**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**(Mark One)**

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

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe transition period from                       to                       **

**CommissionFile No.: 0-16182**

**AXSYS TECHNOLOGIES, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                       |   | **11-1962029**                        |
|--------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)   |   | (I.R.S. Employer  Identification No.) |
| **175 Capital Boulevard, Suite 103  Rocky Hill, Connecticut** |   | **06067**                             |
| (Address of  principal executive offices)                          |   | (Zip Code)                            |

 

**(860) 257-0200**

(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| Title of Each Class           | ** ** | **Name of Each Exchange on Which Registered** |
|-------------------------------|------------|-----------------------------------------------|
| **Common  Stock,**            | ** ** | **The NASDAQ  Stock Market LLC**              |
| **$.01  Par Value Per Share** | ** ** | ** **                                    |

 

 

**Securitiesregistered pursuant to Section 12(g) of the Act:None**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes  o       No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o       No x

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x     No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated by referencein Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer o                 Acceleratedfiler x                 Non-acceleratedfiler o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

The aggregate market valueof the voting and non-voting common stock held by non-affiliates of theregistrant as of the close of business on July 1, 2006 was $129,486,579.

The number of sharesoutstanding of the registrant’s common stock as of February 16, 2007 was 10,660,179.

Parts of the followingdocument are incorporated by reference into Part III of this Annual Reporton Form 10-K: the Proxy Statement for the registrant’s 2007 AnnualMeeting of Stockholders.

 

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**PART I**

**Item 1.**                        BUSINESS

Axsys Technologies, Inc. (together with oursubsidiaries, unless the context suggests otherwise, “Axsys”, “Company”, “we”, “us”or “our”) was originally incorporated in the State of New York in 1959 andreincorporated in the State of Delaware in 1968. We are a leading designer andmanufacturer of precision optical solutions for defense, aerospace, homelandsecurity and high-performance commercial applications. Thesesophisticated solutions are typically found in applications that demand thefinest optical surfaces, highest accuracy and tightest motion controltolerances. Application examples include weapon systems, long-rangesurveillance cameras and highly precise medical imagers. We are also atechnology leader in the supply of infrared surveillance solutions to homelandsecurity market customers such as the U.S. Border Patrol, Army, Navy, AirForce, Coast Guard and various port authorities.

Our solutions are often embedded in larger systemsthat depend on precise optical control for accurate operation of criticalfunctions. We are involved in many large-scale programs including the F-16,F-18, Apache, Stryker, M1A2 Abrams and Bradley Fighting Vehicle. Many ofthe applications with which we are involved include the continuing developmentof next-generation targeting, navigation and imaging systems for fighteraircraft, helicopters, aircraft carriers and armored vehicles. We also supplycritical guidance and seeker components for platforms such as the Minutemanintercontinental ballistic missile and the AIM-9X Sidewinder missile. Ourproducts are included on many platforms within the U.S. National MissileDefense program, or NMD. Our defense products are often used in sophisticatedstabilized optical platforms, or SOPs, which are highly accurate opticalpositioning mechanisms. The SOPs are essential in applications such asmilitary targeting and imaging systems.

In addition to optical solutions, we distributeprecision ball bearings used in a variety of industrial and commercialapplications. We sell our components, sub-systems and bearings to a variety oforiginal equipment manufacturers, or OEMs.

We are organized into twobusinesses: the Optical Systems Group and the Distributed Products Group.Financial information by business segment can be found in Note 15 to theconsolidated financial statements included elsewhere in this annual report.

*Optical SystemsGroup*

The Optical Systems Group designs, manufactures andsells highly precise systems, sub-systems and components that are typically usedin surveillance, long-range observation, tracking and targeting andhigh-performance imaging applications.

Our products can be grouped into four primary areas:reflective optical products, infrared products, motion control products andprecision optical and mechanical structures. However, customer requirementssometimes demand an optical solution that combines products from several ofthese areas. Our defense products are often designed to be integrated intostabilized optical platforms, which are highly accurate optical positioningmechanisms. Stabilized optical platforms are essential in applications such asmilitary targeting and imaging systems.

The focus markets for our Optical Systems Group areaerospace, defense and homeland security. Our products are typically sold toOEMs, which in turn supply a variety of government and commercial end-customers.Our thermal camera systems are typically used for border surveillance,perimeter security and public safety, while sub-systems and components areusually designed for integration into our customers’ high-performance opticalsystems.

The core technologies and manufacturing techniquesthat we use to supply the aerospace and defense industry are transferable tocommercial markets. The commercial markets that we serve include the 

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semiconductor,high-performance graphic arts and medical imaging industries. In all of thesemarkets, highly precise optical and motion control systems are required.

The Optical Systems Group has design and manufacturingfacilities in San Diego, California, Cullman, Alabama, Rochester Hills,Michigan and Nashua, New Hampshire.

For the fiscal year ended December 31,2006, the Optical Systems Group generated $129.9 million, or approximately83.1%, of our total revenues.

*Distributed ProductsGroup*

The Distributed ProductsGroup distributes precision ball bearings, spherical plain bearings andbushings, which are acquired from various domestic and international sources,to OEMs and maintenance, repair and overhaul companies, or MROs. The bearingsand bushings are used in a variety of industrial automation and commercialmarkets. Additionally, the Distributed Products Group designs, manufactures andsells mechanical bearing subassemblies for a variety of customers. TheDistributed Products Group is comprised of the AST Bearings Division located inMontville, New Jersey, with a satellite distribution center in Irvine,California. For the fiscal year ended December 31, 2006, the DistributedProducts Group generated $26.4 million, or approximately 16.9%, of our totalrevenues.

**Market Overview**

Our products are soldmainly to OEMs in a variety of markets that demand the precision andperformance that our products and capabilities provide.

*Optical SystemsGroup*

*MilitarySurveillance and Targeting.**  *Surveillanceand Targeting represents one of the largest growth sectors in the U.S.Department of Defense budget. This sector includes optical sensors and thermalimaging equipment. We have a substantial heritage in this market and continueto focus on protecting and building upon this position. We are involved in manylarge-scale programs including the F-16, F-18, Apache, Stryker MIA2Abrams and Bradley Fighter Vehicle. Many of the applications with which we areinvolved include the continuing development of the next-generation targeting,night vision, navigation and imaging systems for military applications. We area major supplier of optical systems for night-vision optical systems, which arean important component of the U.S. Army’s strategy to “Own the night”.

Optical sensors and thermal imaging equipment arevitally necessary for the U.S. military to maintain its battlefield superiority.Planned upgrade and improvement of such optical and thermal imaging equipmentis not dependent upon spending on new platforms. Even as new platform spendingis projected to be challenging over the next few years, we expect that spendingto upgrade the sensors on existing platforms will continue to thrive.

We have the opportunity to provide value-addedsolutions by integrating our technologies into sophisticated optical systems. Wehave recently developed motorized pan and tilt gimbal systems, which are oftenused to support and position thermal cameras and other sensors.

*HomelandSecurity.*   Since September 11, 2001,government officials have increased their focus on designing plans to reducethe risk of terrorist attacks and prepare for the consequences of terroristattacks. Many of the preventative efforts of these initiatives involve surveillanceand imaging of people, baggage, cargo and vehicles. We are well positioned toparticipate in this emerging market with our imaging and infrared solutions,including the expected increase in spending on border security, as the U.S.Border Patrol upgrades and supplements existing systems on the nation’s bordersto bolster homeland security efforts.

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*NationalMissile Defense.*   Restructuring the country’sdefense and deterrence capabilities to correspond to emerging threats remains ahigh priority for the United States. The deployment of missile defenses is anessential component of this effort. We are an integral member of the contractorteams involved in the rollout of key NMD programs from development toproduction, including EKV, THAAD, PAC-3, SBIRS-High and Airborne Laser.

*OtherAerospace and Defense Opportunities.*   Inconnection with the U.S. government’s efforts to continually enhance agingweaponry, we have the opportunity to be involved in retrofitting the nuclearmissile arsenal with advanced gas bearings. We were chosen as the U.S. AirForce’s Center of Excellence for gas bearing production. We also have a longhistory of involvement with space-based telescopes for use in U.S.-basedsurveillance applications, as well as weather and astronomical research. Weexpect to benefit from the future growth in satellite programs.

*SemiconductorCapital Equipment.*   Our products are used in theprecise inspection of semiconductor wafers. These products include completeauto-focus assemblies, motion control stages and precise distance measuringdevices. We have the opportunity to expand our position in this industry byintroducing new products and marketing to new customers.

*GraphicArts.**  *We werea pioneer in the development of airbearing laser scanners used for digitalimaging of film within the graphic arts market in the early 1990’s. Whiledeclining advertising revenues have negatively impacted the graphic artsmarket, we have expanded our product offering to include marker engines, whichcan increase our average selling price to a customer over six-fold. Although weanticipate a moderate decline in the overall graphic arts market, we expect tomitigate some of this decline with the introduction of marker engines to ourcustomer base.

*Thermal Imaging.**  *Advancements in cooled and uncooled focal plane arraytechnology have improved the quality of infrared images and drastically reducedthe costs of producing thermal imaging camera systems. The development ofuncooled focal plane array technology during the mid-1990s has resultedin a pronounced reduction in the cost of infrared cameras. The market hasresponded with a number of infrared related products designed for a variety ofapplications, including firefighting, surveillance, preventive maintenance andother commercial night vision needs. Furthermore, the availability of moremoderately priced alternatives enables manufacturers to employ the sameinfrared systems or components for both commercial and military applications. Theenhanced total market size accumulated thereby is sufficient to create theeconomies of scale that permit broad deployment. We have been at the forefrontof developing both cooled and uncooled camera product offerings and, like muchof the rest of the infrared market, we have experienced a broad increase inthermal imaging demand as the cost effectiveness of employing infraredcapabilities has escalated.

*DistributedProducts Group*

*Ball Bearings.**  *The markets we serve include industrial automation,semi-conductor capital equipment, aerospace and defense and consumer products. Themarket for the distribution of ball bearings and related products generallyfollows worldwide economic trends. In order to position us for growth, we areintroducing new products, lower cost products and value-added services.

**Technologies,Products and Capabilities**

We utilize several key manufacturing technologies andhave developed software and systems integration capabilities that enable us todesign, manufacture and assemble a wide variety of high-performance precisionoptical and motion control solutions. Our core competencies include:

*ThermalImaging Cameras.**  *We haveleveraged our turnkey optical design, manufacturing and integrationcapabilities into an extensive and growing line of world-class thermal imagingcameras. We 

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currently have a productline of seven integrated thermal imaging systems, approximately 20 cooled anduncooled cameras and five clip-on weapon night sights. Our success in thermalcameras is integrally tied to our coating processes and ability to produceindustry-leading optical lens assemblies. Our cameras, including surveillancesystems, clip-on weapon night sights and handheld imagers, fill a variety ofrequirements of the federal and military customers, municipal first responders,firefighters and commercial entities. We have expanded into the design andmanufacture of thermal cameras and systems intended for a wide range ofsurveillance requirements in the military, homeland security and commercialsectors. We sell weapons sights, both image intensified and uncooled thermalimagers, that are designed to clip onto a soldier’s existing day sight,eliminating the need to change over from a day scope to a dedicated night sightwhile allowing the weapon to retain its boresight after repeated use. We alsomanufacture a line of handheld thermal cameras that we market and sell to firstresponders in municipal fire, law enforcement and security departments, as wellas to the U.S. Border Patrol and the U.S. military. We also manufacture andsell a line of complementary products, which are thermal imaging camerasdesigned specifically for firefighting.

We have designed our entire line of thermal camerasusing a consistent architecture and are therefore able to easily constructexactly the combination of product features that best meet a customer’s needs. Forexample, we essentially use the same electronics processing architecture andoptics across our suite of different cameras. The common design elements of ourthermal imagers permit us to offer a wide variety of thermal cameras to satisfyspecific customer demand. This approach has allowed us to adapt cutting edgefocal plane array technologies for both high-end and low-end marketopportunities. Additionally, our software engineering team has made significantstrides in proprietary designs that drive our complex thermal cameraintegration and allow us to respond to a variety of customer requirements.

*PrecisionOptics.**  *Webelieve we are a leading designer and manufacturer of custom precisionreflective and transmissive optical solutions and components. We providecomplete design, fabrication and testing of glass and metal optics ranging fromsingle and multi-faceted scan mirrors, plano and aspheric mirrors to complextelescope assemblies and thermal camera lenses. We have designed and/ormanufactured numerous optical products for a variety of military andastronomical applications over the past 40 years.

We specialize in the manufacture of diamond-machinedaspheric metal optics that are significantly enhanced for optical figure andoptical finish by post polishing, typically while using custom engineered interferometricnull tests. “Bolt together” assemblies with post polished metal aspheres areroutine. We produce a variety of aspheric surfaces including conic aspheres,general case aspheres, cylindrical aspheres and toric aspheres with up to 0.80-meteraperture. Our precision metal optic products are used in applications whereperformance requirements cannot be met with glass optics. The advantages of ouroptics include lighter weight, thermal stability and ease of mechanicalinterface with housing and actuation devices. We sell our precision metaloptical components for use in high speed electro-mechanical scanners, weaponfire control systems, forward-looking infrared, or FLIR, night vision weaponsystems and high-performance space-borne instruments used on weather,mapping and scientific satellites.

We also specialize in the production of precisionglass lenses using infrared materials through the use of conventional grindingand polishing techniques. We produce aspheric lenses in glass by hand polishingand produce aspheric and diffractive lenses in infrared materials by diamondturning. Surfaces are tested using null test and profilometry. These glasslenses are integrated into sophisticated lens assemblies for use with thermalcameras or imaging systems, or sold as components for use by OEM suppliers invarious infrared applications. Our infrared lens assemblies are tested usinginfrared interferometry.

*PrecisionMotion Control.**  *Wedesign a complete line of brushless and brush type torque motors andservomotors that can be customized to meet customers’ unique specifications. Thedirect drive motor replaces conventional servomotor-gearhead configurationsimproving the response characteristics of the 

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unit. Motors incorporaterare earth magnets with outer diameters ranging from 0.5” to 48” and providepeak torques up to 1,650 ft-lbs.

The gearless DC motor drive is ideally suited for highacceleration applications requiring improved response for rapid start/stopactions such as missile seekers, optical stabilization and turret control. Theabsence of gearing also eliminates errors caused by friction and backlashcreating high threshold sensitivity. These motors achieve accuracies of onearc-second in a high performance positioning system. Our DC torque motors aredesigned using premium materials that offer unique space and weight savingproperties while generating maximum power output. Limited angle torque motorsdo not require commutation electronics and have near zero cogging.

We also manufacture highly reliable multi-speed andsegmented positioning sensors, such as resolvers and induction potentiometers,which provide a high degree of angular accuracy and resolution. These devicestypically accompany our motors to provide position feedback within a highperformance system.

Resolvers are available with transmitter, differentialor receiver functions. These resolvers are specifically designed to withstandhigh-impact shock and environments containing dirt, grease, oil or othercontaminants, and are available housed or un-housed in a variety ofconfigurations. Resolvers are either single or multi-speed (up to 64-speed),with outer diameters ranging from 0.7” to 15”, and provide accuracies to 5 arcseconds.

Induction potentiometers, also defined as lineartransmitters, provide high linearity output over a wide angular range.Induction potentiometers are available in frameless and housed configurationsand brush and brushless designs.

*Electronics.**  *We design and manufacture several key electroniccomponents for the semiconductor capital equipment and high-end digital imagingmarkets, including laser interferometers and electronic controllers and drives.Our electronics components control the speed and position of electro-mechanicalsystems, such as precision motors, actuators, X-Y positioning stages and laserscanners. Laser interferometers, which are designed to permit precise linearposition sensing, are sold to customers principally in the semiconductorcapital equipment market. Electronic controllers coordinate the positioning andspeed of electro-mechanical systems by interfacing with other motion controlcomponents. Drives provide power to a motor based on input from the controllerin order to achieve a designated position or to achieve a specific speed.

*PrecisionMachining.*   We are a leading fabricator ofprecision machined and processed exotic materials. These include beryllium,AlBeMet, titanium, halfnium, quartz and glass used in the defense, space andhigh-performance commercial markets. Operating within a 120,000 square footenvironmentally-controlled manufacturing facility, we provide completefabrication services including manual and CNC milling, turning, EDM, lappingand grinding, chemical and special processing and mechanical assembly. Usingthese technologies, we are able to meet our customers’ extremely high tolerancerequirements. Applications include precision optics, airbearings, heat sinks,structural housings and gimbals. Our airbearings provide high-speed precisionpositioning and are used in high-speed scanners for digital imaging and weaponguidance systems. Our heat sinks are used to dissipate heat in high-performanceavionics and satellite electronics, and our gimbals are used in variousapplications, including positioning optical sensors in FLIR night visionsystems. We also manufacture optical substrates used internally and by ourcustomers in a variety of precision metal optical applications such as weaponfire control systems and space-borne instruments.

Utilizing these core technologies, we have developedan array of solutions to create value-added, vertically integrated solutionsfor the aerospace, defense and high-performance commercial equipment industries.Examples of these solutions include:

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*InfraredZoom Lenses:**  *Wedesign and manufacture sophisticated zoom and multi-field-of-view thermallenses for use in a variety of military applications. These lenses are sold toOEMs who subsequently integrate them with infrared cameras and imagers formilitary and intelligence purposes.

*InfraredCameras and Systems.**  *Wehave developed a broad range of cooled and uncooled camera systems, culminatingin the recently released Electro Optical Sensor Suite, a state-of-the-artintegrated system comprised of a cooled or uncooled thermal imager, pan/tiltmounting, joystick controller, optional visible camera and numerous otherfeatures.

*Motion-ControlSolutions.**  *Weprovide precision micro-positioning systems. These high-performance systems areused in a diverse array of high-end commercial applications such as stabilizedoptical platforms, semiconductor and flat panel process and inspectionssystems, as well as laser imaging systems.

*FastSteering Mirrors.**  *We haveapplied extensive experience designing and building opto-mechanical systems todevelop fast steering mirror, or FSM, technology. The single-axis and two-axis,flexure mounted FSM represents a compact, low cost, high-performance designsolution for a variety of emerging optical scanning and beam stabilizationapplications. Such devices may be used to correct for polygon cross scanerrors, acquire and lock beams within free space laser systems, modulate tiltand cavity control in interferometers, maintain beam stabilization in thepresence of thermal drift and vibration, and provide general two-axis beamscanning.

*MarkerEngines.**  *We haveleveraged our experience providing high-speed airbearing scanners with ourprecision optics and electronics capabilities to produce ultra-high performanceflat bed marker engines. Each engine is self-contained, pre-aligned and readyto integrate into a customer’s system.

*RotaryAirbearing Scanners.*   We design and manufacturerotary airbearing scanners for use in high precision graphic arts and medicalimaging applications, semiconductor mask production and inspectionapplications, as well as defense applications. Airbearing scanners providenumerous advantages over mechanical bearings due to their low noisecharacteristics, repeatability and ability to rotate at high speeds (up to100,000 RPMs). When combined with our electronic controllers, our airbearingscanners provide extremely high cross-scan accuracy and extremely low jitter.

*IntegratedSystems.*   Part of our product strategy is todevelop systems that incorporate multiple products. Our integrationcapabilities create value for the prime contractors by reducing the number ofsuppliers and collapsing the supply chain. One notable example of this strategyis our recent introduction of pan and tilt positioners that are compatible withour infrared cameras as well as other payloads.

Thefollowing table summarizes our core engineering and manufacturing capabilities:

| Core Technologies       |
|-------------------------|
| **Precision Optics**    | ** ** | **Precision Motion Control** | ** ** | **Electronics** | ** ** | **Precision Machining** |
| Infrared Lenses         |   | Multi-Axis Gimbals |   | AC & DC Motor |   | Optical Substrates |
| Infrared Cameras        |   | AC Motors |   | Speed Controls |   | Gimbals and Yokes |
| Optical Lens Assemblies |   | Brush & Brushless |   | Custom DSP Motion |   | Airbearings |
| Telescopes              |   | DC Motors: |   | Controllers |   | Components |
| Thin Film Coating       |   | Torque |   | Motor Drives |   | Structural Housings |
| Polygon Mirrors         |   | Servo |   |   |   | Heat Sinks |
| Monogon Mirrors         |   | Limited Angle |   |   |   |   |
| Aspheric Optics Flat    |   | Resolvers |   |   |   |   |
| Optics Head Mirrors     |   | Synchros |   |   |   |   |
| Fold Mirrors            |   |   |   |   |   |   |
| Collimators             |   |   |   |   |   |   |

 

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***Backlog and Orders***

Axsys recognized, in 2006,bookings of $174.1 million, ending the year with record backlog of $130.4 million,of which 14.8% will be shipped beyond 12 months. Our backlog increased by $17.7million, or 15.7%, compared to our ending backlog of $112.7 million as of December 31,2005.

**Competition**

The markets for our products are competitive. Wecompete primarily on the basis of our ability to design and engineer productsto meet performance specifications set by our customers. Most of our customersare OEMs that purchase component parts or subassemblies, which they incorporateinto their end products. Although most of our customers are OEMs, our thermalimaging cameras and clip-on night sights are typically sold directly toequipment integrators, as well as government, military and commercial end users.Product pricing, quality, customer support, experience, reputation andfinancial stability are also important competitive factors.

There are a limited number of competitors in each ofthe markets for the various types of precision optical, infrared and motioncontrol systems and components that we design, manufacture and sell. Ourcompetitors are often well entrenched, particularly in the aerospace anddefense markets. Some of these competitors have substantially greater resourcesthan we do. We believe that the breadth of our technologies and productofferings provides us with a competitive advantage over certain manufacturersthat supply only discrete components or who are not vertically integrated withenabling technologies.

There are numerous competitors in markets to which wedistribute our precision ball bearings. These competitors vary in size andinclude bearing manufacturers and other distributors. We believe that ourproduct breadth and availability, combined with the value-added services wesupply, provide competitive advantages.

We expect our competitorsto continue to improve the design and performance of their products. We cannotassure you that our competitors will not develop enhancements to, or futuregenerations of, competitive products that will offer superior price orperformance features, or that new technology or processes will not emerge thatrender our products less competitive or obsolete. Increased competitivepressure could lead to lower prices for our products, thereby adverselyaffecting our business, financial condition and results of operations. Wecannot assure you that we will be able to compete successfully in the future.

**Customers**

Our customers include OEMs, equipment integrators andend-users that design or utilize high-precision, performance andthroughput equipment. We sell our products primarily to OEM customers in theaerospace and defense, homeland security, high-end graphic art, medicalimaging, semiconductor capital equipment and industrial automation markets.

BAE Systems, an aerospace and defense systemssupplier, represented 12.1% of our total sales during 2006. Raytheon Company,an aerospace and defense systems supplier, represented 12.3% and 18.9% of ourtotal sales during 2005 and 2004, respectively. Our accounts receivable fromBAE Systems was $2.4 million as of December 31, 2006, and ouraccounts receivable from Raytheon was $1.0 million at December 31, 2005and $4.5 million at December 31, 2004. We participate with BAE Systems onmultiple programs, with the majority of our sales to BAE Systems relating to anarmored vehicle program and a thermal weapons sight program. Both programs areultimately dependent on U.S. Department of Defense spending and could becanceled. However, night vision systems are a high priority for the U.S.military and, therefore, we do not foresee any weakening of demand for theseproducts in the short term.

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We had aggregate sales, both military andnon-military, directly to the U.S. government, including its agencies anddepartments, of approximately $4.8 million in 2006, $4.6 million in 2005, and$2.4 million in 2004. These sales accounted for approximately 3.0% of totalsales in 2006, 3.4% in 2005 and 2.3% in 2004. Approximately 57.3% of totalsales in 2006, 56.3% in 2005 and 46.0% in 2004 were derived from subcontractswith U.S. government contractors. The majority of these contracts are subjectto termination at the convenience of the U.S. government, and certain contractsare also subject to renegotiation. Currently, we are not aware of any proposedtermination or renegotiation of such contracts that would have a materialadverse effect on our business.

Because a substantial partof our business is derived directly from contracts with the U.S. government,U.S. government agencies or departments, or indirectly through subcontracts withU.S. government contractors, our operational results could be materiallyaffected by changes in U.S. government expenditures for projects or programsusing our products. However, we believe that the broad number and diversity ofthe programs with which we are involved and the breadth of our productapplications may lessen our exposure to such risk.

**Sales, Marketingand Customer Support**

As of December 31, 2006, we employed 67 sales,marketing and customer support personnel throughout our organization, comparedto 69 employees in similar functions at the end of 2005. We utilize two OEMsales organizations, one focused on aerospace and defense customers and theother focused on high-performance commercial customers. We have a separatedistributed products sales force that is focused on selling ball bearings,bushings and assemblies, principally to commercial and industrial oriented OEMsas well as MRO distributors.

Our sales organization included 25 direct sales fieldpersonnel, most of whom have engineering backgrounds, with the remainderinvolved in inside sales, customer service, program management, contractadministration and applications engineering. We believe that our sales effortis enhanced by having engineering-trained sales personnel available to meetwith our customers’ engineering personnel. Our application and design engineersare also involved in the sales process.

We also sell our productsthrough a significant number of manufacturers’ sales representatives and agents.Although we believe that we have satisfactory relationships with these salesrepresentatives and agents, we cannot assure you that these relationships willcontinue to be satisfactory or will continue at all.

**Domestic andForeign Sales**

Thetable below presents sales from continuing operations to specific geographicregions. Substantially all of our assets are located within the United States.

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **    | ** ** | **(In thousands)**                     | ** ** |
| United States |       | $                                           | 141,806    |   | $ | 118,218 |   | $ | 91,069 |   |
| Europe        |       | 9,462                                       |       | 10,026 |   | 8,672 |   |
| Other foreign |       | 5,079                                       |       | 5,299 |   | 3,789 |   |
| Total sales   |       | $                                           | 156,347    |   | $ | 133,543 |   | $ | 103,530 |   |

 

**Research,Development and Engineering**

We seek to develop new products and improve existingproducts in order to keep pace with the increasing performance requirements ofour customers. We devote significant resources, a portion of which isreimbursed by customers, to development programs directed at creating newproducts and product enhancements, as well as developing new applications forexisting products. Because we believe 

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that our ability tocompete effectively depends in part on maintaining and enhancing our expertisein applying new technologies and developing new products, we dedicatesubstantial resources to engineering, research and development. As of December 31,2006, we employed 95 individuals in engineering, research and developmentfunctions. We cannot assure you that our product development efforts will besuccessful in producing products that respond to technological changes or newproducts introduced by others.

Our costs associated withresearch, development and engineering expenses were $4.5 million in 2006, $3.8million in 2005 and $2.7 million in 2004. We intend to direct our research anddevelopment activities toward integrating our various technologies andcontinuing to develop sub-systems.

**Raw MaterialsSuppliers**

The raw materials and components that we purchase aregenerally available from multiple suppliers. However, Brush Wellman, Inc.is the only U.S. source for beryllium, which is a material used extensively byour Company. Historically, we have had an excellent relationship with BrushWellman and have not encountered problems in obtaining our supply requirements.While there is an alternative source in Kazakhstan, most of our military contractspreclude the use of non-US material. We believe that a partial or complete lossof Brush Wellman as a supplier of beryllium, or production shortfalls orinterruptions that otherwise impair the supply of beryllium, would have amaterial adverse effect on our business, financial condition and results ofoperations.

In addition, we purchase asubstantial amount of ball bearings that we distribute from two foreignsuppliers. While we believe that we could obtain alternate sources of supply,any interruption in the flow of products from these suppliers, or significantincreases in the cost of these products, could have an adverse effect on ourbusiness, financial condition and results of operations.

**Patents andTrademarks**

We are not dependent upon any single patent ortrademark. We have a combination of patents, trademarks and trade secrets,non-disclosure agreements and other forms of intellectual property protectioncovering our proprietary technology. Although we believe that our patents andtrademarks may have value, we believe that our future success will dependprimarily on the innovation, technical expertise, manufacturing and marketingabilities of our personnel. We cannot assure you as to the degree of protectionoffered by our patents. We cannot assure you that we will be able to maintainthe confidentiality of our trade secrets or that our non-disclosure agreementswill provide meaningful protection of our trade secrets, know-how or otherproprietary information in the event of any unauthorized use, misappropriationor other disclosure.

Competitors in the UnitedStates and foreign countries, many of which have substantially greaterresources, may have applied for or obtained, or may in the future apply for andobtain, patents that will prevent, limit or interfere with our ability to makeand sell some of our products. Although we believe that our products do notinfringe on the patents or other proprietary rights of third parties, we cannotassure you that third parties will not assert infringement claims against us orthat such claims will not be successful.

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**Environmental Regulation**

We believe that we arecurrently in compliance, in all material respects, with federal, state andlocal laws and regulations governing the use and discharge of hazardoussubstances and other pollutants into the environment or otherwise relating tothe protection of the environment and that any non-compliance with such lawswill not have a material adverse effect upon our business, financial condition,results of operations, capital expenditures, earnings or competitive position. Wecannot assure you, however, (1) that changes in federal, state or locallaws, regulations or regulatory policy or the discovery of unknown problems orconditions will not in the future require substantial expenditures or (2) asto the extent of our liabilities, if any, for past failures, if any, to complywith applicable environmental laws, regulations and permits, any of which alsocould have a materially adverse effect on our business, financial condition orresults of operations.

We have incurred, and mayin the future incur, costs and liabilities under the ComprehensiveEnvironmental Response, Compensation and Liability Act, or CERCLA, or similarstate laws for the investigation and cleanup of hazardous waste orcontamination at third party waste disposal sites or at current or formerfacilities, related in part to historical practices or waste disposed of priorto the purchase of facilities by us. We are in the process of remediating twoformerly owned sites in Bedford, Ohio and St. Petersburg, Florida and weare participating as a potentially responsible party, or PRP, at a third-partywaste disposal site in Norwalk, Connecticut. Although liability under CERCLA isjoint and several, meaning that liability can exceed a PRP’s pro rata share ofcleanup costs, we believe, based on currently available information, that costsassociated with these sites will not have a material adverse effect on ourbusiness and financial condition. It is possible, however, that our results ofoperations for a particular fiscal period could be materially affected.

As of December 31,2006, we have an accrual of $666 thousand for future costs related to the Ohioand Florida sites. These estimates have been developed in consultation withoutside environmental and legal consultants handling these matters and arebased upon an analysis of the anticipated remediation plans. We do notanticipate these matters will have a material adverse effect on ourconsolidated financial position. It is possible, however, that future resultsof operations could be materially affected by changes in our assumptions.

In addition, in 2001, wewere notified by the United States Environmental Protection Agency, or the EPA,that it considers us a PRP for the US Cap and Jacket site in Prospect,Connecticut. Our former subsidiary, which was merged into us in 1979, operateda screw machine shop at this location from 1961 to 1978. The EPA demandedreimbursement for its costs incurred in connection with a time-critical removalaction at the site in 2001. In April 2004, the EPA notified us that thetotal amount of these costs was approximately $650 thousand, including indirectcosts and interest accrued through that date. We advised the EPA of ourposition that the contamination must have occurred after our ownership of thesite and that, accordingly, we are not responsible for the EPA’s costs or theremediation of the site. The EPA continued its investigation of the site,including serving us with a formal request for information under Section 104(e) ofCERCLA in July 2004 (to which we responded). The EPA designated no otherPRPs. The EPA informed us that it was prepared to commence a CERCLAcost-recovery action against us if we were unable to amicably resolve thematter. On July 18, 2005, we signed a settlement agreement with the EPA,settling this matter for $175 thousand, plus accrued interest from this datethrough the date of payment. We have no further responsibility to the EPA as itrelates to the EPA’s 2001 removal action at this site. During 2005, we recognizedan after tax charge of $150 thousand in discontinued operations for thesettlement costs and legal expenses associated with the settlement of thismatter.

We use or generate certainhazardous substances in our manufacturing and engineering facilities. Webelieve that our handling of these substances is in compliance with, andexceeds what is required by, applicable local, state and federal environmental,safety and health regulations at each operating location. We invest inprotective equipment, process controls and specialized training to minimizerisks to 

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employees,surrounding communities and the environment due to the presence and handling ofthese hazardous substances. We regularly conduct employee physical examinationsand workplace air monitoring related to these substances. When potential oractual exposure problems have been indicated, we implement corrective actions.In general, re-occurrence has been minimal or non-existent. We do not carryenvironmental impairment insurance. Accordingly, any failure by us to properlymanage exposure to hazardous substances could have a materially adverse effecton our business, financial condition and our operations.

**Employees**

As of December 31,2006, we employed 765 persons, including 536 in manufacturing, 67 in sales, 95in engineering and 67 in administration. Currently, none of our employees arerepresented by unions and we consider our relationship with our employees to besatisfactory. There has been no significant interruption of operations due tolabor disputes.

**AvailableInformation**

Our Internet website ishttp://www.axsys.com. We make available free of charge on our website ourannual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K and amendments to those reports as soonas reasonably practicable after we electronically file or furnish suchmaterials to the Securities and Exchange Commission. In addition, we haveposted the charters for our Audit Committee, Compensation Committee, andNominating and Governance Committee on our website under the heading “Investors.”These charters are not incorporated herein by reference. We will also provide acopy of these documents to shareholders upon request.

**Item 1A.**                RISKFACTORS

You should carefullyconsider each of the risks and uncertainties we describe below and all of theother information in this annual report. The risk and uncertainties we describebelow are not the only ones we face. Additional risks and uncertainties ofwhich we are currently unaware or that we currently believe to be immaterialmay also adversely affect our business.

**We depend on contracts with the U.S. federalgovernment for a significant portion of our sales. Most of these contracts aresubject to termination and renegotiation by the U.S. federal government at anytime.**

The aerospace and defense industry, which representsthe majority of our sales, is largely dependent upon government contracts. Asignificant portion of our business and business development efforts isconcentrated in the aerospace and defense industry. Our business depends, insignificant part, upon the U.S. government’s continued demand in the area ofdefense for high-end, high-performance products of the type that wemanufacture. Approximately 60% of our sales in 2006 and 2005 and 48% in 2004were derived directly from contracts with the U.S. government, or its agenciesor departments, or indirectly from subcontracts with U.S. governmentcontractors.

The majority of these government contracts are subjectto termination and renegotiation. Generally, government contracts andsubcontracts are subject to oversight audits by government representatives andcontain provisions permitting termination, in whole or in part, without priornotice at the government’s convenience upon the payment of compensation onlyfor work done and commitments made at the time of termination. We can give noassurance that one or more of our government contracts or subcontracts will notbe terminated under these circumstances. Also, we can give no assurance that wewould be able to procure new government contracts or subcontracts to offset therevenues lost as a result of any termination of our contracts. Because ourrevenues are dependent on our procurement, performance and payment under ourcontracts, the loss of one or more critical contracts could have a materiallyadverse effect on our business, financial condition and results of operations.

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**The loss of BAESystems as a customer or a significant reduction in sales to BAE Systems couldhave a materially adverse effect on our business, financial condition andresults of operations.**

We rely on key customers. We currently have onecustomer that represents a significant portion of our sales. During 2006,approximately 12.1% of our sales were to BAE Systems. The loss of BAE Systemsas a customer or a significant reduction in sales to BAE Systems could have amaterially adverse effect on our business, financial condition and results ofoperations.

If BAE Systems or any ofour other key customers becomes insolvent or files for bankruptcy, our abilityto recover accounts receivable from that customer would be adversely affectedand any payments we received in the preference period prior to a bankruptcyfiling may be potentially recoverable, which could have a materially adverse effecton our business, financial condition and results of operations.

**U.S. federalgovernment spending priorities may change in a manner adverse to our business.**

We act as asubcontractor for many different government programs. The funding of governmentprograms is subject to congressional appropriations. Although multi-yearcontracts may be authorized in connection with major procurements, Congressgenerally appropriates funds on a fiscal year basis even though a program maycontinue for several years. Consequently, programs are often only partiallyfunded initially, and additional funds are committed only as Congress makesfurther appropriations. The termination of funding for a government programwould result in a loss of anticipated future revenues attributable to thatprogram, which could have a materially adverse effect on our business,financial condition and results of operations. In addition, the termination ofa program or failure to commit additional funds to a program already startedcould increase our overall costs of doing business. Among the factors thatcould materially adversely affect our federal government contracting businessare:

·       budgetaryconstraints affecting federal government spending generally, or defense andintelligence spending in particular, and annual changes in fiscal policies oravailable funding;

·       changesin federal government programs, priorities, procurement policies or requirements;

·       newlegislation, regulations or government union pressures, on the nature andamount of services the government may obtain from private contractors;

·       federalgovernmental shutdowns (such as during the government’s 1996 fiscal year) andother potential delays in the government appropriations process; and

·       delaysin the payment of our invoices by government payment offices due to problemswith, or upgrades to, government information systems, or for other reasons.

These or other factorscould cause federal governmental agencies, or prime contractors where we areacting as a subcontractor, to reduce their purchases under contracts, toexercise their right to terminate contracts or to not exercise options to renewcontracts, any of which could have a materially adverse effect on our business,financial condition and results of operations.

**We could besuspended or debarred from contracting with the federal government.**

We could be debarred orsuspended from contracting with the federal government generally, or anysignificant agency in the intelligence community or Department of Defense, for,among other things, actions or omissions that are deemed by the government tobe so serious or compelling that they affect our contractual responsibilities.For example, we could be debarred for committing a fraud or criminal offense inconnection with obtaining, attempting to obtain or performing a contract, orfor embezzlement, fraud, forgery, falsification or other causes identified inSubpart 9.4 of the Federal Acquisition Regulation. In addition, our reputationor relationship with the government agencies could be impaired. If we were 

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suspendedor debarred, or if our relationship or reputation were impaired, our business,financial condition and results of operations could be materially adverselyaffected.

**The failure toobtain, or any delays in obtaining, export authorizations from the federalgovernment in connection with the export of our products, or the imposition ofsanctions for failing to comply with the export control laws and regulations,could have a materially adverse effect on our business, financial condition andresults of operations.**

We must often obtain theprior review and approval of the federal government in connection with theexport of our products and technology. Such approvals are provided via licensesor other authorizations issued by government agencies under the Arms ExportControl Act, the International Traffic in Arms Regulations, the ExportAdministration Regulations and other laws and regulations that control exportsof hardware and technology to foreign countries and the transfer of technologyto foreign persons wherever located. We can give no assurance that we will besuccessful in obtaining and maintaining the necessary licenses or otherauthorizations required to conduct business in foreign countries or withforeign persons. Recently, heightened government enforcement of the exportcontrol laws and regulations, and an increasingly restrictive federalgovernment policy with respect to the export licensing of certain technologiesincluding infrared and night vision systems, has resulted in lengthened reviewperiods for our license applications and increased risks that such requests forlicenses or other authorizations could be denied. The failure to comply withsuch export control laws and regulations can result in the imposition of sanctions,which may include monetary penalties and the loss of export privileges. Theimposition of such sanctions, or the failure to obtain or delays in obtainingexport licenses or other necessary authorizations that would prevent or delayus from selling our products outside the United States, could have a materiallyadverse effect on our business, financial condition and results of operations.

**We must comply withcomplex procurement laws and regulations.**

We must comply withand are affected by laws and regulations relating to the formation,administration and performance of federal government contracts, which affecthow we do business with our customers and may impose added costs on ourbusiness. Among the most significant regulations are:

·       theFederal Acquisition Regulation, and agency regulations supplemental to theFederal Acquisition Regulation, which comprehensively regulate the formation,administration and performance of government contracts;

·       theTruth in Negotiations Act, which requires certification and disclosure of allcost and pricing data in connection with contract negotiations;

·       theCost Accounting Standards and Cost Principles, which impose accountingrequirements under certain government contracts; and

·       laws,regulations and executive orders restricting the use and dissemination ofinformation classified for national security purposes and the exportation ofcertain products and technical data.

Moreover, we are subjectto industrial security regulations of the Department of Defense and otherfederal agencies that are designed to safeguard against foreigners’ access toclassified information. If we were to come under foreign ownership, control orinfluence, our federal government customers could terminate or decide not torenew our contracts, and it could impair our ability to obtain new contracts.

**We may not be ableto implement our business plan effectively because the industries in which weoperate are subject to fluctuations and other factors that are difficult toforecast.**

Our operatingresults may vary substantially due to factors that are difficult to forecast.Factors such as announcements of technological innovations or new products byus or our competitors, domestic and 

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foreigngeneral economic conditions and the cyclical nature of the industries that weserve could cause substantial variations in our operating results. Theaerospace and defense, semiconductor capital equipment, high-performancegraphic art, medical imaging capital equipment and industrial automation OEMand MRO industries, each of which represents a significant market for ourproducts, have historically been subject to substantial economic fluctuationsdue to changing demands for their products and services, introduction of newproducts and product obsolescence. Any future fluctuations arising from theseor other conditions could have a materially adverse impact on our business,financial condition and results of operations. We have experienced, and expectto continue to experience, significant fluctuations in our quarterly and annualoperating results due to a variety of factors, including:

·       marketacceptance of new and enhanced versions of our products;

·       timingand shipment of significant orders;

·       mixof products sold;

·       lengthof sales cycles;

·       plantopenings and closings;

·       thetiming of acquisitions or dispositions;

·       delaysin raw materials shipments, as well as other manufacturing delays anddisruptions;

·       completionof large projects;

·       thelevel of backlog of orders;

·       domesticand foreign general economic conditions; and

·       demandin the markets that we serve.

To some extent, primarilyin our bearing distribution division, our net sales and operating results for aspecific quarter will depend upon generating orders to be shipped in the samequarter in which the order is received. The failure to receive anticipatedorders or delays in shipments near the end of a particular quarter, due, forexample, to unanticipated rescheduling or cancellations of shipments by ourcustomers or unexpected manufacturing difficulties, may cause our net sales ina particular quarter to fall significantly below expectations, which could havea materially adverse effect on our business, financial condition and results ofoperations for such quarter.

**If we are unable toadapt to technological change, demand for our products may be reduced.**

The rapid pace of technological change will requirecontinuous new product development. Our success will continue to depend insubstantial part upon our ability to introduce new products that keep pace withtechnological developments and evolving industry standards and to applyappropriate levels of engineering, research and development resources necessaryto keep pace with these developments. In addition, our success will depend onhow well we respond to changes in customer requirements and achieve marketacceptance for our products and capabilities. Any failure by us to anticipateor respond adequately to technological developments and customer requirementscould have a materially adverse effect on our business, financial condition andresults of operations. In order to develop new products successfully, we aredependent upon close relationships with our customers and their willingness toshare proprietary information about their requirements and participate incollaborative efforts with us. We cannot assure you that our customers willcontinue to provide us with timely access to information or that we will besuccessful in developing and marketing new products and services or theirenhancements. In addition, we cannot assure you that the new products andservices or their enhancements, if any, that we develop will achieve marketacceptance.

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**We operate inhighly competitive markets with competitors who may have greater resources thanwe possess, which could reduce the volume of products we can sell and ouroperating margins.**

Our markets are extremely competitive. We competeprimarily on the basis of our ability to design and engineer our products tomeet performance specifications set by our customers, most of whom are OEMs whopurchase component parts or sub-systems for inclusion in their end products.Product pricing and quality, customer support, experience, reputation andfinancial stability are also important competitive factors.

There are a limited number of competitors in each ofthe markets for the various types of precision optical and positioning productsthat we sell. Our competitors, especially those in the precision optical andpositioning product lines, are typically focused on a smaller number of productofferings than we are, and they are often well entrenched. Some of ourcompetitors have substantially greater resources than we do. Our competitorscould develop enhancements to or future generations of competitive productsthat will offer superior price or performance features to ours. In addition,new processes or technologies could emerge that render our products lesscompetitive or obsolete.

In addition, a substantial investment is required byan existing or potential customer to integrate components and sub-systems intotheir product design. We believe that once a customer has selected particularcomponents or sub-systems from one vendor, the customer generally relies uponthat vendor to provide equipment for the specific product application and mayseek to rely upon that vendor to meet other component or sub-systemrequirements. Accordingly, we may be at a competitive disadvantage with respectto a prospective customer that chooses to utilize a competitor’s components orsub-systems.

Further, there are numerous competitors in markets towhich we distribute precision ball bearings. Our competitors, who vary in size,include other ball bearings distributors as well as ball bearingsmanufacturers.

The basis of competitionin the industries in which we compete could shift and we may not be able tocompete successfully.

**Our backlog issubject to reduction and cancellation.**

Backlog representsproducts or services that our customers have committed by contract to purchasefrom us. Our backlog as of December 31, 2006 was $130.4 million. Ourbacklog is subject to fluctuations and is not necessarily indicative of futuresales. Moreover, cancellations of purchase orders or reductions of productquantities in existing contracts could materially reduce our backlog and,consequently, future revenues. Our failure to replace canceled or reducedbacklog could result in lower revenues.

**We operate internationally,which exposes us to the risks of doing business abroad.**

Our levels ofinternational sales and purchases could pose risks to our operating results.Our international sales accounted for approximately 9.3% of our sales in 2006,11.5% in 2005 and 12.0% in 2004. In addition, our products are sold to domesticcustomers who use them in products that they sell into international markets.Also, we purchase a substantial portion of our ball bearing products from twoforeign suppliers and certain other products from other foreign suppliers. Ourinternational sales and purchases are subject to a number of risks generallyassociated with international operations, including the following:

·       generaleconomic conditions;

·       importand export duties and restrictions;

·       currencyfluctuations;

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·       changesin regulatory requirements;

·       theimposition of tariffs and other barriers;

·       politicaland economic instability;

·       potentiallyadverse income tax consequences;

·       transportationdelays and interruptions;

·       laborunrest and current and changing regulatory environments;

·       ourability to comply with regulations governing foreign government contracts;

·       difficultiesin staffing and managing multi-national operations; and

·       limitationson our ability to enforce legal rights and remedies.

Any of these factors couldhave a materially adverse effect on our business, financial condition andresults of operations. We cannot assure you that we will continue to operate incompliance with applicable customs, currency exchange control regulations,transfer pricing regulations or any other laws or regulations to which we maybe subject. We also cannot assure you that these laws will not be modified.

**Our sales growthand earnings may be reduced if we cannot implement our acquisition strategy.**

We may not be able to successfully manageacquisitions. As part of our business development strategy, we plan to pursueacquisitions in order to expand our product offerings, add to or enhance ourbase of technical and sales personnel or provide desirable customerrelationships. This growth could result in a significant strain on ourmanagerial, financial, engineering and other resources. The rate of our futureexpansion, if any, in combination with the complexity of the technologiesinvolved in our businesses, may demand an unusually high level of managerialeffectiveness in anticipating, planning, coordinating and meeting ouroperational needs as well as the needs of our customers.

We may not successfullyacquire the most complementary businesses. We cannot assure you that we will beable to acquire complementary businesses on a cost-effective basis, integrateacquired operations into our organization effectively, retain and motivate keypersonnel, or retain customers of acquired firms. We compete for attractiveacquisition candidates with other companies or investors, and that competitioncould increase the cost of pursuing our acquisition strategy or reduce thenumber of attractive candidates to be acquired.

**We may be unable tointegrate our acquired companies successfully.**

If we fail to integrate acquired businessessuccessfully or to manage our growth, that failure could have a materiallyadverse effect on our business, financial condition and results of operations.Further, there can be no assurance that we will be able to maintain or enhancethe profitability of any acquired business or consolidate operations to achievecost savings.

In addition, there may beliabilities that we fail, or are unable, to discover in the course ofperforming due diligence investigations on each company or business we havealready acquired or may acquire in the future. Such liabilities could includethose arising from employee benefits contribution obligations of a prior owneror non-compliance with applicable federal, state or local environmentalrequirements by prior owners for which we, as a successor owner, may beresponsible. In addition, there may be additional costs relating toacquisitions including, but not limited to, possible purchase priceadjustments. We cannot assure you that rights to indemnification by sellers ofassets to us, even if obtained, will be enforceable, collectible or sufficientin amount, scope or duration to fully offset the possible liabilitiesassociated with 

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thebusiness or property acquired. Any such liabilities, individually or in theaggregate, could have a materially adverse effect on our business, financialcondition and results of operations.

**We may experienceproduction delays if suppliers fail to deliver materials to us.**

Many key product components come from single sourcesuppliers. A significant portion of our precision machining business depends onthe adequate supply of specialty metals, such as beryllium, at competitiveprices and on reasonable terms. We currently procure all of our beryllium fromBrush Wellman, the sole U.S. supplier, and expect to continue to rely on BrushWellman for beryllium for the foreseeable future. Although we have notexperienced significant problems with our supplier in the past, we cannotassure you that such relationship will continue or that we will continue toobtain such supplies at cost levels that would not adversely affect our grossprofit. The partial or complete loss of Brush Wellman as a supplier ofberyllium, or production shortfalls or interruptions that otherwise impair oursupply of beryllium, could have a materially adverse effect on our business,financial condition and results of operations. It is uncertain whetheralternative sources of supply could be developed without a material disruptionin our ability to provide beryllium products to our customers.

In addition, we purchase asubstantial amount of the ball bearings that we distribute from two foreignsuppliers. Although we have not experienced significant problems with our othersuppliers in the past, we cannot assure you that such relationships willcontinue or that, in the event of the termination of one or more of ourrelationships with those other suppliers, we would be able to obtainalternative sources of supply without a material disruption in our ability toprovide products to our customers. Any material disruption in our supply ofproducts could have a materially adverse effect on our business, financialcondition and results of operations.

**Our future growthand continued success are dependent on our key personnel.**

Our success depends to asignificant extent on the continued services of our key executive officers andsenior management personnel. The loss of the services of one or more of theseindividuals could have a materially adverse effect on our business, financialcondition and results of operations. We do not maintain key man life insuranceon our executive officers. In addition, since our continued success is largelydependent upon our ability to design, manufacture and sell high-performancesolutions for the high-performance technology market, we are particularlydependent upon our ability to identify, attract, motivate and retain qualifiedtechnical personnel, including engineers and skilled machinists, with the requisiteeducational background and industry experience. Our employees may voluntarilyterminate their employment with us at any time, and competition for personnelis intense. Accordingly, we cannot assure that we will be successful inretaining our existing personnel. The loss of the services of a significantnumber of our technical or skilled personnel, or the future inability toattract technical or skilled personnel, could have a materially adverse effecton our business, financial condition and results of operations.

**Our intellectual property rights are valuable, and anyinability to protect them could reduce the value of our products, services andbrand.**

We must protect our intellectual property rights. Ourability to compete effectively with other companies will depend, in part, onour ability to maintain the proprietary nature of our technology. We rely upona combination of patents, trademarks and trade secrets, non-disclosureagreements and other forms of intellectual property protection to safeguard ourproprietary technology. We cannot assure you as to the degree of protectionoffered by these patents. We also cannot assure you that we will be able tomaintain the confidentiality of our trade secrets or that our non-disclosureagreements will provide meaningful protection of our trade secrets, know-how orother proprietary information in the event of any 

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unauthorized use,misappropriation or disclosure of such trade secrets, know-how or otherproprietary information.

The patents of competitors could impact our business.Competitors in the United States and foreign countries, many of which havesubstantially greater resources than we do and have made substantialinvestments in competing technologies, may have applied for or obtained, or mayin the future apply for and obtain, patents that will prevent, limit orinterfere with our ability to make and sell some of our products. Although webelieve that our existing products do not infringe on the patents or otherproprietary rights of third parties, third parties could assert infringementclaims against us and such claims could be successful.

In addition, we do nothave the right to prohibit the U.S. government from using certain technologiesdeveloped by us or to prohibit third-party companies, including ourcompetitors, from using those technologies in providing products and servicesto the U.S. government. The U.S. government has the right to royalty-free useof technologies that we have developed under U.S. government contracts. We arefree to commercially exploit those government-funded technologies and mayassert our intellectual property rights to seek to block other non-governmentusers thereof, but we cannot assure you that we could successfully do so.

**We are subject to significant environmental, healthand safety laws and regulations and related compliance expenditures andliabilities.**

We are subject to a variety of federal, state andlocal laws, rules and regulations relating to the use, storage, dischargeand disposal of hazardous substances and wastes used or generated during ourengineering, research and development and manufacturing activities. Failure tocomply with applicable environmental requirements could result in substantialliability to us, including civil or criminal penalties, suspension or cessationof our operations, restrictions on our ability to expand our operations orrequirements for the acquisition of additional equipment or other significantexpense, any of which could have a materially adverse effect on our business,financial condition and results of operations. In addition, environmental lawsalso impose obligations and liability for the cleanup of properties affected byhazardous substance spills or releases. These liabilities can be imposed on theparties generating or disposing of such substances or on the owner or operatorof the affected property, often without regard to whether the owner or operatorknew of, or was responsible for, the presence of hazardous substances.Accordingly, we may become liable, either contractually or by operation of law,for remediation costs even if the contaminated property is not presently ownedor operated by us, or if the contamination was caused by third parties. Wecannot assure you (1) that changes in federal, state or local laws,regulations or regulatory policy, or the discovery of unknown problems orconditions, will not in the future require substantial expenditures or (2) asto the extent of our liabilities, if any, for past failures, if any, to complywith applicable environmental laws, regulations and permits, any of which alsocould have a materially adverse effect on our business, financial condition andresults of operations.

We have made and continueto make investments in protective equipment, process controls, manufacturingprocedures and training in order to minimize the risks to our employees,surrounding communities and the environment due to the presence and handling ofhazardous materials. The failure to properly handle these materials could leadto harmful exposure for employees or to the discharge of certain hazardouswaste materials. Since we do not carry environmental impairment insurance, sucha failure could have a materially adverse effect on our business, financialcondition and results of operations.

**As a result of processingberyllium, we are subject to liability and compliance costs.**

The processing of beryllium, one of the materials usedin some of our products, may result in the release of beryllium into theworkplace and the environment and in the creation of beryllium oxide as a 

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by-product.Beryllium is classified as a hazardous air pollutant, a toxic substance and ahazardous substance under environmental, safety and health laws andregulations. Various acute and chronic health effects may result from exposureto beryllium, including the development of a chronic lung disease known aschronic beryllium disease, or CBD. Because of the health risks associated withberyllium, we may be subject to product liability claims and third-partylawsuits and increased levels of scrutiny from federal, state, foreign andinternational regulatory authorities. Concerns over CBD and other potentialadverse health effects relating to beryllium, as well as concerns regardingpotential liability from the use of beryllium, may discourage our customers’use of our beryllium-containing products and significantly reduce demand forour products.

In addition, we arerequired to comply with certain regulatory requirements to process beryllium.In response to these regulatory requirements, we have incurred, and continue toincur, costs for employee training as well as monitoring and protectiveequipment. Any future changes in these regulatory requirements may increase ourcost of compliance, which could have a materially adverse effect on our business,financial condition and results of operations.

**If we are unable to maintain and upgrade ourmanufacturing capabilities, our ability to compete could be materially andadversely impacted.**

We must continue to investsignificant resources to maintain and upgrade our manufacturing capabilities.We have invested, and intend to continue to invest, in state-of-the-artequipment in order to increase, expand, update or relocate our manufacturingcapabilities and facilities. Changes in technology or sales growth beyondcurrently established manufacturing capabilities would require that we makefurther investment. We cannot assure you that we will generate sufficient fundsfrom operations to finance any required investment or that other sources offunding will be available on terms acceptable to us, if at all. In addition,any further expansion could have a materially adverse effect on our business,financial condition and results of operations.

**Failure to anticipate technical problems, estimatecosts accurately or control costs during performance of a fixed-price contractmay reduce our profit or cause a loss.**

We provide our servicesprimarily through firm fixed-price contracts. Substantially all of our netsales for 2006 were derived from firm fixed-price contracts, which require usto perform services under a contract at a stipulated price. We assume greaterfinancial risk on firm fixed-price contracts. Failure to anticipate technicalproblems, estimate costs accurately or control costs during performance of afixed-price contract will reduce our profit or cause a loss. Although webelieve that adequate provision for our costs of performance is reflected inour financial statements, we can give no assurance that this provision isadequate or that losses on firm fixed-price contracts will not occur in thefuture.

**We are dependent in part upon our relationships andstrategic alliances with industry participants in order to generate revenue.**

We rely on the strength of our relationships withmilitary industry organizations to form strategic alliances. If any of ourexisting relationships with our strategic partners were impaired or terminated,we could experience significant delays in the development of our new productsourselves and we would incur additional development costs. We would need tofund the development of our new products internally or identify new strategicpartners.

Some of our likelypartners are also potential competitors, which may impair the viability of newstrategic relationships. While we must compete effectively in the marketplace,our future alliances may depend on our strategic partners’ perception of us. Asa result, our ability to win new and/or follow-on contracts may be dependentupon our relationships within the military industry.

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**Restrictivecovenants under our credit facility may reduce our operating and financialflexibility.**

Our credit facilityrequires us to maintain compliance with certain covenants, including covenantsregarding minimum EBITDA, a minimum fixed charge coverage ratio and a maximumleverage ratio. Our ability to comply with these covenants may be affected byevents beyond our control. Our inability to comply with the required financialcovenants could result in a default under our credit facility. In the event ofany such default, the lenders under our credit facility could elect to declareall outstanding debt, accrued interest and fees under the facility to be dueand immediately payable. If we are unable to repay any of this debt when due,the lenders under our credit facility could foreclose on our assets pledged tothem as security. If the indebtedness under our credit facility were to beaccelerated, our assets may not be sufficient to repay such indebtedness infull.

**A portion of ourbusiness is dependent upon obtaining and maintaining required securityclearances.**

Some of our federalgovernment contracts require our employees to maintain various levels ofsecurity clearances, and at three of our manufacturing facilities, we arerequired to maintain certain facility security clearances complying withfederal government requirements. Obtaining and maintaining security clearancesfor employees involves a lengthy process, and it is difficult to identify,recruit and retain employees who already hold security clearances. If ouremployees are unable to obtain or retain security clearances or if ouremployees who hold security clearances terminate employment with us, anycustomer whose work requires cleared employees could terminate its contract ordecide not to renew its contract upon its expiration. In addition, we expectthat some of the contracts on which we will bid will require us to demonstrateour ability to obtain facility security clearances and perform work withemployees who hold specified types of security clearances. To the extent we arenot able to obtain facility security clearances or engage employees with therequired security clearances for a particular contract, we may not be able tobid on or win new contracts, or effectively re-compete on expiring contracts.

**The concentration of our common stock ownership withour Chairman of the Board and Chief Executive Officer may limit our ability toinfluence corporate matters.**

Our Chairman of the Boardand Chief Executive Officer beneficially owned approximately 18.3% of ourcommon stock outstanding as of December 31, 2006. As a result, he willhave the ability to exert influence with respect to corporate actions,including the election of directors and certain sales or mergers andacquisitions. In addition, the interests of our Chairman of the Board and ChiefExecutive Officer may conflict with the interests of the other holders of ourcommon stock.

**Provisions in our charter documents and under Delawarelaw could discourage a takeover that stockholders may consider favorable.**

Certain anti-takeover provisions could cause harm toour stockholders. Our Restated Certificate of Incorporation, as amended, ourBy-Laws and the General Corporation Law of the State of Delaware, which werefer to as the DGCL, contain various provisions that could delay or impede theremoval of incumbent directors and could make a merger, tender offer or proxycontest involving us more difficult, even if such a transaction would bebeneficial to the interests of the stockholders, or could discourage a thirdparty from attempting to acquire control of us.

We have authorized 4,000,000 shares of our preferredstock, none of which is currently outstanding, and which we could issue withoutfurther stockholder approval and upon terms and conditions, and having rights,privileges and preferences, as the Board of Directors may determine. We have nocurrent plans to issue any preferred stock.

Our By-Laws include provisions establishing advancenotice procedures with respect to stockholder proposals and directornominations, and permitting the calling of special stockholder meetings only bythe 

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written consent ofthree-quarters of the Board of Directors or the Chairman of the Board. OurRestated Certificate of Incorporation provides that in lieu of a meeting, actionmay be taken by written consent of our stockholders only by unanimous consent.These provisions could have the effect of delaying, deterring or preventing achange in control of Axsys, and may adversely affect the voting and otherrights of holders of common stock.

In addition, we aresubject to section 203 of the DGCL, which, among other things and subject tovarious exceptions, restricts certain business transactions between acorporation and a stockholder owning 15% or more of the corporation’s outstandingvoting stock, which we refer to as an interested stockholder in thisprospectus, for a period of three years from the date the stockholder becomesan interested stockholder. These provisions may have the effect of delaying orpreventing a change of control of Axsys without action by the stockholders and,therefore, could adversely affect the price of our common stock. In the eventof a change of control of Axsys, the vesting of outstanding options issuedunder our stock incentive plan may be accelerated at the discretion of thecommittee administering the plan or may be required to be accelerated undercertain circumstances provided for in incentive agreements.

**Item 1B.**               UNRESOLVEDSTAFF COMMENTS

None.

**Item 2.**                        PROPERTIES

Welease approximately 4,740 square feet of office space, located at 175 CapitalBoulevard in Rocky Hill, Connecticut, for our corporate headquarters. Thislease expires in 2012. The principal plants and other significant properties atDecember 31, 2006 are:

| **Location**        | ** ** | ** **                  | ** ** | **Type of Facility** | ** ** | **Square Footage** | ** ** | **Leased/Owned; Expiration** | ** ** |
|---------------------|------------|-----------------------------|------------|--------------------------------|------------|-------------------------|------------|-----------------------------------|------------|
| Cullman, AL         |       | Manufacturing,  Engineering |       |                           | 120,000    |                    |       | Owned                             |       |
| Nashua, NH          |       | Manufacturing,  Engineering |       |                           | 78,000     |                    |       | Owned                             |       |
| San Diego, CA       |       | Manufacturing,  Engineering |       |                           | 64,800     |                    |       | Leased;  2010                     |       |
| Montville, NJ       |       | Distribution                |       |                           | 34,400     |                    |       | Leased;  2009                     |       |
| Rochester Hills, MI |       | Manufacturing,  Engineering |       |                           | 29,000     |                    |       | Leased; 2011                      |       |

 

We believe that ourfacilities are generally sufficient to meet our current and reasonablyanticipated manufacturing, distribution and related requirements. We, however,periodically review space requirements to ascertain whether our facilities aresufficient to meet our needs. All properties are used by the Optical Systemsgroup except Montville, New Jersey, which is used by our Distributed Productsgroup.

**Item 3.**                        LEGALPROCEEDINGS

Axsys is a defendant invarious lawsuits, none of which are expected to have a material adverse effecton Axsys’ business or financial position. It is possible, however, that ourresults of operations for a particular fiscal period could be materiallyaffected.

**Item 4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None during the quarter ended December 31, 2006.

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**PART II**

**Item 5.**                        MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Axsys’common stock trades on the Nasdaq Global Select Market under the symbol “AXYS.”The following table sets forth the range of high and low sales prices asreported by Nasdaq during the fiscal years 2006 and 2005:

| ** **                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| ** **                            | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| Fiscal Years Ended  December 31: |       |     |       |     |       |   |   |   |   |
| First Quarter                         |       | $        | 18.200     |     | $          | 15.760 |   | $ | 22.750 |   | $ | 16.520 |   |
| Second Quarter                        |       | 17.590   |       | 14.900   |       | 22.640 |   | 16.450 |   |
| Third Quarter                         |       | 17.490   |       | 13.890   |       | 20.600 |   | 17.510 |   |
| Fourth Quarter                        |       | 18.140   |       | 16.290   |       | 19.800 |   | 16.800 |   |
|                                       |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

On February 16, 2007, the high sales price was $17.30and the low sales price was $17.04.

On February 16, 2007,the approximate number of holders of record of Axsys’ common stock was 434. Inaddition, we believe that as of that date, there were approximately 2,200beneficial owners.

**Dividend Policy**

Axsys has applied andcurrently intends to continue to apply the retained and current earnings towardthe development of its business and to finance growth. Axsys did not pay cashdividends on the common stock during the three years ended December 31,2006 and does not anticipate paying cash dividends in the foreseeable future. Ourability to declare and make dividends payments is restricted under our creditfacility.

**Issuer Purchases ofEquity Securities**

None during the quarterended December 31, 2006.

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**Item 6.**                        SELECTEDFINANCIAL DATA

Thefollowing selected financial data for the five fiscal years presented below isderived from Axsys’ audited Consolidated Financial Statements as adjusted toreflect the discontinuance of the Automation Group in 2002. The data should beread in conjunction with the consolidated financial statements and the relatednotes thereto included elsewhere in this annual report.

| ** **                                                      | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                                           | ** ** | **2005  (1)(2)** | ** ** | **2004  (3)(4)(7)** | ** ** | **2003  (4)(7)** | ** ** | **2002  (4)(5)(6)(7)** | ** ** |
| ** **                                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                               |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Sales                                                           |       | $                                                                  | 156,347    |   | $ | 133,543 |   | $ | 103,530 |   | $ | 85,109 |   |   | $ | 79,586 |   |   |
| Gross profit                                                    |       | 48,899                                                             |       | 41,646 |   | 30,656 |   | 23,073 |   |   | 20,132 |   |   |
| Income (loss)  from continuing operations                       |       | 10,382                                                             |       | 7,473 |   | 9,159 |   | 4,998 |   |   | (3,014 | ) |   |
| Net income (loss)                                               |       | 10,265                                                             |       | 7,323 |   | 8,664 |   | 4,998 |   |   | (7,061 | ) |   |
| Basic net  earnings (loss) per share from continuing operations |       | $                                                                  | 0.98       |   | $ | 0.93 |   | $ | 1.30 |   | $ | 0.72 |   |   | $ | (0.43 | ) |   |
| Basic earnings  (loss) per share                                |       | $                                                                  | 0.97       |   | $ | 0.91 |   | $ | 1.23 |   | $ | 0.72 |   |   | $ | (1.00 | ) |   |
| Weighted-average  basic common shares outstanding               |       | 10,629                                                             |       | 8,006 |   | 7,020 |   | 6,986 |   |   | 7,038 |   |   |
| Diluted earnings  (loss) per share from continuing operations   |       | $                                                                  | 0.95       |   | $ | 0.90 |   | $ | 1.26 |   | $ | 0.71 |   |   | $ | (0.43 | ) |   |
| Diluted earnings  (loss) per share                              |       | $                                                                  | 0.94       |   | $ | 0.88 |   | $ | 1.19 |   | $ | 0.71 |   |   | $ | (1.00 | ) |   |
| Weighted-average diluted  common shares outstanding             |       | 10,888                                                             |       | 8,355 |   | 7,289 |   | 7,074 |   |   | 7,038 |   |   |

 

| ** **                                                  | ** ** | **At December 31,** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                  | ** ** | **2006**                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                  | ** ** | **(in thousands)**       | ** ** |
|                                                        |       |                          |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Total assets                                                |       | $                             | 172,345    |   | $ | 156,208 |   | $ | 85,815 |   | $ | 66,845 |   | $ | 62,372 |   |
| Long-term capital  lease obligations (less current portion) |       | —                        |       | — |   | 150 |   | 568 |   | 1,191 |   |
| Long-term debt  (less current portion)                      |       | —                        |       | — |   | 3,333 |   | — |   | — |   |
| Shareholders’ equity                                   |       | 131,188                       |       | 119,541 |   | 53,093 |   | 43,898 |   | 39,093 |   |
|                                                             |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          On September 27,2005, we issued and sold 3,450,000 shares of our common stock at a publicoffering price of $18.00 per share. The proceeds of this offering were used toprepay our existing credit facilities in 2005. This prepayment triggered a chargeof $480 thousand for the loss on extinguishment of debt.

(2)          On May 2, 2005, weacquired Diversified Optical Products, or DiOP. We accounted for thisacquisition under the purchase method of accounting and, accordingly, resultsof DiOP’s operations have been included in our Consolidated Statements of Operationssince the date of acquisition.

(3)          On April 8, 2004,we acquired Telic Optics, Inc., or Telic. We accounted for thisacquisition under the purchase method of accounting and, accordingly, theresults of Telic’s operations have been included in our Consolidated Statementsof Operations since the date of acquisition.

(4)          In the second quarter of2004, the Board of Directors announced the declaration of a 3:2 stock spliteffected as a stock dividend payable on June 30, 2004 to stockholders ofrecord on June 15, 2004. Stockholders received a dividend of one additionalshare our common stock for every two shares 

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owned on the record date. Fractionalshares were cashed out, and payments were made to stockholders in lieu offractional shares on June 30, 2004. Share and per share information forall prior periods have been restated to reflect the stock split.

(5)          For 2002, certainengineering costs have been reclassified from cost of goods sold to operatingexpenses to conform to the current presentation.

(6)          In the third quarter of2002, the Automation Group was divested, which included the Fiber Automationdivision and Automation Engineering, Inc., a wholly owned subsidiary. Accordingly,the Automation Group has been accounted for as discontinued operations and theoperating results have been reported separately from continuing operations forall applicable periods. Sales applicable to these discontinued operations were$1.2 million in 2002.

(7)          Inaccordance with SFAS No. 109, we established a $4.6 million valuationallowance against our deferred income tax asset in 2002. As we reported income,we reduced the valuation allowance and utilized $3.2 million in 2004 and $1.4million in 2003 as deferred income tax assets were realized.

**Item 7.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Thefollowing table sets forth selected financial data on a consolidated basis (inthousands):

| ** **                                                    | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales                                                         |       | $                                           | 156,347    |   | $ | 133,543 |   | $ | 103,530 |   |
| Cost of sales                                                 |       | 107,448                                     |       | 91,897 |   | 72,874 |   |
| Gross profit                                                  |       | 48,899                                      |       | 41,646 |   | 30,656 |   |
| Selling, general and administrative expenses                  |       | 28,159                                      |       | 23,957 |   | 18,634 |   |
| Research,  development and engineering expenses               |       | 4,463                                       |       | 3,766 |   | 2,677 |   |
| Operating income                                              |       | 16,277                                      |       | 13,923 |   | 9,345 |   |
| Interest expense                                              |       | (80                                         | )          | (1,684 | ) | (254 | ) |
| Interest income                                               |       | 290                                         |       | 167 |   | 98 |   |
| Loss on  extinguishment of debt                               |       | —                                      |       | (480 | ) | — |   |
| Other (expense)  income                                       |       | (2                                          | )          | 33 |   | (38 | ) |
| Income from  continuing operations before income taxes        |       | 16,485                                      |       | 11,959 |   | 9,151 |   |
| Provision for  (benefit from) income taxes                    |       | 6,103                                       |       | 4,486 |   | (8 | ) |
| Income from  continuing operations                            |       | 10,382                                      |       | 7,473 |   | 9,159 |   |
| Discontinued operations:                                      |       |                                        |       |   |   |   |   |
| Loss from discontinued operations, net of income tax  benefit |       | (117                                        | )          | (150 | ) | (495 | ) |
| Net income                                                    |       | $                                           | 10,265     |   | $ | 7,323 |   | $ | 8,664 |   |

 

Thefollowing table sets forth the percent of sales by segment:

| ** **                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Optical Systems  Group      |       | 83.1                                        | %          | 81.4 | % | 75.5 | % |
| Distributed Products  Group |       | 16.9                                        |       | 18.6 |   | 24.5 |   |

 

***Overview***

Axsys is a leading designer and manufacturer ofprecision optical solutions for defense, aerospace, homeland security and high-performancecommercial applications. These sophisticated solutions are typically found inapplications that demand the finest optical surfaces, highest accuracy andtightest motion 

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control tolerances. Applicationexamples include weapon systems and long-range surveillance cameras. We arealso a technology leader in the supply of infrared surveillance solutions tohomeland security market customers, such as the U.S. Border Patrol, Army, Navy,Air Force, Coast Guard and various port authorities.

Our solutions are often embedded in larger systemsthat depend on precise optical control for accurate operation of criticalfunctions. For example, our products are embedded in several next generationthermal imaging and targeting systems for platforms such as the F-16, F-18,Bradley Fighting Vehicle, M1A2 Abrams and Stryker. We also supply criticalguidance and seeker components for platforms such as the Minutemanintercontinental ballistic missile and the AIM-9X Sidewinder missile. Ourproducts are included on several platforms within the U.S. National MissileDefense program. We are well positioned within this market, with strongpositions on a diverse array of high-profile military programs.

In addition to optical solutions, we also distributeprecision ball bearings used in a variety of industrial and commercialapplications. We sell our components, sub-systems and bearings to a variety ofOEMs.

We are organized into twobusinesses: the Optical Systems Group and the Distributed Products Group.

*Optical SystemsGroup*

The Optical Systems Groupdesigns, manufactures and sells highly precise systems, sub-systems andcomponents that are typically used in surveillance, long-range observation,tracking and targeting and high-performance imaging applications. Customersinclude both governmental and commercial organizations. The Optical SystemsGroup has design and manufacturing facilities in San Diego, California, Cullman,Alabama, Rochester Hills, Michigan, and Nashua, New Hampshire.

*DistributedProducts Group*

The Distributed ProductsGroup distributes precision ball bearings, spherical plain bearings, andbushings, acquired from various domestic and international sources, to OEMs andMROs. Additionally, the Distributed Products Group designs, manufactures andsells mechanical-bearing subassemblies for a variety of customers. TheDistributed Products Group is comprised of the AST Bearings Division located inMontville, New Jersey, with a satellite distribution center in Irvine,California.

*Facilities*

On April 26, 2006, wepurchased a 78,000 square foot building and 10.5 acres of land in Nashua, NewHampshire for $4.0 million. This facility serves as the consolidated manufacturingfacility for our Axsys Technologies IR Systems division, formerly operating attwo facilities in New Hampshire and Massachusetts. The relocation and theclosure of the two existing facilities was completed in the fourth quarter of2006. During 2006, total pre-tax costs associated with the relocation andfacilities’ closures were approximately $325 thousand, with an additional $2.5million of capital expenditures. These costs included equipment relocation,employee training and facility improvements. In addition, we recognized a $106thousand in expense for the cancellation of the existing Salem facility lease.

*Share-BasedCompensation Expense*

Beginning in the first quarter of 2006, we wererequired to record the expense of share-based payment transactions pursuant toStatement of Financial Accounting Standards No. 123 (revised ), “Share-BasedPayment”, or SFAS 123(R). Under the modified prospective method, we were notrequired to restate the 

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prior year financialstatements or include in the current year any expenses related to stock optiongrants vested as of December 31, 2005.

During the first quarter of 2006, we reviewed ourequity compensation program to determine the most appropriate equity awardvehicles based on our objectives and new accounting and regulatory rules. Stockownership guidelines, award types and award amounts were also reviewed toensure market competitiveness. As a result of this review, we began granting amix of restricted stock and stock options to all eligible employees and Directors.Prior to January 1, 2006, only stock option awards were granted.

As of December 31, 2006, there was $2.1 millionof unrecognized compensation cost related to stock option awards, which isexpected to be recognized over a weighted-average period of 1.7 years. As of December 31,2006, we had unamortized compensation expense of $936 thousand associated withrestricted stock awards, which will be amortized over the weighted-averageremaining life of 3.9 years.

Theimpact of SFAS 123(R) on the statement of operations was as follows:

| ** **                                      | ** ** | **Year Ended**             | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **December 31, 2006** | ** ** |
| ** **                                      | ** ** | ***(in thousands)***       | ** ** |
| Cost of sales                                   |       |                            | $          | (78 | ) |   |
| Selling, general  and administrative expenses   |       |                            | (962       | ) |   |
| Research,  development and engineering expenses |       |                            | (53        | ) |   |
| Operating income                                |       |                            | $          | (1,093 | ) |   |
| Net income                                      |       |                            | $          | (689 | ) |   |
| Diluted earnings per  share                     |       |                            | $          | (0.06 | ) |   |

 

*Public StockOffering*

On September 27,2005, we issued and sold 3,450,000 shares of common stock at the publicoffering price of $18.00 per share. We received all of the net proceeds fromthe offering after payment of underwriting discounts and commissions. Gross proceeds from the stock offering were$62.1 million. After underwriting discounts and commissions, we received $57.6million. We utilized $54.6 million to repay all of the amounts outstandingunder our credit facility, including accrued interest and fees, and $791thousand to pay expenses related to the stock offering, and we used theremaining $2.2 million for working capital and general corporate purposes.

*Significant Customers*

BAE Systems, an aerospaceand defense systems supplier, represented 12.1% of our net sales in 2006.Raytheon Company, an aerospace and defense systems supplier, represented 12.3%of our net sales in 2005 and 18.9% in 2004. While BAE, a prime contractor withthe U.S. government, does constitute a significant portion of our business, wedo not currently believe that this is at-risk business. 

*Backlog and Orders*

Axsys recognized, in 2006,bookings of $174.1 million, ending the year with record backlog of $130.4million, of which 14.8% will be shipped beyond 12 months. Our backlog increasedby $17.7 million, or 15.7%, compared to our ending backlog of $112.7 million asof December 31, 2005. As we look forward, we expect continued growth inthe Optical Systems Group, which is supported by the segment’s backlog of$115.9 million at the end of 2006. This group will continue to target ordersthat require highly precise optical and motion control solutions. Examplesinclude surveillance, military navigation and targeting, ‘smart’ weapons, andmedical imaging.

 

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*Acquisition ofDiversified Optical Products, Inc.*

On May 2, 2005, we acquired all of the stock ofDiOP, a manufacturer of high-end thermal camera systems and lenses, for $55.2million in cash plus $1.9 million of legal, audit and other acquisition relatedcosts incurred in connection with the acquisition. The acquisition of DiOPbrought us new, high value technologies, leveraged our existing infrared andmotion control technologies, and provided us with a new base of customers. Further,the combination of DiOP and Axsys positioned us as a leading independentinfrared lens manufacturer. At the time of the acquisition, DiOP employedapproximately 120 people at its Salem, New Hampshire headquarters. DiOP isdoing business as Axsys Technologies IR Systems and the financial results areincluded in our Optical Systems Group’s results.

In connection with the acquisition of DiOP, on May 2,2005, we also entered into a new $70.0 million credit facility with Fleet Bank.The credit facility consisted of a five-year term loan A in the amount of $20.0million, a two-year term loan B in the amount of $35.0 million and a three-yearrevolving line of credit in the maximum amount of $15.0 million. Borrowingsunder this credit facility provided a portion of the consideration used toacquire DiOP.

Pursuant to the terms of the credit facility, we usedthe net proceeds from the 2005 stock offering to repay all of the amountsoutstanding under the term loan B. In addition to repaying term loan B, we alsorepaid in full the amounts outstanding under the term loan A with the netproceeds of the stock offering.

At December 31, 2006,there were no borrowings outstanding under the revolving credit facility;however, $1.1 million of the revolving credit facility was utilized foroutstanding letters of credit

*Acquisition ofTelic Optics, Inc.*

On April 8, 2004, we acquired all of the stock ofTelic, a manufacturer of infrared optical products. The financial results ofTelic are included in our Optical Systems Group’s results.

Telic’s broad infrared optics capabilities increaseour product offerings and complement our strong position in reflective opticalsolutions. In addition, Telic’s products are typically used in ground- andsea-based programs. This complements our historical focus on air- andspace-based programs and expands our overall market and program penetration. Finally,the complementary addition of Telic’s technical capabilities to our coretechnical strengths broadens our technical offering to prime contractors whoare seeking to outsource the fulfillment of their optical requirements.

The initial purchase priceof this acquisition, after a working capital adjustment of $15 thousand, was$14.4 million with an additional earn out payment of up to $4.0 million over 36months following the closing date based on the achievement of certain revenuegoals. Of this additional earn out payment, $1.2 million was earned in 2006 andwill be paid out in 2007 and $2.8 million was earned in 2005 and subsequentlypaid in 2006. This increased the purchase price to $18.4 million at December 31,2006. Included in the purchase price was $438 thousand of legal, audit andother acquisition related expenses that were incurred in connection with theacquisition. We funded the purchase price and associated transaction coststhrough a combination of existing cash balances and outside bank financing.

*James Webb SpaceTelescope*

Since 2004, we received $21.0 million of orders fromBall Aerospace and Technology Corporation, including the original contract andchange orders, to produce the optical mirror substrates for the James WebbSpace Telescope, or JWST. The contract contains $12.4 million of productionsales and $8.6 million for facilitization. We recognized revenue of $3.9million in 2006, $4.0 million in 2005 and $1.0 million in 2004 under thepercentage of completion method of accounting related to the JWST project.

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The JWST, which is currently expected to launch in2013, will replace the Hubble as NASA’s premier space telescope. NorthropGrumman is the prime contractor. The primary mirror is comprised of 18individual lightweight beryllium segments, all of which will be fabricated byAxsys. Because of the large size of the primary mirror, JWST will besignificantly more sensitive than ground-based infrared telescopes, enabling itto search for the first stars and galaxies formed in the universe billions ofyears ago.

Our contract includes theproduction of optical substrates for an engineering development unit, 18primary mirror segments, 2 spare mirrors and support structures. As of December 31,2006, we delivered 16 of the primary mirror segments. We expect to ship thefinal units in 2007.

**Results of SegmentOperations**

The following tables anddiscussion set forth selected financial information from continuing operationson a segment basis for the years ended December 31, 2006, 2005 and 2004. Thesegment tables, shown below, exclude one-time charges, which are shownseparately.

**Optical Systems Group Segment**

*(table in thousands and as a percentage of sales)*

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales         |       | $                                           | 129,928    |   | 100.0 | % | $ | 108,666 |   | 100.0 | % | $ | 78,189 |   | 100.0 | % |
| Cost of sales |       | 89,034                                      |       | 68.5 | % | 74,393 |   | 68.5 | % | 55,429 |   | 70.9 | % |
| Gross profit  |       | $                                           | 40,894     |   | 31.5 | % | $ | 34,273 |   | 31.5 | % | $ | 22,760 |   | 29.1 | % |

 

Sales in the Optical Systems Group segment increased19.6% for the year ended December 31, 2006 compared to 2005, while salesin this segment increased 39.0% for the year ended December 31, 2005compared to 2004. The increase in 2006 sales compared to 2005 was primarily dueto increased demand for our infrared product lines. The success of our thermalimaging cameras and lenses in military and homeland security surveillance andtargeting applications continues to drive our revenue growth.

The increase in 2005 sales compared to 2004 sales wasdue to both the addition of a new revenue stream related to the acquisition ofDiOP and continued organic growth year over year, primarily from our infraredproduct lines.

Gross profit as a percent of sales for the year ended December 31,2006 remained comparable to 2005. The higher sales volume during 2006 did notgenerate incremental margin as we continued to increase our participation onlarge military programs, which generally carry lower than average margins.Gross profit as a percentage of sales for 2005 compared to 2004 increasedmainly due to increased volume, improved sales mix related to our infraredbusiness and improved efficiencies in comparison to the prior year.

The Optical Systems Group,as of December 31, 2006, had a backlog of definitive orders of $115.9million, of which 14.1% is expected to ship beyond the 2007 fiscal year.

**Distributed Products Group Segment**

*(table in thousands and as a percentage of sales)*

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales         |       | $                                           | 26,419     |   | 100.0 | % | $ | 24,877 |   | 100.0 | % | $ | 25,341 |   | 100.0 | % |
| Cost of sales |       | 18,414                                      |       | 69.7 | % | 17,504 |   | 70.4 | % | 17,445 |   | 68.8 | % |
| Gross profit  |       | $                                           | 8,005      |   | 30.3 | % | $ | 7,373 |   | 29.6 | % | $ | 7,896 |   | 31.2 | % |

 

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Sales in the Distributed Products Group increased 6.2%for the year ended December 31, 2006 compared to 2005,  while sales decreased 1.8% for the year ended December 31,2005 comparable to 2004. Sales increased during 2006 compared to 2005 mainlydue to increased activity of new and existing products from some of our largercustomers. During 2005, revenues remained consistent when compared to 2004despite increased pricing pressures and competition.

Gross profit, as a percentof sales, for 2006 was slightly higher than gross profit in the same period inthe prior year mainly due to favorable product mix and a reduction inanti-dumping duty rates. For 2005, gross profit, as a percentage of sales, waslower than gross profit in the comparable period in 2004 year mainly due tocompetitive pricing pressures, continued increasing freight costs and increasedanti-dumping duty rates that were not reflected in our pricing, which wasinclude in our backlog coming into the year.

**Operating Expenses**

*(table in thousandsand as a percentage of sales)*

| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Selling, general  and administrative expenses   |       | $                                           | 28,159     |   | 18.0 | % | $ | 23,957 |   | 17.9 | % | $ | 18,634 |   | 18.0 | % |
| Research, development  and engineering expenses |       | 4,463                                       |       | 2.9 |   | 3,766 |   | 2.8 |   | 2,677 |   | 2.6 |   |

 

*Selling,general and administrative expenses.*   Selling,general and administrative expenses, or SG&A, were $28.2 million in 2006compared to $24.0 million in 2005 and $18.6 million in 2004. SG&A spendingduring 2006 was 17.6% higher than spending during 2005. Several factorscontributed to the increases. During 2006, we implemented SFAS 123(R) forshare-based compensation expensing, which cost totaled $1.1 million. Additionalcosts associated with having DiOP for a full year compared to eight months in2005 were estimated to be $1.0 million. We incurred $431 thousand ofmove-related expenses associated with the consolidation of our IR Systemsdivisions. We incurred $500 thousand of additional professional costs in 2006compared to 2005 as a result of anti-dumping duty issues associated with ourDistributed Products Group and other legal matters associated with the ordinarycourse of business. Lastly, we spent an additional $1.3 million across severalexpense categories associated with the general growth of the business.

The spending increase from 2004 to 2005 was primarilydue to the acquisition of DiOP and the incremental expenses associated with afull year of expense for Telic compared to nine months of expense in 2004. DiOPincurred $3.3 million of SG&A expenses in 2005, while Telic incurred an incremental$400 thousand of SG&A costs compared to the prior year as a result of afull year of operation. Amortization expense totaled $816 thousand in 2005 ascompared to $73 thousand in 2004.

SG&A spending, as a percentage of sales, remainedcomparable to spending in the prior years despite the adoption of FAS123(R) andthe move-related costs associated with consolidation of our IR Systems division.

*Research, development andengineering expenses.*   Research, development andengineering expenses in 2006 increased by $697 thousand and $1.1 millioncompared to 2005 and 2004, respectively. This was primarily a result of ourinfrared product line. This product line is research intensive as wecontinuously make improvements on products to ensure competitiveness in theimaging market place. Our legacy product lines are primarily manufactured andsold to OEMs based on their unique design specifications.

***Other Income and Expenses***

*Interestexpense.*   Interest expense was $80 thousand inthe year ended December 31, 2006, compared to $1.7 million in 2005 and$254 thousand in 2004. The lower interest expense was due to lower overallborrowings on our revolving credit facility during 2006 compared to borrowingsin 2005. The increase in 

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expense in 2005 comparedto 2004 was primarily due to interest on our $55 million term loan incurred inconjunction with the acquisition of DiOP, which was partially offset by lowerinterest paid on capital leases compared to 2004.

*Interestincome.**  *Interestincome was $290 thousand in the year ended December 31, 2006 compared to$167 thousand in 2005 and $98 thousand in 2004. Interest income was primarilycomposed of income from cash and cash equivalents and short-term investments. Theincrease year-over year was primarily due to overall higher interest rates onhigher than average cash on hand.

*Losson extinguishment of debt.**  *In conjunction with our prepayment of the principaland accrued interest on the $20.0 million term loan A and the $35.0 millionterm loan B during 2005, we incurred a charge of $421 thousand for the writeoff of loan origination fees and a charge of $59 thousand for the earlytermination of the related interest rate swap agreement.

*Otherincome and expense, net.**  *Netother expense in 2006 was $2 thousand compared to net other income of $33thousand in 2005 and net other expense of $38 thousand in 2004. Other incomeand expense were composed primarily of the gains and losses incurred as aresult of foreign exchange gains and losses and the disposal of capitalequipment**.**

*IncomeTaxes.*   The consolidated effective income taxrate was 37.0% for the year ended December 31, 2006 compared to 37.5% in2005 and (0.1)% in 2004. The effective rate for 2004 was impacted by thereversal of a previously-established valuation allowance. A valuation allowanceis not required at December 31, 2006 as it is more likely than not thatthe net deferred income tax asset will be realized in the future.

*Discontinuedoperations.**  *In 2006,we recognized an after-tax charge of $202 thousand related to legal and consultingexpenses in conjunction with an environmental clean-up site of a discontinuedoperation. During 2002, Axsys disposed of the Automation Group, which includedfacilities in Wilmington, Massachusetts and Pittsburgh, Pennsylvania. At thetime of the sale, Axsys continued to be responsible for fulfilling theremaining terms of the leases. As of December 31, 2006, we fulfilled allof our contractual obligations related to these sites and we recognized anafter-tax gain of $85 thousand on the reversal of an accrual associated withthese leases.

In 2005, we incurred an after-tax charge of $150thousand from the settlement of the Prospect, Connecticut environmental claimrelated to a previously divested operation. As of December 31, 2005, wehad no further responsibility to the EPA as it relates to this site.

In 2004, we recognized an additional loss reserve inconjunction with the 2002 sale of the Automation Group. The after-tax charge of$421 represents rental expenses for the two facilities within the AutomationGroup. In addition, during 2004, we recognized an after tax charge $74 thousandfor an environmental-related expense for previously divested operations.

*Net income.*   Wehad net income of $10.3 million, or $0.94 per diluted share, in 2006, netincome of $7.3 million, or $0.88 per diluted share, in 2005 and net income of$8.7 million, or $1.19 per diluted share, in 2004. In addition, we issued3,450,000 shares of common stock through a public stock offering in September 2005,which impacted earnings per share.

**Liquidity andCapital Resources**

We fund our operations primarily from cash on hand andcash flow from operations. As of December 31, 2006, cash and cashequivalents totaled $6.0 million. We have maintained a high level of liquidityas evidenced by our current ratio (current assets divided by currentliabilities), which was 2.2 as of December 31, 2006 and 2.1 as of December 31,2005. Maintaining this current ratio supports our goal to maintain a high levelof liquidity to seek growth opportunities.

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During 2006, we borrowed and subsequently repaid $8.0million under our revolving credit facility. The weighted-average interest rateon these borrowings was 6.3%. The $15.0 million revolving credit facilityremains available through May 2008, subject to optional prepayment inaccordance with its terms. Up to $2.0 million of the revolving credit facilitymay be utilized to issue letters of credit. We may elect to have any borrowingunder the revolving credit facility bear interest either at the bank’s prime rateor the LIBOR rate plus a margin of 100 to 275 basis points, depending on ourconsolidated funded debt-to-consolidated EBITDA ratio. We have the option ofselecting the 1-month, 2-month, 3-month or 6-monthLIBOR rate. As of December 31, 2006, there were no borrowings outstandingunder the revolving credit facility. However, as of December 31, 2006,$1.1 million of the revolving credit facility was utilized for outstandingletters of credit. Our credit facility requires us to maintain compliance withcertain covenants, including covenants regarding minimum EBITDA, a minimumfixed charge coverage ratio and a maximum leverage ratio.

Net cash provided by operations was $12.7 million in2006, $7.6 million in 2005 and $7.6 million in 2004. In 2006, our primary sourcesof operating cash were $10.3 million of net income plus non-cash expenses,which primarily consisted of $4.5 million of depreciation and amortization,$1.1 million of share-based compensation expense, $823 thousand decrease in ournet deferred income tax asset and $102 thousand of other non-cash items. Inaddition, we spent $292 thousand on discontinued operations primarily forleases and environmental clean-up activities.

In 2006, we utilized $3.8 million of cash to fundchanges in our operating assets and liabilities. We utilized $2.5 million ofcash to fund an increase in accounts receivable primarily as a result ofincreased sales volume. We used $6.3 million of cash to fund an increase in ourinventories, which resulted from long lead-time orders and increased sales byour Optical Systems Group, which was partially offset by the timing of vendorinvoices and payments resulting in a $3.9 million increase to accounts payableand accrued liabilities. Accrued liabilities increased an additional $2.3 millionas a result of higher excess of billings over costs of $1.8 million associatedwith percentage of completion accounting and additional compensation-relatedexpenses of $1.2 million. Accrued liabilities decreased during 2006 by $700thousand as a result of lower income tax payable, warranty reserves, accruedprofessional fees and other miscellaneous accruals. Additional cash outflows of$956 thousand were for the reduction of deferred income as we completed somelong lead-time orders.

In 2005, our primary sources of operating cash were$7.3 million of net income plus non-cash expenses, which primarily consisted of$4.0 million of depreciation and amortization, $1.3 million decrease in our netdeferred income tax asset and $69 thousand of other non-cash items. Inaddition, we spent $907 thousand on discontinued operations primarily forleases and environmental clean-up activities.

In 2005, we utilized $4.2 million of cash to fundchanges in our operating assets and liabilities. We used $2.6 million of cashto fund an increase in our inventories, which resulted from long lead-timeorders and increased sales from our Optical Systems Group. We also utilized$809 thousand of cash to fund an increase in accounts receivable primarily as aresult of unbilled receivables generated by service contracts and excess ofcost over billings on percentage of completion accounting. Additional cashoutflows of $800 thousand were primarily for the utilization of loss contractreserves, legal and consulting costs associated with environmental activitiesand the reduction of deferred income as we completed some long lead-timeorders.

In 2004, our primary sources of operating cash were$8.7 million of net income plus non-cash expenses, which primarily consisted of$2.7 million of depreciation and amortization and a $242 thousand non-cashcharge related to the modification of stock option grants for a terminatedemployee. These non-cash charges were partially offset by non-cash benefits,including a $1.7 million increase in our net deferred income tax assets, due tothe utilization and reversal of a valuation allowance for these assets. We alsopaid 

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out $902 thousand forliabilities related to discontinued operations, which was offset by anadditional accrual for discontinued operations of $762 thousand.

In 2004, we utilized $2.2 million of cash to fundchanges in our operating assets and liabilities. We used $4.5 million of cashto fund an increase in our accounts receivable, which resulted from salesgrowth and higher deferred income billings in our Optical Solutions Group. Wealso utilized $4.1 million to fund inventory growth in 2004. The inventorygrowth was related to certain large long-term programs in our Optical SystemsGroup. The increases in accounts receivable and inventory were partially offsetby a $2.1 million increase in accounts payable and a $2.6 million increase indeferred income. The increase in deferred income was the result of our strategyto actively negotiate progress payments into certain large dollar contracts forlong lead-time products and long-term programs. This strategy helps to mitigatethe near-term negative cash impact of these contracts. The net change inaccrued expenses and other liabilities and other long-term liabilities was a$784 thousand increase. The increase was related to increased accruals forcompensation-related expenses and an accrual for capital equipment that wasreceived but not invoiced, which were partially offset by the liquidation of aninactive pension plan and the utilization of the reserve for loss contracts. During2004, we also received a $566 thousand federal income tax refund and a $224thousand decrease in current assets primarily due to the timing of insurancepayments.

Net cash used in investing activities was $14.0 millionin 2006, $60.7 million in 2005 and $11.0 million in 2004. During 2006, weutilized $4.0 million of cash to purchase a new facility for our IR Systemsdivision and invested an additional $2.0 million in capital improvements forthe new facility. We had additional capital expenditures of $5.2 million in2006  primarily for manufacturingmachinery and equipment used to support sales growth. We also utilized $2.8million of cash in 2006 for the Telic earn-out payment. During 2006, we alsoreceived $93 thousand of proceeds from the sale of fully depreciated machinery.

We utilized $57.1 million to acquire DiOP in 2005 and$13.7 million to acquire Telic in 2004. The purchase of Telic was partiallyfunded by the sale of $7.0 million of short-term investment securities. Capitalexpenditures were $3.5 million during 2005 and $ 4.2 million during 2004. In2004, we constructed a 20,000 square foot, climate-controlled manufacturingfacility in Cullman, Alabama.

Financing activities provided $199 thousand of cash in2006, $54.1 million in 2005 and $4.1 million in 2004. During 2006, we borrowedand subsequently repaid $8.0 million under our revolving credit facility. Wealso received $140 thousand in proceeds from the exercise of stock options andrecorded a tax benefit of $59 thousand related to the exercise of non-qualifiedstock options. During 2005, we borrowed $55.0 million to purchase DiOP and paidoff $4.4 million of financing related to the acquisition of Telic in April 2004.In addition, we completed a public stock offering of 3,450,000 shares of commonstock, which generated net proceeds of $57.6 million during the third quarterof 2005. In 2005, we made a $1.0 million principal payment and utilized aportion of the net proceeds from the public stock offering to prepay theremaining $54.0 million outstanding under our credit facility. During 2005, wealso received $1.3 million in proceeds from the exercise of stock options andpaid off the remaining $518 thousand of capital lease obligations. During 2004,we obtained a $5.0 million term loan for the acquisition of Telic and received$360 thousand in proceeds from the exercise of stock options. These sources offunds were partially offset by repayments of $667 thousand on the term loan and$473 thousand on our capital leases.

With our existing cash balance, anticipated cash flowsfrom operations and the $15.0 million revolving credit facility, managementbelieves that Axsys has sufficient liquidity to finance its operations, capitalexpenditures, and working capital requirements for at least the next twelvemonths.

Shareholders’ equity was$131.2 million, or $12.33 per common share issued, at December 31, 2006compared to $119.5 million, or $11.24 per common share issued, at December 31,2005. The increase in shareholders’ equity was due primarily to net income of$10.3 million. Most of the remaining increase in shareholders’ equity wasrelated to share-based compensation and the exercise of stock options.

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***Off-Balance Sheet Arrangements***

As part of our ongoingbusiness, we do not participate in transactions that generate relationshipswith unconsolidated entities or financial partnerships established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes. As of December 31, 2006, we are not involvedin any unconsolidated single-purpose entities.

***Contracts and Commitments***

Wehave entered into certain contractual obligations, which will result inmaterial cash outlays over the next several years. A summary of our contractualobligations and commitments for capital leases, minimum lease paymentobligations under non-cancelable operating leases and other obligations as of December 31,2006 are as follows (in thousands):

| ** **                   | ** ** | **PAYMENTS DUE BY PERIOD** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| **CONTRACTUAL  OBLIGATIONS** | ** ** | ** **                                | ** ** | **TOTAL** | ** ** | **LESS THAN  1 YEAR** | ** ** | **1 to 3  YEARS** | ** ** | **3 to 5  YEARS** | ** ** | **AFTER 5  YEARS** | ** ** |
| Operating leases             |       | $                                         | 5,175      |   |   | $ | 1,610 |   |   | $ | 2,994 |   |   | $ | 571 |   |   |   | $ | — |   |   |
| Purchase  obligations        |       | 4,591                                     |       |   | 4,552 |   |   | 39 |   |   | — |   |   |   | — |   |   |
| Other long-term  obligations |       | 1,988                                     |       |   | 699 |   |   | 741 |   |   | 361 |   |   |   | 187 |   |   |
| Total                        |       | $                                         | 11,754     |   |   | $ | 6,861 |   |   | $ | 3,774 |   |   | $ | 932 |   |   |   | $ | 187 |   |   |
|                              |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of December 31, 2006, we had operating leasecommitments for all of our facilities, with the exception of our Cullman,Alabama and Nashua, New Hampshire facilities, which are owned. In addition, ouroperating lease commitments included leases on some office equipment.

As of December 31, 2006, we had various purchaseobligations, which include uninvoiced inventory receipts, capital equipmentcommitments, long-distance phone service and other commitments.

Incorporated in other long-term obligations arecommitments related to environmental remediation plans and building leasesassociated with discontinued operations and employee benefit obligations.

We are involved in various stages of investigation andcleanup related to environmental remediation matters at three sites, whichinclude one site that is in the final stage of monitoring. The ultimate cost ofsite cleanup is difficult to predict given the uncertainties regarding theextent of cleanup, the interpretation of applicable laws and regulations andalternative cleanup methods. As of December 31, 2006, we determined thatit was probable that we would incur approximately $748 thousand of remediationand monitoring costs, of which $182 thousand is included in current liabilitiesand $566 thousand is in other long-term liabilities.

As of December 31, 2006, we were contingentlyliable for $1.1 million under outstanding letters of credit. We have issuedletters of credit for certain business transactions including insuranceprograms and customer deposits.

As of December 31, 2006, we had one pension planfor which benefits and participation have been frozen. Pension benefits underthis plan are generally based upon years of service and compensation. The planis an unfunded plan with an annual payout of approximately $104 thousand.

In December of 2006,we signed an agreement to lease an additional 1,291 square feet of office spacein Rocky Hill, Connecticut for our corporate headquarters. The lease is contingentupon the completion of certain renovations, which are scheduled to be completedin February 2007.

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***Critical AccountingEstimates***

The discussion andanalysis of our financial condition and results of operations are based uponour financial statements, which have been prepared in accordance with generallyaccepted accounting principles in the United States. The preparation of thesefinancial statements requires management to make estimates and judgments thataffect the reported amounts of assets, liabilities and related disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts for revenues and expenses during the reporting period. Onan ongoing basis, management evaluates estimates, including those related toinventory allowances, contingencies, bad debts, warranties, environmentalremediation efforts and income taxes. We base our estimates on historical data,when available, experience, and on various other assumptions that are believedto be reasonable under the circumstances, the combined results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates.

***Critical AccountingPolicies***

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and the disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. The mostsignificant estimates and assumptions relate to inventory valuation and theadequacy of allowances for doubtful accounts, long-term loss contract reservesand environmental contingencies. Actual amounts could differ significantly fromthese estimates.

*Revenue recognition.*   Wemanufacture or distribute products, which are either components orsubassemblies that are sold to other manufacturers or OEMs. We do not sellany finished products directly to consumers. Therefore, we are generally notresponsible for any installation or customer training. However, some of ourcontracts are subject to customer acceptance and generally the customer willinspect and accept the product at our facility prior to shipment. Generally,legal title passes to the customer upon shipment. However, occasionally productis shipped FOB destination. When the product is shipped FOB destination,revenues are not recognized until the customer receives the product.

Our policy is to recognizerevenues when a product is either shipped to or received by the customer basedon the terms of the specific sale. However, certain long-term contracts areaccounted for under the percentage-of-completion model. Revenues and estimatedgross profit are recognized as work is performed based on the percentage thatincurred costs bear to estimated total costs. Cost estimates include direct andindirect costs such as labor, materials and overhead. These contracts requirejudgment relative to assessing risks, estimating, and making assumptions forschedule and technical issues. Contract changes are included when the costs canbe reasonably estimated. We may receive progress payments that exceed costsincurred on these long-term contracts. Such advances are recognized as billingsin excess of costs and are included in accrued expenses and other currentliabilities on our consolidated balance sheets.

Deferred income primarilyresults from the advance billings to our customers for the cost of beryllium,known as material only billings. These material only billings are deferred andsubsequently recognized as revenue only when the associated finished product isshipped.

Certain contracts areaccounted for under the service contract model. Under these contracts, revenuesare deferred and recognized on a straight-line basis over the contract period.

Due to the build-to-ordernature of our products, except for the distribution of ball bearings and themanufacture of infrared cameras, we do not offer price protection and generallydo not offer discounts. To the extent discounts are offered, they are reflectedat the time of the sale as a reduction in revenues. The price is fixed uponacceptance of the purchase order. When customer change orders occur, anypricing changes are reflected in a revised purchase order.

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*Allowance for doubtfulaccounts.*   We periodically review the aging ofour accounts receivable over ninety days to identify potentially uncollectibleaccounts and establish an allowance based on experience and discussion withcustomers. Historically, our estimated allowance has approximated actualwrite-offs. However, actual write-offs could differ from our allowance fordoubtful accounts. If circumstances change (for example, higher than expecteddefaults or an unexpected material adverse change in a customer’s ability tomeet its financial obligations), our estimates of recoverability of amounts dueto us could be reduced by a material amount. Accounts receivable are writtenoff only when all reasonable collection efforts are exhausted.

*Inventory valuation.*   Wevalue our inventory at the lower of the actual cost to purchase and/ormanufacture the inventory or the current estimated market value of theinventory. We regularly review inventory quantities on hand and record aprovision for excess or obsolete inventory based on current requirements andhistorical usage. A significant increase in the demand for our products couldresult in a short-term increase in the cost of inventory purchases while asignificant decrease in demand could result in an increase in the amount ofexcess or obsolete inventory quantities on hand. In addition, some of ourmarkets are characterized by rapid technological change or frequent new productdevelopment that could result in an increase in the amount of obsoleteinventory on hand. Additionally, our estimates of future product demand mayprove to be inaccurate, in which case we may have understated or overstated theprovision required for excess or obsolete inventory.

In the future, if wedetermine our inventory to be overvalued, we would be required to recognizethose costs in our cost of goods sold at the time of such determination. Likewise,if our inventory is undervalued, we may have over-reported our costs of goodssold in previous periods and would be required to recognize additionaloperating income at the time of sale. Therefore, although we make every effortto ensure the accuracy of our forecasts of future product demand, anysignificant unanticipated changes in demand or technological developments couldhave a significant impact on the value of our inventory and our reportedoperating results. Historically, our estimate of inventory reserves hasapproximated actual results.

*Goodwill and IdentifiableIntangible Assets.**  *Inaccordance with SFAS No. 141,*BusinessCombinations*, we allocate the cost of acquired businesses to theassets acquired and liabilities assumed based on their estimated fair values atthe date of acquisition. As part of the purchase price allocation for ouracquired businesses, identifiable intangible assets are recognized as assetsapart from goodwill if they arise from contractual or other legal rights, or ifthey are capable of being separated or divided from the acquired business andsold, transferred, licensed, rented or exchanged.

The values assigned toacquired identifiable intangible assets are determined, as of the date ofacquisition, based on estimates and judgments regarding expectations for theestimated future after-tax cash flows from those assets over their lives,including the probability of expected future contract renewals and sales, lessa cost-of-capital charge, all of which is discounted to present value. Thevalue assigned to goodwill equals the amount of the purchase price of thebusiness acquired in excess of the sum of the amounts assigned to identifiableacquired assets, both tangible and intangible, less liabilities assumed.

We review goodwill andintangible assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of these assets may not be recoverable, andalso review goodwill annually in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets,* orSFAS 142. SFAS 142 requires that goodwill be tested, at a minimum, annually foreach reporting unit. We estimate the fair value of a reporting unit using adiscounted cash flow valuation approach, which is dependent on estimates forfuture operating results, working capital changes, and capital expenditures, aswell as expected growth rates for cash flows and long-term interest rates. Adecline in future operating results or a change in our discount rate (11.5% in2006) in the future could result in a change in the estimated fair value of areporting unit and result in an impairment charge to goodwill, which could havea material adverse effect on our business, financial condition and results ofoperations.

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*Loss contract reserves.**  *Generally, our customer contracts are completedwithin one year of receiving the order. However, occasionally, longer lead-timeorders are received and we monitor these contracts periodically to determine ifour actual costs are comparable to our cost estimates used at the time of orderacceptance. If we determine that our actual costs are significantly exceedingour original estimates, we will record a loss contract reserve. Currently, onelong-term contract is covered by a loss contract reserve. We accrued for thiscontract based on the contract price and the current cost structure, includingestimated cost increases.

*Environmentalcontingencies.**  *We arecurrently involved in two environmental remediation projects and one site thatis in the final stage of monitoring. We accrue for environmental contingencieswhen (1) responsibility for cleanup is determined and (2) costs areprobable and can be reasonably estimated. When costs are not probable andcannot be reasonably estimated, no accrual is made. We have accrued ourestimate of the probable costs for the resolution of these claims. Theseestimates have been developed in consultation with outside environmentalconsultants handling these matters and are based upon an analysis of theanticipated remediation plans. We do not anticipate these projects will have amaterial adverse effect on our consolidated financial position. Although ourestimates to date have proven to be accurate, it is possible that futureresults of operations could be materially affected by changes in ourassumptions.

*Self-insurance.**  *We are self-insured for certainlosses related to general liability, workers’ compensation and medical claims. Ourliability represents an estimate of the ultimate cost of claims incurred as ofthe balance sheet date. The estimated liability is established based on ananalysis of historical data and is reviewed by management on a quarterly basisto ensure that the liability is appropriate. While we believe that ourestimates are reasonable based on the information currently available, ifactual trends, including the severity and frequency of claims, medical costinflation or fluctuations in premiums, differ from our estimates, our resultsfrom operations could be impacted

*Share-based compensation.**  *We elected to use aBlack-Scholes-Merton option-pricing model to value stock options that weregranted subsequent to our adoption of Statement 123(R). The model includesvarious assumptions including expected life, expected volatility, expecteddividend yield and risk-free interest rates. The assumptions are based onhistorical information regarding grants, exercises and cancellations. Webelieve each assumption used in the valuation is reasonable because it takesinto account the experience of the plan and reasonable expectations. Theassumptions, however, involve inherent uncertainties based on market conditionsgenerally outside the control of Axsys. As a result, if other assumptions hadbeen used, stock-based compensation expense could have varied.

*Accounting for incometaxes.**  *Aspart of the process of preparing the consolidated financial statements, we arerequired to estimate the income taxes in each jurisdiction in which we operate.This process involves estimating the actual current tax liabilities togetherwith assessing temporary differences resulting from the differing treatment ofitems for tax and accounting purposes. These differences result in deferred taxassets and liabilities, which are included in the Consolidated Balance Sheet.We must then assess the likelihood that the deferred tax assets will berecovered, and to the extent that we believe that recovery is not more thanlikely, we are required to establish a valuation allowance. If a valuationallowance is established or increased during any period, we are required toinclude this amount as an expense within the tax provision in the ConsolidatedStatements of Operations. Significant judgment is required in determining ourprovision for income taxes, deferred tax assets and liabilities and anyvaluation allowance recognized against net deferred assets. The valuationallowance is based on our estimates of the taxable income in the jurisdictions inwhich we operate and the period over which the deferred tax assets will berecoverable. In the event that actual results differ from these estimates ormanagement adjusts these estimates in future periods, we may need to establishan additional valuation allowance, which could materially impact our results ofoperations.

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*Recently IssuedAccounting Standards*

***In June 2006,the Financial Accounting Standards Board, or FASB, issued Interpretation No. 48,“Accounting for Uncertainty in Income Taxes”, or FIN 48, which prescribes acomprehensive model for how a company should recognize, measure, present anddisclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return (including a decision whether to filea return in a particular jurisdiction). Under FIN 48, the financial statementswill reflect expected future tax consequences of such positions presuming thetaxing authorities’ full knowledge of the position and all relevant facts, butwithout considering time values. FIN 48 substantially changes the applicableaccounting model and is likely to cause greater volatility in income statementsas more items are recognized discretely within income tax expense. FIN 48 alsorevises disclosure requirements and introduces a prescriptive, annual tabularrollfoward of the unrecognized tax benefits. FIN 48 must be adopted no laterthan January 1, 2007. Early adoption is permitted. We are currentlyevaluating the impact of adopting FIN 48 on our consolidated financial positionand results of operations and expect to adopt FIN 48 effective January 1,2007.***

In December 2004, the FASB issued SFAS 123(R), “Share-BasedPayment”, which requires us to expense share-based payments, including employeestock options, based on their fair value. We adopted SFAS 123(R) on January 1,2006. We discuss our adoption of SFAS 123(R) and the adoption’s effects inNote 9 to our consolidated financial statements in this annual report.

*InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costing”, or SFAS 151,which clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs and wasted material. SFAS 151 requires that thoseamounts, if abnormal, be recognized as expenses in the period incurred. In addition,SFAS 151 requires the allocation of fixed production overheads to the cost ofconversion based upon the normal capacity of the production facilities. Weadopted SFAS 151 during the first quarter of 2006. The adoption did not have amaterial impact on our earnings or financial position.*

*Cautionary FactorsThat May Affect Future Results*

This annual reportcontains forward-looking statements within the meaning of Section 21E ofthe Securities Exchange Act, including, without limitation, statements regardingour ability to reduce design and manufacturing lead times and manufacturingcosts, our ability to integrate existing technologies, our ability to implementour strategy to develop and sell, among other things, higher level sub-systems,the changes to be achieved from our cost reduction efforts, our objective togrow through strategic acquisitions and anticipated expenditures forenvironmental remediation. One can identify these forward-looking statements bythe use of the words such as “expect,” “anticipate,” “plan,” “may,” “will,” “estimate”or other similar expressions. Discussion containing such forward-lookingstatements is found in the material set forth under “Business” and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” aswell as within the filing generally. One should understand that many factorscould cause actual results to differ from those expressed or implied in theforward-looking statements. These factors include those discussed below as wellas inaccurate assumptions. We caution the reader that this list of factors maynot be exhaustive. Because these forward-looking statements involve risks anduncertainties, you should be aware that there are important factors that couldcause our actual results, level of activity, performance or achievements todiffer materially from the results, level of activity, performance orachievements expressed or implied by these forward-looking statementsincluding, but not limited to:

·       ourdependence on sales to the U.S. federal government and BAE Systems;

·       changesto U.S. federal government spending priorities;

·       ourability to continue to contract with the federal government or Department ofDefense;

38

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·       ourability to comply with complex procurement laws and regulations;

·       ourability to implement effective business plans in the industries in which weoperate;

·       ourability to adapt to technological change;

·       ourability to compete in the industries in which we operate;

·       thepotential for our backlog to be reduced or cancelled;

·       therisks of doing business internationally;

·       ourability to implement our acquisition strategy and integrate our acquiredcompanies successfully;

·       theavailability and timely delivery of materials to us by our suppliers;

·       ourability to manage costs under our fixed-price contracts effectively;

·       ourability to attract and retain qualified personnel;

·       theability to protect our intellectual property rights;

·       fluctuationsin workers’ compensation and health care costs for our employees;

·       ourability to comply with environmental, health and safety laws and regulations;

·       ourability to maintain and upgrade our manufacturing capabilities to staycompetitive;

·       ourability to comply with restrictive covenants under our credit facility;

·       ourability to maintain security clearances for classified government systems; and

·       the other factors that wedescribe in Item 1A of this annual report.

**Item 7A.**                QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Axsys’market risk sensitive instruments do not subject it to material risk exposures.During the year ended December 31, 2006, we borrowed and subsequentlyrepaid $8.0 million under our revolving credit facility. We paid aweighted-average interest rate of 6.3% on the borrowings, resulting in $46thousand in interest expense. Our$15.0 million revolving credit facility remains available through May 2008,subject to optional prepayment in accordance with its terms. Up to $2.0 millionof the revolving credit facility may be utilized to issue letters of credit. Wemay elect to have any borrowing under the revolving credit facility bearinterest either at the bank’s prime rate or the LIBOR rate plus a margin of 100to 275 basis points, depending on our consolidated funded debt-to-consolidatedEBITDA ratio. We have the option of selecting the 1-month, 2-month,3-month or 6-month LIBOR rate. On December 31, 2006, therewere no borrowings outstanding under the revolving credit facility. However, asof December 31, 2006, $1.1 million of the revolving credit facility wasutilized for outstanding letters of credit.

**Item 8.**                        FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Axsys’ consolidated financial statements, togetherwith the Report of Independent Registered Public Accounting Firm thereon dated February 16,2007, is included in this annual report and listed in the index to financialinformation on page F-1.

The selected quarterlyinformation required by this item is included under the caption “SelectedQuarterly Financial Data (Unaudited)” in Note 18 to the consolidated financialstatements included in this annual report.

39

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**Item 9.**                        CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**Item 9A.**                CONTROLSAND PROCEDURES

*Management’sResponsibility for Financial Statements*

Management is responsible for the integrity andobjectivity of the consolidated financial statements and other financialinformation presented in this annual report. These statements have beenprepared in accordance with generally accepted accounting principles andnecessarily include amounts based on judgments and estimates by management.

The Audit Committee of theBoard of Directors, which is composed solely of independent directors, meetsregularly with the independent auditors and representatives of management toreview accounting, financial reporting, internal control and audit matters, aswell as the nature and extent of the audit effort. The Audit Committee isresponsible for the engagement of the independent auditors. The independentauditors and internal auditor have unrestricted access to the Audit Committee.

*Disclosure Controlsand Procedures*

As of the end of the period covered by this annualreport, management, including our principal executive officer and principalfinancial officer, evaluated the effectiveness of the design and operation ofthe Axsys’ disclosure controls and procedures.

The principal executiveofficer and principal financial officer have concluded, based on their review,that the Axsys’ disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e),were, as of the end of the period covered by this annual report, effective toensure that information required to be disclosed by the Axsys in reports itfiles under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission rules andforms.

*Management’s Reporton Internal Control over Financial Reporting*

Management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in the rules promulgated under the Exchange Act of 1934. Under thesupervision and with the participation of its management, including itsprincipal executive, financial and accounting officers, Axsys has conducted anevaluation of the effectiveness of its internal control over financialreporting based on the framework in “Internal Control-Integrated Framework”issued by the Committee of Sponsoring Organizations of the Treadway Commission.The evaluation included a review of the documentation of controls, evaluationof the design effectiveness of controls, and testing of the operatingeffectiveness of controls.

Based on this evaluation,management has concluded that as of December 31, 2006, Axsys did not haveany material weaknesses in its internal control over financial reporting andits internal control over financial reporting was effective. Management’sassessment of the effectiveness of its internal control over financialreporting on December 31, 2006 has been audited by Ernst & YoungLLP, an independent registered public accounting firm, as stated in theirreport, which is included below in this annual report.

*Changes in InternalControl over Financial Reporting*

No change to the Company’s internal control overfinancial reporting occurred during the fourth quarter of 2006 that hasmaterially affected, or is reasonably likely to materially affect, Axsys’internal control over financial reporting.

40

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Shareholders of Axsys Technologies, Inc.

We have audited management’s assessment, included inthe accompanying *Management’s Report onInternal Control over Financial Reporting*, included at Item 9A, thatAxsys Technologies, Inc. maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin Internal Control-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (the COSO criteria). AxsysTechnologies, Inc.’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

In our opinion, management’s assessment that AxsysTechnologies, Inc. maintained effective internal control over financialreporting as of December 31, 2006 is fairly stated, in all materialrespects, based on the COSO criteria. Also, in our opinion, Axsys Technologies, Inc.maintained, in all material respects, effective internal control over financialreporting as of December 31, 2006, based on the COSO criteria.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets asof December 31, 2006 and 2005, and the related consolidated statements ofoperations, shareholders’ equity and comprehensive income (loss), and cashflows for each of the three years in the period ended December 31, 2006,of Axsys Technologies, Inc. and subsidiaries and our report dated February 16,2007 expressed an unqualified opinion thereon.
|                         | **ERNST &  YOUNG LLP** |
|-------------------------|---------------------------------|
| Hartford, Connecticut   |                            |
| February 16,  2007 |                            |

 

41

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**Item 9B.**               OTHERINFORMATION

None.

**PART III**

**Theinformation required by items 10, 11, 12, 13 and 14 of Part III, otherthan the disclosure regarding the adoption of our Code of Ethics as required byItem 406(a) of Regulation S-K and the table required by Item 201(d) ofRegulation S-K, is incorporated by reference to Axsys’ definitive proxystatement for its 2007 Annual Meeting of Stockholders, or 2007 Proxy Statement,to be filed with the Securities and Exchange Commission within 120 daysfollowing the end of Axsys’ fiscal year ended December 31, 2006. If suchproxy statement is not so filed, that information will be filed as an amendmentto this Form 10-K within 120 days following the end of Axsys’ fiscalyear ended December 31, 2006.**

**Item 10.**                 DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Except for the informationconcerning our Code of Ethics, the information required by this item isincorporated by reference from our 2007 Proxy Statement.

**Code of Ethics**

Axsys adopted a code ofethics applicable to our Chief Executive Officer and Chief Financial Officer,which is a “code of ethics” as defined by applicable rules of theSecurities and Exchange Commission. This code of ethics is publicly availableon our website, www.axsys.com. The information on our website is not part ofthis annual report. If we make any amendments to this code of ethics other thantechnical, administrative, or other non-substantive amendments, or grant anywaivers, including implicit waivers, from a provision of this code of ethics toour Chief Executive Officer or Chief Financial Officer, we will disclose thenature of the amendment or waiver, the effective date and to whom it applies ina report on Form 8-K filed with the Securities and ExchangeCommission.

**Item 11.**                 EXECUTIVECOMPENSATION

The information requiredby this item is incorporated by reference from our 2007 Proxy Statement

**Item 12.**                 SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

Except for the informationconcerning equity compensation plans, the information required by this item isincorporated by reference from our 2007 Proxy Statement under the caption, “SecuritiesOwnership of Directors and Officers.” The following table gives informationabout our equity securities that may be issued under equity compensation plansas of December 31, 2006. Those securities are shares of common stock thatcan be issued under our existing Long-Term Stock Incentive Plan.

42

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**EquityCompensation Plan Information**

| **Plan category**                                      | ** ** | **Number of shares of  common stock to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average exercise  price of outstanding options,  warrants and rights** | ** ** | **Number of shares of common  stock remaining available for  further issuance under equity   compensation plans (excluding  securities reflected in column (a))** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                                                     | ** ** | **(b)**                                                                                                         | ** ** | **(c)**                                                                                                                                                                                                                                                | ** ** |
| Equity  compensation plans approved by security holders     |       |                                                                                                                                                                        | 928,616    |                                                                                                            |       |                                                                                                                                                                                                                                                   | $          | 11.80 |   |   |   | 220,902 |   |   |
| Equity  compensation plans not approved by security holders |       |                                                                                                                                                                        | —     |                                                                                                            |       |                                                                                                                                                                                                                                                   | —     |   |   |   | — |   |   |
| Total                                                       |       |                                                                                                                                                                        | 928,616    |                                                                                                            |       |                                                                                                                                                                                                                                                   | $          | 11.80 |   |   |   | 220,902 |   |   |

 

**Item 13.**                 CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information requiredby this item is incorporated by reference from our 2007 Proxy Statement.

**Item 14.**                 PRINCIPALACCOUNTANT FEES AND SERVICES

The information requiredby this item is incorporated by reference from our 2007 Proxy Statement.

**PART IV**

**Item 15.**                 EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**(a)(1) FinancialStatements**

See accompanying index toconsolidated financial statements and schedule on page F-1 of thisannual report.

**(a)(2) FinancialStatement Schedules**

See accompanying index toconsolidated financial statements and schedule on page F-1 of thisannual report.

**(a)(3) Exhibits**

|      | **Exhibit   Number** | ** **                                                                                                                                                                                                                                                                                       | ** ** | ** ** | **Description** | ** ** |
|------|----------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------|------------|
| 3.1  |                 | Restated Certificate of  Incorporation of Axsys (filed as Exhibit 3(4) to Axsys’ Amendment  No. 2 to Registration Statement on Form S-1, dated  October 17, 1997 (File No. 333-36027) (the “Form S-1”)  and incorporated herein by reference). |
| 3.2  |                 | By-Laws of Axsys (filed  as Exhibit 2 to the Form 8-A dated August 8, 1991(file  No. 000-16182) and incorporated herein by reference).                                                                                                                                       |
| 10.1 |                 | Form of Incentive  Stock Option Agreement, dated as of September 30, 1991 (filed as  Exhibit 10(17) to Axsys’ Annual Report on Form 10-K for the  fiscal year ended December 30, 1991 (File No. 000-16182) and  incorporated herein by reference).*           |

43

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| 10.2  |   | Severance Protection  Agreement between Axsys and Stephen W. Bershad dated as of February 11,  1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated  May 11, 1999, for the fiscal quarter ended March 31, 1999 (File  No. 000-16182) and incorporated herein by reference).*         |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3  |   | Amendment to Axsys  Technologies, Inc. Long-Term Stock Incentive Plan (filed as  Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 (File  No. 000-16182) and incorporated herein by reference).*                                                                                                |
| 10.4  |   | Employment Agreement,  dated as of October 12, 2000, between Axsys and Stephen W. Bershad  (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K  (File No. 000-16182) and incorporated herein by reference). *                                                                                  |
| 10.5  |   | Form of  Indemnification Agreement for all Directors and Officers of Axsys (filed as  Exhibit 10(17) to the December 31, 2001 Form 10-K (File  No. 000-16182) and incorporated herein by reference).*                                                                                                  |
| 10.6  |   | Letter Agreement between  David A. Almeida and Axsys dated as of November 14, 2001 (filed as  Exhibit 10(18) to the December 31, 2001 Form 10-K (File  No. 000-16182) and incorporated herein by reference). *                                                                                         |
| 10.7  |   | Severance Protection  Agreement between Axsys and David A. Almeida dated as of May 13, 2003  (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q  (File No. 000-16182) and incorporated herein by reference).*                                                                                       |
| 10.8  |   | Severance Protection  Agreement between Axsys and Scott B. Conner dated as of December 3, 2004  (filed as Exhibit 10.9 to the December 31, 2004 Form 10-K  (File No. 000-16182) and incorporated herein by reference).*                                                                                |
| 10.9  |   | Summary of Management  Incentive Plan. (filed as Exhibit 10.10 to the December 31, 2004 Form 10-K  (File No. 000-16182) and incorporated herein by reference).*                                                                                                                                             |
| 10.10 |   | Purchase and Sale  Agreement dated February 15, 2006 (filed as Exhibit 99.1 to Axsys’  Form 8-K filed on February 16, 2006 (File No. 000-16182)  and incorporated herein by reference).                                                                                                           |
| 10.11 |   | Letter Agreement between  Stephen W. Bershad and Axsys Technologies, Inc. extending the term of  the initial period of Mr. Bershad’s Employment Agreement (filed as  Exhibit 10.1 to Axsys’ Form 8-K, filed August 8, 2006  (File No. 000-16182) and incorporated herein by reference). |
| 10.12 |   | Amended and Restated  Long-Term Stock Incentive Plan (filed as Exhibit 10.1 to Axsys’  Form 8-K, filed May 5, 2006 (File No. 000-16182)  and incorporated herein by reference).                                                                                                                        |
| 10.13 |   | Credit Agreement, dated  May 2, 2005, by and among Axsys, its subsidiaries and Fleet National  Bank (filed as Exhibit 10.1 to Axsys’ Form 10-Q, filed  July 26, 2005 (File No. 000-16182) and incorporated herein by  reference.)                                                                 |
| 21    |   | Subsidiaries of the  Registrant                                                                                                                                                                                                                                                                                                 |
| 23    |   | Consent of Ernst & Young  LLP                                                                                                                                                                                                                                                                                               |
| 31.1  |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002—Chief Executive Officer                                                                                                                                                                                                                      |
| 31.2  |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002—Chief Financial Officer                                                                                                                                                                                                                      |

44

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| 32.1 |   | Certification pursuant to 18 U.S.C.  Section 1350—Chief Executive Officer |
|------|--------|-------------------------------------------------------------------------------------|
| 32.2 |   | Certification pursuant to 18 U.S.C.  Section 1350—Chief Financial Officer |

 

*                    Indicatesmanagement contracts or compensatory plans or arrangements.

45

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

| Dated: February 20, 2007 | AXSYS TECHNOLOGIES, INC. |
|-------------------------------|--------------------------|
| ** **                    | (Registrant)             |
|                          | By                       | /s/ STEPHEN W. BERSHAD |
|                          |                     | Stephen W. Bershad |
|                          |                     | Chairman of the Board of Directors |
|                          |                     | and Chief Executive Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities indicated this the 21st day of February 2007.
| /s/ STEPHEN W. BERSHAD             |   | Chairman of the Board of Directors and Chief  Executive Officer |
|------------------------------------|--------|-----------------------------------------------------------------|
| Stephen W.  Bershad                |   | (Principal  Executive Officer)                                  |
| /s/  DAVID A. ALMEIDA              |   | Vice President, Chief  Financial Officer, Treasurer             |
| David A. Almeida                   |   | (Principal  Financial and Accounting Officer)                   |
| /s/  ANTHONY J. FIORELLI, Jr. |   | Director                                                        |
| Anthony J.  Fiorelli, Jr.     |   |                                                            |
| /s/  ELIOT M. FRIED                |   | Director                                                        |
| Eliot M. Fried                     |   |                                                            |
| /s/  RICHARD F. HAMM, Jr.     |   | Director                                                        |
| Richard F.  Hamm, Jr.         |   |                                                            |
| /s/  ROBERT G. STEVENS             |   | Director                                                        |
| Robert G. Stevens                  |   |                                                            |

 

46

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**ANNUALREPORT ON FORM 10-K**

**ITEM 8, ITEM 15(a)(1) and(2)**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE**

**FINANCIALSTATEMENTS**

**YEAR ENDED DECEMBER31, 2006**

**AXSYS TECHNOLOGIES,INC.**

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**AXSYS TECHNOLOGIES,INC.**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE**

Thefollowing consolidated financial statements of Axsys Technologies, Inc.are included in Item 8:
| Report of Independent  Registered Public Accounting Firm                                                                                              |   | F-2    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Consolidated Balance  Sheets—December 31, 2006 and 2005                                                                                     |   | F-3    |
| Consolidated Statements of  Operations—For the years ended December 31, 2006, 2005 and 2004                                                 |   | F-4    |
| Consolidated Statements of Cash  Flows—For the years ended December 31, 2006, 2005 and 2004                                                 |   | F-5    |
| Consolidated Statements of  Shareholders’ Equity and Comprehensive Income (Loss)—For the years ended  December 31, 2006, 2005 and 2004 |   | F-6    |
| Notes to the  consolidated financial statements                                                                                                       |   | F-7    |
| The following consolidated  financial statement schedule of Axsys Technologies, Inc. is included in  Item 15(a)(2):                              |   |   |
| Schedule  II—Valuation and qualifying accounts                                                                                                   |   | F-30   |

 

All other schedules for which provision is made in theapplicable accounting regulations of the Securities and Exchange Commission arenot required under the related instructions or are inapplicable and, therefore,have been omitted.

F-1

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Shareholders ofAxsys Technologies, Inc.

We have audited the accompanying consolidated balancesheets of Axsys Technologies, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations,shareholders’ equity and comprehensive income (loss), and cash flows for eachof the three years in the period ended December 31, 2006. Our audits alsoincluded the financial statement schedule listed in the Index at Item 15(a)(2).These financial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Axsys Technologies, Inc. and subsidiaries at December 31,2006 and 2005, and the consolidated results of their operations and their cashflows for each of the three years in the period ended December 31, 2006,in conformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

As discussed in Note 9 to the consolidated financialstatements, effective January 1, 2006, the Company adopted the provisionsof Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment*.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Axsys Technologies, Inc.’s internalcontrol over financial reporting as of December 31, 2006, based oncriteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated February 16, 2007, expressed an unqualified opinion thereon.

**ERNST &YOUNG LLP**

Hartford, ConnecticutFebruary 16, 2007

F-2

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**AXSYS TECHNOLOGIES, INC.Consolidated Balance Sheets(Dollars in thousands, except share and per share data)**

| ** **                                                                                                                                                        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| CURRENT ASSETS:                                                                                                                                                   |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                         |       | $                     | 6,044      |   | $ | 7,079 |   |
| Accounts receivable, net                                                                                                                                          |       | 21,321                |       | 18,821 |   |
| Inventories, net                                                                                                                                                  |       | 44,229                |       | 37,866 |   |
| Income taxes—deferred                                                                                                                                        |       | 3,675                 |       | 3,256 |   |
| Prepaid expenses                                                                                                                                                  |       | 994                   |       | 1,056 |   |
| Other current assets                                                                                                                                              |       | 368                   |       | 126 |   |
| TOTAL CURRENT ASSETS                                                                                                                                              |       | 76,631                |       | 68,204 |   |
| PROPERTY, PLANT  AND EQUIPMENT, net                                                                                                                               |       | 22,860                |       | 15,351 |   |
| INTANGIBLE  ASSETS, net                                                                                                                                           |       | 9,507                 |       | 10,461 |   |
| GOODWILL                                                                                                                                                          |       | 62,231                |       | 61,048 |   |
| OTHER ASSETS                                                                                                                                                      |       | 1,116                 |       | 1,144 |   |
| TOTAL ASSETS                                                                                                                                                      |       | $                     | 172,345    |   | $ | 156,208 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** |
| CURRENT LIABILITIES:                                                                                                                                              |       |                  |       |   |   |
| Accounts payable                                                                                                                                                  |       | $                     | 10,895     |   | $ | 8,019 |   |
| Accrued expenses and other current liabilities                                                                                                                    |       | 18,348                |       | 16,835 |   |
| Deferred income                                                                                                                                                   |       | 6,088                 |       | 7,044 |   |
| TOTAL CURRENT LIABILITIES                                                                                                                                         |       | 35,331                |       | 31,898 |   |
| OTHER LONG-TERM  LIABILITIES                                                                                                                                      |       | 5,826                 |       | 4,769 |   |
| COMMITMENTS AND  CONTINGENCIES (Note 13)                                                                                                                          |       |                  |       |   |   |
| SHAREHOLDERS’ EQUITY:                                                                                                                                        |       |                  |       |   |   |
| Common stock, $.01 par value: authorized 30,000,000  shares, issued 10,643,934  shares at December 31, 2006 and 10,636,734 shares at December 31,  2005 |       | 106                   |       | 106 |   |
| Capital in excess of par                                                                                                                                          |       | 99,111                |       | 97,875 |   |
| Accumulated other comprehensive income                                                                                                                            |       | —                |       | 3 |   |
| Retained earnings                                                                                                                                                 |       | 31,977                |       | 21,712 |   |
| Treasury stock, at cost: 572 shares at  December 31, 2006 and 18,907 shares at December 31, 2005                                                        |       | (6                    | )          | (155 | ) |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                                   |       | 131,188               |       | 119,541 |   |
| TOTAL LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                                                                  |       | $                     | 172,345    |   | $ | 156,208 |   |

 

See accompanying notes to consolidated financial statements.

F-3

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements of Operations(Dollars in thousands, except share and per share data)**

| ** **                                                                                          | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Sales                                                                                               |       | $                                           | 156,347    |   | $ | 133,543 |   | $ | 103,530 |   |
| Cost of sales                                                                                       |       | 107,448                                     |       | 91,897 |   | 72,874 |   |
| Gross profit                                                                                        |       | 48,899                                      |       | 41,646 |   | 30,656 |   |
| Selling, general and administrative expenses                                                        |       | 28,159                                      |       | 23,957 |   | 18,634 |   |
| Research,  development and engineering expenses                                                     |       | 4,463                                       |       | 3,766 |   | 2,677 |   |
| OPERATING INCOME                                                                                    |       | 16,277                                      |       | 13,923 |   | 9,345 |   |
| Interest expense                                                                                    |       | (80                                         | )          | (1,684 | ) | (254 | ) |
| Interest income                                                                                     |       | 290                                         |       | 167 |   | 98 |   |
| Loss on  extinguishment of debt                                                                     |       | —                                      |       | (480 | ) | — |   |
| Other (expense)  income, net                                                                        |       | (2                                          | )          | 33 |   | (38 | ) |
| Income from  continuing operations before income taxes                                              |       | 16,485                                      |       | 11,959 |   | 9,151 |   |
| Provision for  (benefit from) income taxes                                                          |       | 6,103                                       |       | 4,486 |   | (8 | ) |
| INCOME FROM  CONTINUING OPERATIONS                                                                  |       | 10,382                                      |       | 7,473 |   | 9,159 |   |
| Discontinued  operations:                                                                           |       |                                        |       |   |   |   |   |
| Loss from discontinued operations, net of tax  benefit of $63 in 2006, $90 in 2005 and $266 in 2004 |       | (117                                        | )          | (150 | ) | (495 | ) |
| NET INCOME                                                                                          |       | $                                           | 10,265     |   | $ | 7,323 |   | $ | 8,664 |   |
| BASIC EARNINGS  (LOSS) PER SHARE:                                                                   |       |                                        |       |   |   |   |   |
| Continuing operations                                                                               |       | $                                           | 0.98       |   | $ | 0.93 |   | $ | 1.30 |   |
| Discontinued operations                                                                             |       | (0.01                                       | )          | (0.02 | ) | (0.07 | ) |
| Total                                                                                               |       | $                                           | 0.97       |   | $ | 0.91 |   | $ | 1.23 |   |
| Weighted-average  basic common shares outstanding                                                   |       | 10,628,647                                  |       | 8,006,029 |   | 7,020,184 |   |
| DILUTED EARNINGS  (LOSS) PER SHARE:                                                                 |       |                                        |       |   |   |   |   |
| Continuing operations                                                                               |       | $                                           | 0.95       |   | $ | 0.90 |   | $ | 1.26 |   |
| Discontinued operations                                                                             |       | (0.01                                       | )          | (0.02 | ) | (0.07 | ) |
| Total                                                                                               |       | $                                           | 0.94       |   | $ | 0.88 |   | $ | 1.19 |   |
| Weighted-average diluted  common shares outstanding                                                 |       | 10,888,494                                  |       | 8,355,400 |   | 7,289,437 |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements of Cash Flows(Dollars in thousands)**
|                                                                                    | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                              |       |                                        |       |   |   |   |   |
| Net income                                                                         |       | $                                           | 10,265     |   | $ | 7,323 |   | $ | 8,664 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation                                                                       |       | 3,542                                       |       | 3,148 |   | 2,674 |   |
| Amortization                                                                       |       | 954                                         |       | 816 |   | 73 |   |
| Deferred income taxes  (benefit)                                                   |       | 823                                         |       | 1,333 |   | (1,747 | ) |
| Share-based compensation  expense                                                  |       | 1,093                                       |       | — |   | 242 |   |
| Contribution to  401(k) plan                                                  |       | 70                                          |       | 66 |   | 58 |   |
| Loss on disposal of  equipment                                                     |       | 32                                          |       | 3 |   | 19 |   |
| Changes in operating assets and liabilities:                                       |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                |       | (2,500                                      | )          | (809 | ) | (4,464 | ) |
| Inventories                                                                        |       | (6,309                                      | )          | (2,587 | ) | (4,073 | ) |
| Other current assets and  other assets                                             |       | (182                                        | )          | (93 | ) | 787 |   |
| Accounts payable                                                                   |       | 2,876                                       |       | (64 | ) | 2,112 |   |
| Accrued expenses and  other liabilities                                            |       | 3,462                                       |       | 591 |   | 1,232 |   |
| Deferred income                                                                    |       | (956                                        | )          | (481 | ) | 2,649 |   |
| Long-term liabilities                                                              |       | (158                                        | )          | (734 | ) | (448 | ) |
| Net cash provided by  continuing operations                                        |       | 13,012                                      |       | 8,512 |   | 7,778 |   |
| Net cash used in  discontinued operations                                          |       | (292                                        | )          | (907 | ) | (140 | ) |
| NET CASH PROVIDED BY  OPERATING ACTIVITIES                                         |       | 12,720                                      |       | 7,605 |   | 7,638 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                              |       |                                        |       |   |   |   |   |
| Capital expenditures                                                               |       | (11,230                                     | )          | (3,533 | ) | (4,239 | ) |
| Purchase of DiOP, net of  cash acquired                                            |       | —                                      |       | (57,138 | ) | — |   |
| Purchase of Telic, net  of cash acquired                                           |       | —                                      |       | — |   | (13,728 | ) |
| Purchase of Telic–earn-out  payment                                           |       | (2,817                                      | )          | — |   | — |   |
| Net sale of marketable  securities                                                 |       | —                                      |       | — |   | 6,983 |   |
| Proceeds from sale of  equipment                                                   |       | 93                                          |       | — |   | — |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                             |       | (13,954                                     | )          | (60,671 | ) | (10,984 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                              |       |                                        |       |   |   |   |   |
| Proceeds from stock  offering                                                      |       | —                                      |       | 57,620 |   | — |   |
| Proceeds from long-term  debt                                                      |       | 8,000                                       |       | 55,000 |   | 5,000 |   |
| Repayment of borrowings                                                            |       | (8,000                                      | )          | (59,851 | ) | (1,140 | ) |
| Proceeds from the  exercise of options                                             |       | 140                                         |       | 1,301 |   | 360 |   |
| Tax benefit from  exercise of stock options                                        |       | 59                                          |       | — |   | — |   |
| Escheatment and  settlement of preferred stock                                     |       | —                                      |       | 76 |   | (71 | ) |
| Payments under stock  buy-back program                                             |       | —                                      |       | (1 | ) | — |   |
| NET CASH PROVIDED BY  FINANCING ACTIVITIES                                         |       | 199                                         |       | 54,145 |   | 4,149 |   |
| NET CHANGE IN CASH AND  CASH EQUIVALENTS                                           |       | (1,035                                      | )          | 1,079 |   | 803 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF YEAR                                    |       | 7,079                                       |       | 6,000 |   | 5,197 |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                           |       | $                                           | 6,044      |   | $ | 7,079 |   | $ | 6,000 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements of Shareholders’ Equity and Comprehensive Income (Loss)(Dollars in thousands)**

| ** **                                              | ** ** | **Common  Stock** | ** ** | **Capital in  Excess of** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Treasury  Stock** | ** ** | ** ** | ** ** | **Comprehensive**      | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|-------------------------------------|------------|---------------------------------------|------------|--------------|------------|---------------------|------------|------------|------------|------------------------|------------|
| ** **                                              | ** ** | **Amount**        | ** ** | **Par**                             | ** ** | **Income (Loss)**                | ** ** | **Earnings** | ** ** | **Amount**          | ** ** | **Total**  | ** ** | **Income (Loss)** | ** ** |
| Balance at December 31, 2003                       |       |              | $          | 72                                  |       |                                  |       | $            | 39,375     |                |       |       | $          | (39                    | )          |   |   | $ | 5,725 |   |   |   | $ | (1,235 | ) |   | $ | 43,898 |   |   |   |   |   |
| Net income                                              |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | 8,664      |   |   |   | — |   |   | 8,664 |   |   | $ | 8,664 |   |   |
| Foreign exchange contract                               |       |              | —     |                                |       |                                  | —     |         |       |                | (84        | )          |       |                   | —     |   |   |   | — |   |   | (84 | ) |   | (84 | ) |   |
| Gain on swap agreement                                  |       |              | —     |                                |       |                                  | —     |         |       |                | 26         |       |       |                   | —     |   |   |   | — |   |   | 26 |   |   | 26 |   |   |
| Total comprehensive income                              |       |              |       |                                |       |                                  |       |         |       |                |       |       |       |                   |       |   |   |   |   |   |   |   |   |   | $ | 8,606 |   |   |
| Share-based compensation expense                        |       |              | —     |                                |       |                                  | 242        |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 242 |   |   |   |   |   |
| Exercise of stock options                               |       |              | —     |                                |       |                                  | 38         |         |       |                | —     |       |       |                   | —     |   |   |   | 322 |   |   | 360 |   |   |   |   |   |
| Contribution to 401(k) plan                        |       |              | —     |                                |       |                                  | 28         |         |       |                | —     |       |       |                   | —     |   |   |   | 30 |   |   | 58 |   |   |   |   |   |
| Escheatment of preferred stock                          |       |              | —     |                                |       |                                  | (71        | )            |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | (71 | ) |   |   |   |   |
| Balance at December 31, 2004                       |       |              | 72         |                                |       |                                  | 39,612     |         |       |                | (97        | )          |       |                   | 14,389     |   |   |   | (883 | ) |   | 53,093 |   |   |   |   |   |
| Net income                                              |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | 7,323      |   |   |   | — |   |   | 7,323 |   |   | $ | 7,323 |   |   |
| Public stock offering                                   |       |              | 34         |                                |       |                                  | 57,549     |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 57,583 |   |   | — |   |   |
| Foreign exchange contract                               |       |              | —     |                                |       |                                  | —     |         |       |                | 126        |       |       |                   | —     |   |   |   | — |   |   | 126 |   |   | 126 |   |   |
| Termination of swap agreement                           |       |              | —     |                                |       |                                  | —     |         |       |                | (26        | )          |       |                   | —     |   |   |   | — |   |   | (26 | ) |   | (26 | ) |   |
| Total comprehensive income                              |       |              |       |                                |       |                                  |       |         |       |                |       |       |       |                   |       |   |   |   |   |   |   |   |   |   | $ | 7,423 |   |   |
| Exercise of stock options                               |       |              | —     |                                |       |                                  | 597        |         |       |                | —     |       |       |                   | —     |   |   |   | 704 |   |   | 1,301 |   |   |   |   |   |
| Contribution to 401(k) plan                        |       |              | —     |                                |       |                                  | 41         |         |       |                | —     |       |       |                   | —     |   |   |   | 25 |   |   | 66 |   |   |   |   |   |
| Distribution from preferred stock settlement  fund |       |              | —     |                                |       |                                  | 76         |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 76 |   |   |   |   |   |
| Stock buy-back program                                  |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | —     |   |   |   | (1 | ) |   | (1 | ) |   |   |   |   |
| Balance at December 31, 2005                       |       |              | 106        |                                |       |                                  | 97,875     |         |       |                | 3          |       |       |                   | 21,712     |   |   |   | (155 | ) |   | 119,541 |   |   |   |   |   |
| Net income                                              |       |              | —     |                                |       |                                  | —     |         |       |                |       |       |       |                   | 10,265     |   |   |   | — |   |   | 10,265 |   |   | $ | 10,265 |   |   |
| Foreign exchange contract                               |       |              | —     |                                |       |                                  | —     |         |       |                | (3         | )          |       |                   | —     |   |   |   | — |   |   | (3 | ) |   | (3 | ) |   |
| Total comprehensive income                              |       |              |       |                                |       |                                  |       |         |       |                |       |       |       |                   |       |   |   |   |   |   |   |   |   |   | $ | 10,262 |   |   |
| Share-based compensation expense                        |       |              | —     |                                |       |                                  | 1,093      |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 1,093 |   |   |   |   |   |
| Reduction of public stock offering costs           |       |              | —     |                                |       |                                  | 23         |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 23 |   |   |   |   |   |
| Exercise of stock options                               |       |              | —     |                                |       |                                  | 36         |         |       |                | —     |       |       |                   | —     |   |   |   | 104 |   |   | 140 |   |   |   |   |   |
| Contribution to 401(k) plan                        |       |              | —     |                                |       |                                  | 25         |         |       |                | —     |       |       |                   | —     |   |   |   | 45 |   |   | 70 |   |   |   |   |   |
| Tax benefit from exercise of stock options         |       |              | —     |                                |       |                                  | 59         |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 59 |   |   |   |   |   |
| Balance at  December 31, 2006                      |       |              | $          | 106                                 |       |                                  |       | $            | 99,111     |                |       |       | $          | —                 |       |   |   | $ | 31,977 |   |   |   | $ | (6 | ) |   | $ | 131,188 |   |   |   |   |   |

 

See accompanying notes to consolidated financial statements.

F-6

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except share and per share data)**

**December 31,2006**

**Note 1—Summary ofSignificant Accounting Policies**

*Businessoverview.*   The accompanying consolidatedfinancial statements include the accounts of Axsys Technologies, Inc. andits wholly-owned subsidiaries (collectively “Axsys”, “Company”, “we”, “our” or “us”).

Axsys is a leading designer and manufacturer ofprecision optical solutions for defense, aerospace, homeland security andhigh-performance commercial applications. These sophisticated solutions aretypically found in applications that demand the finest optical surfaces,highest accuracy and tightest motion control tolerances. In addition to opticalsolutions, we distribute precision ball bearings used in a variety ofindustrial and commercial applications.

*Principlesof consolidation.**  *Theconsolidated financial statements include the results of Axsys and itswholly-owned subsidiaries. All significant inter-company balances andtransactions have been eliminated in consolidation.

*Revenuerecognition.**  *Revenueis recognized in accordance with the Securities and Exchange Commission StaffAccounting Bulletin, or SAB, No. 104. SAB No. 104 requires that fourbasic criteria must be met before revenue can be recognized: (1) persuasiveevidence of an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed and determinable; and (4) collectibilityis reasonably assured. Shipping and handling costs, such as freight tocustomers, are classified in cost of sales.

Our policy is to recognize revenues when product iseither shipped to or received by the customer based on the terms of thespecific sale. However, certain long-term contracts are accounted for under thepercentage-of-completion model. Revenues and estimated gross profit arerecognized as work is performed based on the percentage that incurred costsbear to estimated total costs. Cost estimates include direct and indirect costssuch as labor, materials and overhead. These contracts require judgmentrelative to assessing risks, estimating, and making assumptions for scheduleand technical issues. Contract changes are included when the costs can bereasonably estimated. We may receive progress payments that exceed costsincurred on these long-term contracts. Such advances are recognized as billingsin excess of costs and are included in accrued expenses and other currentliabilities on our consolidated balance sheet. When incurred costs exceedprogress payments received, the net of costs in excess of billings are includedin accounts receivable on our consolidated balance sheet.

Certain contracts are accounted for under the servicecontract model. Under these contracts, revenues are deferred and recognized ona straight-line basis over the contract period, as services are performed.

Due to the build-to-order nature of our products,except for the distribution of ball bearings, we do not offer price protectionand generally do not offer discounts. To the extent discounts are offered, theyare reflected at the time of the sale as a reduction in revenues. The price isfixed upon acceptance of the purchase order. When customer change orders occur,any pricing changes are reflected in a revised purchase order.

Provisions for estimated losses on contracts arerecognized when losses become evident. These estimates are subject to changeand could result in adjustments to contracts in progress.

F-7

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 1—Summaryof Significant Accounting Policies (Continued)**

*Cashand cash equivalents.*   Cash and cash equivalentsinclude highly liquid investments with a maturity of three months or less atthe date of purchase.

*Financialinstruments.**  *We mayuse derivative instruments, in the form of forward exchange contracts andinterest rate swap agreements, to manage certain foreign currency and interestrate exposures. We view derivative instruments as risk management tools, and wedo not use them for trading or speculative purposes. Derivatives used forhedging purposes are designated as an effective hedge of the identified riskexposure at the inception of the contract. Accordingly, changes in fair valueof the derivative contract must be highly correlated with changes in the fairvalue of the underlying hedged item at inception of the hedge and over the lifeof the hedge contract.

All derivative instruments are recorded in the balancesheet at fair value. Derivatives used to hedge forecasted cash flows associatedwith foreign currency sales and interest rate fluctuations are accounted for ascash flow hedges. Gains and losses on derivatives designated as cash flowhedges are recognized in accumulated other comprehensive income (loss) and inearnings in a manner that matches the timing of the earnings impact of thehedged transactions. The ineffective portion of all hedges, if any, isrecognized currently in earnings. At December 31, 2006, we did not haveany forward exchange contracts or interest rate swap agreements outstanding. AtDecember 31, 2005, we had one forward exchange contract outstanding with atotal gain position of $3, which was included in other current assets. We didnot have any interest rate swap agreements outstanding at December 31,2006 or 2005.

Thetable below presents the fair value of those derivative instruments at December 31:

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Forward exchange  contracts   |       |     | $          | —   |       |   |   | $ | 3 |   |   |
| Interest rate swap  agreement |       |     | —     |     |       |   | — |   |   |

 

The carrying amounts of our other financialinstruments, which include cash equivalents, accounts receivable and accountspayable approximate their fair value due to the short-term nature of suchinstruments.

*Accountsreceivable.*   Receivables consist of amountsbilled and currently due from customers, and unbilled costs and accrued profitsprimarily related to revenues on long-term contracts that have been recognizedfor accounting purposes but not yet billed to customers. Credit is extended tocustomers, typically on net 30-day terms. We do not require collateral.

*Allowancefor doubtful accounts.*   We periodically reviewthe aging of our accounts receivable over 90 days to identify potentiallyuncollectible accounts and establish reserves based on experience anddiscussion with customers. Actual write-offs could differ from our allowancefor doubtful accounts. If circumstances change (for example, higher thanexpected defaults or an unexpected materially adverse change in a customer’sability to meet its financial obligations), our estimates of recoverability ofamounts due to us, could be reduced by a material amount. Accounts receivableare written off only when all reasonable collection efforts are exhausted.

*Inventory.**  *We value our inventory at the lower of the actualcost to purchase and/or manufacture the inventory or the current estimatedmarket value of the inventory with cost generally determined using the 

F-8

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 1—Summaryof Significant Accounting Policies (Continued)**

first in, first out method.A provision for excess or obsolete inventory is recorded based upon an analysisthat considers current inventory levels, historical usage patterns and futuresales expectations.

In November 2004, the Financial Accounting StandardsBoard, or FASB, issued Statement of Financial Accounting Standards, or SFAS,No. 151, “Inventory Costs”, or SFAS 151, which clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial. SFAS 151 requires that those amounts, if abnormal, be recognized asexpenses in the period incurred. In addition, SFAS 151 requires the allocationof fixed production overheads to the cost of conversion based upon the normalcapacity of the production facilities. We adopted SFAS 151 on January 1, 2006.The adoption did not have a material impact on our earnings or financialposition.

*Property,plant and equipment.**  *Property,plant and equipment are stated at cost, less accumulated depreciation andamortization, which includes the depreciation of assets recognized undercapital leases. Depreciation is provided primarily by the straight-line methodusing estimated lives for buildings and improvements of 20 to 40 years and from3 to 8 years for machinery and equipment. Repair and maintenance costs areexpensed as incurred.

*Goodwilland other intangibles.*   Goodwill (representingthe excess of the amount paid to acquire a company over the estimated fairvalue of the net assets acquired) and intangible assets with indefinite usefullives are not amortized but instead are tested for impairment annually, or whenevents or circumstances indicate that its value may have declined. Impairmentexists when the carrying amount of goodwill exceeds its fair market value. TheCompany’s goodwill impairment test is performed by comparing the net presentvalue of projected cash flows to the carrying value of the reporting unit. TheCompany utilizes discount rates determined by management to be similar with thelevel of risk in its current business model. The Company performs the annualimpairment testing during the second quarter of each fiscal year and hasdetermined that, to date, no impairment of goodwill exists. Although no changesare expected, if the actual results of the Company are less favorable than theassumptions the Company makes regarding estimated cash flows, the Company maybe required to record an impairment charge in the future.

Definite-lived intangible assets acquired as part ofbusiness combinations are amortized over their estimated useful lives. Formaterial business combinations, amounts recognized related to purchasedintangibles are determined with the assistance of independent valuations.

*Commitmentsand contingencies.*   We are self-insured forcertain losses related to general liability, workers’ compensation and medicalclaims. Our liability represents an estimate of the ultimate cost of claimsincurred as of the balance sheet date. The estimated liability is establishedbased on an analysis of historical data and is reviewed by management on aquarterly basis to ensure that the liability is appropriate. While we believethat our estimates are reasonable based on the information currently available,if actual trends, including the severity and frequency of claims, medical costinflation or fluctuations in premiums, differ from our estimates, our resultsfrom operations could be impacted.

*Deferredincome.**  *Deferredincome primarily results from the advance billings to our customers formilestone payments for either progress billings or for material billings. Materialbillings primarily occur when customers advance us the cost of beryllium onlong lead-time orders.

F-9

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 1—Summaryof Significant Accounting Policies (Continued)**

*Warranty.*   Weprovide warranties for certain of our products. Provisions for estimatedexpenses related to product warranties are made at the time products are sold. Theseestimates are established using historical information on the nature,frequency, and average cost of warranty claims.

Thefollowing table summarizes product warranty activity:

| Balance at  January 1, 2004   |   | $     | 633    |   |
|------------------------------------|--------|-------|--------|--------|
| Provision                          |   | 360   |   |
| Payments                           |   | (279  | )      |
| Reserve of  acquired subsidiary    |   | 36    |   |
| Balance at  December 31, 2004 |   | 750   |   |
| Provision                          |   | 468   |   |
| Payments                           |   | (479  | )      |
| Reserve of  acquired subsidiary    |   | 403   |   |
| Balance at  December 31, 2005 |   | 1,142 |   |
| Provision                          |   | 362   |   |
| Payments                           |   | (606  | )      |
| Balance at  December 31, 2006 |   | $     | 898    |   |

 

*Losscontract reserves.**  *Generally,our customer contracts are completed within one year of receiving the order. However,occasionally, longer lead-time orders are received and we monitor thesecontracts periodically to determine if our actual costs are comparable to ourcost estimates used at the time of order acceptance. If we determine that ouractual costs are exceeding our original estimates, we will record a losscontract reserve. Currently, one contract is covered by a loss contractreserve. We accrued for this contract based on the contract price and thecurrent cost structure, including estimated cost increases.

*Environmentalcontingencies.**  *We arecurrently involved in three environmental remediation projects. We accrue forenvironmental contingencies when (1) responsibility for cleanup isdetermined and (2) costs are probable and can be reasonably estimated. Whencosts are not probable or cannot be reasonably estimated, no accrual is made. Wehave accrued our estimate of the costs for the resolution of the open claims. Theseestimates have been developed in consultation with outside environmentalconsultants handling these matters and are based upon an analysis of theanticipated remediation plans. We do not anticipate these projects will have amaterial adverse effect on our consolidated financial position. It is possible,however, that future results of operations could be materially affected bychanges in our assumptions.

*Research,development and engineering.**  *Significantcosts are incurred each year in connection with research and developmentprograms and administrative engineering costs, or R&D. Such costs areincluded in operating expenses as incurred. In situations where the customerreimburses the cost of the R&D effort, the revenue generated is recognizedas sales and the expense is included in cost of sales. Research and developmentexpenses, exclusive of engineering costs, were $2,987 in 2006, $2,730 in 2005and $1,571 in 2004.

F-10

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 1—Summaryof Significant Accounting Policies (Continued)**

*Share-basedcompensation.**  *Duringthe first quarter of 2006, Axsys adopted Statement No. 123(R), “ShareBased Payment”, or SFAS 123(R). Prior to 2006, we accounted for stock awardsunder the recognition and measurement principles of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees”, or APB 25, andrelated interpretations. Prior to 2006, generally no compensation expense wasrecognized for stock options granted to employees because all stock optionsgranted generally had exercise prices equal to the market price of theunderlying common stock on the date of the grant. However, during 2004, wemodified the stock option grants of a former officer upon his termination fromAxsys, which resulted in compensation expense of $242.

SFAS 123(R) requires all share-based payments,including grants of stock options, to be recognized in the ConsolidatedStatement of Operations as an operating expense, based on their fair values onthe grant date, over the requisite service period. We elected to adopt SFAS 123(R) underthe modified-prospective transition method. Prior period stock option financialinformation was valued using the Black-Scholes-Merton option pricing model.Axsys was not required to restate prior periods. Under this transition method,share-based compensation expense for the year ended December 31, 2006includes:

(a) Compensation expense for all stock optionawards granted prior to, but not vested as of, December 31, 2006 based onthe fair value estimated at grant date in accordance with the originalprovisions of Statement No. 123, “Accounting for Stock-Based Compensation”;

(b) Compensation expense for all stock optionawards granted subsequent to January 1, 2006, based on the fair valueestimated at grant date in accordance with SFAS 123(R); and

(c) Compensation expense for all restricted stockawards in accordance with the provisions of SFAS 123(R).

Compensation expense for share-based awards isrecognized in the Consolidated Statement of Operations in cost of sales andgeneral and administrative expenses. Total pre-tax share-based compensationexpense was $1,093 in 2006, $0 in 2005 and $242 in 2004.

We recognize compensation expense, net of an estimatedforfeiture rate, on a straight-line basis over the requisite service period ofthe award. The estimated forfeiture rate was based on historical experience. Weapplied the forfeiture rate in calculating the expense related to stock-basedcompensation for both the stock option awards granted prior to, but not vestedas of, December 31, 2005, as well as stock option awards grantedsubsequent to December 31, 2005. Per the provisions of SFAS 123(R),expense is recognized only for those awards expected to fully vest. If actualforfeitures differ from the estimates, a revision to the forfeiture rate willbe necessary.

Prior to adopting SFAS 123(R), we presented all taxbenefits resulting from the exercise of stock options as operating cash flowsin the Consolidated Statement of Cash Flows. SFAS 123(R) requires thebenefits of tax deductions in excess of recognized compensation expense to bereported as a financing cash flow. As a result of adopting SFAS 123(R), $59 ofexcess tax benefits for the year ended December 31, 2006 have beenclassified as a financing cash inflow.

*Incometaxes.**  *Weaccount for income taxes in accordance with SFAS No. 109, “Accounting forIncome Taxes”. As such, deferred income taxes are determined based on thedifferences between the financial statement and tax basis of assets andliabilities at enacted income tax rates in effect in the year in 

F-11

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 1—Summaryof Significant Accounting Policies (Continued)**

which the differences areexpected to reverse. Valuation allowances are established, when necessary, toreduce deferred income tax assets to estimated amounts expected to be realized.Realizability of net deferred income tax assets are evaluated on an ongoingbasis. We consider future taxable income, our most recent operating results andvarious income tax planning strategies in assessing the need for a valuationallowance.

In June 2006,the FASB issued Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes”, or FIN 48, which prescribes a comprehensive model for how acompany should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the company has taken or expects totake on a tax return (including a decision whether to file or not file a returnin a particular jurisdiction). Under FIN 48, the financial statements willreflect expected future tax consequences of such positions presuming the taxingauthorities’ full knowledge of the position and all relevant facts, but withoutconsidering time values. FIN 48 substantially changes the applicable accountingmodel and is likely to cause greater volatility in income statements as moreitems are recognized discretely within income tax expense. FIN 48 also revisesdisclosure requirements and introduces a prescriptive, annual tabularroll-forward of the unrecognized tax benefits. FIN 48 must be adopted no laterthan January 1, 2007. Early adoption is permitted. We are currentlyevaluating the impact of adopting FIN 48 on our consolidated financial positionand results of operations and expect to adopt FIN 48 effective January 1,2007.

*Earningsper share.**  *Basicearnings per share have been computed by dividing net income or loss by theweighted-average number of common shares outstanding. The dilutive effect ofstock options on the weighted-average number of common shares outstanding was 259,847shares for the year ended December 31, 2006, 349,371 shares for the yearended December 31, 2005 and 269,253 shares for the year ended December 31,2004.

Diluted earnings per share for 2006 and 2005 exclude244,160 and 131,538, respectively, potential common shares related to our stockcompensation plans because they were anti-dilutive. There were no anti-dilutivecommon shares related to our stock compensation plans in 2004.

*Estimatesand assumptions.*   The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ fromthose estimates.

Certain amounts inpreviously issued annual financial statements were reclassified to conform tothe 2006 presentation.

**Note 2—Acquisitions**

On May 2, 2005, Axsys acquired all of the capitalstock of Diversified Optical Products, Inc., or DiOP, a manufacturer ofhigh-end thermal camera systems and lenses, for $55,200 in cash plus $1,900 oflegal, audit and other acquisition-related costs incurred in connection withthe acquisition. Goodwill of $45,218 resulted from this acquisition.

F-12

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 2—Acquisitions (Continued)**

On April 8, 2004, weacquired all of the capital stock of Telic Optics, Inc. , or Telic, amanufacturer of infrared optics and optical assemblies. The initial purchaseprice of this acquisition, after a working capital adjustment of $15, was$14,423 with an additional earn out payment of up to $4,000 over 36 monthsfollowing the closing date based on the achievement of certain revenue goals.Of this additional earn out payment, $1,183 was earned in 2006 and will be paidout in 2007 and $2,817 was earned in 2005 and was paid in 2006. This hasresulted in a final purchase price of $18,423 at December 31, 2006.

**Note 3—Balance SheetInformation**

The details of certain balance sheet accounts are asfollows:

| ** **                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| Accounts receivable:                 |       |     |       |     |       |
| Trade receivables                    |       | $        | 21,058     |     | $          | 18,477 |   |
| Unbilled costs and accrued profits   |       | 1,047    |       | 1,211    |       |
| Gross accounts  receivable           |       | 22,105   |       | 19,688   |       |
| Less allowance for doubtful accounts |       | (784     | )          | (867     | )          |
| Accounts receivable, net             |       | $        | 21,321     |     | $          | 18,821 |   |

 

All ofthe December 31, 2006 unbilled costs and accrued profits are expected tobe billed in 2007.

| ** **        | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Inventories:      |       |     |       |     |       |
| Raw materials     |       | $        | 18,825     |     | $          | 12,638 |   |
| Work-in-process   |       | 20,258   |       | 19,138   |       |
| Finished goods    |       | 11,973   |       | 11,165   |       |
| Gross inventories |       | 51,056   |       | 42,941   |       |
| Less reserve      |       | (6,827   | )          | (5,075   | )          |
| Inventories, net  |       | $        | 44,229     |     | $          | 37,866 |   |

 

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Property, plant and  equipment:                |       |     |       |     |       |
| Land                                           |       | $        | 1,841      |     | $          | 291 |   |
| Buildings and improvements                     |       | 10,412   |       | 5,862    |       |
| Machinery and equipment                        |       | 33,974   |       | 30,266   |       |
| Property, plant  and equipment                 |       | 46,227   |       | 36,419   |       |
| Less accumulated depreciation and amortization |       | (23,367  | )          | (21,068  | )          |
| Property, plant and  equipment, net            |       | $        | 22,860     |     | $          | 15,351 |   |

 

F-13

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 3—Balance Sheet Information (Continued)**

| ** **                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|
| Accrued expenses and  other current liabilities:      |       |     |       |     |       |
| Compensation and related benefits                     |       | $        | 5,466      |     | $          | 4,245 |   |
| Income taxes                                          |       | 4,103    |       | 4,234    |       |
| Excess of billings over costs                         |       | 2,444    |       | 668      |       |
| Uninvoiced inventory receipts                         |       | 1,924    |       | 941      |       |
| Accrued acquisition costs—earn out               |       | 1,183    |       | 2,817    |       |
| Warranty                                              |       | 898      |       | 1,142    |       |
| Professional fees                                     |       | 653      |       | 975      |       |
| Other                                                 |       | 1,677    |       | 1,813    |       |
| Total accrued expenses  and other current liabilities |       | $        | 18,348     |     | $          | 16,835 |   |

 

| ** **                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Other long-term  liabilities:                |       |     |       |     |       |
| Deferred income taxes                        |       | $        | 3,670      |     | $          | 2,455 |   |
| Loss contract reserve, less current portion  |       | 922      |       | 1,219    |       |
| Defined benefit pension and health insurance |       | 568      |       | 638      |       |
| Liabilities of discontinued operations       |       | 566      |       | 363      |       |
| Workers’ compensation                   |       | 100      |       | 94       |       |
| Total other long-term  liabilities           |       | $        | 5,826      |     | $          | 4,769 |   |

 

**Note 4—Goodwill andIntangible Assets**

Goodwillincreased during 2004, 2005 and 2006 as follows:

| Balance at  January 1, 2004   |   | $      | 3,600  |   |
|------------------------------------|--------|--------|--------|--------|
| Telic acquisition                  |   | 9,413  |   |
| Balance at  December 31, 2004 |   | 13,013 |   |
| DiOP acquisition                   |   | 45,218 |   |
| Telic earn out                     |   | 2,817  |   |
| Balance at  December 31, 2005 |   | 61,048 |   |
| Telic earn out                     |   | 1,183  |   |
| Balance at  December 31, 2006 |   | $      | 62,231 |   |

 

F-14

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 4—Goodwilland Intangible Assets (Continued)**

The components ofamortizable intangible assets are as follows:

| ** **              | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Weighted-Average  Life** | ** ** |
|-------------------------|------------|---------------------------------|------------|-------------------------------|------------|-------------------------------|------------|----------------------------|------------|
| Customer  relationships |       |                            | $          | 8,000                         |       |                          |       | $                          | (810       | ) |   |   | $ | 7,190 |   |   |   | 19 years |   |   |
| Camera technology       |       |                            | 2,600      |                          |       |                          | (541       | )                          |       |   | 2,059 |   |   |   | 8 years |   |   |
| Backlog                 |       |                            | 400        |                          |       |                          | (400       | )                          |       |   | — |   |   |   | 1 year |   |   |
| Service contract        |       |                            | 200        |                          |       |                          | (65        | )                          |       |   | 135 |   |   |   | 5 years |   |   |
| Developed  software     |       |                            | 150        |                          |       |                          | (27        | )                          |       |   | 123 |   |   |   | 9 years |   |   |
| Amortizable intangibles |       |                            | $          | 11,350                        |       |                          |       | $                          | (1,843     | ) |   |   | $ | 9,507 |   |   |   | 16 years |   |   |

 

Amortizationexpense of $954 in 2006, $816 in 2005 and $73 in 2004 was included in selling,general and administrative expenses.  Estimated amortization expense for each of thefive succeeding years is as follows:

| ** **                         | ** ** | **Amount** | ** ** |
|------------------------------------|------------|------------|------------|
| Year ended  December 31, 2007 |       |       | $          | 814 |   |   |
| Year ended  December 31, 2008 |       |       | 807        |   |   |
| Year ended  December 31, 2009 |       |       | 801        |   |   |
| Year ended  December 31, 2010 |       |       | 769        |   |   |
| Year ended  December 31, 2011 |       |       | 764        |   |   |

 

**Note 5—Long-Term Debt**

***2006Financing Activities:***   During the year endedDecember 31, 2006, we borrowed and subsequently repaid $8,000 from ourrevolving credit facility. We paid a weighted-average interest rate of 6.3% onthe borrowings. As of December 31, 2006, there were no borrowings outstandingunder the revolving credit facility. However, as of December 31, 2006, $1,060of the revolving credit facility was utilized for outstanding letters ofcredit.

***2005 FinancingActivities:***   On May 2, 2005, we enteredinto a credit facility with Fleet Bank in conjunction with the acquisition ofDiOP. The credit facility included a $20,000 five-year term loan facility, orterm loan A, a $35,000 two-year term loan facility, or term loan B, and a$15,000 three-year revolving credit facility. On September 27, 2005, we prepaidthe two term loans in full and terminated the related interest rate swap. Wecontinue to maintain the revolving credit facility. Amounts borrowed under thecredit facility were secured by a lien on all of our assets and the assets ofour subsidiaries, including a pledge of the stock of all of our subsidiaries.

In conjunction with our prepayment of the principaland accrued interest on the $20,000 term loan A and the $35,000 term loan Bduring 2005, we incurred a charge of $421 for the loss on extinguishment ofdebt related to the write off of loan origination fees and $59 for the earlytermination of the related interest rate swap agreement.

F-15

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 5—Long-Term Debt (Continued)**

The $15,000 revolvingcredit facility remains available through May 2008, subject to optionalprepayment in accordance with its terms. Up to $2,000 of the revolving creditfacility may be utilized to issue letters of credit. We may elect to have anyborrowing under the revolving credit facility bear interest either at the bank’sprime rate or the LIBOR rate plus a margin of 100 to 275 basis points,depending on our consolidated funded debt-to-consolidated EBITDA ratio. We havethe option of selecting the 1-month, 2-month, 3-month or 6-monthLIBOR rate. On December 31, 2005, there were no borrowings outstandingunder the revolving credit facility. However, as of December 31, 2005,$1,007 of the revolving credit facility was utilized for outstanding letters ofcredit.

**Note 6—EnvironmentalContingencies**

We are currently involved in two environmentalremediation projects and a third site, which is in the final stage ofmonitoring. We accrue for environmental contingencies on an undiscounted basiswhen responsibility for clean up is determined and costs, including legal fees,are probable and can be reasonably estimated. We are the primary responsibleparty, or PRP, at sites located in Bedford, Ohio and St. Petersburg, Florida. Pursuantto remediation plans approved by each state’s environmental protection agency,we investigated soils and groundwater and conducted certain remedial work,including soil removal. The clean up of each site is currently in process. Wehave incurred costs of $107 in 2006 and approximately $1,799 to date related tothese sites. During 2006, we recognized a charge of $202, net of tax of $109,in discontinued operations related to future costs associated with these sites.We anticipate remediation costs for theses sites to continue through 2011,including estimated expenditures of $120 in 2007.

As of December 31, 2006, we have an accrual of$666 for future costs related to the Ohio and Florida sites. These estimateshave been developed in consultation with outside environmental and legalconsultants handling these matters and are based upon an analysis of theanticipated remediation plans. We do not anticipate these matters will have amaterial adverse effect on our consolidated financial position. It is possible,however, that future results of operations could be materially affected bychanges in our assumptions.

In addition, in 2001, wewere notified by the United States Environmental Protection Agency, or the EPA,that it considered us a PRP for the US Cap and Jacket site in Prospect,Connecticut. The EPA designated no other PRPs. The EPA informed us that it wasprepared to commence a CERCLA cost-recovery action against us if we were unableto amicably resolve the matter. On July 18, 2005, we signed a settlementagreement with the EPA, settling this matter for $175, plus accrued interestfrom this date through the date of payment. We have no further responsibilityto the EPA as it relates to the EPA’s 2001 removal action at this site. During2005, we recognized an after tax charge of $150 in discontinued operations forthe settlement costs and legal expenses associated with the settlement of thismatter.

**Note 7—Litigation**

During 2004, we settled anaction, which was filed in the Court of Chancery in the State of Delaware on May 30,1997, against us and three of our directors on behalf of a purported class ofpersons who purchased our preferred stock. The plaintiff challenged ourdecision to redeem all of our outstanding shares of the preferred stock. Theplaintiff claimed that the defendants (1) breached fiduciary duties in 

F-16

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 7—Litigation(Continued)**

settingthe redemption price too low and unfairly seeking to advantage holders ofcommon stock and (2) breached contractual duties as set forth in theCertificate of Designation governing the preferred stock, as well as an impliedcovenant of good faith and fair dealing. In 2004, we paid $201 to settle thisclaim and reflected the charge as a reduction to paid-in-capital in 2003. Duringthe first quarter of 2005, the settlement fund was closed and $76 of unpaidclaims was returned to us. The cash received is reflected as an increase topaid-in-capital in 2005.

**Note 8—Shareholders’Equity**

*PublicStock Offering:**  *On September 27,2005, Axsys issued and sold 3,450,000 shares of common stock at the publicoffering price of $18.00 per share. Wereceived net proceeds of $57,620 from the offering after payment ofunderwriting discounts and commissions.

*StockRepurchase:**  *In May 2004, our Board ofDirectors authorized the repurchase, from time to time, on the open market orotherwise, of up to 200,000 shares of the Axsys common stock at prevailingmarket prices or at negotiated prices. We plan to use the repurchased sharesfor general corporate purposes, including the satisfaction of commitments underour employee benefit plans and the exercise of stock option grants. As of December 31,2006, we repurchased 77 shares under this authorization.

*StockSplit:**  *TheBoard of Directors declared, on June 1, 2004, a 3:2 stock split to beeffected as a stock dividend payable on June 30, 2004 to stockholders ofrecord on June 15, 2004. Stockholders received a dividend of oneadditional share of Axsys $0.01 par value common stock for every two sharesowned on the record date. Fractional shares were not issued; rather cashpayments were made to shareholders in lieu of fractional shares on June 30,2004. The cash paid for fractional shares was de-minimus.****Inconjunction with the stock split, we issued an additional 2,395,578 sharesresulting in a total of 7,186,734 issued shares of Axsys $0.01 par value stockon June 30, 2004. We reclassified an amount equal to the par value of thenumber of shares issued to common stock from retained earnings. All shareinformation, including the basic and diluted weighted-average number of sharesand net income per share information, for all reporting periods has beenrestated retroactively to reflect the effects of the stock split.

*Paid inCapital:**  *During2004, we recognized $242 of compensation expense related to the modification ofcertain existing stock options, pursuant to the terms of a severancearrangement.

*TreasuryStock:**  *Weuse treasury stock shares for general corporate purposes, including thesatisfaction of commitments under the employee benefit plans and the exerciseof stock options. During 2006, we received 12,444 shares of Axsys common stockas payment in lieu of cash for the exercise of incentive stock options.

F-17

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 8—Shareholders’Equity (Continued)**

Changes in treasury stockwere as follows:

| **Number of shares**        | ** ** | ** ** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Balance at  December 31, 2003    |       | 199,030    |       |       | $          | 1,235      |       |   |
| Exercise of stock  options, net       |       | (64,108    | )          |       | (322       | )          |       |
| Contribution to  the 401(k) plan |       | (4,718     | )          |       | (30        | )          |       |
| Repurchase of  stock                  |       | 12         |       |       | —     |       |       |
| Balance at  December 31, 2004    |       | 130,216    |       |       | 883        |       |       |
| Exercise of stock options, net        |       | (107,878   | )          |       | (704       | )          |       |
| Contribution to  the 401(k) plan |       | (3,464     | )          |       | (25        | )          |       |
| Repurchase of  stock                  |       | 33         |       |       | 1          |       |       |
| Balance at  December 31, 2005    |       | 18,907     |       |       | 155        |       |       |
| Exercise of stock options, net        |       | (14,106    | )          |       | (104       | )          |       |
| Contribution to  the 401(k) plan |       | (4,261     | )          |       | (45        | )          |       |
| Repurchase of  stock                  |       | 32         |       |       | —     |       |       |
| Balance at  December 31, 2006    |       | 572        |       |       | $          | 6          |       |   |

 

***Common Stock:*****  **Shares of common stock authorized and issued were10,643,934 at the end of 2006 and 10,636,734 at the end of 2005. Changes incommon stock were as follows:

| Balance at  December 31, 2004 |   | 7,186,734  |   |
|------------------------------------|--------|------------|--------|
| Stock offering in 2005             |   | 3,450,000  |   |
| Balance at  December 31, 2005 |   | 10,636,734 |   |
| Exercise of stock options          |   | 7,200      |   |
| Balance at  December 31, 2006 |   | 10,643,934 |   |

 

**Note 9—Share-BasedCompensation**

Our Amended and Restated Long-Term Stock IncentivePlan (“Stock Incentive Plan”), as approved by our stockholders, is administeredby the Compensation Committee of the Board of Directors, which selects personseligible to receive awards and determines the number of shares subject to eachaward and the terms, conditions, performance measures and other provisions ofeach award.

Effective January 1, 2006, we adopted SFAS No. 123(R),“Share-Based Payment”, or SFAS 123(R), utilizing the modified prospectiveapproach. As a result of adopting SFAS 123(R) on January 1, 2006, ourincome before taxes, income from continuing operations, net income and basicand diluted earnings per share for the year ended December 31, 2006 were$1,093, $689, $689, $0.06 and $0.06 lower, respectively, than if we hadcontinued to account for share-based compensation under APB No. 25 for ourstock option grants.

Net cash proceeds from the exercise of stock optionswere $140 and the tax benefit realized from stock option exercises was $59 forthe year ended December 31, 2006. Common stock issued in conjunction with 

F-18

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 9—Share-BasedCompensation (Continued)**

share-based awards isissued from our treasury stock. If we do not have a sufficient number oftreasury stock shares available, new shares of common stock are issued.

Thefollowing table illustrates the effect on operating results and per shareinformation as if Axsys had accounted for share-based compensation inaccordance with SFAS 123(R) for all periods presented:

| ** **                                                                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                         | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reported net  income                                                                               |       | $                     | 10,265     |   | $ | 7,323 |   | $ | 8,664 |   |
| Add: Share-based  compensation expense included in reported net income, net of related tax  effect |       | 689                   |       | — |   | 242 |   |
| Deduct: Total  share-based employee compensation expense, net of related tax effect                |       | (689                  | )          | (736 | ) | (1,012 | ) |
| Pro forma net  income                                                                              |       | $                     | 10,265     |   | $ | 6,587 |   | $ | 7,894 |   |
| Pro forma basic earnings per share                                                                 |       | $                     | 0.97       |   | $ | 0.82 |   | $ | 1.12 |   |
| Weighted-average basic common shares outstanding                                                   |       | 10,628,647            |       | 8,006,029 |   | 7,020,184 |   |
| Pro forma diluted earnings per share                                                               |       | $                     | 0.94       |   | $ | 0.80 |   | $ | 1.11 |   |
| Weighted-average  diluted common shares outstanding                                                |       | 10,888,494            |       | 8,212,284 |   | 7,114,686 |   |

 

Weused the Black-Scholes-Merton option-pricing model to estimate the fair valueof share-based awards with the following weighted-average assumptions for theindicated periods: 

| ** **                              | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Dividend yield                          |       |                        | 0.0        | %                           |       |                        | 0.0        | % |   |   | 0.0 | % |   |
| Expected  volatility                    |       |                        | 41.2       | %                           |       |                        | 42.0       | % |   |   | 43.0 | % |   |
| Risk-free  interest rate                |       |                        | 4.6        | %                           |       |                        | 4.4        | % |   |   | 4.2 | % |   |
| Expected life of  options (in years)    |       |                        | 5.9        |                        |       |                        | 6.0        |   |   |   | 6.0 |   |   |
| Weighted-average  grant-date fair value |       |                        | $          | 7.57                        |       |                        |       | $ | 9.47 |   |   |   | $ | 5.34 |   |   |
|                                         |            |                             |            |                             |            |                             |            |  |  |  |  |  |  |  |  |  |

 

The assumptions above are based on multiple factors,including historical patterns by employees in relatively homogeneous groupswith respect to exercise and post-vesting employment termination behaviors,expected future exercising patterns for these same homogeneous groups and thevolatility of our stock price. The volatility assumption used in theBlack-Scholes-Merton pricing model uses historical changes in the market valueof Axsys common stock over a period of five years, which we believe representsthe future volatility of our common stock. The expected life represents theweighted average period of time that stock options are expected to remainoutstanding and is based on historical experience. Stock options are generallygranted with a five-year vesting schedule and a ten-year life.

F-19

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 9—Share-BasedCompensation (Continued)**

Thefollowing table presents stock option activity for the years ended December 31,2006, 2005 and 2004:

| ** **                             | ** ** | **Stock**   | ** ** | **Weighted-average**    | ** ** |
|----------------------------------------|------------|-------------|------------|-------------------------|------------|
| ** **                             | ** ** | **Options** | ** ** | **Exercise Price** | ** ** |
| Outstanding at  December 31, 2003 |       | 691,687     |       |                    | $          | 8.54 |   |   |
| Granted                                |       | 210,278     |       |                    | 11.36      |   |   |
| Forfeited/cancelled                    |       | (14,850     | )          |                    | (10.47     | ) |   |
| Exercised                              |       | (76,009     | )          |                    | (7.17      | ) |   |
| Outstanding at  December 31, 2004 |       | 811,106     |       |                    | 9.36       |   |   |
| Granted                                |       | 224,288     |       |                    | 19.51      |   |   |
| Forfeited/cancelled                    |       | (17,950     | )          |                    | (11.83     | ) |   |
| Exercised                              |       | (118,478    | )          |                    | (12.69     | ) |   |
| Outstanding at  December 31, 2005 |       | 898,966     |       |                    | 11.40      |   |   |
| Granted                                |       | 77,500      |       |                    | 16.17      |   |   |
| Forfeited/cancelled                    |       | (14,100     | )          |                    | (14.54     | ) |   |
| Exercised                              |       | (33,750     | )          |                    | (10.07     | ) |   |
| Outstanding at December 31, 2006  |       | 928,616     |       |                    | $          | 11.80 |   |   |
| Exercisable at  December 31, 2006 |       | 511,383     |       |                    | $          | 10.26 |   |   |

 

| ** **                              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**     | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** **              | ** ** | **Number of  Options** | ** ** | **Weighted-  average  Remaining Life** | ** ** | **Weighted-average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted-  average  Exercise  Price** | ** ** |
| $2.72 to $5.43                          |       |                    | 188,775    |                        |       |   | 5.4 |   |   |   | $ | 4.65 |   |   |   | 126,225 |   |   |   | $ | 4.62 |   |   |
| $5.44 to $8.15                          |       |                    | 179,335    |                        |       |   | 4.6 |   |   |   | 6.81 |   |   |   | 149,777 |   |   |   | 6.89 |   |   |
| $8.16 to $10.87                         |       |                    | 104,550    |                        |       |   | 6.8 |   |   |   | 9.92 |   |   |   | 44.325 |   |   |   | 9.84 |   |   |
| $10.88 to $13.58                        |       |                    | 64,546     |                        |       |   | 3.5 |   |   |   | 11.58 |   |   |   | 46.546 |   |   |   | 11.81 |   |   |
| $13.59 to $16.30                        |       |                    | 132,250    |                        |       |   | 8.5 |   |   |   | 15.39 |   |   |   | 22,350 |   |   |   | 14.29 |   |   |
| $16.31 to $19.02                        |       |                    | 129,872    |                        |       |   | 6.8 |   |   |   | 18.09 |   |   |   | 82,272 |   |   |   | 17.99 |   |   |
| $19.03 to $21.73                        |       |                    | 98,038     |                        |       |   | 8.2 |   |   |   | 20.16 |   |   |   | 24,638 |   |   |   | 19.94 |   |   |
| $21.74 to $24.45                        |       |                    | 31,250     |                        |       |   | 3.4 |   |   |   | 22.88 |   |   |   | 15,250 |   |   |   | 23.54 |   |   |
| $2.72   to $24.45             |       |                    | 928,616    |                        |       |   | 6.2 |   |   |   | $ | 11.80 |   |   |   | 511,383 |   |   |   | $ | 10.26 |   |   |
|                                         |            |                         |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006, there was $2,149 ofunrecognized compensation cost related to share-based payments, which isexpected to be recognized over a weighted-average period of 1.7 years.  We recognize compensation expense, net of anestimated forfeiture rate, on a straight-line basis over the requisite serviceperiod of the award.

Shares available for future share-based grants toemployees and directors under existing plans were 220,902 at December 31,2006. At December 31, 2006, the aggregate intrinsic value of optionsoutstanding was $5,851, and the aggregate intrinsic value of optionsexercisable was $3,927. The total intrinsic value of 

F-20

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 9—Share-BasedCompensation (Continued)**

options exercised was $218for the year ended December 31, 2006. The total intrinsic value of optionsvested was $1,194 for the year ended December 31, 2006.

Of the total stock optionsoutstanding as of December 31, 2006, 511,383 are fully vested. Theweighted average exercise price of these options is $10.26, and the aggregateintrinsic value is $3,927 with a weighted-average contractual term of 5.4years.

*Restricted Stock*

Our Stock Incentive Plan allows for the issuance ofrestricted stock awards that may not be sold or otherwise transferred untilcertain restrictions have lapsed. The unearned share-based compensation relatedto these awards is amortized to compensation expense over the period therestrictions lapse (generally five years). The share-based expense for theseawards is determined based on the market price of our stock at the date ofgrant applied to the total numbers of shares that are anticipated to fullyvest, which is then amortized over the vesting period. Axsys first issuedrestricted stock during 2006.

Thefollowing table presents the restricted stock activity for the year ended December 31,2006: 

| ** **                          | ** ** | **Restricted** | ** ** | **Weighted-average** | ** ** |
|-------------------------------------|------------|----------------|------------|----------------------|------------|
| ** **                          | ** ** | **Stock**      | ** ** | **Fair Value**  | ** ** |
| Granted                             |       |           | 73,800     |                 |       |   | $16.23 |   |   |
| Forfeited                           |       |           | (1,680     | )                    |       |   | 16.17 |   |   |
| Vested                              |       |           | —     |                 |       |   | — |   |   |
| Unvested at  December 31, 2006 |       |           | 72,120     |                 |       |   | $ | 16.23 |   |   |
|                                     |            |                |            |                      |            |  |  |  |  |  |

 

As of December 31,2006, we had unamortized compensation expense of $936 associated with theseawards, which will be amortized over the weighted-average remaining life of 3.9years.

**Note 10—Supplemental CashFlow Information**

Supplementalcash flow information from continuing operations for the years ended December 31,2006, 2005 and 2004 is summarized as follows:

| ** **                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash  received/(paid) during the year for:     |       |     |       |     |       |     |       |
| Interest paid                                  |       | $        | (46        | )        | $          | (1,529   | )          | $ | (177 | ) |
| Interest received                              |       | 289      |       | 159      |       | 99       |       |
| Income tax payments                            |       | (5,382   | )          | (3,666   | )          | (1,558   | )          |
| Income tax refunds                             |       | 11       |       | —   |       | 566      |       |
| Non-cash  consideration from sale of equipment |       | 54       |       | —   |       | —   |       |
|                                                |            |          |            |          |            |          |            |  |  |  |

 

F-21

----

**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 11—Income Taxes**

Theincome tax provision (benefit) from continuing operations consists of:

| ** **                            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current income  taxes:                |       |     |       |     |       |     |       |
| U.S. Federal                          |       | $        | 4,534      |     | $          | 2,682    |       | $ | 1,097 |   |
| State and local                       |       | 746      |       | 471      |       | 376      |       |
|                                  |       | 5,280    |       | 3,153    |       | 1,473    |       |
| Deferred income  taxes:               |       |     |       |     |       |     |       |
| U.S. Federal                          |       | 718      |       | 1,238    |       | (1,216   | )          |
| State and local                       |       | 105      |       | 95       |       | (265     | )          |
|                                  |       | 823      |       | 1,333    |       | (1,481   | )          |
| Total income tax  provision (benefit) |       | $        | 6,103      |     | $          | 4,486    |       | $ | (8 | ) |

 

In 2004, the deferred federal and state income taxbenefit reflected the utilization of a valuation allowance.

Thedifference between the provision (benefit) for income taxes and the amountcomputed by applying the statutory federal income tax rate to Income fromContinuing Operations Before Income Taxes is as follows:

| ** **                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory  rate                              |       | 35       | %          | 35       | %          | 35       | %          |
| Computed expected  income tax provision              |       | $        | 5,770      |     | $          | 4,186    |       | $ | 3,203 |   |
| Increase (decrease) in  income taxes resulting from: |       |     |       |     |       |     |       |
| State and local taxes, net of federal tax benefit    |       | 595      |       | 410      |       | 355      |       |
| Manufacturing deduction                              |       | (128     | )          | (50      | )          | —   |       |
| Tax benefit of credits and net operating losses      |       | (100     | )          | (47      | )          | —   |       |
| Net change in valuation allowance                    |       | —   |       | —   |       | (3,236   | )          |
| Adjustment to tax accrual                            |       | —   |       | (28      | )          | (345     | )          |
| Other                                                |       | (34      | )          | 15       |       | 15       |       |
| Actual tax provision  (benefit)                      |       | $        | 6,103      |     | $          | 4,486    |       | $ | (8 | ) |

 

We reduced the previously recorded valuation allowanceof $3,236 in 2004 as deferred income tax assets were realized. As ofDecember 31, 2006 and 2005, we have determined that a valuation allowancewas not required as it is more likely than not that the net deferred income taxassets will be realized in the future.

At December 31, 2006, we had reserves totaling$4,103, primarily for various state income tax issues.

Deferred income taxes reflect the net federal andstate tax effects of temporary differences between the carrying amounts ofassets and liabilities for financial reporting purposes and the amounts usedfor income tax purposes.

F-22

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 11—Income Taxes (Continued)**

**Significantcomponents of deferred income taxes are as follows:**

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred income tax  assets:          |       |                  |       |   |   |
| Inventories                           |       | $                     | 2,172      |   | $ | 2,439 |   |
| Vacation pay accrual                  |       | 614                   |       | — |   |
| Loss contract reserve                 |       | 460                   |       | 573 |   |
| Environmental reserves                |       | 333                   |       | 224 |   |
| Allowance for doubtful accounts       |       | 308                   |       | 331 |   |
| Exit costs of discontinued operations |       | 289                   |       | 117 |   |
| Pension accruals                      |       | 267                   |       | 311 |   |
| Warranty reserves                     |       | 94                    |       | 188 |   |
| Other, net                            |       | 124                   |       | 86 |   |
| Total deferred income tax assets      |       | 4,661                 |       | 4,269 |   |
| Deferred income tax  liabilities:     |       |                  |       |   |   |
| Property, plant and equipment         |       | (1,214                | )          | (1,335 | ) |
| Intangibles                           |       | (2,456                | )          | (1,120 | ) |
| Total deferred income tax liabilities |       | (3,670                | )          | (2,455 | ) |
| Net deferred income taxes             |       | $                     | 991        |   | $ | 1,814 |   |

 

Deferredincome taxes are included in the Consolidated Balance Sheets as follows:

| ** **                                                                           | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Current deferred  income tax assets                                                  |       | $                     | 3,675      |   | $ | 3,256 |   |
| Noncurrent  deferred income tax assets, included in other assets                     |       | 986                   |       | 1,013 |   |
| Noncurrent  deferred income tax liabilities, included in other long-term liabilities |       | (3,670                | )          | (2,455 | ) |
|                                                                                 |       | $                     | 991        |   | $ | 1,814 |   |

 

**Note 12—PensionArrangements (Continued)**

As of December 31, 2006, we had one pension planfor which benefits and participation have been frozen. The plan, which has anaccrued benefit cost of $407 at December 31, 2006, is an unfunded planwith an annual payout of approximately $104 until such time as the soleparticipant becomes ineligible.

We also sponsor a 401(k) planunder which eligible employees may elect to contribute a percentage of theirearnings. We match employee contributions to this plan in amounts ranging from3% to 5% of the employees’ gross earnings. Our matching contributions were$1,234 in 2006, $1,118 in 2005 and $918 in 2004, of which a portion wasprovided in Axsys stock.

F-23

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 13—Commitments andContingencies**

Futureminimum payments under non-cancelable operating leases (exclusive of propertyexpenses and net of sublease rental income) as of December 31, 2006, areas follows:

| 2007                 |   | $     | 1,610  |   |
|----------------------|--------|-------|--------|--------|
| 2008                 |   | 1,515 |   |
| 2009                 |   | 1,479 |   |
| 2010                 |   | 452   |   |
| 2011 and  thereafter |   | 119   |   |
|                 |   | $     | 5,175  |   |

 

Rent expense under suchleases, net of sublease rental income, amounted to $1,932 in 2006, $1,849 in2005 and $1,598 in 2004. As of December 31, 2006, we were contingentlyliable for $1,060 under outstanding letters of credit. We have issued lettersof credit for certain business transactions including insurance programs and customerdeposits.

**Note 14—DiscontinuedOperations**

We recognized an after-tax charge of $202 in 2006,$150 in 2005 and $74 in 2004 related to legal and consulting expenses inconjunction with an environmental clean-up site of a discontinued operation.(See Note 6 of the consolidated financial statements.)

During 2002, Axsysdisposed of the Automation Group, which included facilities in Wilmington,Massachusetts and Pittsburgh, Pennsylvania. At the time of the sale, Axsyscontinued to be responsible for fulfilling the remaining terms of the leases. Asof December 31, 2006, we fulfilled all of our contractual obligationsrelated to these sites and we recognized an after-tax gain of $85 during 2006on the reversal of an accrual associated with the leases. In 2004, werecognized an additional accrual in conjunction with the 2002 sale of theAutomation Group. The after-tax charge of $421 represented rental expenses forthese two facilities.

Theloss from discontinued operations, net of tax, recognized in the consolidatedstatements of operations includes the following:

| ** **                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Automation Group—operating  leases                 |       | $        | 85         |     | $          | —   |       | $ | (421 | ) |
| Environmental  charges for previously divested business |       | (202     | )          | (150     | )          | (74      | )          |
| Loss from discontinued  operations                      |       | $        | (117       | )        | $          | (150     | )          | $ | (495 | ) |

 

We had cash outflows of$292 in 2006, $907 in 2005 and $140 in 2004 related to legal, consulting andlease commitment expenses for our discontinued operations.

**Note 15—Segment Data**

We are organized into two businesses: the OpticalSystems Group and the Distributed Products Group.

F-24

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 15—SegmentData (Continued)**

The Optical Systems Group designs, manufactures andsells highly precise systems, sub-subsystems and components that are typicallyused in surveillance, long-range observation, tracking and targeting andhigh-performance imaging applications. Customers include both government andcommercial organizations. Our thermal camera systems are typically used forborder surveillance, perimeter security and public safety, while sub-systemsand components are usually designed for integration into our customers’high-performance optical systems. Products can be grouped into four primaryareas: reflective optical products, infrared products, motion control productsand precision optical and mechanical structures. However, customer requirementssometimes demand an optical solution that combines products from several ofthese areas. Our defense products are often designed to be integrated intostabilized optical platforms, which are highly accurate optical positioningmechanisms. Stabilized optical platforms are essential in applications such asmilitary targeting and imaging systems. The Optical Systems Group has designand manufacturing facilities in San Diego, California, Cullman, Alabama,Rochester Hills, Michigan and Nashua, New Hampshire.

The Distributed Products Group distributes precisionball bearings, spherical plain bearings and bushings, which are acquired fromvarious domestic and international sources, to OEMs and maintenance repairorganizations, or MROs. The bearings and bushings are used in a variety ofindustrial automation and commercial markets. Additionally, the DistributedProducts Group designs, manufactures and sells mechanical-bearing subassembliesfor a variety of customers. The Distributed Products Group is comprised of theAST Bearings Division located in Montville, New Jersey, with a satellitedistribution center in Irvine, California.

F-25

----

**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 15—Segment Data (Continued)**

Thefollowing tables present financial data for each segment:

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Sales from continuing  operations:                       |       |     |       |     |       |     |       |
| Optical Systems Group                                    |       | $        | 129,928    |     | $          | 108,666  |       | $ | 78,189 |   |
| Distributed Products Group                               |       | 26,419   |       | 24,877   |       | 25,341   |       |
| Total sales                                              |       | $        | 156,347    |     | $          | 133,543  |       | $ | 103,530 |   |
| Income from  continuing operations before income taxes:  |       |     |       |     |       |     |       |
| Optical Systems Group                                    |       | $        | 20,922     |     | $          | 17,611   |       | $ | 11,821 |   |
| Distributed Products Group                               |       | 1,732    |       | 1,887    |       | 2,566    |       |
| Non-allocated expenses                                   |       | (6,169   | )          | (7,539   | )          | (5,236   | )          |
| Income from continuing operations before income  taxes   |       | $        | 16,485     |     | $          | 11,959   |       | $ | 9,151 |   |
| Capital  expenditures of continuing operations:          |       |     |       |     |       |     |       |
| Optical Systems Group                                    |       | $        | 11,032     |     | $          | 3,311    |       | $ | 4,062 |   |
| Distributed Products Group                               |       | 133      |       | 171      |       | 149      |       |
| Corporate                                                |       | 65       |       | 51       |       | 28       |       |
| Total capital expenditures                               |       | $        | 11,230     |     | $          | 3,533    |       | $ | 4,239 |   |
| Depreciation and  amortization of continuing operations: |       |     |       |     |       |     |       |
| Optical Systems Group                                    |       | $        | 3,293      |     | $          | 2,798    |       | $ | 2,251 |   |
| Distributed Products Group                               |       | 161      |       | 163      |       | 154      |       |
| Corporate                                                |       | 88       |       | 187      |       | 269      |       |
| Total depreciation                                       |       | 3,542    |       | 3,148    |       | 2,674    |       |
| Amortization of intangibles                              |       | 954      |       | 816      |       | 73       |       |
| Total depreciation and amortization                      |       | $        | 4,496      |     | $          | 3,964    |       | $ | 2,747 |   |

 

|                             | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Identifiable assets:        |       |                  |       |   |   |
| Optical Systems  Group      |       | $                     | 146,411    |   | $ | 131,853 |   |
| Distributed Products Group  |       | 14,479                |       | 12,485 |   |
| Non-allocated  assets       |       | 11,455                |       | 11,870 |   |
| Total assets                |       | $                     | 172,345    |   | $ | 156,208 |   |
| Goodwill:                   |       |                  |       |   |   |
| Optical Systems Group       |       | $                     | 60,791     |   | $ | 59,608 |   |
| Distributed  Products Group |       | 1,440                 |       | 1,440 |   |
| Total goodwill              |       | $                     | 62,231     |   | $ | 61,048 |   |

 

Included in non-allocated expenses are general corporateexpense, interest expense, and other income and expense. Identifiable assets bysegment consist of those assets that are used in the segment’s operations. Non-allocatedassets are comprised primarily of short-term investments, cash and cashequivalents, corporate assets and deferred income tax assets.

F-26

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 15—SegmentData (Continued)**

The following tablepresents the non-allocated identifiable assets:

| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Non-allocated assets:                  |       |                  |       |   |   |
| Cash and cash equivalents              |       | $                     | 6,044      |   | $ | 7,079 |   |
| Current deferred income tax assets     |       | 3,675                 |       | 3,256 |   |
| Non-current deferred income tax assets |       | 986                   |       | 1,013 |   |
| Other corporate assets                 |       | 750                   |       | 522 |   |
| Total assets                           |       | $                     | 11,455     |   | $ | 11,870 |   |

 

Thetable below presents sales from continuing operations for specific geographicregions. Substantially all of our assets are located within the United States.

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                           | 141,806    |   | $ | 118,218 |   | $ | 91,069 |   |
| Europe        |       | 9,462                                       |       | 10,026 |   | 8,672 |   |
| Other foreign |       | 5,079                                       |       | 5,299 |   | 3,789 |   |
| Total sales   |       | $                                           | 156,347    |   | $ | 133,543 |   | $ | 103,530 |   |

 

Sales to BAE Systemsrepresented 12.1% of our consolidated sales and 14.6% of sales within theOptical Systems Group in 2006. Sales toRaytheon represented 12.3% of our consolidated sales in 2005 and 18.9%in 2004. Sales to Raytheon alsorepresented 15.2% in 2005 and 25.0% in 2004 of our sales within the OpticalSystems Group. BAE Systems also represented 11.1% of our consolidated accountsreceivable balance as of December 31, 2006. As of December 31, 2005,no individual customer represented more than 10% of our accounts receivablebalance. As of December 31, 2004, Raytheon accounted for 28.9% of ouroutstanding accounts receivable.

Within our Optical Systems Group, we had aggregatesales, both military and non-military, directly to the U.S. government,including its agencies and departments, of $4,760 in 2006, $4,564 in 2005 and$2,367 in 2004. In addition, sales of $89,568 in 2006, $75,118 in 2005 and$47,574 in 2004 were derived from subcontracts with U.S. government contractors.The majority of these contracts are subject to termination at the convenienceof the U.S. government, and certain contracts are also subject to renegotiation.Currently, we are not aware of any proposed termination or renegotiation ofsuch contracts that would have a material adverse effect on our business.

The raw materials and components that we purchase aregenerally available from multiple suppliers. However, beryllium, a material weuse extensively within our Optical Systems Group, is only available from BrushWellman, Inc., the sole U.S. supplier. Historically, we have had anexcellent relationship with Brush Wellman and have not encountered problems inobtaining our supply requirements. However, the partial or complete loss ofBrush Wellman as a supplier of beryllium, or production shortfalls orinterruptions that otherwise impair the supply of beryllium, would have amaterial adverse effect on our business, financial 

F-27

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 15—SegmentData (Continued)**

condition and results ofoperations. If such conditions were to occur, it is uncertain whetheralternative sources could be developed. We paid Brush Wellman $5,314 in 2006,$6,500 in 2005 and $9,660 in 2004.

In addition, within ourDistributed Products Group, we purchase a substantial amount of ball bearingsfrom two foreign suppliers. While we believe that we could obtain alternatesources of supply, any interruption in the flow of products from thesesuppliers, or significant increases in the cost of these products, could havean adverse effect on our business, financial condition and results ofoperations. We paid these two suppliers $6,463 in 2006, $5,820 in 2005 and$6,406 in 2004.

**Note 16—Facilities**

On April 26, 2006,Axsys purchased a 78,000 square foot building and 10.5 acres of land in Nashua,New Hampshire for $4,000. This facility serves as the consolidatedmanufacturing facility for our Axsys Technologies IR Systems division, formerlyoperating at two facilities in New Hampshire and Massachusetts. The relocationand the closure of the two existing facilities were completed in the fourthquarter of 2006. The total pre-tax costs associated with the relocation andfacilities closures were approximately $325, with an additional $2,500 ofcapital expenditures. These costs included equipment relocation, employeetraining and facility improvements. In addition, we recognized a $106 inexpense for the cancellation of the existing Salem facility lease.

**Note 17—Related Party**

A senior managementemployee is a major partner in KFN Realty, Inc., the previous landlord forour manufacturing facility in Salem, New Hampshire, which was acquired on May 2,2005. The current lease expired in December 2006. The aggregate rent paid,including real estate taxes, to the related party amounted to $120 from thedate of acquisition through November 26, 2005. KFN Realty sold thebuilding to an unrelated party in November 2005.

**Note 18—Selected QuarterlyFinancial Data (Unaudited)**

Selectedquarterly financial data for the years ended December 31, 2006 and 2005 issummarized as follows (in thousands, except per share data):

| ** **                                                  | ** ** | **Quarters Ended (Unaudited) :** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Statement of Operations Data:**            | ** ** | **April 1,  2006**                         | ** ** | **July 1,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| Sales                                                       |       | $                                               | 37,458     |   | $ | 38,505 |   |   | $ | 39,775 |   |   |   | $ | 40,609 |   |   |
| Gross profit                                                |       | 11,672                                          |       | 12,303 |   |   | 12,473 |   |   |   | 12,451 |   |   |
| Income from  continuing operations                          |       | 2,390                                           |       | 2,593 |   |   | 2,694 |   |   |   | 2,705 |   |   |
| Net income                                                  |       | 2,390                                           |       | 2,613 |   |   | 2,694 |   |   |   | 2,568 |   |   |
| Diluted net  income per share from continuing operations(1) |       | $                                               | 0.22       |   | $ | 0.24 |   |   | $ | 0.25 |   |   |   | $ | 0.24 |   |   |
| Diluted weighted-average  common shares outstanding         |       | 10,878                                          |       | 10,924 |   |   | 10,883 |   |   |   | 10,923 |   |   |

 

F-28

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Dollars in thousands, except share and per share data)**

**Note 18—SelectedQuarterly Financial Data (Unaudited) (Continued)**

| ** **                                                  | ** ** | **Quarters Ended (Unaudited) :** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------|------------|
| **Statement of Operations Data:**            | ** ** | **April 2,  2005**                         | ** ** | **July 2,  2005** | ** ** | **October 1,  2005(2)** | ** ** | **December 31,  2005** | ** ** |
| Sales                                                       |       | $                                               | 28,648     |   | $ | 33,384 |   |   | $ | 35,571 |   |   |   | $ | 35,940 |   |   |
| Gross profit                                                |       | 8,456                                           |       | 10,334 |   |   | 11,202 |   |   |   | 11,654 |   |   |
| Income from  continuing operations                          |       | 1,607                                           |       | 1,702 |   |   | 1,650 |   |   |   | 2,514 |   |   |
| Net income                                                  |       | 1,607                                           |       | 1,552 |   |   | 1,650 |   |   |   | 2,514 |   |   |
| Diluted net  income per share from continuing operations(1) |       | $                                               | 0.22       |   | $ | 0.23 |   |   | $ | 0.22 |   |   |   | $ | 0.23 |   |   |
| Diluted weighted-average  common shares outstanding         |       | 7,450                                           |       | 7,476 |   |   | 7,632 |   |   |   | 10,949 |   |   |

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(1)          Diluted net income pershare is computed independently for each of the quarters presented. Therefore,the sum of the quarterly amounts may not necessarily equal the total for theyear.

(2)          Inconjunction with our prepayment of the principal and accrued interest on ourformer credit facility, we incurred a charge of $421 for the loss onextinguishment of debt related to the write-off of loan origination fees and$59 for the early termination of the related interest rate swap agreement inthe third quarter of 2005.

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**AXSYS TECHNOLOGIES, INC.**

**SCHEDULE II**

**VALUATIONAND QUALIFYING ACCOUNTS**
| COL. A                         | ** **         | **COL.B**  | ** ** | **COL. C**                              | ** ** | **COL. D**                               | ** ** | **COL. E**                      | ** ** | **COL. F** | ** ** |
|-------------------------------------|--------------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| ** **                          | ** **         | ** ** | ** ** | **Additions**                                | ** ** | ** **                                    | ** ** | ** **                           | ** ** |
| ** **                          | **Classification** | ** ** | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Charged to  Other  Accounts** | ** ** | **Deductions**  | ** ** | **Balance  at End  of Year** | ** ** |
| Year ended  December 31, 2006: |               |       |       |                                         |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |               |       | $          | 5,075                                        |       |                                          |       | $                                    | 1,288      |            |       |   | $ | 640 | (b) |   |   | $ | 176 |   |   | $ | 6,827 |   |
| Allowance for  Doubtful Accounts    |               |       | 867        |                                         |       |                                          | (33        | )                                    |       |            | —     |   |   |   | 52 | (a) |   | 784 |   |
|                                |               |       |       |                                         |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |
| Year ended  December 31, 2005: |               |       |       |                                         |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |               |       | $          | 4,992                                        |       |                                          |       | $                                    | 499        |            |       |   | $ | 265 | (b) |   |   | $ | 681 |   |   | $ | 5,075 |   |
| Allowance for  Doubtful Accounts    |               |       | 685        |                                         |       |                                          | 206        |                                 |       |            | 14         |   |   |   | 38 | (a) |   | 867 |   |
|                                |               |       |       |                                         |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |
| Year ended  December 31, 2004: |               |       |       |                                         |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |               |       | $          | 3,917                                        |       |                                          |       | $                                    | 1,164      |            |       |   | $ | 88 | (b) |   |   | $ | 177 |   |   | $ | 4,992 |   |
| Allowance for Doubtful  Accounts    |               |       | 653        |                                         |       |                                          | 119        |                                 |       |            | —     |   |   |   | 87 | (a) |   | 685 |   |
|                                     |                    |            |            |                                              |            |                                               |            |                                      |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Uncollectible accountswritten off, net of recoveries.

(b)          Relates to adjustmentsto cost accounting standards, which increased gross inventory as well asinventory reserve.

F-30

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**EXHIBITINDEX**
| 3.1   |   | Restated Certificate of Incorporation of Axsys  (filed as Exhibit 3(4) to Axsys’ Amendment No. 2 to  Registration Statement on Form S-1, dated October 17, 1997  (File No. 333-36027) (the “Form S-1”) and incorporated  herein by reference).                                |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2   |   | By-Laws of Axsys (filed  as Exhibit 2 to the Form 8-A dated August 8, 1991(file  No. 000-16182) and incorporated herein by reference).                                                                                                                                                                      |
| 10.1  |   | Form of Incentive  Stock Option Agreement, dated as of September 30, 1991 (filed as  Exhibit 10(17) to Axsys’ Annual Report on Form 10-K for the  fiscal year ended December 30, 1991 (File No. 000-16182)and  incorporated herein by reference).*                                           |
| 10.2  |   | Severance Protection  Agreement between Axsys and Stephen W. Bershad dated as of February 11,  1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated  May 11, 1999, for the fiscal quarter ended March 31, 1999 (File  No. 000-16182) and incorporated herein by reference).*         |
| 10.3  |   | Amendment to Axsys  Technologies, Inc. Long-Term Stock Incentive Plan (filed as  Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 (File  No. 000-16182) and incorporated herein by reference).*                                                                                                |
| 10.4  |   | Employment Agreement,  dated as of October 12, 2000, between Axsys and Stephen W. Bershad  (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K  (File No. 000-16182) and incorporated herein by reference).*                                                                                   |
| 10.5  |   | Form of  Indemnification Agreement for all Directors and Officers of Axsys (filed as  Exhibit 10(17) to the December 31, 2001 Form 10-K (File  No. 000-16182) and incorporated herein by reference).*                                                                                                  |
| 10.6  |   | Letter Agreement between  David A. Almeida and Axsys dated as of November 14, 2001 (filed as  Exhibit 10(18) to the December 31, 2001 Form 10-K (File  No. 000-16182) and incorporated herein by reference). *                                                                                         |
| 10.7  |   | Severance Protection  Agreement between Axsys and David A. Almeida dated as of May 13, 2003  (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q  (File No. 000-16182) and incorporated herein by reference).*                                                                                       |
| 10.8  |   | Severance Protection  Agreement between Axsys and Scott B. Conner dated as of December 3, 2004  (filed as Exhibit 10.9 to the December 31, 2004 Form 10-K  (File No. 000-16182) and incorporated herein by reference).*                                                                                |
| 10.9  |   | Summary of Management  Incentive Plan. (filed as Exhibit 10.10 to the December 31, 2004  Form 10-K (File No. 000-16182) and incorporated herein  by reference).*                                                                                                                                            |
| 10.10 |   | Purchase and Sale  Agreement dated February 15, 2006 (filed as Exhibit 99.1 to Axsys’  Form 8-K filed on February 16, 2006 (File No. 000-16182)  and incorporated herein by reference).                                                                                                           |
| 10.11 |   | Letter Agreement between  Stephen W. Bershad and Axsys Technologies, Inc. extending the term of  the initial period of Mr. Bershad’s Employment Agreement (filed as  Exhibit 10.1 to Axsys’ Form 8-K, filed August 8, 2006  (File No. 000-16182) and incorporated herein by reference). |
| 10.12 |   | Amended and Restated  Long-Term Stock Incentive Plan (filed as Exhibit 10.1 to Axsys’  Form 8-K, filed May 5, 2006 (File no. 000-16182) and  incorporated herein by reference).                                                                                                                             |

F-31

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| 10.13 |   | Credit Agreement, dated  May 2, 2005, by and among Axsys, its subsidiaries and Fleet National  Bank (filed as Exhibit 10.1 to Axsys’ Form 10-Q, filed  July 26, 2005 (File No. 000-16182) and incorporated herein by  reference.) |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21    |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                  |
| 23    |   | Consent of Ernst & Young  LLP                                                                                                                                                                                                                               |
| 31.1  |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002—Chief Executive Officer                                                                                                                                                      |
| 31.2  |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002—Chief Financial Officer                                                                                                                                                      |
| 32.1  |   | Certification pursuant  to 18 U.S.C. Section 1350—Chief Executive Officer                                                                                                                                                                             |
| 32.2  |   | Certification pursuant  to 18 U.S.C. Section 1350—Chief Financial Officer                                                                                                                                                                             |

 

*                    Indicatesmanagement contracts or compensatory plans or arrangements.

F-32

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