10-Q 1 pr589731.txt QUARTERLY REPORT FOR JUNE 30, 2001 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001. OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 333-33438 PRECISION PARTNERS, INC. (Exact name of registrant as specified in its charter) -------------------------------------------------------------------------------- Delaware 22-3639336 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 100 Village Court Suite 301 Hazlet, New Jersey 07730 (Address of principal executive offices) (732) 335-3300 Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities 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 --- --- The number of shares outstanding of the Registrant's Common Stock, $.01 par value, was 100 as of July 31, 2001. 1 PRECISION PARTNERS, INC. FORM 10-Q TABLE OF CONTENTS

2 DISCLOSURE CONCERNING FORWARD-LOOKING STATEMENTS With the exception of the historical information contained in this report, the matters described herein contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain the words "believe," "anticipate," "expect," "estimate," "intend," "project," "will be," "will likely continue," "will likely result," or words or phrases of similar meaning including, statements concerning: o our liquidity and capital resources, o our debt levels and ability to obtain financing and service debt, o competitive pressures and trends in the precision machined parts, tooling and assembly industry, o prevailing interest rates, o legal proceedings and regulatory matters, o general economic and business conditions, and o other factors discussed under "Other Considerations" in Item 2. Forward-looking statements involve risks and uncertainties (including, but not limited to, economic, competitive, governmental and technological factors outside of our control) which may cause actual results to differ materially from the forward-looking statements. These risks and uncertainties may include the ability of management to implement its business strategy in view of our limited operating history; our ability to comply with the covenants in our bank agreement, the highly competitive nature of the precision tooling industry and the intense competition from other makers of precision machined metal parts, tooling and assemblies, our dependence on certain key customers; our ability to consummate suitable acquisitions, our ability to effectively integrate acquisitions or new production programs, our dependence on certain executive officers; and changes in environmental and other government regulations. We operate in a very competitive environment in which new risks can emerge from time to time. It is not possible for management to predict all such risks, nor can it assess the impact of all such risks on our business or the extent to which any risk, or a combination of risks, may cause actual results to differ materially from those contained in forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on forward-looking statements. 3 PART I: FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS Precision Partners, Inc. Condensed Consolidated Balance Sheets (in thousands, except for share data)

See accompanying notes 4 Precision Partners, Inc. Unaudited Condensed Consolidated Statements of Operations (in thousands)

See accompanying notes 5 Precision Partners, Inc. Unaudited Condensed Consolidated Statements of Cash Flows (in thousands)

See accompanying notes 6 NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION Precision Partners, L.L.C. ("LLC") was formed on September 9, 1998 for the purpose of acquiring and operating companies in the business of manufacturing and supplying precision machined parts, tooling and assemblies for original equipment manufacturers. On September 30, 1998, investors contributed approximately $32 million of capital to LLC which was then contributed by LLC to two wholly-owned subsidiaries, Mid State Acquisition Corp. and Galaxy Acquisition Corp., which were established to acquire all of the outstanding capital stock of Mid State Machine Products ("Mid State") and Galaxy Industries Corporation ("Galaxy") on September 30, 1998 (Mid State and Galaxy, collectively the "1998 Acquisitions"). The purchase price, including transaction expenses, was approximately $54,725,000 and was financed by the proceeds of the contributed capital and borrowings under LLC's credit facilities. In February 1999, Precision Partners, Inc. ("Precision" or the "Company") was formed as a wholly-owned subsidiary of Precision Partners Holdings, Inc. ("Holdings"), a wholly-owned subsidiary of LLC. On March 19, 1999, as part of a reorganization, LLC contributed to Precision, through Holdings, its investments and related assets in Galaxy, Mid State and Precision Partners Management Corporation ("Management Corporation"), which comprised substantially all of the assets of LLC ("the 1999 Reorganization"). Simultaneous with this reorganization, Precision purchased all of the issued and outstanding capital stock of Certified Fabricators, Inc. and its sister company Calbrit Design, Inc. (together, "Certified") and purchased substantially all of the assets and assumed certain liabilities of General Automation, Inc. ("General Automation") and Nationwide Precision Products Corp. ("Nationwide"). Also, on September 1, 1999, Precision purchased all of the issued and outstanding capital stock of Gillette Machine & Tool Co., Inc. ("Gillette") using existing cash and borrowings under Precision's credit facilities. The acquisitions of Certified, General Automation, Nationwide, and Gillette are referred to collectively as the "1999 Acquisitions." The 1999 Acquisitions were financed through the net proceeds of the issuance of $100,000,000 aggregate principal amount 12% senior subordinated notes due 2009, together with borrowings under Precision's credit facilities, an equity contribution of approximately $10,000,000 and available cash. The total purchase price, including transaction expenses, was approximately $116,593,000. In connection with the refinancing of Precision's bank credit facilities and the execution of a term loan with General Electric Capital Corporation in December 2000, capital contributions of $6.0 million were made to LLC by investors in 2000 bringing the aggregate capital contributed to $48.1 million. LLC contributed this capital through Holdings to Precision. All significant inter-company balances and transactions have been eliminated in consolidation. Financial information of the guarantor subsidiaries has been omitted because Precision's outstanding senior subordinated notes are fully, unconditionally and jointly and severally guaranteed by all direct and indirect subsidiaries of Precision. Precision has no operations or assets separate from its investments in its subsidiaries. The indenture governing the outstanding Notes as well as the agreements governing the credit facilities (described below) restrict the ability of Precision and its subsidiaries to make dividend payments. 7 The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six month period ended June 30, 2001 are not necessarily, and should not be construed as, indicative of the results that may be achieved for a full year. 2. INVENTORIES AND COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS Inventories consist of the following at: June 30, December 31, 2001 2000 ----------- ----------- (in thousands) (Unaudited) Raw materials $ 5,505 $ 4,061 Work in process 11,202 10,443 Finished goods 4,517 4,350 ----------- ----------- 21,224 18,854 Less reserves 706 219 ----------- ----------- $ 20,518 $ 18,635 =========== =========== Information regarding contract costs, estimated earnings and progress billings on long term contacts consist of the following at: June 30, December 31, 2001 2000 ----------- ----------- (in thousands) (Unaudited) Costs incurred on uncompleted contracts $ 197 $ 237 Estimated earnings on uncompleted contracts 67 22 ----------- ----------- 264 259 Less net progress billings 93 -- ----------- ----------- Costs and estimated earnings on uncompleted contracts in excess of billings $ 171 $ 259 =========== =========== There were no significant billings in excess of net costs and estimated earnings on uncompleted contracts. 8 3. DEBT Long-term debt consists of the following at:

4. LITIGATION Precision or its subsidiaries are defendants from time to time in lawsuits and disputes arising in the normal course of business. Management believes that the ultimate outcome of those matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. 5. INCOME TAXES The tax provisions (benefits) for the three and six months ended June 30, 2001 and 2000 were each impacted by permanent differences between pre-tax loss for financial reporting purposes and tax 9 reporting purposes resulting primarily from non-deductible goodwill generated by the stock acquisitions of Mid State, Galaxy, Certified, and Gillette. Further, in accordance with Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, the Company recorded a valuation allowance equal to the deferred tax assets recorded in relation to the net operating losses incurred during the three and six months ended June 30, 2001. While Precision, on a consolidated basis, has incurred taxable losses during the three and six months ended June 30, 2001, certain of its subsidiaries have generated taxable income for state tax purposes. Thus, Precision recognized state tax provisions of $0.3 million and $0.6 million for the three and six months ended June 30, 2001 as compared to the tax benefits of $0.8 million in each of the three and six months ended June 30, 2000. 6. RECENT ACCOUNTING PRONOUNCEMENTS In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with these Statements. Other intangible assets will continue to be amortized over their useful lives. The Company, as required, will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the nonamortization provisions of the Statement is expected to result in an increase in operating income of approximately $4.0 million per year. During the first quarter of 2002, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the Company. 10 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements, including the notes thereto, included elsewhere in this report. RESULTS OF OPERATIONS The following table sets forth certain unaudited financial information for the periods indicated:

(1) EBITDA is defined as operating income plus depreciation and amortization, excluding amortization of debt issue costs. EBITDA is not a measure of performance under generally accepted accounting principles. While EBITDA should not be used in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data prepared in accordance with generally accepted accounting principles, or as a measure of profitability or liquidity, management believes that it may be used by certain investors as supplemental information to evaluate a company's financial performance. In addition, the definition of EBITDA used in this report may not be comparable to the definition of EBITDA used by other companies. 11 THREE MONTHS ENDED JUNE 30, 2001 COMPARED TO THREE MONTHS ENDED JUNE 30, 2000 NET SALES Net sales increased 9.7% to $47.4 million in the second quarter of 2001 compared to $43.2 million in the second quarter of 2000. The increase is primarily due to continued growth in power generation component sales and the first-time inclusion of sales of heavy construction, off-road diesel engine blocks and heavy truck axle components. These increases were offset in part by continued weakness in aerospace shipments at Certified and lower sales volume in automotive and light truck components at Galaxy, General Automation, and Nationwide. GROSS PROFIT Gross profit increased 3.8% to $9.5 million in the second quarter of 2001 compared to $9.1 million in the second quarter of 2000. Gross margin decreased to 20.0% in the second quarter of 2001 from 21.1% in the comparable period of 2000. Strength in power generation components and the absence of start-up losses, which were incurred in the prior year period, in the heavy construction, off-road diesel engine block plant were offset in part by the impact of lower sales volume in automotive, light truck and aerospace components. Higher than expected start-up costs at Nationwide's truck axle component facility and cost overruns on a completed aerospace job also negatively impacted gross profits. Additionally, depreciation expense and equipment lease expense increased approximately $1.4 million, in the aggregate, over the comparable period, as a result of the completion of various capital projects in fiscal 2000 to support increased delivery requirements and plant expansions for new production contracts. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general, and administrative expenses decreased 11.4% to $6.6 million in the second quarter of 2001 compared to $7.4 million in the second quarter of 2000. Corporate office bonuses accrued in the first quarter of 2001 were reversed and no further corporate bonus accruals were made in the second quarter. Further, Certified significantly lowered its selling, general and administrative costs as a result of the restructuring that took place in the third quarter of 2000. These reductions were offset in part by higher costs at Mid State relating to its strong growth. Additionally, the three months ended June 30, 2000 included severance costs related to corporate management changes. OPERATING INCOME As a result of all of the foregoing, operating income increased to $2.9 million in the second quarter of 2001 from $1.7 million in the second quarter of 2000. Operating income was negatively impacted by $0.2 million of expenses related to the restructuring of Galaxy and Certified. NET INTEREST EXPENSE For the second quarter of 2001, net interest expense increased 4.7% to $4.4 million from $4.2 million for the comparable period of 2000. The increase is primarily attributable to higher average outstanding debt and higher average interest rates in 2001 versus 2000. Higher average debt balances were due to the refinancing and restructuring which occurred in the fourth quarter of 2000 and higher outstanding borrowings under the Company's revolving line of credit. Higher average borrowing rates reflect higher borrowing spreads resulting from the restructuring and refinancing of our credit facilities in the fourth quarter of 2000, partially offset by lower market rates. 12 INCOME TAXES The tax provision for the second quarter of 2001 and the tax benefit for the second quarter of 2000 were each impacted by permanent differences between pre-tax loss for financial reporting purposes and tax reporting purposes resulting primarily from non-deductible goodwill generated by the stock acquisitions. Further, in accordance with Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, the Company recorded a valuation allowance equal to the deferred tax assets recorded in relation to the net operating losses incurred during the quarter ended June 30, 2001. While Precision, on a consolidated basis, has incurred taxable losses during the second quarter of 2001 and management has taken a valuation allowance against those tax benefits, certain of its subsidiaries have generated taxable income for state tax purposes. Thus, Precision recognized a state tax provision totaling $0.3 million for the quarter ended June 30, 2001 versus a tax benefit of $0.8 million in the comparable period of the prior year. NET LOSS Net loss was $2.0 million in the second quarter of 2001 compared to $1.8 million in the second quarter of 2000 due to the aforementioned reasons. DEPRECIATION AND AMORTIZATION Depreciation and amortization increased 21.2% to $4.9 million in the second quarter of 2001 compared to $4.0 million in the second quarter of 2000. The increase is primarily due to increased depreciation expense related to the significant expenditures on capital equipment in 2000 that supported new customer contracts and increased capacity for higher volumes in power generation components. SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO SIX MONTHS ENDED JUNE 30, 2000 NET SALES Net sales increased 10.0% to $96.9 million in the first six months of 2001 compared to $88.1 million in the first six months of 2000. The increase is primarily due to continued growth in power generation component sales and the first-time inclusion of sales of heavy construction, off-road diesel engine blocks and heavy truck axle components, and growth in sales of business and medical machine equipment components. These increases were offset in part by continued weakness in aerospace shipments at Certified and lower sales volume in automotive and light truck components at Galaxy, General Automation and Nationwide. GROSS PROFIT Gross profit decreased 4.7% to $19.3 million in the first six months of 2001 compared to $20.2 million in the first six months of 2000. Gross margin decreased to 19.9% in the first six months of 2001 from 23.0% in the comparable period of 2000. Strength in the power generation, business equipment and medical equipment markets were offset in part by the impact of lower sales volume in automotive, light truck and aerospace components. Higher than expected start-up costs at Nationwide's truck axle component facility, low sales volumes in heavy equipment engine blocks, and cost overruns on a 13 completed aerospace job also negatively impacted gross profits. Additionally, depreciation expense and equipment lease expense increased approximately $2.8 million, in the aggregate, over the comparable period of the prior year, as a result of the completion of various capital projects in fiscal 2000. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general, and administrative expenses decreased 2.5% to $14.6 million in the first six months of 2001 compared to $15.0 million in the first six months of 2000. This is primarily related to Certified significantly lowering its selling, general and administrative costs as a result of the restructuring that took place in the third quarter of 2000. Further, the absence of severance costs related to management changes at the corporate office during 2000 contributed to the period over period reduction in selling, general and administrative costs. These reductions were offset in part by higher costs at Mid State relating to its strong growth. OPERATING INCOME As a result of all of the foregoing, operating income decreased to $4.7 million in the first six months of 2001 from $5.3 million in the comparable period of 2000. Operating income for the period was negatively impacted by approximately $1.0 million in expenses related to the restructuring of Galaxy and Certified. NET INTEREST EXPENSE For the six months ended June 30, 2001, net interest expense increased 7.9% to $9.0 million from $8.3 million for the comparable period of 2000. The increase is primarily attributable to higher average outstanding debt and higher average interest rates in 2001 versus 2000. Higher average debt balances were due to the refinancing and restructuring which occurred in the fourth quarter of 2000 and higher outstanding borrowings under the Company's revolving line of credit. Higher average borrowing rates reflect higher borrowing spreads resulting from the restructuring and refinancing of our credit facilities in the fourth quarter of 2000, partially offset by lower market rates. INCOME TAXES The tax provision for the first six months of 2001 and the tax benefit for the first six months of 2000 were each impacted by permanent differences between pre-tax loss for financial reporting purposes and tax reporting purposes resulting primarily from non-deductible goodwill generated by the stock acquisitions. Further, in accordance with Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, the Company recorded a valuation allowance equal to the deferred tax assets recorded in relation to the net operating losses incurred during the six months ended June 30, 2001. While Precision, on a consolidated basis, has incurred taxable losses during the first six months of 2001 and management has taken a valuation allowance against those tax benefits, certain of its subsidiaries have generated taxable income for state tax purposes. Thus, Precision recognized a state tax provision totaling $0.6 million for the six months ended June 30, 2001 versus a tax benefit of $0.8 million in the comparable period of the prior year. NET LOSS Net loss was $5.2 million in the first six months of 2001 compared to $2.3 million in the same period of 2000 due to the aforementioned reasons and $0.3 million of losses on assets disposed during the six months ended June 30, 2001 included in other expense. 14 DEPRECIATION AND AMORTIZATION Depreciation and amortization increased 20.8% to $9.7 million in the first six months of 2001 compared to $8.0 million in the comparable period of 2000. The increase is primarily due to increased depreciation expense related to the significant expenditures on capital equipment in 2000 that supported new customer contracts and increased capacity for higher volumes in power generation components. LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities for the six months ended June 30, 2001 was $1.8 million compared to $9.0 million in the comparable period of 2000. This decrease primarily reflects the larger net loss generated in the current period and unfavorable working capital fluctuations offset by higher depreciation and higher deferred revenue. Net cash used in investing activities decreased to $2.4 million for the six months ended June 30, 2001 from $2.8 million in the comparable period of 2000. This decrease primarily reflects the proceeds from the sale of assets related to the bearing cap business at Galaxy that was partially offset by an increase in capital expenditures primarily to expand machining capacity and efficiency. Net cash provided by financing activities for the six months ended June 30, 2001 was $1.3 million compared to net cash used in financing activities of $6.6 million for the six months ended June 30, 2000 primarily reflecting scheduled principal repayments on Precision's term loans to its bank group and GECC and net borrowings on its revolving credit facility. Precision's principal sources of liquidity are available borrowings under its revolving credit facility and cash flow from operations. Precision expects that its principal liquidity requirements will continue to be working capital, capital expenditures, debt service and required lease payments. Precision's credit facilities at June 30, 2001 consisted of a $19.5 million bank term loan and a $22.0 million revolving credit facility, including a $2.0 million sublimit for letters of credit, each payable to a bank group maturing on March 31, 2005, and a $19.0 million equipment term loan from GECC maturing December 31, 2005, subject to the borrower's option to extend for 12 months if no default or event of default has occurred or is continuing. As of June 30, 2001, Precision had total debt of approximately $151.1 million, primarily consisting of the outstanding aggregate principal amount of its $100 million senior subordinated notes, the outstanding principal amount on its bank term loan, the outstanding principal amount of its GECC term loan and $12.4 million of outstanding borrowings under its revolving credit facility. Precision's ability to borrow under the revolving credit facility is subject to its compliance with financial covenants and a borrowing base that is based on Precision's eligible accounts receivables and inventory. Precision also leases equipment from GECC under a master lease. As of June 30, 2001, Precision had operating leases outstanding under its master lease agreement with GECC for equipment with a cost of $6.6 million. Rent payments under the amended and restated master lease consist of payments of principal plus interest at a rate per annum of LIBOR plus a margin of 5.0%, subject to reduction in certain circumstances. Precision's debt amortization requirements over the next two years are limited to the term loan payable to the bank group and the GECC equipment term loan facility, and total $15.8 million over this 15 period. Precision's other debt service requirements over the next two years consist primarily of interest expense on those loans, on the senior subordinated notes and on borrowings under the revolving credit facility. Precision's other short-term cash requirements are expected to consist mainly of capital expenditures to maintain and expand Precision's manufacturing capabilities, rental payments under the GECC master lease and working capital requirements. Precision currently expects that its capital expenditures will be approximately $4.5 million in 2001, including capital expenditures to maintain current production capabilities. However, Precision's capital expenditures will be affected by, and may be greater or less than currently anticipated depending upon, among other things, the size and nature of new business opportunities and bank credit limitations. Based upon current operations and the historical results of its subsidiaries, Precision believes that its cash flow from operations, together with borrowings under its revolving credit facility ($9.6 million unused at June 30, 2001), will be adequate to meet its anticipated requirements for working capital, capital expenditures, scheduled lease payments, and scheduled debt service over the next 12 months. However, there can be no assurance that Precision will generate adequate cash flow. In addition, Precision's ability to repay outstanding debt at maturity may depend on the availability of refinancing. On July 18, 2001, the Company borrowed substantially all available funds under its revolving line of credit facility. As of August 10, 2001, the Company maintained a cash balance in its bank accounts of approximately $17.7 million and $20.2 million was outstanding under the revolver. INFLATION We do not believe that inflation has had a significant impact on our cost of operations. OTHER CONSIDERATIONS PRECISION'S SUBSTANTIAL DEBT AND THE SIGNIFICANT DEMANDS ON ITS CASH RESOURCES COULD AFFECT ITS ABILITY TO MAKE PAYMENTS ON THE OUTSTANDING DEBT AND ACHIEVE ITS BUSINESS PLAN. Substantial Debt. Precision has incurred a substantial amount of indebtedness that requires significant interest payments. As of June 30, 2001, Precision had total consolidated debt of $151.1 million and net interest expense of approximately $9.0 million for the six months then ended. In addition, as of the same date, Precision had operating leases outstanding under its master lease agreement with GECC for equipment with a cost of $6.6 million. Subject to the limits contained in the indenture governing Precision's outstanding senior subordinated notes, its bank credit facilities, the GECC master lease and the GECC equipment term loan facility, Precision and its subsidiaries may incur additional indebtedness from time to time to finance capital expenditures, investments or acquisitions or for other general corporate purposes. On July 18, 2001, the Company borrowed substantially all available funds under its revolving line of credit facility. As of August 10, 2001, $20.2 million was outstanding under the revolver and the Company maintained a cash balance in its bank accounts of approximately $17.7 million. Demands on Cash Resources. Precision has substantial demands on its cash resources in addition to operating expenses and interest expense on the senior subordinated notes, including, among others, interest and amortization payments under its credit facilities and the GECC equipment term loan as well as rental payments under the GECC master lease. See "Liquidity and Capital Resources" above. Effects on Precision's Business Strategy. Precision's level of indebtedness and these significant demands on its cash resources could have important effects on Precision's business. For example these demands could, among other things,: 16 o make it more difficult for Precision to satisfy its debt service obligations with respect to the senior subordinated notes and its secured indebtedness under its credit facilities and the GECC equipment term loan; o require Precision to dedicate a substantial portion of its cash flow from operations to debt service, thereby reducing the amount of its cash flow available for working capital, capital expenditures, acquisitions and other general corporate purposes; o limit Precision's flexibility in planning for, or reacting to, changes in its industry (including the pursuit of its growth strategy); o place Precision at a competitive disadvantage compared to its competitors that have fewer debts and significantly greater operating and financing flexibility than Precision does; o limit, along with the financial and other restrictive covenants applicable to Precision's indebtedness, among other things, its ability to borrow additional funds even when necessary to maintain adequate liquidity; and o increase Precision's vulnerability to general adverse economic and industry conditions. Precision's ability to pay interest on its long-term indebtedness and to satisfy its other debt obligations will depend upon its future operating performance and may depend upon the availability of refinancing indebtedness, which will be affected by the instruments governing its indebtedness, including the indenture, the credit facilities, the GECC master lease and the GECC equipment term loan facility, prevailing economic conditions and financial, business and other factors, certain of which are beyond its control. If Precision is unable to service its indebtedness and fund its business, it may be forced to adopt an alternative strategy that may include: o reducing or delaying capital expenditures; o seeking additional debt financing or equity capital; o selling assets; or o restructuring or refinancing its indebtedness. There can be no assurance that any such strategy could be effected on terms satisfactory to Precision or at all. Effect of Additional Debt. Subject to and within the limits of Precision's debt instruments and the GECC master lease, Precision may incur additional indebtedness from time to time to finance capital expenditures, investments and operations or for other purposes, including the borrowing of amounts repaid under its credit facilities. This could further exacerbate the risks described below. PRECISION'S DEBT INSTRUMENTS AND AGREEMENTS RESTRICT ITS ABILITY AND THE ABILITY OF ITS SUBSIDIARIES TO ENGAGE IN SOME BUSINESS TRANSACTIONS. Indenture. The indenture governing Precision's outstanding senior subordinated notes restricts our ability and the ability of some of its subsidiaries to, among other things: o incur additional debt; o pay dividends on or redeem or repurchase capital stock; o issue or allow any person to own preferred stock of subsidiaries; 17 o incur or permit to exist indebtedness senior to the senior subordinated notes, but subordinated to any of its other indebtedness; o in the case of non-guarantor subsidiaries, guarantee debt without also guaranteeing the Notes; o in the case of restricted subsidiaries, create or permit to exist dividend or payment restrictions with respect to Precision; o make investments; o incur or permit to exist liens; o enter into transactions with affiliates; o merge, consolidate or amalgamate with another company; and o transfer or sell assets. Bank Credit Facilities, GECC Master Lease and GECC Equipment Term Loan. Precision's bank credit facilities, the GECC master lease and the GECC equipment term loan also contain similar covenants, as well as a restriction on acquisitions and a number of financial covenants requiring Precision to meet financial ratios and financial condition tests. Precision's ability to borrow under its revolving credit facility and GECC's obligation to lease equipment to Precision and its subsidiaries under the master lease depends upon satisfaction of these covenants and, in the case of the revolving credit facilities, borrowing base requirements. Precision's ability to meet these covenants and requirements can be affected by events beyond its control. There can be no assurance that Precision will meet these requirements. For example, Precision was not in compliance with financial covenants under its credit facilities and the GECC master lease during the third and fourth quarters of 2000. Although Precision has received permanent waivers from its bank group and GECC, and the related covenants have been amended, there can be no assurance that Precision will be able to meet these revised covenants in the future. Effect of Future Breach. Precision's failure to comply with the obligations and covenants in the credit facilities, the GECC equipment term loan, the GECC master lease or the indenture could result in an event of default under one or more of those agreements that, if not cured or waived, could terminate its ability to borrow under the revolving credit facility or lease additional equipment under the GECC master lease, could permit acceleration of the relevant debt and acceleration of debt under other instruments and, in the case of the credit facilities and the GECC equipment term loan, could permit foreclosure on any collateral granted. PRECISION IS STRUCTURED AS A HOLDING COMPANY AND IT DEPENDS ON ITS SUBSIDIARIES IN ORDER TO SERVICE ITS DEBT. Precision is structured as a holding company. Precision's only significant asset is the capital stock or other equity interests of Precision's operating subsidiaries. As a holding company, Precision conducts all of its business through its subsidiaries. Consequently, Precision's cash flow and ability to service its debt obligations are dependent upon the earnings of Precision's operating subsidiaries and the distribution of those earnings to Precision, or upon loans, advances or other payments made by these subsidiaries to Precision. The ability of Precision's subsidiaries to pay dividends or make other payments or advances to Precision will depend upon their operating results and will be subject to applicable laws and contractual restrictions contained in the instruments governing their indebtedness, including Precision's bank credit facilities, the indenture, the GECC master lease and the GECC equipment term loan. Although the indenture limits the ability of these subsidiaries to enter into consensual restrictions on their ability to pay dividends and make other payments to Precision, these limitations are subject to a number of significant qualifications. There can be no assurance that the earnings of Precision's operating subsidiaries will be adequate for Precision to service its debt obligations. 18 PRECISION'S SUCCESS DEPENDS ON ITS ABILITY TO SUCCESSFULLY OPERATE ITS SUBSIDIARIES ON A COMBINED BASIS. Precision's operating subsidiaries operate independently of one another and there can be no assurance that Precision will be able to effectively manage these operating companies on a combined basis. In addition, to the extent management time may be diverted to any one or more of the companies, the other operating companies may be adversely affected. A failure by Precision to operate these businesses profitably or to manage them effectively on a combined basis could have a material adverse effect on its results of operations and financial condition. Although Precision performs a due diligence investigation of each business that it acquires, there may be liabilities of acquired companies, including those previously acquired and those that may be acquired in the future, that Precision fails or is unable to discover during its due diligence investigation and for which it, as a successor owner, may be responsible. In connection with acquisitions, Precision generally seeks to minimize the impact of these liabilities by obtaining indemnities and warranties from the seller that may be supported by deferring payment of a portion of the purchase price. However, these indemnities and warranties, if obtained, may not fully cover the liabilities due to their limited scope, amount, or duration, the financial limitations of the indemnitor or warrantor, or other reasons. THE SUCCESS OF PRECISION'S BUSINESS STRATEGY TO REALIZE A NUMBER OF CROSS SELLING OPPORTUNITIES COULD BE AFFECTED BY A NUMBER OF FACTORS BEYOND ITS CONTROL. As part of its business strategy, Precision intends to pursue and capitalize on a number of cross-selling opportunities it believes exist as a result of the complementary customer bases and manufacturing capabilities of the acquired companies and to implement certain operating improvements. Precision's ability to implement and realize the benefits of this strategy could be affected by a number of factors beyond its control, such as operating difficulties, increased operating costs, regulatory developments, general economic conditions, increased competition, or the inability to obtain adequate financing for Precision's operations on suitable terms. In addition, after gaining experience with its operations under this strategy, Precision may decide to alter or discontinue certain aspects of it. Any failure to implement aspects of Precision's strategy may adversely affect its results of operations, financial condition and ability to service debt. PRECISION'S INABILITY TO ACCESS ADDITIONAL CAPITAL COULD HAVE A NEGATIVE IMPACT ON ITS GROWTH STRATEGY. Precision's current business strategy will require additional capital investment. Capital will be required for, among other purposes, managing acquired companies, acquiring new equipment, maintaining the condition of Precision's existing equipment and completing new acquisitions. To the extent that cash generated internally and cash available under Precision's credit facilities is not sufficient to fund capital requirements, Precision will require additional debt and/or equity financing. There can be no assurance, however, that such financing will be available or, if available, will be available on terms satisfactory to Precision. Future debt financing, if available, may result in increased interest and amortization expense, increased leverage and decreased income available to fund further acquisitions and expansion, and may limit Precision's ability to withstand competitive pressures and render it more vulnerable to economic downturns. If Precision fails to obtain sufficient additional capital in the future, it could be forced to curtail its growth strategy by reducing or delaying capital expenditures and acquisitions, selling assets or restructuring or refinancing its indebtedness. A LOSS OF KEY EMPLOYEES AND HIGHLY SKILLED WORKERS COULD ADVERSELY AFFECT PRECISION'S BUSINESS. 19 Some of Precision's executive officers are key to Precision's management and direction. Precision's future success will depend on its ability to retain capable management. Precision recently appointed a new executive management team, and Precision's continued success will depend in part on the successful integration of that team with the operations of Precision's subsidiaries. Although Precision believes it will be able to attract and retain talented personnel and that it could replace key management personnel should the need arise, the inability to attract or retain such personnel could have a material adverse effect on its business. In addition, because its products and processes are complex and require a high level of precision, Precision is generally dependent on an educated and trained workforce. Precision would be adversely affected by a shortage of skilled employees. FAILURE TO MAINTAIN RELATIONSHIPS WITH PRECISION'S LARGER CUSTOMERS AND FAILURE BY PRECISION'S CUSTOMERS TO CONTINUE TO PURCHASE EXPECTED QUANTITIES DUE TO CHANGES IN MARKET CONDITIONS COULD HAVE AN ADVERSE EFFECT ON ITS OPERATIONS. Precision's largest customer, General Electric Power Systems, accounted for approximately 42% of net sales in the first six months of 2001, and its top ten customers accounted for approximately 83% of its sales during the same period. The termination by General Electric Power Systems or any one or more of Precision's other top 10 customers of their relationship with Precision or their failure to purchase expected quantities from Precision could have a material adverse effect upon Precision's business, financial condition and results of operations. PRECISION'S REVENUES AND OPERATING RESULTS MAY BE SUBJECT TO SIGNIFICANT FLUCTUATION. A significant portion of Precision's revenues is derived from new projects and contracts, the timing of which is subject to a variety of factors beyond Precision's control, including customer budgets and modifications in customer products. Precision cannot predict the degree to which these trends will continue. A portion of Precision's operating expenses is relatively fixed. Cancellations, reductions or delays in orders by a customer or group of customers could have a material adverse effect on our business, financial condition or results of operations. Additionally, Precision may periodically incur cost increases due to hiring and training of new employees in anticipation of future growth. The size, timing and integration of possible future acquisitions may also cause substantial fluctuations in operating results from quarter to quarter. As a result, operating results for any fiscal quarter may not be indicative of the results that may be achieved for any subsequent fiscal quarter or for a full fiscal year. SIGNIFICANT COMPETITION FOR PRECISION PART MANUFACTURING OUTSOURCED BY ORIGINAL EQUIPMENT MANUFACTURERS MAY AFFECT PRECISION'S ABILITY TO SUCCEED. Precision operates in an industry that is highly fragmented and competitive. A variety of suppliers with different subsets of Precision's manufacturing capabilities compete to supply the stringent demands of large original equipment manufacturers. In addition, Precision's customers are continually seeking to consolidate their business among one or more "Preferred" or "Qualified" suppliers. There can be no assurance that Precision will be able to successfully implement new production programs to supply products to original equipment manufacturers. If any customer becomes dissatisfied with Precision's prices, quality or timeliness of delivery, among other things, it could award future business or move existing business to our competitors. There can be no assurance that Precision's products will continue to compete successfully with the products of its competitors, including original equipment manufacturers themselves, many of which are significantly larger and have greater financial and other resources than Precision does. 20 THE CYCLICAL NATURE OF THE INDUSTRIES PRECISION CURRENTLY SERVES COULD HAVE A MATERIAL ADVERSE EFFECT ON ITS BUSINESS. A majority of Precision's revenues are derived from customers that are in industries and businesses that are cyclical in nature and subject to change in general economic conditions, such as the power generation, construction, aerospace and automotive industries. General economic or industry specific downturns could have a material adverse effect on Precision and its business, results of operations and financial condition. PRECISION'S BUSINESS COULD BE ADVERSELY AFFECTED IF IT IS UNABLE TO OBTAIN RAW MATERIALS AND COMPONENTS FROM ITS SUPPLIERS ON FAVORABLE TERMS. Generally, Precision's major raw materials consist of traditional materials such as steel, aluminum, iron, copper, magnesium and bronze, as well as exotic and difficult to machine materials such as titanium, inconel and invar. A portion of its raw materials are supplied by its customers on consignment. Raw materials not supplied by its customers are purchased from several suppliers. Although all of these materials have been available in adequate quantities to meet its production demands in the past, Precision can give you no assurance that such materials will be available in adequate quantities in the future. Precision does not presently anticipate any raw material shortages that would significantly affect production. However, the lead times between the placement of orders for certain raw materials and actual delivery to Precision may vary significantly and Precision may from time to time be required to order raw materials in quantities and at prices less than optimal to compensate for the variability of lead times of delivery. Precision's business could be adversely affected if Precision is unable to obtain raw materials and components from suppliers on favorable terms. PRECISION'S BUSINESS COULD BE ADVERSELY AFFECTED TO THE EXTENT THE U.S. GOVERNMENT TERMINATED OR MODIFIED A CONTRACT WITH PRECISION OR ONE OF ITS CUSTOMERS. Precision is generally not a direct party to any contracts with the U.S. government. However, a portion of its sales are to customers who use the parts, assemblies or tooling Precision supplies to them to fill orders under U.S. government contracts to which they are a party. U.S. government contracts have significant inherent risks, including: o the ability of the U.S. government to terminate a contract for convenience, in which case the other party could be limited to receiving only costs already incurred or committed; o modification of U.S. government contracts due to lack of Congressional funding or changes in such funds; and o an extensive and complex regulatory structure, which could subject the other party to contract termination, civil and criminal penalties and in some cases, suspension or disbarment from future U.S. government contracts. To the extent the U.S. government terminates or modifies a contract with one of Precision's customers, Precision could be adversely affected if the affected customer reduced its purchases from Precision as a result. In addition, in the few instances where Precision is a direct party to a U.S. government contract, the inherent risks described above, as well as risks associated with the competitive bidding atmosphere under which U.S. government contracts are awarded and unreimbursed cost overruns in fixed-price contracts, could have a material adverse effect on its results of operations and financial condition. 21 PRECISION'S EQUIPMENT, FACILITIES AND OPERATIONS ARE SUBJECT TO NUMEROUS ENVIRONMENTAL AND OTHER GOVERNMENT REGULATIONS THAT MAY BECOME MORE STRINGENT IN THE FUTURE AND MAY RESULT IN INCREASED LIABILITY AND INCREASED CAPITAL EXPENDITURES. Precision's equipment, facilities and operations are subject to increasingly complex and stringent federal, state and local laws and regulations pertaining to protection of human health and the environment. These include, among other things, the discharge of contaminants into the environment and the handling and disposition of wastes (including industrial, solid and hazardous wastes). In addition, Precision is required to obtain and maintain regulatory approvals in the United States in connection with its operations. Many environmental laws and regulations provide for substantial fines and criminal sanctions for violations. It is difficult to predict the future development of such laws and regulations or their impact on future earnings and operations, but Precision anticipates that these laws and regulations will continue to require increased capital expenditures because environmental standards will become more stringent. Precision cannot assure you that material costs or liabilities will not be incurred. Certain environmental laws provide for strict, joint and several liability for investigation and remediation of spills and other releases of hazardous materials. These laws typically impose liability whether or not the owner or operator knew of, or was responsible for, the presence of any hazardous materials. Persons who "arrange", as defined under these laws, for the disposal or treatment of hazardous materials also may be liable for the costs of investigation, removal or remediation of such materials at the disposal or treatment site, regardless of whether the affected site is owned or operated by them. Such liability is strict, and may be joint and several. Because Precision owns and operates a number of facilities, and because it arranges for the disposal of hazardous materials at many disposal sites, it may incur costs for investigation, removal and remediation, as well as capital costs associated with compliance with environmental laws and regulations. Although such environmental costs have not been material in the past and are not expected to be material in the future, changes in environmental laws and regulations or unexpected investigations and clean-up costs could have a material adverse effect on Precision's business, financial condition or results of operations. 22 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK Precision's bank term loan provides for interest to be charged at either the LIBOR rate or a base rate plus, in each case, a margin determined in accordance with the credit agreement. Based on Precision's level of outstanding borrowings under its term loan at June 30, 2001, a 100 basis point change in interest rate would result in a $0.2 million annual change in interest expense. Precision's revolving line of credit provides for interest to be charged at either the LIBOR rate or a base rate plus, in each case, a margin determined in accordance with the credit agreement. Based on Precision's level of outstanding borrowings under its revolving line of credit as of June 30, 2001, a 100 basis point change in interest rates would result in a $0.1 million annual change in interest expense. Precision's GECC term loan provides for interest to be charged at the LIBOR rate plus 500 basis points in accordance with the term loan agreement. Based on Precision's level of borrowings under the equipment term loan as of June 30, 2001, a 100 basis points change in interest rates would result in a $0.2 million annual change in interest expense. Precision's $6.6 million operating lease program provides for interest to be charged at the LIBOR rate plus 500 basis points in accordance with the master lease agreement. Based on Precision's level of outstanding operating lease obligations at June 30, 2001, a 100 basis point change in the LIBOR interest rate would result in a $0.1 million annual change in equipment rental expense. The remainder of Precision's debt is at fixed interest rates. Our senior subordinated notes have a carrying value of $100 million, but we believe that the fair value of the senior subordinated notes is substantially below the carrying value. Because the notes are held by a limited number of institutional investors and are not actively traded among those investors or the general public, we are unable to accurately determine the current fair value of the notes. The last trade of these notes known to management took place in March 2001 at approximately 45% of face value. Precision does not own nor is it obligated for other significant debt or equity securities that would be affected by fluctuations in market risk, and our exposure to foreign currency exchange rate risk and commodity price risk is not significant. 23 PART II: OTHER INFORMATION ITEM 1: LEGAL PROCEEDINGS Not applicable. ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3: DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) through (d) Not applicable. ITEM 5: OTHER INFORMATION Not applicable. ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS Not applicable. (b) REPORTS ON FORM 8-K Not applicable. 24 PRECISION PARTNERS, INC. SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PRECISION PARTNERS, INC. Dated: August 13, 2001 By: /s/ Frank R. Reilly ---------------------------------------------- Frank R. Reilly Executive Vice President and Chief Financial Officer

PRECISION PARTNERS INC 10-Q