** **

**SECURITIESAND EXCHANGE COMMISSION**

** **

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

** **

**(MarkOne)**

| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                    | **ANNUAL REPORT PURSUANT TO SECTION  13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                           |   |   |   |
| **For the Fiscal Year ended December 31, 2003**                                                                                                                                                                                                                                                                                                                                                                               |                                                                                           |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                           |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                          | **OR**                                                                                         |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                           |   |   |   |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                         | **TRANSITION REPORT PURSUANT TO  SECTION  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                           |   |   |   |
| **For the transition period from                                   to                                ** |                                                                                           |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                           |   |   |   |
| **Commission File No.: 0-16182**                                                                                                                                                                                                                                                                                                                                                                                              |                                                                                           |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                               |                                                                                                |        |  |  |  |

** **

| **AXSYS  TECHNOLOGIES, INC.**                                        |
|----------------------------------------------------------------------|
| (Exact name of registrant as specified in  its charter)              |
|                                                                 |
| **Delaware**                                                         |   | **11-1962029** |
| (State or other jurisdiction of  incorporation or organization)      |   | (I.R.S. Employer  Identification Number) |
|                                                                 |   |   |
| **175 Capital Boulevard, Suite 103**                                 |   |   |
| **Rocky Hill, Connecticut**                                          |   | **06067** |
| (Address of  principal executive offices)                            |   | (Zip Code) |
|                                                                 |   |   |
| **(860)  257-0200**                                                  |   |   |
| (Registrant’s  telephone number, including area code)           |   |   |
|                                                                 |   |   |
| **Securities registered pursuant to Section  12(g) of the Act:**     |
|                                                                 |
| **Common Stock, par value $.01 per share**                           |
|                                                                 |
| **Securities registered pursuant to Section 12(b) of the Act: None** |

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item405 of Regulation S-K is not contained herein, and will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K o.

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Act). o.

 

Aggregate market value of the voting andnon-voting common equity held by non-affiliates computed by reference to theprice at which the common equity was last sold, or the average bid and askedprice of such common equity, as of the close of business June 30, 2003,$30,218,048.

 

Common Stock outstanding at March 1,2004:  4,660,983 shares.

 

**Documents Incorporated by Reference**

 
| **Document**                                                                                       |   | **Form 10-K Reference** |
|----------------------------------------------------------------------------------------------------|--------|-------------------------|
| Portion of Axsys Technologies, Inc. Notice of Annual Meeting of  Stockholders and Proxy Statement. |   | Part III, Items 10-14   |

 

----

 

**PART I**

 

**Item 1. BUSINESS**

 

Axsys Technologies, Inc. (together with oursubsidiaries, unless the context suggests otherwise, “Axsys” or “we”) is a leading designer and manufacturer of precisionopto-mechanical and electromechanical components and subassemblies used toreflect and direct laser, infrared and multi-spectral energy for use inaerospace, defense and commercial applications.  In addition, we distribute precision ball bearings used in avariety of industrial and commercial applications.  Axsys’ highly engineered components and subassemblies serve ascore technologies in numerous, vital military platforms and programs.  Within the National Missile Defensesystems of the United States, Axsys’ products are on several current missiledefense programs including EKV, THAAD, PAC-3, SBIRS-High and AirborneLaser.  Additionally, Axsys’ productsare on several next generation thermal imaging and targeting systems forplatforms such as F-16, F-18, Comanche, IBAS, M1A2 and Stryker.  Axsys also supplies critical guidance andseeker components for the Minuteman intercontinental ballistic missile and theAIM-9X Sidewinder missile.  Axsys wasincorporated in the State of New York in 1959 and reincorporated in the Stateof Delaware in 1968.  Axsys’ commonstock trades on the Nasdaq Stock Market under the symbol “AXYS”.

 

We sell our components,subassemblies and bearings to a variety of original equipment manufacturers(“OEMs”).  Our focus markets areaerospace and defense, high-performance graphic arts, medical imaging,semiconductor capital equipment, industrial automation and maintenance repairoperations (“MROs”).

 

Axsys offers a wide range ofprecision opto-mechanical and electromechanical components and subassemblies,which allow our customers to meet the needs of rigorous operating environmentssuch as the battlefield or space.  Forthe fiscal year ending December 31, 2003, approximately 58% of Axsys’ revenueswere generated in the Aerospace and Defense sector.  However, the core technologies and manufacturing techniques usedin the Aerospace and Defense industry are transferable to the semiconductor,high-performance graphic arts and medical imaging markets.

 

Within our defense business, Axsysis extremely well positioned on high-profile military platforms, with themajority of our sales in a sole source position.  Axsys’ defense businesses, precision machining, precision opticsand motion control products, are key components required for stabilized opticalplatforms (“SOP”).  The SOP is essentialto military and space targeting and imaging systems.

 

Axsys is organized into threegroups: Aerospace and Defense Group, Commercial Products Group and DistributedProducts Group.

 

The Aerospace and Defense Groupdesigns, manufactures and sells high-end components such as precision positionsensors, high-performance motors, precision metal optics, precision machinedlight-weight structures and opto-mechanical and electromechanicalsubassemblies.  Our products areprincipally oriented toward SOPs that enable our customers to improve imaging,positional performance (accuracy, resolution, speed and power) and weightrequirements in their systems. Principal markets for our products include OEMs serving the aerospaceand defense markets.  The Aerospace andDefense Group is comprised of Motion Control Products in San Diego, California,Precision Machined Products in Cullman, Alabama, and Precision Optical Productsin Rochester Hills, Michigan.

 

The Commercial Products Groupdesigns, manufactures and sells airbearing scanners, micro-positioning stages,laser auto-focus and laser-based distance measuring interferometers.  Our products are sold to OEMs who typicallyproduce equipment that utilizes lasers for imaging or inspection, enabling themto increase the accuracy and throughput of their systems.  Principal markets for our products includegraphic arts and semiconductor capital equipment manufacturers and, recently,the medical imaging market. The Commercial Products Group is located inRochester Hills, Michigan.

 

The Distributed Products Groupdistributes precision ball bearings, spherical plain bearings and bushings,acquired from various domestic and international sources, to OEMs andMROs.  The bearings and bushings areused in a variety of industrial automation and commercial markets.Additionally, the Distributed Products Group designs, manufactures and sellsmechanical-bearing subassemblies for a variety of customers.  The Distributed Products group is comprisedof the AST Bearings Division located in Montville, New Jersey and ourdistribution center in Irvine, California.

 

2

----

 

**Market Overview**

 

Axsys’ products are sold to OEMs in a variety ofmarkets that demand the precision and performance of our products andcapabilities.

 

Aerospaceand Defense

* *

*Defense Electronics:* Defense electronics represents one of the largest growth sectors in theDepartment of Defense (“DoD”) budget. The additional demand will focus on defense electronics products andservices including sensors and thermal imaging.  Axsys is involved in the continuing development of the nextgeneration forward looking infrared (“FLIR”) systems for fighter aircraft,helicopters and armored vehicles including the F-16, F-18, Apache, Comanche,MIA2, Bradley and Stryker.

 

The DoD’s 2004 budget also includes significantallocations of funds for programs that are consistent with the DoD’s emphasison network-centric warfare.  Thegovernment is focused on the development of unmanned aerial vehicles (“UAVs”)to increase endurance and capacity for longer uninterrupted surveillance.  Axsys’ technology is expected to be used toincrease the use of sensors (electro-optical and synthetic aperture radar) onUAVs.  In addition, Axsys expects toparticipate in providing heat sinks, structures, optics and opto-mechanicalsubassemblies on the next generation of defense communications and surveillancesatellites that will support the ground and air-based network-centric warfareplatforms.

 

*National Missile Defense (“NMD*”):  Restructuring the country’s defense anddeterrence capabilities to correspond to emerging threats remains a highpriority for the United States.  Thedeployment of missile defenses is an essential component of this effort. Axsysis an integral member of the contractor teams involved in the rollout of keyNMD programs from development to production, including EKV, THAAD, PAC-3,SBIRS-High and Airborne Laser.

 

*Homeland Security*: Since September 11, 2001, government officials have worked to puttogether a plan that prevents terrorist attacks within the United States,reduces America’s vulnerability to terrorism, minimizes damage, and helpscitizens to recover from attacks.  Atthe forefront of the homeland security initiative is the detection ofbiological and chemical agents.  Thefederal government is taking steps to improve the nation’s ability to protectagainst the threat of bio-terrorism. The 2003 budget proposes to spend $5.9 billion to defend againstbiological terrorism, an increase of $4.5 billion, or 319%, over the 2002level. Axsys is strategically positioned on several contracts to developtelescope systems for measuring biological agents in the air.  In addition, Axsys provides components usedon infrared countermeasures flown by U.S. military aircraft to defeatheat-seeking missiles.  Axsys expects tobenefit from any legislation that would require over 6,000 commercial aircraftflown by U.S. carriers to be equipped with similar countermeasures.

 

*Other Aerospace and Defense Growth Opportunities*:  In connection with the U.S. government’sefforts to continually enhance aging weaponry, Axsys has the opportunity to beinvolved in retrofitting the nuclear missile arsenal with advanced gasbearings.  Axsys was chosen as the U.S.Air Force’s Center of Excellence for gas bearing production.

 

*Technology Integration:*Axsys has the opportunity toprovide value-added solutions by integrating our technologies into subassembliesand sub-systems.  The integrationcapabilities would create value for the prime contractors by reducing thenumber of suppliers and collapsing the supply chain.  Management believes Axsys is strategically positioned to design,develop and manufacture these subassemblies and sub-systems for stabilizedoptical platforms.

 

CommercialProducts

* *

*Health Imaging: *Axsys has positioneditself as a key supplier to the medical imaging sector with an industry leadingairbearing scanner for use in an advanced medical imaging system.  The airbearing scanner Axsys developed hasenabled our customer to reach the highest level of design and performance ofany medical imaging systems available on the market.  Axsys has the opportunity to continue expanding our position inthe sector as the market moves to develop new systems that require the mostadvanced imaging technology.

 

*Semiconductor Capital Equipment*:  The global semiconductor wafer fabricationcapital equipment market grew from $19 billion in revenues in 1995 to a peak of$33 billion in 2000 before declining in 2002 to $16 billion.  We expect this market to grow to over $25billion in 2007, representing a five-year compound annual growth rate of 9.7%.  Axsys has the opportunity to take advantageof the recovery in the semiconductor industry with our existing products andcustomer design-ins, as well as the introduction of our new products into themarket.

 

*Graphic Arts:*Axsys pioneered the development ofairbearing laser scanners used for digital imaging of film within the graphicarts market in the early 1990’s.  Sincethat time, Axsys has maintained our market and technical dominance.  While declining advertising revenues havenegatively impacted the graphic arts market, Axsys has expanded our productoffering to

 

3

----

 

include marker engines, which increases our average selling price to acustomer over six-fold.  While Axsysexpects a moderate decline in the overall graphic arts market, it expects tomitigate this decline with the introduction of marker engines to our customerbase.

 

DistributedProducts Group

* *

*Ball Bearings:* The market for Axsys’ ball bearings distribution follows the overalleconomic trends and should benefit from the forecasted global recovery.  We project that the anticipated recoverycould return sales in the Distributed Products Group to 2000 levels by2007.  In addition, Axsys is introducingnew products, lower cost products and value-added services.

 

**Business Strategy**

 

*Leverage the vertical integration of our operations. *We are a vertically integratedsupplier of precision components and subassemblies for high-technologyapplications. We design and manufacture components and subassemblies for OEMsof aerospace guidance, thermal imaging, graphic arts, medical imaging andsemiconductor and related electronic capital equipment.  Our products are designed to increase theaccuracy and throughput of equipment produced by OEMs.  A focus of our business strategy is toutilize our vertically integrated component manufacturing experience andresources and our electro-mechanical and opto-mechanical integrationcapabilities in the design of higher-level subassemblies that employ ourmicro-positioning and precision optical technologies.

 

*E**nhance our market position throughacquisitions and strategic alliances and divestures of non-core businesses.*  We have historically expanded our marketpresence and capabilities through acquisitions.  We review and consider possible acquisitions on an ongoing basis.

 

*Focus on improving operating efficiencies*.  Our focus has been toward eliminating wastein all aspects of the organization, measured in reduced cycle time, materialcosts, scrap and rework. By implementing this process, we have reduced, andexpect to continue to reduce, our design and manufacturing lead times as wellas manufacturing costs in order to become more competitive in the marketplace.

 

*Evaluate new market and application opportunities toleverage our core capabilities.* In order to grow our sales at a ratein excess of the markets we serve, we continually evaluate new markets andapplications that can benefit from our core capabilities.  Examples include our success in developingan airbearing laser scanner for use in a medical imaging application as well asthe development of fast steering mirrors to serve space and defenseapplications.

 

**Technologies, Products, and Capabilities**

 

We utilize several key manufacturing technologiesand have developed software and systems integration capabilities that enable usto design and manufacture a wide variety of high-performance precision opticaland micro-positioning component systems. These core competencies include:

 

*Magnetics.* Axsys designs a complete line ofbrushless and brush type torque motors and servomotors that can be customizedto meet customers’ unique specifications. The direct drive motor replaces conventional servomotor-gearheadconfigurations improving the response characteristics of the unit.  Motors incorporate rare earth magnets withouter diameters ranging from 0.5” to 48” and provide peak torques up to 1,650ft-lbs.

 

The gearless DC motor drive is ideally suited forhigh acceleration 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, which is accurate to one arc-second in ahigh performance positioning system. Axsys’ DC torque motors are designed using premium materials that offerunique space and weight savings while generating maximum power output.  Limited angle torque motors do not requirecommutation electronics and have near zero cogging.

 

Axsys also manufactures exceptionally reliable,multi-speed and segmented positioning sensors, such as resolvers and inductionpotentiometers, which provide a high degree of angular accuracy and extremelyhigh resolution.  These devicestypically accompany Axsys’ motors to provide position feedback within a highperformance system.

 

Resolvers are available with transmitter,differential or receiver functions. These resolvers are specifically designedto withstand high-impact (shock) and environments containing dirt, grease, oilor other contaminants, and are available housed or

 

4

----

 

un-housed in a variety of configurations. Resolvers are either single or multi-speed (up to 64-speed), with outerdiameters ranging from 0.7” to 15”, and provide accuracies to 5 arc seconds.

 

Induction potentiometers, alsodefined as linear transmitters, provide high linearity output over a wideangular range. Induction potentiometers are available in frameless and housedconfigurations and brush and brushless designs.

 

*Precision Machining.* Axsys is a leading fabricator ofprecision machined and processed exotic and conventional materials.  These include beryllium, AlBeMet, titanium,halfnium, quartz and glass used in the defense, space and high-performancecommercial markets.  Operating within a100,000 square foot environmentally controlled manufacturing facility, Axsysprovides complete fabrication services including manual and CNC milling,turning, EDM, lapping and grinding, chemical and special processing andmechanical assembly.  Using thesetechnologies, Axsys is able to achieve tolerances virtually unmatched in theworld. Applications include precision optics, airbearings, heat sinks,structural housings and gimbals.  Ourairbearings provide high-speed precision positioning and are used in high-speedscanners for digital imaging and weapons guidance systems.  Our heat sinks are used to dissipate heat inhigh-performance avionics and satellite electronics, and our gimbals are usedin various applications, including positioning optical sensors in FLIR nightvision systems.  We also manufactureoptical substrates used internally and by our customers in a variety ofprecision metal optical applications such as weapon fire control systems andspace-borne instruments.

 

*Precision Optics.*Axsys is a leading designer andmanufacturer of custom precision metal optical components and opticalassembles.  Axsys provides completedesign, fabrication and testing of beryllium and aluminum optics ranging from singleand multi-faceted scan mirrors, plano and aspheric mirrors to complex telescopeassemblies.  Axsys has designed and/ormanufactured numerous optical products for a variety of military andastronomical applications over the past forty years.

 

Axsys specializes in the manufacture of diamond machinedaspheric metal optics that are significantly enhanced for optical figure andoptical finish by post polishing, typically while using custom engineeredinterferometric null tests.  “Bolttogether” assemblies with post polished metal aspheres are routine. Axsysproduces a variety of aspheric surfaces including conic aspheres, general caseaspheres, cylindrical aspheres and toric aspheres up to 0.80-meter aperture.Our precision optic products are used in applications where performancerequirements cannot be met with glass optics. The advantages of our optics include lighter weight, thermal stabilityand ease of mechanical interface with housing and actuation devices.  We sell our precision metal opticalcomponents for use in high speed electro-mechanical scanners, weapons firecontrol systems, FLIR night vision weapons systems and high-performancespace-borne instruments used on weather, mapping and scientific satellites.

 

*Electronics.* Axsys designs and manufactures several key electronic components for thesemiconductor capital equipment and high-end digital imaging markets includinglaser interferometers and electronic controllers and drives. Our electronicscomponents control the speed and position of electro-mechanical systems, suchas precision motors, actuators, X-Y positioning stages and laser scanners.  Laser interferometers, which are designed topermit precise linear position sensing, are sold to customers principally inthe semiconductor capital equipment market. Electronic controllers coordinatethe positioning and speed of electro-mechanical systems by interfacing withother motion control components.  Drivesprovide power to a motor based on input from the controller in order to achievea designated position or to achieve a specific speed.

 

Utilizing these core technologies, Axsys hasdeveloped an array of opto-mechanical, electro-mechanical and electro-opticalsubassemblies, which are incorporated into aerospace, defense and highperformance commercial equipment.

 

*Opto-Mechanical Subassemblies:*

 

*Ball Bearing Scanner:*Axsys’ high precision scanners aredesigned and manufactured in both open and closed loop configurations. Thesesophisticated scanners are proven to perform with precision and reliabilityunder the harshest environmental conditions. They are used in guidance andtracking, thermal imaging systems and targeting sights.

 

*Nodding Scanners:* Axsys’ closed loop nodding optical scanners represent a significantadvancement of the state-of-the-art in electro-opto-mechanical scanning systems.  These devices were developed to provideprecise limited angle scanning for thermal imaging camera systems operating indemanding aerospace and military environments. The scanners produce the “frame scan” portion of the image while adetector array produces the “line scan” in a typical thermal imaging cameraapplication. Similar scanners have been developed for 3-D imaging laser radar,or LADAR systems.

 

*Rotary Airbearing Scanners*: Axsys designs and manufacturersrotary airbearing scanners for use in high precision graphic arts and medicalimaging applications, semiconductor mask production and inspection applicationsas well as defense applications.

 

5

----

 

Airbearing scanners provide numerous advantages overmechanical bearings due to their low noise characteristics, repeatability andability to rotate at high speeds (up to 100,000 RPMs).  When combined with Axsys’ electroniccontrollers, Axsys’ airbearing scanners provide extremely high cross-scanaccuracy and extremely low jitter.

 

*Fast Steering Mirrors:*Axsys has applied extensiveexperience designing and building opto-mechanical systems to develop faststeering mirror (“FSM”) technology.  Thesingle-axis and two-axis, flexure mounted, FSM represents a compact, low cost,high performance design solution for a variety of emerging optical scanning andbeam stabilization applications.  Suchdevices may be used to correct for polygon cross scan errors, acquire and lock beamswithin free space laser systems, modulate tilt and cavity control ininterferometers, maintain beam stabilization in the presence of thermal driftand vibration, and provide general two-axis beam scanning.

 

*Electro-Mechanical Subassemblies:*

 

*Actuators: *Axsysproduces several configurations of rotary and linear actuators for the militaryand aerospace sectors.  These areavailable with either AC or DC power system options.

 

*Micro Positioning Stages:*Axsys provides precisionmicro-positioning systems.  These ultrahigh-performance systems are used in a diverse array of high-end commercialapplications such as semiconductor and flat panel process and inspectionssystems as well as laser imaging systems.

 

*Electro-Optical Subassemblies:*

 

*Marker Engines:* Axsys has leveraged our experience providing high-speed airbearingscanners, with our precision optics and electronics capabilities to produceultra-high performance flat bed marker engines.  Each engine is self-contained, pre-aligned and ready to integrateinto a customer’s system.

 

*LaserTrac AutoFocus:*Axsys’ LaserTrac AutoFocus providesreal-time autofocus of most infinite conjugate microscope systems. Thesesystems include lens objectives manufactured by leading microscopemanufacturers.

 

The LaserTrac AutoFocus has been used in highprecision manufacturing applications, including inspection systems processingread-write heads, hard disks, semiconductor wafers, and even razor blades.  The LaserTrac provides increased throughputand greatly reduced operator fatigue.

 

*Interferometer*:

 

Axsys’ laser interferometers are used primarily asfeedback elements in state-of-the-art servo motion control systems found insemiconductor test and measurement equipment.

 

The following table summarizes the componentproducts manufactured and services provided by Axsys:

 
| **Core  Manufacturing Technologies** |
|--------------------------------------|
| **Precision Machining**              |   | **Precision  Optics** |   | **Magnetics** |   | **Electronics** |   | **Subassemblies** |
| Airbearing Components                |   | Polygon Mirrors |   | AC Motors |   | AC & DC Motor Speed Controls |   | Opto-Mechanical  Scanners |
| Optical Substrates                   |   | Monogon Mirrors |   | Brush & Brushless DC |   | Custom DSP Motion |   | Airbearing Ball Bearing |
| Structural Housings                  |   | Flat Optics |   | Motors: |   | Controllers |   | Nodding Scanners |
| Gimbals and Yokes                    |   | Head Mirrors |   | Torque |   | Motor Drives |   | Fast Steering Mirrors |
| Heat Sinks                           |   | Fold Mirrors |   | Servo |   |   |   | Electro-Mechanical |
|                                 |   | Aspherics |   | Limited Angle |   |   |   | Linear Actuator |
|                                 |   | Telescopes |   | Resolvers |   |   |   | Rotary Actuator |
|                                 |   | Collimators |   | Synchros |   |   |   | Micro-Positioning Stages |
|                                 |   |   |   |   |   |   |   | Electro-Optical |
|                                 |   |   |   |   |   |   |   | Marker Engines |
|                                 |   |   |   |   |   |   |   | Laser Autofocus |
|                                 |   |   |   |   |   |   |   | Laser Interferometer |

 

6

----

 

*Precision Ball Bearings.* We distribute a wide range ofprecision ball bearings varying in size, precision tolerance, lubrication andprice. We also provide certain value-added services, such as bearingsubassemblies, bearing relubrication, clean room handling of products andengineering consultation.

 

**Competition**

 

The markets for our products are competitive.  We compete primarily on the basis of ourability to design and engineer products to meet performance specifications setby our customers.  Most of our customersare OEMs that purchase component parts or subassemblies, which they incorporateinto their end products.  Productpricing, quality, customer support, experience, reputation and financialstability are also important competitive factors.

 

There are a limited number of competitors in each ofthe markets for the various types of precision optical and positioningcomponents and subassemblies that we manufacture and sell.  Our competitors, especially those in theprecision optical product lines, typically sell a smaller number of productsthan we do and are often well entrenched. Some of these competitors have substantially greater resources than wedo.  We believe that the breadth of ourtechnologies and product offerings provides us with a competitive advantageover certain manufacturers that supply only discrete components or are notvertically integrated with enabling technologies.

 

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

 

We expect our competitors to continue to improve thedesign and performance of their products. We cannot assure you that our competitors will not develop enhancementsto, or future generations of, competitive products that will offer superiorprice or performance features or that new technology or processes will notemerge that render our products less competitive or obsolete.  Increased competitive pressure could lead tolower prices for Axsys’ products, thereby adversely affecting our business,financial condition and results of operations. We cannot assure you that wewill be able to compete successfully in the future.

 

**Customers**

 

Our customers include OEMs and end-users that designor utilize high-precision, performance and throughput equipment.  We sell our products primarily to OEMcustomers in the aerospace and defense, high-end graphic art, medical imaging,semiconductor capital equipment and industrial automation markets.

 

During 2003, sales to Raytheon Company, an aerospaceand defense systems supplier, represented 15.5% of our net sales. During 2002and 2001, we did not have a concentration of sales with any one customer.  While Raytheon, prime contractor with theU.S. Government, does constitute a significant portion of our business, we donot currently believe that this is at-risk business.

 

In 2003, 2002 and 2001, Axsys had aggregate sales,both military and non-military, directly to the U.S. Government, including ouragencies and departments, of approximately $3.4 million, $4.6 million and $3.0million, respectively. These sales accounted for approximately 4.0% of totalnet sales in 2003, 5.7% in 2002 and 3.4% in 2001.  Approximately 43.0% of net sales in 2003, 40.3% in 2002 and 31.7%in 2001 were derived from subcontracts with U.S. Government contractors.  The majority of these contracts may besubject to termination at the convenience of the U.S. Government, and certaincontracts may also be subject to renegotiation.  Currently, we are not aware of any proposed termination orrenegotiation of such contracts that would have a material adverse effect onour business.

 

Because a substantial part of our business isderived directly from contracts with the U.S. Government, or our agencies ordepartments or indirectly through subcontracts with U.S. Governmentcontractors, our results of operations could be materially affected by changesin U.S. Government expenditures for products using component parts that Axsysproduces.  However, we believe that thebroad number and diversity of our product applications and the strength of ourengineering capabilities may lessen our exposure to such risk.

 

7

----

 

**Sales, Marketing and Customer Support**

 

As of December 31, 2003, we employed 55 sales, marketingand customer support personnel throughout our organization, compared to 54employees in similar functions at the end of 2002.  We organize our sales staff by market segments with a view tobuilding on existing customer relationships and improving cross-sellingopportunities.  We utilize two OEMcomponent sales organizations, one focused on aerospace and defense customersand the other focused on high-performance commercial customers.  We have a separate distributed productssales force that is focused on selling ball bearings, bushings and assemblies,principally to commercial and industrial oriented OEMs as well as MROdistributors.

 

As of December 31, 2003, our direct salesorganization included 21 direct sales field personnel, most of whom have engineeringbackgrounds, with the remainder involved in inside sales, customer service,program management, contract administration and applications engineering.  We believe that our sales effort is enhancedby having engineering-trained sales personnel available to meet with customers’engineering personnel.  Our applicationand design engineers are also involved in the sales process.

 

We also sell our products through a significantnumber of manufacturers’ sales representatives and agents.  Although we believe that we havesatisfactory relationships with these sales representatives and agents, wecannot assure you that these relationships will continue to be satisfactory orwill continue at all.

 

**Domestic and Foreign Sales**

 

For information concerning our domestic and foreignnet sales and identifiable assets from continuing operations, see Note 14 tothe Consolidated Financial Statements.

 

**Research, Development and Engineering**

 

We seek to develop new component products andsub-systems and improve existing products in order to keep pace with theincreasing performance requirements of our customers.  We devote significant resources, a portion of which is reimbursedby customers, to development programs directed at creating new products andproduct enhancements, as well as developing new applications for existingproducts.  Because we believe that ourability to compete effectively depends in part on maintaining and enhancing ourexpertise in applying new technologies and developing new products, we dedicatesubstantial resources to engineering, research and development.  At December 31, 2003, we employed 62individuals in engineering, research and development functions.  We cannot assure you that our productdevelopment efforts will be successful in producing products that respond totechnological changes or new products introduced by others.

 

Our costs associated with research, development andengineering expenses were $2.1 million in 2003, $2.0 million in 2002, and $2.6million in 2001.  We intend to directour research and development activities toward integrating our varioustechnologies and continuing to develop sub-systems.

 

**Raw Materials Suppliers**

 

The raw materials and components that we purchaseare generally available from multiple suppliers.  However, beryllium, a material used extensively by the PrecisionMachined Products operation of our Aerospace & Defense Group, is onlyavailable from Brush Wellman, Inc. (“Brush Wellman”), 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 of Brush Wellman as a supplier ofberyllium, or production shortfalls or interruptions that otherwise impair thesupply of beryllium to Axsys, would have a material adverse effect on ourbusiness, financial condition and results of operations.  If such conditions were to occur, it isuncertain whether alternative sources could be developed.

 

In addition, we purchase a substantial amount ofball bearings that we distribute from two foreign suppliers.  While we believe that we could obtainalternate sources of supply, any interruption in the flow of products fromthese suppliers, or significant increases in the cost of these products, couldhave an adverse effect on our business, financial condition and results ofoperations.

 

8

----

 

**Patents and Trademarks**

 

We arenot dependent upon any single patent or trademark.  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 and trademarks may have value, webelieve that our future success will depend primarily on the innovation,technical expertise, manufacturing and marketing abilities of our personnel. Wecannot assure you as to the degree of protection offered by our patents. Wecannot assure you that we will be able to maintain the confidentiality of ourtrade secrets or that our non-disclosure agreements will provide meaningfulprotection of our trade secrets, know-how or other proprietary information inthe event of any unauthorized use, misappropriation or other disclosure.

 

Competitorsin the United States and foreign countries, many of which have substantiallygreater resources, may have applied for or obtained, or may in the future applyfor and obtain, patents that will prevent, limit or interfere with our abilityto make and sell some of our products. Although we believe that our products do not infringe on the patents orother proprietary rights of third parties, we cannot assure you that thirdparties will not assert infringement claims against us or that such claims willnot be successful.

 

**Environmental Regulation**

 

Webelieve that we are currently in compliance in all material respects withfederal, state and local laws and regulations governing the discharge ofmaterials into the environment or otherwise relating to the protection of theenvironment and that any non-compliance with such laws will not have a materialadverse effect upon our business, financial condition, results of operations,capital expenditures, earnings or competitive position. We cannot assure you,however, (a) that changes in federal, state or local laws, regulations orregulatory policy or the discovery of unknown problems or conditions will notin the future require substantial expenditures or (b) as to the extent of ourliabilities, if any, for past failures, if any, to comply with applicableenvironmental laws, regulations and permits, any of which also could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

Axsys has been identified as a potentially responsible party (“PRP”)under the Comprehensive Environmental Response, Compensation and Liability Act(“CERCLA”) with respect to three third-party waste disposal sites.  Although liability under CERCLA is joint andseveral, meaning that liability can exceed a PRP’s *pro rata* share of cleanupcosts, 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 ispossible, however, that our results of operations for a particular fiscalperiod could be materially affected.

 

Pursuant to a remedial plan approved by the Ohio EnvironmentalProtection Agency (“Ohio EPA”) in 1993, Axsys investigated soils andgroundwater at a site formerly owned by a division of Axsys, and has conductedcertain remedial work at this site including soil removal.  Axsys has incurred costs of $182,000 in 2003and approximately $782,000 to date.   Wereceived the approval of the Ohio EPA for an alternate closure plan related tothis site.  As of September 7, 2003,installation of the remediation system was in progress.  We anticipate that actual expenditures willbe incurred over a period of several years. As of December 31, 2003, we have accrued $280,000 for expenses relatedto this site.

 

During 1999, Axsys sold the land and building of a previouslydiscontinued Sensor Systems division in St. Petersburg, Florida.  We conducted investigations of soil andgroundwater at the former facility and received approval of the remedial actionplan from the Florida Department of Environmental Protection.  During the second quarter of 2003, weinstalled the remediation systems and have begun the clean up of the site.   In 2003, we spent $276,000 on the clean upof this facility and have incurred approximately $629,000 to date.  As of December 2003, we have accrued$436,000 for expenses related to this site.

 

On December21, 2001, Axsys received a letter from the United States EnvironmentalProtection Agency (“EPA”) notifying us that we are considered to be apotentially responsible party at a site located in Prospect, Connecticut, whichuntil 1978 was owned by a former subsidiary.  The letter also demanded payment of approximately $25,000 in pastresponse costs and unspecified future costs. Although we may be obligated under CERCLA for contributions towardsresponse costs incurred as a result of alleged releases of hazardous substancesat the site, we are still investigating our responsibilities to the site.  In addition, it is our policy to accrueenvironmental cleanup related costs when those costs are believed to beprobable and can be reasonably estimated. The quantification of environmental exposure, if any, with respect tothis site requires an assessment of many factors, including the quality ofinformation available, the assessment stage of

 

9

----

 

each investigation, preliminaryfindings and the length of time involved in remediation. As Axsys has notdetermined if any liability exists, a meaningful range of exposure cannot beestimated.  Axsys has responded to theEPA’s demand and received a response in March of 2004 requesting additionalinformation. We will reply to the EPA by April of 2004.

 

We use or generate certain hazardous substances in our manufacturingand engineering facilities.  We believethat our handling of these substances is in compliance with applicable local,state and federal environmental, safety and health regulations at each operatinglocation.  We invest in protective equipment,process controls and specialized training to minimize risks to employees,surrounding communities and the environment due to the presence and handling ofthese hazardous substances.  Weperiodically conduct employee physical examinations and workplace airmonitoring regarding these substances. When exposure problems or potential have been indicated, we implementcorrective actions.  In general,re-occurrence has been minimal or non-existent.  We do not carry environmental impairment insurance.

 

**Employees**

As of December31, 2003, we employed 553 persons, including 383 in manufacturing, 55 in sales,62 in engineering and 53 in administration. We consider our relationship with our employees to be satisfactory.  There has been no significant interruptionof operations due to labor disputes.

 

**Available Information**

 

OurInternet website is http://www.axsys.com. We make available free of charge onour website our annual reports on Form 10-K, quarterly reports onForm 10-Q, current reports on Form 8-K, reports filed pursuant toSection 16 and amendments to those reports as soon as reasonably practicableafter we electronically file or furnish such materials to the SEC. In addition,we have posted the charters for our Audit Committee, Compensation Committee, andNominating and Governance Committee on our website at www.axsys.com under theheadings “Investors.” These charters are not incorporated by reference. We willalso provide a copy of these documents to shareholders upon request.

** **

**Item 2. PROPERTIES**

 

Axsys leases the executive office, located at 175 Capital Boulevard inRocky Hill, Connecticut.    Theprincipal plants and other significant properties at February 1, 2004 are:

** **
| **Location**        |   | **Type of  Facility**      |   | **Square  Footage** |   | **Leased/Owned;  Expiration** |   |
|---------------------|--------|----------------------------|--------|---------------------|--------|-------------------------------|--------|
|                |   |                       |   |                |   |                          |   |
| Cullman, AL         |   | Manufacturing, Engineering |   | 100,000             |   | 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; 2006                  |   |
| Irvine, CA          |   | Distribution               |   | 7,800               |   | Leased; 2005                  |   |

 

We believe that our facilities are generally sufficient to meet ourcurrent and reasonably anticipated manufacturing, distribution and relatedrequirements.  We, however, periodicallyreview space requirements to ascertain whether our facilities are sufficient tomeet our needs.

 

**Item3.  LEGAL PROCEEDINGS**

 

Axsys is a defendant in various lawsuits, none of which is expected tohave a material adverse effect on Axsys’ business or financial position.  It is possible, however, that our results ofoperations for a particular fiscal period could be materially affected.

 

**Item4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

None during the quarter ended December 31, 2003.

 

10

----

 

**PART II**

 

**Item5.  MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED STOCKHOLDER MATTERS**

 

Axsys’ common stock trades on the Nasdaq National Market (“Nasdaq”) underthe Symbol “AXYS”. The following table sets forth the range of high and lowsales prices as reported by Nasdaq:

 
|                            |   | **2003** |   | **2002** |   |
|---------------------------------|--------|----------|--------|----------|--------|
|                            |   | **High** |   | **Low**  |   | **High** |   | **Low** |   |
| Fiscal Years Ended December 31: |   |     |   |     |   |   |   |   |   |
| First Quarter                   |   | $        | 8.300  |     | $      | 7.000 |   | $ | 10.000 |   | $ | 6.470 |   |
| Second Quarter                  |   | 9.800    |   | 7.260    |   | 9.000 |   | 6.890 |   |
| Third Quarter                   |   | 12.750   |   | 9.560    |   | 8.889 |   | 7.600 |   |
| Fourth Quarter                  |   | 14.730   |   | 12.070   |   | 8.030 |   | 6.600 |   |
|                                 |        |          |        |          |        |  |  |  |  |  |  |  |  |

 

On March 1, 2004, the high and low salesprice were $15.22 and $14.55, respectively.

On March 1, 2004, the approximate number ofholders of record of Axsys’ common stock was 545.

 

**DividendPolicy**

 

Axsys has applied and currently intends to continue to apply the retainedand current earnings toward the development of the business and to financegrowth.  Axsys did not pay dividends onthe common stock during the three years ended December 31, 2003, and does notanticipate paying cash dividends in the foreseeable future.

 

11

----

 

**Item6.  SELECTED FINANCIAL DATA**

 

The following selected financial data for the five fiscal years presentedbelow is derived from Axsys’ audited Consolidated Financial Statements asadjusted to reflect the discontinuance of the Fiber Automation Division andAutomation Engineering, Inc. in 2002 and Beau Interconnect in 1999.  The data should be read in conjunction withthe Consolidated Financial Statements and the related Notes thereto includedelsewhere herein.

 
|                                                                                                                                                     |   | **Years  Ended December 31,**             |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                                                                     |   | **2003**                                  |   | **2002  (1) (2)** |   | **2001  (1) (2)** |   | **2000  (2) (3) (4)** |   | **1999  (5)** |   |
|                                                                                                                                                     |   | **(In thousands, except per share data)** |   |
| **Statement  of Operations Data:**                                                                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Net sales                                                                                                                                                |   | $                                         | 85,109 |   | $ | 79,586 |   | $ | 86,131 |   | $ | 90,421 |   | $ | 85,418 |   |
| Gross margin                                                                                                                                             |   | 23,073                                    |   | 20,132 |   | 13,747 |   | 19,213 |   | 21,005 |   |
| (Loss) income from continuing operations  before discontinued operations and cumulative effect of change in accounting  principle                        |   | 4,998                                     |   | (3,014 | ) | (5,266 | ) | (3,932 | ) | (9,203 | ) |
| Net (loss) income                                                                                                                                        |   | 4,998                                     |   | (7,061 | ) | (7,152 | ) | 9,523 |   | (7,122 | ) |
| Basic net (loss) earnings per share from  continuing operations before discontinuing operations and cumulative effect  of change in accounting principle |   | $                                         | 1.07   |   | $ | (0.64 | ) | $ | (1.12 | ) | $ | (0.84 | ) | $ | (1.95 | ) |
| Basic (loss) earnings per share                                                                                                                          |   | $                                         | 1.07   |   | $ | (1.50 | ) | $ | (1.53 | ) | $ | 2.05 |   | $ | (1.51 | ) |
| Weighted average basic common shares  outstanding                                                                                                        |   | 4,657                                     |   | 4,692 |   | 4,688 |   | 4,657 |   | 4,715 |   |
| Diluted (loss) earnings per share from  continuing operations before discontinued operations and cumulative effect of  change in accounting principle    |   | $                                         | 1.06   |   | $ | (0.64 | ) | $ | (1.12 | ) | $ | (0.84 | ) | $ | (1.95 | ) |
| Diluted (loss) earnings per share                                                                                                                        |   | $                                         | 1.06   |   | $ | (1.50 | ) | $ | (1.53 | ) | $ | 2.05 |   | $ | (1.51 | ) |
| Weighted average diluted common shares  Outstanding                                                                                                      |   | 4,716                                     |   | 4,692 |   | 4,688 |   | 4,657 |   | 4,715 |   |

 

 
|                                                        |   | **At  December 31,** |   |
|-------------------------------------------------------------|--------|----------------------|--------|
|                                                        |   | **2003**             |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                        |   | **(in thousands)**   |   |
| **Balance  Sheet Data:**                                    |   |                 |   |   |   |   |   |   |   |   |   |
| Total assets                                                |   | 66,845               |   | 62,372 |   | 68,636 |   | 73,592 |   | 64,150 |   |
| Long-term capital lease obligations (less  current portion) |   | 568                  |   | 1,191 |   | 1,392 |   | 1,485 |   | 1,793 |   |
| Shareholders’ equity                                   |   | 43,898               |   | 39,093 |   | 46,440 |   | 53,421 |   | 43,299 |   |

 

----

(1)  For 2002 and 2001 certain engineering costs have beenre-classed from cost of goods sold to operating expenses to conform to the 2003presentation

 

(2)  In the third quarter of 2002, the Automation Group wasdivested, which included the Fiber Automation Division and AutomationEngineering, Inc., a wholly owned subsidiary. Accordingly, the Automation Group has been accounted for as discontinuedoperations and the operating results have been reported separately fromcontinuing operations for all applicable periods.  Revenues applicable to these discontinued operations were $1.2million in 2002, $3.1 million in 2001 and $1.4 million in 2000.

 

(3)  In September 2000, Axsys acquired the stock of WestlakeTechnology Corporation (“Westlake”). This acquisition was accounted for under the purchase method of accountingand, accordingly, the results of Westlake’s operations have been included inAxsys’ Consolidated Statements of Operations since the date ofacquisition.  See Note 3 to theConsolidated Financial Statements.

 

(4)  In March 2000, we sold theBeau Interconnect division (“Beau”). Accordingly, Beau has been accounted for as a discontinued operation andthe related net assets and operating results have been reported separately fromcontinuing operations in all years presented. Revenues applicable to this discontinued operation were $846,000 during2000 and

 

12

----

 

$19.3 millionduring 1999.  The net assets of Beau atDecember 31, 1999 have been included in current assets.  All prior periods have been restated to reflectthe divestiture.

 

(5)  Includes the effects of a pre-tax special charge of$784,000 and an impairment of assets charge of $8,993,000 in 1999.

 

**Item 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

The followingtables set forth selected financial data on a consolidated basis (inthousands):

 
|                                                          |   | **Years  Ended December 31,** |   |
|---------------------------------------------------------------|--------|-------------------------------|--------|
|                                                          |   | **2003**                      |   | **2002** |   | **2001** |   |
| Sales                                                         |   | $                             | 85,109 |   | $ | 79,586 |   | $ | 86,131 |   |
| Cost of sales                                                 |   | 62,036                        |   | 59,454 |   | 72,384 |   |
| Gross margin                                                  |   | 23,073                        |   | 20,132 |   | 13,747 |   |
| Selling, general and administrative  expenses                 |   | 15,986                        |   | 16,262 |   | 18,497 |   |
| Research, development and engineering  expenses               |   | 2,059                         |   | 2,049 |   | 2,608 |   |
| Restructuring and special charges                             |   | —                        |   | 1,854 |   | 1,360 |   |
|                                                          |   |                          |   |   |   |   |   |
| Operating income (loss)                                       |   | 5,028                         |   | (33 | ) | (8,718 | ) |
| Interest expense                                              |   | (172                          | )      | (212 | ) | (199 | ) |
| Interest income                                               |   | 115                           |   | 190 |   | 352 |   |
| Other income                                                  |   | 263                           |   | 10 |   | 207 |   |
| Income (loss) from continuing operations before  income taxes |   | 5,234                         |   | (45 | ) | (8,358 | ) |
| (Provision  for) benefit from income taxes                    |   | (236                          | )      | (2,969 | ) | 3,092 |   |
| Income (loss) from continuing operations                      |   | 4,998                         |   | (3,014 | ) | (5,266 | ) |
| Discontinued operations:                                      |   |                          |   |   |   |   |   |
| Loss from discontinued operations, net of tax  benefit        |   | —                        |   | (4,582 | ) | (1,886 | ) |
| Cumulative effect of change in accounting  principle          |   | —                        |   | 535 |   | — |   |
|                                                          |   |                          |   |   |   |   |   |
| Net income (loss)                                             |   | $                             | 4,998  |   | $ | (7,061 | ) | $ | (7,152 | ) |

 

| **Percentage of Sales by Segment:** |   | **Years Ended December 31,** |       |
|-------------------------------------|--------|------------------------------|------------|
|                                |   | **2003**                     |       | **2002** |   | **2001** |   |
| **Aerospace and Defense Group**     |   | **58.4**                     | **%**      | **57.6** | **%** | **49.8** | **%** |
| **Commercial Products Group**       |   | **15.9**                     | ** ** | **17.1** | ** ** | **23.5** | ** ** |
| **Distributed Products Group**      |   | **25.7**                     | ** ** | **25.3** | ** ** | **26.7** | ** ** |

** **

**Executive Summary**

** **

*2003 Significant events*

 

Axsys recorded bookings in excess of $92 millionending the year with record backlog of $69.0 million, of which 12% is shippablebeyond 12 months.  As we look forward,we expect continued growth in the Aerospace and Defense Group, which issupported by the segment’s backlog of $51.3 million at the end of 2003. We willcontinue to focus on the national missile defense market, homeland securityinitiatives, unmanned vehicle applications and new weapons platforms within theGroup. In our Commercial Products Group, we anticipate a recovery in thesemiconductor market and expect to expand our market position within the healthimaging market. We also believe that our fast steering mirror technology willbe disruptive to existing galvanometer technology in markets that utilizelasers for material processing.

 

During 2003,we announced that we are part of the team that has been selected by NorthropGrumman Corporation to produce the mirrors to be included in NASA’s James WebbSpace Telescope.  As a member of theteam, Axsys will produce the beryllium mirror substrates and support structuresfor an engineering development unit, 18 optical mirror segments and two spareunits and support structures that comprise the 6.5 meter primary mirror as wellas the secondary mirror. Our customer will complete the assembly of the mirrorsand support structures.

 

We expect our selection to result in a multi-year,multi-million dollar order with production delivery beginning in 2005 andcontinuing for three years.   We expectfinal contract negotiations to be completed in early 2004.

 

13

----

 

Also during 2003, we announced our agreement to sellhigh performance airbearing scanners to Eastman Kodak Company’s Health ImagingGroup. The scanners are used in laser optics assemblies of imaging systems thatprint medical images from magnetic resonance imaging, computed tomography,computed radiography, digital radiography and other medical modalities ontoradiographic film.  Kodak’s exactingspecifications required us to develop the most advanced scanner we havedesigned to date in terms of positional accuracy.  Incorporating newly developed airbearings and electronics, thescanner is about ten times more accurate than those produced for the graphicarts market.

* *

*2002 Significant events*

 

During 2002,Axsys decided to exit the automation market and focus on our otherbusinesses.  As part of this decision, wesold three of our business units, our wholly owned subsidiary Teletrac, Inc.(“Teletrac”), our wholly owned subsidiary Automation Engineering, Inc. (“AEI”)and our Fiber Automation Division (“FAD”).

 

On April 5,2002, we sold all of the stock of our Teletrac to Storage Test Solutions(“STS”) of Aurora, Colorado.  Teletrac,which was based in Santa Barbara, California, designed and manufacturedhigh-performance spin stands that are used in the test and certification ofdata storage recording heads found in magnetic disk drives. Axsys sold thestock of Teletrac in exchange for an interest-bearing $850,000 note, whichprovides for payments equal to ten percent of the revenues generated from thesales of spin stands by STS with the balance, if any, due in five years.  Because of the uncertain market conditionsfor data storage products and the terms of the note, Axsys has reserved theentire value of this note and will record any principal and interest paymentsas ordinary income during the period received. As a result of this sale, an asset impairment and cost of sale charge of$1.0 million has been included in Axsys’ Consolidated Statement ofOperations.  Under applicable accountingprinciples, Teletrac has not been treated as a discontinued operation and resultsof operations in 2001 and through the date of sale in 2002 are recorded incontinuing operations.  Revenuesapplicable to the data storage business were $6,000 in 2002 and $2.1 million in2001.

 

As a result ofthe sale, we closed our Santa Barbara manufacturing facility and relocated ourmicro-positioning stage, laser interferometer and autofocus product lines toour Imaging Systems division located in Rochester Hills, Michigan during thesecond quarter of 2002. The total pre-tax cost of $1.1 million associated withthe relocation and facility closure included a charge of $436,000 for thirtyterminated employees and a charge of $123,000 for the disposal of excessfurniture and fixtures.  A charge of$136,000 was incurred as a result of the write-off of certain inventory relatedto the termination of certain minor product lines.  Other costs of $358,000 associated with the relocation includedcosts for the equipment relocation, employee training and recruitment andfacility upgrades in Michigan, which were expensed as incurred.

 

OnOctober 28, 2002, we sold all of the stock of AEI to an investor group.  AEI designed and manufactured flexibleautomation systems for the photonics market.  AEI has been accounted for as a discontinued operation and the relatednet assets and operating results have been reported separately from continuingoperations in all years presented. Revenues applicable to this discontinued operation were $0.9 million in2002 and $2.5 million in 2001.

 

On November 5, 2002, we sold the net assets of FADto Palomar Technologies, Inc.  FADdesigned and manufactured nano-positioning stages and fiber alignment testtools.  FAD has been accounted for as adiscontinued operation and the related net assets and operating results havebeen reported separately from continuing operations in all yearspresented.  Revenues applicable to thisdiscontinued operation were $0.4 million in 2002 and $0.6 million in 2001.

 

The following table presents the 2002 financialresults for the sold businesses and the presentation in our consolidatedstatement of financial results (in thousands):

 

|                         |   | **Teletrac, Inc.  (Data Storage  Business)** |   | **Automation Engineering,  Inc.** |   | **Fiber  Automation  Division** |   |
|------------------------------|--------|----------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
| **Continuing Operations:**   |   |                                         |   |                              |   |                            |   |
| Sales                        |   | $                                            | 6      |                              | $      | —                          |   | $ | — |   |
| Operating loss               |   | (404                                         | )      | —                            |   | —                          |   |
|                         |   |                                         |   |                              |   |                            |   |
| **Discontinued Operations:** |   |                                         |   |                              |   |                            |   |
| Loss on sale                 |   | $                                            | — |                              | $      | (1,031                          | )      | $ | (678 | ) |
| Operating loss               |   | —                                       |   | (1,389                            | )      | (1,303                          | )      |

 

14

----

 

*2001 Significant Events*

 

During thesecond quarter of 2001, we adopted a major cost reduction program (the “CostReduction Plan”), which resulted in a pretax charge to earnings ofapproximately $9.2 million, or $5.8 million after-tax.  In 2002, an additional charge of $20,000 wasaccrued for rent expense at the Manchester facility.  All cash costs have been spent through December 31, 2003.

 

Axsys closed a small manufacturingfacility in Manchester, Connecticut and consolidated the activities into theImaging Systems unit in Rochester Hills, Michigan.  We also closed a small, satellite facility in Newbury Park,California, and consolidated it into our former facility in Santa Barbara,California.  Pre-tax charges associatedwith these shutdowns were $138,000 for facility exit costs.  We reduced our workforce at five locationsby 59 people or 9% of the total workforce. We accrued $1.0 million for allseverance and outplacement costs and $250,000 to cover any legal expensesrelated to the cost reduction program.

 

We alsoreviewed our inventory and other assets. We recorded a charge of $2.9 millionto cover expected losses on two long-term defense contracts.  The earnings charge also includes anincrease in reserves for excess and obsolete inventories of approximately $4.4million.  The obsolete and excessinventory was disposed of during 2001 and 2002.  Other costs associated with the Cost Reduction Plan include thewrite-off of $293,000 in tooling and $85,000 in software costs.   The Cost Reduction Plan reduced expenses byapproximately $2.0 million in the second half of 2001, with cost reductionsreaching an annualized rate of approximately $4.3 million.  These cost savings were realized in reducedcost of sales and operating expenses as result of the closure of two facilitiesand the additional reduction in workforce.

 

During 2001,Axsys recorded the following amounts in the Consolidated Statement ofOperations and through December 31, 2003 incurred the following cash andnon-cash costs in connection with the 2001 Cost Reduction Plan (in thousands):

 
|                    |   | **Cost of  Sales** |   | **Selling,  General &   Administrative  Expense** |   | **Restructuring  Charge** |   | **Total** |   |
|-------------------------|--------|--------------------|--------|-------------------------------------------------------|--------|---------------------------|--------|-----------|--------|
| Inventory write-downs   |   | $                  | 4,425  |                                                  | $      | —                    |   | $         | — |   | $ | 4,425 |   |
| Loss contract reserves  |   | 2,943              |   | —                                                |   | —                    |   | 2,943     |   |
| Work force reductions   |   | —             |   | —                                                |   | 1,242                     |   | 1,242     |   |
| Fixed asset write-downs |   | 293                |   | 85                                                    |   | —                    |   | 378       |   |
| Facilities              |   | —             |   | 20                                                    |   | 118                       |   | 138       |   |
| Other                   |   | —             |   | 102                                                   |   | —                    |   | 102       |   |
| Total                   |   | $                  | 7,661  |                                                  | $      | 207                       |   | $         | 1,360  |   | $ | 9,228 |   |
|                    |   |               |   |                                                  |   |                      |   |      |   |
| Cash                    |   | —             |   | 122                                                   |   | 1,360                     |   | 1,482     |   |
| Non-cash                |   | 7,661              |   | 85                                                    |   | —                    |   | 7,746     |   |

 

The followingtable shows the balance sheet activity for the restructuring accrual account,which includes the costs associated with the accrued restructuring charge andthe fixed asset write-downs, as of December 31, 2003 (in thousands):

 

|                         |   | **Restructuring  Accrual** |   |
|------------------------------|--------|----------------------------|--------|
| 2001 Charges                 |   | $                          | 1,738  |   |
| 2001 Activity                |   | (1,080                     | )      |
| Balance at December 31, 2001 |   | 658                        |   |
| 2002 Activity                |   | (593                       | )      |
| Balance at December 31, 2002 |   | 65                         |   |
| 2003 Activity                |   | (65                        | )      |
| Balance at December 31, 2003 |   | $                          | — |   |

 

15

----

 

**Resultsof Segment Operations**

The following tablesand discussion set forth selected financial information from continuingoperations on a segment basis for the years ended December 31, 2003, 2002, and2001.  The segment tables, shown below,exclude one-time charges, which are shown separately.

 

## ***Aerospace and Defense Segment***

*(table in thousands and as a percentage ofsales)*

* *
|          |   | **Years  Ended December 31,** |   |
|---------------|--------|-------------------------------|--------|
|          |   | **2003**                      |   | **2002** |   | **2001** |   |
| Sales         |   | $                             | 49,700 |   | 100.0 | % | $ | 45,869 |   | 100.0 | % | $ | 42,914 |   | 100.0 | % |
| Cost of sales |   | 38,718                        |   | 77.9 | % | 36,463 |   | 79.5 | % | 35,174 |   | 82.0 | % |
| Gross margin  |   | $                             | 10,982 |   | 22.1 | % | $ | 9,406 |   | 20.5 | % | $ | 7,740 |   | 18.0 | % |

 

Sales in theAerospace and Defense segment increased 8.4% for the year ended December 31,2003 compared to 2002.  In addition,sales in this segment increased 6.9% for the year ended December 31, 2002compared to 2001.  The increases inrevenue are primarily due to increased sales of our beryllium-machined andoptical products including increased sales for products utilized in the UnitedStates missile defense program and nuclear weapons.

 

Gross margin as a percent of salesfor the year ended December 31, 2003 increased compared to the prior year dueto increased volume and favorable sales mix due to shipments of higher marginoptical products and higher margin engineering prototypes.  Operational improvements, including improvedquality, material procurement and facility management contributed to improvedmargins in 2002 compared to 2001.

 

## ***Commercial Products Group Segment***

*(table in thousands and as a percentage ofsales)*

* *
|          |   | **Years  Ended December 31,** |   |
|---------------|--------|-------------------------------|--------|
|          |   | **2003**                      |   | **2002** |   | **2001** |   |
| Sales         |   | $                             | 13,546 |   | 100.0 | % | $ | 13,569 |   | 100.0 | % | $ | 20,192 |   | 100.0 | % |
| Cost of sales |   | 8,010                         |   | 59.1 | % | 8,488 |   | 62.6 | % | 13,734 |   | 68.0 | % |
| Gross margin  |   | $                             | 5,536  |   | 40.9 | % | $ | 5,081 |   | 37.4 | % | $ | 6,458 |   | 32.0 | % |

 

Sales in the Commercial Products Group segment forthe year ended December 31, 2003 were comparable to sales in 2002.  While we continue to experience a generaldownturn in the market for airbearing scanners sold into the graphic artsmarket, sales of our health-imaging scanners resulted in additional revenues of$1.3 million.

 

The 32.8% decline in sales from 2001 to 2002 was aresult of the general downturn in the graphic arts scanner market, which beganin the second quarter of 2001.  Inaddition, we sold our data storage business in Santa Barbara, California, whichreported $6,000 of sales in 2002 and $2.1 million of sales in 2001.  The revenue from the data storage sales isincluded in the above table.

 

Gross margin,as a percent of sales, increased during 2003 as compared to 2002 and 2001.  The margin improvements are generally due toproduct mix and operational improvements, including the closure of the SantaBarbara facility during the second quarter of 2002 and the closure of amanufacturing support facility in Connecticut during the second quarter of2001.  These closures resulted in annualcost savings of $1.8 million.

 

## ***Distributed Products Group Segment***

*(table in thousands and as a percentage ofsales)*

 
|          |   | **Years  Ended December 31,** |   |
|---------------|--------|-------------------------------|--------|
|          |   | **2003**                      |   | **2002** |   | **2001** |   |
| Sales         |   | $                             | 21,863 |   | 100.0 | % | $ | 20,148 |   | 100.0 | % | $ | 23,025 |   | 100.0 | % |
| Cost of sales |   | 15,308                        |   | 70.0 | % | 14,367 |   | 71.3 | % | 15,815 |   | 68.7 | % |
| Gross margin  |   | $                             | 6,555  |   | 30.0 | % | $ | 5,781 |   | 28.7 | % | $ | 7,210 |   | 31.3 | % |

 

Sales in theDistributed Products segment increased 8.5% for the year ended December 31,2003 as compared to 2002 largely as a result of new orders from consumerproduct manufacturers.  Sales in fiscalyear 2002 declined by 12.5% compared to fiscal year 2001 primarily due to theoverall weakness in the U.S. economy.

 

16

----

 

Gross margin as a percent of sales increased 1.3% in 2003 compared to2002, while 2002 margins were 2.6% lower than margins in 2001.  During 2003 and 2002, we recorded excessinventory reserves, which accounted for 1.3% of sales in 2003 and 1.1% in 2002as compared to 0.2% in 2001.  Theincrease in excess inventory reserves is primarily the result of depressedmarket conditions, which began in early 2001.  Adjusting for the inventory reserve, gross margin percentages have remainedrelatively stable, as we have reacted to the depressed market conditions bylowering overhead and reducing spending.

 

***One-time Charges included in Cost of Sales (Non-allocated)***

*(table in thousands and as a percentage ofsales)*

* *
|             |   | **Years  Ended December 31,** |   |
|------------------|--------|-------------------------------|--------|
|             |   | **2003**                      |   | **2002** |   | **2001** |   |
| One-time charges |   | —                        |   | — |   | $ | 136 |   | 0.2 | % | $ | 7,661 |   | 8.9 | % |
|                  |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

During 2002, we recorded a one-timecharge of $136,000 for the elimination of some small product lines resultingfrom the closure of the California facility. During the second quarter of 2001,in conjunction with the Cost Reduction Plan, we recorded a one-time charge of$7.6 million, which primarily included a $4.4 million charge for excess and obsolete inventory disposals and $2.9million charge for loss contract reserves for two long-term governmentcontracts.

 

## ***OperatingExpenses***

*(table in thousands and as a percentage ofsales)*

 
|                                            |   | **Years  Ended December 31,** |   |
|-------------------------------------------------|--------|-------------------------------|--------|
|                                            |   | **2003**                      |   | **2002** |   | **2001** |   |
| Selling, general and administrative  expenses   |   | $                             | 15,986 |   | 18.8 | % | $ | 16,262 |   | 20.4 | % | $ | 18,497 |   | 21.5 | % |
| Research, development and engineering  expenses |   | 2,059                         |   | 2.4 | % | 2,049 |   | 2.6 | % | 2,608 |   | 3.0 | % |
| Restructuring and special charges               |   | —                        |   | — |   | 1,854 |   | 2.3 | % | 1,360 |   | 1.6 | % |

 

*Selling, general and administrative expenses*.  Selling, general and administrative expenses(“SG&A) were $16.0 million in 2003 compared to $16.3 million in 2002, a netdecrease of $276,000. During the second quarter of 2002, we recorded a one-timecharge of $372,000 associated with the closure of the Santa Barbara, Californiafacility and subsequent relocation of the product lines to our Michiganfacility.  Compared to 2001 spendinglevels, SG&A expenses were 12.1% lower in 2002.  The 2002 Santa Barbara, California facility closure resulted insavings during 2002 of $1.0 million. During 2001, Axsys implemented a restructuring plan, which closed twofacilities and reduced administrative headcount by 9 employees.  The savings impact to SG&A in 2002 was$1.1 million.

 

*Research, development and engineeringexpenses*. Research, development and engineering expenses in 2003 increased $10,000compared to 2002.  As part of the 2001Cost Reduction Plan, we closed an engineering facility in Manchester,Connecticut.  This closure resulted in atermination of eight engineers with annual compensation and benefits ofapproximately $600,000.

 

*Restructuring and special charges*.  There were no restructuring and specialcharges in 2003 compared to $1.9 million in 2002 and $1.4 million in 2001.

 

During 2002, restructuring chargesincluded $286,000 for termination expenses incurred in connection with thetermination of our Chief Operating Officer as a result of a segment realignmentand the subsequent disposal of the Automation Group, $1.0 million associatedwith asset write-downs and severance expenses resulting from the sale ofTeletrac and $559,000 of costs relating to the relocation of some CommercialOEM product lines from Santa Barbara, California to Rochester Hills, Michigan.

 

During 2001, in conjunction with the Cost Reduction Plan, Axsysrecorded restructuring charges of $1.4 million.  The restructuring charges were recorded for severance pay andbenefits for terminated employees and exit costs relating to the closing of twofacilities.

 

***OtherIncome and Expenses***

*Interest expense*.Interest expense was $172,000 in the year ended December 31, 2003, compared to$212,000 in 2002 and $199,000 in 2001. Interest expense is primarily forinterest payments on capital leases.  The decrease in expense in 2003 compared to 2002 is primarily a resultof lower capital lease balances.

 

*Interest income.*  Interest income was $115,000 in the yearended December 31, 2003 compared to $190,000 in 2002 and $352,000 in 2001.   The decline in interest income since 2001is a result of lower prevailing interest rates and lower average investmentbalances.   Interest income of $11,000in 2003, $39,000 in 2002 and $64,000 in 2001 from a note receivable

 

17

----

 

from the 1998 sale of SensorSystems has declined as the principal balance has been reduced.  In 2003, interest income of $10,000 wasreceived from a note receivable from Storage Test Solutions.

** **

***Otherincome and expense, net.****  *Netother income in 2003 was $263,000 compared to net other income of $10,000 in2002 and $207,000 in 2001.  We receivedincome of $232,000 in 2003, $298,000 in 2002 and $232,000 in 2001, which wasrecovered from a fully reserved note from the 1998 sale of Sensor Systems.  This note was paid in full during the fourthquarter of 2003.  During 2002, werecorded a charge of $200,000 for the disposal of fixed assets.

 

*Taxes*.  The consolidated effective tax rate was 4.5%for the year ended December 31, 2003 compared to 2.6% in 2002 and 37.0% in2001.  The effective tax rate in 2003and 2002 was primarily for state taxes. No federal tax expense was incurred as a result of the tax valuationallowance recorded in 2002.  During2002, we established a valuation allowance, which was partially offset by ananticipated capital loss carry back benefit relating to the sale of Teletrac,Inc. The effective tax rate for discontinued operations in 2002 is 37.8%.  The tax provision for continuing operationsfor 2002 was $3.0 million, primarily as a result of two events.  In accordance with the Statement ofFinancial Accounting Standards No. 109, in 2002, we established a $4.6 millionvaluation allowance against our deferred tax asset.  The tax expense recorded as a result of the valuation allowancewas partially offset by a tax benefit resulting in a permanent book and taxbasis difference on the sale of Teletrac, Inc.   As we record income in the future, we will reduce the valuationallowance and accordingly, we utilized $1.8 million of the reserve in2003.  At December 31, 2003, wecontinued to recognize a portion of our deferred tax asset as we have a prudentand feasible tax planning strategy, which we would implement before allowingany of our deferred tax benefits to expire.

 

*Discontinued operations.* During the third quarter of 2002, we decided to divest our AutomationGroup.  We completed the disposal of theGroup in the fourth quarter of 2002. During 2002, we recorded a special charge of  $1.7 million, net of taxes, which included $729,000 for the impairmentof assets and $980,000 of closing related expenses.   The loss, net of tax, from these operations included indiscontinued operations was $2.7 million in 2002 compared to $1.9 million in2001.  The remainder of the loss fromdiscontinued operations in 2002 included a $203,000 charge for an environmentalrelated expense for a previously divested operation, which was partially offsetby $24,000 of income from the reversal of unutilized reserves primarilyassociated with the sale of the Beau Interconnect division in 2000.

 

*Net income (loss)*.    We had net income of $5.0 million in 2003,a net loss of $7.1 million in 2002 and net loss of $7.2 million in 2001. During2002, we sold our Automation Group, which resulted in a net loss of $4.4million including both operating losses and a loss on the sale.  In addition, we recorded a tax provision of$2.9 million from continuing operations, which was primarily the result of theestablishment of a valuation allowance to reduce our net deferred taxassets.  In 2001, we recorded arestructuring and special charge associated with our Cost Reduction Plan of$5.8 million, net of taxes.  Inaddition, our Automation Group incurred a net loss of $1.9 million.

 

## ***Liquidity and Capital Resources***

 

Axsys funds our operations primarily from cash onhand, short-term investments, cash flow from operations and, to a limitedextent, capital lease financing.  As ofDecember 31, 2003, cash and cash equivalents totaled $5.2 million andshort-term investments totaled $7.0 million. Over the past several years, wehave maintained a high level of liquidity as evidenced by our current ratiowhich was 3.0, 2.9 and 3.5 as of December 31, 2003, 2002 and 2001,respectively.  This strategy wasnecessary as we restructured Axsys and discontinued unprofitable businesses.  With this process complete, management mayelect to reduce Axsys’ liquidity to a safe, but more competitive, level byinvesting in more profitable long-term investments and growth opportunities.

 

Net cash provided by or (used in) operations was$6.5 million, $1.8 million and ($1.8) million for the years ended December 31,2003, 2002 and 2001, respectively. In 2003, our primary sources of operatingcash were $5.0 million of net income, $2.9 million of depreciation and a $1.5million federal income tax refund. The income tax refund was partially offsetby a new $563,000 income tax receivable that was recorded in 2003.  One of our primary uses of cash wasinventory, which grew $2.7 million in 2003. The inventory growth was related to certain large programs in ourAerospace and Defense group.  The cashoutflows for inventory were almost entirely offset by a $1.1 million increasein accounts payable and a $1.4 million increase in deferred income.  The increase in deferred income was theresult of our strategy to actively negotiate progress payments into certain largedollar contracts for long-lead time products. This strategy helps us tomitigate the near-term negative cash impact of these contracts.  In 2003, we reduced accrued expenses andother liabilities and long-term liabilities by over $1.0 million.  This was primarily due to the utilization ofreserves for environmental remediation, loss contracts and restructuring.  We also used $306,000 to fund increases inaccounts receivable and other current assets. In addition, we utilized $836,000to fund obligations related to our discontinued operations.

 

18

----

 

In 2002, Axsys’ net loss of $7.1 million includedthe following non-cash items: a $4.6 million deferred tax valuation allowance,which was partially offset by a $2.7 million increase in our deferred taxasset, $2.7 million of depreciation, $751,000 of losses on capital assetdisposals and $888,000 non-cash restructuring and special charges.  We also received a $3.5 million federalincome tax refund.  The impact of therefund was partially offset by a new income tax receivable for $1.6 million,which was booked in 2002 but not received until 2003.  During 2002, we collected $2.5 million in deferred income for ourberyllium-based products, which were partially offset by a $1.5 millionincrease in inventories for these products. Trade accounts payable declined by $1.3 million largely due to thetiming of inventory receipts in the fourth quarter.   In 2002, accrued expenses and other liabilities decreased$936,000 primarily due to payments for the remediation of two environmentalsites, state taxes, and the 2001 Cost Reduction Plan.

 

During 2002, net cash provided by discontinuedoperations was $2.3 million, which was primarily an increase in accruedliabilities and an asset impairment charge taken as a result of the sale of theAutomation group. During 2002, discontinued operations, including the loss onsale, from the Automation Group generated net losses of $4.6 million.

 

In 2001, Axsys’ net loss of $7.2 million was morethan offset by depreciation and amortization of $2.9 million and non-cashrestructuring and special charges of $7.7 million.  Accounts receivables also declined $3.1 million, reflecting lowerfourth quarter sales in 2001.  Inventoryincreased by $595,000, primarily for long-lead time products in our Aerospaceand Defense Group.  This increase waspartially offset by a $434,000 increase in deferred income resulting fromprogress payments received for these products. Current income tax receivableincreased by $3.2 million, due to an anticipated significant tax refund, whichwas received in 2002, for net operating losses generated in 2001.  Trade accounts payable declined by $2.5million in response to lower production volume and reduced year-end capitalspending compared to the prior year. Net deferred income tax assets also increased $1.2 million primarilybecause our loss contract reserve is not deductible for tax purposes until itis utilized.  In addition, we spent $1.4million on our discontinued operations.

 

Net cash (used in) investing activities was ($10.0)million, ($.8) million and ($2.3) million for the years ended December 31,2003, 2002 and 2001, respectively. During 2003, we invested $7.0 million inshort-term investment securities.  Thefunds were invested in short-term investment securities in order to minimizeinterest rate risk and to allow for rapid redeployment when profitablelong-term investment or expansion opportunities are identified. In 2003, wealso invested $3.0 million in capital equipment.  In 2002, we invested $1.4 million in capital equipment, net of$905,000 of capital lease proceeds and we received $541,000 in net proceedsfrom the sale of discontinued operations. In 2001, we invested $2.3 million in capital equipment, net of $762,000in capital lease proceeds.  During thepast three years, investments in capital were made primarily to upgrade andexpand our precision machining capabilities and our test and measurementequipment in our Aerospace and Defense Group. Over the past three years, these investments have contributed to thesales and profitability growth of the Group.

 

In 2004, we anticipate increasing capitalexpenditures to approximately $3.5 to 4.0 million. While the majority will beinvested in machinery and equipment, we also plan to spend approximately $1.0million dollars to add 20,000 square feet of climate-controlled manufacturingspace to our Cullman, Alabama facility. The additional space will be needed to produce the beryllium mirrorsubstrates and support structures for an engineering development unit, 18optical mirror segments and two spare units and support structures thatcomprise the 6.5 meter primary mirror as well as the secondary mirror for theJames Webb Space Telescope (JWST).  TheJWST is a multi-year, multi-million dollar program with initial productiondeliveries beginning in 2005. We are in the process of finalizing the contractfor the JWST order and expect to break ground on the facility addition in March2004.  We also expect the final contractto include funding for the approximately $8.0 million of specialized machiningequipment that will be required to produce the mirrors.

 

Net cash (used in) financing activities was ($1.3)million, ($0.9) million and ($0.8) million for the years ended December 31,2003, 2002 and 2001, respectively. These funds were used to repay capital leases.  In 2003, we utilized $208,000 to retire five of our capitalleases with the highest interest rates before their maturity date. Theprepayment penalties on these leases had expired, which enabled us to achieve amodest interest savings.  Our remainingcapital leases contain prepayment penalties, which decline each year on theanniversary date of their funding.  Asthe penalties decline, management may decide to prepay some or all of theremaining leases.

 

As of December 31, 2003, total debt, which consistedentirely of capital leases, was $1.0 million. Total debt as a percentage oftotal capitalization (total debt and shareholders’ equity) was 2.2 percent atDecember 31, 2003 and 5.7 percent at December 31, 2002.  Given our high level of liquidity, lowleverage, positive cash flow from operations and strong relationship with ourprimary bank, management believes that, if necessary, we will be able to obtainsignificant amounts of financing on favorable terms in order to profitablyexpand the business.

 

19

----

 

Shareholder’s equity was $43.9 million, or $9.16 pershare, at December 31, 2003 compared to $39.1 million or $8.16 per share, atDecember 31, 2002.  The increase inshareholders’ equity was due primarily to net income of $5.0 million.

 

## ***Off-BalanceSheet Arrangements***

 

As part of our ongoing business, we do notparticipate in transactions that generate relationships with unconsolidatedentities or financial partnerships established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes.  As of December 31, 2003, weare not involved in any unconsolidated single-purpose entities.

 

## ***Contractsand Commitments***

 

Axsys has entered into certain contractualobligations, which will result in material cash outlays over the next severalyears.  A summary of our contractualobligations and commitments for capital leases, minimum lease paymentobligations under non-cancelable operating leases and other obligations are asfollows (in thousands):

 
|                              |   | **PAYMENTS  DUE BY PERIOD** |   |
|-----------------------------------|--------|-----------------------------|--------|
| **CONTRACTUAL CASH  OBLIGATIONS** |   | **TOTAL**                   |   | **LESS THAN  1 YEAR** |   | **1 to 3  YEARS** |   | **4 to 5  YEARS** |   | **AFTER 5  YEARS** |   |
| Capital leases                    |   | $                           | 1,057  |   | $ | 465 |   | $ | 592 |   | $ | — |   | $ | — |   |
| Operating leases                  |   | 6,688                       |   | 1,456 |   | 2,300 |   | 1,901 |   | 1,031 |   |
| Purchase obligations              |   | 402                         |   | 371 |   | 31 |   | — |   | — |   |
| Other long-term obligations       |   | 2,626                       |   | 1,201 |   | 1,094 |   | 149 |   | 182 |   |
| Total                             |   | $                           | 10,773 |   | $ | 3,493 |   | $ | 4,017 |   | $ | 2,050 |   | $ | 1,213 |   |

 

As of December 31, 2003, Axsys had operating lease commitments for all ofour facilities, with the exception of our Cullman, Alabama facility, which isowned.  In addition, our operating leasecommitments included leases on some office equipment.

 

As of December 31, 2003, Axsys has various purchase obligations, whichinclude long-distance phone service, ATM lines and other commitments.  We did not include cellular phone servicecommitments, as we determined the exposure to be minimal.

 

Included in other long-term obligations includes our commitments relatedto environmental remediation plans, building leases associated withdiscontinued operations, preferred stock litigation settlement and theliquidation of a defined benefit pension plan.

 

Axsys is involved in the various stages of investigation and cleanuprelated to environmental remediation matters at a number of sites.  The ultimate cost of site cleanup isdifficult to predict given the uncertainties regarding the extent of cleanup, theinterpretation of applicable laws and regulations and alternative cleanupmethods.  As of December 31, 2003, Axsysdetermined that it was probable that it would incur approximately $772,000 ofremedial costs, of which $406,000 is included in current liabilities and$366,000 is in other long-term liabilities.

 

During 2002, Axsys disposed of the Automation Group,which included facilities in Wilmington, Massachusetts and Pittsburgh,Pennsylvania.  As part of the terms ofthe sale, we remain obligated under the operating leases for thesefacilities.   Both leases expire in 2006and we anticipated our commitment to be $1.5 million, of which $741,000 isincluded in current liabilities on our Consolidated Balance Sheets.  We are anticipating sub-leasing these facilitiesand believe that our current reserves levels are adequate to cover ourexposure.  However, given theuncertainties regarding the real estate market in both of these regions, wecannot be certain that we will either locate sublease tenants or will be ableto sublease the facilities at our contractual rates.  We feel based on currently available information, that costsassociated with these sites will not have a material adverse effect on ourbusiness and financial condition.  It ispossible, however, that our results of operations for a particular fiscalperiod could be materially affected.

 

As of December31, 2003, Axsys has two letters of credit totaling $231,000 opened in 2001 assecurity deposits on building leases in Wilmington, Massachusetts andPittsburgh, Pennsylvania.  These lettersof credit are renewed annually for the term of the lease.

 

20

----

 

OnMay 30, 1997, an action was filed in the Court of Chancery in the State ofDelaware against Axsys and three of the directors on behalf of a purportedclass of persons who purchased Axsys’ preferred stock.  The plaintiff has challenged our decision toredeem all of our outstanding shares of the preferred stock.  The plaintiff claimed that the defendants(1) breached fiduciary duties in setting the redemption price too low andunfairly seeking to advantage holders of common stock and (2) breachedcontractual duties as set forth in the Certificate of Designation governing thepreferred stock, as well as an implied covenant of good faith and fairdealing.   In March 1998, the Courtdismissed the plaintiff’s claim of breach of fiduciary duties but declined todismiss the plaintiff’s claims concerning the purported breach of contract andimplied covenant of good faith and fair dealing.  In January of 2001, the plaintiff filed an amended complaintasserting the same causes of action raised in the original complaint.  We filed an answer, in January of 2001,denying the material substantive allegations of the amended complaint andasserting, as affirmative defenses, the failure to state a claim and thedefense that plaintiff is not an adequate class representative.  As of December 31, 2003, we have reached anagreement with the plaintiff in principle to settle the action, althoughdefinitive documentation of the settlement has not been filed with theCourt.  In conjunction with thislitigation, we estimate our exposure for the potential settlement to be$201,000.

 

Axsys has a pension plan for which benefits and participation have beenfrozen.  Pension benefits under thisplan are generally based upon years of service and compensation.  Our funding policy has been to contributeamounts sufficient to meet the minimum funding requirements set forth in theEmployee Retirement Income Security Act of 1974, plus such additional amountsas may be determined to be appropriate from time to time.  During 2003, we began the process toliquidate the funded plan and we anticipate the plan will be fully liquidatedin 2004 with an estimated additional cash cost of $140,000.

 

***Backlog***

A substantial portion of our business is of abuild-to-order nature requiring various engineering, manufacturing, testing andother processes to be performed prior to shipment.  As a result, a significant portion of our annual sales is in ourbacklog of orders at the beginning of the year.  Our backlog of orders increased by 12.0 percent or $7.4 million,to $68.9 million at December 31, 2003 from $61.5 million at December 31,2002.   We believe that a substantialportion of our backlog of orders at December 31, 2003 will be shipped over thenext twelve months.   However,approximately 12% of our current backlog will be shipped in 2005 and beyond.  The majority of our longer-term backlogconsists of firm contracts with prime contractors of the United StatesGovernment for our beryllium-machined products.

 

*****CriticalAccounting Estimates*****

The discussion and analysis of our financialcondition and results of operations are based upon our financial statements,which have been prepared in accordance with generally accepted accountingprinciples in the United States. The preparation of these financial statementsrequires management to make estimates and judgments that affect the reportedamounts of assets, liabilities and related disclosure of contingent assets andliabilities at the date of the financial statements and the reported amountsfor revenues and expenses during the reporting period. On an ongoing basis,management evaluates estimates, including those related to inventoryallowances, contingencies, bad debts and income taxes. We base our estimates onhistorical data, when available, experience, and on various other assumptionsthat are believed to be reasonable under the circumstances, the combinedresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates.

 

***Critical Accounting Policies***

**The preparation of financial statementsin conformity with generally accepted accounting principles requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and the disclosure of contingent assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting periods. The most significant estimates and assumptions relate to inventoryvaluation and the adequacy of allowances for doubtful accounts, long-term losscontract reserves and environmental contingencies.  Actual amounts could differ significantly from these estimates.**

 

*Revenue recognition*.  We manufacture or distribute products, whichare either components or subassemblies that are sold to other manufacturers orOEMs.  We do not sell any finishedproducts directly to consumers. Therefore, we are generally not responsible for any installation orcustomer training.   However, some ofour contracts are subject to customer acceptance and generally the customerwill inspect and accept the product at our facility prior to shipment.  Legal title passes to the customer uponshipment.

 

All revenues are recorded when product is eithershipped to or received by the customer. Terms are principally FOB shipping point, although occasionally productis shipped FOB destination.  When theproduct is shipped FOB destination, revenues are not recorded until thecustomer receives the product.

 

21

----

 

Deferred income primarily results from the advancebillings to our customers for the cost of beryllium, known as material onlybillings.   These material only billingsare deferred and subsequently recognized as revenue only when the associatedfinished product is shipped.

 

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, they are reflected at the time ofthe sale as a reduction in revenues.  Theprice is fixed upon acceptance of the purchase order.  When customer change orders occur, any pricing changes arereflected in revised purchase orders.

 

***Allowance for doubtful accounts***.  We periodically review the aging of ouraccounts receivable over ninety days to identify potentially uncollectibleaccounts and establish reserves based on experience and discussion withcustomers.  Actual write-offs coulddiffer from our allowance for doubtful accounts.  If circumstances change, (i.e., higher than expected defaults oran unexpected material adverse change in a customers ability to meet ourfinancial obligations) our estimates of recoverability of amounts due to uscould be reduced by a material amount.

** **

***Inventory valuation***. We value our inventory at the lower of the actual cost to purchaseand/or manufacture the inventory or the current estimated market value of theinventory.  We regularly reviewinventory quantities on hand and record a provision for excess or obsoleteinventory based on current requirements and historical usage.  As demonstrated during 2003, demand for ourproducts can fluctuate.  A significantincrease in the demand for our products could result in a short-term increasein the cost of inventory purchases while a significant decrease in demand couldresult in an increase in the amount of excess or obsolete inventory quantitieson hand.  In addition, some of ourindustries are characterized by rapid technological change or frequent newproduct development that could result in an increase in the amount of obsoleteinventory on hand.  Additionally, ourestimates of future product demand may prove to be inaccurate, in which case wemay have understated or overstated the provision required for excess orobsolete inventory.    In the future, ifwe determine 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 goods sold in previous periods and wouldbe required to recognize additional operating income at the time of sale.   Therefore, although we make every effort toensure the accuracy of our forecasts of future product demand, any significantunanticipated changes in demand or technological developments could have asignificant impact on the value of our inventory and our reported operatingresults.

 

*Long-term loss contract reserves*:  Generally, our customer contracts arecompleted within one year of receiving the order.  However, occasionally longer lead time orders are received withsales under these long-term contracts currently recorded under the percentageof completion method. We monitor our long-term contracts periodically todetermine if our actual costs are comparable to our cost estimates used at thetime of order acceptance.  If wedetermine that our actual costs are significantly exceeding our originalestimates, we will record a loss contract reserve.  Currently, two long-term contracts are covered by a loss contractreserve, which was established in 2001. We accrued for these contracts based onthe contract price and the current cost structure, including estimated costincreases.  To the extent futuremanufacturing costs (i.e., labor rates and material costs) change, our losscontract reserves will be impacted.

** **

*Environmental contingencies.*  We are currently involved in severalenvironmental remediation projects.   Weaccrue for environmental contingencies when (1) responsibility for cleanup isdetermined and (2) costs are probable and reasonably estimatable.  When costs are not probable and reasonablyestimatable, no accrual is made.  Asdiscussed in Note 4 to the Consolidated Financial Statements, we have accruedour estimate of the probable costs for the resolution of these claims.  These estimates have been developed inconsultation with outside environmental consultants handling these matters andare based upon an analysis of the anticipated remediation plans.  We do not anticipate these projects willhave a material adverse effect on our consolidated financial position. It ispossible, however, that future results of operations could be materiallyaffected by changes in our assumptions.

 

## ***RecentlyIssued Accounting Standards***

 

InMay 2003, the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standards (“SFAS”) No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity.”SFAS 150 requires that certain financial instruments that, under previousguidance, could be accounted for as equity, now be classified as liabilities.These financial instruments include mandatorily redeemable shares, instrumentsthat require the issuer to buy back some of its shares in exchange for cash orother assets and certain obligations that can be settled with shares. SFAS 150also requires additional disclosures about alternative ways of settling thesetypes of instruments and the capital structure of entities. Most of theprovisions of SFAS 150 were effective for all financial

 

22

----

 

instrumentsentered into or modified after May 31, 2003, and otherwise were effective atthe beginning of the first interim period beginning after June 15, 2003. Thisaccounting pronouncement has not had a significant impact on our financialposition or results of operations.

 

InApril 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities,” which amends and clarifiesfinancial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts and for hedgingactivities under SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities.”  SFAS No. 149,which is to be applied prospectively, is effective for contracts entered intoor modified after June 30, 2003, and for hedging relationships designated afterJune 20, 2003.  The adoption of this newstandard did not have a material impact on our results of operations orfinancial position.

 

InJanuary 2003, the FASB issued FASB Interpretation No. 46, “Consolidation ofVariable Interest Entities.” FIN 46 provides guidance on how to identify avariable interest entity (VIE) and determine when the assets, liabilities andresults of operations of a VIE need to be included in a company’s financialstatements. FIN 46 also requires additional disclosures by primarybeneficiaries and other significant variable interest holders in a VIE. Theprovisions of FIN 46 were effective immediately for all VIEs created afterJanuary 31, 2003. For VIEs created before February 1, 2003, the provisions ofFIN 46 were required to be adopted at the beginning of the first interim periodending after December 15, 2003. Currently, we do not have any VIEs andtherefore this accounting pronouncement will not have a significant impact onour financial position or results of operations.

 

InNovember 2002, the EITF reached a consensus on Issue No. 00-21, “RevenueArrangements with Multiple Deliverables.” EITF 00-21 provides guidance on howto account for arrangements that involve the delivery or performance ofmultiple products, services or rights to use assets. The provisions of EITF00-21 apply to revenue arrangements entered into in interim periods beginningafter June 15, 2003 and were adopted by us during the fourth quarter of fiscal2003. This accounting pronouncement has not had a significant impact on ourfinancial position or results of operations.

 

***Cautionary Factors That May Affect Future Results***

 

This filing contains forward-looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934, asamended, including, without limitation, statements regarding our ability toreduce design and manufacturing lead times and manufacturing costs, our abilityto integrate existing technologies, our ability to implement our strategy todevelop and sell, among other things, higher level sub-systems, the changes tobe achieved from our cost reduction efforts, our objective to grow throughstrategic acquisitions and anticipated expenditures for environmentalremediation.  One can identify theseforward-looking statements by the 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’s Discussion and Analysis of Financial Condition and Results ofOperations,” as well as within the filing generally.  One should understand that many factors could cause actualresults to differ from those expressed or implied in the forward-lookingstatements.  These factors include thosediscussed below as well as inaccurate assumptions.  Axsys cautions the reader, however, that this list of factors maynot be exhaustive.

 

***Risk Factors***

 

The following risk factors should be consideredcarefully in addition to the other information contained in this filing.

 

*The Aerospace and Defense industry, which represents themajority of our sales, is largely dependent upon government contracts. *A significant portion of ourbusiness and business development efforts are concentrated in the aerospace anddefense industry.  Our business depends,in significant part, upon the U.S. Government’s continued demand in the area ofdefense for high-end, high performance components and sub-systems of the typethat we manufacture.  Approximately 47%of our net sales in 2003, 46% of net sales in 2002 and 35% in 2001 were deriveddirectly from contracts with the U.S. Government, or its agencies ordepartments, or indirectly from subcontracts with U.S. Governmentcontractors.  The majority of theseGovernment contracts are subject to termination and renegotiation.  As a result, our business, financialcondition and results of operations may be materially affected by changes inU.S. Government expenditures for defense.   In addition, we cannot assure you that current and future Governmentprograms will continue to use our products.

 

We act as a subcontractor for many differentgovernment programs. The funding of government programs is subject tocongressional appropriations. Although multi-year contracts may be authorizedin connection with major procurements, Congress generally appropriates funds ona fiscal year basis even though a program may continue for several years.Consequently, programs are often only partially funded initially, andadditional funds are committed only as Congress makes

 

23

----

 

further appropriations. The termination of funding for a governmentprogram would result in a loss of anticipated future revenues attributable tothat program. That could have a negative impact on our operations. In addition,the termination of a program or failure to commit additional funds to a programalready started could increase our overall costs of doing business.

 

Generally, government contracts and subcontracts aresubject to oversight audits by government representatives and containprovisions permitting termination, in whole or in part, without prior notice atthe government’s convenience upon the payment of compensation only for workdone and commitments made at the time of termination. We can give no assurancethat one or more of our government contracts or subcontracts will not beterminated 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. As our revenuesare dependent on our procurement, performance and payment under our contracts,the loss of one or more critical contracts could have a negative impact on ourfinancial condition.

 

Our government business is also subject to specificprocurement regulations and a variety of socio-economic and other requirements.These requirements, although customary in government contracts, increase ourperformance and compliance costs. These costs might increase in the future,reducing our margins, which could have a negative effect on our financialcondition. Failure to comply with these regulations and requirements could leadto suspension or debarment, for cause, from government contracting orsubcontracting for a period of time. Among the causes for debarment are violationsof various statutes, including those related to:

 

•     procurement integrity

•     export control

•     government security regulations

•     employment practices

•     protection of the environment

•     accuracy of records and the recording ofcosts

 

The termination of a government contract orrelationship as a result of any of these acts would have a negative impact onour operations and could have a negative effect on our reputation and abilityto procure other government contracts in the future.

 

Licenses are required from government agencies underthe Arms Export Control Act of 1976 for export of our products. We can give noassurance that we will be successful in maintaining these necessary licenses inorder to conduct business abroad.

 

Certain employees are required to hold and maintainsecurity clearances with the Department of Defense and/or the Department ofEnergy.  These clearances are requiredas we may have access to classified documents. We can give no assurance that wewill be successful in maintaining these necessary clearances in order toconduct business with the U.S. government.

 

*Our operating results may vary substantially due to factorsthat are difficult to forecast. *Factors such asannouncements of technological innovations or new products by Axsys or ourcompetitors, domestic and foreign, general economic conditions and the cyclicalnature of the industries that we serve could cause substantial variations inour operating results.  The defense,aerospace, semiconductor capital equipment, high-performance graphic art,medical imaging capital equipment, industrial automation OEM and MRO markets,each of which represents a significant market for our products, havehistorically been subject to substantial economic fluctuations due to changingdemands for their products and services, introduction of new products andproduct obsolescence. Any future fluctuations arising from these or otherconditions could have an adverse impact on our business, financial condition orresults of operations.  We haveexperienced, and expect to continue to experience, significant fluctuations inour quarterly and annual operating results due to a variety of factors,including:

 

**•**      market acceptance of new and enhancedversions of our products

•      timing and shipment of significant orders

•      mix of products sold

•      length of sales cycles

•      plant openings and closings

•      the timing of acquisitions or dispositions

•      delays in raw materials shipments, as wellas other manufacturing delays and disruptions;

•      completion of large projects

 

24

----

 

•      the level of backlog of orders

•      domestic and foreign general economicconditions, and

•      demand in the markets that we serve

 

To some extent, primarily in our bearing distribution division, our netsales and operating results for a specific quarter will depend upon generatingorders to be shipped in the same quarter in which the order is received.  The failure to receive anticipated orders ordelays in shipments near the end of a particular quarter, due, for example, tounanticipated rescheduling or cancellations of shipments by our customers orunexpected manufacturing difficulties, may cause our net sales in a particularquarter to fall significantly below expectations, which could have a materialadverse effect on our business, financial condition and results of operationsfor such quarter.

 

***The rapid pace oftechnological change will require continuous new product development. ***Oursuccess will continue to depend in substantial part upon our ability to introducenew products that keep pace with technological developments and evolvingindustry standards and to apply appropriate levels of engineering, research anddevelopment resources necessary to keep pace with these developments.  In addition, our success will depend on howwell we respond to changes in customer requirements and achieve marketacceptance for our products and capabilities. Any failure by Axsys to anticipate or respond adequately totechnological developments and customer requirements could have a materialadverse effect on our business, financial condition and results ofoperations.  In order to develop newproducts successfully, we are dependent upon close relationships with ourcustomers and their willingness to share proprietary information about theirrequirements and participate in collaborative 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 cannotassure you that the new products and services or their enhancements, if any,that we develop, will achieve market acceptance.

** **

***Our markets areextremely competitive. ***  We compete primarily on the basisof our ability to design and engineer our products to meet performancespecifications set by our customers, most of whom are OEMs who purchasecomponent parts or sub-systems for inclusion in their end products.  Product pricing and quality, customer support,experience, reputation and financial stability are also important competitivefactors.

 

There are a limitednumber of competitors in each of the markets for the various types of precisionoptical and positioning components and sub-systems that we sell.  Our competitors, especially those in theprecision optical and positioning product lines, are typically focused on asmaller number of product offerings than we are, and they are often wellentrenched.  Some of our competitorshave substantially greater resources than we do.  Our competitors could develop enhancements to or futuregenerations of competitive products that will offer superior price orperformance features to ours.  Inaddition, new processes or technologies could emerge that render our productsless competitive or obsolete.

 

In addition, asubstantial investment is required by an existing or potential customer tointegrate components and sub-systems into their product design.  We believe that once a customer has selectedparticular components or sub-systems from one vendor, the customer generallyrelies upon that vendor to provide equipment for the specific productapplication and may seek to rely upon that vendor to meet other component orsub-system requirements.  Accordingly,Axsys may be at a competitive disadvantage with respect to a prospectivecustomer that chooses to utilize a competitor’s components or sub-systems.

 

Further, there arenumerous competitors in markets to which we distribute precision ballbearings.  Our competitors, who vary insize, include other ball bearings distributors as well as ball bearingmanufacturers.

 

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

** **

***Our levels ofinternational sales and purchases could pose risks to our operating results.***  Our international sales fromcontinuing operations accounted for approximately 14.2% of net sales in 2003,18.1% in 2002, and 21.0% in 2001.  Inaddition, our products are sold to domestic customers who use them in productsthey sell to international markets. Also, we purchase a substantial portion ofour ball bearing products from two foreign suppliers and certain other productsfrom other foreign suppliers.  Ourinternational sales and purchases are subject to a number of risks generallyassociated with international operations, including general economicconditions, import and export duties and restrictions, currency fluctuations,changes in regulatory requirements, tariffs and other barriers, political andeconomic instability and potentially

** **

**25**

----

** **

**adverse tax consequences.  Any of these factors could have a materialadverse effect on our business, financial condition and results of operations.**

** **

*We may not be able to successfully manage expandedoperations and acquisitions.** ***As part of ourbusiness development strategy, we plan to pursue acquisitions in order toexpand our product offerings, add to or enhance our base of technical and salespersonnel or provide desirable customer relationships.  This growth could result in a significantstrain on our managerial, financial, engineering and other resources.  The rate of our future expansion, if any, incombination with the complexity of the technologies involved in our businesses,may demand an unusually high level of managerial effectiveness in anticipating,planning, coordinating and meeting our operational needs as well as the needsof our customers.  Additionally, wecannot assure you that Axsys will be able to acquire complementary businesseson a cost-effective basis, integrate acquired operations into our organizationeffectively, retain and motivate key personnel, or retain customers of acquiredfirms.  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. Axsys reviews and considerspossible acquisitions on an on-going basis.

 

*Many key productcomponents come from single source suppliers*.  A significant portion of our precisionmachining business depends on the adequate supply of specialty metals, such asberyllium, at competitive prices and on reasonable terms. We currently procureall of our beryllium from Brush Wellman, the sole U.S. supplier, and expect tocontinue to rely on Brush Wellman for beryllium for the foreseeablefuture.  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 grossmargins.  The partial or complete lossof Brush Wellman as a supplier of beryllium, or production shortfalls orinterruptions that otherwise impair our supply of beryllium, would have amaterial adverse effect on our business, financial condition and results ofoperations.  It is uncertain whetheralternative sources of supply could be developed without a material disruptionin our ability to provide beryllium products to our customers.

 

Although we have notexperienced significant problems with our other suppliers in the past, wecannot assure you that such relationships will continue or that, in the eventof a termination of our relationships with those other suppliers, we would beable to obtain alternative sources of supply without a material disruption inour ability to provide products to our customers.  In addition, we purchase a substantial amount of ball bearingsthat we distribute from two foreign suppliers. Any material disruption in our supply of products would have a materialadverse effect on our business, financial condition or results of operations.

** **

***Our future successdepends on our ability to retain key personnel. ***Axsys’ successdepends to a significant extent on the continued services of our key executiveofficers and senior management personnel. The loss of the services of one or more of these individuals may have amaterial adverse effect on our business, financial condition and results ofoperations.  We do not maintain key manlife insurance on our executive officers. In addition, since our continued success is largely dependent upon ourability to design, manufacture and sell high-performance components andsub-systems 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 voluntarily terminate their employment with usat any time, and competition for personnel is intense.  Accordingly, we cannot assure that we willbe successful in retaining our existing personnel.  The loss of the services of a significant number of our technicalor skilled personnel, or the future inability to attract technical or skilledpersonnel, could have a material adverse effect on our business, financialcondition and results of operations.

** **

***We must protect our intellectual propertyrights.  ***The patents of competitors could impact our business.  Our ability to compete effectively withother companies will depend, in part, on our ability to maintain theproprietary nature of our technology. We rely upon a combination of patents, trademarks and trade secrets,non-disclosure agreements and other forms of intellectual property protectionto safeguard our proprietary technology. We cannot assure you as to the degree of protection offered by thesepatents.  We also cannot assure you thatwe will be able to maintain the confidentiality of our trade secrets or thatour non-disclosure agreements will provide meaningful protection of our tradesecrets, know-how or other proprietary information in the event of anyunauthorized use, misappropriation or disclosure of such trade secrets,know-how or other proprietary information.

** **

Competitors in the United States and foreigncountries, many of which have substantially greater resources than we do andhave made substantial investments in competing technologies, may have appliedfor or obtained, or may in the future apply for and obtain, patents that willprevent, limit or interfere with our ability to make and sell some of ourproducts.

 

26

----

 

Although we believe that our existing products do notinfringe on the patents or other proprietary rights of third parties, thirdparties could assert infringement claims against us and such claims could besuccessful.

** **

***We must comply with strict environmentalregulations; both compliance and non-compliance could result in materialliabilities or costs. ***We are subject to a variety of federal, state and local laws, rules andregulations relating to the use, storage, discharge and disposal of hazardouschemicals used during our engineering, research and development andmanufacturing activities.  Failure tocomply with applicable environmental requirements could result in substantialliability to Axsys, suspension or cessation of our operations, restrictions onour ability to expand our operations or requirements for the acquisition ofadditional equipment or other significant expense, any of which could have amaterial adverse effect on our business, financial condition and results ofoperations.  In addition, we cannotassure you  (a) that changes in federal,state or local laws, regulations or regulatory policy, or the discovery ofunknown problems or conditions, will not in the future require substantial expenditures,or (b) as to the extent of our liabilities, if any, for past failures, if any,to comply with applicable environmental laws, regulations and permits, any ofwhich also could have a material adverse effect on our business, financialcondition and results of operations.

** **

**We have made and continue to makeinvestments in protective equipment, process controls, manufacturing proceduresand training in order to minimize the risks to our employees, surroundingcommunities and the environment due to the presence and handling of hazardousmaterials.  The failure to properlyhandle these materials could lead to harmful exposure for employees or to thedischarge of certain hazardous waste materials.   Since Axsys does not carry environmental impairment insurance,such a failure could lead to a material adverse effect on our business,financial condition and results of operations. Also, environmental problemscould develop in the future which would have a material adverse effect on ourbusiness, financial condition and results of operations.**

** **

***We must continue to invest significantresources to maintain and upgrade our manufacturing capabilities. ***Wehave invested, and intend to continue to invest, in state-of-the-art equipmentin order to increase, expand, update or relocate our manufacturing capabilitiesand facilities.  Changes in technologyor sales growth beyond currently established manufacturing capabilities wouldrequire that we make further investment. We cannot assure you that we will generate sufficient funds fromoperations to finance any required investment or that other sources of fundingwill be available on terms acceptable to us, if at all.  In addition, any further expansion couldnegatively impact our business, financial condition or results and operations.

** **

***One shareholder controls a significantblock of Axsys stock and this concentration could affect important operatingdecisions. ***The Chairman of the Board and Chief Executive Officer of Axsys ownsapproximately 27% of the outstanding common stock as of December 31, 2003.  As a result, he will have the ability toexert influence with respect to corporate actions, including the election ofdirectors and certain sales or mergers and acquisitions.

** **

***Our stock price has been volatile and maycontinue to fluctuate substantially. ***The price of our common stock may be subject to significantfluctuations.  That price volatility maybe attributable, at least in part, to the limited number of shares generallyavailable for sale in the public market. In addition, factors, such as, actual or anticipated quarterlyfluctuations in our financial results, changes in recommendations or earningsestimates by securities analysts, announcements of technological innovations ornew commercial products or services and the timing of announcements ofacquisitions or dispositions by Axsys or our competitors, as well as conditionsin our markets generally, may have a significant adverse effect on the marketprice of our common stock.  Furthermore,the stock market historically has experienced volatility which has particularlyaffected the market prices of securities of many technology companies and whichsometimes has been unrelated to the operating performances of such companies.

** **

***Certain anti-takeover provisions couldcause harm to our shareholders. ***Our Certificate of Incorporation, as amended (the “Certificate ofIncorporation”), our By-Laws (the “By-Laws”) and the Delaware GeneralCorporation Law (“DGCL”) contain various provisions which could delay or impedethe removal of incumbent directors and could make a merger, tender offer orproxy contest involving Axsys more difficult, even if such a transaction wouldbe beneficial to the interests of the shareholders, or could discourage a thirdparty from attempting to acquire control of Axsys.

 

We have authorized 4,000,000 shares of our preferredstock, none of which is currently outstanding, and which we could issue withoutfurther shareholder approval and upon terms and conditions, and having rights,privileges and preferences, as the Board of Directors may determine.  We have no current plans to issue anypreferred stock.

 

27

----

 

The By-Laws include provisions establishing advancenotice procedures with respect to shareholder proposals and directornominations, and permitting the calling of special shareholder meetings only bythe written consent of three-quarters of the Board of Directors or the Chairmanof the Board.  The Certificate of Incorporationprovides that in lieu of a meeting, action may be taken by written consent ofour shareholders only by unanimous consent. These provisions could have the effect of delaying, deterring orpreventing a change in control of Axsys, and may adversely affect the votingand other rights of holders of common stock.

 

In addition, we are subject to section 203 of theDGCL, which, among other things and subject to various exceptions, restrictscertain business transactions between a corporation and a shareholder owning15% or more of the corporation’s outstanding voting stock (an “interestedshareholder”) for a period of three years from the date the shareholder becomesan interested shareholder.  Theseprovisions may have the effect of delaying or preventing a change of control ofAxsys without action by the shareholders and, therefore, could adversely affectthe price of our common stock.  In theevent of a change of control of Axsys, the vesting of outstanding optionsissued under our long-term stock incentive plan may be accelerated at the discretionof the committee administering the plan or may be required to be acceleratedunder certain circumstances provided for in incentive agreements.

 

*Absenceof Dividends on Common Stock.*

Axsys does not anticipate paying dividends on ourcommon stock in the foreseeable future.

 

**Item 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Axsys’ market risk sensitive instruments do not subject Axsys tomaterial market risk exposures.

 

**Item8.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The response to this Item is included in Item 14(a) of this Report.

 

**Item9.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

#### ** **

#### **Item 9A.  CONTROLS AND PROCEDURES**

 

Withinthe 90 days prior to the filing date of this report, Axsys carried out anevaluation, under the supervision and with the participation of our management,including the chief executive officer and principal financial officer, of theeffectiveness of the design and operation of Axsys’ disclosure controls and procedurespursuant to Rule 13a-14 under the Securities Exchange Act of 1934. Based uponthat evaluation, the chief executive officer and principal financial officerconcluded that our disclosure controls and procedures are effective in timelyalerting them to material information relating to Axsys required to be includedin our periodic SEC filings.

 

Subsequent tothe date we carried out our evaluation, there have been no significant changesin our internal controls or in other factors that could significantly affectthese internal controls.

 

**PART III**

 

The information required by items 10, 11, 12, 13 and 14 of Part III, otherthan the table required by Item 201(d) of Regulation S-K, is incorporated byreference to Axsys’ definitive proxy statement for our 2004 Annual Meeting ofStockholders to be filed with the Securities and Exchange Commission within 120days following the end of Axsys’ fiscal year ended December 31, 2003.  If such proxy statement is not so filed, thatinformation will be filed as an amendment to this Form 10-K within 120 daysfollowing the end of Axsys’ fiscal year ended December 31, 2003.

 

28

----

 

**Item 10.  DIRECTORSAND EXECUTIVE OFFICERS**

#### ** **

#### **Exceptfor the information concerning our Code of Ethics, the information required bythis item is incorporated by reference from our 2004 Proxy Statement.**

**** ****

****Code of Ethics****

 

Axsys adopteda code of ethics applicable to our Chief Executive Officer and Chief FinancialOfficer, 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.   Theinformation in our website is not part of this report.  If we make any amendments to this code ofethics other than technical, administrative, or other non-substantiveamendments, or grants any waivers, including implicit waivers, from a provisionof this code of ethics to our Chief Executive Officer or Chief FinancialOfficer, we will disclose the nature of the amendment or waiver, our effectivedate and to whom it applies in a report on Form 8-K filed with the Securitiesand Exchange Commission.

#### ** **

#### **Item 11. EXECUTIVECOMPENSATION**

 

The information required by this item isincorporated by reference from our 2004 Proxy Statement.

 

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

 

Exceptfor the information concerning equity compensation plans, the informationrequired by this item is incorporated by reference from our 2004 ProxyStatement under the caption, “Securities Ownership of Directors andOfficers.”   The following table givesinformation about our equity securities that may be issued under equitycompensation plans as of December 31, 2003. Those securities are shares of common stock that can be issued under ourexisting Long-Term Stock Incentive Plan.

 
| **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 price of  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     |   | 461,122                                                                                                          |   | $                                                                                           | 12.80  |                                                                                                                                                              | 272,528 |   |
|                                                        |   |                                                                                                             |   |                                                                                        |   |                                                                                                                                                              |    |
| Equity compensation plans not approved by  security holders |   | —                                                                                                           |   | —                                                                                      |   | —                                                                                                                                                            |    |
| Total                                                       |   | 461,122                                                                                                          |   | $                                                                                           | 12.80  |                                                                                                                                                              | 272,528 |   |

 

#### **Item 13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The information required by this item is incorporated by reference fromour 2004 Proxy Statement.

 

#### **Item 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Theinformation required by Item 14 is incorporated by reference to Axsys’definitive proxy statement for its 2004 Annual Meeting of Stockholders to befiled with the Securities and Exchange Commission within 120 days following theend of Axsys’ fiscal year ended December 31, 2003.

 

29

----

 

**PARTIV**

 

**Item15.  EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8-K**

 

**(a)(1)and (2) and (d) Financial Statements**

 

See accompanying index to consolidated financial statements and schedule.

 

**(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 and incorporated herein by reference).                                                                                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.1                |   | Severance Agreement between Axsys and Kenneth F. Stern dated as of  June 10, 1996 (filed as Exhibit 10(16) to the Form S-1 and incorporated  herein by reference).*                                                                                                                                       |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.2                |   | 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 and incorporated herein by reference).*                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.3                |   | 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 (the “March  31, 1999 Form 10-Q”) and incorporated herein by reference).* |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.4                |   | Severance Protection Agreement between Axsys and Kenneth F. Stern  dated as of February 11, 1999 (filed as Exhibit 10(4) to the March 31, 1999  Form 10-Q and incorporated herein by reference).*                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.5                |   | Amendment to Axsys Technologies, Inc. Long-Term Stock Incentive Plan  (filed as Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 and  incorporated herein by reference).*                                                                                                                    |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.6                |   | 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 and incorporated herein by reference). *                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.7                |   | Form of Indemnification Agreement for all Directors and Officers of  Axsys (filed as Exhibit 10(17) to the December 31, 2001 Form 10-K and  incorporated herein by reference).*                                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.8                |   | 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  and incorporated herein by reference). *                                                                                                                  |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.9                |   | Change in registrant’s certifying accountant (filed as Exhibit 16 to  the May 23, 2002 Form 8-K and incorporated herein by reference).                                                                                                                                                               |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.10               |   | Letter Agreement between Stephen W. Bershad and Axsys dated November  6, 2003, extending term of initial period of the Employment Agreement.*                                                                                                                                                             |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.11               |   | Amended and Restated Severance Protection Agreement between Axsys and  Kenneth F. Stern dated as of May 13, 2003 (filed as Exhibit 10.1 to the June  28, 2003 Form 10-Q and incorporated herein by reference).*                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                      |
| 10.12               |   | 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 and  incorporated herein by reference).*                                                                                                                |

 

30

----

 
| **Exhibit  Number** |   | **Description**                                                                  |
|---------------------|--------|----------------------------------------------------------------------------------|
| 10.13               |   | Summary of Management Incentive Plan*                                            |
|                |   |                                                                             |
| 14.1                |   | Code of Ethics – Senior Financial Officers                                  |
|                |   |                                                                             |
| 21                  |   | Subsidiaries of the Registrant                                                   |
|                |   |                                                                             |
| 23                  |   | Consent of Ernst and Young LLP                                                   |
|                |   |                                                                             |
| 31.1                |   | Certification pursuant to Rule 13a-14(a) – Chief Executive Officer          |
|                |   |                                                                             |
| 31.2                |   | Certification pursuant to Rule 13a – 14(a) – 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 |

 

----

* Indicates management contracts or compensatory plans or arrangements.

 

**(b)       Reports on Form 8-K**

 

Report on Form 8-K filed on October 27, 2003regarding the financial results for the third quarter ended September 27, 2003.

 

31

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon Axsys’ behalf by the undersigned, thereunto duly authorized.

 

 
| Dated: | March 4, 2004 |                               | AXSYS TECHNOLOGIES, INC. |
|--------|---------------|------------------------------------|--------------------------|
|   |          | **(Registrant)**                   |
|   |          |                               |
|   |          | By                                 | /s/ STEPHEN W. BERSHAD   |   |
|   |          | Stephen W. Bershad                 |
|   |          | Chairman of the Board of Directors |
|   |          | and Chief Executive Officer        |

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities indicated this the 4thday of March 2004.

 
|   | /s/ Stephen W. Bershad       |   | Chairman of the Board of Directors and Chief Executive Officer     |
|--------|------------------------------|--------|--------------------------------------------------------------------|
|   | Stephen W. Bershad           |   |                                                               |
|   |                         |   |                                                               |
|   |                         |   |                                                               |
|   | /s/ David A. Almeida         |   | Vice President, Chief Financial Officer, Treasurer & Secretary |
|   | David A. Almeida             |   |                                                               |
|   |                         |   |                                                               |
|   |                         |   |                                                               |
|   | /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            |   |                                                               |
|        |                              |        |                                                                    |  |  |

 

32

----

**ANNUAL REPORT ON FORM 10-K**

 

**ITEM 8, ITEM 14(a)(1) and (2) and ITEM 14(d)**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE**

 

**FINANCIAL STATEMENTS**

 

**YEAR ENDED DECEMBER 31, 2003**

 

**AXSYS TECHNOLOGIES, INC.**

 

----

 

**FORM 10-K – ITEM 14(a)(1) and (2) and Item14(d)**

 

**AXSYS TECHNOLOGIES, INC.**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND FINANCIAL STATEMENT SCHEDULE**

 
| The following consolidated financial  statements of Axsys Technologies, Inc. are included in Item 8:              |   |
|-------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                              |   |
| Report of Independent Auditors                                                                                    |   |
|                                                                                                              |   |
| Consolidated Balance Sheets — December 31, 2003 and 2002                                                     |   |
|                                                                                                              |   |
| Consolidated Statements of Operations — For  the years ended December 31, 2003, 2002 and 2001                |   |
|                                                                                                              |   |
| Consolidated Statements of Cash Flows — For  the years ended December 31, 2003, 2002 and 2001                |   |
|                                                                                                              |   |
| Consolidated Statements of Shareholders’  Equity — For the years ended December 31, 2003, 2002 and 2001 |   |
|                                                                                                              |   |
| Notes to consolidated financial statements                                                                        |   |
|                                                                                                              |   |
| The  following consolidated financial statement schedule of Axsys Technologies,  Inc., is included in Item 14(d): |   |
|                                                                                                              |   |
| Schedule II — Valuation and qualifying  accounts                                                             |   |

 

All other schedules for which provision is made in the applicableaccounting regulation of the Securities and Exchange Commission are notrequired under the related instructions or are inapplicable and, therefore,have been omitted.

 

F-1

----

 

REPORT OF INDEPENDENT AUDITORS

 

To the Shareholders of

Axsys Technologies, Inc.:

 

We haveaudited the accompanying consolidated balance sheets of Axsys Technologies,Inc., a Delaware corporation, and its subsidiaries as of December 31, 2003 and2002 and the related consolidated statements of operations, shareholders’equity and cash flows for each of the three years in the period ended December31, 2003.  Our audits also included thefinancial statement schedule listed in the Index at Item 14(d).  These financial statements and the scheduleare the responsibility of management. Our responsibility is to express an opinion on these financialstatements and schedule based on our audits.

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States.  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Axsys Technologies,Inc. and subsidiaries at December 31, 2003 and 2002 and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2003 in conformity with accounting principlesgenerally accepted in the United States. Also, in our opinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

 

As discussedin Note 1 to the Consolidated Financial Statements, effectiveJanuary 1, 2002, the Company adopted Statement of Financial AccountingStandards No. 142 “Goodwill and Other Intangible Assets”.

 

 
|   | **ERNST & YOUNG LLP** |
|--------|---------------------------|

 

Hartford, Connecticut

February 16, 2004,

except for Note 4 as to which the date is March 1, 2004

 

F-2

----

 

**AXSYS TECHNOLOGIES, INC.**

**ConsolidatedBalance Sheets**

(Dollars in thousands, exceptshare and per share data)

 
|                                                                                                         |   | **December  31,** |   |
|--------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                         |   | **2003**          |   | **2002** |   |
| ASSETS                                                                                                       |   |              |   |   |   |
|                                                                                                         |   |              |   |   |   |
| CURRENT ASSETS:                                                                                              |   |              |   |   |   |
| Cash and cash equivalents                                                                                    |   | $                 | 5,197  |   | $ | 9,920 |   |
| Short-term investments                                                                                       |   | 6,983             |   | — |   |
| Accounts receivable, net of allowance for  doubtful accounts of $ 653 in 2003 and $509 in 2002               |   | 10,197            |   | 10,068 |   |
| Inventories                                                                                                  |   | 24,786            |   | 22,080 |   |
| Income taxes – deferred and current                                                                     |   | 2,203             |   | 4,077 |   |
| Other current assets                                                                                         |   | 1,223             |   | 1,046 |   |
| TOTAL CURRENT ASSETS                                                                                         |   | 50,589            |   | 47,191 |   |
|                                                                                                         |   |              |   |   |   |
| PROPERTY, PLANT AND EQUIPMENT, net                                                                           |   | 11,315            |   | 11,263 |   |
|                                                                                                         |   |              |   |   |   |
| EXCESS OF COST OVER NET ASSETS ACQUIRED                                                                      |   | 3,600             |   | 3,600 |   |
|                                                                                                         |   |              |   |   |   |
| OTHER ASSETS                                                                                                 |   | 1,341             |   | 318 |   |
|                                                                                                         |   |              |   |   |   |
| TOTAL ASSETS                                                                                                 |   | $                 | 66,845 |   | $ | 62,372 |   |
|                                                                                                         |   |              |   |   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                    |   |              |   |   |   |
|                                                                                                         |   |              |   |   |   |
| CURRENT LIABILITIES                                                                                          |   |              |   |   |   |
| Accounts payable                                                                                             |   | $                 | 4,240  |   | $ | 3,108 |   |
| Accrued expenses and other liabilities                                                                       |   | 7,955             |   | 9,285 |   |
| Deferred income                                                                                              |   | 4,546             |   | 3,115 |   |
| Current portion of long-term capital lease  obligations                                                      |   | 423               |   | 1,055 |   |
| TOTAL CURRENT LIABILITIES                                                                                    |   | 17,164            |   | 16,563 |   |
|                                                                                                         |   |              |   |   |   |
| CAPITAL LEASES, less current portion                                                                         |   | 568               |   | 1,191 |   |
|                                                                                                         |   |              |   |   |   |
| OTHER LONG-TERM LIABILITIES                                                                                  |   | 5,215             |   | 5,525 |   |
|                                                                                                         |   |              |   |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                |   |              |   |   |   |
|                                                                                                         |   |              |   |   |   |
| SHAREHOLDERS’ EQUITY                                                                                    |   |              |   |   |   |
| Common stock, $.01 par value:                                                                                |   |              |   |   |   |
| authorized 30,000,000 shares, issued  4,792,674 at December 31, 2003 and 2002                                |   | 47                |   | 47 |   |
| Capital in excess of par                                                                                     |   | 39,375            |   | 39,587 |   |
| Accumulated other comprehensive loss                                                                         |   | (39               | )      | — |   |
| Retained earnings                                                                                            |   | 5,750             |   | 752 |   |
| Treasury stock, at cost, 132,687 and  138,988 shares at December 31, 2003 and December 31, 2002 respectively |   | (1,235            | )      | (1,293 |   |
|                                                                                                         |   |              |   |   |   |
| TOTAL SHAREHOLDERS’ EQUITY                                                                              |   | 43,898            |   | 39,093 |   |
|                                                                                                         |   |              |   |   |   |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                              |   | $                 | 66,845 |   | $ | 62,372 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-3

----

 

**AXSYS TECHNOLOGIES, INC.**

**Consolidated Statements of Operations**

 

(Dollars in thousands, exceptshare and per share data)

 
|                                                                                                                  |   | **Years  Ended December 31,** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                                                  |   | **2003**                      |   | **2002** |   | **2001** |   |
|                                                                                                                  |   |                          |   |   |   |   |   |
| Sales                                                                                                                 |   | $                             | 85,109 |   | $ | 79,586 |   | $ | 86,131 |   |
| Cost of sales                                                                                                         |   | 62,036                        |   | 59,454 |   | 72,384 |   |
| Gross margin                                                                                                          |   | 23,073                        |   | 20,132 |   | 13,747 |   |
|                                                                                                                  |   |                          |   |   |   |   |   |
| Selling, general and administrative  expenses                                                                         |   | 15,986                        |   | 16,262 |   | 18,497 |   |
| Research, development and engineering  expenses                                                                       |   | 2,059                         |   | 2,049 |   | 2,608 |   |
| Restructuring and special charges                                                                                     |   | —                        |   | 1,854 |   | 1,360 |   |
| OPERATING INCOME (LOSS)                                                                                               |   | 5,028                         |   | (33 | ) | (8,718 | ) |
| Interest expense                                                                                                      |   | (172                          | )      | (212 | ) | (199 | ) |
| Interest income                                                                                                       |   | 115                           |   | 190 |   | 352 |   |
| Other income, net                                                                                                     |   | 263                           |   | 10 |   | 207 |   |
| Income (loss) from continuing operations  before income taxes and cumulative effect of change in accounting principle |   | 5,234                         |   | (45 | ) | (8,358 | ) |
| Provision for (benefit from) income taxes                                                                             |   | 236                           |   | 2,969 |   | (3,092 | ) |
| INCOME (LOSS) FROM CONTINUING OPERATIONS  BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE                  |   | 4,998                         |   | (3,014 | ) | (5,266 | ) |
|                                                                                                                  |   |                          |   |   |   |   |   |
| Discontinued operations:                                                                                              |   |                          |   |   |   |   |   |
| Loss from discontinued operations, net of  tax benefit of $2,787 in 2002, and $1,108 in 2001                          |   | —                        |   | (4,582 | ) | (1,886 | ) |
| Cumulative effect of change in accounting  principle                                                                  |   | —                        |   | 535 |   | — |   |
|                                                                                                                  |   |                          |   |   |   |   |   |
| NET INCOME (LOSS)                                                                                                     |   | $                             | 4,998  |   | $ | (7,061 | ) | $ | (7,152 | ) |
|                                                                                                                  |   |                          |   |   |   |   |   |
| BASIC EARNINGS (LOSS) PER SHARE:                                                                                      |   |                          |   |   |   |   |   |
| Continuing operations                                                                                                 |   | $                             | 1.07   |   | $ | (0.64 | ) | $ | (1.12 | ) |
| Discontinued operations                                                                                               |   | —                        |   | (0.97 | ) | (0.41 | ) |
| Cumulative effect of change in accounting  principle                                                                  |   | —                        |   | 0.11 |   | — |   |
| Total                                                                                                                 |   | $                             | 1.07   |   | $ | (1.50 | ) | $ | (1.53 | ) |
|                                                                                                                  |   |                          |   |   |   |   |   |
| Weighted average basic common shares  outstanding                                                                     |   | 4,657,396                     |   | 4,691,621 |   | 4,688,307 |   |
|                                                                                                                  |   |                          |   |   |   |   |   |
| DILUTED EARNINGS (LOSS) PER SHARE:                                                                                    |   |                          |   |   |   |   |   |
| Continuing operations                                                                                                 |   | $                             | 1.06   |   | $ | (0.64 | ) | $ | (1.12 | ) |
| Discontinued operations                                                                                               |   | —                        |   | (0.97 | ) | (0.41 | ) |
| Cumulative effect of change in accounting  principle                                                                  |   | —                        |   | 0.11 |   | — |   |
| Total                                                                                                                 |   | $                             | 1.06   |   | $ | (1.50 | ) | $ | (1.53 | ) |
|                                                                                                                  |   |                          |   |   |   |   |   |
| Weighted average diluted common shares  outstanding                                                                   |   | 4,716,228                     |   | 4,691,621 |   | 4,688,307 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-4

----

 

**AXSYS TECHNOLOGIES, INC.**

#### **ConsolidatedStatements of Cash Flows**

(Dollars in thousands)

 
|                                                                                         |   | **Years  Ended December 31,** |   |
|----------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                         |   | **2003**                      |   | **2002** |   | **2001** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                        |   |                          |   |   |   |   |   |
| Net income (loss)                                                                            |   | $                             | 4,998  |   | $ | (7,061 | ) | $ | (7,152 | ) |
| Adjustments to reconcile net income (loss)  cash provided by (used in) operating activities: |   |                          |   |   |   |   |   |
| Impairment of assets                                                                         |   | —                        |   | 313 |   | — |   |
| Cumulative effect of change in accounting  principle                                         |   | —                        |   | (535 | ) | — |   |
| Depreciation and amortization                                                                |   | 2,920                         |   | 2,663 |   | 2,932 |   |
| Non-cash restructuring and special charges                                                   |   | —                        |   | 888 |   | 7,746 |   |
| Loss on disposal of capital equipment                                                        |   | 55                            |   | 751 |   | 261 |   |
| Deferred income taxes, net                                                                   |   | —                        |   | 1,964 |   | (1,217 | ) |
| Changes in operating assets and  liabilities:                                                |   |                          |   |   |   |   |   |
| Accounts receivable                                                                          |   | (129                          | )      | 594 |   | 3,062 |   |
| Inventories                                                                                  |   | (2,706                        | )      | (1,516 | ) | (595 | ) |
| Current income tax receivable                                                                |   | 1,042                         |   | 1,552 |   | (3,157 | ) |
| Other current assets                                                                         |   | (177                          | )      | (436 | ) | 57 |   |
| Accounts payable                                                                             |   | 1,132                         |   | (1,343 | ) | (2,476 | ) |
| Accrued expenses and other liabilities                                                       |   | (492                          | )      | (936 | ) | (434 | ) |
| Deferred income                                                                              |   | 1,431                         |   | 2,507 |   | 391 |   |
| Long-term liabilities                                                                        |   | (504                          | )      | (51 | ) | (143 | ) |
| Other-net                                                                                    |   | (194                          | )      | 70 |   | 290 |   |
| Net cash provided by (used in) continuing  operations                                        |   | 7,376                         |   | (576 | ) | (435 | ) |
| Net cash (used in) provided by discontinued  operations                                      |   | (838                          | )      | 2,334 |   | (1,374 | ) |
| NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES                                          |   | 6,538                         |   | 1,758 |   | (1,809 | ) |
|                                                                                         |   |                          |   |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                        |   |                          |   |   |   |   |   |
| Capital expenditures, net                                                                    |   | (3,027                        | )      | (1,380 | ) | (2,258 | ) |
| Purchases of short-term investments                                                          |   | (6,983                        | )      | — |   | — |   |
| Net proceeds from sale of discontinued  operations                                           |   | —                        |   | 541 |   | — |   |
|                                                                                         |   |                          |   |   |   |   |   |
| NET CASH USED IN INVESTING ACTIVITIES                                                        |   | (10,010                       | )      | (839 | ) | (2,258 | ) |
|                                                                                         |   |                          |   |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                        |   |                          |   |   |   |   |   |
| Repayment of borrowings                                                                      |   | (1,255                        | )      | (898 | ) | (822 | ) |
| Proceeds from the exercise of options                                                        |   | 4                             |   | — |   | — |   |
|                                                                                         |   |                          |   |   |   |   |   |
| NET CASH USED IN FINANCING ACTIVITIES                                                        |   | (1,251                        | )      | (898 | ) | (822 | ) |
|                                                                                         |   |                          |   |   |   |   |   |
| NET (DECREASE) INCREASE IN CASH AND CASH  EQUIVALENTS                                        |   | (4,723                        | )      | 21 |   | (4,889 | ) |
|                                                                                         |   |                          |   |   |   |   |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  YEAR                                              |   | 9,920                         |   | 9,899 |   | 14,788 |   |
|                                                                                         |   |                          |   |   |   |   |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                                     |   | $                             | 5,197  |   | $ | 9,920 |   | $ | 9,899 |   |

 

 

See accompanying notes to consolidatedfinancial statements.

 

F-5

----

 

**AXSYSTECHNOLOGIES, INC.**

**ConsolidatedStatements of Shareholders’ Equity**

(Dollars in thousands, except share and pershare data)

 
|                                  |   | **Common Stock** |       | **Capital in  Excess  of  Par** |       | **Accumulated  Other  Comprehensive  Loss** |   | **Retained  Earnings** |   | **Treasury** |   | **Total** |   | **Comprehensive  Income (Loss)** |   |
|---------------------------------------|--------|------------------|------------|---------------------------------|------------|---------------------------------------------|--------|------------------------|--------|--------------|--------|-----------|--------|----------------------------------|--------|
| **Shares**                            |   | **Amount**       | **Shares** |                            | **Amount** |
| Balance at December 31, 2000          |   | 4,792,674        |       | $                               | 47         |                                        | $      | 39,675                 |   | $            | — |      | $      | 14,965                           |   | (108,553 | ) | $ | (1,266 | ) | $ | 53,421 |   |   |   |
|                                  |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| Net loss                              |   | —           |       | —                          |       | —                                      |   | —                 |   | (7,152       | )      | —    |   | —                           |   | (7,152 | ) | (7,152 | ) |
| Total comprehensive loss              |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   | $ | (7,152 | ) |
| Exercise of stock options             |   | —           |       | —                          |       | (70                                         | )      | —                 |   | —       |   | 8,400     |   | 189                              |   | 119 |   |   |   |
| Treasury stock received               |   | —           |       | —                          |       | —                                      |   | —                 |   |         |   | (3,304    | )      | (35                              | )      | (35 | ) |   |   |
| Contribution to 401(k) plan           |   | —           |       | —                          |       | 16                                          |   | —                 |   | —       |   | 6,581     |   | 71                               |   | 87 |   |   |   |
| Balance at                            |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| December 31, 2001                     |   | 4,792,674        |       | 47                              |       | 39,621                                      |   | —                 |   | 7,813        |   | (96,876   | )      | (1,041                           | )      | 46,440 |   |   |   |
|                                  |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| Net loss                              |   | —           |       | —                          |       | —                                      |   | —                 |   | (7,061       | )      | —    |   | —                           |   | (7,061 | ) | (7,061 | ) |
| Total comprehensive loss              |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   | $ | (7,061 | ) |
| Shares received from sale of business |   | —           |       | —                          |       | —                                      |   | —                 |   | —       |   | (51,856   | )      | (356                             | )      | (356 | ) |   |   |
| Contribution to 401(k) plan           |   | —           |       | —                          |       | (34                                         | )      | —                 |   | —       |   | 9,744     |   | 104                              |   | 70 |   |   |   |
| Balance at                            |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| December 31, 2002                     |   | 4,792,674        |       | 47                              |       | 39,587                                      |   | —                 |   | 752          |   | (138,988  | )      | (1,293                           | )      | 39,093 |   |   |   |
|                                  |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| Net income                            |   | —           |       | —                          |       | —                                      |   | —                 |   | 4,998        |   | —    |   | —                           |   | 4,998 |   | 4,998 |   |
| Foreign exchange contract             |   | —           |       | —                          |       | —                                      |   | (39                    | )      | —       |   | —    |   | —                           |   | (39 | ) | (39 | ) |
| Total comprehensive income            |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   | $ | 4,959 |   |
| Exercise of stock options             |   | —           |       | —                          |       | (1                                          | )      | —                 |   | —       |   | 600       |   | 5                                |   | 4 |   |   |   |
| Contribution to 401(k) plan           |   | —           |       | —                          |       | 2                                           |   | —                 |   | —       |   | 5,701     |   | 53                               |   | 55 |   |   |   |
| Escheatment of preferred stock        |   | —           |       | —                          |       | (12                                         | )      | —                 |   | —       |   | —    |   | —                           |   | (12 | ) |   |   |
| Preferred stock settlement            |   | —           |       | —                          |       | (201                                        | )      | —                 |   | —       |   | —    |   | —                           |   | (201 | ) |   |   |
| Balance at                            |   |             |       |                            |       |                                        |   |                   |   |         |   |      |   |                             |   |   |   |   |   |
| December 31, 2003                     |   | 4,792,674        |       | $                               | 47         |                                        | $      | 39,375                 |   | $            | (39    | )         | $      | 5,750                            |   | (132,687 | ) | $ | (1,235 | ) | $ | 43,898 |   |   |   |

 

See accompanying notes toconsolidated financial statements.

 

F-6

----

 

**AXSYSTECHNOLOGIES, INC.**

**NOTESTO THE CONSOLIDATED FINANCIAL STATEMENTS**

**(Dollarsin thousands, except per share data)**

 

**December 31, 2003**

 

**Note1 - Summary of Significant Accounting Policies**

 

Businessoverview.  The accompanying consolidatedfinancial statements include the accounts of Axsys Technologies, Inc. and ourwholly owned subsidiaries (collectively “Axsys” or “we”).  All material inter-company transactions andbalances have been eliminated in consolidation.

 

Axsys is aglobal leader in the design, manufacturing and distribution of precisioncomponents and assemblies for high technology markets.   In addition, Axsys distributes precisionball bearings for use in a variety of industrial and commercial applications.

 

*New accountingstandards.*

 

In May 2003,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 150, “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.” SFAS 150requires that certain financial instruments that, under previous guidance,could be accounted for as equity, now be classified as liabilities. Thesefinancial instruments include mandatorily redeemable shares, instruments thatrequire the issuer to buy back some of its shares in exchange for cash or otherassets and certain obligations that can be settled with shares. SFAS 150 alsorequires additional disclosures about alternative ways of settling these typesof instruments and the capital structure of entities. Most of the provisions ofSFAS 150 were effective for all financial instruments entered into or modifiedafter May 31, 2003, and otherwise were effective at the beginning of the firstinterim period beginning after June 15, 2003. The adoption of this standard hasnot had a significant impact on our financial position or results ofoperations.

 

In April 2003,the FASB issued SFAS No. 149, “Amendment of Statement 133 on DerivativeInstruments and Hedging Activities,” which amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts and for hedging activitiesunder SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.”  SFAS No. 149, which is tobe applied prospectively, is effective for contracts entered into or modifiedafter June 30, 2003, and for hedging relationships designated after June 20,2003.  The adoption of this new standarddid not have a material impact on our results of operations or financialposition.

 

In January2003, the FASB issued FASB Interpretation (“FIN”) No. 46, “Consolidation ofVariable Interest Entities.” FIN 46 provides guidance on how to identify avariable interest entity (VIE) and determine when the assets, liabilities andresults of operations of a VIE need to be included in a company’s financialstatements. FIN No. 46 also requires additional disclosures by primarybeneficiaries and other significant variable interest holders in a VIE. Theprovisions of FIN No. 46 were effective immediately for all VIEs created afterJanuary 31, 2003. For VIEs created before February 1, 2003, the provisions ofFIN No. 46 were required to be adopted at the beginning of the first interimperiod ending after December 15, 2003. Currently, we do not have any VIEs andtherefore the adoption of this accounting pronouncement will not have asignificant impact on our financial position or results of operations.

 

In November2002, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF IssueNo.00-21, “Revenue Arrangements with Multiple Deliverables".  EITF No. 00-21 provides guidance on how todetermine when an arrangement that involves multiple revenue-generating activitiesor deliverables should be divided into separate units of accounting for revenuerecognition purposes.  It furtherstates, that if this division is required, the arrangement consideration shouldbe allocated among the separate units of accounting.  The guidance in the consensus is effective for revenuearrangements entered into in fiscal periods that began after June 15,2003.  The adoption of this standard didnot have a material impact on our financial position or results of operations.

 

*Principles of consolidation. *The consolidatedfinancial statements include the results of Axsys and its 100% wholly ownedsubsidiaries.  The results of companiesdisposed of during the fiscal year are included in the consolidated financialstatements up to the date of disposal. All significant intercompany balancesand transactions have been eliminated in consolidation.

 

----

 

*Revenue recognition.*  Revenue is recognized in accordance with theSecurities and Exchange Commission Staff Accounting Bulletin (“SAB”) No.101.  SAB 101 requires that four basiccriteria must be met before revenue can be recognized:  (1) persuasive evidence of an arrangementexists; (2) delivery has occurred or services rendered; (3) the fee is fixedand determinable; and (4) collectibility is reasonably assured.  Shipping & handling costs, such asfreight to customers, are classified in cost of sales.  Revenue under most government long-termfixed-price contracts is accounted for under the percentage of completion modelusing the units of delivery method measured as products are shipped.  Provisions, for estimated losses oncontracts, are recorded when losses become evident.  These estimates are subject to change and could result inadjustments on contracts in progress.

 

*Cash and cash equivalents.*  Cash and cash equivalents include highlyliquid investments with an original maturity of three months or less at thedate of purchase.

 

*Short-term investments*.   Short-term investments include investmentsin federal agency notes and commercial paper with maturities ranging from 3months to 12 months at the date of purchase. All short-term investments areclassified as held-to-maturity and are recorded at amortized cost.

 

*Financial instruments.*    Weuse derivative instruments, in the form of forward contracts, to manage certainforeign currency exposures. Derivative instruments are viewed as riskmanagement tools by the Corporation and are not used for trading or speculativepurposes. Derivatives used for hedging purposes must be designated as aneffective hedge of the identified risk exposure at the inception of thecontract. Accordingly, changes in fair value of the derivative contract must behighly correlated with changes in the fair value of the underlying hedged itemat inception of the hedge and over the life of the hedge contract.

 

All derivative instruments arerecorded on the balance sheet at fair value. Derivatives used to hedgeforecasted cash flows associated with foreign currency commitments areaccounted for as cash flow hedges. Gains and losses on derivatives designatedas cash flow hedges are recorded in other comprehensive income and reclassifiedto earnings 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.  AtDecember 31, 2003, we had one forward contract outstanding with a fair value of$39.

 

The carrying amounts of ourother financial instruments, which include cash equivalents, short-terminvestments and accounts payable approximate their fair value due to the short-termnature of such instruments.

 

*Accounts receivable*.  Accounts receivable, which include onlytrade accounts receivables, are recorded at fair value.  Credit is extended to customers typically onnet 30-day terms with periodic reviews of the aging of accounts receivable toidentify potentially uncollectible accounts and establish reserves based onexperience and discussion with customers. Axsys does not require collateral. As of December 31, 2003 and 2002, no individual customer representedmore than 10% of our accounts receivable balance.

 

*Research, development and engineering.*  Significant costs are incurred each year inconnection with research and development programs and administrativeengineering costs (R,D&E”).  Suchcosts are included in operating expenses as incurred. In situations where thecustomer reimburses the cost of the R&D effort, the revenue generated isrecorded as sales and the expense is included in cost of sales. Research anddevelopment expenses, exclusive of administrative engineering costs were $756in 2003, $1,003 in 2002 and $1,704 in 2001.

 

*Inventory.*  Inventory values include all costs directlyassociated with manufacturing products: materials, labor and manufacturingoverhead.  These values are stated atthe lower of cost or market with cost generally determined using the first-in,first-out method.

 

*Property, plant and equipment.*  Property, plant and equipment are stated atcost, less accumulated depreciation, which includes the amortization of assetsrecorded under capital leases. Depreciation is provided primarily by the straight-line method usingestimated lives for buildings and improvements of 20 to 25 years and from 3 to8 years for machinery and equipment. Repair and maintenance costs are expensed as incurred.

 

----

 

*Excess of cost over net assets acquired.*  In 2001 the excess of cost over net assets(“Goodwill”) acquired was amortized over periods ranging from 5 to 35 yearsusing the straight-line method.  In June2001, SFAS No. 142, “Goodwill and Other Intangible Assets”, was issued and wasadopted by Axsys in the first quarter of 2002. In accordance with the adoption of SFAS No. 142, we ceased amortizinggoodwill in 2002.  For the year endedDecember 31, 2001, goodwill amortization of $140 was offset by negative amortizationof $143.  If we had applied theprovisions of this statement in 2001, earnings per share would not have beendifferent from the amounts reported.  Inaccordance with the adoption of SFAS No. 142, the negative goodwill of $535 asof December 31, 2001 was reversed as a cumulative effect of a change inaccounting principle in the first quarter of 2002.  Axsys annually reviews goodwill to assess recoverability fromfuture operations using undiscounted cash flows.  We have completed our annual impairment testing and the remaininggoodwill of $3.6 million is determined not to be impaired as of December 31,2003.  Impairments are recognized inoperating results when a permanent diminution in value occurs.

 

*Deferred income. *Deferred income is recorded when Axsysreceives milestone payments from customers for either progress billings or formaterial billings.  Material billingsprimarily occur when customers advance us the cost of beryllium on long-leadtime orders.   Revenue is recorded whenthe finished product is shipped.

 

*Environmental contingencies.*  Environmental contingencies are accrued forwhen responsibility for cleanup is determined and when costs are probable andreasonably estimatable.

 

*Earnings per share.*  Basic earnings per share have been computedby dividing net income or loss by the weighted average number of common sharesoutstanding.  The dilutive effect ofstock options on the weighted average number of common shares outstanding was58,832 shares for the year ended December 31, 2003.  When there is a loss from continuing operations, the computationof the dilutive net loss per share is based on the weighted average basicshares outstanding.  Potentiallydilutive common stock options aggregating 16,766 in 2002 and 36,364 in 2001have been excluded from the computation of diluted net loss per shared becausetheir inclusion would have been anti-dilutive.

 

*Stock-based compensation. *Axsys has adoptedthe disclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and accounts for stock based compensation under the provisions ofAccounting Principle Board Opinion No. 25 “Accounting Stock Issued toEmployees” using the intrinsic value method. The exercise price on stock options is either greater than or equal tothe closing market price on the day of grant and accordingly no compensationcost has been recognized.  We do notgrant stock options below market value. Pro forma information regarding net income (loss) and net income (loss)per share is required by SFAS No. 123 for awards as if Axsys had accounted forsuch awards under the fair value method.

 

The followingtable illustrates the effect on net income/(loss) and income/(loss) per shareif we had applied the fair value recognition provisions of SFAS No. 123:

 
|                                                          |   | **2003**  |   | **2002**  |   | **2001**  |   |
|---------------------------------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Reported net income (loss)                                    |   | $         | 4,998  |      | $      | (7,061    | )      | $ | (7,152 | ) |
| Stock option related employee compensation  expense           |   | (1,135    | )      | (1,339    | )      | (1,021    | )      |
| Pro forma net income (loss)                                   |   | 3,863     |   | (8,400    | )      | (8,173    | )      |
|                                                          |   |      |   |      |   |      |   |
| Pro forma basic income (loss) per share                       |   | $         | 0.83   |      | $      | (1.79     | )      | $ | (1.74 | ) |
| Weighted average basic and diluted common  shares outstanding |   | 4,657,396 |   | 4,691,621 |   | 4,688,307 |   |
|                                                          |   |      |   |      |   |      |   |
| Pro forma diluted income (loss) per share                     |   | $         | 0.82   |      | $      | (1.79     | )      | $ | (1.74 | ) |
| Weighted average basic and diluted common  shares outstanding |   | 4,716,228 |   | 4,691,621 |   | 4,688,307 |   |

 

----

 

The fair valueof each option granted in 2003, 2002 and 2001 was estimated on the date ofgrant using the Black-Scholes option-pricing model with the followingassumptions: expected volatility of 68% in 2003, 68% in 2002 and 71% in 2001;risk-free interest rate of 4.27% in 2003, 5.0% in 2002 and 5.0% in 2001;expected lives of 6 years; and no dividend yield. Using this model, theweighted-average fair value of options granted was $5.38 during 2003, $4.53during 2002, and $9.95 during 2001.  Forpro forma purposes, the estimated fair value of the Axsys’ Stock Incentiveawards to employees is amortized over the options’ vesting period, which isgenerally five years.  Because the SFASNo. 123 method of accounting has not been applied to options granted prior toJanuary 1, 1995, the resulting pro forma compensation cost may not berepresentative of that to be expected in future years. The Black-Scholes optionvaluation model was developed for use in estimating the fair value of tradedoptions, which have no vesting restrictions and are fully transferable.  In addition, the Black-Scholes modelrequires the input of highly subjective assumptions including the expectedstock price volatility.  Becausestock-based awards to Axsys employees have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, inmanagement’s opinion, the existing model does not necessarily provide areliable single measure of the fair value of our Stock Incentive awards toemployees.

 

*Estimates and assumptions.*The preparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

Certain amounts in previouslyissued annual financial statements were reclassified to conform to the 2003presentation.

 

#### **Note 2 –Restructuring and Special Charges**

#### ** **

*Fiscal Year 2002*

*Relocation of OEM Product Lines:*  During the second quarter of 2002, Axsysclosed the Santa Barbara, California facility and relocated various commercialproduct lines to Rochester Hills, Michigan. The total pre-tax cost of $1,053associated with the relocation and facility closure included a charge of $436for thirty terminated employees and a charge of $123 for the disposal of excessfurniture and fixtures.  A charge of$136 was incurred as a result of the write-off of certain inventory related tothe termination of certain minor product lines.  Other costs of $358 associated with the relocation included costsfor the equipment relocation, employee training and recruitment and facilityupgrades in Michigan, which were expensed as incurred.

 

*Sale of Teletrac, Inc.: *On April 5, 2002,Axsys sold all of the stock of the Teletrac, Inc. (“Teletrac”) subsidiary toStorage Test Solutions (“STS”) of Aurora, Colorado. In connection with the saleof Teletrac, we recorded a pretax charge of $1,009 associated with assetwrite-downs, severance payments and legal expenses.  This pretax charge is recorded in restructuring and other specialcharges.

 

*Segment reorganization:*   In March 2002, Axsys announced areorganization of the market segments into three major groups.  The strategic realignment resulted in achange in the composition of Axsys’ reportable segments.  This plan resulted in a restructuring chargeof $286 pre-tax for the termination of three salaried employees in the formerAutomation Group, which has been included in the loss from discontinuedoperations. (See Note 3 of the Consolidated Financial Statements.)   In addition, as part of the segmentreorganization, we incurred a pre-tax charge of $286 for the termination of theChief Operating Officer, which is recorded in restructuring and other specialcharges.

 

----

 

During 2002,Axsys recorded the following amounts as restructuring and special charges inthe Consolidated Statement of Operations related to the 2002 Restructuring andSpecial Charge:

 
|                        |   | **Cost of  Sales** |   | **Selling,  General &  Administrative  Expense** |   | **Restructuring  Charge** |   | **Total** |   |
|-----------------------------|--------|--------------------|--------|------------------------------------------------------|--------|---------------------------|--------|-----------|--------|
| Relocation of product lines |   | $                  | 136    |                                                 | $      | 358                       |   | $         | 559    |   | $ | 1,053 |   |
| Sale of Teletrac            |   | —             |   | —                                               |   | 1,009                     |   | 1,009     |   |
| Segment Reorganization      |   | —             |   | —                                               |   | 286                       |   | 286       |   |
| Total                       |   | $                  | 136    |                                                 | $      | 358                       |   | $         | 1,854  |   | $ | 2,348 |   |
| Cash costs                  |   | —             |   | 358                                                  |   | 1,102                     |   | 1,460     |   |
| Non-cash costs              |   | 136                |   | —                                               |   | 752                       |   | 888       |   |

 

 

ThroughDecember 31, 2003, we had expended all cash costs in connection with the 2002restructuring and special charges. Total cost savings associated with the 2002 Restructuring and SpecialCharges are estimated to be $2.8 million annually.  These savings are the result of the closure of the Santa Barbara,California facility and the termination of the Chief Operating Officer.

 

The followingtable shows the balance sheet activity for the restructuring accrual account asof December 31, 2003 in conjunction with the 2002 restructuring activities:

 
|                         |   | **Restructuring  Accrual** |   |
|------------------------------|--------|----------------------------|--------|
| 2002 Charges                 |   | $                          | 1,854  |   |
| 2002 Activity                |   | (1,734                     | )      |
| 2003 Activity                |   | (70                        | )      |
| Balance at December 31, 2003 |   | $                          | 50     |   |

 

The balance atDecember 31, 2003 represents a warranty reserve related to the product lines atthe former Santa Barbara, California facility, which were either sold ordiscontinued.

 

*Fiscal Year 2001*

*2001 Cost reductionplan:* During the second quarter of 2001, we adopted amajor cost reduction program (the “Cost Reduction Plan”), which resulted in apretax charge to earnings of approximately $9,208, or $5,801 after-tax.  In 2002, an additional charge of $20 wasaccrued for rent expense at the Manchester facility.  All cash costs have been spent through December 31, 2003.

 

Axsys closed asmall manufacturing facility in Manchester, Connecticut and consolidated theactivities into the Imaging Systems unit in Rochester Hills, Michigan.  We also closed a small, satellite facilityin Newbury Park, California, and consolidated it into our former facility inSanta Barbara, California.  Pre-taxcharges associated with these shutdowns were $138 for facility exit costs.  We reduced our workforce at five locationsby 59 people or 9% of the total workforce. We accrued $992 for all severanceand outplacement costs and $250 to cover any legal expenses related to the costreduction program.

 

We alsoreviewed our inventory and other assets. We recorded a charge of $2,943 tocover expected losses on two long-term defense contracts.  The earnings charge also includes anincrease in reserves for excess and obsolete inventories of approximately$4,425.  The obsolete and excessinventory was disposed of during 2001 and 2002.  Other costs associated with the Cost Reduction Plan include thewrite-off of $293 in tooling and $85 in software costs.   The Cost Reduction Plan reduced expenses byapproximately $2,000 in the second half of 2001, with cost reductions reachingan annualized rate of approximately $4,300. These cost savings were realized in reduced cost of sales and operatingexpenses as a result of the closure of two facilities and the additionalreduction in workforce.

 

----

 

Through December 31, 2002, Axsys recorded the following amounts in theConsolidated Statement of Operations in connection with the 2001 Cost ReductionPlan:

 
|                    |   | **Cost of  Sales** |   | **Selling,  General &  Administrative  Expense** |   | **Restructuring  Charge** |   | **Total** |   |
|-------------------------|--------|--------------------|--------|------------------------------------------------------|--------|---------------------------|--------|-----------|--------|
| Inventory write-downs   |   | $                  | 4,425  |                                                 | $      | —                    |   | $         | — |   | $ | 4,425 |   |
| Loss contract reserves  |   | 2,943              |   | —                                               |   | —                    |   | 2,943     |   |
| Work force reductions   |   | —             |   | —                                               |   | 1,242                     |   | 1,242     |   |
| Fixed asset write-downs |   | 293                |   | 85                                                   |   | —                    |   | 378       |   |
| Facilities              |   | —             |   | 20                                                   |   | 118                       |   | 138       |   |
| Other                   |   | —             |   | 102                                                  |   | —                    |   | 102       |   |
| Total                   |   | $                  | 7,661  |                                                 | $      | 207                       |   | $         | 1,360  |   | $ | 9,228 |   |

 
|     |   | **Cost of  Sales** |   | **Selling,  General &  Administrative  Expense** |   | **Restructuring  Charge** |   | **Total** |   |
|----------|--------|--------------------|--------|------------------------------------------------------|--------|---------------------------|--------|-----------|--------|
| Cash     |   | $                  | — |                                                 | $      | 122                       |   | $         | 1,360  |   | $ | 1,482 |   |
| Non-cash |   | 7,661              |   | 85                                                   |   | —                    |   | 7,746     |   |
|          |        |                    |        |                                                      |        |                           |        |           |        |  |  |  |  |

#### ** **

The following table shows the balance sheet activity for therestructuring accrual account, which includes the costs associated with theaccrued restructuring charge and the fixed asset write-downs, as of December31, 2003:

 
|                         |   | **Restructuring  Accrual** |   |
|------------------------------|--------|----------------------------|--------|
| 2002 Charges                 |   | $                          | 1,738  |   |
| 2002 Activity                |   | (1,080                     | )      |
| Balance at December 31, 2001 |   | 658                        |   |
| 2002 Activity                |   | (593                       | )      |
| Balance at December 31, 2002 |   | 65                         |   |
| 2003 Activity                |   | (65                        | )      |
| Balance at December 31, 2003 |   | $                          | — |   |

 

Cashexpenditures included other costs directly related to the Cost Reduction Plan,such as relocation and other integration costs.  These costs were not eligible for recognition at the commitmentdate and were expensed as incurred.  Weincurred $102 of these costs through December 31, 2001 and no charges wereincurred during 2002 or 2003.  All cashcosts for the plan have been fully expended.

 

**Note3 - Discontinued Operations**

 

During thethird quarter of 2002, Axsys decided to sell the Automation Group, whichconsisted of the Fiber Automation Division in Pittsburgh, Pennsylvania and theAEI subsidiary in Wilmington, Massachusetts. On November 5, 2002, we sold the net assets of our Fiber AutomationDivision.  On October 28, 2002, we soldthe stock of AEI.  The Automation Groupwas included in our Commercial Products Group segment.

 

----

 

In conjunctionwith the sale of the Automation Group, we recorded, in 2002, a loss fromdiscontinued operations of $1,709, net of taxes. This loss included a charge of$729 for the impairment of assets and $980 of closing related expenses.  The operating loss, net of tax, from discontinuedoperations for 2002 was $2,692.  TheAutomation Group generated an after-tax loss of $1,886 during 2001.  Revenues from the Automation Group were$1,177 in 2002 compared to $3,079 in 2001.

 

The loss fromdiscontinued operations, net of tax, recorded in the Consolidated Statements ofOperations includes the following:

 
|                                                                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Automation Group - operating loss                                       |   | $        | — |     | $      | (2,692   | )      | $ | (1,886 | ) |
| Automation Group - loss on sale                                         |   | —   |   | (1,709   | )      | —   |   |
| Environmental charges for previously  divested business                 |   | —   |   | (203     | )      | —   |   |
| Reversal of unutilized reserves from a  previously disposed of business |   | —   |   | 22       |   | —   |   |
| Loss from discontinued operations                                       |   | $        | — |     | $      | (4,582   | )      | $ | (1,886 | ) |

 

**Note 4 –Environmental Contingencies**

 

We arecurrently involved in several environmental remediation projects.   We accrue for environmental contingencieson an undiscounted basis when (1) responsibility for clean-up is determined and(2) costs are probable and reasonably estimatable.

 

Pursuant to aremedial plan approved by the Ohio Environmental Protection Agency (“Ohio EPA”)in 1993, Axsys investigated soils and groundwater at a site formerly owned by adivision of Axsys, and has conducted certain remedial work at this siteincluding soil removal.  Axsys hasincurred costs of $182 in 2003 and approximately $798 to date.   We received the approval of the Ohio EPAfor an alternate closure plan related to this site.  As of December 31, 2003, the remediation system is installed andwe anticipate beginning clean up during 2004. Actual expenditures will continue to be incurred over a period ofseveral years.  As of December 31, 2003,we have accrued $280 for expenses related to this site.

 

During 1999,Axsys sold the land and building of a previously discontinued Sensor Systemsdivision in St. Petersburg, Florida.  Weconducted investigations of soil and groundwater at the former facility andreceived approval of the remedial action plan from the Florida Department ofEnvironmental Protection.  During thesecond quarter of 2003, we installed the remediation systems and have begun theclean up of the site.   In 2003, wespent $276 on the clean up of this facility and have incurred approximately$642 to date.  As of December 2003, wehave accrued $436 for expenses related to this site.

 

On December21, 2001, Axsys received a letter from the United States EnvironmentalProtection Agency (“EPA”) notifying us that we are considered to be apotentially responsible party for a site located in Prospect, Connecticut,which until 1978 was owned by a former subsidiary.   The letter also demanded payment of approximately $25 in pastresponse costs and unspecified future costs. In November of 2002, we filed a response to the EPA challenging ourliability for this site.  In March of2004, we received a request for additional information from the EPA which wewill submit to the EPA by April of 2004. In 2002, a charge to discontinuedoperations was recorded for $203, net of taxes, related to attorney fees inconnection with researching our connection to the site and response to the EPA.  In 2003, we spent $66 in attorney andconsulting fees and we have incurred approximately $207 to date.  As of December 31, 2003, we have accrued$119 for expenses related to this site.

 

Theseestimates have been developed in consultation with outside environmentalconsultants handling these matters and are based upon an analysis of theanticipated remediation plans.  We donot anticipate these projects 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.

 

----

 

**Note 5 - Litigation**

 

On May 30,1997, an action was filed in the Court of Chancery in the State of Delawareagainst Axsys and three of the directors on behalf of a purported class ofpersons who purchased Axsys’ preferred stock. The plaintiff has challenged our decision to redeem all of ouroutstanding shares of the preferred stock. The plaintiff claimed that the defendants (1) breached fiduciary dutiesin setting the redemption price too low and unfairly seeking to advantageholders of common 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 March 1998, the Court dismissed the plaintiff’s claim of breach offiduciary duties but declined to dismiss the plaintiff’s claims concerning thepurported breach of contract and implied covenant of good faith and fairdealing.  In January of 2001, theplaintiff filed an amended complaint asserting the same causes of action raisedin the original complaint.  We filed ananswer, in January of 2001, denying the material substantive allegations of theamended complaint and asserting, as affirmative defenses, the failure to statea claim and the defense that plaintiff is not an adequate classrepresentative.  As of December 31,2003, we have reached an agreement with the plaintiff in principle to settlethe action, although definitive documentation of the settlement has not beenfiled with the Court.  In conjunctionwith this litigation, we have accrued $201 for the potential settlement.  This charge was accounted for as a reductionto Paid-in-Capital in accordance with generally accepted accounting principles.

 

**Note 6 –Shareholders’ Equity**

 

Axsys uses treasury stock shares for general corporate purposes,including the satisfaction of commitments under the employee benefit plans andthe exercise of stock options.   During2001, Axsys accepted 3,304 shares of stock in lieu of cash for the exercise ofa stock option grant.

 

During 2002,we sold our wholly owned subsidiary AEI to an investor group who individuallyowned shares of Axsys common stock.  Asa group, the investors owned 9.2% of Axsys common stock prior to the sale ofAEI, with individual ownership ranging from 1.8% to 4.6%.  The sales price included both cash and areturn of 51,856 shares of Axsys stock. The common stock was valued at $6.87 per share, which represented theaverage of the mean of the bid and ask prices of the common stock at the closeof trading on the Nasdaq Stock Market for each of the consecutive trading daysimmediately preceding the closing date.

 

**Note7 – Capital Lease Obligations**

 
|                      |   | **2003** |   | **2002** |   |
|---------------------------|--------|----------|--------|----------|--------|
|                      |   |     |   |     |   |
| Capital lease obligations |   | $        | 991    |     | $      | 2,246 |   |
| Less current portion      |   | 423      |   | 1,055    |   |
|                      |   | $        | 568    |     | $      | 1,191 |   |

 

Axsys hasfinanced the acquisition of certain machinery and equipment with capital leaseobligations.  During 2001, weestablished a $3,000 capital lease line of credit.  The capital lease line of credit was utilized to purchase $762 ofequipment in 2001 and $905 of equipment in 2002 before it expired in October2002. The weighted average interest rates on capital leases were 5.4% and 6.1%at December 31, 2003 and 2002, respectively.

 

Minimum annuallease payments, including interest, on capital leases for the years 2004 to2006 are $465, $439, and $153, respectively.  All capital lease obligations mature by the end of 2006.

 

----

 

**Note 8 – WarrantyAccruals**

 

Axsys issueswarranties for approximately 45% of our products.  The product warranty liability is generally based on volume,historical return percentages and the warranty period.  The following table summarizes productwarranty activity for 2003:

 
|   |   | **Balance at  December 31,  2002** |   | **Provision,  changes  and other** |   | **Payments** |   | **Balance at  December 31,  2003** |   |
|--------|--------|------------------------------------|--------|------------------------------------|--------|--------------|--------|------------------------------------|--------|
|   |   | $                                  | 722    |                               | 190    |         | (229   | )                                  | $      | 683 |   |
|        |        |                                    |        |                                    |        |              |        |                                    |        |  |  |

 

**Note9 - Balance Sheet Information**

 

The details of certain balance sheet accountsare as follows:

 
|              |   | **2003** |   | **2002** |   |
|-------------------|--------|----------|--------|----------|--------|
| Inventories:      |   |     |   |     |   |
| Raw materials     |   | $        | 3,234  |     | $      | 3,267 |   |
| Work-in-process   |   | 14,049   |   | 11,315   |   |
| Finished goods    |   | 7,503    |   | 7,498    |   |
| Total inventories |   | $        | 24,786 |     | $      | 22,080 |   |

 
|                                            |   | **2003** |   | **2002** | ** ** |
|-------------------------------------------------|--------|----------|--------|----------|------------|
| Property, plant and equipment:                  |   |     |   |     |       |
| Land                                            |   | $        | 291    |     | $          | 291 |   |
| Buildings and improvements                      |   | 4,374    |   | 4,338    |       |
| Machinery and equipment                         |   | 22,373   |   | 19,611   |       |
| Total property, plant and equipment             |   | 27,038   |   | 24,240   |       |
| Less accumulated depreciation and  amortization |   | (15,723  | )      | (12,977  | )          |
| Net property, plant and equipment               |   | $        | 11,315 |     | $          | 11,263 |   |

 
|                                          |   | **2003** |   | **2002** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|
| Accrued expenses and other liabilities:       |   |     |   |     |   |
| Compensation and related benefits             |   | $        | 3,083  |     | $      | 3,153 |   |
| Income taxes                                  |   | 1,053    |   | 766      |   |
| Liabilities of discontinued operations        |   | 776      |   | 1,674    |   |
| Warranty                                      |   | 683      |   | 722      |   |
| Stock redemption                              |   | 426      |   | 674      |   |
| Environmental - short-term                    |   | 469      |   | 685      |   |
| Loss contracts - short-term                   |   | 295      |   | 433      |   |
| Professional fees                             |   | 359      |   | 426      |   |
| Restructuring accrual - 2002                  |   | 50       |   | 185      |   |
| Other                                         |   | 761      |   | 567      |   |
| Total accrued expenses and other  liabilities |   | $        | 7,955  |     | $      | 9,285 |   |

 
|                                          |   | **2003** |   | **2002** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|
| Other long-term liabilities:                  |   |     |   |     |   |
| Loss contracts – long-term               |   | $        | 1,781  |     | $      | 2,000 |   |
| Deferred taxes                                |   | 1,504    |   | 1,310    |   |
| Defined benefit pension and health  insurance |   | 812      |   | 903      |   |
| Environmental – long-term                |   | 366      |   | 674      |   |
| Workers’ compensation                    |   | 535      |   | 422      |   |
| Other                                         |   | 217      |   | 216      |   |
| Total other long-term liabilities             |   | $        | 5,215  |     | $      | 5,525 |   |

 

----

 

**Note10 – Goodwill**

 

Goodwill was$3,600 at December 31, 2003 and December 31, 2002. Axsys records goodwill atthe reportable unit and annually in the second quarter reviews the goodwill todetermine if any impairment exists.  Asof December 31, 2003, we determined that goodwill was not considered to beimpaired.  The following tablesummarizes our reporting units

 
| **Segment**                 |   | **Reporting  Unit**                       |   | **Status**     |
|-----------------------------|--------|-------------------------------------------|--------|----------------|
| Aerospace and Defense Group |   | • Motion  Control Products           |   | Active         |
|                        |   | • Precision  Machined Products       |   | Active         |
|                        |   | • Precision  Optical Products        |   | Active         |
|                        |   |                                      |   |           |
| Commercial Products Group   |   | • Imaging  Systems – Commercial |   | Active         |
|                        |   | • Integrated  Systems                |   | Closed in 2002 |
|                        |   | • Fiber  Automation Division         |   | Sold in 2002   |
|                        |   | • Axsys  Automation Engineering      |   | Sold in 2002   |
|                        |   |                                      |   |           |
| Distributed Products Group  |   | • AST  Bearings Division             |   | Active         |

 

The changes in the carrying amount of goodwill for fiscal 2003 and 2002are as follows:

 
| **Reporting  Unit**            |   | **Motion  Control  Products** |   | **Integrated  Systems** |   | **AST  Bearings** |   | **Total** |   |
|--------------------------------|--------|-------------------------------|--------|-------------------------|--------|-------------------|--------|-----------|--------|
| Balance at 12/31/2001          |   | 2,160                         |   | (535                    | )      | 1,440             |   | $         | 3,065  |   |
| Write-off of negative goodwill |   | —                        |   | 535                     |   | —            |   | —    |   |
| Balance at 12/31/2002          |   | 2,160                         |   | —                  |   | 1,440             |   | $         | 3,600  |   |
| Impairment                     |   | —                        |   | —                  |   | —            |   | —    |   |
| Balance at 12/31/2003          |   | $                             | 2,160  |                    | $      | —            |   | $         | 1,440  |   | $ | 3,600 |   |
|                                |        |                               |        |                         |        |                   |        |           |        |  |  |  |  |

 

The effects of not amortizing goodwill for all periods presented wouldhave been an increase in net loss in 2001 by $3 with no corresponding change tobasic or diluted loss per share.

 

**Note 11 - Supplemental Cash Flow Information**

 

Supplemental cash flow information from continuing operations for theyears ended December 31, 2003, 2002 and 2001 is summarized as follows:

 
|                                                  |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash (received)/paid during the year for:             |   |     |   |     |   |     |   |
| Interest income (expense) – net                  |   | $        | 10     |     | $      | (32      | )      | $ | (341 | ) |
| Income tax refunds – net                         |   | (1,093   | )      | (3,095   | )      | (1,522   | )      |
|                                                  |   |     |   |     |   |     |   |
| Non-cash investing activities:                        |   |     |   |     |   |     |   |
| Equipment acquired under capital leases               |   | $        | — |     | $      | 905      |   | $ | 762 |   |
| Stock proceeds from sale of AEI                       |   | —   |   | 356      |   | —   |   |
| Treasury stock issued for defined  contribution plans |   | 53       |   | 104      |   | 71       |   |

#### ** **

----

 

#### **Note 12 - IncomeTaxes**

#### ** **

The income tax provision (benefit) fromcontinuing operations consists of:

 
|                           |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Current taxes:                 |   |     |   |     |   |     |   |
| U.S. Federal                   |   | $        | — |     | $      | (1,595   | )      | $ | (2,553 | ) |
| State and local                |   | 236      |   | 300      |   | 130      |   |
|                           |   | 236      |   | (1,295   | )      | (2,423   | )      |
| Deferred taxes:                |   |     |   |     |   |     |   |
| U.S. Federal                   |   | (195     | )      | 3,910    |   | (613     | )      |
| State and local                |   | 195      |   | 354      |   | (56      | )      |
|                           |   | —   |   | 4,264    |   | (669     | )      |
| Total tax provision (benefit): |   | $        | 236    |     | $      | 2,969    |   | $ | (3,092 | ) |

 

The current federal and the deferred federal and state taxes reflectthe utilization of the valuation allowance.

 

The difference between the provision for taxes and the amount computedby applying the statutory federal income tax rate to Income (Loss) fromContinuing Operations Before Taxes and Cumulative Effect of Change inAccounting Principle are as follows:

 
|                                               |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Federal statutory rate                             |   | 35       | %      | 35       | %      | 35       | %      |
| Computed expected tax provision (benefit)          |   | $        | 1,832  |     | $      | (16      | )      | $ | (2,925 | ) |
| Increase (decrease) in taxes resulting from:       |   |     |   |     |   |     |   |
| Net change in valuation allowance                  |   | (1,395   | )      | 4,631    |   | —   |   |
| State and local taxes, net of federal tax  benefit |   | 348      |   | 91       |   | 28       |   |
| Tax benefit of credits & net operating  losses |   | (434     | )      | —   |   | —   |   |
| Net alternative minimum tax activity               |   | 245      |   | —   |   | —   |   |
| Tax basis adjustment – sale of subsidiary     |   | —   |   | (1,434   | )      | —   |   |
| Adjustment to tax accrual                          |   | (318     | )      | (300     | )      | —   |   |
| Tax exempt interest                                |   | —   |   | —   |   | (55      | )      |
| Other                                              |   | (42      | )      | (3       | )      | (140     | )      |
| Actual tax provision (benefit):                    |   | $        | 236    |     | $      | 2,969    |   | $ | (3,092 | ) |

 

Deferredincome taxes reflect the net federal and state tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes.

 

At December 31, 2003, we had a net operatingloss carryforward of approximately $795, which expires in 2022.  We also had credit carryforwards ofapproximately $1.1 million, which expire at various times between 2018 and2021.  In accordance with the SFAS No.109, we recognized a valuation allowance during 2002 in the amount of $4,631 tooffset a portion of the recorded deferred tax asset.   During 2003, the valuation allowance was reduced by $1,395 asdeferred tax assets were realized. Available and prudent tax planning strategies support the deferred taxasset currently recorded on the books.

 

----

 

Significant components of the Axsys’ deferredtaxes are as follows:

 
|                                  |   | **December  31,** |   |
|---------------------------------------|--------|-------------------|--------|
|                                  |   | **2003**          |   | **2002** |   |
| Deferred tax asset:                   |   |              |   |   |   |
| Inventories                           |   | $                 | 2,193  |   | $ | 2,009 |   |
| Tax credit carry-forward              |   | 1,144             |   | 1,056 |   |
| Net operating loss carry-forward      |   | 310               |   | 1,354 |   |
| Loss contract reserve                 |   | 809               |   | 949 |   |
| Exit costs of discontinued operations |   | 316               |   | 673 |   |
| Note receivable – Sensor Systems |   | 170               |   | 368 |   |
| Note receivable – STS            |   | 332               |   | 332 |   |
| Allowance for doubtful accounts       |   | 255               |   | 201 |   |
| Pension accruals                      |   | 383               |   | — |   |
| Other, net                            |   | 228               |   | 399 |   |
| Total deferred tax asset              |   | 6,140             |   | 7,341 |   |
| Valuation allowance                   |   | (3,236            | )      | (4,631 | ) |
| Net deferred tax asset                |   | $                 | 2,904  |   | $ | 2,710 |   |
| Long-term deferred tax liability:     |   |              |   |   |   |
| Property, plant and equipment         |   | $                 | (1,504 | ) | $ | (1,310 | ) |

 

**Note13 – Segment Data**

 

In 2002, Axsysannounced a strategic realignment, which resulted in three major segments,which correspond to the major markets we serve.  The strategic realignment has resulted in a change in the compositionof our reportable segments and, accordingly, all prior periods reported havebeen restated.  We classify ourbusinesses under three major groups, the Aerospace and Defense Group,Commercial Products Group and Distributed Products Group.

 

The Aerospaceand Defense Group designs, manufactures and sells high-end components such asprecision position sensors, high-performance motors, precision metal optics,precision machined light-weight structures and opto-mechanical andelectro-mechanical subassemblies.  Theseproducts enable Original Equipment Manufacturers (“OEMs”) to improve imaging,positional performance (accuracy, resolution, speed and power), and weightrequirements in their systems. Principal markets for these products include OEMs serving the aerospaceand defense markets.

 

The CommercialProducts Group designs, manufactures and sells airbearing scanners,micro-positioning stages and laser-based distance measuring interferometers andautofocus.  These products are sold toOEMs enabling them to increase the accuracy and throughput of theirsystems.  Principal markets for theseproducts include OEMs serving the graphic arts, semiconductor capital equipmentand medical imaging markets.

 

TheDistributed Products Group distributes precision ball bearings, acquired fromvarious domestic and international sources, to OEMs and Maintenance RepairOperations (“MRO”) distributors.  Theball bearings are used in a variety of industrial automation and commercialmarkets.  Additionally, the DistributedProducts Group designs, manufactures and sells mechanical-bearing subassembliesfor a variety of customers.

 

As discussedin Note 3, we sold our Fiber Automation Division and our AutomationEngineering, Inc. subsidiary, which were previously included in the CommercialProducts Group.  These businesses havebeen accounted for as discontinued operations and, accordingly, the relatedoperating results have been reported separately from continuing operations.  Segment data below excludes thesediscontinued businesses.

 

----

 

The following tables present financial data for each Axsys segment:

 
|                                                       |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net sales from continuing operations:                      |   |     |   |     |   |     |   |
| Aerospace and Defense Group                                |   | $        | 49,700 |     | $      | 45,869   |   | $ | 42,914 |   |
| Commercial Products Group                                  |   | 13,546   |   | 13,569   |   | 20,192   |   |
| Distributed Products Group                                 |   | 21,863   |   | 20,148   |   | 23,025   |   |
| Total sales                                                |   | $        | 85,109 |     | $      | 79,586   |   | $ | 86,131 |   |
|                                                       |   |     |   |     |   |     |   |
| Income (loss) from continuing operations  before taxes:    |   |     |   |     |   |     |   |
| Aerospace and Defense Group                                |   | $        | 3,906  |     | $      | 3,088    |   | $ | 1,817 |   |
| Commercial Products Group                                  |   | 3,157    |   | 1,964    |   | 362      |   |
| Distributed Products Group                                 |   | 1,900    |   | 1,211    |   | 2,639    |   |
| Non-allocated expenses                                     |   | (3,729   | )      | (6,308   | )      | (13,176  | )      |
| Income (loss) from continuing operations  before taxes     |   | $        | 5,234  |     | $      | (45      | )      | $ | (8,358 | ) |
|                                                       |   |     |   |     |   |     |   |
| Capital expenditures from continuing  operations:          |   |     |   |     |   |     |   |
| Aerospace and Defense Group                                |   | $        | 2,621  |     | $      | 1,923    |   | $ | 2,088 |   |
| Commercial Products Group                                  |   | 287      |   | 209      |   | 261      |   |
| Distributed Products Group                                 |   | 103      |   | 124      |   | 130      |   |
| Corporate                                                  |   | 16       |   | 29       |   | 541      |   |
| Total capital expenditures                                 |   | $        | 3,027  |     | $      | 2,285    |   | $ | 3,020 |   |
|                                                       |   |     |   |     |   |     |   |
| Depreciation and amortization from  continuing operations: |   |     |   |     |   |     |   |
| Aerospace and Defense Group                                |   | $        | 2,064  |     | $      | 1,995    |   | $ | 2,297 |   |
| Commercial Products Group                                  |   | 358      |   | 155      |   | 157      |   |
| Distributed Products Group                                 |   | 219      |   | 223      |   | 222      |   |
| Corporate                                                  |   | 279      |   | 290      |   | 259      |   |
| Total depreciation                                         |   | $        | 2,920  |     | $      | 2,663    |   | $ | 2,935 |   |
|                                                       |   |     |   |     |   |     |   |
| Amortization of goodwill                                   |   | —   |   | —   |   | (3       | )      |
| Total depreciation and amortization                        |   | $        | 2,920  |     | $      | 2,663    |   | $ | 2,932 |   |

 
|                        |   | **December  31,** |   |
|-----------------------------|--------|-------------------|--------|
|                        |   | **2003**          |   | **2002** |   |
| Identifiable assets:        |   |              |   |   |   |
| Aerospace and Defense Group |   | $                 | 33,236 |   | $ | 30,466 |   |
| Commercial Products Group   |   | 4,330             |   | 4,158 |   |
| Distributed Products Group  |   | 12,366            |   | 11,949 |   |
| Non-allocated assets        |   | 16,913            |   | 15,799 |   |
| Total assets                |   | $                 | 66,845 |   | $ | 62,372 |   |

 

Included innon-allocated expenses are the following: restructuring and special charges,general corporate expense, interest expense, amortization of goodwill and otherincome and expense.  Identifiable assetsby segment consist of those assets that are used in the segments’operations.  Non-allocated assets arecomprised primarily of short-term investments, cash and cash equivalents,corporate assets and net deferred tax assets.

 

----

 

The following table presents the non-allocated identifiable assets:

 
|                                                   |   | **December  31,** |   |
|--------------------------------------------------------|--------|-------------------|--------|
|                                                   |   | **2003**          |   | **2002** |   |
| Non-allocated assets:                                  |   |              |   |   |   |
| Short-term investments                                 |   | $                 | 6,983  |   | $ | — |   |
| Cash and cash equivalents                              |   | 5,197             |   | 9,920 |   |
| Income taxes – current and deferred income  taxes |   | 2,203             |   | 4,077 |   |
| Long-term deferred tax asset                           |   | 1,264             |   | 239 |   |
| Corporate prepaid insurance                            |   | 709               |   | 684 |   |
| Corporate property, plant and equipment                |   | 510               |   | 823 |   |
| Miscellaneous other corporate assets                   |   | 47                |   | 56 |   |
| Total assets                                           |   | $                 | 16,913 |   | $ | 15,799 |   |

 

The following table presents sales from continuing operations bygeographic region.  Substantially all ofour assets are located within the United States.

 
|          |   | **Years  Ended December 31,** |   |
|---------------|--------|-------------------------------|--------|
|          |   | **2003**                      |   | **2002** |   | **2001** |   |
| United States |   | $                             | 73,051 |   | $ | 65,179 |   | $ | 68,036 |   |
| Europe        |   | 8,991                         |   | 10,951 |   | 14,178 |   |
| Other foreign |   | 3,067                         |   | 3,456 |   | 3,917 |   |
| Total sales   |   | $                             | 85,109 |   | $ | 79,586 |   | $ | 86,131 |   |

 

During 2003, sales activity with one customer, Raytheon Company,represented 15.5% of our net sales. During 2002 and 2001, we did not have a concentration of sales with anyone customer.

 

**Note 14 - Pension Arrangements**

 

Axsys has two pension plans for which benefits and participation havebeen frozen.  Pension benefits underthese plans are generally based upon years of service and compensation. Thereis a non-funded plan with an annual payout of approximately $110.   The funding policy for the other plan is tocontribute amounts sufficient to meet the minimum funding requirements setforth in the Employee Retirement Income Security Act of 1974, plus suchadditional amounts as may be determined to be appropriate from time to time.  During 2003, we began the process toliquidate the funded plan and we anticipate the plan will be fully liquidatedin 2004.

 

The following table summarizes the components of net periodic pensioncost for the defined benefit plans:

 
|                                           |   | **Years  Ended December 31,** |   |
|------------------------------------------------|--------|-------------------------------|--------|
|                                           |   | **2003**                      |   | **2002** |   | **2001** |   |
| Interest cost on projected benefit  obligation |   | $                             | 92     |   | $ | 86 |   | $ | 82 |   |
| Expected return on plan assets                 |   | (44                           | )      | (54 | ) | (43 | ) |
| Recognized net actuarial loss                  |   | 53                            |   | 43 |   | 52 |   |
| Effect of special events                       |   | —                        |   | (48 | ) | — |   |
| Total pension expense                          |   | $                             | 101    |   | $ | 27 |   | $ | 91 |   |

 

----

 

Assumptions used in accounting for thedefined benefit plans as of the plans’ measurement dates were:

 
|                                                                    |   | **December  31,** |   |
|-------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                    |   | **2003**          |   | **2002** |   |
| Weighted-average assumptions used to determine benefit obligations  at: |   |              |   |   |   |
| Weighted-average discount rate                                          |   | 5.75              | %      | 7.00 | % |
| Rate of compensation increase                                           |   | N/A               |   | N/A |   |

 
|                                                                                         |   | **December  31,** |   |
|----------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                         |   | **2003**          |   | **2002** |   |
| Weighted-average  assumptions used to determine net periodic benefit costs for years ending: |   |              |   |   |   |
| Discount rate                                                                                |   | 7.00              | %      | 7.50 | % |
| Expected long-term return on plan assets                                                     |   | 6.00              | %      | 6.00 | % |
| Rate of compensation increase                                                                |   | N/A               |   | N/A |   |

 

The following table sets forth the change inbenefit obligation, change in plan assets and the funded status recognized inthe consolidated balance sheets for the Axsys’ defined benefit pension plans:

 
|                                            |   | **2003** |   | **2002** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| Change in benefit obligation:                   |   |     |   |     |   |
| Benefit obligation at beginning of year         |   | $        | 1,186  |     | $      | 1,179 |   |
| Interest cost                                   |   | 92       |   | 86       |   |
| Actuarial loss                                  |   | 211      |   | 258      |   |
| Benefits/settlements paid                       |   | (104     | )      | (337     | )      |
| Benefit obligation at end of year               |   | $        | 1,385  |     | $      | 1,186 |   |
|                                            |   |     |   |     |   |   |
| Change in plan assets:                          |   |     |   |     |   |   |
| Fair value of plan assets at beginning of  year |   | $        | 837    |     | $      | 989 |   |   |
| Actual return                                   |   | 28       |   | 80       |   |   |
| Employer contribution                           |   | 145      |   | 105      |   |   |
| Benefits/settlements paid                       |   | (104     | )      | (337     | )      |   |
| Fair value of plan assets at end of year        |   | $        | 906    |     | $      | 837 |   |   |
|                                            |   |     |   |     |   |   |   |   |
|                                                 |        |          |        |          |        |  |  |  |  |  |  |  |  |  |  |

 
|                                   |   | **2003** |   | **2002** |   |
|----------------------------------------|--------|----------|--------|----------|--------|
| Funded status                          |   | $        | 479    |     | $      | 349 |   |
| Unrecognized net actuarial (loss) gain |   | (27      | )      | 147      |   |
| Accrued benefit cost at December 31    |   | $        | 452    |     | $      | 496 |   |

 

Unrecognizednet gains and losses are amortized over the average future service lives ofparticipants.  Asset managementobjectives include maintaining an adequate level of diversification to reduceinterest rate and providing adequate liquidity to meet immediate and futurebenefit payment requirements.   Planassets for the fully funded plan are invested in a managed portfolio consistingprimarily of equity securities, real estate and bonds.  The asset allocation of pension benefitplans at December 31 were:

 
| **Asset  Category**   |   | **2003** |   | **2002** |   |
|-----------------------|--------|----------|--------|----------|--------|
| Money Market Account  |   | $        | 194    |     | $      | 161 |   |
| Debt Securities       |   | 178      |   | 169      |   |
| Real Estate           |   | 176      |   | 162      |   |
| Government Securities |   | 170      |   | 167      |   |
| Other                 |   | 188      |   | 178      |   |
| Total                 |   | $        | 906    |     | $      | 837 |   |

 

----

 

Benefitpayments, including amounts to be paid from corporate assets, and reflectingexpected future service, as appropriate, are expected to be as follows:

 
| 2004 |   | $   | 1,020  |   |
|------|--------|-----|--------|--------|
| 2005 |   | 104 |   |
| 2006 |   | 105 |   |
| 2007 |   | 106 |   |
| 2008 |   | 107 |   |

 

Axsys also sponsors a 401(k) plan under which eligible employees mayelect to contribute a percentage of their earnings.  Axsys matches employee contributions to this plan in amountsranging from 3% to 5% of the employees’ gross earnings.  Our matching contributions from continuingoperations were $719 in 2003, $720 in 2002, and $811 in 2001.

 

**Note 15 - Stock Options**

 

In 1991, Axsysshareholders approved the Axsys’ Long-Term Stock Incentive Plan (the“Plan”).   Shareholders approvedamendments to and restatement of the Plan in May 2000 and May 2001, which,among other things, increased the number of shares of common stock authorizedfor issuance under the Plan by 200,000 each year.  As of December 31, 2003, the total number of shares of commonstock authorized for issuance under the Plan was 800,000 shares, of which 272,528shares of common stock remain available for grant under the Plan.  The Stock Incentive Plan Committee of theBoard of Directors (the “Committee”) administers the Plan.  The Committee selects participants from amongthose executives and other employees of Axsys and the subsidiaries who materiallycontribute to the success of Axsys and determines the amounts, times, forms,terms and conditions of grants. Grants may be in the form of options topurchase shares of common stock, stock appreciation rights, restricted stockand performance units (collectively, “Stock Incentives”).  Generally, each grant vests 20 percent peryear for five years, is exercisable upon vesting and expires in ten years.

 

A summary of all outstandingstock options is presented in the table below:

 
|                             |   | **Stock  Options** |   | **Weighted-average  Exercise Price** |   |
|----------------------------------|--------|--------------------|--------|--------------------------------------|--------|
|                             |   |               |   |                                 |   |   |
| Outstanding at December 31, 2001 |   | 537,965            |   | $                                    | 18.84  |   |
|                             |   |               |   |                                 |   |
| Granted                          |   | 172,620            |   | 6.91                                 |   |
| Forfeited/Cancelled              |   | (193,850           | )      | (18.77                               | )      |
| Outstanding at December 31, 2002 |   | 516,735            |   | $                                    | 14.90  |   |
|                             |   |               |   |                                 |   |
| Granted                          |   | 129,662            |   | 8.50                                 |   |
| Forfeited/Cancelled              |   | (184,675           | )      | (15.51                               | )      |
| Exercised                        |   | (600               | )      | (6.69                                | )      |
|                             |   |               |   |                                 |   |
| Outstanding at December 31, 2003 |   | 461,122            |   | $                                    | 12.80  |   |
| Exercisable at December 31, 2003 |   | 160,385            |   | $                                    | 19.01  |   |

 

----

 

The followingtable summarizes information about stock options outstanding at December 31,2003:

 
|                          |   | **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** |   |
|                          |   |                     |   |                                   |   |   |   |   |   |   |   |
| $3.75 to $7.00                |   | 109,800                  |   | 8.1                                    |   | $ | 6.76 |   | 5,800 |   | $ | 6.69 |   |
| $7.01 to $10.00               |   | 129,252                  |   | 8.9                                    |   | 8.37 |   | 12,118 |   | 9.66 |   |
| $10.01 to $15.00              |   | 105,425                  |   | 6.7                                    |   | 12.35 |   | 51,170 |   | 12.80 |   |
| $15.01 to $20.00              |   | 32,995                   |   | 5.4                                    |   | 17.70 |   | 19,547 |   | 17.70 |   |
| $20.01 to $25.00              |   | 17,500                   |   | 2.3                                    |   | 20.66 |   | 10,100 |   | 20.48 |   |
| $25.01 to $30.00              |   | 58,650                   |   | 4.0                                    |   | 26.63 |   | 57,150 |   | 26.65 |   |
| $30.01 to $36.00              |   | 7,500                    |   | 6.8                                    |   | 36.00 |   | 4,500 |   | 36.00 |   |
|                          |   |                     |   |                                   |   |   |   |   |   |   |   |
| $3.75 to $36.00               |   | 461,122                  |   | 7.1                                    |   | $ | 12.80 |   | 160,385 |   |   | $ | 19.01 |   |   |
|                               |        |                          |        |                                        |        |  |  |  |  |  |  |  |  |  |  |

 

**Note16 - Commitments and Contingencies**

 

Future minimumpayments under non-cancelable operating leases (exclusive of property expensesand net of sublease rental income), as of December 31, 2003, are as follows:

 
| 2004                |   | $     | 1,456  |   |
|---------------------|--------|-------|--------|--------|
| 2005                |   | 1,327 |   |
| 2006                |   | 973   |   |
| 2007                |   | 943   |   |
| 2008                |   | 958   |   |
| 2009 and thereafter |   | 1,031 |   |
|                |   | $     | 6,688  |   |

 

Rent expenseunder such leases, net of sublease rental income, amounted to $1,400 in 2003,$1,517 in 2002, and $1,608 in 2001. Axsys anticipates receiving an aggregate of$40 in future sublease rental income.  Axsys has two letters of credit totaling $231 opened in 2001 as securitydeposits on building leases in Wilmington, Massachusetts and Pittsburgh,Pennsylvania.  These letters of creditare renewed annually for the term of the lease.

 

In the normalcourse of business, we are liable for contract completion and productperformance. In the opinion of management, such obligations will notsignificantly affect our financial position or annual results of operations.

 

        Axsysis involved in various stages of investigation and cleanup related toenvironmental remediation matters at a number of sites.   In addition, Axsys has various lawsuits,claims, commitments and contingent liabilities arising from the ordinaryconduct of our business; however, they are not expected to have a materialadverse effect on the business and financial condition.  It is possible, however, that the results ofoperations for a particular fiscal period could be materially affected.  (See Note 4 and 5 of the ConsolidatedFinancial Statements)

 

----

 

**Note17 – Selected Quarterly Financial Data**

 

Selected quarterly financial data for the years ended December 31, 2003and 2002 is summarized as follows (in thousands, except per share data):

** **
|                                                              |   | **Quarters  Ended (Unaudited) :** |   |
|-------------------------------------------------------------------|--------|-----------------------------------|--------|
| **Statement of Operations Data:**                                 |   | **March  2003**                   |   | **June  2003** |   | **September  2003** |   | **December  2003** |   |
| Net sales                                                         |   | $                                 | 20,373 |   | $ | 21,693 |   | $ | 21,203 |   | $ | 21,840 |   |
| Gross margin                                                      |   | 5,447                             |   | 5,986 |   | 5,714 |   | 5,926 |   |
| Income from continuing operations before  discontinued operations |   | 874                               |   | 1,436 |   | 1,225 |   | 1,463 |   |
| Net income                                                        |   | 874                               |   | 1,436 |   | 1,225 |   | 1,463 |   |
| Diluted net income per share applicable to  common shareholders   |   | $                                 | 0.19   |   | $ | 0.31 |   | $ | 0.26 |   | $ | 0.31 |   |
| Diluted weighted-average common shares  outstanding               |   | 4,669                             |   | 4,693 |   | 4,735 |   | 4,660 |   |

 
|                                                                                           |   | **Quarters  Ended (Unaudited) (1) (2) (3):** |   |
|------------------------------------------------------------------------------------------------|--------|----------------------------------------------|--------|
| **Statement of Operations Data:**                                                              |   | **March  2002**                              |   | **June  2002** |   | **September  2002** |   | **December  2002** |   |
| Net sales                                                                                      |   | $                                            | 19,092 |   | $ | 20,586 |   | $ | 19,086 |   | $ | 20,822 |   |
| Gross margin                                                                                   |   | 4,397                                        |   | 5,258 |   | 4,984 |   | 5,493 |   |
| (Loss) income from continuing operations  before discontinued operations                       |   | (1,861                                       | )      | (1,234 | ) | (791 | ) | 872 |   |
| Net (loss) income                                                                              |   | (2,225                                       | )      | (2,093 | ) | (3,299 | ) | 556 |   |
| Diluted net (loss) income per share from  continuing operations before discontinued operations |   | $                                            | (0.40  | ) | $ | (0.26 | ) | $ | (0.17 | ) | $ | 0.19 |   |
| Diluted net (loss) income per share  applicable to common shareholders                         |   | $                                            | (0.47  | ) | $ | (0.45 | ) | $ | (0.70 | ) | $ | 0.12 |   |
| Diluted weighted-average common shares  outstanding                                            |   | 4,697                                        |   | 4,699 |   | 4,703 |   | 4,667 |   |

 

----

(1) Certain engineering expenses have been re-classed from costs ofgoods sold to operating expenses to conform to the 2003 presentation

 

(2) In the fourth quarter of 2002, Axsys established a valuationallowance to offset a portion of our net deferred tax asset.  Accordingly, all periods presented in 2002have been adjusted to reflect the valuation allowance.

 

(3) In the third quarter of 2002, the Automation Group wasdivested.  Accordingly, the AutomationGroup has been accounted for as discontinued operations for all periodspresented

 

----

 

**AXSYS TECHNOLOGIES,INC.**

**SCHEDULE II VALUATIONAND QUALIFYING ACCOUNTS**

 

**(Dollars inthousands)**

 
| **COL. A**                         |   | **COL.B**                            |   | **COL. C**                          |   | **COL. D**                     |   | **COL. E**     |   | **COL. F**                     |   |
|------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|--------------------------------|--------|----------------|--------|--------------------------------|--------|
|                               |   |                                 |   | **Additions**                       |   |                           |   |           |   |                           |   |
| **Classification**                 |   | **Balance at  Beginning  of Period** |   | **Charged to  Costs and  Expenses** |   | **Charge to  Other  Accounts** |   | **Deductions** |   | **Balance at  End  of Period** |   |
|                               |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Year ended December 31, 2003:      |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Inventory Valuation Reserve        |   | $                                    | 3,593  |                                | $      | 512                            |   | $              | 70     |                           | $      | 258 |   | $ | 3,917 |   |
| Allowance for Doubtful Accounts    |   | 509                                  |   | 234                                 |   | —                         |   | 90             |   | 653                            |   |
| Cost Reduction Program Accrual     |   | 65                                   |   | —                              |   | —                         |   | 65             |   | —                         |   |
| Relocation of Product Line Accrual |   | 50                                   |   | —                              |   | —                         |   | —         |   | 50                             |   |
| Segment Reorganization             |   | 70                                   |   | —                              |   | —                         |   | 70             |   | —                         |   |
| Environmental Accrual              |   | 1,359                                |   | —                              |   | —                         |   | 524            |   | 835                            |   |
|                               |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Year ended December 31, 2002:      |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Inventory Valuation Reserve        |   | $                                    | 3,482  |                                | $      | 540                            |   | $              | 48     |                           | $      | 477 |   | $ | 3,593 |   |
| Allowance for Doubtful Accounts    |   | 654                                  |   | 113                                 |   | —                         |   | 258            | (a)    | 509                            |   |
| Cost Reduction Program Accrual     |   | 658                                  |   | 20                                  |   | —                         |   | 613            |   | 65                             |   |
| Relocation of Product Line Accrual |   | —                               |   | 1,053                               |   | —                         |   | 1,003          |   | 50                             |   |
| Sale of Teletrac Accrual           |   | —                               |   | 1,009                               |   | —                         |   | 1,009          |   | —                         |   |
| Segment Reorganization             |   | —                               |   | 286                                 |   | —                         |   | 216            |   | 70                             |   |
| Environmental Accrual              |   | 1,449                                |   | 185                                 |   | —                         |   | 275            |   | 1,359                          |   |
|                               |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Year ended December 31, 2001:      |   |                                 |   |                                |   |                           |   |           |   |                           |   |
| Inventory Valuation Reserve        |   | $                                    | 4,402  |                                | $      | 4,731                          |   | $              | 7      |                           | $      | 5,658 |   | $ | 3,482 |   |
| Allowance for Doubtful Accounts    |   | 497                                  |   | 228                                 |   | —                         |   | 71             | (a)    | 654                            |   |
| Cost Reduction Program Accrual     |   | —                               |   | 1,738                               |   | —                         |   | 1,080          |   | 658                            |   |
| Strategic Realignment Accrual      |   | 752                                  |   | —                              |   | —                         |   | 752            |   | —                         |   |
| Environmental Accrual              |   | 1,598                                |   | —                              |   | —                         |   | 149            |   | 1,449                          |   |

 

----

(a)  Uncollectible accountswritten off, net of recoveries.

 

----

 

**EXHIBITINDEX**

 
| **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 and incorporated herein by reference).                                                                                                                                                                                          |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.1                |   | Severance Agreement between Axsys and  Kenneth F. Stern dated as of June 10, 1996 (filed as Exhibit 10(16) to the  Form S-1 and incorporated herein by reference).*                                                                                                                                        |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.2                |   | 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 and  incorporated herein by reference).*                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.3                |   | 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 (the “March 31, 1999 Form 10-Q”) and incorporated herein by  reference).* |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.4                |   | Severance Protection Agreement between  Axsys and Kenneth F. Stern dated as of February 11, 1999 (filed as Exhibit  10(4) to the March 31, 1999 Form 10-Q and incorporated herein by reference).*                                                                                                          |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.5                |   | Amendment to Axsys Technologies, Inc.  Long-Term Stock Incentive Plan (filed as Exhibit A to Axsys’ Proxy Statement  dated April 24, 2000 and incorporated herein by reference).*                                                                                                                     |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.6                |   | 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 and incorporated herein by reference).*                                                                                                             |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.7                |   | Form of Indemnification Agreement for all  Directors and Officers of Axsys (filed as Exhibit 10(17) to the December 31,  2001 Form 10-K and incorporated herein by reference).*                                                                                                                            |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.8                |   | 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 and incorporated herein by reference).*                                                                                                                    |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.9                |   | Change in registrant’s certifying  accountant (filed as Exhibit 16 to the May 23, 2002 Form 8-K and incorporated  herein by reference).                                                                                                                                                               |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.10               |   | Letter Agreement between Stephen W. Bershad  and Axsys dated November 6, 2003, extending term of initial period of the  Employment Agreement.*                                                                                                                                                             |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.11               |   | Amended and Restated Severance Protection Agreement between Axsys and  Kenneth F. Stern dated as of May 13, 2003 (filed as Exhibit 10.1 to the June  28, 2003 Form 10-Q and incorporated herein by reference).*                                                                                            |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.12               |   | 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 and incorporated herein by reference).*                                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 10.13               |   | Summary of Management Incentive Plan*                                                                                                                                                                                                                                                                      |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 14.1                |   | Code of Ethics – Senior Financial Officers                                                                                                                                                                                                                                                            |
|                |   |                                                                                                                                                                                                                                                                                                       |
| 21                  |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                             |

 

----

 
| **Exhibit  Number** |   | **Description**                                                                  |
|---------------------|--------|----------------------------------------------------------------------------------|
|                |   |                                                                             |
| 23                  |   | Consent of Ernst and Young LLP                                                   |
|                |   |                                                                             |
| 31.1                |   | Certification pursuant to Rule 13a-14(a) – Chief Executive Officer          |
|                |   |                                                                             |
| 31.2                |   | Certification pursuant to Rule 13a – 14(a) – 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 |

 

----

* Indicates management contracts or compensatory plans or arrangements

 

----