**SECURITIES AND EXCHANGE COMMISSION**WASHINGTON,D.C. 20549

**FORM 10-K**

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**Forthe Fiscal Year ended December 31, 2004**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                               to                              **

**CommissionFile 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:**

**CommonStock, par value $.01 per share**

**Securities registered pursuant toSection 12(b) of the Act:**None

Indicate by check mark whether the Registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:  Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K o.

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

Aggregate market value of the voting and non-votingcommon equity held by non-affiliates computed by reference to the price atwhich the common equity was last sold, or the average bid and asked price ofsuch common equity, as of the close of business July 2, 2004, $72,692,670.

Common Stock outstanding at February 16, 2005:  7,062,462 shares.

**DocumentsIncorporated 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 |

 

 

 

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**PART I**

**Item 1.**                        BUSINESS

Axsys Technologies, Inc. (together with oursubsidiaries, unless the context suggests otherwise, “Axsys”, “Company”, “we”, “us”or “our”) is a leading designer and manufacturer ofprecision optical solutions for use in aerospace, high performance commercialand defense applications. These solutions are typically comprised of highlyaccurate optical and/or motion control devices. Our solutions are oftenembedded in larger systems that depend on precise optical control for accurateoperation of critical functions. In addition tooptical solutions, we distribute precision ball bearings used in a variety ofindustrial and commercial applications. Axsys was incorporated in theState of New York in 1959 and reincorporated in the State of Delaware in 1968and our common stock trades on the Nasdaq Stock Market under the symbol “AXYS”.

Axsys is organized intotwo groups: Optical Systems Group and Distributed Products Group.

The Optical Systems Groupdesigns, manufactures and sells highly precise assemblies and components whichare typically embedded in optical systems for both government and commercialapplications. Products can be grouped into four primary areas: precision metaloptical products, infrared optical products, motion control products, andprecision machined light-weight structures. However, customerrequirements sometimes demand an optical solution that combines products fromtwo or three of these areas into a sophisticated optical system. The OpticalSystems Group has design and manufacturing facilities in San Diego, California,Cullman, Alabama, Rochester Hills, Michigan, and North Billerica,Massachusetts.

On April 8, 2004 (the “Closing Date”), Axsysacquired all of the stock of Telic Optics, Inc. (“Telic”), a privatelyowned manufacturer of infrared optical products. The financial results of Telicare included in our Optical Systems Group from the dateof acquisition.

Telic’s broad infrared optics capabilities increaseour product offerings and complement our strong position in reflective opticalsolutions. In addition, Telic’s products are typically used in ground-andsea-based programs. This complements our historical focus on air-andspace-based programs and expands our overall market and programpenetration. Finally, the complementary addition of Telic’s technicalcapabilities to our core technical strengths is expected to increase ourcompetitive advantage by broadening our technical offerings to prime contractors who areseeking to outsource the fulfillment of their optical requirements.

The focus markets, for ourOptical Systems Group, are aerospace and defense, high-performancegraphic arts, medical imaging, and semiconductor capital equipment. Axsysproducts are typically sold to original equipment manufacturers (“OEMs”), whichin turn supply a variety of government and commercial end-customers.

For the fiscal year endingDecember 31, 2004, approximately 61% of our company-wide revenueswere generated in the aerospace and defense market. Within this market segment,we arewell positioned on many high-profile military platforms, with themajority of our revenues generated from programs on which we are in a soleprovider position. For example, our products are embeddedin several next generation thermal imaging and targeting systems for platformssuch as the F-16, F-18, Bradley Fighting Vehicle, M1A2 Abrams andStryker. We also supply critical guidance and seeker components for platformssuch as the Minuteman intercontinental ballistic missile and the AIM-9XSidewinder missile. In addition, within the U.S. National Missile Defenseprogram our products are included on several platforms including EKV, THAAD,PAC-3, SBIRS-High and Airborne Laser. Ourdefense products are typically designed into sophisticated stabilized opticalplatforms (“SOP”), which are highly accurate optical positioning mechanisms. TheSOP is essential in applications such as military targeting and imagingsystems.

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The core technologies andmanufacturing techniques that we use to supply the aerospace and defenseindustry are transferable to commercial markets. The commercial markets that weserve include the semiconductor, high-performance graphic arts andmedical imaging industries. In all of these markets, highly precise opticalsystems are required. For example, doctors need precise optical performancefrom medical imaging machines in order to make accurate diagnoses. Similarly,the semiconductor industry demands precise inspection of silicon wafers toensure accurate chip performance.

TheDistributed Products Group distributes precision ball bearings, spherical plainbearings and bushings, which are acquired from various domestic andinternational sources, to OEMs and maintenance repair organizations (“MROs”). Thebearings and bushings are used in a variety of industrial automation andcommercial markets. Additionally, the Distributed Products Group designs,manufactures and sells mechanical-bearing subassemblies for a variety ofcustomers. The Distributed Products Group is comprised of the AST BearingsDivision located in Montville, New Jersey, with a satellite distribution centerin Irvine, California.

**Market Overview**

Our Company’s products aresold mainly to OEMs in a variety of markets that demand the precision andperformance that our products and capabilities provide.

*Optical SystemsGroup*

*Defense Electronics:  *Defenseelectronics represents one of the largest growth sectors in the Department ofDefense (“DoD”) budget. This sector includes the growing market for opticalsensors and thermal imaging equipment. Our Company has a substantial heritagein this market and continues to focus on protecting and building upon thisposition.  We are involved in many large-scaleprograms including the continuing development of next generation forwardlooking infrared (“FLIR”) systems for fighter aircraft, helicopters and armoredvehicles including the F-16, F-18, Apache, MIA2 Abrams, BradleyFighter Vehicle and Stryker.

Optical sensors and thermal imaging equipment arevitally necessary for the U.S. military to maintain its battlefield superiority.Planned upgrade and improvement of such optical and thermal imaging equipmentis not dependent upon spending on new platforms. In fact, even as new platformspending is projected to be challenging over the next few years, spending toupgrade the sensors on existing platforms will continue to thrive. In addition,we expect to participate 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-centricwarfare platforms.

*Homeland Security:  *Since September 11,2001, government officials have designed plans to reduce the risk of terroristattacks and prepare for the consequences of terrorist attacks. Many of thepreventative efforts of these initiatives involve surveillance and imaging ofpeople, baggage, cargo and vehicles. We are well positioned to participate inthis emerging market with our imaging and infrared solutions.

*National Missile Defense (“NMD”):  *Restructuringthe country’s defense and deterrence capabilities to correspond to emergingthreats remains a high priority for the United States. The deployment ofmissile defenses is an essential component of this effort. We are an integralmember of the contractor teams involved in the rollout of key NMD programs fromdevelopment to production, including EKV, THAAD, PAC-3, SBIRS-Highand Airborne Laser.

*Other Aerospace and Defense Opportunities:  *Inconnection with the U.S. government’s efforts to continually enhance agingweaponry, we have the opportunity to be involved in retrofitting the nuclearmissile arsenal with advanced gas bearings. Our Company was chosen as the U.S.Air Force’s Center of Excellence for gas bearing production. We also have along history of involvement with space-based 

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telescopes for use in U.S.-basedsurveillance applications, as well as weather and astronomical research. Weexpect to benefit from the future growth in satellite programs.

*Technology Integration:  *OurCompany has the opportunity to provide value-added solutions byintegrating our technologies into sophisticated optical systems. Theintegration capabilities would create value for the prime contractors byreducing the number of suppliers and collapsing the supply chain. We believe weare strategically positioned to design, develop and manufacture these systemsfor stabilized optical platforms.

*Health Imaging:  *We have positioned ourselves as a keysupplier to the medical imaging sector with an industry leading airbearingscanner solution. The airbearing scanner that we developed has enabled ourcustomer to reach the highest level of design and performance of any medicalimaging systems available on the market. We have the opportunity to continueexpanding our position in the sector as the market moves to develop new systemsthat require the most advanced imaging technology.

*Semiconductor Capital Equipment:  *Ourproducts are used in the precise inspection of semiconductor wafers.  These products include complete auto-focusassemblies, motion control stages and precise distance measuring devices. Wehave the opportunity to expand our position in this industry by introducing newproducts and marketing to new customers.

*Graphic Arts:  *Wepioneered the development of airbearing laser scanners used for digital imagingof film within the graphic arts market in the early 1990’s. While declining advertising revenues havenegatively impacted the graphic arts market, we have expanded our productoffering to include marker engines, which can increase our average sellingprice to a customer over six-fold. Although we anticipate a moderate decline inthe overall graphic arts market, we expect to mitigate this decline with theintroduction of marker engines to our customer base.

*DistributedProducts Group*

*Ball Bearings:  *The markets we serve include industrial automation, semi-conductor capital equipment, aerospace anddefense and consumer products. The market for the distributionof ball bearings and related productsgenerally follows worldwide economic trends. In order to position us for growth,we are introducing new products, lower cost products and value-addedservices.

**Technologies,Products, and Capabilities**

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

*Precision Optics.  *OurCompany is a leading designer and manufacturer of custom precision reflectiveand transmissive optical solutions and components. We provide complete design,fabrication and testing of glass and metal optics ranging from single and multi-facetedscan mirrors, plano and aspheric mirrors to complex telescope assemblies andthermal camera lenses. We have designed and/or manufactured numerous opticalproducts for a variety of military and astronomical applications over the pastforty years.

We specialize in the manufacture of diamond-machinedaspheric metal optics that are significantly enhanced for optical figure andoptical finish by post polishing, typically while using custom engineeredinterferometric null tests. “Bolt together” assemblies with post polished metalaspheres are routine. We produce a variety of aspheric surfaces including conicaspheres, general case aspheres, cylindrical aspheres and toric aspheres up to0.80-meter aperture. Our precision metal optic products are used inapplications where performance requirements cannot be met with glass optics. Theadvantages of our optics include lighter weight, thermal stability and ease ofmechanical interface with housing and actuation devices. We sell our precisionmetal optical components for use in high speed electro-mechanicalscanners, weapons 

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fire control systems, FLIRnight vision weapons systems and high-performance space-borneinstruments used on weather, mapping and scientific satellites.

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

*Precision Motion Control.  *Wedesign a complete line of brushless and brush type torque motors andservomotors that can be customized to meet customers’ unique specifications. Thedirect drive motor replaces conventional servomotor-gearheadconfigurations improving the response characteristics of the unit. Motorsincorporate rare earth magnets with outer diameters ranging from 0.5” to 48”and provide peak torques up to 1,650 ft-lbs.

The gearless DC motor drive is ideally suited for highacceleration applications requiring improved response for rapid start/stopactions such as missile seekers, optical stabilization and turret control. Theabsence of gearing also eliminates errors caused by friction and backlashcreating high threshold sensitivity. These motors achieve accuracies of one arc-secondin a high performance positioning system. Our DC torque motors are designedusing premium materials that offer unique space and weight savings whilegenerating maximum power output. Limited angle torque motors do not requirecommutation electronics and have near zero cogging.

We also manufacture exceptionally reliable multi-speed and segmentedpositioning sensors, such as resolvers and induction potentiometers, whichprovide a high degree of angular accuracy and extremely high resolution. Thesedevices typically accompany our motors to provide position feedback within ahigh performance system.

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

Induction potentiometers,also defined as 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.  *We area leading fabricator of precision machined and processed exotic andconventional materials. These include beryllium, AlBeMet, titanium, halfnium,quartz and glass used in the defense, space and high-performancecommercial markets. Operating within a 120,000 square foot environmentally-controlledmanufacturing facility, Axsys provides complete fabrication services includingmanual and CNC milling, turning, EDM, lapping and grinding, chemical andspecial processing and mechanical assembly. Using these technologies, we are able to achieve tolerances virtuallyunmatched in the world. Applications include precision optics, airbearings,heat sinks, structural housings and gimbals. Our airbearings provide high-speedprecision positioning and are used in high-speed scanners for digitalimaging and weapons guidance systems. Our heat sinks are used to dissipate heatin high-performance avionics and satellite electronics, and our gimbalsare used in various applications, including positioning optical sensors in FLIRnight vision systems. We also manufacture optical substrates used internallyand by our customers in a variety of precision metal optical applications suchas weapon fire control systems and space-borne instruments.

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*Electronics.  *We design andmanufacture several key electronic components for the semiconductor capitalequipment and high-end digital imaging markets, including laserinterferometers and electronic controllers and drives. Our electronicscomponents control the speed and position of electro-mechanical systems,such as precision motors, actuators, X-Y positioning stages and laserscanners. Laser interferometers, which are designed to permit precise linearposition sensing, are sold to customers principally in the semiconductorcapital equipment market. Electronic controllers coordinate the positioning andspeed of electro-mechanical systems by interfacing with other motioncontrol components. Drives provide power to a motor based on input from thecontroller in order to achieve a designated position or to achieve a specificspeed.

Thefollowing table summarizes our core engineering and manufacturing capabilities:

**Core Manufacturing Technologies**
| Precision Optics                                                                                                                                                | ** ** | ** **                                                                                                                   | ** ** | **Precision Motion  Control**                                                                 | ** ** | **Electronics**                                                                             | ** ** | **Precision Machining** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|-------------------------|
| Infrared Lenses  Telescopes Thin Film Coating Polygon Mirrors Monogon Mirrors Aspheric  Optics Flat Optics Head Mirrors Fold Mirrors Collimators |       | Multi-Axis Gimbals AC Motors  Brush & Brushless

DC Motors:  Torque  Servo  Limited Angle

Resolvers  Synchros |       | AC & DC Motor Speed Controls

Custom DSP Motion  Controllers

Motor Drives |       | Optical Substrates Gimbals and Yokes Airbearings  Components Structural Housings Heat Sinks |

 

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

*Infrared Zoom Lenses:  *Wedesign and manufacture sophisticated zoom and multi-field-of-view thermal lenses for usein a variety of military applications. These lenses are sold to OEMs whosubsequently integrate them with infrared cameras and imagers for military andintelligence purposes.

*Fast Steering Mirrors:  *Wehave applied extensive experience designing and building opto-mechanicalsystems to develop fast steering mirror (“FSM”) technology. The single-axisand two-axis, flexure mounted FSM represents a compact, low cost, highperformance design solution for a variety of emerging optical scanning and beamstabilization applications. Such devices may be used to correct for polygoncross scan errors, acquire and lock beams within free space laser systems,modulate tilt and cavity control in interferometers, maintain beamstabilization in the presence of thermal drift and vibration, and providegeneral two-axis beam scanning.

*Marker Engines:  *We haveleveraged our experience providing high-speed airbearing scanners with our precision optics andelectronics capabilities to produce ultra-high performance flat bedmarker engines. Each engine is self-contained, pre-aligned andready to integrate into a customer’s system.

*LaserTrac AutoFocus:  *OurLaserTrac AutoFocus provides real-time autofocus for most infiniteconjugate microscope systems. These systems include lens objectivesmanufactured by leading microscope manufacturers. The LaserTrac AutoFocus hasbeen used in high precision manufacturing applications, including inspectionsystems processing read-write heads, hard disks, semiconductor wafers andeven razor blades. The LaserTrac provides increased throughput and greatlyreduced operator fatigue.

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*Ball Bearing Scanner:  *Ourhigh precision scanners are designed and manufactured in both open and closedloop configurations. These sophisticated scanners are proven to perform withprecision and reliability under the harshest environmental conditions. They areused in guidance and tracking, thermal imaging systems and targeting sights.

*Nodding Scanners:  *Axsys’closed loop nodding optical scanners represent a significant advancement of thestate-of-the-art in electro-opto-mechanicalscanning systems. These devices were developed to provide precise limited anglescanning for thermal imaging camera systems operating in demanding aerospaceand military environments. The scanners produce the “frame scan” portion of theimage while a detector array produces the “line scan” in a typical thermalimaging camera application. Similar scanners have been developed for 3-Dimaging laser radar, or LADAR systems.

*Rotary Airbearing Scanners:  *Wedesign and manufacturer rotary airbearing scanners for use in high precision graphicarts and medical imaging applications, semiconductor mask production andinspection applications, as well as defense applications. Airbearing scannersprovide numerous advantages over mechanical bearings due to their low noisecharacteristics, repeatability and ability to rotate at high speeds (up to100,000 RPMs). When combined with our electronic controllers, our airbearingscanners provide extremely high cross-scan accuracy and extremely lowjitter.

*Actuators:  *We produce several configurations of rotary and linear actuatorsfor the military and aerospace sectors. These are available with either AC orDC power system options.

*Micro-positioning Stages:  *Weprovide precision micro-positioning systems. These ultra high-performancesystems are used in a diverse array of high-end commercial applicationssuch as semiconductor and flat panel process and inspections systems as well aslaser imaging systems.

*Interferometer:  *Our laserinterferometers are used primarily as feedback elements in state-of-the-artservo motion control systems found in semiconductor test and measurementequipment.

*Precision Ball Bearings.  *Wedistribute a wide range of precision ball bearings varying in size, precisiontolerance, lubrication and price. We also provide certain value-addedservices, such as bearing subassemblies, bearing re-lubrication, cleanroom handling of products and engineering consultation.

**Competition**

The markets for our products are competitive. Wecompete primarily on the basis of our ability to design and engineer productsto meet performance specifications set by our customers. Most of our customersare OEMs that purchase component parts or subassemblies, which they incorporateinto their end products. Product pricing, quality, customer support,experience, reputation and financial stability are also important competitivefactors.

There are a limited number of competitors in each ofthe markets for the various types of precision optical and motion controlsystems and components that we manufacture and sell. Our competitors,especially those in the precision optical product lines, typically sell asmaller number of products than we do and are often well entrenched. Some ofthese competitors have substantially greater resources than we do. We believethat the breadth of our technologies and product offerings provides us with acompetitive advantage over certain manufacturers that supply only discretecomponents or are not vertically integrated with enabling technologies.

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

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We expect our competitorsto continue to improve the design and performance of their products. We cannotassure you that our competitors will not develop enhancements to, or futuregenerations of, competitive products that will offer superior price or performancefeatures, or that new technology or processes will not emerge that render ourproducts less competitive or obsolete. Increased competitive pressure couldlead to lower prices for our products, thereby adversely affecting ourbusiness, financial condition and results of operations. We cannot assure youthat we will 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 productsprimarily to OEM customers in the aerospace and defense, high-end graphic art,medical imaging, semiconductor capital equipment and industrial automationmarkets.

Sales to Raytheon Company (“Raytheon”), an aerospaceand defense systems supplier, represented18.9% of our net sales in 2004 and 15.5% in 2003. Our accounts receivable forRaytheon at December 31, 2004 was $4.5 million and as of December 31,2003 was $696 thousand. During 2002, we did not have a concentration of saleswith any one customer. While Raytheon, a prime contractor with the U.S.government, does constitute a significant portion of our business, we do notcurrently believe that this is at-risk business.

We had aggregate sales, both military andnon-military, directly to the U.S. government, including its agencies anddepartments, of approximately $2.4 million in 2004, $3.4 million in 2003 and$4.6 million in 2002. These sales accounted for approximately 2.3% of total netsales in 2004, 4.0% in 2003 and 5.7% in 2002. Approximately 46.0% of net salesin 2004, 43.0% in 2003 and 40.3% in 2002 were derived from subcontracts withU.S. government contractors. The majority of these contracts are subject totermination at the convenience of the U.S. government, and certain contractsare also subject to renegotiation. Currently, we are not aware of any proposedtermination or renegotiation of such contracts that would have a materialadverse effect on our business.

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

**Sales,Marketing and Customer Support**

As of December 31, 2004, we employed 56 sales,marketing and customer support personnel throughout our organization, comparedto 55 employees in similar functions at the end of 2003. We utilize two OEMsales organizations, one focused on aerospace and defense customers and theother focused on high-performance commercial customers. We have a separatedistributed products sales force that is focused on selling ball bearings,bushings and assemblies, principally to commercial and industrial oriented OEMsas well as MRO distributors.

As of December 31, 2004, our direct salesorganization included 22 direct sales field personnel, most of whom haveengineering backgrounds, with the remainder involved in inside sales, customerservice, program management, contract administration and applicationsengineering. We believe that our sales effort is enhanced by havingengineering-trained sales personnel available to meet with our customers’engineering personnel. Our application and design engineers are also involvedin the sales process.

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

**Domestic and Foreign Sales**

For information concerningour domestic and foreign net sales and identifiable assets from continuingoperations, see Note 17 to the Consolidated FinancialStatements.

**Research,Development and Engineering**

We seek to develop new products and improve existingproducts in order to keep pace with the increasing performance requirements ofour customers. We devote significant resources, a portion of which isreimbursed by customers, to development programs directed at creating newproducts and product enhancements, as well as developing new applications forexisting products. Because we believe that our ability to compete effectivelydepends in part on maintaining and enhancing our expertise in applying newtechnologies and developing new products, we dedicate substantial resources toengineering, research and development. On December 31, 2004, we employed75 individuals in engineering, research and development functions. We cannotassure you that our product development efforts will be successful in producingproducts that respond to technological changes or new products introduced byothers.

Our costs associated withresearch, development and engineering expenses were $2.7 million in 2004, $2.1million in 2003, and $2.0 million in 2002. We intend to direct our research anddevelopment activities toward integrating our various technologies andcontinuing to develop sub-systems.

**Raw Materials Suppliers**

The raw materials and components that we purchase aregenerally available from multiple suppliers. However, beryllium, a materialused extensively by our Company, is only available 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 ofBrush Wellman as a supplier of beryllium, or production shortfalls orinterruptions that otherwise impair the supply of beryllium, would have amaterial adverse effect on our business, financial condition and results ofoperations. If such conditions were to occur, it is uncertain whetheralternative sources could be developed.

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

**Patents and Trademarks**

We are not dependent upon any single patent ortrademark. We have a combination of patents, trademarks and trade secrets, non-disclosureagreements and other forms of intellectual property protection covering ourproprietary technology. Although we believe that our patents and trademarks mayhave value, we believe that our future success will depend primarily on theinnovation, technical expertise, manufacturing and marketing abilities of ourpersonnel. We cannot assure you as to the degree of protection offered by ourpatents. We cannot assure you that we will be able to maintain theconfidentiality of our trade secrets or that our non-disclosure agreements willprovide meaningful protection of our trade secrets, know-how or otherproprietary information in the event of any unauthorized use, misappropriationor other disclosure.

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

**Environmental Regulation**

We believe that we are currently in compliance, in allmaterial respects, with federal, state and local laws and regulations governingthe discharge of materials into the environment or otherwise relating to theprotection of the environment and that any non-compliance with such laws willnot have a material adverse 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 locallaws, regulations or regulatory policy or the discovery of unknown problems orconditions will not in the future require substantial expenditures or (b) asto the extent of our liabilities, if any, for past failures, if any, to complywith applicable environmental laws, regulations and permits, any of which alsocould have a material adverse effect on our business, financial condition orresults of operations.

Axsys has been identified as a potentially responsibleparty (“PRP”) under the Comprehensive Environmental Response, Compensation andLiability Act (“CERCLA”) with respect to three third-party waste disposal sites.Although liability under CERCLA is joint and several, meaning that liabilitycan exceed a PRP’s *pro rata* shareof cleanup costs, we believe, based on currently available information, thatcosts associated with these sites will not have a material adverse effect onour business and financial condition. It is possible, however, that our resultsof operations for a particular fiscal period could be materially affected.

Pursuant to a remediation plan approved by the OhioEnvironmental Protection Agency in 1993, we investigated soils and groundwaterat a formerly owned site, and have conducted certain remediation work at thissite including soil removal. We have incurred costs of $118 thousand in 2004and approximately $916 thousand to date. We anticipate remediation costs forthis site to continue through 2009, including estimated expenditures of $64thousand in 2005.

During 1999, we sold the land and building of apreviously discontinued division in St. Petersburg, Florida. We conductedinvestigations of soil and groundwater at the former facility and receivedapproval of the remediation action plan from the Florida Department ofEnvironmental Protection. The remediation system was installed in 2003, andclean up of the site is still in progress. In 2004, we spent $43 thousand onthe clean up of this facility and have incurred approximately $685 thousand todate. We anticipate remediation costs for this site to continue through 2007,including estimated expenditures of $56 thousand in 2005.

In December 2001, we received a letter from theUnited States Environmental Protection Agency (“EPA”) notifying us that we areconsidered a potentially responsible party for a site located in Prospect,Connecticut, where our former subsidiary operated a screw machine shop from1961 to 1978, and demanding that we reimburse the EPA for its costs incurred inconnection with a time-critical removal action taken by the EPA at the site in2001. The former subsidiary was merged with Axsys in 1979. In April 2004,the EPA notified us that the total amount of such costs is approximately $650thousand, including indirect costs and interest. At a meeting with the EPA in April 2004,we advised the EPA of our position that we are not responsible for these costsor the contamination at the site. We have had subsequent communications withthe EPA concerning our respective positions, and the EPA advised us that theywere not prepared to proceed with settlement discussions until they hadconducted a further investigation of the activities of our former subsidiary atthe site. In July 2004, the EPA served us with a 

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104(e) letterrequesting detailed information concerning the activities of our formersubsidiary at the site. We responded to the 104(e) letter on January 17,2005. The EPA has designated no other potentially responsible parties. During2004, we recognized a charge of $32 thousand, net of tax of $18 thousand indiscontinued operations, for additional legal expenses related to this site. Wepaid $121 thousand in 2004 and$328 thousand to date primarily in legal fees related to this site.

During 2004, we recognized a charge of $42 thousand,net of tax of $23 thousand, relatedto our share of the settlement of an environmental claim concerning apreviously discontinued operation.

As of December 2004, we have an accrual of $711thousand for future costs related to these sites. These estimates have beendeveloped in consultation with outside environmental and legal consultantshandling these matters and are based upon an analysis of the anticipatedremediation plans. We do not anticipate these matters will have a materialadverse effect on our consolidated financial position. It is possible, however,that future results of operations could be materially affected by changes inour assumptions.

We use or generate certainhazardous substances in our manufacturing and engineering facilities. Webelieve that our handling of these substances is in compliance with applicablelocal, state and federal environmental, safety and health regulations at eachoperating location. We invest in protective equipment, process controls andspecialized training to minimize risks to employees, surrounding communitiesand the environment due to the presence and handling of these hazardoussubstances. We periodically conduct employee physical examinations andworkplace air monitoring related to these substances. When exposure problems orpotential have been indicated, we implement corrective actions. In general,re-occurrence has been minimal or non-existent. We do not carry environmentalimpairment insurance.

**Employees**

As of December 31,2004, we employed 645 persons, including 459 in manufacturing, 56 in sales, 75in engineering and 55 in administration. We currently do not have any unionsand we consider our relationship with our employees to be satisfactory. Therehas been no significant interruption of operations due to labor disputes.

**Available Information**

Our Internet web site is http://www.axsys.com.We make available free of charge on our web site our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K, reportsfiled pursuant to Section 16 and amendments to those reports as soon asreasonably practicable after we electronically file or furnish such materialsto the Securities and Exchange Commission (“SEC”). In addition, we have postedthe charters for our Audit Committee, Compensation Committee, and Nominatingand Governance Committee on our web site under the headings “Investors.”These charters are not incorporated hereinby reference. We will also provide a copy of these documents to shareholdersupon request.

11

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**Item 2.   PROPERTIES**

Axsysleases approximately 4,740 square feet of office space, located at 175 CapitalBoulevard in Rocky Hill, Connecticut, for our corporate headquarters. Thislease expires in 2010. The principal plants and other significant properties atFebruary 1, 2005 are:
| **Location**         | ** ** | ** **                  | ** ** | **Type of Facility** | ** ** | **Square Footage** | ** ** | **Leased/Owned; Expiration** | ** **   |
|----------------------|------------|-----------------------------|------------|--------------------------------|------------|-------------------------|------------|-----------------------------------|--------------|
| Cullman, AL          |       | Manufacturing,  Engineering |       |                           | 120,000    |                    |       |                              | 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 |   |   |
| North Billerica,  MA |       | Manufacturing,  Engineering |       |                           | 19,900     |                    |       |                              | Leased; 2007 |   |   |
| Irvine, CA           |       | Distribution                |       |                           | 7,800      |                    |       |                              | Leased; 2005 |   |   |

 

We believe that ourfacilities are generally sufficient to meet our current and reasonablyanticipated manufacturing, distribution and related requirements. We, however,periodically review space requirements to ascertain whether our facilities aresufficient to meet our needs.

**Item 3.   LEGAL PROCEEDINGS**

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

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

None during the quarter ended December 31, 2004.

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**PART II**

**Item 5.        MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITYSECURITIES**

Axsys’common stock trades on the Nasdaq National Market (“Nasdaq”) under the Symbol “AXYS”.The following table sets forth the range of high and low sales prices asreported by Nasdaq:
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| ** **                            | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| Fiscal Years Ended  December 31: |       |     |       |     |       |   |   |   |   |
| First Quarter                         |       | $        | 10.700     |     | $          | 8.820 |   | $ | 5.533 |   | $ | 4.666 |   |
| Second Quarter                        |       | 15.670   |       | 9.710    |       | 6.533 |   | 4.840 |   |
| Third Quarter                         |       | 14.860   |       | 12.200   |       | 8.500 |   | 6.373 |   |
| Fourth Quarter                        |       | 18.840   |       | 12.750   |       | 9.820 |   | 8.047 |   |
|                                       |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

On February 16, 2005, the high sales price was$20.25 and the low sales price was $19.16.

On February 16, 2005,the approximate number of holders of record of Axsys’ common stock was 480. Inaddition, we believe that as of that date, there were approximately 1,300beneficial owners.

**Dividend Policy**

Axsys has applied andcurrently intends to continue to apply the retained and current earnings towardthe development of the business and to finance growth. Axsys did not pay cashdividends on the common stock during the three years ended December 31,2004, and does not anticipate paying cash dividends in the foreseeable future.

**Share Repurchases**

On****May 11, 2004, Axsys’ Board ofDirectors authorized the repurchase, from time to time, on the open market orotherwise, of up to 200,000 shares of the our common stock at prevailing marketprices or at negotiated prices.  We planto use the repurchased shares for general corporate purposes, including thesatisfaction of commitments under our employee benefit plans and the exerciseof stock option grants.
| ** **                                      | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average  Price Paid    per Share  ** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly   Announced Plans or  Programs** | ** ** | **Maximum Number of  Shares that May Yet  Be Purchased Under  the Plans or Programs** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 3 – October 30,  2004    |       |                                         | —     |                                                                 |       |                                                                                                                                   | $          | —                                                                                                                                  |       |   |   | — |   |   |   | — |   |   |
| October 31 –  November 27, 2004  |       |                                         | —     |                                                                 |       |                                                                                                                                   | —     |                                                                                                                                    |       |   | — |   |   |   | — |   |   |
| November 28 –  December 31, 2004 |       |                                         | 12         |                                                                 |       |                                                                                                                                   | 17.81      |                                                                                                                                    |       |   | 12 |   |   |   | 199,988 |   |   |
| Total                                           |       |                                         | 12         |                                                                 |       |                                                                                                                                   | $          | 17.81                                                                                                                                   |       |   |   | 12 |   |   |   | 199,988 |   |   |

 

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**Item 6.**                        SELECTEDFINANCIAL DATA

Thefollowing selected financial data for the five fiscal years presented below isderived from Axsys’ audited Consolidated Financial Statements as adjusted toreflect the discontinuance of the Automation Group, in 2002. The data should beread in conjunction with the Consolidated Financial Statements and the relatedNotes thereto included elsewhere herein.
| ** **                                                                                                                                                   | ** ** | **Years Ended December 31,**                        | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                                                                   | ** ** | **2004(1)(2)**                                                     | ** ** | **2003(2)** | ** ** | **2002(2)(3)(4)** | ** ** | **2001(2)(3)(4)** | ** ** | **2000(2)(4)(5)(6)** | ** ** |
| ** **                                                                                                                                                   | ** ** | **(In thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                                                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net sales                                                                                                                                                    |       | $                                                                  | 103,530    |   | $ | 85,109 |   |   | $ | 79,586 |   |   |   | $ | 86,131 |   |   |   | $ | 90,421 |   |   |
| Gross profit                                                                                                                                                 |       | 30,656                                                             |       | 23,073 |   |   | 20,132 |   |   |   | 13,747 |   |   |   | 19,213 |   |   |
| Income (loss)  from continuing operations before discontinued operations and cumulative  effect of change in accounting principle                            |       | 9,159                                                              |       | 4,998 |   |   | (3,014 | ) |   |   | (5,266 | ) |   |   | (3,932 | ) |   |
| Net income (loss)                                                                                                                                            |       | 8,664                                                              |       | 4,998 |   |   | (7,061 | ) |   |   | (7,152 | ) |   |   | 9,523 |   |   |
| Basic net  earnings (loss) per share from continuing operations before discontinued  operations and cumulative effect of change in accounting principle |       | $                                                                  | 1.30       |   | $ | 0.72 |   |   | $ | (0.43 | ) |   |   | $ | (0.75 | ) |   |   | $ | (0.56 | ) |   |
| Basic earnings  (loss) per share                                                                                                                             |       | $                                                                  | 1.23       |   | $ | 0.72 |   |   | $ | (1.00 | ) |   |   | $ | (1.02 | ) |   |   | $ | 1.36 |   |   |
| Weighted-average  basic common shares outstanding                                                                                                            |       | 7,020                                                              |       | 6,986 |   |   | 7,038 |   |   |   | 7,032 |   |   |   | 6,986 |   |   |
| Diluted earnings  (loss) per share from continuing operations before discontinued operations  and cumulative effect of change in accounting principle   |       | $                                                                  | 1.26       |   | $ | 0.71 |   |   | $ | (0.43 | ) |   |   | $ | (0.75 | ) |   |   | $ | (0.56 | ) |   |
| Diluted earnings  (loss) per share                                                                                                                           |       | $                                                                  | 1.19       |   | $ | 0.71 |   |   | $ | (1.00 | ) |   |   | $ | (1.02 | ) |   |   | $ | 1.36 |   |   |
| Weighted-average  diluted common shares outstanding                                                                                                          |       | 7,289                                                              |       | 7,074 |   |   | 7,038 |   |   |   | 7,032 |   |   |   | 6,986 |   |   |

 
| ** **                                                       | ** ** | **At December 31,** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                       | ** ** | **2004**                      | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                       | ** ** | **(in thousands)**       | ** ** |
| **Balance Sheet Data:**                                          |       | $                             | 85,815     |   | $ | 66,845 |   |   | $ | 62,372 |   |   |   | $ | 68,636 |   |   |   | $ | 73,592 |   |   |
| Total assets                                                     |       | 150                           |       | 568 |   |   | 1,191 |   |   |   | 1,392 |   |   |   | 1,485 |   |   |
| Long-term capital  lease obligations (less current portion) |       | 3,333                         |       | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Long-term debt  (less current portion)                           |       | 53,093                        |       | 43,898 |   |   | 39,093 |   |   |   | 46,440 |   |   |   | 53,421 |   |   |
| Shareholders’ equity                                        |       |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                  |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          On April 8, 2004,Axsys acquired the stock of Telic Optics, Inc. (“Telic”). This acquisitionwas accounted for under the purchase method of accounting, and, accordingly,the results of Telic’s operations have been included in our ConsolidatedStatements of Operations since the date of acquisition.

(2)          In the second quarter of2004, the Board of Directors announced the declaration of a 3:2 stock spliteffected as a stock dividend payable on June 30, 2004 to stockholders ofrecord on June 15, 2004. Stockholders received a dividend of oneadditional share of Axsys Technologies, Inc. $0.01 par value 

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common stock for every twoshares owned on the record date. Fractional shares were cashed out, andpayments were made to shareholders in lieu of fractional shares on June 30,2004. Share and per share information for all prior periods have been restatedto reflect the stock split.

(3)          For 2002 and 2001,certain engineering costs have been reclassified from cost of goods sold tooperating expenses to conform to the current presentation.

(4)          In the third quarter of2002, the Automation Group was divested, which included the Fiber Automationdivision and Automation Engineering, Inc., a wholly owned subsidiary. Accordingly,the Automation Group has been accounted for as discontinued operations and theoperating results have been reported separately from continuing operations forall applicable periods. Revenues applicable to these discontinued operationswere $1.2 million in 2002, $3.1 million in 2001 and $1.4 million in 2000.

(5)          In September 2000,our Company acquired the stock of Westlake Technology Corporation (“Westlake”).This acquisition was accounted for under the purchase method of accounting and,accordingly, the results of Westlake’s operations have been included in ourConsolidated Statements of Operations since the date of acquisition.

(6)          In March 2000, we sold the Beau Interconnectdivision (“Beau”). Accordingly, Beau has been accounted for as adiscontinued operation and the related net assets and operating results havebeen reported separately from continuing operations in all years presented. Revenuesapplicable to this discontinued operation were $846 thousand during 2000.

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

Thefollowing table sets forth selected financial data ona consolidated basis (in thousands):
| ** **                                                     | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Sales                                                          |       | $                                           | 103,530    |   | $ | 85,109 |   | $ | 79,586 |   |
| Cost of sales                                                  |       | 72,874                                      |       | 62,036 |   | 59,454 |   |
| Gross profit                                                   |       | 30,656                                      |       | 23,073 |   | 20,132 |   |
| Selling, general  and administrative expenses                  |       | 18,684                                      |       | 15,986 |   | 16,262 |   |
| Research,  development and engineering expenses                |       | 2,677                                       |       | 2,059 |   | 2,049 |   |
| Restructuring and  special charges                             |       | (50                                         | )          | — |   | 1,854 |   |
| Operating income  (loss)                                       |       | 9,345                                       |       | 5,028 |   | (33 | ) |
| Interest expense                                               |       | (254                                        | )          | (172 | ) | (212 | ) |
| Interest income                                                |       | 98                                          |       | 115 |   | 190 |   |
| Other (expense)  income                                        |       | (38                                         | )          | 263 |   | 10 |   |
| Income (loss)  from continuing operations before income  taxes |       | 9,151                                       |       | 5,234 |   | (45 | ) |
| (Benefit from)  provision for income taxes                     |       | (8                                          | )          | 236 |   | 2,969 |   |
| Income (loss)  from continuing operations                      |       | 9,159                                       |       | 4,998 |   | (3,014 | ) |
| Discontinued operations:                                       |       |                                        |       |   |   |   |   |
| Loss from discontinued operations, net of income tax  benefit  |       | (495                                        | )          | — |   | (4,582 | ) |
| Cumulative effect of change in accounting principle            |       | —                                      |       | — |   | 535 |   |
| Net income (loss)                                              |       | $                                           | 8,664      |   | $ | 4,998 |   | $ | (7,061 | ) |

 

The following table sets forth the percent of salesby segment:

 
| ** **                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **  2004  **            | ** ** | **  2003  ** | ** ** | **  2002  ** | ** ** |
| Optical Systems  Group      |       |                                        | 75.5       | % |   |   | 74.3 | % |   |   | 74.7 | % |   |
| Distributed Products  Group |       |                                        | 24.5       |   |   |   | 25.7 |   |   |   | 25.3 |   |   |

 

***Overview***

Axsys Technologies is aleading designer and manufacturer of precision optical solutions for use inaerospace, high performance commercial and defense applications. Thesesolutions are typically comprised of highly accurate optical and/or motioncontrol devices. Our solutions are often embedded in larger systems that dependon precise optical control for accurate operation of critical functions. Inaddition to optical solutions, we distribute precision ball bearings used in avariety of industrial and commercial applications.

*Operating Segments*

During 2004, we modified our segment reporting by combiningwhat were previously referred to as the ‘Aerospace and Defense’ and ‘CommercialProducts’ groups into a new segment, ‘Optical Systems.’ This change reflectsthe increasing collaboration among our facilities in thedevelopment of products that serve both the aerospace and commercial markets.

Our business is now organized into two groups: OpticalSystems Group and Distributed Products Group. The Optical Systems Groupdesigns, manufactures and sells highly precise assemblies and components whichare typically embedded in optical systems for both government and commercial 

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applications. The OpticalSystems Group plans to continue focusing on growth markets that require highlyprecise optical and related motion control solutions. These markets includehomeland security initiatives, unmanned vehicle applications, the nationalmissile defense market, new weapons platforms, and performance commercialmarkets. An example of a target commercial market is the material processingbusiness, where we are offering a potentially innovative technology called a ‘faststeering mirror’ that has the opportunity to displace existing galvanometertechnology in laser positioning applications. The Optical Systems Group hasdesign and manufacturing facilities in San Diego, California; Cullman, Alabama;Rochester Hills, Michigan; and North Billerica, Massachusetts.

The Distributed ProductsGroup distributes precision ball bearings, spherical plain bearings, andbushings, acquired from various domestic and international sources, to OEM’sand maintenance repair organizations (“MROs”). Additionally, the DistributedProducts Group designs, manufactures and sells mechanical-bearing subassembliesfor a variety of customers. The Distributed Products Group is comprised of theAST Bearings Division located in Montville, New Jersey, with a satellitedistribution center in Irvine, California.

*SignificantCustomers*

Raytheon Company (“Raytheon”),an aerospace and defense systems supplier,represented 18.9% of our net sales in 2004 and 15.5% in 2003. During 2002, wedid not have a concentration of sales with any one customer. While Raytheon, aprime contractor with the U.S. government, does constitute a significantportion of our business, we do not currently believe that this is at-riskbusiness. 

*Backlog and Orders*

Axsys recognized in 2004 bookings in excess of$119.2 million, ending the year with record backlog of $88.2 million, of which12.2% will be shipped beyond 12 months. As we look forward, we expect continuedgrowth in the Optical Systems Group, which is supported by the segment’sbacklog of $75.6 million at the end of 2004. This group will continue to targetorders that require highly precise optical and motion control solutions. Examplesinclude surveillance, military navigation and targeting, ‘smart’ weapons, andmedical imaging.

*Acquisition ofTelic Optics, Inc.*

On April 8, 2004 (the “Closing Date”), Axsysacquired all of the stock of Telic Optics, Inc. (“Telic”), aprivately-owned manufacturer of infrared optical products. The financialresults of Telic are included in our Optical Systems Group, since the date ofacquisition.

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

The initial purchase price of this acquisition was$14.4 million with an additional earn out of up to $4.0 million over the 36months following the Closing Datebased on certain revenue goals. If revenue goals are achieved, the earn outwill increase the amount of Goodwill on our balance sheet and the totalpurchase price could reach $18.4 million. In addition, $438 thousand of legal,audit and other acquisition related expenses were paid during 2004. Axsysfunded the initial cash portion of the purchase price and associatedtransaction costs through a combination of existing cash balances and outsidebank financing.

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Included in Axsys’ fullyear 2004 financial results were $5.3 million of revenues, $2.4 million ofgross profit and $1.6 million of operating income from the operations of Telic.

*James Webb SpaceTelescope*

During 2004, Axsys received an $18.6 milliondefinitive contract from Ball Aerospace and Technology Corporation to producethe optical mirror substrates for the James Webb Space Telescope (“JWST”). Thecontract contains $9.9 million of production revenues and $8.7 million forfacilitization. During 2004, we recognized $1.0 million of revenues under thepercentage of completion method of accounting related to the JWST project.

The JWST, which is due to launch in 2011, will replacethe Hubble as NASA’s premier space telescope. Northrop Grumman is the primecontractor. The primary mirror is comprised of 18 individual lightweightberyllium segments, all of which will be fabricated by Axsys. Because of thelarge size of the primary mirror, JWST will be significantly more sensitivethan ground-based infrared telescopes, enabling it to search for the firststars and galaxies formed in the universe billions of years ago.

Axsys’ contract includesthe production of optical substrates for an engineering development unit, 18primary mirror segments and support structures. We expect to complete theengineering development unit in the first quarter of 2005, with delivery of all18 segments by the end of 2006.

*Divestitures*

During 2002, Axsys decided to exit the automationmarket and focus on our other businesses. As part of this decision, we soldthree of our business units: our wholly-owned subsidiary Teletrac, Inc. (“Teletrac”),our wholly-owned subsidiary Automation Engineering, Inc. (“AEI”) and ourFiber Automation Division (“FAD”).

We sold the stock of Teletrac, which serves the datastorage business, in exchange for an interest-bearing $850 thousand note, whichprovides for payments equal to ten percent of the revenues generated from theTeletrac business with the balance, if any, due in five years. Because of theuncertain market conditions for data storage products and the terms of thenote, Axsys has reserved the entire value of this note and will record anyprincipal and interest payments as ordinary income during the period received. Asa result of this sale, an asset impairment and cost of sale charge of $1.0million has been included in Axsys’ Consolidated Statement of Operations. Underapplicable accounting principles, Teletrac has not been treated as adiscontinued operation and results of operations through the date of sale in2002 are recognized in continuing operations. Revenues applicable to the datastorage business were $6 thousand in 2002.

As a result of the sale, we closed our Santa Barbaramanufacturing facility and relocated our micro-positioning stage, laser interferometerand autofocus product lines to our facility located in Rochester Hills,Michigan during the second quarter of 2002. The total pre-tax cost of $1.1million associated with the relocation and facility closure included a chargeof $436 thousand for thirty terminated employees and a charge of $123 thousandfor the disposal of excess furniture and fixtures. A charge of $136 thousandwas incurred as a result of the write-off of certain inventory related to thetermination of certain minor product lines. Other costs of $358 thousandassociated with the relocation included costs for the equipment relocation,employee training and recruitment and facility upgrades in Michigan, which wereexpensed as incurred.

The sale of stock of AEIand the sale of the net assets of FAD have been accounted for as discontinued operations  andthe related net assets and operating results have been reported separately fromcontinuing operations in all years presented. Revenues applicable to thesediscontinued operations were $1.2 million in 2002.

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**Results of Segment Operations**

The following tables anddiscussion set forth selected financial information from continuing operationson a segment basis for the years ended December 31, 2004, 2003, and 2002. Thesegment tables, shown below, exclude one-time charges, which are shownseparately.

***Optical Systems Group Segment***

*(table in thousands and as a percentage of sales)*
| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Sales         |       | $                                           | 78,189     |   | 100.0 | % | $ | 63,246 |   | 100.0 | % | $ | 59,438 |   | 100.0 | % |
| Cost of sales |       | 55,429                                      |       | 70.9 | % | 46,728 |   | 73.9 | % | 44,951 |   | 75.6 | % |
| Gross profit  |       | $                                           | 22,760     |   | 29.1 | % | $ | 16,518 |   | 26.1 | % | $ | 14,487 |   | 24.4 | % |

 

Sales in the Optical Systems Group segment increased23.6% for the year ended December 31, 2004 compared to 2003, while salesin this segment increased 6.4% for the year ended December 31, 2003compared to 2002. Our 2004 revenues included $5.3 million of sales from our2004 acquisition of Telic. Telic’s capabilities enhance our product offeringsto include sophisticated infrared optical solutions used in sea- andground-based defense applications. We have also experienced significant growthin sales of our motion control solutions and beryllium structures, both ofwhich are used in a variety of highly precise targeting, surveillance andmissile defense system platforms. During 2004, we recognized $1.0 million ofrevenues from the JWST contract under the percentage of completion method ofaccounting. In addition, sales of our airbearing scanners, which are used inmedical imaging applications, increased during 2004.

Gross profit as a percent of sales for the year ended December 31,2004 increased compared to 2003 and 2002 mainly due to increased volume, salesmix and improved efficiencies in comparison to the past two years. In addition,the acquisition of Telic, which generally earns higher margins, contributed toour continued growth in gross profit for 2004.

The Optical Systems Group,as of December 31, 2004, had a backlog of definitive orders of $75.6million, of which 12.5% is expected to ship beyond the 2005 fiscal year.

***Distributed Products Group Segment***

*(table in thousands and as a percentage of sales)*
| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Sales         |       | $                                           | 25,341     |   | 100.0 | % | $ | 21,863 |   | 100.0 | % | $ | 20,148 |   | 100.0 | % |
| Cost of sales |       | 17,445                                      |       | 69.0 | % | 15,308 |   | 70.0 | % | 14,367 |   | 71.3 | % |
| Gross profit  |       | $                                           | 7,896      |   | 31.0 | % | $ | 6,555 |   | 30.0 | % | $ | 5,781 |   | 28.7 | % |

 

Sales in the Distributed Products Group increased forthe year ended December 31, 2004 in relation to 2003 and 2002 as a resultof increased revenues primarily in the industrial automation and consumer goodsmarkets as well as a general increase in new customer activity across multiplemarkets.

Gross profit as a percentof sales increased in 2004 compared to the prior two years primarily as a resultof production efficiencies, higher sales volume and favorable product mix.

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

*(table in thousands and as a percentage of sales)*
| ** **       | ** ** | **Years Ended December 31,** | ** ** |
|------------------|------------|---------------------------------------------|------------|
| ** **       | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| One-time charges |       | —                                      |       | — |   | — |   | — |   | $ | 136 |   | 0.2 | % |
|                  |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

During 2002, we recognizeda one-time charge of $136 thousand for the elimination of some small productlines resulting from the closure of the California facility.

***Operating Expenses***

*(table in thousands and as a percentage of sales)*
| ** **                                      | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Selling, general  and administrative expenses   |       | $                                           | 18,611     |   | 18.2 | % | $ | 15,986 |   | 18.8 | % | $ | 16,262 |   | 20.4 | % |
| Research,  development and engineering expenses |       | 2,677                                       |       | 2.6 |   | 2,059 |   | 2.4 |   | 2,049 |   | 2.6 |   |
| Restructuring and  special charges (credits)    |       | (50                                         | )          | (0.05 | ) | — |   | — |   | 1,854 |   | 2.3 |   |

 

*Selling, general and administrative expenses*.   Selling,general and administrative expenses (“SG&A) were $18.6 million in 2004compared to $16.0 million in 2003 and $16.3 million in 2002. Telic incurred$793 thousand of SG&A in 2004. Payments for incentives were higher in 2004compared to the prior two years as a result of increased production. Inaddition, we spent more on advertising during 2004 than in the prior two yearsas we attended more trade shows during the year,and we incurred additional compensation expense of $242 thousand as a result ofthe termination of an executive officer and the modification of stock optiongrants under the terms of the severance agreement.

*Research, development and engineering expenses*.   Research,development and engineering expenses in 2004 increased $618 thousand comparedto 2003 primarily due to increased efforts on a variety of projects developedto increase our sales in space and commercial markets.

*Restructuring and special charges*.   Duringthe second quarter of 2004, we reversed a $50 thousand reserve associated withproduct lines that were either discontinued or sold during 2002. There were norestructuring and special charges in 2003 compared to $1.9 million in 2002.

During 2002, restructuringcharges included $286 thousand for termination expenses incurred in connectionwith the termination of our Chief Operating Officer as a result of a segmentrealignment and the subsequent disposal of the Automation Group, $1.0 millionassociated with asset write-downs and severance expenses resulting from thesale of Teletrac and $559 thousand of costs relating to the relocation of someCommercial OEM product lines from Santa Barbara, California to Rochester Hills,Michigan.

***Other Income and Expenses***

*Interest expense*.   Interestexpense was $254 thousand in the year ended December 31, 2004, compared to$172 thousand in 2003 and $212 thousand in 2002. The increase in expense in2004 compared to 2003 is primarily due to interest on our $5.0 million loan,taken in conjunction with the acquisition of Telic, which was partially offsetby lower interest paid on capital leases compared to 2003.

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*Interest income.  *Interestincome was $98 thousand in the year ended December 31, 2004 compared to$115 thousand in 2003 and $190 thousand in 2002. Interest income is primarilycomposed of income from cash and cash equivalents and short-term investments. Inaddition, we received $9 thousand in 2003 and $39 thousand in 2002 in interestincome from a note receivable from the 1998 sale of Sensor Systems, which waspaid in full during the fourth quarter of 2003.

*Other income and expense, net.  *Netother expense in 2004 was $38 thousand compared to net other income of $263thousand in 2003 and $10 thousand in 2002. Currently, other income and expensesis composed of the effects of foreign exchange transactions partially offset bya return of a legal escrow**.**We had recovered$232 thousand in 2003 and $298 thousand in 2002 from a fully reserved note fromthe 1998 sales of Sensor Systems. This note was paid in full during the fourthquarter of 2003. During 2002, we recognized a charge of $200 thousand for thedisposal of fixed assets.

*Income Taxes*.   Theconsolidated effective income tax rate was (0.1%) for the year ended December 31,2004 compared to 4.5% in 2003 and 2.6% in 2002. The effective rate for eachyear was impacted by the creation and utilization of a valuation allowance. Inaccordance with the Statement of Financial Accounting Standards No. 109,we established a $4.6 million valuation allowance against our deferred incometax asset in 2002. As we reported income, we reduced the valuation allowanceand utilized $3.2 million in 2004 and $1.4 million in 2003 as deferred incometax assets were realized. Available and prudent tax planning strategies supportthe deferred income tax asset on the books at December 31, 2004.

For 2005, we expect the consolidated effective incometax rate of Axsys to be approximately 37.5%. The 2005 effective income tax ratereflects the provisions in the American Jobs Creation Act of 2004, which phaseout the deduction for export sales and creates a new deduction for U.S.production activities.

*Discontinued operations.  *During2004, we incurred an additional charge of $421 thousand, net of taxes of $226thousand, related to the 2002 divestiture of our Automation Group. In 2002, webelieved that we would be able to sublease two facilities formerly occupied byour divested businesses. However, we have not been able to locate tenants forthese facilities. These leases will expire in 2006 and the additional charge issufficient to cover the remaining lease obligations.

In addition, during 2004 we recognized a charge of $74thousand, net of taxes of $41 thousand, for an environmental-related expensefor previously divested operations.

We completed the disposal of the Automation Group inthe fourth quarter of 2002. The sale of the Automation Group resulted in a lossof $1.7 million, net of taxes of $1.0 million, which included $729 thousand forthe impairment of assets and $980 thousand of closing related expenses. Inaddition, the operating loss from these facilities, which is also included indiscontinued operations, was $2.7 million, net of taxes of $1.6 million, in2002. The remainder of the loss from discontinued operations in 2002 included a$203 thousand charge, net of taxes of $123 thousand, for anenvironmental-related expense for a previously divested operation, which waspartially offset by $24 thousand of income, net of taxes of $13 thousand fromthe reversal of unutilized reserves primarily associated with the sale of theBeau Interconnect division in 2000.

*Net income (loss)*.   Wehad net income of $8.7 million in 2004, net income of $5.0 million in 2003 anda net loss of $7.1 million in 2002. Included in the $8.7 million net income for2004 is a loss from discontinued operations of $495 thousand as a result of thediscontinuation of our Automation Group and charges incurred for environmentalrelated expenses. During 2002, we sold our Automation Group, which resulted ina net loss of $4.4 million including both operating losses and a loss on thesale. In addition, we recognized an income tax provision of $2.9 million from continuingoperations, which was primarily the result of the establishment of a valuationallowance to reduce our net deferred income tax assets.

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***Liquidity and Capital Resources***

We fund our operations primarily from cash on hand andcash flow from operations. As of December 31, 2004, cash and cashequivalents totaled $6.0 million. During 2003 and 2002, we maintained a highlevel of liquidity as evidenced by our current ratio, which was 2.9 as of December 31,2003 and 2.8 as of December 31, 2002. This strategy was necessary as werestructured Axsys and discontinued unprofitable businesses. With this processcomplete, we began to seek growth opportunities. To that end, we completed theacquisition of Telic on April 8, 2004 and as a result our current ratiodecreased to 2.3 as of December 31, 2004. Axsys funded the initial cashportion of the purchase price and associated transaction costs through acombination of existing cash balances and outside financing. In connection withthe transaction, Axsys arranged a $10.0 million credit facility with Bank ofAmerica, which included a $5.0 million acquisition-related, five-year term loanand a $5.0 million, two-year revolving line of credit that may be used forworking capital and general corporate purposes. As of December 31, 2004,we had not drawn on the revolving line of credit.

Net cash provided by operations was $7.6 million in2004, $6.8 million in 2003 and $1.8 million in 2002. In 2004, our primarysources of operating cash were $8.7 million of net income plus non-cashexpenses, which primarily consists of $2.7 million of depreciation andamortization. These non-cash charges were partially offset by non-cashbenefits, including a $1.8 million increase in our net deferred income taxasset, due to the utilization and reversal of a valuation allowance for theseassets. We also paid out $902 thousand for liabilities related to discontinuedoperations, which was offset by an additional accrual for discontinuedoperations of $762 thousand.

In 2004, we utilized $2.2 million of cash to fundchanges in our operating assets and liabilities. We used $4.5 million of cashto fund an increase in our accounts receivable, which resulted from salesgrowth and higher deferred income billings in our Optical Solutions Group. Wealso utilized $4.1 million to fund inventory growth in 2004. The inventorygrowth was related to certain large long-term programs in our Optical SystemsGroup. The increases in accounts receivable and inventory were partially offsetby a $2.1 million increase in accounts payable and a $2.6 million increase indeferred income. The increase in deferred income was the result of our strategyto actively negotiate progress payments into certain large dollar contracts forlong-lead time products and long-term programs. This strategy helps to mitigatethe near-term negative cash impact of these contracts. The net change inaccrued expenses and other liabilities and other long-term liabilities was a$834 thousand increase. The increase was related to increased accruals forcompensation-related expenses and an accrual for capital equipment that wasreceived but not invoiced, which were partially offset by the liquidation of aninactive pension plan and the utilization of the reserve for loss contracts. During2004, we also received a $563 thousand federal income tax refund.

In 2003, our primary sources of operating cash were$5.0 million of net income, $2.9 million of depreciation and a $1.5 millionfederal income tax refund. The income tax refund was partially offset by a $563thousand income tax receivable that was recognized in 2003. One of our primaryuses of cash was inventory, which grew $2.7 million in 2003. The inventorygrowth was related to certain large programs in our Optical Systems Group. Thecash outflows for inventory were almost entirely offset by a $1.1 millionincrease in accounts payable and a $1.4 million increase in deferred income. In2003, we reduced accrued expenses and other liabilities and long-termliabilities by $612 thousand. This was primarily due to the utilization ofreserves for loss contracts and restructuring. In addition, we utilized $1.3million to fund obligations related to our discontinued operations.

In 2002, Axsys’ net loss of $7.1 million included thefollowing non-cash items: a $4.6 million deferred income tax valuationallowance, which was partially offset by a $2.7 million increase in ourdeferred income tax asset, $2.7 million of depreciation, $751 thousand oflosses on capital asset disposals and $888 thousand non-cash restructuring andspecial charges. We also received a $3.5 million federal income tax refund. Theimpact of the refund was partially offset by an income tax receivable for $1.6million, which was booked in 

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2002 but not receiveduntil 2003. During 2002, we collected $2.5 million in deferred income for ourberyllium-based products, which was partially offset by a $1.5 million increasein inventories for these products. Trade accounts payable declined by $1.3million largely due to the timing of inventory receipts in the fourth quarter.In 2002, accrued expenses and other liabilities decreased $643 thousandprimarily due to payments for state income taxes, and our 2001 cost reductionplan.

During 2002, net cash provided by discontinuedoperations was $2.0 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. Inaddition, during 2002, we paid $344 thousand in expenses related to theremediation of environmental sites located at former facilities.

Net cash used in investing activities was $11.0million in 2004, $10.0 million in 2003 and $839 thousand in 2002. In 2004, weutilized $13.7 million to acquire Telic ournew subsidiary.The purchase of Telic was partially funded by the sale of $7.0 million ofshort-term investment securities. Capital expenditures were $4.2 million in2004, or $1.2 million more than in 2003. The additional capital was used toconstruct a 20,000 square foot, climate-controlled manufacturing facility inCullman, AL. The additional space is being used 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 JWST.

During 2003, we invested $7.0 million in short-terminvestment securities. The funds were invested in short-term investmentsecurities in order to minimize interest rate risk and to allow for rapidredeployment when profitable long-term investment or expansion opportunitieswere identified. In 2003, we also invested $3.0 million in capital equipment. In2002, we invested $1.4 million in capital equipment, net of $905 thousand ofcapital lease proceeds, and we received $541 thousand in net proceeds from thesale of discontinued operations.

In 2005, we expect to spend between $3.0 and $3.5million on capital equipment. The majority of this capital investment will beused to purchase production and testing equipment, which will expand ourcapacity and improve our efficiency. We also plan to use some of these funds torenovate and expand our recently acquired facility in North Billerica,Massachusetts. We anticipate spending additional funds to replace theinformation technology platformin our San Diego, California facility. Currently, we are evaluating variousinformation technologysystems and the costs and benefits of potentially rolling the new system out toadditional facilities. As a result, we are unable to estimate the cost ortiming of the information technology platform investment at this time.

Financing activities provided $4.1 million of cash in2004 and used $1.5 million of cash in 2003 and $898 thousand of cash in 2002. During2004, we obtained a $5.0 million term loan for the acquisition of Telic andreceived $360 thousand in proceeds from the exercise of stock options. Thesesources of funds were partially offset by repayments of $667 thousand on theterm loan and $473 thousand on our capital leases.

In 2003 and 2002, funds were used to repay capitalleases. In 2003, we utilized $208 thousand to retire five of our capital leaseswith the highest interest rates before their maturity date. The prepaymentpenalties on these leases had expired, which enabled us to achieve a modestinterest savings. Our remaining capital leases contain prepayment penalties,which decline each year on the anniversary date of their funding. As thepenalties decline, management may decide to prepay some or all of the remainingleases. During 2003, we paid $201 thousand to settle litigation regarding ourpreferred stock, which was liquidated in 1997.

As of December 31, 2004, total debt, whichconsisted of a term loan and capital leases, was $4.9 million. Total debt as apercentage of total capitalization (total debt and shareholders’ equity) was8.4% at 

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December 31, 2004 and2.2% at December 31, 2003. 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, so that we will be able tocontinue to profitably expand the business.

Shareholder’s equity was$53.1 million, or $7.52 per common share outstanding, at December 31, 2004compared to $43.9 million, or $6.28 per share, at December 31, 2003. Theincrease in shareholders’ equity was due primarily to net income of $8.7million. Most of the remaining increase in shareholders’ equity was related tothe exercise of stock options and stock option compensation.

***Off-Balance Sheet Arrangements***

As part of our ongoingbusiness, we do not participate in transactions that generate relationshipswith unconsolidated entities or financial partnerships established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes. As of December 31, 2004, we are not involvedin any unconsolidated single-purpose entities.

***Contracts andCommitments***

Axsys has entered intocertain contractual obligations, which will result in material cash outlaysover the next several years. A summary of our contractual obligations andcommitments for capital leases, minimum lease payment obligations undernon-cancelable operating leases and other obligations are as follows (inthousands):
| ** **                                 | ** ** | **PAYMENTS DUE BY PERIOD** | ** ** |
|--------------------------------------------|------------|-------------------------------------------|------------|
| **CONTRACTUAL CASH OBLIGATIONS** | ** ** | ** **                                | ** ** | **TOTAL** | ** ** | **LESS THAN  1 YEAR** | ** ** | **1 to 3  YEARS** | ** ** | **3 to 5  YEARS** | ** ** | **AFTER 5  YEARS** | ** ** |
| Notes Payable                              |       | $                                         | 4,741      |   |   | $ | 1,165 |   |   | $ | 2,203 |   | $ | 1,373 |   |   | $ | — |   |   |
| Capital leases                             |       | 540                                       |       |   | 387 |   |   | 153 |   | — |   |   | — |   |   |
| Operating leases                           |       | 6,348                                     |       |   | 1,548 |   |   | 2,468 |   | 2,206 |   |   | 126 |   |   |
| Purchase  obligations                      |       | 1,297                                     |       |   | 1,114 |   |   | 183 |   | — |   |   | — |   |   |
| Other long-term  obligations               |       | 1,522                                     |       |   | 817 |   |   | 504 |   | 123 |   |   | 78 |   |   |
| Total                                      |       | $                                         | 14,448     |   |   | $ | 5,031 |   |   | $ | 5,511 |   | $ | 3,702 |   |   | $ | 204 |   |   |
|                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of December 31,2004, Axsys had operating lease commitments for all of our facilities, with theexception of our Cullman, Alabama facility, which is owned. In addition, ouroperating lease commitments included leases on some office equipment.

As of December 31,2004, Axsys has various purchase obligations, which include long-distance phoneservice, ATM lines and other commitments. We did not include cellular phoneservice commitments, as we determined the obligationto be minimal.

Incorporated in otherlong-term obligations are commitments related to environmental remediationplans and building leases associated with discontinued operations.

Axsys is involved in thevarious stages of investigation and cleanup related to environmentalremediation matters at a number of sites. The ultimate cost of site cleanup isdifficult to predict given the uncertainties regarding the extent of cleanup,the interpretation of applicable laws and regulations and alternative cleanupmethods. As of December 31, 2004, Axsys determined that it was probablethat it would incur approximately $603 thousand of remedial costs, of which$200 thousand is included in current liabilities and $403 thousand is in otherlong-term liabilities.

During 2002, Axsysdisposed of the Automation Group, which included facilities in Wilmington,Massachusetts (“Wilmington”) and Pittsburgh, Pennsylvania (“Pittsburgh”). Aspart of the terms of the sale, we remain obligated under the operating leasesfor these facilities. Both leases expire in 2006 and we 

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anticipateour remaining commitment to be $811 thousand. Since 2002, we have beensub-leasing a small portion of our Wilmington facility, however, given theuncertainties regarding the real estate market in both of these regions, we donot believe that we will be able to locate a sublease tenant for the Pittsburghfacility nor be able to sublease the entire Wilmington facility at ourcontractual rates. Therefore, we have fully reserved for our remaining leasecommitments for both facilities and any remaining costs associated with thesesites will not have a material adverse effect on our business and financialcondition. It is possible, however, that our results of operations for aparticular fiscal period could be materially affected.

As of December 31, 2004, we were contingentlyliable for $680 thousand under outstanding letters of credit. We have issuedletters of credit for certain business transactions including insuranceprograms and building lease security deposits.

As of December 31,2004, we had one pension plan for which benefits and participation have beenfrozen. Pension benefits under this plan are generally based upon years ofservice and compensation. The plan is an unfunded plan with an annual payout ofapproximately $105 thousand.

***Backlog***

A substantial portion ofour business is of a build-to-order nature requiring various engineering,manufacturing, testing and other processes to be performed prior to shipment. Asa result, a significant portion of our annual sales is in our backlog of ordersat the beginning of the year. Our backlog of orders increased by 28% or $19.3million, to $88.2 million at December 31, 2004 from $68.9 million at December 31,2003. We believe that a substantial portion of our backlog of orders at December 31,2004 will be shipped over the next twelve months. However, approximately 12% of our current backlog will be shipped in2006 and beyond. The majority of our longer-term backlog consists of firmcontracts with prime contractors of the United States government for our beryllium-machinedproducts.

***Critical Accounting Estimates***

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

***Critical Accounting Policies***

The preparation offinancial statements in conformity with generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting periods. The most significantestimates and assumptions relate to inventory valuation and the adequacy ofallowances for doubtful accounts, long-term loss contract reserves andenvironmental contingencies. Actual amounts could differ significantly fromthese estimates.

*Revenue recognition*.   We manufacture or distributeproducts, which are either components or subassemblies that are sold to othermanufacturers or OEMs. We do not sell any finished products directly toconsumers. Therefore, we are generally not responsible for any installation orcustomer training. 

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However,some of our contracts are subject to customer acceptance and generally thecustomer will inspect and accept the product at our facility prior to shipment.Generally,  legal title passes to thecustomer upon shipment. However,occasionally product is shipped FOB destination. When the product is shippedFOB destination, revenues are not recognized until the customer receives theproduct.

Our policy is to recognizerevenues when product is either shipped to or received by the customer. However,certain long-term contracts are accounted for under the percentage ofcompletion model. Incurred costs and estimated gross profits are recognized as sales as workis performed based on the percentage that incurred costs bear to estimatedtotal costs using our estimates of costs and contract value. Cost estimatesinclude direct and indirect costs such as labor, materials and overhead. Thesecontracts require judgment relative to assessing risks, estimating contractrevenues and costs, and making assumptions for schedule and technical issues. Contractchange orders are included when they can be reasonably estimated andrealization is probable. We may receive progress payments that exceed costsincurred on these long-term contracts. Such advances are recognized as billingsin excess of costs and are included in accrued expenses and other currentliabilities on our Consolidated Balance Sheets.

Deferred income primarily results from the advancebillings to our customers for the cost of beryllium, known as material onlybillings. These material only billings are deferred and subsequently recognizedas revenue only when the associated finished 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, theyare reflected at the time of the sale as a reduction in revenues. The price isfixed upon acceptance of the purchase order. When customer change orders occur,any pricing changes are reflected in revised purchase orders.

*Allowance for doubtful accounts*.   Weperiodically review the aging of our accounts receivable over ninety days toidentify potentially uncollectible accounts and establish reserves based onexperience and discussion with customers. Actual write-offs could differ fromour allowance for doubtful accounts. If circumstances change, (i.e., higherthan expected defaults or an unexpected material adverse change in a customersability to meet our financial obligations) our estimates of recoverability ofamounts due to us could be reduced by a material amount.

*Inventory valuation*.   Wevalue our inventory at the lower of the actual cost to purchase and/ormanufacture the inventory or the current estimated market value of theinventory. We regularly review inventory quantities on hand and record aprovision for excess or obsolete inventory based on current requirements andhistorical usage. A significant increase in the demand for our products couldresult in a short-term increase in the cost of inventory purchases while asignificant decrease in demand could result in an increase in the amount ofexcess or obsolete inventory quantities on hand. In addition, some of our markets are characterized by rapidtechnological change or frequent new product development that could result inan increase in the amount of obsolete inventory 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, if we determine our inventory to be overvalued,we would be required to recognize those costs in our cost of goods sold at thetime of such determination. Likewise, if our inventory is undervalued, we mayhave over-reported our costs of goods sold in previous periods and would berequired to recognize additional operating income at the time of sale.Therefore, although we make every effort to ensure the accuracy of ourforecasts of future product demand, any significant unanticipated changes indemand or technological developments could have a significant impact on thevalue of our inventory and our reported operating results.

*Loss contract reserves.  *Generally,our customer contracts are completed within one year of receiving the order. However,occasionally longer lead-time orders are received and we monitor thesecontracts 

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periodically to determine whether our actual costs arecomparable to our cost estimates used at the time of order acceptance. If wedetermine that our actual costs are significantly exceeding our originalestimates, we will record a loss contract reserve. Currently, one contract iscovered by a loss contract reserve. We accrued for this contract based on thecontract price and the current cost structure, including estimated costincreases. To the extent future manufacturing costs (i.e., labor rates andmaterial costs) change, our loss contract reserves will be impacted.

*Environmental contingencies.  *Weare currently involved in several environmental remediation projects. We accruefor environmental contingencies when (1) responsibility for cleanup isdetermined and (2) costs are probable and can be reasonably estimated. Whencosts are not probable and can be reasonably estimated, no accrual is made. Asdiscussed in Note 8 to the Consolidated FinancialStatements, we have accrued our estimate of the probable costs for theresolution of these claims. These estimates have been developed in consultationwith outside environmental consultants handling these matters and are basedupon an analysis of the anticipated remediation plans. We do not anticipatethese projects will have a material adverse effect on our consolidatedfinancial position. It is possible, however, that future results of operationscould be materially affected by changes in our assumptions.

*Self Insurance:  *Weare self-insured for certain losses related to general liability, workers’compensation and medical claims. Our liability represents an estimate of theultimate cost of claims incurred as of the balance sheet date. The estimatedliability is established based on an analysis of historical data and isreviewed by management on a quarterly basis to ensure that the liability isappropriate. While we believe that our estimates are reasonable based on theinformation currently available, if actual trends, including the severity andfrequency of claims, medical cost inflation or fluctuations in premiums, differfrom our estimates, our results from operations could be impacted.

*Accounting for Income Taxes:  *As part of the process of preparing theconsolidated financial statements, we are required to estimate the income taxesin each jurisdiction in which we operate. This process involves estimating theactual current tax liabilities together with assessing temporary differencesresulting from the differing treatment of items for tax and accounting purposes. These differences result in deferred taxassets and liabilities, which are included in the Consolidated Balance Sheet.We must then assess the likelihood that the deferred tax assets will be recovered,and to the extent that we believe that recovery is not more than likely, we arerequired to establish a valuation allowance. If a valuationallowance is established or increased during any period, we are required to include this amount as anexpense within the tax provision in the Consolidated  Statements of Operation. Significant judgment is required in determining our provision for income taxes, deferred taxassets and liabilities and any valuation allowance recognized against netdeferred assets. The valuation allowance is based on our estimates of thetaxable income in the jurisdictions in which we operate and the period over which the deferred tax assets will berecoverable. In the event that actual results differ from these estimates or management adjusts these estimates in future periods, we mayneed to establish an additional valuation allowance, which could materiallyimpact our results of operations.

***Recently Issued Accounting Standards***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123(revised 2004) (“Statement 123 (R)”), “Share-Based Payment”, which revised SFASNo. 123, “Accounting for Stock-Based Compensation”. This statementsupercedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”.The revised statement addresses the accounting for share-based payment transactionswith employees and other third parties, eliminates the ability to account forshare-based compensation transactions using APB 25 and requires that thecompensation costs relating to such transactions be recognized in theconsolidated statement of operations. The revised statement is effective as ofthe first interim period beginning after June 15, 2005. Axsys will adoptthe statement on July 3, 2005 as required. The impact of adoption ofStatement 123 (R) 

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cannot be predicted atthis time because it will depend on levels of share-based payments granted inthe future. However, had Axsys adopted Statement 123 (R) in prior periods,the impact of that standard would have approximated the impact of Statement 123as described in the disclosure of pro forma net income (loss) and net income(loss) per share in the stock-based compensation accounting policy noteincluded in Note 1 to the consolidated financial statements. 

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4,” to clarify that abnormal amounts of idle facility expense, freight,handling costs and wasted material (spoilage) should be recognized as currentperiod charges, and that fixed production overheads should be allocated toinventory based on normal capacity of production facilities. This statement iseffective for Axsys’ fiscal year 2006. Axsys is in the process of evaluatingwhether the adoption of SFAS 151 will have a significant impact on our overallresults of operations or financial position.

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

This filing containsforward-looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934, as amended, including, without limitation,statements regarding our ability to reduce design and manufacturing lead timesand manufacturing costs, our ability to integrate existing technologies, ourability to implement our strategy to develop and sell, among other things,higher level sub-systems, the changes to be achieved from our cost reductionefforts, our objective to grow through strategic acquisitions and anticipatedexpenditures for environmental remediation. One can identify theseforward-looking statements by the use of the words such as “expect,” “anticipate,”“plan,” “may,” “will,” “estimate” or other similar expressions. Discussioncontaining such forward-looking statements is found in the material set forthunder “Business” and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” as well as within the filing generally. Oneshould understand that many factors could cause actual results to differ fromthose expressed or implied in the forward-looking statements. These factorsinclude those discussed below as well as inaccurate assumptions. Axsys cautionsthe reader, however, that this list of factors may not 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, whichrepresents the majority of our sales, is largely dependent upon governmentcontracts.*   A significant portion of our business andbusiness development efforts are concentrated in the aerospace and defenseindustry. Our business depends, in significant part, upon the U.S. government’scontinued demand in the area of defense for high-end, high performance productsof the type that we manufacture. Approximately 48% of our net sales in 2004,47% of net sales in 2003 and 46% in 2002 were derived directly from contractswith the U.S. government, or its agencies or departments, or indirectly from subcontractswith U.S. government contractors. The majority of these government contractsare subject to termination and renegotiation. As a result, our business,financial condition and results of operations may be materially affected bychanges in U.S. government expenditures for defense. In addition, we cannotassure you that current and future government programs will continue to use ourproducts.

*We currently have one customer thatrepresents a significant portion of our accounts receivable balance.  *Asof December 31, 2004, Raytheon Corporation, an aerospace and defensesystems supplier, accounted for 28.9% of our outstanding accounts receivable. Asof December 31, 2003 and 2002, no individual customer represented morethan 10% of our accounts receivable balance. Credit is extended to customerstypically on net 30-day terms with periodic reviews of the aging of accountsreceivable to identify potentially uncollectible accounts. We do not requirecollateral.

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*We act as a subcontractor for manydifferent government programs.  *The funding ofgovernment programs is subject to congressional appropriations. Althoughmulti-year contracts may be authorized in connection with major procurements,Congress generally appropriates funds on a fiscal year basis even though aprogram may continue for several years. Consequently, programs are often onlypartially funded initially, and additional funds are committed only as Congressmakes 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 governmentbusiness is also subject to specific procurement regulations and a variety ofsocio-economic and other requirements. These requirements, although customaryin government contracts, increase our performance and compliance costs. Thesecosts might increase in the future, reducing our margins, which could have anegative effect on our financial condition. Failure to comply with these regulationsand requirements could lead to suspension or debarment, for cause, fromgovernment contracting or subcontracting for a period of time. Among the causesfor debarment are violations of various statutes, including those related to:

·       procurementintegrity

·       exportcontrol

·       governmentsecurity regulations

·       employmentpractices

·       protectionof the environment, and

·       accuracyof records and the recording of costs

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 required as we may have access to classifieddocuments. We can give no assurance that we will be successful in maintainingthese necessary clearances in order to conduct business with the U.S.government.

*Our operating results may varysubstantially due to factors that are difficult to forecast.  *Factorssuch as announcements of technological innovations or new products by Axsys orour competitors, domestic and foreign general economic conditions and the cyclicalnature of the industries that we serve could cause 

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substantialvariations in our operating results. The defense, aerospace, semiconductorcapital equipment, high-performance graphic art, medical imaging capitalequipment, industrial automation OEM and MRO markets, each of which representsa significant market for our products, have historically been subject tosubstantial economic fluctuations due to changing demands for their productsand services, introduction of new products and product obsolescence. Any futurefluctuations arising from these or other conditions could have an adverseimpact on our business, financial condition or results 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:

·       marketacceptance of new and enhanced versions of our products

·       timingand shipment of significant orders

·       mixof products sold

·       lengthof sales cycles

·       plantopenings and closings

·       thetiming of acquisitions or dispositions

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

·       completionof large projects

·       thelevel of backlog of orders

·       domesticand foreign general economic conditions, and

·       demandin the markets that we serve.

To some extent, primarily in our bearing distributiondivision, our net sales and operating results for a specific quarter willdepend upon generating orders to be shipped in the same quarter in which theorder is received. The failure to receive anticipated orders or delays inshipments 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 of technological change will requirecontinuous new product development.  *Our success willcontinue to depend in substantial part upon our ability to introduce newproducts that keep pace with technological developments and evolving industrystandards and to apply appropriate levels of engineering, research anddevelopment resources necessary to keep pace with these developments. Inaddition, our success will depend on how well we respond to changes in customerrequirements and achieve market acceptance for our products and capabilities. Anyfailure by Axsys to anticipate or respond adequately to technologicaldevelopments and customer requirements could have a material adverse effect onour business, financial condition and results of operations. In order todevelop new products successfully, we are dependent upon close relationshipswith our customers and their willingness to share proprietary information abouttheir requirements and participate in collaborative efforts with us. We cannotassure you that our customers will continue to provide us with timely access toinformation or that we will be successful in developing and marketing newproducts and services or their enhancements. In addition, we cannot assure youthat the new products and services or their enhancements, if any, that we develop,will achieve market acceptance.

*Our markets are extremely competitive.  *Wecompete primarily on the basis of our ability to design and engineer ourproducts to meet performance specifications set by our customers, most of whomare OEMs who purchase component parts or sub-systems for inclusion in their endproducts. Product pricing and 

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quality, customer support,experience, reputation and financial stability are also important competitivefactors.

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

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

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

The basis of competition in the industries in which wecompete could shift and we may not be able to compete successfully.

*Our levels of international sales and purchasescould pose risks to our operating results.  *Ourinternational sales from continuing operations accounted for approximately12.2% of net sales in 2004, 14.2% in 2003, and 18.1% in 2002. In addition, ourproducts are sold to domestic customers who use them in products that they sellinto international markets. Also, we purchase a substantial portion of our ballbearing products from two foreign suppliers and certain other products fromother foreign suppliers. Our international sales and purchases are subject to anumber of risks generally associated with international operations, includinggeneral economic conditions, import and export duties and restrictions,currency fluctuations, changes in regulatory requirements, tariffs and otherbarriers, political and economic instability and potentially adverse income taxconsequences. Any of these factors could have a material adverse effect on ourbusiness, financial condition and results of operations.

*We may not be able to successfully manageacquisitions.  *As part of our business developmentstrategy, we plan to pursue acquisitions in order to expand our productofferings, add to or enhance our base of technical and sales personnel orprovide desirable customer relationships. This growth could result in asignificant strain on our managerial, financial, engineering and otherresources. The rate of our future expansion, if any, in combination with thecomplexity of the technologies involved in our businesses, may demand anunusually high level of managerial effectiveness in anticipating, planning,coordinating and meeting our operational needs as well as the needs of ourcustomers.

We may not successfully acquire the most complementarybusinesses. Axsys cannot assure you that we will be able to acquirecomplementary businesses on a cost-effective basis, integrate acquiredoperations into our organization effectively, retain and motivate keypersonnel, or retain customers of acquired firms. We compete for attractiveacquisition candidates with other companies or investors, and that competitioncould increase the cost of pursuing our acquisition strategy or reduce thenumber of attractive candidates to be acquired. Axsys reviews and considerspossible acquisitions on an on-going basis.

*Many key product components come from single sourcesuppliers*.   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 

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U.S. supplier, and expectto continue to rely on Brush Wellman for beryllium for the foreseeable future. Althoughwe have not experienced significant problems with our supplier in the past, wecannot assure you that such relationship will continue or that we will continueto obtain such supplies at cost levels that would not adversely affect ourgross margins. The partial or complete loss of Brush Wellman as a supplier ofberyllium, or production shortfalls or interruptions that otherwise impair oursupply of beryllium, would have a material adverse effect on our business,financial condition and results of operations. It is uncertain whetheralternative sources of supply could be developed without a material disruptionin our ability to provide beryllium products to our customers.

Although we have not experienced significant problemswith our other suppliers in the past, we cannot assure you that suchrelationships will continue or that, in the event of the termination of one ormore of our relationships with those other suppliers, we would be able toobtain alternative sources of supply without a material disruption in ourability to provide products to our customers. In addition, we purchase asubstantial amount of the ball bearings that we distribute from two foreignsuppliers. Any material disruption in our supply of products would have amaterial adverse effect on our business, financial condition or results ofoperations.

*Our future success depends on our ability to retainkey personnel.  *Axsys’ success depends to a significantextent on the continued services of our key executive officers and seniormanagement personnel. The loss of the services of one or more of theseindividuals may have a material adverse effect on our business, financialcondition and results of operations. We do not maintain key man life insuranceon our executive officers. In addition, since our continued success is largelydependent upon our ability to design, manufacture and sell high-performancesolutions for the high-performance technology market, we are particularlydependent upon our ability to identify, attract, motivate and retain qualifiedtechnical personnel, including engineers and skilled machinists, with therequisite educational background and industry experience. Our employees mayvoluntarily terminate their employment with us at any time, and competition forpersonnel is intense. Accordingly, we cannot assure that we will be successfulin retaining our existing personnel. The loss of the services of a significantnumber of our technical or skilled personnel, or the future inability toattract technical or skilled personnel, could have a material adverse effect onour business, financial condition and results of operations.

*We must protect our intellectual property rights.  *Thepatents of competitors could impact our business. Our ability to competeeffectively with other companies will depend, in part, on our ability tomaintain the proprietary nature of our technology. We rely upon a combinationof patents, trademarks and trade secrets, non-disclosure agreements and otherforms of intellectual property protection to safeguard our proprietarytechnology. We cannot assure you as to the degree of protection offered bythese patents. We also cannot assure you that we will be able to maintain theconfidentiality of our trade secrets or that our non-disclosure agreements willprovide meaningful protection of our trade secrets, know-how or otherproprietary information in the event of any unauthorized use, misappropriationor 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. Although we believe that our existing products do not infringe on thepatents or other proprietary rights of third parties, third parties couldassert infringement claims against us and such claims could be successful.

*We must comply with strict environmentalregulations; both compliance and non-compliance could result in materialliabilities or costs.*   We are subject to a variety offederal, state and local laws, rules and regulations relating to the use,storage, discharge and disposal of hazardous chemicals used during ourengineering, research and development and manufacturing activities. Failure to complywith applicable environmental requirements could result in substantialliability to Axsys, suspension or cessation of our 

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operations, restrictionson our 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 cannot assure 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 substantialexpenditures, or (b) as to the extent of our liabilities, if any, for pastfailures, if any, to comply with applicable environmental laws, regulations andpermits, any of which also could have a material adverse effect on ourbusiness, financial condition and results of operations.

We have made and continue to make investments inprotective equipment, process controls, manufacturing procedures and trainingin order to minimize the risks to our employees, surrounding communities andthe environment due to the presence and handling of hazardous materials. Thefailure to properly handle these materials could lead to harmful exposure foremployees or to the discharge of certain hazardous waste materials. Since Axsysdoes not carry environmental impairment insurance, such a failure could lead toa material adverse effect on our business, financial condition and results ofoperations. Also, environmental problems could develop in the future whichwould have a material adverse effect on our business, financial condition andresults of operations.

*We must continue to invest significant resources tomaintain 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 technology or sales growth beyond currentlyestablished manufacturing capabilities would require that we make furtherinvestment. 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, anyfurther expansion could negatively impact our business, financial condition orresults and operations.

*One shareholder controls a significant block ofAxsys’ stock and this concentration could affect important operating decisions.*   TheChairman of the Board and Chief Executive Officer of Axsys owns approximately27% of the outstanding common stock as of December 31, 2004. As a result,he will have the ability to exert influence with respect to corporate actions,including the election of directors and certain sales or mergers andacquisitions.

*Our stock price has been volatile and may continueto fluctuate substantially.  *The price of our commonstock may be subject to significant fluctuations. That price volatility may beattributable, at least in part, to the limited number of shares generallyavailable for sale in the public market. In addition, factors, such as, actualor anticipated quarterly fluctuations in our financial results, changes inrecommendations or earnings estimates by securities analysts, announcements oftechnological innovations or new commercial products or services and the timingof announcements of acquisitions or dispositions by Axsys or our competitors,as well as conditions in our markets generally, may have a significant adverseeffect on the market price of our common stock. Furthermore, the stock markethistorically has experienced volatility which has particularly affected themarket prices of securities of many technology companies and which sometimeshas been unrelated to the operating performances of such companies.

*Certain anti-takeover provisions could cause harmto our shareholders.  *Our Certificate of Incorporation,as amended (the “Certificate of Incorporation”), our By-Laws (the “By-Laws”)and the Delaware General Corporation Law (“DGCL”) contain various provisionswhich could delay or impede the removal of incumbent directors and could make amerger, tender offer or proxy contest involving Axsys more difficult, even ifsuch a transaction would be beneficial to the interests of the shareholders, orcould discourage a third party 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 

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rights, privileges andpreferences, as the Board of Directors may determine. We have no current plansto issue any preferred stock.

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 Incorporation provides that in lieu of ameeting, action may be taken by written consent of our shareholders only byunanimous consent. These provisions could have the effect of delaying,deterring or preventing a change in control of Axsys, and may adversely affectthe voting and 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. These provisions may have the effect of delaying orpreventing a change of control of Axsys without action by the shareholders and,therefore, could adversely affect the price of our common stock. In the eventof a change of control of Axsys, the vesting of outstanding options issuedunder our 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.

*Absence of Cash Dividends onCommon Stock.  *Axsys does not anticipate paying cashdividends on our common stock in the foreseeable future.

**Item 7a.**                 QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

Axsys’ market risksensitive instruments do not subject Axsys to material market risk exposures.

**Item 8.**                        FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

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

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

None.

**Item 9A.**                CONTROLS ANDPROCEDURES

Within the 90 days prior to the filing date of thisreport, Axsys carried out an evaluation, under the supervision and with theparticipation of our management, including the chief executive officer andprincipal financial officer, of the effectiveness of the design and operationof Axsys’ disclosure controls and procedures pursuant to Rule 13a-14 underthe Securities Exchange Act of 1934. Based upon that evaluation, the chiefexecutive officer and principal financial officer concluded that our disclosurecontrols and procedures are effective in timely alerting them to materialinformation relating to Axsys required to be included in our periodic SECfilings.

Subsequent to the date wecarried out our evaluation, there have been no significant changes in ourinternal controls or in other factors that could significantly affect theseinternal controls.

Item 9B.               OTHER INFORMATION

None.

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**PART III**

The information requiredby items 10, 11, 12, 13 and 14 of Part III, other than the disclosureregarding the adoption of our Code of Ethics as required by Item 406(a) ofRegulation S-K and the table required by Item 201(d) of Regulation S-K, isincorporated by reference to Axsys’ definitive proxy statement for our 2005Annual Meeting of Stockholders (“2005 Proxy Statement”) to be filed with theSecurities and Exchange Commission within 120 days following the end of Axsys’fiscal year ended December 31, 2004. If such proxy statement is not sofiled, that information will be filed as an amendment to this Form 10-Kwithin 120 days following the end of Axsys’ fiscal year ended December 31,2004.

**Item10.**                 DIRECTORSAND EXECUTIVE OFFICERS OF THEREGISTRANT

Except for the informationconcerning our Code of Ethics, the information required by this item isincorporated by reference from our 2005 Proxy Statement.

**Code of Ethics**

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

**Item 11.**                 EXECUTIVECOMPENSATION

The information requiredby this item is incorporated by reference from our 2005 Proxy Statement.

**Item12.**                 SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Except for theinformation concerning equity compensation plans, the information required bythis item is incorporated by reference from our 2005 Proxy Statement under thecaption, “Securities Ownership of Directors and Officers.” The following tablegives information about our equity securities that may be issued under equitycompensation plans as of December 31, 2004. Those securities are shares ofcommon stock that can be issued under our existing Long-Term Stock IncentivePlan. 
| **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     |       |       | 811,106    |                                                                                                                                                                        |       |                                                                                                                               | $          | 9.36                                                                                                                                                                                                                                             |       |   |   | 212,760 |   |   |
| Equity compensation plans not approved by security  holders |       |       | —     |                                                                                                                                                                        |       |                                                                                                                               | —     |                                                                                                                                                                                                                                             |       |   | — |   |   |
| Total                                                       |       |       | 811,106    |                                                                                                                                                                        |       |                                                                                                                               | $          | 9.36                                                                                                                                                                                                                                             |       |   |   | 212,760 |   |   |

 

**Item13.**                 CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information requiredby this item is incorporated by reference from our 2005 Proxy Statement.

**Item14.**                 PRINCIPALACCOUNTANT FEES AND SERVICES

The information requiredby this item is incorporated by reference from our 2005 Proxy Statement.

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**PART IV**

**Item 15.      EXHIBITS,FINANCIAL STATEMENT SCHEDULES**

**(a)(1) and (2) and (c) FinancialStatements**

Seeaccompanying 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             |       | 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).*                                                                                        |
| 10.2             |       | Severance Protection  Agreement between Axsys and Stephen W. Bershad dated as of February 11,  1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated  May 11, 1999, for the fiscal quarter ended March 31, 1999 (the  “March 31, 1999 Form 10-Q”) and incorporated herein by reference).* |
| 10.3             |       | Amendment to Axsys  Technologies, Inc. Long-Term Stock Incentive Plan (filed as  Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 and  incorporated herein by reference).*                                                                                                                                             |
| 10.4             |       | Employment Agreement,  dated as of October 12, 2000, between Axsys and Stephen W. Bershad  (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K  and incorporated herein by reference).*                                                                                                                                |
| 10.5             |       | Form of  Indemnification Agreement for all Directors and Officers of Axsys (filed as  Exhibit 10(17) to the December 31, 2001 Form 10-K and  incorporated herein by reference).*                                                                                                                                               |
| 10.6             |       | Letter Agreement between  David A. Almeida and Axsys dated as of November 14, 2001 (filed as  Exhibit 10(18) to the December 31, 2001 Form 10-K and  incorporated herein by reference).*                                                                                                                                       |
| 10.7             |       | Severance Protection  Agreement between Axsys and David A. Almeida dated as of May 13, 2003  (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q and  incorporated herein by reference).*                                                                                                                                    |
| 10.8             |       | Letter Agreement between  Stephen W. Bershad and Axsys dated November 11, 2004, extending term of  initial period of the Employment Agreement.*                                                                                                                                                                                               |
| 10.9             |       | Severance Protection  Agreement between Axsys and Scott B. Conner dated as of December 3,  2004*                                                                                                                                                                                                                                              |
| 10.10            |       | Summary of Management  Incentive Plan*                                                                                                                                                                                                                                                                                                             |
| 14               |       | Code of Ethics—Senior Financial Officers (filed  as Exhibit 14.1 to the December 31, 2003  Form 10-K and incorporated herein by reference).                                                                                                                                                                                    |
| 21               |       | Subsidiaries of  the Registrant                                                                                                                                                                                                                                                                                                                    |
| 23               |       | Consent of Ernst and  Young LLP                                                                                                                                                                                                                                                                                                                    |
| 31.1             |       | Certification pursuant  to Rule 13a-14(a)—Chief Executive Officer                                                                                                                                                                                                                                                                        |

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| 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 |

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*                    Indicatesmanagement contracts or compensatory plans or arrangements.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Dated:   | February 23, 2005                                            |                   | AXSYS TECHNOLOGIES, INC. |
|----------|-------------------------------------------------------------------|------------------------|--------------------------|
|     | (Registrant)                                                      |
|     | By                                                                | /s/ STEPHEN W. BERSHAD |
|     | Stephen W. Bershad                                                |
| * * | *Chairman of the Board of Directors  and Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities indicated this the 23rdday of February 2005.
| /s/ STEPHEN W. BERSHAD             |   | Chairman of the  Board of Directors and Chief |
|------------------------------------|--------|-----------------------------------------------|
| Stephen W.  Bershad                |   | Executive Officer                             |
| /s/  DAVID A. ALMEIDA              |   | Vice President,  Chief Financial Officer,     |
| David A. Almeida                   |   | Treasurer & Secretary           |
| /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                  |   |                                          |

 

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**ANNUAL REPORT ON FORM 10-K**

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

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ANDFINANCIAL STATEMENT SCHEDULE**

**FINANCIAL STATEMENTS**

**YEAR ENDED DECEMBER 31, 2004**

**AXSYS TECHNOLOGIES, INC.**

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**FORM 10-K—ITEM 14(a)(1) and(2) and Item 14(d)AXSYS TECHNOLOGIES, INC.**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE**

Thefollowing consolidated financial statements of Axsys Technologies, Inc.are included in Item 8:
| Report of Independent  Registered Public Accounting Firm.                                                                                              |   | F-2 |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----|
| Consolidated  Balance Sheets—December 31, 2004 and 2003                                                                                      |   | F-3 |
| Consolidated  Statements of Operations—  For the years ended December 31, 2004, 2003 and 2002                                                |   | F-4 |
| Consolidated  Statements of Cash Flows—  For the years ended December 31, 2004, 2003 and 2002                                                |   | F-5 |
| Consolidated  Statements of Shareholders’ Equity and Comprehensive Income (Loss)—  For the years ended December 31, 2004, 2003 and 2002 |   | F-6 |
| Notes  to consolidated financial statements                                                                                                            |   | F-7 |

 

Thefollowing consolidated financial statement schedule of Axsys Technologies, Inc.,is included in Item 14(d):
| Schedule II—Valuation and  qualifying accounts. |   | F-31 |
|------------------------------------------------------|--------|------|

 

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

F-1

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REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders ofAxsys Technologies, Inc.:

We have audited the accompanying consolidated balancesheets of Axsys Technologies, Inc., and subsidiaries as of December 31,2004 and 2003, and the related consolidated statements of operations,shareholders’ equity and comprehensive income (loss), and cash flows for eachof the three years in the period ended December 31, 2004. Our audits alsoincluded the financial statement schedule listed in the Index at Item 14(d). Thesefinancial statements and the schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all material respects,the consolidated financial position of Axsys Technologies, Inc. andsubsidiaries at December 31, 2004 and 2003, and the consolidated resultsof their operations and their cash flows for each of the three years in theperiod ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles. Also, in our opinion, the related financial statementschedule, when considered in relation to the basic financial statements takenas a whole, presents fairly in all material respects the information set forththerein.
|                       | **ERNST & YOUNG LLP** |
|-----------------------|--------------------------------|
| Hartford, Connecticut | ** **                     |
| February 8, 2005 | ** **                     |

 

F-2

----

**AXSYS TECHNOLOGIES, INC.Consolidated Balance Sheets(Dollars in thousands, except share and per share data)**
| ** **                                                                                                        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ***ASSETS***                                                                                                      |       |                  |       |   |   |
| CURRENT ASSETS:                                                                                                   |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                        |       | $                     | 6,000      |   | $ | 5,197 |   |
| Short-term  investments                                                                                           |       | —                |       | 6,983 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $685 in 2004 and $653  in 2003                    |       | 15,715                |       | 10,197 |   |
| Inventories, net                                                                                                  |       | 29,698                |       | 24,786 |   |
| Income taxes—deferred  and current                                                                           |       | 3,553                 |       | 2,203 |   |
| Other current  assets                                                                                             |       | 1,020                 |       | 1,223 |   |
| TOTAL CURRENT ASSETS                                                                                              |       | 55,986                |       | 50,589 |   |
| PROPERTY, PLANT AND EQUIPMENT, net                                                                                |       | 13,337                |       | 11,315 |   |
| NET INTANGIBLE ASSET                                                                                              |       | 2,127                 |       | — |   |
| GOODWILL                                                                                                          |       | 13,013                |       | 3,600 |   |
| OTHER ASSETS                                                                                                      |       | 1,352                 |       | 1,341 |   |
| TOTAL ASSETS                                                                                                      |       | $                     | 85,815     |   | $ | 66,845 |   |
| ***LIABILITIES  AND SHAREHOLDERS’ EQUITY***                                                                  | ** ** | ** **            | ** ** | ** ** | ** ** |
| CURRENT LIABILITIES:                                                                                              |       |                  |       |   |   |
| Accounts payable                                                                                                  |       | $                     | 6,459      |   | $ | 4,240 |   |
| Accrued expenses  and other current liabilities                                                                   |       | 9,513                 |       | 8,170 |   |
| Deferred income                                                                                                   |       | 7,195                 |       | 4,546 |   |
| Current portion  of long-term capital lease obligations                                                           |       | 368                   |       | 423 |   |
| Current portion  of long term debt                                                                                |       | 1,000                 |       | — |   |
| TOTAL CURRENT LIABILITIES                                                                                         |       | 24,535                |       | 17,379 |   |
| CAPITAL LEASES, less current portion                                                                              |       | 150                   |       | 568 |   |
| LONG TERM DEBT, less current portion                                                                              |       | 3,333                 |       | — |   |
| OTHER LONG-TERM LIABILITIES                                                                                       |       | 4,704                 |       | 5,000 |   |
| COMMITMENTS AND  CONTINGENCIES                                                                                    |       |                  |       |   |   |
| SHAREHOLDERS’ EQUITY:                                                                                        |       |                  |       |   |   |
| Common stock,  $.01 par value: authorized 45,000,000 shares, issued 7,186,734 at  December 31, 2004 and 2003 |       | 72                    |       | 72 |   |
| Capital in excess  of par                                                                                         |       | 39,612                |       | 39,375 |   |
| Accumulated other  comprehensive loss                                                                             |       | (97                   | )          | (39 | ) |
| Retained earnings                                                                                                 |       | 14,389                |       | 5,725 |   |
| Treasury stock,  at cost: 130,216 shares at December 31, 2004 and 199,030 shares at December 31,  2003  |       | (883                  | )          | (1,235 | ) |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                   |       | 53,093                |       | 43,898 |   |
| TOTAL LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                  |       | $                     | 85,815     |   | $ | 66,845 |   |

 

 

See accompanying notes to consolidated financial statements.

F-3

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements ofOperations(Dollars in thousands, except share and per share data)**
| ** **                                                                                                             | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Sales                                                                                                                  |       | $                                           | 103,530    |   | $ | 85,109 |   | $ | 79,586 |   |
| Cost of sales                                                                                                          |       | 72,874                                      |       | 62,036 |   | 59,454 |   |
| Gross profit                                                                                                           |       | 30,656                                      |       | 23,073 |   | 20,132 |   |
| Selling, general and administrative expenses                                                                           |       | 18,684                                      |       | 15,986 |   | 16,262 |   |
| Research,  development and engineering expenses                                                                        |       | 2,677                                       |       | 2,059 |   | 2,049 |   |
| Restructuring and  special charges (credits)                                                                           |       | (50                                         | )          | — |   | 1,854 |   |
| OPERATING INCOME  (LOSS)                                                                                               |       | 9,345                                       |       | 5,028 |   | (33 | ) |
| Interest expense                                                                                                       |       | (254                                        | )          | (172 | ) | (212 | ) |
| Interest income                                                                                                        |       | 98                                          |       | 115 |   | 190 |   |
| Other (expense)  income, net                                                                                           |       | (38                                         | )          | 263 |   | 10 |   |
| Income (loss)  from continuing operations before income taxes and cumulative effect of  change in accounting principle |       | 9,151                                       |       | 5,234 |   | (45 | ) |
| (Benefit from)  provision for income taxes                                                                             |       | (8                                          | )          | 236 |   | 2,969 |   |
| INCOME (LOSS)  FROM CONTINUING OPERATIONS BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING  PRINCIPLE                  |       | 9,159                                       |       | 4,998 |   | (3,014 | ) |
| Discontinued  operations:                                                                                              |       |                                        |       |   |   |   |   |
| Loss from discontinued operations, net of tax  benefit of $267 in 2004 and $2,787 in 2002                              |       | (495                                        | )          | — |   | (4,582 | ) |
| Cumulative effect  of change in accounting principle                                                                   |       | —                                      |       | — |   | 535 |   |
| NET INCOME (LOSS)                                                                                                      |       | $                                           | 8,664      |   | $ | 4,998 |   | $ | (7,061 | ) |
| BASIC EARNINGS  (LOSS) PER SHARE:                                                                                      |       |                                        |       |   |   |   |   |
| Continuing operations                                                                                                  |       | $                                           | 1.30       |   | $ | 0.72 |   | $ | (0.43 | ) |
| Discontinued operations                                                                                                |       | (0.07                                       | )          | — |   | (0.65 | ) |
| Cumulative effect of change in accounting principle                                                                    |       | —                                      |       | — |   | 0.08 |   |
| Total                                                                                                                  |       | $                                           | 1.23       |   | $ | 0.72 |   | $ | (1.00 | ) |
| Weighted-average basic common shares  outstanding                                                                      |       | 7,020,184                                   |       | 6,986,094 |   | 7,037,432 |   |
| DILUTED EARNINGS  (LOSS) PER SHARE:                                                                                    |       |                                        |       |   |   |   |   |
| Continuing operations                                                                                                  |       | $                                           | 1.26       |   | $ | 0.71 |   | $ | (0.43 | ) |
| Discontinued operations                                                                                                |       | (0.07                                       | )          | — |   | (0.65 | ) |
| Cumulative effect of change in accounting principle                                                                    |       | —                                      |       | — |   | 0.08 |   |
| Total                                                                                                                  |       | $                                           | 1.19       |   | $ | 0.71 |   | $ | (1.00 | ) |
| Weighted-average  diluted common shares outstanding                                                                    |       | 7,289,437                                   |       | 7,074,342 |   | 7,037,432 |   |

 

See accompanying notes to consolidated financial statements.

F-4

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements ofCash Flows(Dollars in thousands)**
| ** **                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                           | 8,664      |   | $ | 4,998 |   | $ | (7,061 | ) |
| Adjustments to reconcile net income (loss) to cash  provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                        |       | 2,747                                       |       | 2,920 |   | 2,663 |   |
| Deferred income taxes  (benefits)                                                     |       | (1,747                                      | )          | — |   | 1,964 |   |
| Stock option  compensation expense                                                    |       | 242                                         |       | — |   | — |   |
| Contribution to 401(k) plan                                                      |       | 58                                          |       | 55 |   | 70 |   |
| Non-cash restructuring  and special charges (credits)                                 |       | (50                                         | )          | — |   | 888 |   |
| Loss on disposal of  capital equipment                                                |       | 19                                          |       | 55 |   | 751 |   |
| Impairment of assets                                                                  |       | —                                      |       | — |   | 313 |   |
| Cumulative effect of  change in accounting principle                                  |       | —                                      |       | — |   | (535 | ) |
| Changes in operating assets and liabilities:                                          |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                   |       | (4,464                                      | )          | (129 | ) | 594 |   |
| Inventories                                                                           |       | (4,073                                      | )          | (2,706 | ) | (1,516 | ) |
| Other  current assets and other assets                                                |       | 787                                         |       | 868 |  | 1,116 |  |
| Accounts payable                                                                      |       | 2,112                                       |       | 1,132 |   | (1,343 | ) |
| Accrued expenses and  other liabilities                                               |       | 1,282                                       |       | (108 | ) | (592 | ) |
| Deferred income                                                                       |       | 2,649                                       |       | 1,431 |   | 2,507 |   |
| Long-term liabilities                                                                 |       | (448                                        | )          | (504 | ) | (51 | ) |
| Net cash provided by  (used in) continuing operations                                 |       | 7,778                                       |       | 8,012 |   | (232 | ) |
| Net cash (used in)  provided by discontinued operations                               |       | (140                                        | )          | (1,261 | ) | 1,990 |   |
| NET CASH PROVIDED BY  OPERATING ACTIVITIES                                            |       | 7,638                                       |       | 6,751 |   | 1,758 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |       |                                        |       |   |   |   |   |
| Capital expenditures                                                                  |       | (4,239                                      | )          | (3,027 | ) | (1,380 | ) |
| Purchase of Telic  Optics, Inc., net of cash acquired                            |       | (13,728                                     | )          | — |   | — |   |
| Net sale (purchase) of  marketable securities                                         |       | 6,983                                       |       | (6,983 | ) | — |   |
| Net proceeds from sale  of discontinued operations                                    |       | —                                      |       | — |   | 541 |   |
| NET CASH USED IN  INVESTING ACTIVITIES                                                |       | (10,984                                     | )          | (10,010 | ) | (839 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |       |                                        |       |   |   |   |   |
| Proceeds from (repayment  of) borrowings, net                                         |       | 3,860                                       |       | (1,255 | ) | (898 | ) |
| Proceeds from the  exercise of options                                                |       | 360                                         |       | 4 |   | — |   |
| Escheatment and  settlement of preferred stock                                        |       | (71                                         | )          | (213 | ) | — |   |
| NET CASH PROVIDED BY  (USED IN) FINANCING ACTIVITIES                                  |       | 4,149                                       |       | (1,464 | ) | (898 | ) |
| NET CHANGE IN CASH AND  CASH EQUIVALENTS                                              |       | 803                                         |       | (4,723 | ) | 21 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF YEAR                                       |       | 5,197                                       |       | 9,920 |   | 9,899 |   |
| CASH AND CASH EQUIVALENTS AT END OF YEAR                                              |       | $                                           | 6,000      |   | $ | 5,197 |   | $ | 9,920 |   |

 

See accompanying notes to consolidated financial statements.

F-5

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**AXSYS TECHNOLOGIES, INC.Consolidated Statements ofShareholders’ Equity and Comprehensive Income (Loss)(Dollars in thousands, except share and per share data)**
| ** **                               | ** ** | **Common  Stock** | ** ** | **Capital in  Excess of** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Treasury  Stock** | ** ** | ** ** | ** ** | **Comprehensive**      | ** ** |
|------------------------------------------|------------|-------------------|------------|-------------------------------------|------------|---------------------------------------|------------|--------------|------------|---------------------|------------|------------|------------|------------------------|------------|
| ** **                               | ** ** | **Amount**        | ** ** | **Par**                             | ** ** | **Loss**                              | ** ** | **Earnings** | ** ** | **Amount**          | ** ** | **Total**  | ** ** | **Income (Loss)** | ** ** |
| Balance at December 31, 2001   |       |              | $          | 72                                  |       |                                  |       | $            | 39,621     |                |       |       | $          | —                 |       |   |   | $ | 7,788 |   |   |   | $ | (1,041 | ) |   | $ | 46,440 |   |   |   |   |   |
| Net loss                                 |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | (7,061     | ) |   |   | — |   |   | (7,061 | ) |   | $ | (7,061 | ) |   |
| Total comprehensive loss                 |       |              |       |                                |       |                                  |       |         |       |                |       |       |       |                   |       |   |   |   |   |   |   |   |   |   | $ | (7,061 | ) |   |
| Shares received—sale of business    |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | —     |   |   |   | (356 | ) |   | (356 | ) |   |   |   |   |
| Contribution to 401(k) plan         |       |              | —     |                                |       |                                  | (34        | )            |       |                | —     |       |       |                   | —     |   |   |   | 104 |   |   | 70 |   |   |   |   |   |
| Balance at December 31, 2002   |       |              | 72         |                                |       |                                  | 39,587     |         |       |                | —     |       |       |                   | 727        |   |   |   | (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         | )            |       |                | —     |       |       |                   | —     |   |   |   | 5 |   |   | 4 |   |   |   |   |   |
| Contribution to 401(k) plan         |       |              | —     |                                |       |                                  | 2          |         |       |                | —     |       |       |                   | —     |   |   |   | 53 |   |   | 55 |   |   |   |   |   |
| Escheatment of preferred  stock          |       |              | —     |                                |       |                                  | (12        | )            |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | (12 | ) |   |   |   |   |
| Preferred stock settlement               |       |              | —     |                                |       |                                  | (201       | )            |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | (201 | ) |   |   |   |   |
| Balance at December 31, 2003   |       |              | 72         |                                |       |                                  | 39,375     |         |       |                | (39        | )          |       |                   | 5,725      |   |   |   | (1,235 | ) |   | $ | 43,898 |   |   |   |   |   |
| Net income                               |       |              | —     |                                |       |                                  | —     |         |       |                | —     |       |       |                   | 8,664      |   |   |   | — |   |   | 8,664 |   |   | $ | 8,664 |   |   |
| Foreign exchange contract                |       |              | —     |                                |       |                                  | —     |         |       |                | (84        | )          |       |                   | —     |   |   |   | — |   |   | (84 | ) |   | (84 | ) |   |
| Gain on Swap                             |       |              | —     |                                |       |                                  | —     |         |       |                | 26         |       |       |                   | —     |   |   |   | — |   |   | 26 |   |   | 26 |   |   |
| Total comprehensive income               |       |              |       |                                |       |                                  |       |         |       |                |       |       |       |                   |       |   |   |   |   |   |   |   |   |   | $ | 8,606 |   |   |
| Exercise of stock options                |       |              | —     |                                |       |                                  | 38         |         |       |                | —     |       |       |                   | —     |   |   |   | 322 |   |   | 360 |   |   |   |   |   |
| Contribution to 401(k) plan         |       |              | —     |                                |       |                                  | 28         |         |       |                | —     |       |       |                   | —     |   |   |   | 30 |   |   | 58 |   |   |   |   |   |
| Escheatment of preferred  stock          |       |              | —     |                                |       |                                  | (71        | )            |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | (71 | ) |   |   |   |   |
| Stock option compensation                |       |              | —     |                                |       |                                  | 242        |         |       |                | —     |       |       |                   | —     |   |   |   | — |   |   | 242 |   |   |   |   |   |
| Balance at  December 31, 2004  |       |              | $          | 72                                  |       |                                  |       | $            | 39,612     |                |       |       | $          | (97                    | )          |   |   | $ | 14,389 |   |   |   | $ | (883 | ) |   | $ | 53,093 |   |   |   |   |   |

 

See accompanying notes to consolidated financial statements.

F-6

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**AXSYS TECHNOLOGIES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) December 31, 2004**

**Note 1—Summary of Significant Accounting Policies**

*Business overview*.   Theaccompanying consolidated financial statements include the accounts of AxsysTechnologies, Inc. and our wholly-owned subsidiaries (collectively “Axsys”,“Company”, “we”, “our” or “us”).

Axsys is a global leader in the design, manufacturingand distribution of precision components and assemblies for high technologymarkets. In addition, we distribute precision ball bearings for use in avariety of industrial and commercial applications.

*Principles of consolidation.  *Theconsolidated financial statements include the results of Axsys and ourwholly-owned subsidiaries. The results of companies disposed of during thefiscal year are included in the consolidated financial statements up to thedate of disposal. All significant inter-company balances and transactions havebeen eliminated in consolidation.

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

Our policy is to recognize revenues when product iseither shipped to or received by the customer based on the terms of thespecific sale. However, certain long-term contracts are accounted for under thepercentage of completion model. Revenues and estimated gross profit arerecognized as work is performed based on the percentage that incurred costs todate bear to estimated total costs. Cost estimates include direct and indirectcosts such as labor, materials and overhead. These contracts require judgmentrelative to assessing risks, estimating future costs, and making assumptionsfor schedule and technical issues. Contract changes are included when the costscan be reasonably estimated. We may receive progress payments that exceed costsincurred on these long-term contracts. Such advances are recognized as billingsin excess of costs and are included in accrued liabilities and other currentliabilities on our Consolidated Balance Sheets.

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

*Cash and cash equivalents*.   Cashand cash equivalents include highly liquid investments with an originalmaturity of three months or less at the date of purchase.

*Short-term investments*.   Short-terminvestments include investments in federal agency notes and commercial paperwith maturities ranging from 3 months to 12 months at the date of purchase. Allshort-term investments are classified as held-to-maturity and are recognized atamortized cost.

*Financial instruments.  *Weuse derivative instruments, in the form of forward contracts and interest rateswap agreements, to manage certain foreign currency and interest rateexposures. We view derivative instruments as risk management tools, and we donot use them for trading or speculative purposes. Derivatives used for hedgingpurposes must be designated as an effective hedge of the identified riskexposure at the inception of the contract. Accordingly, changes in fair valueof the derivative contract must 

F-7

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

**Note1—Summary of Significant Accounting Policies (Continued)**

be highly correlated withchanges in the fair value of the underlying hedged item at inception of thehedge and over the life of the hedge contract.

All derivative instruments are recognized in thebalance sheet at fair value. Derivatives used to hedge forecasted cash flowsassociated with foreign currency sales and interest rate fluctuations areaccounted for as cash flow hedges. Gains and losses on derivatives designatedas cash flow hedges are recognized in accumulated other comprehensive income(loss) and in earnings in a manner that matches the timing of the earningsimpact of the hedged transactions. The ineffective portion of all hedges, ifany, is recognized currently in earnings. At December 31, 2004, we hadfour forward exchange contracts outstanding with a total loss position of $123included in our accrued liabilities. We also had one interest rate swapagreement with a fair value of $26 relating to a $5,000 variable rate loanincluded in our other assets.

Thetable below presents the fair value of those derivative instruments at December 31:
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Forward exchange  contracts   |       | $        | (123       | )        | $          | (39 | ) |
| Interest rate swap  agreement |       | 26       |       | —   |       |
|                               |            |          |            |          |            |  |  |

 

The carrying amounts of our other financialinstruments, which include cash equivalents, short-term investments, accountsreceivable and accounts payable approximate their fair value due to theshort-term nature of such instruments. In addition, the carrying value oflong-term debt approximates fair value due to the variable interest rate itbears.

*Accounts receivable*.   Accountsreceivable include only trade accounts receivables. Credit is extended tocustomers typically on net 30-day terms. We do not require collateral.

As of December 31, 2004, Raytheon Corporation, anaerospace and defense systems supplier, accounted for 28.9% of our outstandingaccounts receivable. As of December 31, 2003, no individual customerrepresented more than 10% of our accounts receivable balance.

*Allowance for doubtful accounts*.   Weperiodically review the aging of our accounts receivable over ninety days toidentify potentially uncollectible accounts and establish reserves based onexperience and discussion with customers. Actual write-offs could differ fromour allowance for doubtful accounts. If circumstances change, (i.e., higherthan expected defaults or an unexpected material adverse change in a customersability to meet our financial obligations) our estimates of recoverability ofamounts due to us could be reduced by a material amount. Accounts receivableare written off only when all reasonable collection efforts are exhausted.

*Research, development and engineering.  *Significantcosts are incurred each year in connection with research and developmentprograms and administrative engineering costs (“R&D”). Such costs areincluded in operating expenses as incurred. In situations where the customerreimburses the cost of the R&D effort, the revenue generated is recognizedas sales and the expense is included in cost of sales. Research and developmentexpenses, exclusive of engineering costs, were $1,571 in 2004, $756 in 2003 and$1,003 in 2002.

F-8

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

**Note1—Summary of Significant Accounting Policies (Continued)**

*Inventory.  *We value ourinventory at the lower of the actual cost to purchase and/or manufacture theinventory or the current estimated market value of the inventory with costgenerally determined using the first in,first out method. A provision for excess or obsolete inventory isrecorded based upon an analysis that considers current inventory levels,historical usage patterns and future sales expectations.

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43, Chapter 4,” to clarify thatabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial (spoilage) should be recognized as current period charges, and thatfixed production overheads should be allocated to inventory based on normalcapacity of production facilities. This statement is effective for Axsys’fiscal year 2006 and is not expected to have a material impact on ourfinancial position or results of operations.

*Property, plant and equipment.  *Property,plant and equipment are stated at cost, less accumulated depreciation, whichincludes the depreciation of assets recognized under capital leases. Depreciationis provided primarily by the straight-line method using estimated lives forbuildings and improvements of 20 to 25 years and from 3 to 8 years formachinery and equipment. Repair and maintenance costs are expensed as incurred.

*Goodwill and other intangibles.  *Weadopted SFAS No. 142, “Goodwill and Other Intangible Assets”, during 2002.In accordance with SFAS No. 142, goodwill is not amortized. In accordancewith the adoption of SFAS No. 142, the negative goodwill of $535 as of December 31,2001 was reversed as a cumulative effect of a change in accounting principle inthe first quarter of 2002. We annually review goodwill to assess recoverabilityfrom future operations using undiscounted cash flows. We have completed ourannual impairment testing and the goodwill of $13.0 million was determined notto be impaired as of December 31, 2004. Impairments are recognized inoperating results when a permanent diminution in value occurs.

Goodwill was $13,013 at December 31, 2004 and$3,600 at December 31, 2003. Goodwill increased in 2004 as a result of thepurchase of Telic Optics, Inc. (“Telic”). There were no changes togoodwill in 2003.

Intangible assets acquired as part of businesscombinations are amortized over their estimated useful lives unless theiruseful lives are determined to be indefinite. For material businesscombinations, amounts recognized related to purchased intangibles aredetermined with the assistance of independent valuations.

*Commitments and contingencies*.   Weare self-insured for certain losses related to general liability, workers’compensation and medical claims. Our liability represents an estimate of theultimate cost of claims incurred as of the balance sheet date. The estimatedliability is established based on an analysis of historical data and isreviewed by management on a quarterly basis to ensure that the liability isappropriate. While we believe that our estimates are reasonable based on theinformation currently available, if actual trends, including the severity andfrequency of claims, medical cost inflation or fluctuations in premiums, differfrom our estimates, our results from operations could be impacted.

*Deferred income.  *Deferredincome is recognized when we receive milestone payments from customers foreither progress billings or for material billings. Material billings primarilyoccur when customers advance us the cost of beryllium on long-lead time orders.

F-9

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

**Note1—Summary of Significant Accounting Policies (Continued)**

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

Thefollowing table summarizes product warranty activity for 2004:
| **Balance at  December 31,  2003** | ** ** | **Provision, changes  and other** | ** ** | **Payments** | ** ** | **Balance at  December 31,  2004** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|----------------------------------------------|------------|
| $633                                         |       | $396                                        |       | $(279)       |       | $750                                         |       |

 

*Loss contract reserves.  *Generally,our customer contracts are completed within one year of receiving the order. However,occasionally longer lead-time orders are received and we monitor thesecontracts periodically to determine if our actual costs are comparable to ourcost estimates used at the time of order acceptance. If we determine that ouractual costs are significantly exceeding our original estimates, we will recorda loss contract reserve.

*Environmental contingencies.  *Weare currently involved in several environmental remediation projects. We accruefor environmental contingencies when (1) responsibility for cleanup isdetermined and (2) costs are probable and can be reasonably estimated. Whencosts are not probable and cannot be reasonably estimated, no accrual is made. Wehave accrued our estimate of the probable costs for the resolution of theseclaims. These estimates have been developed in consultation with outsideenvironmental consultants handling these matters and are based upon an analysisof 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.

*Income taxes.  *Weaccount for income taxes in accordance with SFAS 109. As such, deferred incometaxes are determined based on the differences between the financial statementand tax basis of assets and liabilities at enacted income tax rates in effectin the year in which the differences are expected to reverse. Valuationallowances are established, when necessary, to reduce deferred income taxassets to estimated amounts expected to be realized. Realizability of netdeferred income tax assets are evaluated on an ongoing basis. We considerfuture taxable income, our most recent operating results and various income taxplanning strategies in assessing the need for a valuation allowance. In theconsideration of the realizability of net deferred income tax assets, recentlosses must be given more weight than any projections of future profitability.

*Earnings per share.  *Basicearnings per share have been computed by dividing net income or loss by theweighted-average number of common shares outstanding. The dilutive effect ofstock options on the weighted-average number of common shares outstanding was269,253 shares for the year ended December 31, 2004 and 88,248 shares asof December 31, 2003. When there is a loss from continuing operations, thecomputation of the dilutive net loss per share is based on the weighted-averagebasic shares outstanding. Potentially dilutive common stock options aggregating16,766 as of December 31, 2002 have 

F-10

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

**Note1—Summary of Significant Accounting Policies (Continued)**

been excluded from thecomputation of diluted net loss per share because their inclusion would havebeen anti-dilutive.

Diluted EPS for 2004 excludes 173,475 potentialcommon shares related to our stock compensation plans because the optionexercise price was greater than the average market price of our common stockfor the period.

*Stock-based compensation.  *Wehave adopted the disclosure-only provisions of SFAS No. 123, “Accountingfor Stock-based Compensation” and account for stock-based compensation underthe provisions of Accounting Board Opinion No. 25, “Accounting for StockIssued to Employees” using the intrinsic value method. The exercise price onstock options is either greater than or equal to the closing market price onthe day of grant, and, accordingly, no compensation cost has been recognized. Wedo not grant stock options with exercise prices below market value. Pro formainformation regarding net income (loss) and net income (loss) per share isrequired by SFAS No. 123 for awards as if we had accounted for such awardsunder the fair value method.

Thefollowing table illustrates the effect on net income/(loss) and income/(loss)per share if we had applied the fair value recognition provisions of SFAS No. 123:
| ** **                                                    | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Reported net  income (loss)                                   |       | $         | 8,664      |      | $          | 4,998     |       | $ | (7,061 | ) |
| Stock  option-related employee compensation expense           |       | (773      | )          | (755      | )          | (959      | )          |
| Pro forma net  income (loss)                                  |       | $         | 7,891      |      | $          | 4,243     |       | $ | (8,020 | ) |
| Pro forma basic income (loss) per share                       |       | $         | 1.12       |      | $          | 0.61      |       | $ | (1.14 | ) |
| Weighted-average basic and diluted common shares  outstanding |       | 7,020,184 |       | 6,986,094 |       | 7,037,432 |       |
| Pro forma diluted income (loss) per share                     |       | $         | 1.08       |      | $          | 0.60      |       | $ | (1.14 | ) |
| Weighted-average  basic and diluted common shares outstanding |       | 7,289,437 |       | 7,074,342 |       | 7,037,432 |       |

 

The fair value of each option granted in 2004, 2003and 2002 was estimated on the date of grant using the Black-Scholesoption-pricing model with the following assumptions: expected volatility of 43%of 2004, 68% in 2003 and 68% in 2002; risk-free interest rate of 4.24% in 2004,4.27% in 2003 and 5.0% in 2002; expected lives of 6 years; and no dividend yield.Using this model, the weighted-average fair value of options granted was $7.05during 2004, $5.45 during 2003 and $4.53 during 2002. For pro forma purposes,the estimated fair value of the our Company’s stock incentive awards toemployees is amortized over the options’ vesting period, which is generallyfive years. The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options, which have no vesting restrictionsand are fully transferable. In addition, the Black-Scholes model requires theinput of highly subjective assumptions including the expected stock pricevolatility.

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123 (revised 2004) (“Statement 123 (R)”), “Share-based 

F-11

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

**Note1—Summary of Significant Accounting Policies (Continued)**

Payment”, which revisedSFAS No. 123, “Accounting for Stock-based Compensation”. This statement supercedesAPB Opinion No. 25, “Accounting for Stock Issued to Employees”. Therevised statement addresses the accounting for share-based payment transactionswith employees and other third parties, eliminates the ability to account forshare-based compensation transactions using APB 25 and requires that thecompensation costs relating to such transactions be recognized in theconsolidated statement of operations. The revised statement is effective as ofthe first interim period beginning after June 15, 2005. Axsys will adoptthe statement in the third quarter of 2005 as required. The impact of adoptionof Statement 123 (R) cannot be predicted at this time because it willdepend on levels of share-based payments granted in the future. However, hadAxsys adopted Statement 123 (R) in prior periods, the annual impact ofthat standard would have approximated the impact of Statement 123 as describedin the disclosure of pro forma net income (loss) and net income (loss) pershare in the stock-based compensation accounting policy note included in Note 1to the consolidated financial statements.

*Estimates and assumptions.  *Thepreparation 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. Actualresults could differ from those estimates.

Certain amounts inpreviously issued annual financial statements were reclassified to conform tothe 2004 presentation.

**Note2—Acquisitions**

On April 8, 2004 (the “Closing Date”), weacquired all of the stock of Telic, a privately owned manufacturer of infraredoptics and optical assemblies. Telic’s broad infrared optics capabilitiesincrease our product offerings and complement our strong position in reflectiveoptical solutions. In addition, Telic’s products are typically used inground-and sea-based programs. This complements our historical focus on air-and space-based programs and expands our overall market and program penetration.Finally, the complementary addition of Telic’s technical capabilities to ourcore technical strengths is expected to increase our competitive advantage bybroadening our technical offering to prime contractors who are seeking tooutsource the fulfillment of their optical requirements.

The initial purchase price of this acquisition, aftera working capital adjustment of $15, was $14,423 with an additional earn outpayment of up to $4,000 over the 36 months following the Closing Date based onthe achievement of certain revenue goals. If revenue goals are achieved, theearn out could increase the total purchase price to $18,423. Included inthe purchase price was $438 of legal, audit and other acquisition relatedexpenses that were incurred in connection with the acquisition. We funded thepurchase price and associated transaction costs through a combination ofexisting cash balances and outside bank financing.

F-12

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

**Note2—Acquisitions (Continued)**

The acquisition has beenaccounted for according to the purchase method of accounting, and, accordingly,the consolidated statements of operations include the results of Telic sincethe date of the acquisition. The assets acquired and the liabilities assumedwere recognized at their estimated fair values within our Optical SystemsGroup.
| **Fair value:**                         | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| Assets acquired                         |       | $          | 3,084      |   |
| Liabilities  assumed                    |       | (274       | )          |
| Customer  relationship intangible asset |       | 2,200      |       |
| Goodwill                                |       | 9,413      |       |
| Purchase price                          |       | 14,423     |       |
| Less: cash  acquired                    |       | (695       | )          |
| Net cash paid                           |       | $          | 13,728     |   |

 

Goodwill acquired through the purchase of Telic isdeductible for income tax purposes.

Unauditedpro forma results of operations for the years ended December 31, 2004 and2003, as if Axsys had purchased Telic as of the beginning of each year, are presented below. The proforma results include estimates and assumptions, which we believe arereasonable. However, the pro forma results do not include any cost savings orother effects of the planned integration of Telic, and are not necessarilyindicative of the results which would have occurred if the business combinationhad been in effect on the dates indicated, or which may result in the future.
| ** **                  | ** ** | **As Originally  Reported  2004** | ** ** | **Pro Forma  2004** | ** ** | **As Originally  Reported  2003** | ** ** | **Pro Forma  2003** | ** ** |
|-----------------------------|------------|----------------------------------------|------------|--------------------------|------------|----------------------------------------|------------|--------------------------|------------|
| Net sales                   |       |                                   | $          | 103,530                  |       |                                   | $          | 105,289                  |       |   | $ | 85,109 |   |   |   | $ | 94,998 |   |   |
| Net income                  |       |                                   | 8,664      |                     |       | 9,183                                  |       |                     | 4,998      |   |   |   | 7,999 |   |   |
| Earnings per common  share: |       |                                   |       |                     |       |                                   |       |                     |       |   |   |   |   |   |   |
| Basic                       |       |                                   | $          | 1.23                     |       |                                   | $          | 1.31                     |       |   | $ | 0.72 |   |   |   | $ | 1.14 |   |   |
| Diluted                     |       |                                   | $          | 1.19                     |       |                                   | $          | 1.26                     |       |   | $ | 0.71 |   |   |   | $ | 1.13 |   |   |

 

**Note 3—Balance Sheet Information**

Thedetails of certain balance sheet accounts are as follows:
| ** **        | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------|------------|------------|------------|------------|------------|
| Inventories       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Raw materials     |       | $          | 6,431      |       | $          | 5,050 |   |
| Work-in-process   |       | 18,371     |       | 14,662     |       |
| Finished goods    |       | 9,888      |       | 8,991      |       |
| Gross inventories |       | 34,690     |       | 28,703     |       |
| Less reserve      |       | (4,992     | )          | (3,917     | )          |
| Inventories, net  |       | $          | 29,698     |       | $          | 24,786 |   |

 

F-13

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

**Note3—Balance Sheet Information (Continued)**
| ** **                                     | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|
| Property, plant  and equipment:                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Land                                           |       | $          | 291        |       | $          | 291 |   |
| Buildings and improvements                     |       | 5,653      |       | 4,374      |       |
| Machinery and equipment                        |       | 25,437     |       | 22,373     |       |
| Property, plant  and equipment                 |       | 31,381     |       | 27,038     |       |
| Less accumulated depreciation and amortization |       | (18,044    | )          | (15,723    | )          |
| Property, plant and  equipment, net            |       | $          | 13,337     |       | $          | 11,315 |   |

                                                
| ** **                                            | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|
| Accrued expenses  and other current liabilities:      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensation and related benefits                     |       | $          | 4,548      |       | $          | 3,083 |   |
| Income taxes                                          |       | 970        |       | 1,053      |       |
| Liabilities of discontinued operations                |       | 922        |       | 1,301      |       |
| Warranty                                              |       | 750        |       | 633        |       |
| Professional fees                                     |       | 392        |       | 574        |       |
| Stock redemption                                      |       | 291        |       | 426        |       |
| Other                                                 |       | 1,640      |       | 1,100      |       |
| Total accrued expenses  and other current liabilities |       | $          | 9,513      |       | $          | 8,170 |   |

 
| ** **                                   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| Other long-term  liabilities:                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deferred income taxes                        |       | $          | 1,656      |       | $          | 1,504 |   |
| Loss contract reserve                        |       | 1,595      |       | 1,781      |       |
| Defined benefit pension and health insurance |       | 649        |       | 812        |       |
| Liabilities of discontinued operations       |       | 405        |       | 366        |       |
| Workers’ compensation                   |       | 199        |       | 535        |       |
| Other                                        |       | 200        |       | 2          |       |
| Total other long-term liabilities            |       | $          | 4,704      |       | $          | 5,000 |   |

 

**Note 4—Intangible Assets**

As part of the acquisitionof Telic, we recognized an intangible asset of $2,200 representing the value ofcustomer relationships. Amortization of this intangible asset is determinedusing the straight-line method of amortization over 22 years. Amortizationexpense of $74 in 2004 was included in selling, general and administrativeexpenses. There was no amortization expense in 2003 or 2002. Amortizationexpense for each of the next five years is expected to be $100.

**N**ote 5—Capital Lease Obligations
| ** **                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|
| Capital lease  obligations |       | $        | 518        |     | $          | 991 |   |
| Less current  portion      |       | (368     | )          | (423     | )          |
|                       |       | $        | 150        |     | $          | 568 |   |

 

F-14

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

**Note5—Capital Lease Obligations (Continued)**

At December 31, 2004 the cost of assets undercapital leases was $1,521 with accumulated depreciation of $544 and at December 31,2003 was $1,703 with accumulated depreciation of $401.

Minimum annual leasepayments, including interest, on capital leases are $387 in 2005, and $153 in2006. All capital lease obligations mature by the end of 2006.

**Note6—Long-term Debt**

On April 8, 2004, in connection with theacquisition of Telic, we entered into an unsecured Credit Facility (“CreditFacility”) with Bank of America (“Bank”). The Credit Facility is comprised of a$5,000 two-year Revolving Credit Facility (“Revolving Credit Facility”) and a$5,000 five-year Term Loan facility (“Term Loan”). Repayments of amounts underthe Credit Facility are guaranteed by all of our subsidiaries.

The Credit Facility requires that we maintain certainminimum financial covenants, restricts our ability to incur securedindebtedness, and contains various customary provisions, including affirmativecovenants, representations and warranties and events of default. As of December 31,2004, we were in compliance with the covenants and other terms thereof.

*Revolving Credit Facility:  *The$5,000 Revolving Credit Facility is available through April 8, 2006,subject to optional prepayment in accordance with its terms. Up to $1,000 ofthe Revolving Credit Facility may be utilized to issue letters of credit. Wemay elect to have any borrowing under the Revolving Credit Facility bearinterest either at the Bank’s prime rate or the 1-month LIBOR rate plus amargin of 100 to 150 basis points, depending on our consolidated fundeddebt-to-consolidated EBITDA ratio, as defined. At December 31, 2004, therewere no borrowings outstanding under the $5,000 Revolving Credit Facility. However,as of December 31, 2004, $680 of the Revolving Credit Facility wasutilized for outstanding letters of credit.

Subject to the terms of the Revolving Credit Facility,we can borrow up to a maximum of $5,000. We are required to pay certain fees,including an unused commitment fee ranging from 20 to 40 basis points per annumon the average daily-unused portion of the Revolving Credit Facility. Theunused commitment fee, which will vary depending on our consolidated fundeddebt-to-consolidated EBITDA ratio, as defined, is payable quarterly, inarrears.

*Term Loan:  *TheTerm Loan is scheduled to mature on April 8, 2009, subject to optionalprepayment in accordance with its terms, with annual principal paymentstotaling $1,000. The Term Loan bears interest at a rate per annum equal to the1-month LIBOR rate plus a margin of 100 to 150 basis points, depending on ourconsolidated funded debt-to-consolidated EBITDA ratio, as defined. The interestrate on the term loan was 3.06% as of December 31, 2004. We paid a $40commitment fee for the Term Loan. As of December 31, 2004, the balance ofthe Term Loan was $4,333.

F-15

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

**Note6—Long-term Debt** (Continued)

*InterestRate Swap:  *On April 8, 2004, we enteredinto an interest rate swap agreement with the Bank to hedge interest ratefluctuations on the Term Loan. The interest rate swap has been designated as acash flow hedge. Under the terms of the interest rate swap, we receive paymentsbased on the 1-month LIBOR rate and make payments based upon a fixed rate of3.2%. The notional amount of the interest rate swap at inception was $5,000 andit expires on April 8, 2009. The notional amount decreases as principalpayments are made on the term loan.

**Note 7—Restructuring and Special Charges**

*Fiscal Year 2004:  *During2004, we reversed a warranty reserve of $50 related to the product lines at theformer Santa Barbara, California facility, which were either sold ordiscontinued, as no longer required.

*Fiscal Year 2002:*

*Relocation of OEM Product Lines**:  *During 2002, we closed our Santa Barbara, Californiafacility and relocated various commercial product lines to Rochester Hills,Michigan. The total cost of $1,053 associated with the relocation and facilityclosure included a charge of $436 for thirty terminated employees and a chargeof $123 for the disposal of excess furniture and fixtures. A charge of $136 wasincurred as a result of the write-off of certain inventory related to thetermination of certain minor product lines. Other costs of $358 associated withthe relocation included costs for the equipment relocation, employee trainingand recruitment and facility upgrades in Michigan, which were expensed asincurred.

*Sale of Teletrac, Inc.**:  *On April 5, 2002, we sold all of the stock ofthe Teletrac, Inc. (“Teletrac”) subsidiary to Storage Test Solutions (“STS”)of Aurora, Colorado. In connection with the sale of Teletrac, we recognized acharge of $1,009 associated with asset write-downs, severance payments andlegal expenses. This charge is recognized in restructuring and other specialcharges.

*Reorganization:  *InMarch 2002, we announced the strategic realignment of our business. Thisplan resulted in a restructuring charge of $178, net of tax of $108 for thetermination of three salaried employees in the former Automation Group, whichhas been included in the loss from discontinued operations. In addition, aspart of the segment reorganization, we incurred a charge of $286 for thetermination of the Chief Operating Officer, which is included in restructuringand other special charges.

F-16

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

**Note7—Restructuring and Special Charges (Continued)**

During 2002, we recognizedthe following amounts as restructuring and special charges in the ConsolidatedStatement of Operations related to the 2002 restructuring and special charge:
| ** **                   | ** ** | **Cost of Sales** | ** ** | **Selling, General and  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 |   |

 

ThroughDecember 31, 2003, we had expended all cash costs in connection with the2002 restructuring and special charges. The following table shows the balancesheet activity for the restructuring accrual through December 31, 2004 inconjunction with the 2002 restructuring activities:
| ** **                         | ** ** | **Restructuring  Accrual** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| 2002 Charges                       |       |                       | $          | 1,854 |   |   |
| 2002 Activity                      |       |                       | (1,734     | ) |   |
| 2003 Activity                      |       |                       | (70        | ) |   |
| 2004 Activity                      |       |                       | (50        | ) |   |
| Balance at  December 31, 2004 |       |                       | $          | — |   |   |

 

**Note 8—Environmental Contingencies**

We are currently involved in several environmentalremediation projects. We accrue for environmental contingencies on anundiscounted basis when responsibility for clean up is determined and costs,including legal fees, are probable and can be reasonably estimated.

Pursuant to a remediation plan approved by the OhioEnvironmental Protection Agency (“Ohio EPA”) in 1993, we investigated soils andgroundwater at a formerly owned site, and have conducted certain remediationwork at this site including soil removal. We have incurred costs of $118 in2004 and approximately $916 to date. We anticipate remediation costs for thissite to continue through 2009, including estimated expenditures of $64 in 2005.

During 1999, we sold the land and building of apreviously discontinued division in St. Petersburg, Florida. We conductedinvestigations of soil and groundwater at the former facility and receivedapproval of the remediation action plan from the Florida Department ofEnvironmental Protection. The remediation system was installed in 2003, andclean up of the site is still in progress. In 2004, we spent $43 on the cleanup of this facility and have incurred approximately $685 to date. We anticipateremediation costs for this site to continue through 2007, including estimatedexpenditures of $56 in 2005.

In December 2001, we received a letter from theUnited States Environmental Protection Agency (“EPA”) notifying us that we areconsidered a potentially responsible party for a site located in Prospect,Connecticut, where our former subsidiary operated a screw machine shop from1961 to 1978, and demanding that we reimburse the EPA for its costs incurred inconnection with a time-critical removal 

F-17

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

**Note8—Environmental Contingencies (Continued)**

action taken by the EPA atthe site in 2001. The former subsidiary was merged with Axsys in 1979. In April 2004,the EPA notified us that the total amount of such costs is approximately $650,including indirect costs and interest. At a meeting with the EPA in April 2004,we advised the EPA of our position that we are not responsible for these costsor the contamination at the site. We have had subsequent communications withthe EPA concerning our respective positions, and the EPA advised us that theywere not prepared to proceed with settlement discussions until they hadconducted a further investigation of the activities of our former subsidiary atthe site. In July 2004, the EPA served us with a 104(e) letter requestingdetailed information concerning the activities of our former subsidiary at thesite. We responded to the 104(e) letter on January 17, 2005. The EPAhas designated no other potentially responsible parties. During 2004, werecognized a charge of $32, net of tax of $18 in discontinued operations, foradditional legal expenses related to this site. During 2004, we paid **$**121 in legal fees and we have incurredapproximately $328 to date in legal fees.

During 2004, we recognized a charge of $42, net of taxof $23 related to our share of the settlement of an environmental claimconcerning a previously discontinued operation.

As of December 2004,we have an accrual of $711 for future costs related to these sites. Theseestimates have been developed in consultation with outside environmental andlegal consultants handling these matters and are based upon an analysis of theanticipated remediation plans. We do not anticipate these matters will have amaterial adverse effect on our consolidated financial position. It is possible,however, that future results of operations could be materially affected bychanges in our assumptions.

**Note9—Litigation**

During 2004, we were named as a co-defendant in thecase Parker, et al v. Brush Wellman, Inc. et al., a punitive class actionlawsuit brought by a group of named plaintiffs who are employees, formeremployees, or family members of employees and former employees, of LockheedMartin Corporation (“Lockheed”). The plaintiffs claim that they have sufferedpersonal injuries or are at an increased risk of developing personal injuriesas a result of exposure to beryllium-containing materials used at Lockheed’sfacility. The plaintiffs purport to represent a class of persons whomthey claim are similarly situated. The defendants include Lockheed and variousother companies, including Axsys, who are alleged to have suppliedberyllium-containing materials used at the facility. The case is currentlypending in the United States District Court for the Northern District ofGeorgia. We have filed a motion to dismiss based on a lack of personaljurisdiction.

Because the case is in its preliminary stages and nomeaningful, substantive discovery has been performed, it is premature for us,along with our attorneys, to attempt to evaluate likely outcomes of the case. During2004, we spent $56 in legal costs and as of December 31, 2004 we had $24accrued for future legal expenses.

During 2004, we settled anaction, which was filed in the Court of Chancery in the State of Delaware on May 30,1997, against Axsys and three of the directors on behalf of a purported classof persons who purchased our preferred stock. The plaintiff challenged ourdecision to redeem all of our outstanding shares of the preferred stock. Theplaintiff claimed that the defendants (1) breached fiduciary duties insetting the redemption price too low and unfairly seeking to advantage holdersof common stock and 

F-18

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

**Note9—Litigation (Continued)**

(2) breachedcontractual duties as set forth in the Certificate of Designation governing thepreferred stock, as well as an implied covenant of good faith and fair dealing.We paid $201 to settle this claim and reflected the charge as a reduction topaid-in-capital in 2003.

**Note 10—Shareholders’ Equity**

*Stock Repurchase:  *During2004, our Board of Directors authorized the repurchase, from time to time, onthe open market or otherwise, of up to 200,000 shares of the Axsys common stockat prevailing market prices or at negotiated prices. We plan to use therepurchased shares for general corporate purposes, including the satisfactionof commitments under our employee benefit plans and the exercise of stockoption grants. As of December 31, 2004, we repurchased 12 shares underthis authorization.

*Stock Split:  *TheBoard of Directors declared on June 1, 2004, a 3:2 stock split to beeffected as a stock dividend payable on June 30, 2004 to stockholders ofrecord on June 15, 2004. Stockholders received a dividend of oneadditional share of Axsys $0.01 par value common stock for every two sharesowned on the record date. Fractional shares were not issued; rather cashpayments were made to shareholders in lieu of fractional shares on June 30,2004. The cash paid for fractional shares was de minimus.

In conjunction with the stock split, we issued anadditional 2,395,578 shares resulting in a total of 7,186,734 issued shares ofAxsys $0.01 par value stock on June 30, 2004. We reclassified an amountequal to the par value of the number of shares issued to common stock fromretained earnings. All share information, including the basic and dilutedweighted-average number of shares and net income per share information, for allreporting periods have been restated retroactively to reflect the effects ofthe stock split.

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

*Treasury Stock:  *Weuse treasury stock shares for general corporate purposes, including thesatisfaction of commitments under the employee benefit plans and the exerciseof stock options. During 2004, we received 11,902 shares of Axsys $0.01 parvalue common stock as payment in lieu of cash for the exercise of incentivestock options.

During 2002, we sold our wholly owned subsidiaryAutomation Engineering, Inc. (“AEI”) to an investor group who individuallyowned shares of Axsys common stock. As a group, the investors owned 9.2% ofAxsys common stock prior to the sale of AEI, with individual ownership rangingfrom 1.8% to 4.6%. The sales price included both cash and a return of 77,784shares of Axsys stock. The common stock was valued at $4.58 per share, whichrepresented the average of the mean of the bid and ask price of the commonstock at the close of trading on the Nasdaq Stock Market for the trading daysimmediately preceding the closing date.

F-19

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

**Note10—Shareholders’ Equity (Continued)**

Changes in treasury stockwere as follows:
| **Number of shares**         | ** ** | ** ** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Balance at  December 31, 2001     |       | 145,314    |       | $          | 1,041      |       |
| Shares received  from sale of business |       | 77,784     |       | 356        |       |
| Contribution to  the 401(k) plan  |       | (14,616    | )          | (104       | )          |
| Balance at  December 31, 2002     |       | 208,482    |       | 1,293      |       |
| Exercise of stock options              |       | (900       | )          | (5         | )          |
| Contribution to  the 401(k) plan  |       | (8,552     | )          | (53        | )          |
| Balance at  December 31, 2003     |       | 199,030    |       | 1,235      |       |
| Exercise of stock options, net         |       | (64,108    | )          | (322       | )          |
| Contribution to  the 401(k) plan  |       | (4,718     | )          | (30        | )          |
| Repurchase of  stock                   |       | 12         |       | —     |       |
| Balance at December 31,  2004     |       | 130,216    |       | $          | 883        |       |

 

*Common Stock:*

Shares of common stockauthorized and issued were 7,186,734 shares at the end of 2004, 2003 and 2002.

**Note 11—Supplemental Cash Flow Information**

Supplementalcash flow information from continuing operations for the years ended December 31, 2004,2003 and 2002 is summarized as follows:
| ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash received/(paid)  during the year for: |       |     |       |     |       |     |       |
| Interest paid                              |       | $        | (177       | )        | $          | (108     | )          | $ | (149 | ) |
| Interest received                          |       | 99       |       | 118      |       | 181      |       |
| Income tax payments                        |       | (1,558   | )          | (429     | )          | (383     | )          |
| Income tax refunds                         |       | 566      |       | 1,522    |       | 3,478    |       |
| Non-cash investing  activities:            |       |     |       |     |       |     |       |
| Equipment acquired under capital leases    |       | —   |       | —   |       | 905      |       |
| Stock proceeds  from sale of AEI           |       | —   |       | —   |       | 356      |       |
|                                            |            |          |            |          |            |          |            |  |  |  |

 

F-20

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

**Note12—Income Taxes**

Theincome tax (benefit) provision from continuing operations consists of:
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current income  taxes:                 |       |     |       |     |       |     |       |
| U.S. Federal                           |       | $        | 1,097      |     | $          | —   |       | $ | (1,595 | ) |
| State and local                        |       | 376      |       | 236      |       | 300      |       |
|                                   |       | 1,473    |       | 236      |       | (1,295   | )          |
| Deferred income taxes:                 |       |     |       |     |       |     |       |
| U.S. Federal                           |       | (1,216   | )          | (195     | )          | 3,910    |       |
| State and local                        |       | (265     | )          | 195      |       | 354      |       |
|                                   |       | (1,481   | )          | —   |       | 4,264    |       |
| Total income tax  (benefit) provision: |       | $        | (8         | )        | $          | 236      |       | $ | 2,969 |   |

 

The current and deferred federal and state incometaxes reflect the creation of a valuation allowance in 2002 and the utilizationof the valuation allowance in 2003 and 2004.

The difference between theprovision for income taxes and the amount computed by applying the statutoryfederal income tax rate to Income (Loss) from Continuing Operations BeforeIncome Taxes and Cumulative Effect of Change in Accounting Principle isas follows:
| ** **                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal statutory  rate                              |       | 35       | %          | 35       | %          | 35       | %          |
| Computed expected  income tax provision (benefit)    |       | $        | 3,203      |     | $          | 1,832    |       | $ | (16 | ) |
| Increase (decrease) in  income taxes resulting from: |       |     |       |     |       |     |       |
| Net change in valuation allowance                    |       | (3,236   | )          | (1,395   | )          | 4,631    |       |
| State and local taxes, net of federal tax benefit    |       | 355      |       | 348      |       | 91       |       |
| Tax benefit of credits and net operating losses      |       | —   |       | (434     | )          | —   |       |
| Net alternative minimum tax activity                 |       | —   |       | 245      |       | —   |       |
| Tax basis adjustment—sale of subsidiary         |       | —   |       | —   |       | (1,434   | )          |
| Adjustment to tax accrual                            |       | (345     | )          | (318     | )          | (300     | )          |
| Other                                                |       | 15       |       | (42      | )          | (3       | )          |
| Actual tax (benefit) provision:                      |       | $        | (8         | )        | $          | 236      |       | $ | 2,969 |   |

 

At December 31, 2004, we had credit carryforwardsof approximately $403, which expire at various times between 2018 and 2022. Inaccordance with the SFAS No. 109, we recognized a valuation allowanceduring 2002 in the amount of $4,631 to offset a portion of the recognizeddeferred income tax asset. During 2003 and 2004, the valuation allowance wasreduced by $1,395 and $3,236, respectively as deferred income tax assets wererealized and since, as of December 31,2004, it ismore likely than not that the net deferred income tax assets will be realizedin the future.

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

F-21

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

**Note12—Income Taxes (Continued)**

Significant components ofdeferred income taxes are as follows:
| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Deferred income tax  assets:                   |       |                  |       |   |   |
| Inventories                                    |       | $                     | 2,361      |   | $ | 2,193 |   |
| Tax credit carry-forward                       |       | 403                   |       | 1,144 |   |
| Net operating loss carry-forward               |       | —                |       | 310 |   |
| Loss contract reserve                          |       | 720                   |       | 809 |   |
| Exit costs of discounted operations            |       | 318                   |       | 316 |   |
| Sensor Systems accruals                        |       | 134                   |       | 170 |   |
| Note receivable—STS                       |       | —                |       | 332 |   |
| Allowance for doubtful accounts                |       | 254                   |       | 255 |   |
| Pension accruals                               |       | 296                   |       | 383 |   |
| Warranty reserves                              |       | 193                   |       | 161 |   |
| Other, net                                     |       | 124                   |       | 67 |   |
| Total deferred income tax asset                |       | 4,803                 |       | 6,140 |   |
| Valuation allowance                            |       | —                |       | (3,236 | ) |
| Net deferred income tax assets                 |       | $                     | 4,803      |   | $ | 2,904 |   |
| Long-term  deferred income tax liabilities:    |       |                  |       |   |   |
| Property, plant and equipment                  |       | $                     | (1,464     | ) | $ | (1,504 | ) |
| Intangibles                                    |       | (192                  | )          | — |   |
| Net long-term  deferred income tax liabilities |       | $                     | (1,656     | ) | $ | (1,504 | ) |

 

**Note 13—Pension Arrangements**

As of December 31, 2004, we had one pension planfor which benefits and participation have been frozen. Pension benefits underthis plan are generally based upon years of service and compensation. The planis an unfunded plan with an annual payout of approximately $105 until such timeas the sole participant becomes ineligible.

During2004, we terminated and liquidated a fully-funded pension plan. The netdistribution from this plan was in excess of $900. The following tablesummarizes the components of net periodic pension cost for the defined benefitplans:
| ** **                                     | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                     | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Interest cost on  projected benefit obligation |       | $                                           | 51         |   | $ | 92 |   | $ | 86 |   |
| Expected return  on plan assets                |       | (27                                         | )          | (44 | ) | (54 | ) |
| Recognized net  actuarial loss                 |       | 60                                          |       | 53 |   | 43 |   |
| Effect of special  events                      |       | —                                      |       | — |   | (48 | ) |
| Total pension  expense                         |       | $                                           | 84         |   | $ | 101 |   | $ | 27 |   |

 

F-22

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

**Note13—Pension Arrangements (Continued)**

Assumptions used inaccounting for the defined benefit plans as of the plans’ measurement dateswere:
| ** **                                                              | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                              | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Weighted-average  assumptions used to determine benefit obligations at: |       |                  |       |   |   |
| Weighted-average  discount rate                                         |       | 5.75                  | %          | 5.75 | % |

 
| ** **                                                                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                   | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Weighted-average  assumptions used to determine net periodic benefit costs for years ending: |       |                  |       |   |   |
| Discount rate                                                                                |       | 5.75                  | %          | 5.75 | % |
| Expected long-term  return on plan assets                                                    |       | 6.00                  | %          | 6.00 | % |

 

Thefollowing table sets forth the change in benefit obligation, change in planassets and the funded status recognized in the Consolidated Balance Sheets forour defined benefit pension plans:
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Change in benefit  obligation:                 |       |     |       |     |       |
| Benefit obligation at beginning of year        |       | $        | 1,385      |     | $          | 1,186 |   |
| Interest cost                                  |       | 51       |       | 92       |       |
| Actuarial loss                                 |       | 26       |       | 211      |       |
| Benefits/settlements paid                      |       | (1,012   | )          | (104     | )          |
| Benefit obligation at end of year              |       | 450      |       | 1,385    |       |
| Change in plan  assets:                        |       |     |       |     |       |
| Fair value of plan assets at beginning of year |       | 906      |       | 837      |       |
| Actual return                                  |       | 12       |       | 28       |       |
| Employer contribution                          |       | 104      |       | 145      |       |
| Benefits/settlements paid                      |       | (1,012   | )          | (104     | )          |
| Fair value of plan assets at end of year       |       | 10       |       | 906      |       |
| Funded status                                  |       | 440      |       | 479      |       |
| Unrecognized net  actuarial loss               |       | —   |       | (27      | )          |
| Accrued benefit cost at  December 31      |       | $        | 440        |     | $          | 452 |   |

 

Unrecognized net gains and losses are amortized overthe average future service lives of participants. Asset management objectives includemaintaining an adequate level of diversification and providing adequate liquidity to meetimmediate and future benefit payment requirements. Plan assets for the fullyfunded plan were invested in a managed portfolio consisting primarily of equitysecurities, real estate and bonds.

F-23

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

**Note13—Pension Arrangements (Continued)**

The asset allocation ofpension benefit plans at December 31 was:
| **Asset Category** | ** ** | ** ** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|----------|------------|
| Money market account    |       | $          | —     |     | $          | 194      |       |
| Debt securities         |       | —     |       | 178      |       |
| Real estate             |       | —     |       | 176      |       |
| Government  securities  |       | —     |       | 170      |       |
| Other                   |       | 10         |       | 188      |       |
| Total                   |       | $          | 10         |     | $          | 906      |       |

 

We also sponsor a 401(k) planunder which eligible employees may elect to contribute a percentage of their earnings.We match employee contributions to this plan in amounts ranging from 3% to 5%of the employees’ gross earnings. Our matching contributions, were $918 in2004, $719 in 2003, and $720 in 2002 of which a portion was provided in Axsysstock.

**Note 14—Stock Options**

In 1991, our shareholders approved our Long-term StockIncentive Plan (the “Plan”). Shareholders approved amendments to andrestatement of the Plan in May 2000 and May 2001, which, among other things,increased the number of shares of common stock authorized for issuance underthe Plan by 300,000 each year. As of December 31, 2004, the total number ofshares of common stock authorized for issuance under the Plan was 1,200,000shares, of which 212,760 shares of common stock remain available for grantunder the Plan. The Compensation Committee of the Board of Directors (the“Committee”) administers the Plan. The Committee selects participants fromamong those executives and other employees of Axsys and the subsidiaries whomaterially contribute to the success of our Company and determines the amounts,times, forms, terms and conditions of grants. Grants may be in the form ofoptions to purchase shares of common stock, stock appreciation rights,restricted stock and performance units (collectively, “Stock Incentives”).Generally, each grant vests 20 percent per year for five years, is exercisableupon vesting and expires in ten years.

F-24

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

**Note 14—Stock Options**(Continued)

During2004, we modified the stock option grants of a former officer, which resultedin compensation expense of $242. A summary of all outstanding stock options ispresented in the table below:
| ** **                             | ** ** | **Stock  Options** | ** ** | **Weighted-average  Exercise Price** | ** ** |
|----------------------------------------|------------|--------------------|------------|-------------------------------------------|------------|
| Outstanding at  December 31, 2002 |       | 775,103            |       |                                      | $          | 9.93 |   |   |
| Granted                                |       | 194,497            |       |                                      | 5.67       |   |   |
| Forfeited/cancelled                    |       | (277,013           | )          |                                      | (10.34     | ) |   |
| Exercised                              |       | (900               | )          |                                      | (4.46      | ) |   |
| Outstanding at  December 31, 2003 |       | 691,687            |       |                                      | $          | 8.54 |   |   |
| Granted                                |       | 210,278            |       |                                      | 11.36      |   |   |
| Forfeited/cancelled                    |       | (14,850            | )          |                                      | (10.47     | ) |   |
| Exercised                              |       | (76,009            | )          |                                      | (7.17      | ) |   |
| Outstanding at December 31, 2004  |       | 811,106            |       |                                      | $          | 9.36 |   |   |
| Exercisable at  December 31, 2004 |       | 302,619            |       |                                      | $          | 11.29 |   |   |

 

The following tablesummarizes information about stock options outstanding at December 31,2004:
| ** **                                       | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |                                        |
|--------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|---------------------------------------------|
| **Range ofExercise Prices**            | ** ** | ** **                   | ** ** | **Number of  Options**  | ** ** | **Weighted-  average  Remaining Life** | ** ** | **Weighted-average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted-average  Exercise  Price** | ** ** |
| $  2.72 to $  5.43 |       | 220,200                      |       |                         | 7.5        |                                        |   |   | $ | 4.66 |   |   | 51,300 |   |   | $ | 4.62 |   |   |   |
| $  5.44 to $  8.15 |       | 197,035                      |       |                         | 6.6        |                                        |   |   | 6.89 |   |   | 82,500 |   |   | 7.18 |   |   |   |
| $  8.15 to $10.87            |       | 144,750                      |       |                         | 7.5        |                                        |   |   | 9.94 |   |   | 33,000 |   |   | 9.86 |   |   |   |
| $10.87 to $13.58                       |       | 90,646                       |       |                         | 4.4        |                                        |   |   | 11.94 |   |   | 37,944 |   |   | 12.43 |   |   |   |
| $13.58 to $16.30                       |       | 56,250                       |       |                         | 9.5        |                                        |   |   | 14.29 |   |   | 600 |   |   | 14.75 |   |   |   |
| $16.30 to $19.02                       |       | 90,975                       |       |                         | 2.0        |                                        |   |   | 17.72 |   |   | 88,275 |   |   | 17.74 |   |   |   |
| $19.02 to $24.45                       |       | 11,250                       |       |                         | 5.8        |                                        |   |   | 24.00 |   |   | 9,000 |   |   | 24.00 |   |   |   |
| $  2.72 to $24.45            |       | 811,106                      |       |                         | 6.4        |                                        |   |   | $ | 9.36 |   |   | 302,619 |   |   | $ | 11.29 |   |   |   |
|                                                  |            |                              |            |                              |            |                                             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Note 15—Commitments and Contingencies**

Futureminimum payments under non-cancelable operating leases (exclusive of propertyexpenses and net of sublease rental income), as of December 31, 2004, areas follows:
| 2005                 |   | $      | 1,548  |   |
|----------------------|--------|--------|--------|--------|
| 2006                 |   | 1,282  |   |
| 2007                 |   | 1,186  |   |
| 2008                 |   | 1,102  |   |
| 2009 and  thereafter |   | 1,230  |   |
|                 |   | $6,348 |   |

 

F-25

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

**Note15—Commitments and Contingencies (Continued)**

Rent expense under such leases, net of sublease rentalincome, amounted to $1,598 in 2004, $1,400 in 2003 and$1,517 in 2002. We anticipate receiving an aggregate of $6in future sublease rental income. As of December 31, 2004, we werecontingently liable for $680 under outstanding letters of credit. We haveissued letters of credit for certain business transactions including insuranceprograms and building lease security deposits.

In the normal course ofbusiness, we are liable for contract completion and product performance. In theopinion of management, such obligations will not significantly affect our financialposition or annual results of operations.

**Note 16—Discontinued Operations**

During 2004, we recognized a charge of $74, net of taxof $41, related to legal and consulting expenses related to environmental cleanup sites. (See Note 11 of the Consolidated Financial Statements.) In 2004, wealso recognized an additional loss reserve in relation to the 2002 sale of theAutomation Group. The charge of $421, net of tax $226, represents rentalexpenses for two facilities.

During 2002, we sold the Automation Group, whichconsisted of two manufacturing facilities, one in Pittsburgh, Pennsylvania andthe other in Wilmington, Massachusetts. In conjunction with the sale of theAutomation Group, we recognized, in 2002, a loss from discontinued operationsof $1,709, net of taxes of $1,029. This loss included a charge of $729 for theimpairment of assets and $980 of closing related expenses. The operating lossfrom discontinued operations for 2002 was $2,692, net of taxes of $1,638. Revenuesfrom the Automation Group were $1,177 in 2002.

Theloss from discontinued operations, net of tax, recognized in the ConsolidatedStatements of Operations includes the following:
| ** **                                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Automation  Group—operating loss                                   |       | $        | (421       | )        | $          | —   |       | $ | (2,692 | ) |
| Automation  Group—loss on sale                                     |       | —   |       | —   |       | (1,709   | )          |
| Environmental  charges for previously divested businesses               |       | (74      | )          | —   |       | (203     | )          |
| Reversal of  unutilized reserves from a previously disposed of business |       | —   |       | —   |       | 22       |       |
| Loss from discontinued  operations                                      |       | $        | (495       | )        | $          | —   |       | $ | (4,582 | ) |

 

**Note17—Segment Data**

Our Company’s continuedgrowth led us to modify our segments in 2004. All of our engineering andmanufacturing facilities are selling products and solutions into both theaerospace and defense and the commercial markets. In addition, we are developingmore sophisticated solutions that draw from the diverse technical capabilitiesof all of our facilities. As a result of these operational changes, we combinedour former Aerospace and Defense Group and our former Commercial Products Groupinto a single reporting segment, Optical Systems Group. This new segmentstructure incorporates all the facilities, engineers and staff contributing toour optics strategy and more accurately reflects the way we manage ourbusiness.

F-26

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

**Note17—Segment Data (Continued)**

The Optical Systems Group designs, manufactures andsells highly precise assemblies and components which are typically embedded inoptical platforms for both government and commercial applications. Products canbe grouped into four primary areas; precision metal optical products, infraredoptical products, motion control products, and precision machined lightweightstructures. However, customer requirements sometimes demand an optical solutionthat combines products from two or three of these areas into a sophisticatedoptical system. The Optical Systems Group has design and manufacturingfacilities and each facility is identified as a reporting unit as follows:Motion Control Products in San Diego, California, Precision Machined Productsin Cullman, Alabama, Imaging Systems in Rochester Hills, Michigan and IRSystems in North Billerica, Massachusetts.

The Distributed Products Group distributes precisionball bearings, spherical plain bearings and bushings, acquired from variousdomestic and international sources, to original equipment manufacturers andmaintenance repair organizations. The bearings and bushings are used in avariety of industrial automation and commercial markets. Additionally, theDistributed Products Group designs, manufacturers and sells mechanical-bearingsubassemblies for a variety of customers. The Distributed Products group iscomprised of the reporting unit AST Bearings Division located in Montville, NewJersey, with a satellite distribution center in Irvine, California.

Segment information for all prior periods has beenrestated to reflect the new operating segments.

The following tablespresent financial data for each segment:
| ** **                                                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales from  continuing operations:                                                                           |       |     |       |     |       |     |       |
| Optical Systems Group                                                                                            |       | $        | 78,189     |     | $          | 63,246   |       | $ | 59,438 |   |
| Distributed Products Group                                                                                       |       | 25,341   |       | 21,863   |       | 20,148   |       |
| Total sales                                                                                                      |       | $        | 103,530    |     | $          | 85,109   |       | $ | 79,586 |   |
| Income (loss)  from continuing operations before income taxes and cumulative change in  accounting principle:    |       |     |       |     |       |     |       |
| Optical Systems Group                                                                                            |       | $        | 11,063     |     | $          | 7,063    |       | $ | 5,052 |   |
| Distributed Products Group                                                                                       |       | 2,566    |       | 1,900    |       | 1,211    |       |
| Non-allocated expenses                                                                                           |       | (4,478   | )          | (3,729   | )          | (6,308   | )          |
| Income (loss) from continuing operations before  income taxes and cumulative change in accounting principle |       | $        | 9,151      |     | $          | 5,234    |       | $ | (45 | ) |
| Capital  expenditures of continuing operations:                                                                  |       |     |       |     |       |     |       |
| Optical Systems Group                                                                                            |       | $        | 4,062      |     | $          | 2,908    |       | $ | 1,227 |   |
| Distributed Products Group                                                                                       |       | 149      |       | 103      |       | 124      |       |
| Corporate                                                                                                        |       | 28       |       | 16       |       | 29       |       |
| Total capital expenditures                                                                                       |       | $        | 4,239      |     | $          | 3,027    |       | $ | 1,380 |   |

 

F-27

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

**Note 17—Segment Data (Continued)**
| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Depreciation and  amortization of continuing operations: |       |     |       |     |       |     |       |
| Optical Systems Group                                    |       | $        | 2,251      |     | $          | 2,422    |       | $ | 2,150 |   |
| Distributed Products Group                               |       | 154      |       | 219      |       | 223      |       |
| Corporate                                                |       | 269      |       | 279      |       | 290      |       |
| Total depreciation                                       |       | 2,674    |       | 2,920    |       | 2,663    |       |
| Amortization of intangibles                              |       | 73       |       | —   |       | —   |       |
| Total depreciation and amortization                      |       | $        | 2,747      |     | $          | 2,920    |       | $ | 2,663 |   |

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Identifiable assets:       |       |                  |       |   |   |
| Optical Systems Group      |       | $                     | 61,552     |   | $ | 37,566 |   |
| Distributed Products Group |       | 12,787                |       | 12,366 |   |
| Non-allocated assets       |       | 11,476                |       | 16,913 |   |
| Total assets               |       | $                     | 85,815     |   | $ | 66,845 |   |
| Goodwill:                  |       |                  |       |   |   |
| Optical Systems Group      |       | $                     | 11,573     |   | $ | 2,160 |   |
| Distributed Products Group |       | 1,440                 |       | 1,440 |   |
| Total goodwill             |       | $                     | 13,013     |   | $ | 3,600 |   |

 

Included in non-allocated expenses are generalcorporate expense, interest expense, and other income and expense. Identifiableassets by segment consist of those assets that are used in the segments’operations. Non-allocated assets are comprised primarily of short-terminvestments, cash and cash equivalents, corporate assets and net deferredincome tax assets.

Thefollowing table presents the non-allocated identifiable assets:
| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Non-allocated  assets:                 |       |                  |       |   |   |
| Cash and cash equivalents              |       | $                     | 6,000      |   | $ | 5,197 |   |
| Income taxes—deferred and current |       | 3,553                 |       | 2,203 |   |
| Long-term deferred income tax asset    |       | 1,250                 |       | 1,264 |   |
| Short-term investments                 |       | —                |       | 6,983 |   |
| Other corporate assets                 |       | 673                   |       | 1,266 |   |
| Total assets                           |       | $                     | 11,476     |   | $ | 16,913 |   |

 

F-28

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

**Note17—Segment Data (Continued)**

The table below presentssales from continuing operations to specific geographic regions. Substantiallyall of our assets are located within the United States.
| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| United States |       | $                                           | 91,069     |   | $ | 73,051 |   | $ | 65,179 |   |
| Europe        |       | 8,672                                       |       | 8,991 |   | 10,951 |   |
| Other foreign |       | 3,789                                       |       | 3,067 |   | 3,456 |   |
| Total sales   |       | $                                           | 103,530    |   | $ | 85,109 |   | $ | 79,586 |   |

 

Sales activity with one customer, Raytheon,represented 25% in 2004 and 21% in 2003 of our net sales within the OpticalSystems Group. During 2002, we did not have a concentration of sales with anyone customer.

Within ourOptical Systems Group, we had aggregate sales, both military and non-military,directly to the U.S. government, including its agencies and departments, of$2,367 in 2004, $3,397 in 2003 and $4,570 in 2002. In addition, sales of$47,574 in 2004, $36,633 in 2003 and $32,356 in 2002 were derived fromsubcontracts with U.S. government contractors. The majority of these contractsare subject to termination at the convenience of the U.S. government, andcertain contracts are also subject to renegotiation. Currently, we are notaware of any proposed termination or renegotiation of such contracts that wouldhave a material adverse effect on our business.

The raw materials and components that we purchase aregenerally available from multiple suppliers. However, beryllium, a material weuse extensively within our Optical Systems Group, is only available from BrushWellman, Inc. (“Brush Wellman”), the sole U.S. supplier. Historically, wehave had an excellent relationship with Brush Wellman and have not encounteredproblems in obtaining our supply requirements. However, the partial or completeloss of Brush Wellman as a supplier of beryllium, or production shortfalls orinterruptions that otherwise impair the supply of beryllium, would have amaterial adverse effect on our business, financial condition and results ofoperations. If such conditions were to occur, it is uncertain whetheralternative sources could be developed. We paid Brush Wellman $9,660 in 2004,$5,855 in 2003 and $12,462 in 2002.

In addition, within our Distributed Products Group,we purchase a substantial amount of ball bearings that we distribute from twoforeign suppliers. While we believe that we could obtain alternate sources ofsupply, any interruption in the flow of products from these suppliers, orsignificant increases in the cost of these products, could have an adverseeffect on our business, financial condition and results of operations. We paidthese two suppliers $6,406 in 2004, $5,438 in 2003 and $3,114 in 2002.

F-29

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

**Note18—Selected Quarterly Financial Data**

Selectedquarterly financial data for the years ended December 31, 2004 and 2003 issummarized as follows (in thousands, except per share data):
| ** **                                                        | ** ** | **Quarters Ended (Unaudited):** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Statement of Operations Data:**                  | ** ** | ** **                                | ** ** | **March  2004** | ** ** | **June  2004** | ** ** | ** September   2004** | ** ** | ** December   2004** | ** ** |
| Net sales                                                         |       | $                                         | 23,406     |   | $ | 25,729 |   |   | $ | 26,356 |   |   |   | $ | 28,039 |   |   |
| Gross profit                                                      |       | 6,781                                     |       | 7,821 |   |   | 7,949 |   |   |   | 8,105 |   |   |
| Income from  continuing operations before discontinued operations |       | 1,613                                     |       | 1,975 |   |   | 1,927 |   |   |   | 3,644 |   |   |
| Net income                                                        |       | 1,613                                     |       | 1,975 |   |   | 1,927 |   |   |   | 3,149 |   |   |
| Diluted net  income per share from continuing operations          |       | $                                         | 0.23       |   | $ | 0.27 |   |   | $ | 0.27 |   |   |   | $ | 0.49 |   |   |
| Diluted net  income per share applicable to common shareholders   |       | $                                         | 0.23       |   | $ | 0.27 |   |   | $ | 0.27 |   |   |   | $ | 0.43 |   |   |
| Diluted weighted-average  common shares outstanding               |       | 7,117                                     |       | 7,224 |   |   | 7,241 |   |   |   | 7,408 |   |   |
|                                                                   |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                        | ** ** | **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 profit                                                      |       | 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 from continuing operations          |       | $                                         | 0.12       |   | $ | 0.20 |   |   | $ | 0.17 |   |   |   | $ | 0.20 |   |   |
| Diluted net income  per share applicable to common shareholders   |       | $                                         | 0.12       |   | $ | 0.20 |   |   | $ | 0.17 |   |   |   | $ | 0.20 |   |   |
| Diluted weighted-average  common shares outstanding               |       | 7,004                                     |       | 7,040 |   |   | 7,103 |   |   |   | 7,156 |   |   |
|                                                                   |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

F-30

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

**SCHEDULE II**

**VALUATION AND QUALIFYING ACCOUNTS**
| **COL. A**                     | ** ** | **COL.B**  | ** ** | **COL. C**                                | ** ** | **COL. D**                               | ** ** | **COL. E**                      | ** ** | **COL. F** | ** ** |
|-------------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| ** **                          | ** ** | ** ** | ** ** | **Additions**                                  | ** ** | ** **                                    | ** ** | ** **                           | ** ** |
| **Classification**                  | ** ** | ** ** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Charged to  Other  Accounts** | ** ** | **Deductions**  | ** ** | **Balance at End   of Period** | ** ** |
| Year ended  December 31, 2004: |       |       |       |                                           |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |       |       | $          | 3,917                                          |       |                                          |       | $                                    | 1,164      |            |       |   | 88 | (b) |   |   | $ | 177 |   |   |   | $ | 4,992 |   |   |
| Allowance for  Doubtful Accounts    |       |       | 653        |                                           |       |                                          | 119        |                                 |       |            | —     |   |   |   | 87 | (a) |   |   | 685 |   |   |
| Year ended  December 31, 2003: |       |       |       |                                           |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |       |       | $          | 3,593                                          |       |                                          |       | $                                    | 512        |            |       |   | $ | 70 | (b) |   |   | $ | 258 |   |   |   | $ | 3,917 |   |   |
| Allowance for  Doubtful Accounts    |       |       | 509        |                                           |       |                                          | 234        |                                 |       |            | —     |   |   |   | 90 | (a) |   |   | 653 |   |   |
| Year ended  December 31, 2002: |       |       |       |                                           |       |                                          |       |                                 |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Inventory  Valuation Reserve        |       |       | $          | 3,482                                          |       |                                          |       | $                                    | 540        |            |       |   | $ | 48 | (b) |   |   | $ | 477 |   |   |   | $ | 3,593 |   |   |
| Allowance for Doubtful  Accounts    |       |       | 654        |                                           |       |                                          | 113        |                                 |       |            | —     |   |   |   | 258 | (a) |   |   | 509 |   |   |
|                                     |            |            |            |                                                |            |                                               |            |                                      |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Un-collectible accountswritten off, net of recoveries.

(b)          Result of adjustments tocost accounting standards, which increased gross inventory as well as inventoryreserve.

F-31

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**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                  |       | 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).*                                                                                        |
|     10.2                  |       | Severance Protection  Agreement between Axsys and Stephen W. Bershad dated as of February 11,  1999 (filed as Exhibit 10(1) to Axsys’ Form 10-Q, dated  May 11, 1999, for the fiscal quarter ended March 31, 1999 (the  “March 31, 1999 Form 10-Q”) and incorporated herein by reference).* |
|     10.3                  |       | Amendment to Axsys  Technologies, Inc. Long-Term Stock Incentive Plan (filed as  Exhibit A to Axsys’ Proxy Statement dated April 24, 2000 and  incorporated herein by reference).*                                                                                                                                             |
|     10.4                  |       | Employment Agreement,  dated as of October 12, 2000, between Axsys and Stephen W. Bershad  (filed as Exhibit 10(27) to the December 31, 2000 Form 10-K  and incorporated herein by reference).*                                                                                                                                |
|     10.5                  |       | Form of  Indemnification Agreement for all Directors and Officers of Axsys (filed as  Exhibit 10(17) to the December 31, 2001 Form 10-K and  incorporated herein by reference).*                                                                                                                                               |
|     10.6                  |       | Letter Agreement between  David A. Almeida and Axsys dated as of November 14, 2001 (filed as  Exhibit 10(18) to the December 31, 2001 Form 10-K and incorporated  herein by reference).*                                                                                                                                       |
|     10.7                  |       | Severance Protection  Agreement between Axsys and David A. Almeida dated as of May 13, 2003  (filed as Exhibit 10.2 to the June 28, 2003 Form 10-Q and  incorporated herein by reference).*                                                                                                                                    |
|     10.8                  |       | Letter Agreement between  Stephen W. Bershad and Axsys dated November 11, 2004, extending term of  initial period of the Employment Agreement.*                                                                                                                                                                                               |
|     10.9                  |       | Severance Protection  Agreement between Axsys and Scott B. Conner dated as of December 3,  2004*                                                                                                                                                                                                                                              |
|     10.10                 |       | Summary of Management  Incentive Plan*                                                                                                                                                                                                                                                                                                             |
|     14                    |       | Code of Ethics—Senior  Financial Officers (filed as Exhibit 14.1 to the December 31, 2003  Form 10-K and incorporated herein by reference).                                                                                                                                                                                    |
|     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                                                                                                                                                                                                                                                                |

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*                    Indicatesmanagement contracts or compensatory plans or arrangements.

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