to operating margin.  These contracts were substantially completedin 2005.

EnergySegment

Netsales increased 22.5% to $30,982 from $25,292 in the same period of 2005.  The increase was primarily driven by higherdemand for Detroit Stoker’s alternative fuel products, such as coal and woodburning stokers, in response to recent high and volatile prices for oil and naturalgas.  Operating income from the Energysegment increased 217.7% to $7,268, or 23.5% of sales, from $2,288, or 9.0% ofsales, during the same period in 2005.

Theoperating margin improved as a result of restructuring activities completed in2005.  The full benefits of therestructuring plan, including its outsourcing strategy for manufacturingactivities, were not fully realized until the fourth quarter of 2005.  Also contributing to the increase inoperating margin were the economies of scale related to the higher sales volumelevels in 2006.

**Discontinued TransportationOperations**

Foradditional information regarding the discontinued Transportation operations,see Note K to the Consolidated Condensed Financial Statements included in thisQuarterly Report on Form 10-Q.

**Funded Backlog**

|                 | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------------|------------|
| Defense segment |       | $                            | 628,462    |                        | $          | 487,366 |   |
| Energy segment  |       | 11,580                       |       | 8,499                       |       |
| Total           |       | $                            | 640,042    |                        | $          | 495,865 |   |

 

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TheCompany’s funded backlog for continuing operations, defined as orders placedfor which funds have been appropriated or purchase orders received, was$640,042 at September 30, 2006, an increase of $144,177 or 29.1%, from December31, 2005.

The Company received$128,061 of funded new orders for products and services during the thirdquarter of 2006, a decrease of $35,557, or 21.7%, compared to $163,618 for thesame period in 2005. Included in the third quarter 2006 were funded new ordersof $117,836 in the Defense segment and $10,225 in the Energy segment.

The Company received$571,168 of funded new orders for products and services during the nine monthsended September 30, 2006, an increase of $87,159 or 18.0%, compared to $484,009for the same period in 2005. Included in the nine months ended September 30,2006 were funded new orders of $537,105 in the Defense segment and $34,063 inthe Energy segment.

The U.S Army hasongoing efforts to maintain high levels of readiness and availability, whileconcurrently reducing logistical support costs for all of its systems. AAI, forits part, has maintained an exceptionally high availability rate for the Shadow200 TUAS, but is also focused on reducing the costs of logistical support,based on continually improving reliability of the Shadow 200 system.  As part of these efforts, during the thirdquarter AAI and the U.S. Army evaluated fleet-wide inventory levels related tothe Shadow 200 TUAS logistical support, which confirmed sufficient levels ofShadow 200 TUAS logistical support inventories. During the inventory evaluation, the Company temporarily suspended majorreleases of labor, material and repair orders related to the Company’slong-term performance based logistical (“PBL”) contract that provides Shadow200 TUAS logistical support. This delayed the conversion of funded PBL backlogto sales. In the fourth quarter of 2006, the Company expects that labor,material, and repair orders related to Shadow 200 TUAS PBL support will moreclosely reflect experience in the first half of 2006.

The Companyanticipates that continued improvement in Shadow 200 TUAS reliability willreduce base PBL per-system revenues; however, this reduction may be partiallyor completely offset by increased demand for logistical support due toincreased Shadow 200 TUAS flight hours, the increasing number of fieldedsystems, and increased refurbishment orders, or “reset”, related to wartimedeployment. The Company believes that improvements in PBL efficiencies may alsoincrease the attractiveness of the Shadow 200 TUAS for other military applications,increasing the total number of purchased systems over the long-term.

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**Liquidity and Capital Resources**

**Overview**

TheCompany’s principal source of liquidity is cash on hand, cash generated fromoperations and availability under the Company’s $100 million revolving creditfacility entered into by the Company and AAI with a syndicate of six banks (“CreditFacility”) that expires July 17, 2009. On September 30, 2006, the Company had cash and cash equivalents of$137,722 and availability under its Credit Facility of $97,605.  Based upon cash on hand, cash expected to begenerated from operations and availability under the Credit Facility, theCompany expects to have sufficient cash to meet its requirements for at leastthe next twelve months.

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.

Asa part of the Company’s strategy to explore the sale of non-core assets, theCompany continues its engagement with 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 Companycontinues to explore potential Transactions involving Detroit Stoker.  From time to time, the Company and potentialbuyers may (i) have discussions regarding a potential Transaction, (ii)negotiate the preliminary terms of a potential Transaction, and (iii) enterinto customary non-binding agreements in order to facilitate any suchdiscussions and negotiations.  Noassurances can be given regarding whether a Transaction involving DetroitStoker will occur or the timing or proceeds from any such Transaction.

TheCompany intends to complement its organic growth strategy for its Defensesegment through select acquisitions that broaden its product and serviceofferings, deepen its capabilities, and allow entry into new markets.  Acquisition candidates may include public andprivate companies and divisions, subsidiaries and product lines of suchcompanies.  As part of this initiative,the Company acquired ESL in April 2005, Aerosonde in June 2006, and enteredinto a definitive agreement to acquire McTurbine, Inc. in November 2006.

**Sources and Uses of Cash**

Thefollowing is a discussion of the Company’s major operating, investing, andfinancing activities for the nine month periods ended September 30, 2006 and2005.  The financial informationpresented in the table below is summarized from the Company’s ConsolidatedCondensed Statements of Cash Flows.

|                                                                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Operating  activities:                                                        |       |                                                |       |   |   |
| Net cash provided by continuing operations                                    |       | $                                                   | 70,012     |   | $ | 30,638 |   |
| Net cash used in operating activities by  discontinued operations             |       | (1,841                                              | )          | (3,418 | ) |
| Net cash  provided by operating activities                                    |       | 68,171                                              |       | 27,220 |   |
| Net cash (used  in) provided by investing activities by continuing operations |       | (11,853                                             | )          | 91,240 |   |
| Net cash  provided by (used in) financing activities by continuing operations |       | 3,908                                               |       | (132,989 | ) |
| Increase  (decrease) in cash and cash equivalents                             |       | $                                                   | 60,226     |   | $ | (14,529 | ) |

 

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## ***Operating Activities***

Net cash provided bycontinuing operations in the nine months ended September 30, 2006 increased$39,374 compared to the nine months ended September 30, 2005.  This increase was generally due to the timingof cash receipts related to milestone billings primarily involving theplacement of orders to subcontract vendors regarding the Company’s Shadow 200TUAS program. The cash flow from advanced payments is designated for futureexpenditures on the Shadow 200 TUAS program. Cash flow from advanced payments increased by $29,454 in the nine monthsended September 30, 2006 compared to the nine months endedSeptember 30, 2005.

The Company’s cash flowsfrom operations are dependent on the timing of receipts from various U.S.government payment offices and, as a result, may differ from period to periodand such differences could be significant.

Netcash used by the discontinued Transportation operations in the nine monthsended September 30, 2006 primarily related to expenses attributable to ongoinglitigation involving AAI’s claims under a labor and materials bond, asdiscussed in Note 17 to the Consolidated Financial Statements included in PartII, Item 8 of the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005 and Note L to the Consolidated Condensed Financial Statementsincluded in part I, Item 1 of this Quarterly Report on Form 10-Q.

## ***Investing Activities***

Cash used for thepurchase of property and equipment declined by $13,126 in the nine months endedSeptember 30, 2006 compared to the nine months ended September 30, 2005.  The decrease primarily relates to activitiesin 2005 that included $7,470 for the purchase and improvement of a building inSouth Carolina, $3,616 for implementation of AAI’s enterprise resource planning(“ERP”) system, and $4,990 for Defense facility improvements including $2,016for enhancements to the UAS production facilities.  The Company anticipates that futurerequirements will include expenditures incurred during the ordinary course ofbusiness.  See “*Capital Expenditures*” below.

On December 29, 2004, theCompany invested $124,619 in U.S. treasury bills maturing February 24,2005.  On February 23, 2005, the Companyredeemed the U.S. treasury bills and received approximately $373 of short-termcapital gain thereon, repaid the cash collateral to its broker-dealer togetherwith $444 of related interest charges, and collected the $25,000 deposit plus$86 of accrued interest thereon.

During the nine monthsended September 30, 2005, the Company invested $12,780 in marketable commonstock securities of one entity that are available for sale.

On June 19, 2006, theCompany purchased Aerosonde Pty Ltd and Aerosonde North America for $6,701, netof cash acquired.  On April 4, 2005, theCompany purchased ESL Defence Limited, for $9,883, net of cash acquired.  On November 7, 2006 the Company entered intoan agreement to acquire McTurbine, Inc. for $31,000, subject to increase ordecrease based on closing net worth.

Net cash provided byinvesting activities in the nine months ended September 30, 2005 includedproceeds of $7,555 from the sale of certain undeveloped property adjacent tothe Company’s Hunt Valley, MD corporate headquarters.

## ***Financing Activities***

The Company’s financingactivities in the nine months ended September 30, 2006 provided $3,908 of cash,including a decrease in restricted cash of $4,810, proceeds from the exerciseof stock options of $2,414, excess tax benefits from stock-based paymentarrangements of $1,059, offset by dividends paid of $3,409 and repayment oflong-term debt of $966.

The Company’s financingactivities in the nine months ended September 30, 2005 used $132,989 of cash,including approximately $124,619 for the repayment of collateral received froma securities lending transaction of U.S. treasury bills that were soldconcurrently.  In connection with thesecurities lending transaction, the Company also received the $25,000refundable deposit from its broker-dealer together with a decrease of $4,033 inrequired collateral.  Financingactivities in 2005 also included $34,225 for the purchase of the Company’scommon stock, $3,705 for the payment of dividends, $947 for the repayment oflong-term debt and proceeds from the exercise of stock options of $1,474.

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**Debt and Related Covenants**

The Credit Facility entered into on July 18, 2005 bythe Company and AAI contains affirmative, negative and financial covenantscustomary 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 completedescription of the Company’s long-term debt, including the terms and conditionsof each debt instrument, please see Note 7 to the Consolidated FinancialStatements included in Part II, Item 8 of the Company’s Annual Report on Form10-K for the year ended December 31, 2005. The Company was in compliance with all of its covenants under the CreditFacility as of September 30, 2006.

**Cash Requirements**

***Capital Expenditures***

TheCompany expects that capital expenditures in 2006 will be significantly lowerthan in 2005.

Capital expenditures duringthe nine months ended September 30, 2005 were significantly higher than duringthe nine months ended September 30, 2006 primarily due to the purchase of afacility in Charleston, South Carolina for AAI Services Corporation to supportthe growth in its operations, enhancements to certain of the Company’s UASproduction facilities, including the purchase of new manufacturing equipment toincrease production output and efficiency, and implementation of the Company’sERP System.

Asof September 30, 2006, the Company had no significant commitments for capitalexpenditures.

***Other Cash Requirements***

During the nine monthsended September 30, 2006, the Company paid three quarterly cash dividends of$0.10 per share for an aggregate amount of $3,409.  The payment of any futuredividends will be at the discretion of the Board of Directors and will dependupon, among other things, the Company’s corporate strategy, future earnings,operations, capital requirements, and the Company’s financial condition andgeneral business conditions.  Shouldthe Company distribute a cash dividend in any quarterly period in excess of$0.10 per share, the conversion rate provided for in the Indenture governingthe 3.75% Convertible Senior Notes would be adjusted.  In addition, the Company’s Credit Facilityimposes certain restrictions on the payment of dividends.

The Company does not expect additional cashrequirements to exit the discontinued Transportation operations subsequent toSeptember 30, 2006 except legal fees to be incurred related to claims made byAAI in pursuit of payment under a surety bond. (See Note L to the Consolidated Condensed Financial Statements includedin this Quarterly Report on Form 10-Q for a discussion of AAI’s claims.)

For additional information regarding the Company’scontingencies, please see the discussion under the heading “*Contingent Matters*” below.

During2006 the Company expects to contribute cash to the UIC Retirement Pension Planof $1,170, and expects to contribute cash to the union pension plan of $935 inthe Energy segment of which $779 was funded in the nine months ended September30, 2006.   Further, the Company expectsto pay other post-retirement benefits of approximately $2,597 in 2006, of which$2,210 was paid during the nine months ended September 30, 2006.

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**ContingentMatters**

**Off-Balance Sheet Arrangements**

Inconnection with certain contracts, United Industrial’s operating subsidiarieshave committed to certain performance guaranties. The ability to perform underthese guaranties may, in part, be dependent on the performance of otherparties, including partners and subcontractors. If United Industrial’soperating subsidiaries are unable to meet these performance obligations, theperformance guaranties could have a material adverse effect on product marginand the Company’s results of operations, liquidity or financial position.United Industrial’s operating subsidiaries monitor the progress of theirpartners and subcontractors, and as of September 30, 2006 United Industrialdoes not believe that the performance of these partners and subcontractors willadversely affect these contracts. No assurances can be given, however, as tothe liability of United Industrial’s operating subsidiaries if partners orsubcontractors are unable to perform their obligations.

**Other Contingent Matters**

TheCompany is involved in various lawsuits and claims, including asbestos-relatedlitigation and environmental matters. There have been no material changes in any legal proceedings since theCompany filed its Annual Report on Form 10-K for the year ended December 31,2005.  For further information, refer tothe Consolidated Financial Statements and Notes thereto included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005 and Note L tothe Consolidation Condensed Financial Statements included in Part I, Item 1 ofthis Quarterly Report on Form 10-Q.

##### **MarketableEquity Securities**

TheCompany’s investment in marketable equity securities consists of an investmentin common stock of one company in the Aerospace and Defense industry.   Unrealized holding gains and losses deemedtemporary on available-for-sale securities are excluded from earnings and arereported as a separate component of other comprehensive income until realized.  If an unrealized holding loss is deemed to beother-than-temporary, such unrealized loss is charged to earnings whenidentified.  The Company’s basis in theinvestment is $12,602.  An unrealizedgain of $824 in the third quarter was recorded in other comprehensive income atSeptember 30, 2006.  At September 30,2006 the cumulative net unrealized loss recorded in other comprehensive incomewas $3,890.  In June 2006, the investeecompany disclosed the indictment of the investee company and its chairman andsuspension of certain of its plants from receiving U.S. government contracts,and possible delisting of its common stock.  Management believes that thedisclosure by the investee Company caused the significant devaluation of theircommon stock and resulted in the recording at June 30, 2006 of an unrealizedloss of $6,074 in the second quarter in other comprehensive income.  In September 2006, the investee companyannounced that its company stock will not be delisted.  In October 2006, the investee companyannounced that the suspension of certain of its plants from receiving U.S.government contracts had been lifted. Management continues to evaluate the financial stability of the investeeCompany in relation to the severity and duration of the unrealized loss.  Based on that evaluation and the Company’sability and intent to hold the investment for a reasonable period of timesufficient for a forecasted recovery of fair value, the Company does notconsider this investment to be other-than-temporarily impaired at September 30,2006.

**Critical Accounting Policies**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements, as well as reported amounts of revenues andexpenses during the reporting period. Judgments and assessments of uncertainties are required in applying theCompany’s accounting policies in many areas. Actual results could differ from these estimates.

There have been no revisions to the CriticalAccounting Policies as disclosed in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005.

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**Item3. - Quantitative and Qualitative Disclosures about Market Risk**

**InterestRate**

On September 15, 2004,the Company issued and sold $120,000 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 September 30, 2006 was approximately $520 and atDecember 31, 2005 was approximately $457. Accordingly, the Company recognized a loss of $63 for the nine monthsended September 30, 2006 as the result of the change in fair value of theembedded derivatives.

Each of the embeddedderivatives may result in certain payments to the holders of the 3.75%Convertible Senior Notes.

Therehas been no material change in the interest rate market risk or contingentpayment features from December 31, 2005 (see Item 7A in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005).

**Foreign Currency**

There has been nomaterial changes from December 31, 2005 (see Item 7A in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005).

**Marketable Equity Securities**

For a discussion ofmarket risk related to an investment in a marketable equity security of  one company see Note F to the ConsolidatedCondensed Financial Statements included in Part I, Item 1 of this QuarterlyReport on Form 10-Q.

**Item4. - Controls and Procedures**

(a)                The Company maintains disclosure controls andprocedures designed to ensure that it is able to collect the information it isrequired to disclose in the reports it files with the SEC, and to process,summarize and disclose this information within the time periods specified inthe rules of the SEC.  The Company’smanagement 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, 2006.  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, 2006 to ensure that the Company is able to collect,process, and disclose the information it is required to disclose in the reportsit files with the SEC within the required time periods.

(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, 2006, 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**

Referenceis made to the information contained in the section entitled “*Management’s Discussion and Analysis of FinancialCondition and Results of Operations*” set forth above in Item 2 ofPart I and to Note 17 to the Consolidated Condensed Financial Statementsincluded in Part II, Item 8 of the Company’s Annual Report on Form 10-K for theyear ended December 31, 2005 and Note L to the Consolidated Condensed FinancialStatements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

**Item6. - Exhibits**

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

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

32.1           Section 1350 Certification by the Chief Executive Officer ofthe Company.

32.2           Section 1350 Certification by the Chief Financial Officer ofthe Company.

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SIGNATURE

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.
|               |   | UNITED INDUSTRIAL CORPORATION |
|-------------------------|--------|-------------------------------|
|                    |   |                          |   |   |
|                    |   |                          |   |   |
| Date: November  9, 2006 |   | By:                           |   | /s/ James H. Perry |
|               |   |                     |   | James H. Perry |
|               |   |                     |   | Vice President, |
|               |   |                     |   | Chief Financial Officer, and Controller |
|               |   |                     |   | (as duly authorized officer and  principal accounting officer) |

 

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INDEX OF EXHIBITSFILED HEREWITH

**Exhibit No.**

31.1                     Rule13a-14(a)/15d-14(a) Certification by the Chief Executive Officer of theCompany.

31.2                     Rule13a-14(a)/15d-14(a) Certification of the Chief Financial Officer of theCompany.

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

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

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