10-K 1 a12-29158_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-K

 

(Mark one)

 

x      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934.

 

For the fiscal year ended December 31, 2012

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934.

 

For the transition period from            to           

 

Commission file number 333-171547

 


 

Colt Defense LLC
Colt Finance Corp.

(Exact name of Registrant as specified in its charter)

 

Delaware

 

32-0031950

Delaware

 

27-1237687

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

547 New Park Avenue, West Hartford, CT

 

06110

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (860) 232-4489

 

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

 


 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes x No o

 

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

 

Indicate by check mark whether the Registrant had submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for shorter period that the Registrant was required to submit and post such files). Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained tot the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by a check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

 

 

 

Non-accelerated filer x

 

Smaller reporting company o

 

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

 

The number of shares outstanding of the Registrant’s common stock as of March 25, 2013: None.

 

Documents incorporated by reference: None

 

 

 



Table of Contents

 

COLT DEFENSE LLC
TABLE OF CONTENTS

 

 

 

Page

PART I

 

 

Item 1.

Business

3

Item 1A.

Risk Factors

10

Item 1B.

Unresolved Staff Comments

24

Item 2.

Properties

24

Item 3.

Legal Proceedings

24

Item 4.

Mine Safety Disclosures

25

 

 

 

PART II

 

 

Item 5.

Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

26

Item 6.

Selected Financial Data

26

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

27

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

42

Item 8.

Financial Statements and Supplementary Data

43

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

75

Item 9A.

Controls and Procedures

75

Item 9B.

Other Information

75

 

 

 

PART III

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

76

Item 11.

Executive Compensation

78

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stock Matters

87

Item 13.

Certain Relationships and Related Transactions and Director Independence

89

Item 14.

Principal Accountant Fees and Services

90

 

 

 

PART IV

 

 

Item 15.

Exhibits and Financial Statement Schedules

92

 

Signatures

95

 

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This Annual Report on Form 10-K, including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, that are subject to the “safe harbor” created by those sections. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or our future financial performance and/or operating performance are not statements of historical fact and reflect only our current expectations regarding these matters. These statements are often, but not always, made through the use of words such as “may,” “will,” “expect,” “anticipate,”“believe,” “intend,” “predict,” “potential,” “estimate,” “plan” or variations of these words or similar expressions. These statements inherently involve a wide range of known and unknown uncertainties.  Our actual actions and results may differ materially from what is expressed or implied by these statements. Factors that could cause such a difference include, but are not limited to, those set forth as “Risk Factors” under Item 1A herein. Given these factors, you should not rely on forward-looking statements, assume that past financial performance will be a reliable indicator of future performance nor use historical trends to anticipate results or trends in future periods. We expressly disclaim any obligation or intention to provide updates to the forward-looking statements and estimates and assumptions associated with them.

 

Certain monetary amounts, percentages and other figures included in this report have been subject to rounding adjustments.  Accordingly, figures shown as totals in certain tables may not be the arithmetic aggregation of the figures that precede them and figures expressed as percentages in the text may not total 100% or, as applicable, when aggregated may not be the arithmetic aggregation of the percentages that precede them.

 

In this Annual Report on Form 10-K, unless the context otherwise requires, or unless specifically stated otherwise, references to the terms “we,” “our,” “us,” “Colt Defense” and the “Company” refer to Colt Defense LLC, Colt Finance Corp. and all of their subsidiaries that are consolidated under GAAP.

 

PART I

 

Item 1.                   Business

 

Company overview

 

Colt Defense LLC was formed in 2002 as a Delaware limited liability company as a result of the re-organization of Colt’s Manufacturing Company, Inc. (“Colt’s Manufacturing”). The defense and law enforcement rifle business, under Colt Defense, was separated from the commercial handgun business. Through their respective affiliates, Sciens Management LLC, referred to herein as “Sciens Management”, and funds managed by an affiliate of The Blackstone Group, L.P., referred to herein as the “Blackstone Funds”, beneficially own a substantial portion of Colt Defense’s limited liability company interests.

 

We are one of the world’s leading designers, developers and manufacturers of small arms weapons systems for individual soldiers and law enforcement personnel. We have supplied small arms weapons systems to more than 80 countries by expanding our portfolio of products and services to meet evolving military and law enforcement requirements around the world.  Our products have proven themselves under the most severe and varied battle conditions. We also modify our rifles and carbines for civilian use and sell them to Colt’s Manufacturing, which sells them into the commercial market.

 

We have historically been the U.S. military’s sole supplier of the M4 carbine, the U.S. Army’s standard issue rifle, the Canadian military’s exclusive supplier of the C8 carbine and C7 rifle and a supplier of other small arms weapons systems to U.S., Canadian and international  law enforcement agencies.  Furthermore, our development and sales of M4 carbines and over 50 years of sales of M16 rifles have resulted in a global installed base of more than 7 million M16/M4 small arms weapons systems.  Our expertise in designing and manufacturing small arms weapons systems enables us to integrate new technologies and features to upgrade our large installed base, develop international co-production opportunities and capitalize on our experience building to stringent military standards to make commercial rifles and carbines with exceptional reliability, performance and accuracy.

 

We trace our history to Colonel Samuel Colt, who launched a company that is part of American folklore.  A post-Civil War slogan stated, “Abe Lincoln may have freed all men, but Sam Colt made them equal.”  Samuel Colt’s success story began with the issuance of a U.S. patent in 1836 for a revolving cylinder handgun firing five or six rounds.  Colt’s revolver provided its user with greatly increased firepower, since prior to his invention, only one- and two-barrel flintlock pistols were available.  In addition, Colt pioneered the mass production of firearms, which

 

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made large numbers of high quality, affordable firearms available for the first time.  As a direct result of his invention and the marketing and sales success that followed, Samuel Colt and his small arms played a prominent role in the history of a developing America.  We have been a leading supplier of small arms weapons systems to the U.S. military since the Mexican-American War in 1847 and have supplied our products to international customers for nearly as long.

 

Industry overview

 

We compete in the global market for small arms weapons systems designed for military, law enforcement and civilian (commercial) use.  Our end customers include U.S. and foreign military forces, law enforcement and security agencies and through an arrangement with Colt’s Manufacturing, domestic sporting and hunting enthusiasts. Government funding for our military products is primarily linked to the spending trends of U.S., Canadian and other foreign militaries and national and border security agencies.  Efforts to reduce the U.S. federal budget deficit and the wind-down of military operations in Iraq and Afghanistan will likely result in flat to declining U.S. defense budgets for the foreseeable future. Austerity measures will also pressure the European defense market spending. At this point, it is unclear how extensive defense budget cuts will be or specifically how small arms weapons programs will be impacted by the cuts. International markets outside of Europe appear to be less impacted by budget constraints.

 

As a result of our continued emphasis on the law enforcement and commercial (“LE/Commercial”) markets, we have seen strong year-over-year sales growth into these markets. Law enforcement agencies at all levels of government (federal, state and municipal) are experiencing budgetary pressures, but Colt’s Manufacturing has seen continued strong demand in the commercial rifle market.

 

Business Segment

 

Our small arms weapons systems segment represents our core business, as substantially all of our operations are conducted through this segment. The small arms weapons systems segment consists of two operating segments,   which have similar economic characteristics and have been aggregated into the Company’s only reportable segment.  The small arms weapons systems segment of our business designs, develops and manufactures small arms weapons systems for military and law enforcement personnel both domestically and internationally and, indirectly, for the domestic commercial market.  For a discussion of our financial performance, see “Results of Operations” in Item 7 of this Form 10-K.

 

Products

 

Our name, products and services connote quality, reliability, performance and integrity in the U.S., Canada and around the world.  We believe these strengths facilitate sales of our products and allow us to expand our sales of small arms weapons systems and related products and services.

 

Our product line includes:

 

·                       Military, law enforcement and commercial  rifles and carbines;

 

·                       machine guns, grenade launchers and other products for military and law enforcement customers; and

 

·                       a range of weapons-related products, parts, accessories and services.

 

Below is a brief description of some of our significant products.

 

Small Arms Weapons Systems

 

Proprietary Legacy Military Weapons Systems

 

M4 5.56mm carbine.  The M4 carbine, the standard weapon of issue for the U.S. Army, was first approved for use by the U.S. military in 1993. Due to its size and performance, it is not only well suited for special operations and elite battle units of the U.S. military and similar units of other militaries, but also for general purpose forces as well.  The M4 is a fully/semi-automatic, air-cooled, magazine-fed, gas-operated carbine.  The M4 carbine is designed for

 

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simplicity of operation, maximum interchangeability of parts and ease of maintenance.  This combination of favorable characteristics has contributed to a durable, high performance system with low life cycle maintenance costs.  The M4 carbine features a four-position sliding butt stock allowing it to adapt to soldiers of different sizes and physical characteristics as well as various firing positions.  The M4 carbine is the first military weapon to fully utilize the flat top upper receiver, which provides the user flexibility in accessorizing the weapon.

 

M16 5.56mm Rifle.  The M16 is a fully/semi-automatic, air-cooled, magazine-fed, gas-operated rifle.  This rifle has been produced since the 1960s, and until the transition to the M4 carbine, it was the standard weapon of issue for the U.S. Army.  The M16A4 rifle version features a removable carrying handle with an integral rail-mounting system.  When the carrying handle is removed, any accessory device with a rail grabber, such as an optical sight, can be mounted on the weapon.

 

Variations of the M4 carbine and M16 rifle offered include, among others: the M4 Commando, C8 carbine, C8SFW, C7 rifle, Infantry Automatic Rifle, Sub-Compact Weapon and the 9mm Submachine Gun.

 

Proprietary New Weapons Systems

 

CM901 Multi-caliber, Modular Weapon System.  The CM901™ modular weapon system is a newly designed modular carbine that can change calibers in the field, from 5.56mm up to and including 7.62 x 51mm NATO.  The CM901™ is a fully/semi-automatic, air-cooled, magazine-fed, gas-operated carbine.  By simply disengaging the take-down and pivot pins on the universal lower receiver, the user can quickly change from a 5.56mm Close Quarter Battle short barrel configuration to a full length 7.62 x 51mm Extended Range Carbine configuration.  The CM901™ has a free-floating barrel system to improve operator accuracy and hit probability.  With an adaptor, the CM901™ is designed to accept all legacy M4/M16 Colt upper receiver assemblies making it both compatible with our customers’ current M4/M16 inventory and familiar in functionality to the soldier.

 

Advanced Piston Carbine (APC).  The new Colt P0923 Advanced Piston Carbine is a modular, 5.56mm, piston-operated, lightweight, one-piece upper receiver, magazine-fed carbine capable of firing in automatic and semi-automatic modes.  The Colt P0923 incorporates a unique articulating link piston operating system that reduces the inherent stress in the piston stroke by allowing for deflection and thermal expansion.  The P0923 is specifically designed for ease of cleaning, disassembly, and assembly of the carbine.

 

Military Handgun

 

M45A1 Close Quarters Battle Pistol. The M45A1 (Close Quarters Battle Pistol — CQBP) is a variation of the ubiquitous Colt 1911 pistol which first entered military service over one-hundred years ago in 1911.  This marks the first time since the end of World War II that a Colt 1911 has been delivered to the U.S. Government as a service pistol.  The M45A1 is a semiautomatic, magazine-fed, .45 ACP handgun with an enclosed slide which also includes features compliant with the U.S. Marine Corps specifications for their new service pistol including self-illuminating (tritium) night sights and an integral MIL-STD-1913 “Picatinny” rail. This product is manufactured for us by Colt’s Manufacturing.

 

Commercial and Law Enforcement Weapons Systems

 

LE/Commercial Model Rifles and Carbines. Our LE/Commercial rifles and carbines include numerous variants of our military rifles and carbines.  Weapons systems sold to law enforcement customers tend to closely resemble our military products and can be made and sold in automatic and semiautomatic fire configurations.  Rifles and carbines that we manufacture for Colt’s Manufacturing (which sells them to the commercial market) are available in semiautomatic fire mode only.

 

Military Weapon Systems Under License

 

M240 and M249Machine Guns.  The M240 is a belt-fed, gas-operated medium machine gun that utilizes the 7.62 x 51mm NATO cartridge. The M249 is a belt-fed, gas-operated light machine gun that utilizes the 5.56 x 45 mm NATO cartridge.  We manufacture the M240 and the M249 under licenses for sale exclusively to the U.S. Government.

 

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Spares/Other

 

Spares and Accessories.  We produce and provide spare parts and replacement kits for our small arms weapon systems.  With certain customers, we also provide the overhaul services associated with the spare parts and replacement kits.  We also provide engineering services to the Canadian Government. Due to the flexibility of our small arms weapons systems, we offer our customers procurement services whereby we will accessorize the small arms we sell to meet the customer’s specifications.  The M4 carbines, M16 rifles and other variants are the platform for the U.S. military’s current generation modular weapon system, which incorporates a rail adapter system into the weapons.  These rail systems provide multiple mounting surfaces for various accessory devices, including flashlights, optical sights, thermal sights, backup iron sights, laser sighting and targeting devices.  Accordingly, there is a large base of components using the rail adapter system and a significant investment by the U.S. military and foreign countries in these components. On a limited basis, we also produce subcomponents for other prime government defense contractors.

 

EAGLE 40mm Grenade Launcher.  The EAGLE grenade launcher is a lightweight, single-shot, 40mm weapon designed specifically to work with the new generation of weapons equipped with one piece upper receivers, including the Model CM901 modular weapon system.  The EAGLE is a side opening launcher that will accommodate the whole range of 40mm high explosive and special purpose ammunition (including non-lethal ammunition).  The launcher can be configured for left- or right-handed shooters.  It has a maximum effective range of 400 meters with low recoil.  The EAGLE is also available as a stand-alone unit.

 

Law Enforcement Sales and Training.

 

We provide armorer’s and tactical training courses for the law enforcement community.  Armorer’s courses cover design, theory, compatibility, disassembly, assembly, maintenance and troubleshooting.  Tactical training courses address the use of tactical rifles and handguns in various law enforcement scenarios.

 

Research and development

 

We conduct research and development activities to continually enhance our existing products, develop new products to meet our customers’ needs and requirements and address new market opportunities.  Our ability to compete for new government contracts and commercial sales depends, to a large extent, on the success of our product development programs at creating innovations and improvements.  In 2012, research and development expenditures were $4.7 million, compared to $5.6 million in 2011 and $4.5 million 2010. For a discussion of risks associated with product development, see “Risk Factors” in Item 1A of this Form 10-K.

 

Co-production programs

 

We have entered into co-production transactions with partners in foreign countries, including Canada and Malaysia, and we continue to be willing to enter into new relationships.  All manufacturing license agreements that we enter into with non-U.S. counterparties have finite terms and require approval by the U.S. State Department.

 

Customer and customer concentration

 

We sell our products and services to a customer base that includes:

 

·                       U.S. Government, including the Foreign Military Sales Program (“FMS”) sales by the U.S. Government;

 

·                       Canadian Government;

 

·                       direct sales to other foreign governments;

 

·                       domestic law enforcement agencies and select distributors servicing law enforcement agencies; and

 

·                       Colt’s Manufacturing, which sells our products into the domestic commercial market through a network of distributors.

 

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A significant portion of our net sales is derived from a limited number of customers. In 2012, we had four customers that each accounted for more than 10% of our net sales. In total, sales to these four customers accounted for almost 77% of our net sales.   In 2011, we had two customers that each accounted for more than 10% of our net sales and together accounted for 42% of our net sales. In 2010, one customer accounted for 55% of our net sales and there were no other customers that exceeded 10% of net sales. For additional information on customer concentration and the related risks, see “Risk Factors” in Item 1A and “Note 13 Segment Information” in Item 8 of this Form 10-K.

 

Government contracts

 

Our U.S. Government business is performed under fixed-price contracts pursuant to which the U.S. Government ordinarily commits to purchase a minimum quantity over a multi-year period but has the option to purchase a greater quantity at a pre-committed price.  Substantially all of our contracts have been awarded to us after competitive solicitations. There is intense competition for the U.S. Government contracts for which we compete.

 

U.S. Government contracts are, by their terms, subject to termination by the U.S. Government for either its convenience or default by the contractor.  Termination for convenience is at the U.S. Government’s discretion and occurs when there is a determination that termination of the contract is in the U.S. Government’s interest, such as when there is a change in the U.S. Government’s needs.  Fixed-price contracts provide for payment upon termination for items delivered to and accepted by the U.S. Government and, if the termination is for convenience, for payment of fair compensation of work performed plus the costs of settling and paying claims by terminated subcontractors, other settlement expenses, and a reasonable profit on the costs incurred.

 

The U.S. Government also regulates the methods under which costs are allocated to U.S. Government contracts.  Under U.S. Government regulations, certain costs, including certain financing costs, portions of research and development costs, lobbying expenses, certain types of legal expenses, and certain marketing expenses related to the preparation of bids and proposals, are not allowed for pricing purposes. We are subject to a variety of audits performed by U.S. Government agencies in connection with our U.S. Government contracts.  Such audits can occur prior to, during or after the completion of a given contract.

 

Since 1976, our Canadian subsidiary and its predecessor have served as the Government of Canada’s Strategic Source for Small Arms. This relationship requires our Canadian subsidiary to work closely and cooperate with the Department of National Defense and Canadian Forces regarding its strategic source of supply for the design, development, manufacture, testing and overhaul of small arms, including but not limited to the C7 and C8 family of weapons, and maintain the Small Arms Center for Excellence, the Canadian Government’s center to test, improve and develop small arms.

 

For a discussion of the risks associated with U.S. and Canadian government contracts, see “Risk Factors” in Item 1A of this Form 10-K.

 

Marketing and distribution

 

Our marketing strategy focuses on the following three specific sales channels: the U.S. and Canadian Governments; the International market; and the U.S. LE/Commercial market.

 

U.S. and Canadian Government sales typically consist of sales to the U.S. Department of Defense, the Canadian Department of National Defense and other U.S. and Canadian agencies.  For the U.S. and Canadian Governments, we utilize a direct sales force that maintains significant interaction with the customer and end user.  This level of interaction enables us to respond to feedback and guidance from weapon system operators on a real-time basis.

 

International sales are ordinarily to a military or law enforcement unit of a foreign government.  We interact with the international market through a global network of independent, commission-based sales representatives, as well as a direct sales force.  Sales representatives work in coordination with our direct sales force in promoting our products, indentifying opportunities, submitting quotes and bids, finalizing sales contracts and associated paperwork and providing delivery and after-sale support.  Our products also enter the international market via the U.S. Government FMS program.  FMS sales, which we characterize as sales to the U.S. Government for financial reporting purposes, are sales to the U.S. Government for the benefit of a foreign end-user, to which the product is shipped. For additional information on sales and long-lived assets by geographic area, see “Note 13 Segment Information” in Item 8 of this Form 10-K.

 

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U.S. LE/Commercial sales consist of sales to distributors, including Colt’s Manufacturing, and sales to law enforcement agencies.  We interact with commercial and law enforcement customers through both a direct sales force and a domestic network of independent, commission-based sales representatives.

 

Sources and availability of raw materials

 

The raw materials in our products consist primarily of metals, principally steel and aluminum, and polymers.  We purchase bar steel and aluminum forgings for machining operations that we conduct at our facilities but most of our purchased inventory consists of parts that are already fully or partially machined or processed.  The critical machined and processed purchased parts are manufactured pursuant to proprietary specifications.  In some cases, we are dependent on sole-source suppliers.  In order to mitigate the risk associated with sole-source suppliers, we usually enter into long-term or volume purchase arrangements.  We have also broadened our supplier base for certain parts in order to meet the increased demand associated with the commercial market.  We have not been materially adversely affected by price fluctuations relating to essential raw materials.

 

Backlog

 

Because a substantial portion of our business is of a build-to-order nature, we generally have a significant backlog of orders to be manufactured and shipped. Our backlog decreased from $176.7 million at December 31, 2011 to $165.9 million at December 31, 2012 due in part to shipments on a large, long-term, international order. The decline in international backlog was partially offset by year over year increases in both our U.S. Government and LE/Commercial backlog. We expect approximately 81% of our backlog of orders as of December 31, 2012 to be shipped over the next twelve months.  Management uses our backlog to project sales and plan our business on an ongoing basis.  Our total backlog represents the estimated remaining sales value of work to be performed under firm, and when applicable, funded contracts.

 

Competition

 

The markets we serve are highly competitive. Our principal competitor for U.S. Government business has been FN Manufacturing LLC, the U.S. subsidiary of FN Herstal, S.A. We also face competition for U.S. Government business from smaller companies that compete for small business set-aside contracts.  Other domestic commercial “black rifle” manufacturers, including Remington Arms Company LLC, have participated in recent procurement competitions.  Although we anticipate that robust competition for U.S. military contracts will continue to exist, entrance barriers are high due to rigorous production and quality standards to which defense contractors are subject.  Accordingly, we believe that our ability to consistently ship large quantities of high-quality product on time and our long track record provide us with a competitive advantage over potential new entrants into this market.

 

In Canada, we are the exclusive supplier of the C7 rifle and C8 carbine to the Canadian Department of National Defense and are the center of excellence with respect to other small arms projects for the Canadian Government.

 

Outside Canada and the United States, our principal competitors for foreign military and law enforcement sales are foreign small arms manufacturers.  In countries that already have inventories of M16 rifles and M4 carbines in service as a result of prior purchases directly from us or through the U.S. Government’s FMS program, we believe our incumbency provides a competitive advantage.

 

Our primary competition in the U.S. for commercial and law enforcement model rifles and carbines are domestic rifle manufacturers that sell similar products primarily or exclusively into the commercial market.  There are many such competitors and the domestic commercial market for rifles and carbines is extremely competitive.

 

Intellectual property

 

We own or license common law and registered trademarks that are used to identify our products and services.  Certain of our trademarks are registered in the United States and in certain foreign jurisdictions.  We have an exclusive, worldwide, license right from New Colt Holding Corp. (“New Colt”) to use the widely recognized Colt® brand name for the sale of small arms, spare parts and other products and services for military use and to use the Colt brand name for the sale of firearms, except handguns, plus spare parts and related products, for law enforcement use.  This license also includes the use of the principal long-standing Colt trademarks.  This license

 

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is fully paid for its initial 20-year term, which expires December 31, 2023, and may be extended indefinitely at our option for successive five-year periods upon payment of $250 thousand for each additional five-year period.

 

Our proprietary firearms technology consists primarily of trade secrets such as proprietary drawings and know-how and also includes patents and other intellectual property rights.  We engage in a number of measures to protect our trade secrets. We also identify and protect with patents those patentable inventions generated by our ongoing research and development activities that we believe may provide us with a competitive advantage or other future value. Patents are filed and maintained in the United States, Canada and other jurisdictions as appropriate.

 

We have entered into licenses with third parties pertaining to portions of our firearms technology.  The U.S. Government is licensed to use our M16 rifle and M4 carbine technology for competitive procurements for military use.  The Canadian Government is licensed to use our M16 rifle and M4 carbine technology for its military and law enforcement needs.  We also have entered into a license agreement with a manufacturer in Malaysia pursuant to which the manufacturer will assemble the M4 carbine and machine certain components for use in that country.

 

For a discussion of the risks associated with our intellectual property, see “Risk Factors” in Item 1A of this Form 10-K.

 

Environmental laws and regulations

 

We are subject to various federal, state, local, provincial and foreign laws and regulations governing the protection of human health and the environment.  In the U.S., we employ a full-time manager whose responsibilities include our compliance with environmental laws and regulations.  In 2012, we did not make any significant capital expenditures for equipment required by environmental laws and regulations, but we incurred aggregate expenses of $0.5 million for remediation of environmental conditions. For a discussion of the risks associated with environmental compliance, see “Risk Factors” in Item 1A of this Form 10-K.

 

Employees

 

As of December 31, 2012, we had approximately 552 active, full-time employees, of whom 452 employees were located in the U.S. and 100 employees were located in Canada.  In the U.S., approximately 68% of our workforce is represented by a union and is covered by a new collective bargaining agreement that became effective April 1, 2012 and expires on March 31, 2014.  The new collective bargaining agreement contains new features that focus on cost containment for health and pension plans. Beginning April 1, 2013, all of our U.S. employees will participate in a new consumer-directed health plan. In addition, all employees who are subject to the collective bargaining agreement and commenced service after April 1, 2012 are not eligible to participate in the hourly defined benefit plan. Instead, they are eligible to participate in our defined contribution retirement plan. For additional information about changes to our defined benefit and defined contribution plans, see “Note 8 Pension, Savings and Postretirement Benefits” in Item 8 of this Form 10-K.

 

None of our Canadian employees are subject to collective bargaining agreements.  Of our total workforce, 460 were directly or indirectly involved in the production process.  For a discussion of the risks associated with labor, see “Risk Factors” in Item 1A of this Form 10-K.

 

Available Information

 

Copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available, at your request, without charge, from Colt Defense LLC, 547 New Park Avenue, West Hartford, CT 06110, Attention: Chief Financial Officer. Our telephone number at that address is (860) 232-4489.

 

The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site at http://www.sec.gov that contains the reports and other information that are filed electronically with the SEC.

 

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Item 1A.                                              Risk Factors

 

Our operations could be affected by various risks, many of which are beyond our control. Based on current information, we believe that the following identifies the most significant risks that could affect our business. Investors should carefully consider the following risk  factors, together with all of the information included in this Form 10-K, in evaluating our company, our business and our prospects.

 

Risks related to our business

 

We make a significant portion of our net sales to a limited number of customers, and a decrease in sales to these customers could have a material adverse effect on our business.

 

A significant portion of our net sales is derived from a limited number of customers.  For the year ended December 31, 2012, our top ten customers represented approximately 90% of our net sales.  Our four largest customers, which each accounted for more than 10% of our net sales, accounted for approximately 77% of our net sales for the year ended December 31, 2012.  In 2013, we expect to continue to derive a significant portion of our business from sales to a relatively small number of customers.  If we were to lose one or more of our top customers, or if one or more of these customers significantly decreased orders for our products without another customer generating offsetting new orders, our business would be materially and adversely affected.

 

We are subject to risks related to a lack of product revenue diversification.

 

We derive a substantial percentage of our net sales from a limited number of products, especially variants of our M4 carbine and other small arms weapons systems, and we expect these products to continue to account for a large percentage of our net sales in the near term.  Continued market acceptance of these products is, therefore, critical to our future success.  We cannot predict how long the M4 carbine and related products will continue to be the primary small arms weapons system of choice for the U.S. Government and certain of our other customers.  Our business, operating results, financial condition, and cash flows could be adversely affected by:

 

·                       a decline in demand for the M4 carbine and related small arms weapons systems;

 

·                       future U.S. Government procurements of the M4 carbine, including spare parts, will be on a competitive basis;

 

·                       a failure to achieve continued market acceptance of our key products;

 

·                       export restrictions or other regulatory, legislative or multinational actions which could limit our ability to sell those products to key customers or markets, especially existing and potential international customers;

 

·                       improved competitive alternatives to our products gaining acceptance in the markets in which we participate;

 

·                       increased pressure from competitors that offer broader product lines;

 

·                       technological change that we are unable to address with our products; or

 

·                       a failure to release new or enhanced versions of our products to our military or other customers on a timely basis.

 

Any of the above events could impact our ability to maintain or expand our business with certain customers.

 

In addition, the Army recently announced the award to a competitor of ours of a five-year indefinite delivery, indefinite quantity (“IDIQ”) contract to supply the Army with the M4 carbine.  Competition for contracts to supply spare parts to the U.S. Army is also intense and our competitors have demonstrated their ability to compete successfully for spare parts contracts.

 

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If our Memorandum of Understanding with Colt’s Manufacturing were not to be renewed, our sales of rifles and carbines into the commercial market could be significantly impacted.

 

Sales to Colt’s Manufacturing accounted for approximately 34% of our sales in 2012 as compared to 6% of sales in 2011. Colt’s Manufacturing sells those rifles and carbines to distributors and retailers who resell them into the domestic commercial market. Our sales to Colt’s Manufacturing occur under a written Memorandum of Understanding that by its terms expires at the end of April 2013.  If the Memorandum of Understanding is not renewed or replaced by another agreement, we will not be able to continue selling rifles and carbines to Colt’s Manufacturing after the current agreement expires.

 

We would face two impediments to selling rifles and carbines directly to the commercial market if we wished to do so after termination of the Memorandum of Understanding.  First, we are not licensed to sell Colt-branded products to the commercial market.  Second, our limited liability company agreement prohibits us from selling rifles and carbines directly to the commercial market, under any brand, without the consent of Sciens Management and the Blackstone Funds.  There is no assurance that such consent could be obtained.  Even if such consent were obtained, there is no assurance that customers in the domestic commercial market will continue to purchase our products if they are not marketed and sold under the Colt name and are marketed and sold instead under a different brand name.

 

For these reasons, termination of the Memorandum of Understanding could have a material adverse effect on our business.

 

New federal and state laws and regulations may restrict our ability to continue to sell the products that we currently sell into the domestic commercial market, which could materially adversely affect our revenues.

 

A significant portion of our revenues is derived from sales into the domestic commercial market of variants of our military and law enforcement rifles and carbines.  Since December 2012, there has been an extremely sharp increase in political and public support for new “gun control” laws and regulations in the United States.  Some proposed legislation, including legislation that has been introduced and is under active consideration in Congress and in state legislatures, would ban and/or restrict the sale of substantially all of our products, in their current configurations, into the commercial market, either throughout the United States or in particular states.  It is also possible that the President of the United States could issue Executive Orders that would adversely affect our ability to sell, or customers’ ability to purchase, our products.  The political environment for enactment of new “gun control” measures at the federal, state and local level is evolving rapidly and additional significant change in the domestic legal and regulatory environment during 2013 is likely.

 

In light of the uncertain and evolving political, legal and regulatory environment, it is not clear what measures might be necessary in order to redesign our products to comply with applicable law, nor whether it will even be possible in every instance to do so.  To the extent that redesigns of our products are possible, we may need to spend significant amounts of capital in order to effectuate such redesigns and may incur associated sales, marketing, legal and administrative costs in connection with the introduction of new models.  Furthermore, there is no assurance that customers will accept redesigned rifles and carbines.

 

A substantial decline in sales into the domestic commercial market for any of these reasons would have a material adverse effect on our business.

 

It is possible that demand for commercial versions of our product could experience a sudden decline.

 

Previous patterns of demand in the domestic commercial rifle market suggest that demand for our products in that market could experience a rapid, material decline at any time.  For example, demand that was intense in late 2008 and early 2009 declined suddenly in mid-2009, when perceptions that the new administration in Washington might entail new “gun control” legislation subsided.  There are indications that that the commercial market has recently experienced a surge in demand due to renewed concerns relating to “gun control” laws and regulations.  To the extent that is the case, if the market determines that the risk is not as great as anticipated, there could be a similar rapid decline in sales into the commercial market. A rapid decline in demand for our products in the commercial market could cause Colt’s Manufacturing to cancel purchase orders that we have included in our backlog.

 

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Our manufacturing facilities may experience disruptions adversely affecting our financial position and results of operations.

 

We currently manufacture our products primarily at our facilities in West Hartford, Connecticut and Kitchener, Ontario, Canada.  We lease our West Hartford facility from an affiliate of one of our sponsors.  The term of this lease has been extended to October 25, 2015.  The lease does not provide for renewal of the term after the lease maturity and we may not be able to continue to occupy the property on acceptable terms or be able to find suitable replacement manufacturing facilities on satisfactory terms and conditions. Any natural disaster or other serious disruption at either of our facilities due to a fire, electrical outage or any other calamity could damage our capital equipment or supporting infrastructure or disrupt our ability to ship our products from, or receive our supplies at, these facilities.  Any such event could materially impair our ability to manufacture and deliver our products.  Even a short disruption in our production output could delay shipments and cause damage to relationships with customers, causing them to reduce or eliminate the amount of products they purchase from us.  Any such disruption could result in lost net sales, increased costs and reduced profits, which could have a material adverse affect on our financial position and results of operations.

 

Our sponsors control us and may have conflicts of interest with us or you now or in the future.

 

Through their respective affiliates, our sponsors, Sciens Management and the Blackstone Funds, beneficially own a substantial portion of the Company’s limited liability company interests.  Under the terms of the Company’s limited liability company agreement, our sponsors and our union have the right to appoint our Governing Board and our sponsors, subject to maintaining certain equity ownership levels, have specified veto or approval rights which may be exercised in their discretion.  As such, our sponsors have the ability to prevent specified transactions that might be in the best interests of the noteholders or to cause the Company to engage in transactions in which the sponsors have interests that might conflict with the interests of the noteholders.  Members of the Company’s Governing Board are not required to abide by the same standard of care under the Delaware Limited Liability Company Act as the standard of care required of directors of a Delaware corporation.  Additionally, Sciens Management and the Blackstone Funds are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that may directly or indirectly compete with or otherwise be adverse to us.  They may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us.

 

We are subject to significant withholding taxes if we repatriate the earnings of our Canadian subsidiary.

 

As a result of current U.S. and Canadian tax laws and our existing legal structure, we cannot use profits from our Canadian subsidiary in the parent company business without incurring significant tax expense.  Our inability to bring profits from our Canadian subsidiary into the parent company in a tax-efficient manner diminishes the value of profits generated in Canada.

 

Our long-term growth plan includes the expansion of our global operations.  Such global expansion may not prove successful, and may divert significant capital, resources, and management time and attention and could adversely affect our ongoing operations.

 

Net direct sales to customers outside the United States accounted for approximately 48% of our net sales for the year ended December 31, 2012.  We intend to continue to focus considerable efforts on expanding our international presence, which will require our management’s time and attention and may detract from our efforts in the United States and our other existing markets and adversely affect our operating results in these markets.  Our products and overall marketing approach may not be accepted in other markets to the extent needed to continue the profitability of our international operations.  Any further international expansion will likely intensify our risks associated with conducting international operations, including:

 

·                       difficulty in predicting the timing of international orders and shipments;

 

·                       increased liquidity requirements as a result of bonding or letters of credit requirements;

 

·                       unexpected changes in regulatory requirements;

 

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·                       changes in foreign legislation;

 

·                       multinational agreements restricting international trade in small arms weapons systems;

 

·                       possible foreign currency controls, currency exchange rate fluctuations or devaluations;

 

·                       tariffs;

 

·                       difficulties in staffing and managing foreign operations;

 

·                       difficulties in obtaining and managing vendors and distributors;

 

·                       potential negative tax consequences;

 

·                       greater difficulties in protecting intellectual property rights;

 

·                       greater potential for violation of U.S. and foreign anti-bribery and export-import laws; and

 

·                       difficulties collecting or managing accounts receivable.

 

General economic and political conditions in these foreign markets may also impact our international net sales, as such conditions may cause customers to delay placing orders or to deploy capital to other governmental priorities.  These and other factors may have a material adverse effect on our future international net sales.

 

We are required by Section 404 of the Sarbanes-Oxley Act to evaluate the effectiveness of our internal control over financial reporting; however, our independent registered public accounting firm is not required to attest to the effectiveness of our internal control over financial reporting.

 

Section 404 of the Sarbanes-Oxley Act requires the Company to perform a comprehensive evaluation and report of its internal controls. This report must contain an assessment by management of the effectiveness of our internal control over financial reporting as of the end of our fiscal year and a statement as to whether or not our internal controls are effective.  However, our independent registered public accounting firm is not required to issue an opinion on management’s assessment or the effectiveness of our internal control over financial reporting. To comply with these requirements, we have documented and tested our internal control procedures and our management has assessed and issued a report concerning our internal control over financial reporting.  Our efforts to comply with Section 404 have resulted in, and are likely to continue to result in, significant costs, the commitment of time and operational resources and the diversion of management’s attention.  We may not prevent or detect material misstatements or errors, controls may become inadequate because of changes in circumstances, the degree of compliance with the policies or procedures may deteriorate and become ineffective and/or investors may not have an accurate financial evaluation of the Company or market perception of our financial condition may be adversely affected and customer perception of our business may suffer.

 

The markets in which we compete are highly competitive and we may be unsuccessful at designing new products to meet changing customer demand, introducing them on a timely basis or pricing them competitively.

 

In each of our markets — military, law enforcement and commercial — there are numerous competitors offering similar products at prices that are attractive to customers. Some competitors have greater financial, technical, marketing, manufacturing and distribution resources than we do, or may have broader product lines.  Our ability to compete successfully for U.S., Canadian and other military and law enforcement contracts depends on our success at offering better product performance than our competitors at a lower price and on the readiness and capacity of our facilities, equipment and personnel to produce quality products consistently.  Our ability to compete successfully in the domestic commercial market depends on our continuing to distinguish our products from similar product offered by competitors and to command pricing that reflects the value connoted by the Colt brand.

 

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While part of our strategy is to pursue strategic acquisitions, we may not be able to identify businesses that we can acquire on acceptable terms, we may not be able to obtain necessary financing or may face risks due to additional indebtedness, and our acquisition strategy may incur significant costs or expose us to substantial risks inherent in the acquired business’s operations.

 

Our strategy of pursuing strategic acquisitions may be negatively impacted by several risks, including the following:

 

·                       We may not successfully identify companies that have complementary product lines or technological competencies or that can diversify our revenue or enhance our ability to implement our business strategy.

 

·                       We may not successfully acquire companies if we fail to obtain financing, or to negotiate the acquisition on acceptable terms, or for other related reasons.

 

·                       We may incur additional expenses due to acquisition due diligence, including legal, accounting, consulting and other professional fees and disbursements.  Such additional expenses may be material, will likely not be reimbursed and would increase the aggregate investment cost of any acquisition.

 

·                       Any acquired business will expose us to the acquired company’s liabilities and to risks inherent to its industry.  We may not be able to ascertain or assess all of the significant risks.

 

·                       We may require additional financing in connection with any future acquisition.  Such financing may adversely impact, or be restricted by, our capital structure and our ability to pay amounts owed under the notes when due and payable.  Increasing our indebtedness could increase the risk of a default that would entitle the holder to declare all of such indebtedness due and payable, as well as the risk of cross-defaults under other debt facilities.

 

·                       Achieving the anticipated potential benefits of a strategic acquisition will depend in part on the successful integration of the operations, administrative infrastructures and personnel of the acquired company or companies in a timely and efficient manner.  Some of the challenges involved in such an integration include:

 

·                       demonstrating to the customers of the acquired company that the consolidation will not result in adverse changes in quality, customer service standards or business focus;

 

·                       preserving important relationships of the acquired company;

 

·                       coordinating sales and marketing efforts to effectively communicate the expanded capabilities of the combined company; and

 

·                       coordinating the supply chains.

 

·                        Our limited liability company agreement prohibits us from entering certain new lines of business without the consent of Sciens Management and the Blackstone Funds.  There is no assurance that such consent could be obtained.

 

Any integration is expected to be complex, time-consuming and expensive and may harm the newly-consolidated company’s business, financial condition and results of operations.

 

We license the Colt name and trademarks from an entity we do not control.

 

We license the Colt trademarks and service marks from New Colt.  There are events that are outside of our control that pose a risk to our rights under the license agreement, including the bankruptcy of New Colt or the licensing of the trademarks and service marks to manufacturers that tarnish the quality, reputation and goodwill of these marks; actions or omissions by New Colt that abandon or forfeit some or all of its rights to these marks or that diminish the value of the marks; failure by New Colt to take appropriate action to deter infringement of these marks; and certain

 

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breaches by New Colt of the agreement governing our license to these marks.  Furthermore, the licensor can seek to terminate the license agreement if it believes we have breached our obligations under the license. In addition, prosecuting certain claims against third parties to protect the value of the Colt trademarks and services marks could depend, in part, on the participation of New Colt, and any delay or refusal to cooperate in such dispute could prejudice our business interests or rights.  Impairment of the value of the Colt trademarks and service marks, or the loss of our right to use them under the license agreement, would negatively affect our business.

 

Our U.S. and Canadian Government contracts are generally multi-year contracts that are funded by government appropriations annually.  A reduction in the defense budget of our government customers would have a material adverse effect on our business.

 

Our primary contracts with the U.S. Government are IDIQ contracts under which the customer places orders at its discretion.  Although these contracts generally have a four- or five-year term, they are funded annually by government appropriations.  Furthermore, our primary contracts with the Canadian Government are funded annually by Canadian Government appropriations.  Agreements with other foreign governments may also have similar conditions or may otherwise be dependent on initial or continued funding by such governments.  Accordingly, our net sales from year to year with respect to such customers are dependent on government appropriations and subject to uncertainty.  The U.S. Government’s ability to place orders under our most recent IDIQ contract for the M4 carbine expired on December 31, 2010.

 

The U.S. or Canadian Government, or a foreign government, may decide to reduce government defense spending in the programs in which we participate.  Sovereign budget deficits are likely to put long-term pressure on defense budgets in many of the European countries to which we sell our products. There can be no assurances that the amount spent on defense by countries to which we sell our products will be maintained or that individual defense agencies will allocate a percentage of their budget for the purchase of small arms. The loss of, or significant reduction in, government funding, for any program in which we participate, could have a material adverse effect on our sales and earnings.

 

We may not receive the full amount of orders authorized under indefinite delivery, indefinite quantity contracts.

 

Our contracts with the U.S. Government are ordinarily IDIQ contracts under which the U.S. Government may order up to a maximum quantity specified in the contract but is only obligated to order a minimum quantity.  We may incur capital or other expenses in order to be prepared to manufacture the maximum quantity that may not be fully recouped if the U.S. Government orders a smaller amount.  The U.S. Government may order less than the maximum quantity for any number of reasons, including a decision to purchase the same product from others despite the existence of an IDIQ contract.  Our failure to realize anticipated revenues from IDIQ contracts could negatively affect the results of our operations.

 

Our dependence on large government customers, including foreign governments, could result in significant fluctuations in our period-to-period performance.

 

Our operating results and cash flow are materially dependent upon the timing of securing government contracts and manufacturing and delivering products according to our customers’ timetables.  Uncertainty and volatility in the timing of orders and the tendency of these orders to be proportionately large in value is likely to continue to affect our net sales.  We do not recognize sales until delivery of the product or service has occurred and title and risk of loss have passed to the customer, which may be in a non-U.S. location.  This may extend the period of time during which we carry inventory and may result in an uneven distribution of net sales from these contracts between periods.  As a result, our period-to-period performance may fluctuate significantly, and you should not consider our performance during any particular period as indicative of longer-term results.

 

In addition, we are subject to business risks specific to companies engaged in supplying defense-related equipment and services to the U.S. Government and other governments.  These risks include the ability of the U.S. Government and other government counterparties to suspend or permanently prevent us from receiving new contracts or from extending existing contracts based on violations or suspected violations of procurement laws or regulations, terminate our existing contracts or not purchase the full agreed-upon number of small arms weapons systems or other products to be delivered by us.

 

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Government contracts are subject to competitive bidding, and bidding for such contracts may require us to incur additional costs.

 

We obtain a significant portion of our U.S. Government and other government contracts through competitive bidding.  We will not win all of the contracts for which we compete and, even when we do, contracts awarded to us may not result in a profit.  We are also subject to risks associated with the substantial expense, time and effort required to prepare bids and proposals for competitively awarded contracts that may not be awarded to us.  In addition, our customers may require terms and conditions that require us to reduce our price or provide more favorable terms if we provide a better price or terms under any other contract for the same product.  Such “most favored nation” clauses could restrict our ability to profitably compete for government and other contracts.

 

In order for us to sell our products overseas, we are required to obtain certain licenses or authorizations, which we may not be able to receive or retain.

 

Export licenses are required for us to export our products and services from the United States and Canada and issuance of an export license lies within the discretion of the issuing government.  In the United States, substantially all of our export licenses are processed and issued by the Directorate of Defense Trade Controls (“DDTC”) within the U.S. Department of State.  In the case of large transactions, DDTC is required to notify Congress before it issues an export license.  Congress may take action to block the proposed sale.  As a result, we may not be able to obtain export licenses or to complete profitable contracts due to domestic political or other reasons that are outside our control.  We cannot be sure, therefore, of our ability to obtain the governmental authorizations required to export our products.  Furthermore, our export licenses, once obtained, may be terminated or suspended by the U.S. or Canadian Government at any time.  Failure to receive required licenses or authorizations or any termination or suspension of our export privileges could have a material adverse effect on our financial condition, results of operations and cash flow.

 

Labor disruptions by our employees could adversely affect our business.

 

The United Automobile, Aerospace & Agricultural Implement Workers of America (“Union”) represents our West Hartford workforce pursuant to a collective bargaining agreement that expires on March 31, 2014.  Failure to reach agreement with the Union on the terms of a new collective bargaining agreement upon the expiration of the current agreement could lead to a strike or lockout, either of which would adversely affect our operations.

 

The terms of our collective bargaining agreement limit our flexibility in various labor matters including the ability to quickly change our staffing levels in response to business needs or to make changes to our employee benefits in order to reduce our costs. As a result, our labor costs may be higher than those of our competitors, which could place us at a disadvantage when bidding for government contracts or pricing our products in the commercial market.

 

Additionally, the workforce of Colt’s Manufacturing shares space with us at our West Hartford manufacturing facility, and is subject to the same Union collective bargaining agreement as our West Hartford employees. Positions taken by Colt’s Manufacturing with respect to matters covered by the collective bargaining agreement could adversely affect our ability to enforce the collective bargaining agreement and could adversely affect our operations.

 

Our government contracts are subject to audit and our business could suffer as a result of a negative audit by government agencies.

 

As a U.S. and Canadian Government contractor, we are subject to financial audits and other reviews by the U.S. and Canadian Governments of our costs, performance, accounting and other business practices relating to certain of our significant U.S. and Canadian Government contracts.  We are audited and reviewed on a continual basis.  Based on the results of their audits, the U.S. and Canadian Governments may challenge the prices we have negotiated for our products, our procurement practices and other aspects of our business practices.  Although adjustments arising from government audits and reviews have not caused a material decline in our results of operations in the past, future audits and reviews may have such effects.  In addition, under U.S. and Canadian Government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of our research and development costs, and some marketing expenses may not be reimbursable or allowed in our negotiation of fixed-price contracts.  Further, as a U.S. and Canadian Government contractor, we are subject to a

 

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higher risk of investigations, criminal prosecution, civil fraud, whistleblower lawsuits and other legal actions and liabilities than purely private sector companies, the results of which could cause our results of operations to suffer.

 

As a U.S. and Canadian Government contractor, we are subject to a number of procurement rules and regulations.

 

We must comply with and are affected by laws and regulations relating to the award, administration, and performance of our U.S. and Canadian Government contracts.  Government contract laws and regulations affect how we do business with our customers and vendors and, in some instances, impose added costs on our business.  In many instances, we are required to self-report to the responsible agency if we become aware of a violation of applicable regulations.  In addition, we have been, and expect to continue to be, subjected to audits and investigations by government agencies regarding our compliance with applicable regulations.  A violation of specific laws and regulations could result in the imposition of fines and penalties or the termination of our contracts or debarment from bidding on future contracts.  These fines and penalties could be imposed for failing to follow procurement integrity and bidding rules, employing improper billing practices or otherwise failing to follow cost accounting standards, receiving or paying kickbacks, filing false claims, or failing to comply with other applicable procurement regulations.  Additionally, the failure to comply with the terms of our government contracts also could harm our business reputation.  It also could result in payments to us being withheld.  If we violate specific laws and regulations, it could result in the imposition of fines and penalties or the termination of our contracts or debarment from bidding on contracts, which could have a material adverse effect on our net sales and results of operations.

 

Our contracts with foreign governments often contain ethics and other requirements that subject us to some of the same risks. Also, we and our independent sales representatives are required to comply with numerous laws and regulations, including the U.S. Foreign Corrupt Practices Act and similar anti-bribery laws in other jurisdictions. By contract or law in certain foreign jurisdictions, the actions of our representatives can subject us to legal risk or liability. Violation of contractual terms with our customers, or applicable local law in foreign jurisdictions, could interfere with our ability to perform or collect payment under our contracts.

 

Our government and other sales contracts contain termination provisions such that they can be cancelled at any time at the government’s sole discretion.

 

U.S. Government and other government counterparties may terminate contracts with us either for their convenience or if we default by failing to perform.  Termination for convenience provisions generally would enable us to recover only our costs incurred or committed, and settlement expenses and profit on the work completed, prior to termination.  Termination for default provisions do not permit these recoveries and make us liable for excess costs incurred by the U.S. Government or other government counterparties in procuring undelivered items from another source.  In addition, a termination arising out of our default could expose us to liability and have a material adverse effect on our ability to compete for future contracts and orders.

 

We may lose money on our fixed unit price contracts, and our contract prices may be adjusted to reflect price reductions or discounts that are requested by our customers.

 

We provide our products and services primarily through fixed unit price contracts.  In a fixed unit price contract, we provide our products and services at a predetermined price, regardless of the costs we incur.  Accordingly, we must fully absorb any increases in our costs that occur during the life of the contract, notwithstanding the difficulty of estimating all of the costs we will incur in performing these contracts and in projecting the ultimate level of sales that we may achieve.  Our failure to estimate costs accurately, including as a result of price volatility relating to raw materials, or to anticipate technical problems of a fixed unit price contract may reduce our profitability or cause a loss.  From time to time, we have also accommodated our customers’ requests for price reductions or discounts in the past, and customers may continue to make such requests in the future.

 

Some of our contracts with foreign governments are or will be subject to the fulfillment of offset commitments or industrial cooperation agreements that could  impose additional costs on us and that we might not be able to timely satisfy, possibly resulting in the assessment of penalties or even debarment from doing further business with that government.

 

Some countries that we are or are planning on doing business with impose offset purchase commitments, also known as industrial cooperation commitments, in return for purchasing our products and services. These

 

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commitments vary from country to country and generally require us to commit to make direct or indirect purchases, or investments in the local economy. The gross amount of the offset purchase commitment arising from a sales contract is typically a function of the value of the contract.  Failure to satisfy offset purchase commitments can result in penalties or blacklisting against awards of future contracts.  We have paid penalties that were assessed by foreign governments and incurred transaction costs to trade credits to satisfy offset purchase commitments in the past.  We may be subject to future penalties or transaction costs or even disbarment from doing business with a government.

 

Our remaining gross offset purchase commitment is the total amount of offset purchase commitments reduced for claims submitted and approved by the governing agencies.  At December 31, 2012 and 2011, our remaining gross offset purchase commitments totaled $68.2 million and $58.5 million respectively. We have evaluated our settlement of our remaining gross offset purchase commitments through probable planned spending and other probable satisfaction plans to determine our net offset purchase commitment.  We have accrued $1.8 million and $1.6 million as of December 31, 2012 and 2011, respectively, based on our estimated cost of settling the remaining net offset purchase commitment. We may incur costs to settle our offset purchase commitments that are in excess of the amounts accrued, which could have a material adverse effect on our earnings.

 

We face risks associated with international currency exchange.

 

Our Canadian subsidiary conducts most of its business in either the Canadian dollar or the Euro. Fluctuations in those foreign currency exchange rates could affect the sale of our products or the cost of goods and operating margins and could result in exchange losses.  In addition, currency devaluation could result in losses on the deposits that we hold in those currencies. When our Canadian operating results are translated into U.S. dollars, fluctuations in those currencies relative to the U.S. dollar affect our operating results. We do not hedge our foreign currency exposure. We cannot predict the impact of future exchange rate fluctuations on our operating results.

 

We intend to incur additional costs to develop new products and variations that diversify our product portfolio, and we may not be able to recover these additional costs.

 

The development of additional products and product variations is speculative and may require additional and, in some cases, significant expenditures for marketing, research, development and manufacturing equipment.  The new products or product variations that we introduce may not be successful, or they may not generate an amount of net sales that is sufficient to fully recover the additional costs incurred for their development.  In addition, we may not successfully develop new products or product variations that are superior to products offered by other companies.

 

Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.

 

Despite our efforts to protect our proprietary technology, unauthorized persons may be able to copy, reverse engineer or otherwise use some of our proprietary technology.  It also is possible that others will develop and market similar or better technology to compete with us.  Furthermore, existing intellectual property laws may afford only limited protection, and the laws of certain countries do not protect proprietary technology as well as United States law.  For these reasons, we may have difficulty protecting our proprietary technology against unauthorized copying or use, and the efforts we have taken or may take to protect our proprietary rights may not be sufficient or effective.  Significant impairment of our intellectual property rights could harm our business or our ability to compete.  Protecting our intellectual property rights is costly and time consuming and we may not prevail.  Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand.

 

If we lose key management or are unable to attract and retain qualified individuals required for our business, our operating results and growth may suffer.

 

Our ability to operate our business is dependent on our ability to hire and retain qualified senior management.  Our senior management is intimately familiar with our small arms weapons systems and those offered by our competitors, as well as the situations in which small arms weapons systems are utilized in combat and law enforcement activities.  Our senior management also brings an array of other important talents and experience to the Company, including managerial, financial, governmental contracts, sales, legal and compliance.  We believe their backgrounds, experience and knowledge gives us expertise that is important to our success.  Losing the services of these or other members of our management team, particularly if they depart the Company to join a competitor’s

 

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business, could harm our business and expansion efforts.  The Company’s success also is dependent on its ability to hire and retain technically skilled workers.  Competition for some qualified employees, such as engineering professionals, is intense and may become even more competitive in the future.  If we are unable to attract and retain qualified employees, our operating results, growth and ability to obtain future contracts could suffer.

 

Misconduct by employees or agents could harm us and is difficult to detect and deter.

 

Our employees or representatives may engage in misconduct, fraud or other improper activities including engaging in violations of the U.S. Arms Export Control Act or Foreign Corrupt Practices Act or numerous other state and federal laws and regulations, as well as the corresponding laws and regulations in the foreign jurisdictions into which we sell products that could have adverse consequences on our prospects and results of operations,.  Misconduct by employees or agents, including foreign sales representatives, could include the export of defense articles or technical data without an export license, the payment of bribes in order to obtain business, failure to comply with applicable U.S. or Canadian Government or other foreign government procurement regulations, violation of government requirements concerning the protection of classified information and misappropriation of government or third-party property and information.  It is not always possible to deter misconduct by agents and employees and the precautions we take to detect and prevent this activity may not be effective in all cases. The occurrence of any such activity could result in our suspension or debarment from contracting with the government procurement agency, as well as the imposition of fines and penalties, which would cause material harm to our business.

 

Failure to comply with applicable firearms laws and regulations in the U.S. and Canada could have a material adverse effect on our business.

 

As a firearms manufacturer doing business in the U.S. and Canada, we are subject to the National Firearms Act and the Gun Control Act in the U.S. and the Firearms Act in Canada, together with other federal, state or provincial, and local laws and regulations that pertain to the manufacture, sale and distribution of firearms in and from the U.S. and Canada.  In the U.S., we are issued a Federal Firearms License by, and pay Special Occupational Taxes, to the Bureau of Alcohol, Tobacco, Firearms and Explosives of the U.S. Department of Justice to be able to manufacture firearms and destructive devices in the U.S. Similarly, in Canada, we are issued a Business Firearms License by the Chief Provincial Firearms Officer of Ontario, to enable us to manufacture firearms and destructive devices in Canada.  These federal agencies also require the serialization of receivers or frames of our firearm products and recordkeeping of our production and sales.  Our places of business are subject to compliance inspections by these agencies.  Compliance failures, which constitute violations of law and regulation, could result in the assessment of fines and penalties by these agencies, including license revocation.  Any curtailment of our privileges to manufacture, sell, or distribute our products could have a material adverse effect on our business.

 

If we fail to maintain certain quality assurance standards, we may lose existing key customers and have difficulty attracting new customers.

 

Our U.S. and Canadian production facilities are both ISO 9001:2008 certified.  ISO 9001 is an international standard certification granted by the International Organization of Standardization (“ISO”) that confirms that a supplier can consistently provide good quality products and services.  Some of our government contracts require that we maintain ISO certification. A failure to maintain our ISO certification may cause us to lose existing customers or have difficulty attracting new customers, which could have a material adverse effect on our business, financial condition and results of operations.

 

Third parties may assert that we are infringing their intellectual property rights.

 

Although we do not believe our business activities infringe upon the rights of others, nor are we aware of any pending or contemplated actions to such effect, it is possible that one or more of our products infringe, or any of our products in development will infringe, upon the intellectual property rights of others.  We may also be subject to claims of alleged infringement of intellectual property rights asserted by third parties whose products or services we use or combine with our own intellectual property and for which we may have no right to intellectual property indemnification.  Our competitors may also assert that our products infringe intellectual property rights held by them.  Moreover, as the number of competitors in our markets grows, the possibility of an intellectual property infringement claim against us may increase.  In addition, because patent applications are maintained under conditions of confidentiality and can take many years to issue, our products may potentially infringe upon patent

 

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applications that are currently pending of which we are unaware and which may later result in issued patents.  If that were to occur and we were not successful in obtaining a license or redesigning our products, we could be subject to litigation.

 

Regardless of the merits of any infringement claims, intellectual property litigation can be time-consuming and costly.  Determining whether a product infringes a patent involves complex legal and factual issues that may require the determination of a court of law.  An adverse finding by a court of law may require us to pay substantial damages or prohibit us from using technologies essential to our products covered by third-party intellectual property, or we may be required to enter into royalty or licensing agreements that may not be available on terms acceptable to us, if at all.  Inability to use technologies or processes essential to our products could have a material adverse effect on our financial condition, results of operations and cash flow.

 

We may incur higher employee medical costs in the future.

 

Our employee medical plans are self-insured. As of December 31, 2012, the average age of the production employees working in our West Hartford, CT facility is 53 years. Approximately 20% of those employees are age 65 or over. The age of our workforce and the level of benefits that we offer, which are subject to our collective bargaining agreement, could result in higher than anticipated future medical claims. We have stop loss coverage in place for catastrophic events, but the aggregate impact may have an effect on our profitability.

 

We may be unable to realize expected benefits from our cost reduction efforts and our profitability may be hurt or our business otherwise might be adversely affected.

 

In order to operate more efficiently and control costs, we have historically and continue to evaluate various cost reduction initiatives, including workforce reductions. These plans are intended to generate operating expense savings through direct and indirect overhead expense reductions as well as other savings. We may undertake further workforce reductions or cost saving actions in the future. If we do not successfully manage these activities, the expected efficiencies and benefits might be delayed or not realized, and our operations and business could be disrupted. Risks associated with these actions and other workforce management issues include delays in implementation of anticipated workforce reductions, additional unexpected costs, adverse effects on employee morale and the failure to meet operational targets due to the loss of employees, any of which may impair our ability to achieve anticipated cost reductions or may otherwise harm our business, which could have a material adverse effect on our cash flows, competitive position, financial condition or results of operations.

 

Significant risks are inherent in the day-to-day operations in our business.

 

The day-to-day activities of our business involve the operation of machinery and other operating hazards, including worker exposure to lead and other hazardous substances.  As a result, our operations can cause personal injury or loss of life, severe damage to and destruction of property and equipment, and interruption of our business.  In addition, our weapon systems are designed to kill and therefore can cause accidental damage, injury or death or can potentially be used in incidents of workplace violence.

 

We could be named as a defendant in a lawsuit asserting substantial claims upon the occurrence of any of these events.  Although we maintain insurance protection in amounts we consider to be adequate, this insurance could be insufficient in coverage and may not be effective under all circumstances or against all hazards to which we may be subject.  If we are not fully insured against a successful claim, there could be a material adverse effect on our financial condition and result of operations.

 

Our West Hartford, Connecticut facility is inspected from time to time by the U.S. Occupational Safety and Health Administration and similar agencies.  We have been cited for violation of U.S. occupational safety and health regulations in the past and could be cited again in the future.  A violation of these regulations can result in substantial fines and penalties.  We are subject to similar regulations at our Canadian manufacturing facility.

 

Environmental laws and regulations may subject us to significant costs and liabilities.

 

We are subject to various U.S. and Canadian environmental, health and safety laws and regulations, including those related to the discharge of hazardous materials into the air, water or soil and the generation, storage, treatment, handling, transportation, disposal, investigation and remediation of hazardous materials.  Certain of these laws and regulations require our facilities to obtain and operate under permits or licenses that are subject to periodic renewal

 

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or modification.  These laws, regulations or permits can require the installation of pollution control equipment or operational changes to limit actual or potential impacts to the environment.  A violation of these laws, regulations or permit conditions can result in substantial fines or penalties.

 

Certain environmental laws impose strict as well as joint and several liability for the investigation and remediation of spills and releases of hazardous materials and damage to natural resources, without regard to negligence or fault on the part of the person being held responsible.  In addition, certain laws require and we have incurred costs for, the investigation and remediation of contamination upon the occurrence of certain property transfers or corporate transactions.  We are potentially liable under these and other environmental laws and regulations for the investigation and remediation of contamination at properties we currently or have formerly owned, operated or leased and at off-site locations where we may be alleged to have sent hazardous materials for treatment, storage or disposal.  We may also be subject to related claims by private parties alleging property damage or personal injury as a result of exposure to hazardous materials at or in the vicinity of these properties.  Environmental litigation or remediation, new laws and regulations, stricter or more vigorous enforcement of existing laws and regulations, the discovery of unknown contamination or the imposition of new or more stringent clean-up requirements may require us to incur substantial costs in the future.  As such, we may incur material costs or liabilities in the future.

 

We may have to utilize significant cash to meet our unfunded pension obligations, and postretirement health care liabilities and these obligations are subject to increase.

 

Our employees at our West Hartford facility participate in our defined benefit pension plans.  Under the terms of our current collective bargaining agreement, the accrual of benefits for employees participating in our bargaining unit pension plan was frozen effective December 31, 2012. We also have a salaried pension plan. The accrual of benefits for employees participating in the salaried plan was frozen effective December 31, 2008.  At December 31, 2012, our aggregate unfunded pension liability totaled $6.8 million.  Declines in interest rates or the market values of the securities held by the plans, or other adverse changes, could materially increase the underfunded status of our plans and affect the level and timing of required cash contributions.  To the extent we use cash to reduce these unfunded liabilities, the amount of cash available for our working capital needs would be reduced.  Under the Employee Retirement Income Security Act of 1974, as amended, or ERISA, the Pension Benefit Guaranty Corporation, or PBGC, has the authority to terminate an underfunded tax-qualified pension plan under limited circumstances.  In the event our tax-qualified pension plans are terminated by the PBGC, we could be liable to the PBGC for the underfunded amount.

 

We also have a postretirement health plan for our union employees.  The postretirement health plan is unfunded.  We derive postretirement benefit expense from an actuarial calculation based on the provisions of the plan and a number of assumptions provided by us including information about employee demographics, retirement age, turnover, mortality, discount rate, amount and timing of claims, and a health care inflation trend rate. In connection with our collective bargaining agreement, we have capped certain retirees to approximately $250 (not in thousands) per employee per month.  The unfunded post-retirement health care benefit obligation was $14.1 million at December 31, 2012.

 

Our cash is highly concentrated with one financial institution.

 

We have a concentration of cash in accounts with a single financial institution. Our holdings in this institution significantly exceed the insured limits of the Federal Deposit Insurance Corporation. Although we believe that the risk of loss associated with out uninsured deposit accounts is low given the financial strength and reputation of our depository institution, we could suffer losses with respect to the uninsured balances if the depository institution failed and the institution’s assets were insufficient to cover its deposits and/or the Federal government did not take actions to support deposits in excess of existing FDIC insured limits. Any such losses could have a material adverse effect on our liquidity, financial condition and results of operations.

 

We have a substantial amount of indebtedness, which could have a material adverse effect on our financial health and our ability to obtain financing in the future and to react to changes in our business.

 

We now have, and will continue to have, a substantial amount of indebtedness, which requires significant interest payments.  As of December 31, 2012, we had approximately $247.6 million of debt outstanding and we reported a total deficit in our Consolidated Balance Sheets of $151.3 million.

 

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Our significant amount of indebtedness could have important consequences to holders of the notes.  For example, it could:

 

·                       make it more difficult for us to pay interest and principal on our notes, as payments become due, especially during general negative economic and market industry conditions because if our net sales decrease due to general economic or industry conditions, we may not have sufficient cash flow from operations to make our scheduled debt payments or to refinance our indebtedness;

 

·                       increase our vulnerability to adverse economic, regulatory and general industry conditions;

 

·                       require us to dedicate a substantial portion of our cash flow from operations to payments on our debt, which would reduce the availability of our cash flow from operations to fund working capital, capital expenditures, acquisitions or other general corporate purposes;

 

·                       limit our flexibility in planning for, or reacting to, changes in our business and industry in which we operate and, consequently, place us at a competitive disadvantage to our competitors with less debt;

 

·                       limit our ability to obtain additional debt or equity financing, particularly in the current economic environment; and

 

·                       increase our cost of borrowing.

 

Despite our current levels of debt, we may still incur substantially more debt.  This could further exacerbate the risks described above.

 

We and our subsidiaries may be able to incur substantial additional indebtedness in the future.  The credit agreement for our senior secured revolving loan (the “Credit Agreement”) provides up to $50.0 million of borrowing capacity, of which none had been borrowed as of December 31, 2012. Borrowings under the Credit Agreement are effectively senior to the notes to the extent of the value of the assets securing the indebtedness. We may also incur other additional indebtedness that ranks equally with the notes and the holders of that debt will be entitled to share ratably in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of our business.  This may have the effect of reducing the amount of proceeds paid to holders of our notes.

 

Although covenants under the indenture governing the notes and the Credit Agreement limit our ability to incur certain additional indebtedness, these restrictions are subject to a number of qualifications and exceptions, and the indebtedness incurred in compliance with these restrictions could be substantial.  If we add new debt to our current debt levels, the related risks that we now face could intensify, making it less likely that we will be able to fulfill our obligations to holders of the notes.

 

We face the risk of breaching covenants under the Credit Agreement and other future financings and may not be able to comply with certain covenants in the indenture covering the notes.

 

The Credit Agreement contains a financial covenant that is applicable upon an event of default or a lack of availability under the borrowing base formula. This covenant pertains to our fixed charge coverage ratio. Our ability to meet the financial or other covenants can be affected by failure of our business to generate sufficient cash flow and by various risks, uncertainties and events beyond our control, and we cannot provide assurance that we will meet these tests. Failure to comply with any of the covenants in the Credit Agreement or any future financing agreement could result in a default under those agreements and other agreements containing cross-default provisions, including the indenture governing the notes.

 

Upon the occurrence of an event of default under the Credit Agreement, all amounts outstanding can be declared immediately due and payable and all commitments to extend further credit may be terminated. Such acceleration of repayment under the Credit Agreement could result in an event of default under the indenture governing the notes. Under these circumstances, we might not have sufficient funds or other resources to satisfy all of our obligations, including our ability to repay borrowings under the Credit Agreement and our obligations under the notes.

 

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We may not be able to generate enough cash to service our indebtedness and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful.

 

Our ability to make scheduled payments on, or to refinance, our debt and to fund planned capital expenditures and pursue our acquisition strategy will depend on our ability to generate cash.  This is subject, in part, to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.  Accordingly, our business may not generate sufficient cash flows from operations to enable us to pay our indebtedness, including the notes, or to fund our other liquidity needs.  In addition, we will be permitted to make certain distributions to our members, including distributions in amounts based on their allocated taxable income and gains.  Any such payments may reduce our ability to make payments on our debt, including the notes.

 

If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital or restructure or refinance our indebtedness, including the notes.  We may not be able to take any of these actions, these actions may not be successful enough to permit us to meet our scheduled debt service obligations or these actions may not be permitted under the terms of our existing or future debt agreements, including the Credit Agreement or the indenture that will govern the notes.  In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations.  The Credit Agreement and the indenture that govern the notes restrict our ability to dispose of assets and use the proceeds from the disposition.  We may not be able to consummate those dispositions or to obtain the proceeds that we could realize from them, and these proceeds may not be adequate to meet any debt service obligations then due.

 

If we cannot make scheduled payments on our debt, we will be in default and, as a result:

 

·        our debt holders could declare all outstanding principal and interest to be due and payable;

 

·        the lenders under our Credit Agreement could terminate their commitments to lend us money and foreclose against the assets securing their borrowings; and

 

·        we could be forced into bankruptcy or liquidation, which could result in holders of our notes losing their investment in our notes.

 

Our ability to bid for large contracts may depend on our ability to obtain performance guarantees from financial institutions.

 

In the normal course of our business we may be asked to provide performance guarantees to our customers in relation to our contracts. Some customers may require that our performance guarantees be issued by a financial institution in the form of a letter of credit, surety bond or other financial guarantee. A deterioration of our credit rating and financial position may prevent us from obtaining such guarantees from financial institutions or make the process more difficult or expensive. If we are not able to obtain performance guarantees or if such performance guarantees were to become expensive, we could be prevented from bidding on or obtaining certain contracts or our profit margins with respect to those contracts could be adversely affected, which could in turn have a material adverse effect on our revenue, financial condition and results of operations.

 

We may not be able to finance a change of control offer required by the indenture governing our outstanding notes.

 

If we were to experience specific kinds of change of control events, we are required to offer to purchase all of the notes then outstanding at 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase.  If a change of control were to occur, we may not have sufficient funds to purchase the notes.  In fact, we expect that we would require third-party debt or equity financing to purchase all of such notes, but we may not be able to obtain that financing on favorable terms or at all.  Further, our ability to repurchase the notes may be limited by law.

 

Any of our existing and future senior secured indebtedness, including our Credit Agreement, would likely restrict our ability to repurchase the notes, even when we are required to do so by the indenture in connection with a change of control.  A change of control could therefore result in a default under such senior secured indebtedness and could

 

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cause the acceleration of our debt.  The inability to repay such debt, if accelerated, and to purchase all of the tendered notes, would constitute an event of default under the indenture.

 

Holders of the notes may not be able to determine when a change of control giving rise to their right to have the notes repurchased has occurred following a sale that potentially constitutes a sale of “substantially all” of our assets.

 

The definition of change of control in the indenture governing the notes includes a phrase relating to the sale of “all or substantially all” of our assets.  There is no precise established definition of the phrase “substantially all” under applicable law.  Accordingly, the ability of a holder of notes to require us to repurchase its notes as a result of a sale of less than all of our assets to another person may be uncertain.

 

Holders of the notes should not expect Colt Finance Corp. to participate in making payments on the notes.

 

Colt Finance Corp. is a wholly owned subsidiary of Colt Defense LLC that was incorporated to accommodate the issuance of the Senior Notes by Colt Defense LLC. Colt Finance Corp. will not have any operations or assets of any kind and will not have any revenue other than as may be incidental to its activities as a co-issuer of the Senior Notes.  Holders of the notes should not expect Colt Finance Corp. to participate in servicing any of the obligations on the notes.

 

Item 1B.                Unresolved Staff Comments

 

Not applicable.

 

Item 2.                   Properties

 

Our principal properties include the facility housing our corporate headquarters in West Hartford, Connecticut and our facility in Kitchener, Ontario, Canada.  The West Hartford location is also our primary engineering, manufacturing and research and development facility.  We lease this approximately 310,000 square foot facility pursuant to a lease expiring October 25, 2015.  For additional information about this lease, see “Certain Relationships and Related Party Transactions” in Item 13 of this Form 10-K.  We own our facility in Kitchener, Ontario, Canada. It is approximately 48,000 square feet in size and is utilized for manufacturing, engineering and research and development.

 

We believe that our properties, both owned and leased, are in good condition and are suitable and adequate for our operations, and our manufacturing facilities have the capacity to meet existing and planned production requirements.

 

Item 3.                   Legal Proceedings

 

We are involved in various legal claims and disputes in the ordinary course of our business.  As such, the Company accrues for such liabilities when it is both (i) probable that a loss has occurred and (ii) the amount of the loss can be reasonably estimated in accordance with ASC 450, Contingencies.  The Company evaluates, on a quarterly basis, developments affecting various legal claims and disputes that could cause an increase or decrease in the amount of the liability that has been previously accrued.  During the first quarter of 2012, we accrued $0.7 million related to a potential settlement of a dispute.  Subsequently, we settled the matter for $0.6 million. There is no litigation pending that is likely to substantially negatively affect our financial condition, results of operations and cash flows.

 

As a U.S. and Canadian government contractor, we are subject to numerous regulatory and contractual requirements pertaining to nearly every aspect of our operations, including purchasing, accounting, employment, and subcontracting among others.  Many of the agencies with regulatory or contractual authority over particular aspects of our government contracting activities are permitted or required to audit our operations as part of their responsibilities.  As a result, we are routinely audited by U.S. and Canadian government agencies in the ordinary course of our business.  In addition, our government contracts, or the regulations that are incorporated into them, often require that we voluntarily report violations of law that come to our attention and it is our policy to do so whenever required.  There are no material proceedings pending in connection with our activities as a contractor to the U.S. and Canadian governments.

 

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As a company that manufactures and sells military and law enforcement products domestically and overseas, we are subject to numerous U.S., Canadian and foreign statutes and regulations, including in particular regulations administered by the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives, as well as the International Traffic in Arms Regulations and Foreign Corrupt Practices Act.  We employ attorneys and other individuals whose responsibilities include legal compliance to advise us on our compliance obligations on a continuous basis.  Those individuals attend external educational programs as required in order to stay current in the respective fields and they conduct internal training of relevant employees.  In addition, we have written policies in place in every area with respect to which a written policy is required or, in our view, appropriate.  There are no material proceedings pending with regard to our compliance with applicable statutes and regulations.

 

Item 4.                   Mine Safety Disclosures

 

Not applicable.

 

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PART II

 

Item 5.                                                         Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

There is no established trading market for our membership units. In addition, our membership units are subject to transfer restrictions pursuant to our operating agreement.  As of December 31, 2012, there were 132,174 membership units outstanding, which were held by 24 members.

 

During 2012, we made a $3.3 million distribution to our members. In addition, we made distributions to our members in 2011 and 2010 of $12.9 million and $5.0 million, respectively.  In 2013, we do not anticipate making a distribution to our members based on our 2012 results.

 

Our Credit Agreement and the indenture governing our Senior Notes contain covenants that limit our ability to pay dividends or other distributions.  For additional information about the covenants contained in our debt agreements, see “Note 5 Notes Payable and Long Term Debt” in Item 8 of this Form 10-K.

 

Item 6.                   Selected Financial Data

 

The following table sets forth our historical consolidated financial data as of and for the dates indicated.  The data as of and for the years ended December 31, 2012, 2011, 2010, 2009 and 2008 have been derived from our audited consolidated financial statements.  Our selected financial data should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”  and our Consolidated Financial Statements and the accompanying notes thereto included in Item 8, “Financial Statements and Supplementary Data,” which are included elsewhere in this Annual Report on Form 10-K.  All amounts are presented in thousands.

 

 

 

For the Year Ended December 31,

 

 

 

2012

 

2011 (b)

 

2010 (b)

 

2009 (b)

 

2008 (b)

 

Statement of operations data:

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

213,328

 

$

208,810

 

$

175,805

 

$

270,163

 

$

269,119

 

Operating income

 

18,557

 

32,503

 

18,478

 

63,861

 

70,380

 

Interest expense

 

24,579

 

24,010

 

24,598

 

18,845

 

19,266

 

(Loss) Income from continuing operations (a)

 

(7,055

)

4,988

 

(10,276

)

29,493

 

49,330

 

Net (loss) income attributable to Colt Defense LLC members

 

(7,055

)

4,988

 

(11,065

)

29,661

 

44,463

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance sheet data (at period ended):

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

42,373

 

$

38,236

 

$

61,444

 

$

72,705

 

$

29,248

 

Inventories

 

40,561

 

36,215

 

31,641

 

35,448

 

26,997

 

Property and equipment, net

 

22,134

 

22,589

 

21,741

 

17,919

 

13,736

 

Total assets

 

162,968

 

164,956

 

167,587

 

187,252

 

109,838

 

Total debt and capital lease obligations

 

247,573

 

248,334

 

249,215

 

250,058

 

195,100

 

Total deficit

 

(151,287

)

(142,834

)

(141,398

)

(110,818

)

(130,668

)

 


(a)                                 As a limited liability company, the Company is treated as a partnership for U.S. federal and state income tax reporting purposes and, therefore, is not subject to U.S. federal or state income taxes other than withholding tax on foreign royalties and interest.  The taxable income (loss) of the Company is reported to the members for inclusion in their individual tax returns.  Colt Canada files separate income tax returns in Canada.  Distributions to members equal to 45 percent of taxable income are made in any year in which U.S. taxable income is allocated to the Company’s members and to the extent the Company’s Governing Board determines that sufficient funds are available.

 

(b)                                 Certain amounts have been revised to correct prior period errors identified as follows: operating income, (loss) income from continuing operations and net (loss) income attributable to Colt Defense LLC members increased (decreased) by ($208) and $105 in 2011 and 2010, respectively, and total deficit decreased by $338, $229, $1,396 and $1,396 at December 31, 2011, 2010, 2009 and 2008, respectively.  For additional information about the revision, see “Note 2 Summary of Accounting Policies” in item 8 of this Form 10-K.

 

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Item 7.                         Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

2012 Highlights

 

Our 2012 net sales of $213.3 million represented a 2% increase from 2011.  Adjusted EBITDA from continuing operations (“Adjusted EBITDA”) decreased by 30% from $38.9 million to $27.0 million and net income decreased from net income of $5.0 million to a net loss of $7.1 million from 2011 to 2012 respectively.  In 2012, we experienced 254% growth in our LE/Commercial market. As a result, LE/Commercial sales, which tend to carry relatively lower margins, grew from 12% of net sales in 2011 to 42% of net sales in 2012. We experienced additional margin compression in 2012 as we began initial production on several new products, such as the M240, CM901 and the M45A1, as well as new variations of our existing products. As a result, our profitability did not grow proportionately with our sales. For additional information and a reconciliation of Adjusted EBITDA from continuing operations to (loss) income from continuing operations, see “Note 13 Segment Information” in Item 8 of this Form 10-K.

 

Business Overview

 

We are one of the world’s leading designers, developers and manufacturers of small arms weapons systems for individual soldiers and law enforcement personnel. We have supplied small arms weapons systems to more than 80 countries by expanding our portfolio of products and services to meet evolving military and law enforcement requirements around the world.  Our products have proven themselves under the most severe and varied battle conditions. We also modify our rifles and carbines for civilian use and sell them to Colt’s Manufacturing, which sells them into the U.S. commercial market.

 

We have been the U.S. military’s sole supplier of the M4 carbine, the U.S. Army’s standard issue rifle, the Canadian military’s exclusive supplier of the C8 carbine and C7 rifle and a supplier of small arms weapons systems to U.S., Canadian and international law enforcement agencies.  Furthermore, our development and sales of M4 carbines and the 50 years of sales of M16 rifles have resulted in a global installed base of more than 7 million M16/M4 small arms weapons systems.  Our expertise in designing and manufacturing small arms weapons systems enables us to integrate new technologies and features to upgrade our large installed base, develop international co-production opportunities and capitalize on our experience building to stringent military standards to make commercial rifles and carbines with exceptional reliability, performance and accuracy.

 

Industry Overview

 

We compete in the global market for small arms weapons systems designed for military, law enforcement and commercial use.  Our end customers include U.S. and foreign militaries, law enforcement and security agencies and domestic sporting and hunting enthusiasts. The funding for our proprietary military products is primarily linked to the spending trends of U.S., Canadian and other foreign militaries and national and border security agencies.  Efforts to reduce the U.S. federal budget deficit and the wind-down of military operations in Iraq and Afghanistan will likely result in flat to declining U.S. defense budgets for the near future. Austerity measures will also pressure the European defense market spending. At this point, it is unclear how extensive defense budget cuts will be or specifically how small arms weapons programs will be impacted by the cuts. International markets outside of Europe have not demonstrated the same budget constraints.

 

As a result of our continued emphasis on the law enforcement and commercial (“LE/Commercial”) markets, we have seen strong year-over-year sales growth into these markets. Law enforcement agencies at all levels of government (federal, state and municipal) are experiencing budgetary pressures, but Colt’s Manufacturing has seen continued strong demand in the commercial rifle market.

 

Company Outlook, Trends and Uncertainties

 

We believe the competitive and evolving nature of the small arms weapons systems industry provides both challenges to, and opportunities for, the continued growth of our business in both the global military and the commercial and law enforcement markets. Our outlook is driven by international military and U.S. commercial demand for rifles and carbines, with a relatively small, but stable, base of U.S. Government business. Rifle and carbine production rates for the international and commercial markets now approximate our historical peak production levels of the M4 for the U.S. Army. However, both of these markets have inherent risk factors.

 

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The U.S. commercial market for modern sporting rifles (“MSR’s”) has continued to grow and is now a significant part of our overall business.  This market provides growth opportunities for the company as well as regulatory uncertainties as the potential imposition of new “gun control” laws and regulations at the state and federal level have become a part of the national dialogue.  International business tends to have attractive margins but is slow to develop and the timing is difficult to predict.  U.S. Government procurement of the M4 carbine in 2013 and beyond, including spare parts, will be on a competitive basis and budget pressures could limit U.S. Government demand for our products.  Efforts to determine if a new carbine can offer significant improvement over the M4 continue within the U.S. Army, but budgetary factors will be the dominant influence on U.S. purchases of any carbine.

 

Commercial market legislation, international sales volumes and timing, and the U.S. Government’s purchasing decisions will influence our revenues and cash flows. As a result of the competitive and evolving nature of this industry, our revenue growth, profitability and backlog have been or may be negatively impacted, or we may be impacted in multiple ways, including but not limited to the following:

 

·                       if we lose one or more of our top customers or if one or more of these customers significantly decreases orders for our products;

 

·                       if the U.S. military selects other small arms manufacturers to supply the M4 carbine for use by U.S. military personnel or we are not able to continue to successfully compete for international sales;

 

·                       if commercial demand, which tends to be volatile, ebbs or if new federal and state laws and regulations are enacted that limit our ability to continue selling our products we could experience a significant decline in commercial product orders and sales;

 

·                       general economic and political conditions in the foreign markets where we currently, or may seek to, do business may impact our international sales, as such conditions may cause customers to delay placing orders or to deploy capital to other governmental priorities;

 

·                       we may not be able to identify businesses that we can acquire on acceptable terms; we may not be able to obtain necessary financing or may face risks due to indebtedness; and our acquisition strategy may incur significant costs or expose us to numerous risks inherent in the acquired business’s operations; and

 

In addition to the above, we face additional sources of uncertainty regarding our sales into the U.S. commercial market.  All of our sales into the domestic commercial market are currently made to Colt’s Manufacturing, which sells them to commercial distributors and retailers.  These sales occur under a written Memorandum of Understanding that by its terms expires in April 2013.  Termination or non-renewal of the Memorandum of Understanding would likely end our ability to sell Colt-branded rifles and carbines into the commercial market because we are not licensed to use the Colt name and trademarks in connection with sales to the commercial market.  There is no assurance that we will be able to sell rifles and carbines into the commercial market under a different brand name if the Memorandum of Understanding with Colt’s Manufacturing is not renewed or extended.  Our limited liability company agreement prohibits us from selling rifles and carbines directly to the commercial market without the consent of our sponsors, Sciens Management and the Blackstone Funds.  There is no assurance that such consent could be obtained.  If we are unable to sell MSR’s into the U.S. commercial market because our Memorandum of Understanding terminates or federal and state regulations change, then our access to short- and long-term capital could be adversely affected.

 

Other factors, including those that may impact our prospective industry trends and uncertainties, that are described in “Risk Factors” in Item 1A of this Form 10-K.

 

Backlog

 

Any of the foregoing may negatively impact our backlog, which we view as a key indicator of our future performance.  Our backlog decreased from $176.7 million at December 31, 2011 to $165.9 million at December 31, 2012 due in part to shipments on a large, long-term, international order. In addition, as the commercial component of our business continues to grow, backlog becomes less of an indicator of future sales volume. The decline in international backlog was partially offset by year over year increases in both our U.S. Government and

 

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LE/Commercial backlog. Our backlog, when applicable, includes only orders for which funding is authorized by the customer.  Backlog does not include the portion of any IDIQ contract for which a specific, contractually binding purchase order has not been received, or unexercised options associated with existing firm contracts.  Because the value of these arrangements is subject to the customer’s future exercise of an indeterminate quantity of delivery orders, we recognize these contracts in backlog only when specific, contractually binding purchase orders are received.

 

Sales

 

A significant portion of our sales are derived from a limited number of customers. Our top ten customers represented approximately 90% of our net sales for the year ended December 31, 2012.  For the year ending December 31, 2013, we expect to continue to derive a significant portion of our business from sales to a relatively small number of customers.  If we were to lose one or more of our top customers, or if one or more of these customers significantly decreased orders for our products and we were not able to replace these sales, our business would be materially and adversely affected.

 

As a result of the expiration of our M4 IDIQ contract in December 2010 and U.S. Government’s re-evaluation of its carbine procurement strategy, our customer mix has shifted. Our net sales to the U.S. Government, which includes foreign military sales through the U.S. Government, has decreased to 11% of net sales in 2012 from 31% of net sales in 2011 and 55% of net sales in 2010.  Conversely, we have experienced strong growth in commercial sales which have grown from 6% of sales in 2011 to 34% of sales in 2012.

 

Employee Union Matters

 

In 2012, we negotiated a new, two-year collective bargaining agreement with the Union that represents our West Hartford workforce. This agreement, which expires on March 31, 2014, applies to approximately 68% of our U.S. workforce.  Failure to reach agreement with the Union on the terms of a new collective bargaining agreement upon the expiration of the current agreement could lead to a strike or lockout, either of which would adversely affect our operations.  For additional information on how this agreement impacts pension, savings and postretirement benefits, see “Note 8 Pension, Savings and Postretirement Benefits” in Item 8 of this Form 10-K.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition, results of operations, liquidity and capital resources is based on our financial statements, which have been prepared in accordance with U.S. GAAP.  The application of GAAP requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities.  We base these estimates on historical experience and on various other assumptions that we consider reasonable under the circumstances.  Note 2 of our financial statements contains a summary of our significant accounting policies, many of which require the use of estimates and assumptions.  We believe that of our significant accounting policies, the following are noteworthy because they are based on estimates and assumptions that require more complex, subjective judgments by management, and can materially affect reported results.  Changes in these estimates or assumptions could materially affect our financial condition and results of operations.

 

Revenue Recognition

 

Net sales are gross sales net of discounts.  Our revenues are derived primarily from sales of our products.  We recognize revenue when evidence of an arrangement exists, delivery of the product or service has occurred, title and risk of loss have passed to the customer, the sales price is fixed or determinable, and collectability of the resulting receivable is reasonably assured.

 

Our contracts with the U.S. Government to produce the M4 carbine and other products have been multi-year sole source negotiated contracts in which we have provided cost and pricing data to support our prices.  In developing our contract estimates, we consider our current manufacturing costs (consisting primarily of material, labor and overhead), plus as applicable, our estimates of future cost increases over the life of the contract.  These contracts are subject to post-award audit and the imposition of retroactive price adjustments and penalties in the event we failed to disclose material events or made errors in the calculation of our costs.  Historically, we have not experienced such adjustments.

 

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These contracts are not subject to price adjustment for subsequent changes in our cost of materials, labor or overhead.  Contracts with the U.S. Government for other rifles and spare parts are subject to firm fixed pricing.  Sales of law enforcement and commercial model rifles are based on purchase orders.

 

The majority of our contracts with the Canadian Government are sole source contracts because of our Canadian operation’s status as Canada’s strategic source of small arms.  We provide full cost backup to the Canadian Government using negotiated labor and overhead rates to support our pricing.  In developing our contract estimates, we consider our current manufacturing costs (consisting primarily of material, labor and overhead), plus as applicable, our estimates of future cost increases over the life of the contract.  These contracts are not subject to price adjustment for subsequent changes in our costs.  However, they may be subject to re-pricing resulting from changes in negotiated labor and overhead rates.  Contracts won competitively with the Canadian Government are firm fixed and are not subject to adjustment.  All contracts contain discretionary audit clauses, which allow the Canadian Government to recover monies where extraordinary profits have been realized.  Canadian sales of law enforcement model rifles are based on contracts that are competitively bid using firm, fixed prices, which are not subject to adjustment.  Contracts received through the Canadian Commercial Corporation are subject to discretionary audit.  We review the revenue recognition on all of these contracts on a quarterly basis and if necessary provide reserves against our contracts; however, we have not incurred any such contract losses for any period presented.

 

Goodwill and Intangible Assets Valuation (Possible Impairment)

 

At December 31, 2012, we had goodwill of $14.9 million and intellectual property (intangible assets) deemed to have finite lives with a net carrying value of $6.0 million, which are amortized over 15-30 year lives.  We test goodwill for impairments annually as of the end of our third fiscal quarter, or immediately if conditions indicate that either a goodwill or intellectual property impairment could exist.  Goodwill is tested for impairment using a two-step process.  In the first step, the fair value of the reporting unit is compared to its carrying value.  If the fair value of the reporting unit exceeds the carrying value of its net assets, goodwill is considered not impaired and no further testing is required.  If the carrying value of the net assets exceeds the fair value of the reporting unit, a second step of the impairment test is performed in order to determine the implied fair value of a reporting unit’s goodwill.  Determining the implied fair value of goodwill requires a valuation of the reporting unit’s tangible and intangible assets and liabilities in a manner similar to the allocation of purchase price in a business combination.  If the carrying value of the reporting unit’s goodwill exceeds the implied fair value of its goodwill, goodwill is deemed impaired and is written down to the extent of the difference.

 

Management estimates the fair value of each reporting unit primarily using the income approach. Specifically the discounted cash flow (“DCF”) model was utilized for the valuation of each reporting unit. Management develops cash flow forecasts based on existing firm orders, expected future orders, contracts with suppliers, labor agreements and general market conditions. We discount the cash flow forecasts using the weighted-average cost of capital method at the date of evaluation. We also calculate the fair value of our reporting units using the market approach in order to corroborate our DCF model results. These methodologies used in the current year are consistent with those used in the prior year.

 

Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions.  These estimates and assumptions include the development of cash flow forecasts, risk-adjusted discount rates and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are also unpredictable in nature and inherently uncertain.  Actual future results may differ from those estimates.

 

For finite-lived assets, impairment testing is performed whenever events or changes in circumstances (“Triggering Events”) indicate that the carrying amount may not be recoverable.  We will recognize an impairment loss if the carrying value exceeds its fair value.  Any change in the remaining useful lives of the intangible assets could have a significant impact on our reported results of operations.

 

Since December 2012, there has been an extremely sharp increase in political and public support for new “gun control” laws and regulations in the United States.  Some proposed legislation, including legislation that has been introduced and is under active consideration in Congress and in state legislatures, would ban and/or restrict the sale of substantially all of our products, in their current configurations, into the commercial market, either throughout the

 

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United States or in particular states.  We considered this potential adverse change in our business climate to be a Triggering Event. Therefore, in addition to our annual goodwill impairment testing, we also performed a sensitivity analysis to determine the impact that a material decrease in LE/Commercial sales would have on our valuation. There was no indication of impairment as a result of our 2012 impairment analysis. The fair value of our reporting units was substantially in excess of carrying value for all scenarios that we tested.

 

Retirement Benefits

 

Our pension and other postretirement benefit costs and obligations are dependent on various assumptions.  Our major assumptions relate primarily to discount rates, long-term return on plan assets and medical cost trend rates.  We base the discount rate assumption on current investment yields of high quality fixed income investments during the retirement benefits maturity period.  Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment, as well as target asset allocations.

 

Our medical cost trend assumptions are developed based on historical cost data, the near-term outlook, an assessment of likely long-term trends and the cap limiting our required contributions.  Actual results that differ from our assumptions are accumulated and are amortized generally over the estimated future working life of the plan participants.

 

Our major assumptions vary by plan and the weighted-average rates used.  Each assumption has different sensitivity characteristics, and, in general, changes, if any, have moved in the same direction over the last several years.  For fiscal 2012, changes in the weighted-average rates for the benefit plans would have the following impact on our net periodic benefit cost:

 

·                       A decrease of 25 basis points in the long-term rate of return on assets would have increased our net 2012 benefit cost by approximately $0.1 million; and

 

·                       A decrease of 25 basis points in the liability discount rate would have an immaterial impact on our 2012 net benefit cost.

 

Recent Accounting Pronouncements

 

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income - In February 2013, the Financial Accounting Standards Board (“FASB”) issued ASU 2013-02, which requires disclosure of significant amounts reclassified out of accumulated other comprehensive income by component and their corresponding effect on the respective line items of net income. This guidance is effective for the Company beginning in the first quarter of 2013. We are currently evaluating what impact, if any, ASU 2013-02 will have on our financial statements.

 

Presentation of Comprehensive Income — In June 2011, FASB issued ASU 2011-05, which requires an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income, or in two separate but consecutive statements. This update eliminates the option to present components of other comprehensive income as part of the statement of equity, but it does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. In December 2011, FASB issued ASU 2011-12, which amends ASU 2011-05. This amendment defers the requirement to present components of reclassifications of other comprehensive income on the face of the income statement. Both standards were effective for us beginning on January 1, 2012. The adoption of these standards had no impact on our operating results or financial position.

 

Intangibles — Goodwill and Other — In September 2011, FASB issued ASU 2011-08, which provides entities the option to perform a qualitative assessment in order to determine whether additional quantitative impairment testing is necessary. This amendment is effective for reporting periods beginning after December 15, 2011. This amendment does not impact the quantitative testing methodology, should it be necessary. We adopted this standard on January 1, 2012 and it had no impact on our operating results or financial position.

 

Fair Value Measurement — In May 2011, FASB issued an amendment to revise the wording used to describe the requirements for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, the FASB does not intend for the amendments to result in a change in the application of existing

 

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fair value measurement requirements, such as specifying that the concepts of the highest and best use and valuation premise in a fair value measurement are relevant only when measuring the fair value of nonfinancial assets. Other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements such as specifying that, in the absence of a Level 1 input, a reporting entity should apply premiums or discounts when market participants would do so when pricing the asset or liability. We adopted this standard on January 1, 2012 and it had no impact on our operating results or financial position.

 

Key Performance Measures

 

Our management reviews and analyzes several key performance indicators in order to manage our business and assess the quality and potential variability of our earnings and cash flows.  These key performance indicators include:

 

·                       Net sales;

 

·                       Net sales growth;

 

·                       Gross profit as a percentage of net sales;

 

·                       Operating income as a percentage of net sales;

 

·                       Adjusted EBITDA; and

 

·                       Adjusted EBITDA as a percentage of net sales (“Adjusted EBITDA margin”).

 

For the years ended December 31, 2012, 2011 and 2010, these key performance measures were ($ in thousands):

 

 

 

Year Ended December 31,

 

 

 

2012

 

2011

 

2010

 

Net sales

 

$

213,328

 

$

208,810

 

$

175,805

 

Net sales growth

 

2.2

%

18.8

%

(34.9

)%

Gross profit as a percentage of net sales

 

24.0

%

31.3

%

25.3

%

Operating income as a percentage of net sales

 

8.7

%

15.6

%

10.5

%

Adjusted EBITDA (a)

 

$

27,032

 

$

38,859

 

$

23,859

 

Adjusted EBITDA margin

 

12.7

%

18.6

%

13.6

%

 


(a)                                 Adjusted EBITDA is used by management as the primary measure of the operating performance of our business.  Adjusted EBITDA consists of income (loss) from continuing operations before interest, income taxes, depreciation and amortization of intangible assets, Sciens fees and expense, and other income or expenses.  For additional information on our operating segments and a reconciliation of Adjusted EBITDA to income (loss) from continuing operations, see “Note 13 Segment Information” in Item 8 of this Form 10-K.

 

Results of Operations

 

The following table sets forth our results of operations in dollars and as a percentage of total net sales for the periods presented ($ in thousands):

 

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Year Ended December 31,

 

 

 

2012

 

%

 

2011 (a)

 

%

 

2010 (a)

 

%

 

Statement of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

213,328

 

100.0

%

$

208,810

 

100.0

%

$

175,805

 

100.0

%

Cost of sales

 

162,177

 

76.0

 

143,478

 

68.7

 

131,278

 

74.7

 

Gross profit

 

51,151

 

24.0

 

65,332

 

31.3

 

44,527

 

25.3

 

Selling and commissions

 

13,059

 

6.1

 

13,612

 

6.5

 

9,344

 

5.3

 

Research and development

 

4,747

 

2.2

 

5,578

 

2.7

 

4,536

 

2.6

 

General and administrative

 

14,285

 

6.7

 

13,098

 

6.3

 

11,621

 

6.6

 

Amortization of purchased intangibles

 

503

 

0.2

 

541

 

0.3

 

548

 

0.3

 

Total operating expenses

 

32,594

 

15.3

 

32,829

 

15.7

 

26,049

 

14.8

 

Operating income

 

18,557

 

8.7

 

32,503

 

15.6

 

18,478

 

10.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other expense (income):

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

24,579

 

11.5

 

24,010

 

11.5

 

24,598

 

14.0

 

Debt prepayment expense

 

 

0.0

 

295

 

0.1

 

1,246

 

0.7

 

Other (income) expenses, net

 

(717

)

(0.3

)

39

 

0.0

 

411

 

0.2

 

 

 

23,862

 

11.2

 

24,344

 

11.7

 

26,255

 

14.9

 

(Loss) income from continuing operations before provision for foreign income taxes

 

(5,305

)

(2.5

)

8,159

 

3.9

 

(7,777

)

(4.4

)

Provision for foreign income taxes

 

1,750

 

0.8

 

3,171

 

1.5

 

2,499

 

1.4

 

(Loss) income from continuing operations

 

(7,055

)

(3.3

)

4,988

 

2.4

 

(10,276

)

(5.8

)

(Loss) from discontinued operations

 

 

0.0

 

 

0.0

 

(665

)

(0.4

)

(Loss) on disposal of discontinued operations

 

 

0.0

 

 

0.0

 

(208

)

(0.1

)

Net (loss) income

 

(7,055

)

(3.3

)

4,988

 

2.4

 

(11,149

)

(6.3

)

Less: net loss attributable to non-controlling interest

 

 

0.0

 

 

0.0

 

84

 

0.0

 

Net (loss) income attributable to Colt Defense LLC members

 

$

(7,055

)

(3.3

)%

$

4,988

 

2.4

%

$

(11,065

)

(6.3

)%

 


(a)           Certain amounts have been revised to correct prior period errors identified. For additional information about the revision, see “Note 2 Summary of Accounting Policies” in Item 8 of this Form 10-K.

 

Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011

 

Net Sales

 

The following table shows net sales for the year ended December 31, 2012 and December 31, 2011 by product category ($ in thousands):

 

 

 

Year Ended December 31,

 

 

 

2012

 

2011

 

%
Change

 

Weapon systems

 

$

160,788

 

$

125,141

 

28.5

%

Spares /other

 

52,540

 

83,669

 

(37.2

)%

Total

 

$

213,328

 

$

208,810

 

2.2

%

 

Net sales for 2012 were $213.3 million, an increase of $4.5 million, or 2.2%, from $208.8 million in 2011.   In fiscal 2012, weapon system sales increased by $35.6 million compared to 2011. The growth came from LE/Commercial and international markets where sales grew $64.6 million and $2.5 million, respectively. These increases were partially offset by a $31.5 million decline in sales to the U.S. Government from the comparable period in 2011, as the U.S. Government continued to evaluate its carbine procurement strategy.

 

Spares/other sales decreased $31.1 million from $83.6 million in 2011 to $52.5 million in 2012. Spares sales to the U.S. Government declined $9.8 million in 2012, mainly because our IDIQ contract for the M249 spare barrel was completed. In addition, international spares sales were $20.7 million lower in 2012. In 2011, we had a $19.5 million spares sale to a single customer that did not repeat in 2012.  While we have historically sold small arms weapons systems to over 80 countries, the number and mix of countries that buy our spare parts, replacement kits, accessories and other items each year varies as each individual country assesses its requirements. These orders also tend to be large in size. As a result, these sales tend to fluctuate significantly from year to year.

 

Cost of Sales/Gross Margin

 

Our cost of sales consists of direct labor and benefits, materials, subcontractor costs and manufacturing overhead, including depreciation and amortization, utilities, and maintenance and repairs. Gross margin decreased from 31.3% in 2011 to 24.0% in 2012.  The decline in gross margin was mainly due to a mix shift that resulted from the strong growth in Commecial/LE sales with lower gross margins as well as the unfavorable margin impact of new model and product offerings, which tend to carry lower margins in their early stages of introduction. In addition, cost of

 

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sales for 2012 includes a $1.3 million expense related to the curtailment of our bargaining unit pension plan. This non-recurring expense decreased our 2012 gross margin by 0.6%.

 

Selling and Commissions Expense

 

Selling expense consists primarily of compensation, advertising, promotions, travel, trade shows, consulting fees and marketing materials.  In addition, we pay commissions to independent foreign sales representatives on certain direct foreign sales and to domestic sales representatives on most LE/Commercial sales, which generally are a percentage of the selling price.

 

During 2012, selling and commission expenses decreased by $0.5 million to $13.1 million. Commission expense was $2.1 million lower in 2012 compared to 2011 due to a change in customer mix. Lower commission expense was partially offset by a $1.6 million increase in selling expense, primarily due to higher professional fees, compensation and travel expenses to support sales efforts in the international and LE/Commercial markets.

 

Research and Development Expense

 

Research and development expenses consist primarily of compensation and benefits and experimental work materials for our employees who are responsible for the development and enhancement of new and existing products.  In 2012, our research and development expense decreased by $0.8 million to $4.7 million. The higher expenses in 2011 were mainly associated with a project that was being developed for NATO trials in early 2012.

 

General and Administrative Expense

 

General and administrative expense consists of compensation and benefits, professional services and other general office administration expenses.  These costs do not increase proportionately with changes in sales. During 2012, general and administrative costs, increased by $1.2 million to $14.3 million.  In 2012, we expensed approximately $0.6 million to settle a legal dispute.  In addition, legal expenses increased $0.7 million in 2012 for matters including our protest of the U.S. Army’s M4 contract award to another vendor, the negotiation of a new labor union contract and legal expenses related to a dispute. These increases were partially offset by lower consulting fees in 2012.

 

Interest Expense

 

Our interest expense in 2012 was $24.6 million, an increase of $0.6 million from $24.0 million in 2011.  The increase in 2012 was primarily due to $0.3 million of interest expense related to a Connecticut tax audit settlement.  In addition, we had higher amortization of deferred financing fees and unused line fees associated with the Credit Agreement. For additional information about the Credit Agreement, see “—Liquidity and Capital Resources.”

 

Debt Prepayment Expense

 

Debt prepayment expense in 2012 was $0.3 million lower than 2011.  During 2011, we incurred $0.3 million of debt prepayment expense to terminate a $10.0 million revolving line of credit when we entered into the Credit Agreement.

 

Other (Income) Expense, net

 

In 2012, net other income was $0.8 million higher, mainly due to higher service income from Colt’s Manufacturing resulting from a new contract that was effective July 1, 2012.

 

Income Taxes

 

As a limited liability company, we are treated as a partnership for U.S. federal and state income tax reporting purposes and therefore, we are not subject to U.S. federal or state income taxes.  Our taxable income (loss) is reported to our members for inclusion in their individual tax returns.  The income tax that we incurred results from Canadian federal and provisional income taxes as well as withholding tax required on royalty and interest income received from our Canadian subsidiary.  For 2012, we had foreign income tax expense of $1.8 million compared to $3.2 million for 2011, primarily due to lower non-U.S. income.

 

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Year Ended December 31, 2011 Compared to the Year Ended December 31, 2010

 

Net Sales

 

Sales

 

The following table shows net sales for the year ended December 31, 2011 and December 31, 2010 by product category ($ in thousands):

 

 

 

Year Ended December 31,

 

 

 

2011

 

2010

 

%
Change

 

Weapon systems

 

$

125,141

 

$

120,737

 

3.6

%

Spares /other

 

83,669

 

55,068

 

51.9

%

Total

 

$

208,810

 

$

175,805

 

18.8

%

 

Net sales for 2011 were $208.8 million, an increase of $33.0 million, or 18.8%, from $175.8 million in 2010.  Weapon system sales increased in 2011 compared to the same period in 2010 by $4.4 million. The growth came from international and LE/Commercial markets where sales grew $24.0 million and $13.8 million, respectively. These increases were partially offset by a $33.4 million decline in sales of carbines to the U.S. Government from the comparable period in 2010, as the U.S. Government continued to evaluate its carbine procurement strategy.

 

Spares/other sales increased 51.9% from $55.1 million in 2010 to $83.7 million in 2011. The increase was mainly due to higher international sales to several customers, the largest of which was the United Arab Emirates.  While we have historically sold small arms weapons systems to over 80 countries, the number and mix of countries that buy our spare parts, replacement kits, accessories and other items each year varies as each individual country assesses its requirements. As a result, these sales tend to fluctuate from year to year.

 

Cost of Sales/Gross Margin

 

Our cost of sales consists of direct labor and benefits, materials, subcontractor costs and manufacturing overhead, including depreciation and amortization, utilities cost, and maintenance and repairs. Gross margin in 2011 increased to 31.3% from 25.3% in 2010.  Several factors drove the year over year gross margin improvement. In 2010, we shut down our West Hartford facility for two weeks in July and had one week per month furloughs for production workers from February through August, which had a significant adverse impact on our 2010 gross margins. We did not have any plant shutdowns and we only had one four-day, partial furlough in 2011. A favorable sales channel mix also generated higher margins in 2011. In addition, our West Hartford facility benefited from lower expenses related to excess and obsolete inventory in 2011 compared to the prior year. These favorable variances were partially offset by higher expense related to offset purchase commitments. For additional information about offset purchase commitments, see “—Contractual Obligations and Commitments.”

 

Selling and Commissions Expense

 

Selling expense consists of primarily commissions, salaries, travel, trade shows, marketing materials, and customer training.  In addition, we pay commissions to independent foreign sales representatives on most direct foreign sales, which generally are a percentage of the selling price.  Foreign sales usually yield higher gross profit percentages, which offset the higher cost of commissions.

 

During 2011, selling and commission expenses increased by $4.3 million to $13.6 million. Commission expense was $2.8 million higher in 2011 compared to 2010 primarily due to an increase in commissionable international sales. We also made a larger investment in marketing in 2011 to support our sales strategy in the LE/Commercial markets.

 

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Research and Development Expense

 

In 2011, research and development expenses increased by $1.0 million to $5.6 million. The increase was mainly due to costs associated with development projects at our Canadian subsidiary.

 

General and Administrative Expense

 

General and administrative expense consists of compensation and benefits expense, fees for professional services and other general office administration expenses.  These costs do not increase proportionately with increases in sales. During 2011, general and administrative costs, increased by $1.5 million over 2010.  The year over year increase was mainly due to higher compensation expense, a one-time severance expense and increased outside professional fees related to both the filing of our Registration statement on Form S-4 and other consulting services.

 

Interest Expense

 

Our interest expense in 2011 was $24.0 million, a decrease of $0.6 million from $24.6 million in 2010.  In the first nine months of 2010, we had a $50.0 million revolving credit facility (“the Revolver”). In the fourth quarter of 2010, we amended the Revolver and reduced it to a $10.0 million letter of credit facility, which resulted in $0.5 million of year over year interest savings during 2011.

 

Debt Prepayment Expense

 

Debt prepayment expense in 2011 was $0.9 million lower than 2010.  During 2010, we incurred $1.2 million of debt prepayment expenses related to the revolver amendment compared to $0.3 million of debt prepayment expense to terminate the revolver in 2011.

 

Other Expense, net

 

Net other expenses were $0.4 million lower in 2011, mainly due to lower foreign exchange losses compared to 2010.

 

Income Taxes

 

As a limited liability company, we are treated as a partnership for U.S. federal and state income tax reporting purposes and therefore, we are not subject to U.S. federal or state income taxes.  Our taxable income (loss) is reported to our members for inclusion in their individual tax returns.  The income tax that we incurred results from Canadian federal and provisional income taxes as well as withholding tax required on royalty and interest income received from our Canadian subsidiary.  For 2011, we had foreign income tax expense of $3.2 million compared to $2.5 million for 2010.

 

Discontinued Operations

 

We dissolved Colt Rapid Mat as of December 31, 2010. In 2010, we recognized a loss from this discontinued operation of $0.7 million and a loss on disposal of $0.2 million. The loss on disposal is primarily due to the disposal of our non-controlling interest and the liquidation of our assets.

 

Liquidity and Capital Resources

 

Our primary liquidity requirements are for debt service, working capital and capital expenditures.  We have historically funded these requirements through internally-generated operating cash flow.  In order to support the growth in our working capital requirements related to our expanding international business, on September 29, 2011, we entered into a Credit Agreement with Wells Fargo Capital Finance, LLC.  Under the terms of the Credit Agreement, senior secured revolving loans are available up to $50.0 million, inclusive of $20.0 million available for letters of credit.  Revolving loans are subject to, among other things, the borrowing base, which is calculated monthly based on specified percentages of eligible accounts receivable and inventory and specified values of fixed assets.  Under the Credit Agreement, our obligations are secured by a first-priority security interest in substantially all our assets, including accounts receivable, inventory and certain other collateral. The Credit Agreement matures on September 28, 2016.

 

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Borrowings under the Credit Agreement bear interest at a variable rate based on the London Inter-Bank Offer Rate (“LIBOR”), the Canadian Banker’s Acceptance Rate or the lender’s prime rate, as defined in the Credit Agreement, plus a spread. The interest rate spread on borrowings and fees for letters of credit varies based on both the rate option selected and our quarterly average excess availability under the Credit Agreement. There is an unused line fee ranging from .375% to .50% per annum, payable quarterly on the unused portion under the facility and a $40 thousand annual servicing fee.

 

The Credit Agreement limits our ability to incur additional indebtedness, make investments or certain payments, pay dividends and merge, acquire or sell assets. In addition, certain covenants would be triggered if excess availability were to fall below the specified level, including a fixed charge coverage ratio requirement.  Excess availability is determined as the lesser of our borrowing base or $50.0 million, reduced by outstanding obligations under the credit agreement and trade payables that are more than 60 days past due. Furthermore, if excess availability falls below $11.0 million or an event of default occurs, the lender may assume control over the Company’s cash until such event of default is cured or waived or the excess availability exceeds such amount for 60 consecutive days.

 

The Credit Agreement contains customary events of default, including, without limitation, payment defaults, breaches of representations and warranties, cross-defaults with other material indebtedness, certain events of bankruptcy or insolvency, judgments in excess of a certain threshold and the failure of any guaranty or security document supporting the agreement to be in full force and effect. In addition, if excess availability falls below $9.0 million and the fixed charge coverage ratio is less than 1.0 to 1.0, the Company would be in default under the Credit Agreement. As of December 31, 2012, we were in compliance with all covenants and restrictions.

 

As of December 31, 2012, there was a $6 thousand advance and $1.7 million of letters of credit outstanding under the Credit Agreement. The $6 thousand advance, which was automatically made by Wells Fargo on our behalf in order to pay a letter of credit fee, was non-interest bearing and we repaid it in full in January 2013.

 

On February 24, 2012, we obtained an amendment from the lender under the Credit Agreement which clarified the calculation of certain fees payable thereunder.

 

On September 29, 2011, in conjunction with our entering into the Credit Agreement, we terminated an existing credit facility. From November 10, 2009 through October 31, 2010, the Company was party to a $50.0 million senior secured revolving credit facility.  On November 1, 2010, the senior secured credit facility was amended to provide for a $10.0 million letter of credit facility.  The letter of credit facility existed for the sole purpose of supporting our letter of credit requirements.

 

On November 10, 2009, Colt Defense LLC (“Parent”) and Colt Finance Corp, our 100%-owned finance subsidiary, jointly and severally co-issued $250 million senior unsecured notes. The Senior Notes bear interest at 8.75% and mature November 15, 2017.  Interest is payable semi-annually in arrears on May 15 and November 15, commencing on May 15, 2010.  We issued the Senior Notes at a discount of $3.5 million from their principal value.  This discount will be amortized as additional interest expense over the life of the indebtedness. Proceeds from the Senior Notes were used to repay the outstanding balances of our then outstanding senior secured credit facility and senior subordinated notes ($189.3 million), settle outstanding interest rate swap agreements ($5.4 million), pay a prepayment premium on our senior subordinated notes ($0.6 million) and pay financing costs ($12.8 million).  The balances of the proceeds were available for general corporate purposes.

 

No principal repayments are required until maturity. However, in the case of a change in control of our company, we are required to offer to purchase the outstanding notes at a price equal to 101% of their principal amount, together with accrued and unpaid interest.  In addition, the Senior Notes may be redeemed at our option under certain conditions as follows:

 

·                       at any time prior to November 15, 2013, we may redeem some or all of the notes at a price equal to 100% of the principal amount of the notes together with accrued and unpaid interest plus a make whole premium, as defined in the indenture; and

 

·                       on and after November 15, 2013, we may redeem all or, from time to time, a part of the notes at the following redemption process (expressed as a percentage of principal amount of the notes to be redeemed) plus accrued and unpaid interest, including additional interest, if any on the notes to the

 

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applicable redemption date if redeemed during the twelve month period beginning on November 15 of the years indicated below:

 

Year

 

Percentage

 

2013

 

104.375

%

2014

 

102.187

%

2015 and thereafter

 

100.000

%

 

The Senior Notes are not guaranteed by any of our subsidiaries and they do not have any financial condition covenants which require us to maintain compliance with any financial ratios or measurements on a periodic basis.  The Senior Notes do contain incurrence-based covenants that, among other things, limit our ability to incur additional indebtedness, enter into certain mergers or consolidations, incur certain liens and engage in certain transactions with our affiliates.  Under certain circumstances, we are required to make an offer to purchase our notes offered hereby at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest to the date of purchase with the proceeds of certain asset dispositions.  In addition, the indenture restricts our ability to pay dividends or make other restricted payments (as defined in the indenture) to our members, subject to certain exceptions, unless certain conditions are met, including that (1) no default under the indenture shall have occurred and be continuing, (2) we shall be permitted by the indenture to incur additional indebtedness and (3) the amount of the dividend or payment may not exceed a certain amount based on, among other things, our consolidated net income.  Such restrictions are not expected to affect our ability to meet our cash obligations for the next 12 months. The indenture does not restrict our ability to pay dividends or provide loans to the Parent or the net assets of our subsidiaries, inclusive of the co-issuer, Colt Finance Corp. Additionally, the Senior Notes contain certain cross default provisions with other indebtedness, if such indebtedness in default aggregates to $20.0 million or more.

 

On May 11, 2011, Colt Defense completed an exchange offer for up to $250.0 million in the aggregate principal amount of our registered 8.75% Senior Notes due 2017 for up to a like aggregate principal amount of our outstanding 8.75% Senior Notes due 2017 issued pursuant to Rule 144A.  The Company did not recognize any gain or loss for accounting purposes as a result of the exchange offer.

 

Our cash used in or generated from operating activities is generally a reflection of our operating results adjusted for non-cash charges or credits such as depreciation and amortization and changes in working capital including accounts receivable and our investment in inventory.  Historically, tax distributions to our members have been made in amounts equal to 45% of our taxable income, as defined, for the applicable period.  Our Governing Board may also declare other distributions to our members from time to time. In addition, our cash requirements and liquidity could be impacted by potential acquisitions.

 

Changes in accounts receivable and inventory can cause significant fluctuations in our cash flow from operations.  U.S. Government receivables are generally collected within 20 days. Payment terms for international orders are negotiated individually with each customer. As a result, international receivables, a growing portion of our receivable base, tend to experience a longer collection cycle. LE/Commercial receivables, which have grown significantly in 2012, are generally collected within 10 days as distributors take advantage of payment terms. To date, we have not experienced any significant credit losses.

 

Our renewed emphasis on the international and LE/Commercial markets have also caused increased fluctuations and an overall increase in our inventory levels. Certain large international orders tend to ship at the end of large production runs, which can cause greater fluctuations in inventory levels. In addition, we need to maintain higher inventory levels to support an expanded product offering.

 

At December 31, 2012, we had cash and cash equivalents totaling $42.4 million.  We believe that our existing cash balances, Credit Agreement availability and forecasted operating cash flows are sufficient to meet our obligations for the next twelve months. On March 22, 2013, we purchased 31,165.589 common units from the Blackstone Funds for an aggregate purchase price of $14.0 million. For additional information about this transaction, see “Note 18 Subsequent Events” in Item 8 of this Form 10-K.  Other than this transaction, we are not aware of any significant events or conditions that are likely to have a material impact on our liquidity.

 

Cash Flows

 

The following table sets forth our consolidated cash flows for the years ended December 31, 2012, 2011 and 2010:

 

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Year Ended December 31,

 

 

 

2012

 

2011

 

2010

 

Cash provided by (used in) operating activities

 

$

12.4

 

$

(0.7

)

$

1.7

 

Cash (used in) investing activities

 

(3.9

)

(7.0

)

(6.9

)

Cash (used in) financing activities

 

(4.5

)

(15.8

)

(6.2

)

 

Cash Flows Provided by Operating Activities

 

Net cash provided by operating activities for 2012 was $12.4 million, compared to $0.7 million used in operating activities in 2011.  While we had a net loss in 2012, it was more than offset by changes in our operating assets and liabilities, which provided $10.4 million of cash in 2012, but used $12.9 million in 2011.

 

During 2012, changes in operating assets and liabilities provided $10.4 million of cash. Accounts receivable provided $8.1 million as we collected on a $16.1 million international receivable that was outstanding at the end of 2011, which was partially offset by increased sales in the latter part of the fourth quarter of 2012. A $4.2 million increase in inventory related to higher production levels and an expanded product offering was more than offset by a largely related $5.2 million increase in accounts payable and accrued expenses. Customer deposits and deferred revenue increased $2.0 million as we collected more deposits from international customers. These sources of cash were partially offset by a $1.0 increase in prepaid expenses and other assets mainly due to a Canadian income tax receivable.

 

Net cash used in operating activities for 2011 was $0.7 million, compared to $1.7 million provided by operating activities in 2010.  The unfavorable variance was mainly due to changes in operating assets and liabilities, which were a $12.9 million net use of cash in 2011 compared to a $5.0 million source of cash in 2010. This unfavorable change in operating assets and liabilities was largely offset by increased profitability as net income increased to $5.0 million, up from an $11.1 million net loss in 2010.

 

The changes in our operating assets and liabilities, which were a net use of cash in 2011, were driven by not only our overall sales growth, but also a change in our sales mix as international and LE/Commercial sales grew and U.S. Government sales declined.  Accounts receivable increased by $15.8 million primarily due to $16.1 million of accounts receivable with an international customer related to fourth quarter shipments. Inventory, which was a $4.8 million use of cash in 2011, mainly grew to support the initial shipments of the M240 to the U.S. Government and an anticipated large international shipment in 2012. These uses of cash were partially offset by growth-driven increases in accounts payable and accrued expenses.

 

Cash Flows Used in Investing Activities

 

Net cash used in investing activities was $3.9 million in 2012 compared to $7.0 million in 2011. In both years, the primary use of cash was for capital expenditures.  In 2012, capital expenditures were $4.4 million compared to $5.6 million in 2011. These capital expenditures mainly reflect purchases of equipment associated with new products, including the M240 and the CM901, additional production capacity and modernization initiatives.

 

In 2012, we had a $0.5 million favorable change in restricted cash as an older cash-collateralized letter of credit expired and new letters of credit were placed under the Credit Agreement without cash collateral. Conversely,   in 2011 we used $1.4 million of cash to fund an increase in restricted cash used to secure our outstanding letters of credit.

 

Net cash used in investing activities from continuing operations of $7.0 million in both 2011 and 2010 was primarily for capital expenditures.  In 2011, capital expenditures were $5.6 million compared to $7.4 million in 2010. These capital expenditures mainly reflect purchases of equipment associated with contract awards for new products including the M240 and the M249 and modernization initiatives. In addition, in 2011 we invested $0.5 million in the expansion of our Canadian facility.

 

In addition to capital expenditures, we used $1.4 million of cash to fund an increase in restricted cash used to secure our outstanding letters of credit on 2011. In 2010, restricted cash was a $0.5 million source of cash as our cash required to collateralize outstanding letters of credit decreased.

 

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Cash Flows Used in Financing Activities

 

Net cash used in financing activities in 2012 was $4.5 million as compared to $15.8 million of cash used in financing activities in 2011.  The primary reason for the favorable variance was a decrease in distributions to our members from $12.9 million in 2011 to $3.3 million in 2012.  Payments on capital leases were $1.1 million in 2012, a slight decrease from $1.2 million in 2011 as all of our capital leases matured in late 2012. In addition, we used $1.6 million to pay debt issuance costs associated with the Credit Agreement in 2011.

 

Net cash used in financing activities in 2011 was $15.8 million as compared to $6.2 million of cash used in financing activities in 2010.  A $12.9 million distribution to members was the primary use of cash in 2011. In addition, we used $1.6 million to pay debt issuance costs and $1.2 million for capital lease payments in 2011.

 

Net cash (used in) provided by financing activities consisted of the following ($ in millions):

 

 

 

Year Ended December 31,

 

 

 

2012

 

2011

 

2010

 

Capital lease obligation payments

 

$

(1.2

)

$

(1.2

)

$

(1.1

)

Debt issuance costs (a)

 

 

(1.7

)

(0.1

)

Distributions paid to members(b)

 

(3.3

)

(12.9

)

(5.0

)

Total

 

$

(4.5

)

$

(15.8

)

$

(6.2

)

 


(a)                                 In 2011, we incurred debt issuance costs when we entered on to the Credit Agreement with Wells Fargo and terminated the J.P. Morgan credit facility.  During 2010, we amended the revolving credit facility with J.P. Morgan and incurred additional financing costs.

 

(b)                                 2012 and 2010 reflect tax distributions made to members.  In 2010, the Governing Board also declared a special distribution to members of $12.9 million, which was paid to members in 2011.

 

Contractual Obligations and Commitments

 

We have contractual obligations and commercial commitments that may affect our financial condition.  The following table identifies material obligations and commitments as of December 31, 2012 (in millions):

 

 

 

 

 

Payments Due by Period

 

 

 

Total

 

Less than
1 Year

 

13-35
Months

 

36-60
Months

 

More than
5 Years

 

Long-term debt principal payments(a)

 

$

250.0

 

$

 

$

 

$

250.0

 

$

 

Interest payments

 

107.0

 

22.0

 

44.1

 

40.9

 

 

Operating leases

 

2.7

 

0.9

 

1.8

 

0.0

 

 

Payments to pension trust(b)

 

8.9

 

0.7

 

2.2

 

2.5

 

3.5

 

Postretirement healthcare payments(b)

 

7.8

 

0.6

 

1.4

 

1.6

 

4.2

 

Purchase obligations(c)

 

2.4

 

2.4

 

 

 

 

Total contractual obligations

 

$

378.8

 

$

26.6

 

$

49.5

 

$

295.0

 

$

7.7

 

 


(a)                                 Includes $250 million of Senior Notes which were issued at a discount of $3.5 million.

 

(b)                                 Payments to the pension trust and post retirement plan are required pursuant to our plan.

 

(c)                                  We had unconditional purchase obligations related to capital expenditures for machinery.

 

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Offset Purchase Commitments

 

We have certain Industrial Cooperation Agreements, which stipulate our commitments to provide offsetting business to certain countries that have purchased our products. We generally settle our offset purchase commitments under Industrial Cooperation Agreements through on-going business and/or cooperating with other contractors on their spending during the related period. Additionally, we identify future purchases and other satisfaction plans for the remainder of the offset purchase commitment period and should there be a projected net purchase commitment after such consideration, we accrue the estimated cost to settle the offset purchase commitment.

 

Our remaining gross offset purchase commitment is the total amount of offset purchase commitments reduced for claims submitted and approved by the governing agencies.  At December 31, 2012 and 2011, our remaining gross offset purchase commitments totaled $68.2 million and $58.5 million, respectively. We have evaluated our settlement of our remaining gross offset purchase commitments through probable planned spending and other probable satisfaction plans to determine our net offset purchase commitment.  We have accrued $1.8 million and $1.6 million as of December 31, 2012 and 2011, respectively, based on our estimated cost of settling the remaining net offset purchase commitment.

 

Performance Guarantees

 

In the normal course of our business we may be asked to provide performance guarantees to our customers in relation to our contracts. Some customers may require that our performance guarantees be issued by a financial institution in the form of a letter of credit. As of December 31, 2012, we had $3.7 million in outstanding letters of credit, of which $1.3 million were fully collateralized by cash.

 

Pension Plans and Postretirement Health Care Obligations

 

We have two domestic defined benefit plans that cover a significant portion of our salaried and hourly paid employees.  Effective December 31, 2012, we froze the pension benefits under our hourly defined benefit plan. The benefits under our salaried defined benefit plan have been frozen since December 31, 2008.  As a result, participants retain the benefits that they have already accrued, however no additional benefits will accrue after the effective date of the freeze.

 

We derive pension benefit expense from an actuarial calculation based on the defined benefit plans’ provisions and management’s assumptions regarding discount rate and expected long-term rate of return on assets.  Management determines the expected long-term rate of return on plan assets based upon historical actual asset returns and the expectations of asset returns over the expected period to fund participant benefits based on the current investment mix of our plans.  Management sets the discount rate based on the yield of high quality fixed income investments expected to be available in the future when cash flows are paid. In addition, management also consults with independent actuaries in determining these assumptions.  The excess of the projected benefit obligations over assets of the plans is $6.8 million at December 31, 2012.  We anticipate we will make a contribution of approximately $1.5 million to our pension plans in 2013.

 

We also have a postretirement health plan for our domestic union employees.  The postretirement health plan is unfunded.   We derive postretirement benefit expense from an actuarial calculation based on the provisions of the plan and a number of assumptions provided by us including information about employee demographics, retirement age, turnover, mortality, discount rate, amount and timing of claims, and a health care inflation trend rate. In connection with our collective bargaining agreement, we have capped certain retirees to approximately $250 (not in thousands) per employee per month.  The unfunded post-retirement health care benefit obligation was $14.1 million at December 31, 2012.

 

401(k) Plan

 

We have a domestic contributory savings plan (“401(k) Plan”) under Section 401(k) of the Internal Revenue Code covering substantially all U.S. employees.  The 401(k) Plan allows participants to make voluntary contributions of up to 15% of their annual compensation, on a pretax basis, subject to IRS limitations.  During 2012, employees represented by the collective bargaining agreement who were hired after April1, 2012 were eligible for the employer match for up to 3% of their salaries, subject to eligibility rules. Effective January 1, 2013, all employees represented by the collective bargaining agreement will be eligible for the employer match for up to 3% of their salaries.  For all other employees, we match 50% of their elective deferrals up to the first 6% of eligible deferred compensation. The employer match expense in 2012 was $0.3 million.

 

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In addition, we have a defined contribution pension plan (“Canadian Plan”) for our employees in Canada, whereby the employees must make a minimum of 1% contribution but can contribute up to 2.5% of their gross earnings.  The Canadian Plan requires employer matching.  There is a 700 hours worked eligibility requirement.  There is no vesting period.  In Canada, we also have a profit sharing plan, which provides for a contribution calculated at up to 7% of the net operating earnings, minus the employer contributions to the Canadian Plan.  The funds are distributed proportionately based on annual remuneration.  We incurred expenses related to these plans of $0.6 million in 2012.

 

Transactions With Certain Other Parties

 

In May 2011, we signed a Memorandum of Understanding with Colt’s Manufacturing to jointly coordinate the marketing and sales of rifles into the commercial market. All sales under the Memorandum of Understanding are based on a negotiated discount. Accounts receivable for product sales to Colt’s Manufacturing were $12.5 million and $2.2 million at December 31, 2012 and December 31, 2011, respectively. Transactions with Colt’s Manufacturing were as follows (in millions):

 

 

 

Year Ended December 31,

 

 

 

2012

 

2011

 

2010

 

Net sales of rifles to Colt’s Manufacturing

 

$

73.3

 

$

11.7

 

$

0.9

 

Service fee income earned

 

1.1

 

0.4

 

0.4

 

 

For additional information on transactions with related and certain other parties, see “Note 11 Transactions With Related and Certain Other Parties” in Item 8 of this Form 10-K.

 

Off-balance Sheet Arrangements

 

At December 31, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC.

 

Impact of Inflation

 

Although inflationary increases in certain costs, particularly labor, outsourced parts and raw materials, could potentially have an impact on our operating results, inflation has not significantly impacted our overall operations in the last three years.

 

Item 7.A                                                Quantitative and Qualitative Disclosures About Market Risk

 

Foreign Currency Exposure

 

We are subject to foreign currency exchange risks relating to receipts from customers, payments to suppliers and some intercompany transactions.  As a matter of policy, we do not engage in currency speculation and therefore, we have no derivative financial instruments to hedge this exposure.  In our Consolidated Statements of Operations, we had a foreign currency gain of $0.2 million for 2012 and foreign currency losses of $0.3 million and $0.7 million for 2011 and 2010, respectively.  The foreign currency amounts reported in the Consolidated Statements of Operations may change materially should our international business continue to grow or if changes in the Canadian dollar or Euro versus the U.S. dollar fluctuate materially.

 

Interest Rate Exposure

 

As of December 31, 2012, we had $250.0 million in principal amount of fixed-rate Senior Notes outstanding. A hypothetical 100 basis point increase in interest rates would not impact the interest expense on our fixed-rate debt, which is not hedged. We had no variable rate debt outstanding at December 31, 2012.

 

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Table of Contents

 

Item 8.                                                         Financial Statements and Supplemental Data

 

Index to Consolidated Financial Statements

 

 

Page

 

 

Report of Independent Registered Public Accounting Firm

44

 

 

Consolidated Balance Sheets

45

 

 

Consolidated Statements of Operations

46

 

 

Consolidated Statements of Comprehensive Loss

47

 

 

Consolidated Statements of Changes in Cash Flows

48

 

 

Consolidated Statements of Changes in Deficit

49

 

 

Notes to Consolidated Financial Statements

50

 

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Table of Contents

 

Report of Independent Registered Public Accounting Firm

 

To the Members and Governing Board of Colt Defense LLC:

 

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, changes in deficit and changes in cash flows present fairly, in all material respects, the financial position of Colt Defense LLC and its Subsidiaries (the “Company”) at December 31, 2012 and December 31, 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

/s/ PricewaterhouseCoopers LLP

 

Hartford, Connecticut

March 26, 2013

 

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Table of Contents

 

Colt Defense LLC and Subsidiaries

Consolidated Balance Sheets

For the Years Ended December 31,

(In thousands of dollars)

 

 

 

2012

 

2011

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

42,373

 

$

38,236

 

Restricted cash

 

777

 

1,241

 

Accounts receivable, net

 

22,683

 

30,575

 

Inventories

 

40,561

 

36,215

 

Other current assets

 

3,416

 

2,481

 

Total current assets

 

109,810

 

108,748

 

 

 

 

 

 

 

Property and equipment, net

 

22,134

 

22,589

 

Goodwill

 

14,947

 

14,713

 

Intangible assets with finite lives, net

 

6,037

 

6,635

 

Deferred financing costs

 

7,642

 

9,312

 

Long-term restricted cash

 

810

 

810

 

Other assets

 

1,588

 

2,149

 

Total assets

 

$

162,968

 

$

164,956

 

 

 

 

 

 

 

LIABILITIES AND DEFICIT

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Line of credit

 

$

6

 

$

 

Capital lease obligations — current portion

 

 

1,148

 

Accounts payable

 

13,055

 

11,114

 

Accrued expenses

 

20,315

 

16,189

 

Pension and retirement obligations - current portion

 

626

 

609

 

Customer advances and deferred income

 

10,002

 

8,804

 

Accrued distributions to members

 

 

3,343

 

Total current liabilities

 

44,004

 

41,207

 

 

 

 

 

 

 

Long-term debt

 

247,567

 

247,186

 

Pension and retirement liabilities

 

20,261

 

17,896

 

Other long-term liabilities

 

2,423

 

1,501

 

Total long-term liabilities

 

270,251

 

266,583

 

Total liabilities

 

314,255

 

307,790

 

Commitments and Contingencies (Note 6 and 12)

 

 

 

 

 

Deficit:

 

 

 

 

 

Accumulated deficit

 

(137,446

)

(129,704

)

Accumulated other comprehensive loss

 

(13,841

)

(13,130

)

Total deficit

 

(151,287

)

(142,834

)

Total liabilities and deficit

 

$

162,968

 

$

164,956

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Colt Defense LLC and Subsidiaries

Consolidated Statements of Operations

For the Years Ended December 31,

(In thousands of dollars)

 

 

 

2012

 

2011

 

2010

 

 

 

 

 

 

 

 

 

Net sales

 

$

213,328

 

$

208,810

 

$

175,805

 

Cost of sales

 

162,177

 

143,478

 

131,278

 

Gross profit

 

51,151

 

65,332

 

44,527

 

Operating expenses:

 

 

 

 

 

 

 

Selling and commissions

 

13,059

 

13,612

 

9,344

 

Research and development

 

4,747

 

5,578

 

4,536

 

General and administrative

 

14,285

 

13,098

 

11,621

 

Amortization of purchased intangibles

 

503

 

541

 

548

 

Total operating expenses

 

32,594

 

32,829

 

26,049

 

Operating income

 

18,557

 

32,503

 

18,478

 

 

 

 

 

 

 

 

 

Other (income)/expense:

 

 

 

 

 

 

 

Interest expense

 

24,579

 

24,010

 

24,598

 

Debt prepayment expense

 

 

295

 

1,246

 

Other (income) expense, net

 

(717

)

39

 

411

 

Total other expenses, net

 

23,862

 

24,344

 

26,255

 

 

 

 

 

 

 

 

 

(Loss) income from continuing operations before provision for foreign income taxes

 

(5,305

)

8,159

 

(7,777

)

Provision for foreign income taxes

 

1,750

 

3,171

 

2,499

 

(Loss) income from continuing operations

 

(7,055

)

4,988

 

(10,276

)

Discontinued operations:

 

 

 

 

 

 

 

Loss from discontinued operations

 

 

 

(665

)

Loss on disposal of discontinued operations

 

 

 

(208

)

Net (loss) income

 

(7,055

)

4,988

 

(11,149

)

Less: Net loss (income) from discontinued operations attributable to non-controlling interest

 

 

 

84

 

Net (loss) income attributed to Colt Defense LLC members

 

$

(7,055

)

$

4,988

 

$

(11,065

)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

Colt Defense LLC and Subsidiaries

Consolidated Statements of Comprehensive Loss

For the Years Ended December 31,

(In thousands of dollars)

 

 

 

2012

 

2011

 

2010

 

 

 

 

 

 

 

 

 

Net (loss) income

 

$

(7,055

)

$

4,988

 

$

(11,149

)

 

 

 

 

 

 

 

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

518

 

(444

)

1,415

 

Change in pension and postretirement benefit plans, net

 

(1,229

)

(5,202

)

(3,089

)

Comprehensive loss

 

$

(7,766

)

$

(658

)

$

(12,823

)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

Colt Defense LLC and Subsidiaries

Consolidated Statements of Changes in Cash Flows

For the Years Ended December 31,

(In thousands of dollars)

 

 

 

2012

 

2011

 

2010

 

Operating Activities

 

 

 

 

 

 

 

Net (loss) income

 

$

(7,055

)

$

4,988

 

$

(11,149

)

Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:

 

 

 

 

 

 

 

Loss from discontinued operations

 

 

 

873

 

Depreciation and amortization

 

5,696

 

5,476

 

4,562

 

Amortization of financing fees

 

1,653

 

1,498

 

1,918

 

Pension curtailment expense

 

1,325

 

 

 

Deferred foreign income taxes

 

39

 

(271

)

(161

)

Loss (gain) on sale/disposals of fixed assets

 

4

 

(12

)

(8

)

Amortization of debt discount

 

381

 

348

 

318

 

Debt prepayment expense

 

 

295

 

1,246

 

Amortization of deferred income

 

(79

)

(125

)

(188

)

Common unit compensation expense

 

17

 

 

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

8,091

 

(15,761

)

5,501

 

Inventories

 

(4,158

)

(4,765

)

3,901

 

Prepaid expenses and other current assets

 

(984

)

405

 

(198

)

Accounts payable and accrued expenses

 

5,201

 

8,001

 

(5,052

)

Accrued pension and retirement liabilities

 

(172

)

(622

)

(1,075

)

Customer advances and deferred income

 

2,001

 

(46

)

1,967

 

Other liabilities, net

 

463

 

(71

)

(69

)

Net cash provided by (used in) operating activities from continuing operations

 

12,423

 

(662

)

2,386

 

Net cash used in operating activities from discontinued operations

 

 

(33

)

(732

)

Net cash provided by (used in) operating activities

 

12,423

 

(695

)

1,654

 

Investing Activities

 

 

 

 

 

 

 

Purchases of property and equipment

 

(4,410

)

(5,600

)

(7,440

)

Proceeds from sale/disposal of property

 

66

 

12

 

19

 

Change in restricted cash

 

464

 

(1,380

)

465

 

Net cash used in investing activities from continuing operations

 

(3,880

)

(6,968

)

(6,956

)

Net cash provided by investing activities from discontinued operations

 

 

 

14

 

Net cash used in investing activities

 

(3,880

)

(6,968

)

(6,942

)

Financing Activities

 

 

 

 

 

 

 

Debt issuance costs

 

 

(1,636

)

(75

)

Line of credit advance

 

6

 

 

 

Capital lease obligation payments

 

(1,148

)

(1,229

)

(1,146

)

Distributions paid to members

 

(3,343

)

(12,889

)

(4,976

)

Net cash used in financing activities from continuing operations

 

(4,485

)

(15,754

)

(6,197

)

Net cash used in financing activities from discontinued operations

 

 

 

(15

)

Net cash used in financing activities

 

(4,485

)

(15,754

)

(6,212

)

Effect of exchange rates on cash

 

79

 

209

 

239

 

Change in cash and cash equivalents

 

4,137

 

(23,208

)

(11,261

)

Cash and cash equivalents, beginning of period

 

38,236

 

61,444

 

72,705

 

Cash and cash equivalents, end of period

 

$

42,373

 

$

38,236

 

$

61,444

 

Supplemental Disclosure of Cash Flow Information

 

 

 

 

 

 

 

Cash paid for interest

 

$

22,198

 

$

22,075

 

$

22,817

 

Cash paid for foreign income taxes

 

3,207

 

2,574

 

3,313

 

Non-cash consideration for sale of equipment

 

75

 

 

 

Accrued debt issuance costs

 

 

17

 

 

Accrued purchases of fixed assets

 

516

 

364

 

78

 

Accrued distributions to members

 

 

3,343

 

15,606

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

Colt Defense LLC and Subsidiaries

Consolidated Statements of Changes in Deficit

For the Years Ended December 31,

(In thousands of dollars)

 

 

 

Member
Units

 

Accumulated
Members’
Deficit

 

Accumulated
Other
Comprehensive
Loss

 

Non-
Controlling
Interest

 

Total

 

Balance, December 31, 2009

 

132,174

 

$

(104,912

)

$

(5,810

)

$

(96

)

$

(110,818

)

Disposal of non-controlling interest

 

 

 

 

180

 

180

 

Distributions to members

 

 

(17,937

)

 

 

(17,937

)

Net loss

 

 

(11,065

)

 

(84

)

(11,149

)

Other comprehensive (loss)/income:

 

 

 

 

 

 

 

 

 

 

 

Pension and postretirement health liabilities

 

 

 

(3,089

)

 

(3,089

)

Foreign currency translation

 

 

 

1,415

 

 

1,415

 

Comprehensive loss

 

 

 

 

 

(12,823

)

Balance, December 31, 2010

 

132,174

 

(133,914

)

(7,484

)

 

(141,398

)

 

 

 

 

 

 

 

 

 

 

 

 

Distributions to members

 

 

(778

)

 

 

(778

)

Net income

 

 

4,988

 

 

 

4,988

 

Other comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

Pension and postretirement health liabilities

 

 

 

(5,202

)

 

(5,202

)

Foreign currency translation

 

 

 

(444

)

 

(444

)

Comprehensive loss

 

 

 

 

 

(658

)

Balance, December 31, 2011

 

132,174

 

(129,704

)

(13,130

)

 

(142,834

)

 

 

 

 

 

 

 

 

 

 

 

 

Common unit compensation expense

 

 

17

 

 

 

17

 

Distribution to members

 

 

(704

)

 

 

(704

)

Net loss

 

 

(7,055

)

 

 

(7,055

)

Other comprehensive (loss)/income:

 

 

 

 

 

 

 

 

 

 

 

Pension and postretirement health liabilities

 

 

 

(1,229

)

 

(1,229

)

Foreign currency translation

 

 

 

518

 

 

518

 

Comprehensive loss

 

 

 

 

 

(7,766

)

Balance, December 31, 2012

 

132,174

 

$

(137,446

)

$

(13,841

)

$

 

$

(151,287

)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

 

Colt Defense LLC and Subsidiaries

Notes to Consolidated Financial Statements

(in thousands of dollars, except unit and per unit data)

 

1.              Nature of Business

 

Colt Defense LLC was formed in 2002 as a Delaware limited liability company as a result of the re-organization of Colt’s Manufacturing Company, Inc. The defense and law enforcement rifle business was separated from the commercial handgun business. We are one of the world’s leading designers, developers and manufacturers of small arms weapons systems for individual soldiers and law enforcement personnel. We have supplied small arms weapons systems to more than 80 countries by expanding our portfolio of products and services to meet evolving military and law enforcement requirements around the world.  Our products have proven themselves under the most severe and varied battle conditions. We also modify our rifles and carbines for civilian use and sell them to Colt’s Manufacturing Company LLC (“Colt’s Manufacturing”), which sells these MSR’s into the U.S. commercial market.

 

2.              Summary of Significant Accounting Policies

 

Basis of Accounting and Consolidation

 

The accompanying consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP). Our consolidated financial statements include the accounts of Colt Defense LLC and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.

 

Reclassification of Prior Period Amounts

 

Certain prior period amounts have been reclassified to conform to the current year’s presentation.

 

Use of Estimates

 

The preparation of consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

 

Cash and Cash Equivalents

 

Cash and cash equivalents consists of cash and short-term, highly liquid investments with original maturities of three months or less at the date of purchase.

 

Restricted Cash

 

Restricted cash at December 31, 2012 and 2011 consists of funds deposited to secure standby letters of credit primarily for performance guarantees related to our international business.

 

Revenue, Accounts Receivable and Credit Policies

 

We recognize revenue when evidence of an arrangement exists, delivery of the product or service has occurred and title and risk of loss have passed to the customer, the sales price is fixed or determinable, and collectability of the resulting receivable is reasonably assured. For certain “bill and hold” sales to the U.S. and Canadian governments, such sales and related accounts receivable are recognized upon inspection and acceptance of the rifles, including title transfer, by a government official and after we place the accepted rifles in a government approved location at our premises where they are held waiting shipping instructions. The

 

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sales value of such bill and hold sales where the shipments were still located at our premises at December 31, 2012, 2011 and 2010 were $0, $6,840 and $9,026, respectively.

 

We account for revenues and earnings under two long-term government contracts/programs with interrelated multiple elements (procurement of parts, manufacturing and refurbishment services) using concepts of proportionate performance. These contracts effect reported results for all periods presented. We estimate the total profit on each contract as the difference between the total estimated revenue and total estimated cost of the contract and recognize that profit over the remaining life of the contract using an output measure (the ratio of rifles completed to the total number of rifles to be refurbished under the contract). We compute an earnings rate for each contract, including general and administrative expense, to determine operating earnings. We review the earnings rate quarterly to assess revisions in contract values and estimated costs at completion. Any changes in earnings rates and recognized contract to date earnings resulting from these assessments are made in the period the revisions are identified. Contract costs include production costs, related overhead and allocated general and administrative costs. Amounts billed and collected on this contract in excess of revenue recorded are reflected as customer advances and deferred income in the Consolidated Balance Sheets.

 

Anticipated contract losses are charged to operations as soon as they are identified. Anticipated losses cover all costs allocable to the contracts, including certain general and administrative expenses. If a contract is cancelled by the government for its convenience, we can make a claim against the customer for fair compensation for worked performed plus costs of settling and paying claims by terminated subcontractors, other settlement expenses and a reasonable profit on costs incurred. When we have a customer claim, revenue arising from the claims process is either recognized as revenue or as an offset against a potential loss only when the amount of the claim can be estimated reliably and its realization is probable. We had no claims recorded at any year-end presented.

 

Credit is extended based on an evaluation of each customer’s financial condition. Generally, collateral is not required, other than in connection with some foreign sales. If the circumstances warrant, we require foreign customers to provide either a documentary letter of credit or a prepayment.

 

Credit losses are provided for, primarily using a specific identification basis. Once a customer is identified as high risk based on the payment history and creditworthiness, we will provide an allowance for the estimated uncollectible portion. Accounts are considered past due based on the original invoice date. Write-offs of uncollectible accounts receivable occur when all reasonable collection efforts have been made. Neither provisions nor write-offs were material for any period presented. Our allowance for doubtful accounts at December 31, 2012 was $0 and at December 31, 2011 was $1.

 

 

 

Total

 

Balance at December 31, 2010

 

$

216

 

Provision for (recovery of) doubtful accounts

 

(209

)

Write-offs

 

(6

)

Balance at December 31, 2011

 

$

1

 

Provision for (recovery of) doubtful accounts

 

1

 

Write-offs

 

(2

)

Balance at December 31, 2012

 

$

 

 

Accounts receivable represent amounts billed and currently due from customers. There were no material amounts that were not expected to be collected within one year from the balance sheet date.

 

Inventories

 

Inventories are stated at the lower of cost, determined using the first-in, first-out method, or market. Cost includes materials, labor and manufacturing overhead related to the purchase and production of inventories.

 

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We review market value based on historical usage and estimates of future demand.  Based on these reviews, inventory write-downs are recorded, as necessary, to reflect estimated obsolescence, excess quantities and declines in market value.

 

Property and Equipment

 

Property and equipment are recorded at cost. Depreciation of building and equipment (including assets recorded under capital leases) and amortization of leasehold improvements are computed using the straight-line method over the estimated useful life of the assets or for leasehold improvements, over the life of the lease term if shorter. Depreciation and amortization of property and equipment for the years ended December 31, 2012, 2011 and 2010 was $4,891, $4,633 and $3,712, respectively. We did not enter into any capital leases during 2012 or 2011.

 

Expenditures that improve or extend the lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

 

Property and equipment consist of:

 

 

 

December 31,

 

Estimated

 

 

 

2012

 

2011

 

Useful Life

 

Land

 

$

362

 

$

354

 

 

Building

 

2,718

 

2,521

 

33

 

Machinery and equipment

 

37,749

 

34,086

 

7-10

 

Furniture, fixtures and leasehold improvements

 

6,378

 

6,089

 

3-5

 

 

 

47,207

 

43,050

 

 

 

Less accumulated depreciation and amortization

 

(28,162

)

(23,531

)

 

 

 

 

19,045

 

19,519

 

 

 

Construction in process

 

3,089

 

3,070

 

 

 

Property and equipment, net

 

$

22,134

 

$

22,589

 

 

 

 

Goodwill

 

Goodwill is tested for impairment annually as of the end of our third fiscal quarter, or when events or circumstances indicate that its value may have declined. Impairment exists when the carrying amount of goodwill exceeds its fair market value. Management estimates the fair value of each reporting unit primarily using the income approach. Specifically the discounted cash flow (“DCF”) model was utilized for the valuation of each reporting unit. Management develops cash flow forecasts based on existing firm orders, expected future orders, contracts with suppliers, labor agreements and general market conditions. We discount the cash flow forecasts using the weighted-average cost of capital method at the date of evaluation. We also calculate the fair value of our reporting units using the market approach in order to corroborate our DCF model results. These methodologies used in the current year are consistent with those used in the prior year.

 

Since December 2012, there has been an extremely sharp increase in political and public support for new “gun control” laws and regulations in the United States.  Some proposed legislation, including legislation that has been introduced and is under active consideration in Congress and in state legislatures, would ban and/or restrict the sale of substantially all of our products, in their current configurations, into the commercial market, either throughout the United States or in particular states.  We considered this potential adverse change in our business climate to be a Triggering Event. Therefore, in addition to our annual goodwill impairment testing, we also performed a sensitivity analysis to determine the impact that a material decrease in LE/Commercial sales would have on our valuation. As of December 31, 2012, the fair value of our reporting units was substantially in excess of carrying value for all scenarios that we tested.

 

There were no impairment indicators of any goodwill during 2012, 2011 or 2010.  Changes in the carrying amount of goodwill are as follows:

 

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Total

 

Balance at December 31, 2010

 

$

14,950

 

Effect of foreign currency translation

 

(237

)

Balance at December 31, 2011

 

14,713

 

Effect of foreign currency translation

 

234

 

Balance at December 31, 2012

 

$

14,947

 

 

As of December 31, 2012 and 2011, there was an accumulated impairment of $1,245 on the gross book value of $16,192.

 

Intangible Assets

 

We review long-lived assets, including intangible assets subject to amortization, for impairment whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. Impairment losses, where identified, are determined as the excess of the carrying value over the estimated fair value of the long-lived asset. We assess the recoverability of the carrying value of assets held for use based on a review of projected undiscounted cash flows. When long-lived assets are reclassified to “held for sale”, we compare the asset’s carrying amount to its estimated fair value less cost to sell to evaluate impairment. No long-lived assets have been reclassified to held for sale for any period presented.

 

The net carrying value of our intangible assets with finite lives follows:

 

 

 

As of December 31, 2012

 

 

 

Gross

 

 

 

 

 

Estimated

 

 

 

Carrying