10-Q 1 form10q_3rdfy02.txt SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 -------------------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 Commission file number 33-96190 AEARO CORPORATION (Exact name of registrant as specified in its charter) ------------------------ Delaware 13-3840450 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 5457 West 79th Street 46268 Indianapolis, Indiana (Zip Code) (Address of principal executive offices) (317) 692-6666 (Registrant's telephone number, including area code) ------------------------ Indicate by check mark whether the 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 of the registrant's common stock, par value $.01 per share, outstanding as of August 14, 2002 was 101,912.5. - 1 - Aearo Corporation TABLE OF CONTENTS Form 10-Q for the Quarterly Period Ended June 30, 2002 PART I-FINANCIAL INFORMATION...................................................3 ---------------------------- Item 1. Financial Statements................................................3 ------- -------------------- Condensed Consolidated Balance Sheets - Assets......................3 ---------------------------------------------- Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity..............................4 -------------------------------------- Condensed Consolidated Statements of Operations.....................5 ----------------------------------------------- Condensed Consolidated Statements of Cash Flows.....................6 ----------------------------------------------- Notes To Condensed Consolidated Financial Statements................7 ---------------------------------------------------- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..........................................14 ------------------------------------------------------------ Item 3. Quantitative and Qualitative Disclosures About Market Risk.........23 ------- ---------------------------------------------------------- PART II - OTHER INFORMATION...................................................25 --------------------------- Item 1. Legal Proceedings..................................................25 ------- ----------------- Item 2. Changes in Securities and Use of Proceeds..........................26 ------- ----------------------------------------- Item 3. Defaults Upon Senior Securities....................................26 ------- ------------------------------- Item 4. Submission of Matters to a Vote of Security Holders................26 ------- --------------------------------------------------- Item 5. Other Information..................................................26 ------- ----------------- Item 6. Exhibits and Reports on Form 8-K...................................26 ------- -------------------------------- SIGNATURES....................................................................27 ---------- CERTIFICATIONS................................................................28 -------------- EXHIBIT INDEX.................................................................29 ------------- - 2 - PART I-FINANCIAL INFORMATION Item 1. Financial Statements AEARO CORPORATION Condensed Consolidated Balance Sheets - Assets (Dollars in Thousands) -------------- -------------- June 30, September 30, 2002 2001 -------------- -------------- (Unaudited) CURRENT ASSETS: Cash and cash equivalents $ 11,459 $ 18,233 Accounts receivable (net of reserve for doubtful accounts of $1,249 and $831 respectively) 48,724 42,428 Inventories 33,666 29,564 Deferred and prepaid expenses 3,656 2,325 ------------- ------------- Total current assets 97,505 92,550 ------------- ------------- PROPERTY, PLANT AND EQUIPMENT, NET 48,929 47,003 INTANGIBLE ASSETS, NET 123,046 118,200 OTHER ASSETS 2,652 3,549 ------------- ------------ Total assets $ 272,132 $ 261,302 ============ =============

The accompanying notes are an integral part of these condensed consolidated financial statements. - 3 - AEARO CORPORATION Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity (Dollars in Thousands) -------------------- -- ------------------ June 30, September 30, 2002 2001 -------------------- ------------------ (Unaudited) CURRENT LIABILITIES: Current portion of long-term debt $ 11,314 $ 8,393 Accounts payable and accrued liabilities 41,276 37,896 Accrued interest 5,663 2,691 U.S. and foreign income taxes 2,813 2,265 ---------------- -------------- Total current liabilities 61,066 51,245 ---------------- -------------- LONG-TERM DEBT 186,134 193,836 DEFERRED INCOME TAXES 429 383 OTHER LIABILITIES 6,503 5,982 ---------------- -------------- Total liabilities $ 254,132 $ 251,446 ---------------- -------------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value- (Redemption value of $106,102 and $96,801, respectively) Authorized--200,000 shares Issued and outstanding--45,000 shares - - Common stock, $.01 par value- Authorized--200,000 shares Issued and outstanding--101,913 and 102,088 shares, respectively 1 1 Additional paid-in capital 32,226 32,374 Accumulated earnings (deficit) 1,094 (2,494) Accumulated other comprehensive loss (15,321) (20,025) ----------------- -------------- Total stockholders' equity 18,000 9,856 ---------------- -------------- Total liabilities and stockholders' equity $ 272,132 $ 261,302 ================ ==============

The accompanying notes are an integral part of these condensed consolidated financial statements. - 4 - Condensed Consolidated Statements of Operations (DOLLARS IN THOUSANDS) (Unaudited) ------------------------------------ --- ------------------------------------- For the Three Months Ended For the Nine Months Ended June 30, June 30, ------------------------------------ ------------------------------------- 2002 2001 2002 2001 ---------------- ---------------- ---------------- ----------------- NET SALES $ 76,435 $ 72,138 $ 208,761 $ 214,542 COST OF SALES 40,024 39,007 110,312 115,676 --------------- --------------- --------------- --------------- Gross profit 36,411 33,131 98,449 98,866 SELLING AND ADMINISTRATIVE 24,914 19,570 68,602 65,664 RESEARCH AND TECHNICAL SERVICES 1,493 1,138 4,251 3,987 AMORTIZATION OF INTANGIBLES 1,570 1,593 4,686 4,882 OTHER CHARGES (INCOME), NET 330 (87) 368 437 --------------- --------------- --------------- --------------- Operating income 8,104 10,917 20,542 23,896 INTEREST EXPENSE, NET 4,972 5,451 15,018 17,131 --------------- --------------- --------------- --------------- Income before provision for income taxes 3,132 5,466 5,524 6,765 PROVISION FOR INCOME TAXES 850 454 1,936 1,105 --------------- --------------- --------------- --------------- Net income $ 2,282 $ 5,012 $ 3,588 $ 5,660 =============== =============== =============== ===============

The accompanying notes are an integral part of these condensed consolidated financial statements. - 5 - Condensed Consolidated Statements of Cash Flows (DOLLARS IN THOUSANDS) (Unaudited) ----------------------------------------- For the Nine Months Ended June 30, ----------------------------------------- 2002 2001 ------------------- ------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 3,588 $ 5,660 Adjustments to reconcile net income to cash provided by operating activities- Depreciation 7,976 7,695 Amortization of intangible assets and deferred financing costs 5,842 5,990 Deferred income taxes -- (150) Other, net 288 186 Changes in assets and liabilities-(net of effects of acquisitions) Accounts receivable (2,226) 1,276 Inventories (1,385) (1,178) Accounts payable and accrued liabilities 829 (4,809) Other, net (21) (731) ------------- ------------- Net cash provided by operating activities 14,891 13,939 ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (5,846) (5,804) Cash paid for Iron Age Vision (706) -- Cash paid for Leader (3,636) -- Cash paid for Chesapeake (3,000) -- Proceeds provided by disposals of property, plant and equipment 13 36 ------------- ------------- Net cash used by investing activities (13,175) (5,768) ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolving credit facility, net -- 11,750 Repayment of bonds (2,000) -- Repayment of term loans (6,097) (13,301) Repayment of capital lease obligations (100) -- Repayment of long-term debt (102) (97) Other (147) 173 ------------- ------------- Net cash used by financing activities (8,446) (1,475) ------------- ------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH (44) (1,237) ------------- ------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (6,774) 5,459 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 18,233 3,495 ------------- ------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 11,459 $ 8,954 ============= ============= NON-CASH INVESTING AND FINANCING ACTIVITIES: Capital lease obligations $ 1,421 $ -- ============= ============= CASH PAID FOR: Interest $ 10,952 $ 13,646 ============= ============= Income taxes $ 1,536 $ 1,557 ============= =============

The accompanying notes are an integral part of these condensed consolidated financial statements. - 6 - Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited) 1) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary to present fairly, in accordance with accounting principles generally accepted in the United States of America, the Company's financial position, results of operations and cash flows for the interim periods presented. The results of operations for the interim periods shown in this report are not necessarily indicative of results for any future interim period or for the entire year. These condensed consolidated financial statements do not include all disclosures associated with annual financial statements and accordingly should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K405. 2) COMPANY BACKGROUND Aearo Corporation, a Delaware corporation, and its direct wholly owned subsidiary, Aearo Company, a Delaware corporation (collectively referred to herein as "the Company") manufactures and sells products under the brand names: AOSafety(R), E-A-R(R), and Peltor(R). These products are sold through three reportable segments, which are Safety Products, Safety Prescription Eyewear and Specialty Composites. 3) SIGNIFICANT ACCOUNTING POLICIES Use of Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Revenue Recognition. The Company recognizes revenue upon shipment of its products to customers. Foreign Currency Translation. Assets and liabilities of the Company's foreign operations are translated at period-end exchange rates. Income and expenses are translated at the approximate average rate during the period. Foreign currency translation adjustments are recorded as a separate component of stockholders' equity. Foreign currency gains and losses arising from transactions by any of the Company's subsidiaries are reflected in net income. Shipping and Handling Fees and Costs. Shipping and handling costs include payments to third parties for the delivery of products to customers, as well as internal salaries and overhead costs incurred to store, move and prepare finished products for shipment. Shipping and handling costs are included with selling and administrative expenses in the accompanying condensed consolidated statement of operations. Shipping and handling costs in the three months ended June 30, 2001 and 2002 were $4.3 million and $4.6 million, respectively. Shipping and handling costs in the nine months ended June 30, 2001 and 2002 were $12.8 and $12.8 million, respectively. The Company recovers a portion of its shipping and handling costs from its customers and records this recovery in net sales. Income Taxes. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates. Intangible Assets. Intangible assets consist primarily of the goodwill, patents, and trademarks purchased in business acquisitions. Intangible assets are amortized over their estimated useful lives. The accompanying notes are an integral part of these condensed consolidated financial statements. - 7 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited) Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections". This statement rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt", and an amendment of that Statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". This Statement also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers". This Statement amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. The provisions of this statement related to the rescission of SFAS No. 4 will be applied in fiscal years beginning after May 15, 2002. The Company is in the process of evaluating the impact of this statement on its financial statements and will adopt the provisions of this statement in the first quarter of fiscal year 2003. Impairment or Disposal of Long-Lived Assets. In August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and superceded SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and Accounting Principles Board ("APB") No. 30, "Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions". SFAS No 144 is effective in fiscal years beginning after December 15, 2001, with early adoption permitted. The Company is currently assessing the impact of adopting this standard and has not yet determined the effect of adoption on its financial position and results of operations. Asset Retirement Obligations. In July 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 is effective for fiscal years beginning after June 15, 2002, and establishes accounting standards requiring the recording of the fair value of liabilities associated with the retirement of long-lived assets in the period in which they are incurred. The Company is currently assessing the impact of adopting this standard and has not yet determined the effect of adoption on its financial position and results of operations. Business Combinations, Goodwill and Other Intangibles. In June 2001, the FASB issued two new pronouncements: SFAS No. 141, "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangibles." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that the use of the pooling-of-interest method is no longer allowed. SFAS No. 142 requires that upon adoption, amortization of goodwill of approximately $3.2 million annually will cease and instead, the carrying value of goodwill be evaluated for impairment on an annual basis. Identifiable intangible assets will continue to be amortized over their useful lives and reviewed for impairment in accordance with SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets to be Disposed Of". SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. The Company is evaluating the impact of the adoption of these standards and has not yet determined the effect of adoption on its financial position and results of operations. Accounting for Derivative Instruments and Hedging Activities. The Company adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" on October 1, 2000. SFAS No. 133 requires that every derivative instrument be recorded in the balance sheet as either an asset or a liability measured at its fair value. The accompanying notes are an integral part of these condensed consolidated financial statements. - 8 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited) The Company has formally documented its hedging relationships, including identification of the hedging instruments and the hedge items, as well as its risk management objectives and strategies for undertaking each hedge transaction. From time to time the Company enters into foreign currency forward contracts and interest rate swap and collar agreements, which are derivatives as defined by SFAS No. 133. The Company enters into foreign currency forward contracts to mitigate the effects of changes in foreign currency rates on profitability and enters into interest rate swap and collar agreements to hedge its variable interest rate risk. These derivatives are cash flow hedges. For all qualifying and highly effective cash flow hedges, the changes in the fair value of the derivatives are recorded in other comprehensive income. Amounts accumulated in other comprehensive income will be reclassified as earnings when the related product sales affect earnings for foreign currency forward contracts or when related interest payments affect earnings for interest rate collar agreements. As a result of the foreign currency forward contracts, the Company has recorded a derivative liability of $0.6 million at June 30, 2002. All foreign currency forward contracts are executed in exchange traded markets for which quoted prices exist and will expire over the next 3 months. During the nine month period ending June 30, 2002, amounts reclassified into earnings resulting from foreign currency forward contracts were minimal. All foreign currency forward contracts were determined to be highly effective; therefore no ineffectiveness was recorded. The Company also executes foreign currency forward contracts for up to 30-day terms to protect against the adverse effects that exchange rate fluctuations may have on the foreign-currency-denominated trade activities (receivables, payables and cash) of foreign subsidiaries. These contracts have not been designated as hedges under SFAS No. 133 and accordingly, the gains and losses on both the derivative and foreign-currency-denominated trade activities are recorded as transaction adjustments in current earnings. The impact on earnings was a loss of approximately $0.1 million for the nine month period ended June 30, 2002. The Company also entered into an interest rate collar arrangement during October 2001 to protect $25.0 million of adjustable Term Loan debt (as defined below in Note 6). The collar was not designated as a hedge under SFAS No. 133. The fair value of the interest rate collar remained unchanged and accordingly there was no charge to earnings in the nine month period ended June 30, 2002. 4) COMPREHENSIVE INCOME Comprehensive income consisted of the following (Dollars in thousands): For the Three Months For the Nine Months Ended June 30, Ended June 30, ------------------------ ------------------------- 2002 2001 2002 2001 ---------- ---------- ---------- ----------- Net income $ 2,282 $ 5,012 $ 3,588 $ 5,660 Foreign currency translation adjustment 4,622 (1,633) 5,320 (5,027) Unrealized gain (loss) on derivative instruments (752) 613 (616) (70) ---------- ---------- ---------- -------=--- Comprehensive income $ 6,152 $ 3,992 $ 8,292 $ 563 ========== ========== ========== ===========

The accompanying notes are an integral part of these condensed consolidated financial statements. - 9 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited) 5) INVENTORIES Inventories consisted of the following (Dollars in thousands): June 30, September 30, 2002 2001 ------------ -------------- Raw materials $ 8,634 $ 7,259 Work in process 8,733 8,364 Finished goods 16,299 13,941 ------------ -------------- $ 33,666 $ 29,564 ============ ============== Inventories, which include materials, labor and manufacturing overhead, are stated at the lower of cost or market, cost being determined using the first-in, first-out method. 6) DEBT The Company's debt structure includes: (a) $98.0 million of Senior Subordinated Notes (Notes) due 2005, which are publicly held and redeemable at the option of the Company, in whole or in part, at various redemption prices, and (b) up to an aggregate of $135.0 million under a Credit Agreement with various banks to provide Senior Bank Facilities comprised of (i) a secured term loan facility consisting of loans providing for up to $100.0 million of term loans (collectively the Term Loans) with a portion of the Term Loans denominated in foreign currencies, (ii) a secured revolving credit facility (Revolving Credit Facility) providing for up to $30.0 million of revolving loans for general corporate purposes, and (iii) a U.K. overdraft facility of up to an equivalent of $5.0 million in Great Britain Pounds for working capital requirements as needed. The amount outstanding on the Term Loans at June 30, 2002, was approximately $95.6 million. No amounts were outstanding under the Revolving Credit Facility or the U.K. overdraft facility. Under the terms of both the Senior Bank Facilities and the Notes indenture, Aearo Company is required to comply with certain financial covenants and restrictions. Aearo Company was in compliance with all financial covenants and restrictions at June 30, 2002. 7) COMMITMENTS AND CONTINGENCIES Lease Commitments. The Company leases certain transportation vehicles, warehouse facilities, office space, and machinery and equipment under cancelable and non-cancelable leases, most of which expire within 10 years and may be renewed by the Company. Contingencies. Various lawsuits and claims arise against the Company in the ordinary course of its business. Most of these lawsuits and claims are product liability matters that arise out of the use of safety eyewear and respiratory product lines manufactured by the Company as well as products purchased for resale. In addition, the Company may be contingently liable with respect to numerous lawsuits involving respirators sold by its predecessors, American Optical Corporation and Cabot Corporation ("Cabot"), arising out of agreements entered into when the AOSafety(R) Division was sold by American Optical Corporation to Cabot in April 1990 and when later sold by Cabot to the Company in 1995. These lawsuits typically involve plaintiffs alleging that they suffer from asbestosis or silicosis, and that such condition results in part from respirators which were negligently designed or manufactured. The defendants in these lawsuits are often numerous, and include, in addition to respirator manufacturers, employers of the plaintiffs and manufacturers of sand (used in sand blasting) and asbestos. Responsibility for legal costs, as well as for settlements and judgments, is shared The accompanying notes are an integral part of these condensed consolidated financial statements. - 10 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited) contractually by the Company, Cabot, American Optical Corporation and a prior owner of American Optical Corporation. Liability is allocated among the parties based on the number of years each company owned the AOSafety Division and the alleged years of exposure of the individual plaintiff. The Company's share of the contingent liability is further limited by an agreement entered into between the Company and Cabot whereby, so long as the Company pays to Cabot an annual fee of $400,000, Cabot will retain responsibility and liability for, and indemnify the Company against, asbestos and silicosis related legal claims asserted after July 11, 1995 (the date of the Company's formation) alleged to arise out of the use of respirators manufactured prior to July 11, 1995. This annual fee was negotiated as part of the 1995 agreement between the Company and Cabot. To date, the Company has elected to pay the annual fee. The Company could potentially be liable for these exposures if the Company elects to discontinue its participation in this arrangement, or if Cabot is no longer able to meet its obligations in these matters. With these arrangements in place, however, the Company's potential liability is limited to exposures alleged to arise from the use of respirators manufactured after July 11, 1995. The Company may also be responsible for certain claims of acquired companies other than the AOSafety(R) Division that are not covered by, and are unrelated to, the agreement with Cabot. At June 30, 2002, the Company has reserved approximately $5.0 million for product liabilities including those arising from asbestosis or silicosis litigation. The reserve is reevaluated periodically and may result in additional charges to operations if additional information becomes available. As is standard in the insurance industry, the Company's product liability insurance excludes asbestos and silicosis related respiratory claims. Therefore, the Company's accrual has not been reduced for estimated insurance recoveries. Consistent with the general environment experienced by other companies involved in asbestos-related litigation, there has been an increase in the number of asserted legal claims that could potentially involve the Company. Since the Company, until recently, has not been directly named in the lawsuits, it has very little available information regarding specific numbers of claims that affect the Company directly. Various factors increase the difficulty in determining the Company's potential liability, if any, in such claims, including the fact that the defendants in these lawsuits are often numerous and the claims generally do not specify the amount of damages sought. Additionally, the bankruptcy filings of other companies with asbestos-related litigation could affect the Company's cost over time. However, it is management's opinion, taking into account currently available information, historical experience, uncertainties, the Cabot agreement and the Company's reserve, that these suits and claims should not result in final judgments or settlements that, in the aggregate, would have a material effect on the Company's financial condition or results of operation. 8) SEGMENT REPORTING The Company manufactures and sells products under the brand names: AOSafety(R), E-A-R(R), and Peltor(R). These products are sold through three reportable segments, which are Safety Products, Safety Prescription Eyewear and Specialty Composites. The Safety Products segment manufactures and sells hearing protection devices, non-prescription safety eyewear, face shields, reusable and disposable respirators, hard hats and first aid kits. The Safety Prescription Eyewear segment manufactures and sells prescription eyewear products that are designed to protect the eyes from the typical hazards encountered in the industrial work environment. The Company's Safety Prescription Eyewear segment purchases component parts (lenses and the majority of its frames) from various suppliers, grinds, shapes and applies coatings to the lenses in accordance with the customer's prescription, and then assembles the glasses using the customer's choice of frame. The Specialty Composites segment manufactures a wide array of energy-absorbing materials that are incorporated into other manufacturers' products to control noise, vibration and shock. The accompanying notes are an integral part of these condensed consolidated financial statements. - 11 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited Net Sales by Business Segment (Dollars in thousands): For the Three Months Ended For the Nine Months Ended June 30, June 30, ---------------------------- --------------------------- ------------- ------------ ------------ ------------ 2002 2001 2002 2001 ------------- ------------ ------------ ----------- Safety Products $ 55,034 $ 52,901 $ 150,417 $ 155,149 Safety Prescription Eyewear 11,118 10,074 30,662 29,716 Specialty Composites 10,283 9,163 27,682 29,677 ------------- ------------ ------------ ----------- Total $ 76,435 $ 72,138 $ 208,761 $ 214,542 ============= ============ ============ ===========

Inter-segment sales of the Specialty Composites segment to the Safety Products segment totaled $1.3 million and $1.1 million for the three months ended June 30, 2002 and 2001, respectively. Inter-segment sales totaled $2.6 million and $3.1 million for the nine months ended June 30, 2002 and 2001, respectively. The inter-segment sales value is determined at fully absorbed inventory cost at standard rates plus 25%. EBITDA by Business Segment and reconciliation to income before provision for income taxes (Dollars in thousands): For the Three Months Ended For the Nine Months Ended June 30, June 30, ------------------------------------ -------------------------------- 2002 2001 2002 2001 ---------------- --------------- ------------- --------------- Safety Products $ 10,940 $ 11,367 $ 29,122 $ 28,953 Safety Prescription Eyewear 484 650 1,484 1,724 Specialty Composites 1,468 408 2,452 1,622 Reconciling Items (285) 2,655 415 4,059 ---------------- --------------- ------------- --------------- Total EBITDA 12,607 15,080 33,473 36,358 Depreciation 2,868 2,574 7,976 7,695 Amortization 1,570 1,593 4,686 4,882 Non-operating Costs (Income) 65 (4) 269 (115) Interest 4,972 5,451 15,018 17,131 ---------------- --------------- ------------- --------------- Income before provision for income taxes $ 3,132 $ 5,466 $ 5,524 $ 6,765 ================ =============== ============= ===============

The Company evaluates the performance of its operating entities based on EBITDA, which is defined by the Company as earnings before interest, taxes, depreciation, amortization, and non-operating income or expense. Non-operating income or expense is further defined as extraordinary gains or losses, or gains or losses from sales of assets other than in the ordinary course of business. While the Company believes EBITDA is a useful indicator of its ability to service debt, EBITDA should not be considered as a substitute for net income (loss) determined in accordance with accounting principles generally accepted in the United States of America as an indicator of operating performance or as an alternative to cash flow as a measure of liquidity. Investors should be aware that EBITDA as presented above may not be comparable to similarly titled measures presented by other companies and comparisons could be misleading unless all companies and analysts calculate this measure in the same fashion. Reconciling items include unallocated selling, administrative, research and technical expenses as well as manufacturing profit realized on intercompany transactions not allocable to a specific segment. The accompanying notes are an integral part of these condensed consolidated financial statements. - 12 - AEARO CORPORATION Notes To Condensed Consolidated Financial Statements JUNE 30, 2002 (Unaudited 9) RESTRUCTURING CHARGE During fiscal 2001, the Company recorded an unusual charge of $11.4 million relating to a restructuring plan announced by the Company to improve its competitive position and long-term profitability. The plan includes the closure of its Ettlingen, Germany plant, significantly reorganizing operations at the Company's Varnamo, Sweden plant, rationalizing the manufacturing assets and product mix of its Specialty Composites business unit and a reduction of products and product lines. The unusual charge includes cash charges of $2.3 million, which includes $1.8 million for severance and other separation costs to cover the reduction of 5% of the Company's work force and $0.5 million for other costs associated with this plan. The unusual charge also includes non-cash charges of $9.1 million, which includes $3.2 million for non-cancelable long-term lease obligations, $2.9 million for asset impairments, $2.4 million for inventory disposals and $0.6 million related to the sale of the Company's Ettlingen, Germany location. As of June 30, 2002, there is approximately $ 5.6 million accrued related to the restructuring. 10) ACQUISITIONS On December 14, 2001, the Company acquired Iron Age Vision from Iron Age Corporation of Pittsburgh, Pennsylvania for approximately $0.7 million. Iron Age Vision was the safety prescription eyewear division of Iron Age Corporation. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations", and accordingly, the operating results of Iron Age Vision have been included with those of the Company subsequent to December 14, 2001. On January 21, 2002 the Company acquired the industrial safety business of Montreal, Canada based Leader Industries, Inc. for approximately $3.6 million. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations", and accordingly, the operating results of Leader Industries, Inc. have been included with those of the Company subsequent to January 22, 2002. On May 7, 2002, the Company acquired the assets of Chesapeake Optical Company of Baltimore, Maryland for approximately $3.0 million. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations", and accordingly, the operating results of Chesapeake Optical have been included with those of the Company subsequent to May 7, 2002. The accompanying notes are an integral part of these condensed consolidated financial statements. - 13 - Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company, including notes thereto. This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in such forward-looking statements. The factors that might cause such a difference include, among others, the following: risks associated with indebtedness; risks related to acquisitions; risks associated with the conversion to a new management information system; high level of competition in the Company's markets; importance and costs of product innovation; risks associated with international operations; product liability exposure; unpredictability of patent protection and other intellectual property issues; dependence on key personnel; the risk of adverse effect of economic and regulatory conditions on sales; and risks associated with environmental matters. Critical Accounting Policies The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). GAAP requires the use of estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. The Company believes its use of estimates and underlying accounting assumptions adhere to GAAP and are consistently applied. The Company revises its estimates and assumptions as new information becomes available. The Company believes that of its significant accounting policies (see Notes to the Consolidated Financial Statements in the Company's Annual Report on Form 10-K405) the following policies involve a higher degree of judgment and/or complexity. Income Taxes - The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes", which requires deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Recognition of a deferred tax asset is dependent on generating sufficient future taxable income prior to the expiration of the tax loss and credit carryforwards. Due to the uncertainties of realizing these tax benefits, the Company has recorded a full valuation allowance against these losses and credit carryforwards. The Company evaluates the adequacy of the valuation allowance by assessing prudent and feasible tax planning strategies. The ultimate amount of deferred tax assets realized could be different from those recorded, as influenced by potential changes in enacted tax laws and the availability of future taxable income. Accrued Liabilities -The Company has established reserves for potential liabilities. A significant amount of judgment and use of estimates is required to quantify the Company's ultimate exposure in these matters and the valuation of reserves is periodically reviewed. While the Company believes that the current level of reserves is adequate, changes in the future could impact these determinations. Restructuring - The Company recorded an unusual charge in fiscal 2001 based on a restructuring plan to improve its competitive position and long-term profitability. The provision recorded was based on estimates of the expected costs associated with site closures, consolidation of products and product lines, disposal of assets, contract terminations or other costs directly related to the restructuring. To the extent that actual costs may differ from amounts recorded, revisions to the estimated reserves would be required. - 14 - Impairment of Long-Lived Assets - The Company evaluates long-lived assets, including other intangibles and related goodwill, of identifiable business activities for impairment when events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. Cash flows used in the potential impairment evaluation are based on management's estimates and assumptions. Changes in business conditions could potentially require future adjustments to asset valuations. Results of Operations -- Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001 Results of Operations (Dollars in Thousands) (Unaudited) Three Months Ended June 30, ------------------------------------------------ 2002 % 2001 % ---------------------- ----------------------- Safety Products $ 55,034 72.0 $ 52,901 73.3 Safety Prescription Eyewear 11,118 14.5 10,074 14.0 Specialty Composites 10,283 13.5 9,163 12.7 ----------- --------- ----------- ----------- Total net sales 76,435 100.0 72,138 100.0 Cost of Sales 40,024 52.4 39,007 54.1 Gross profit 36,411 47.6 33,131 45.9 Operating Expenses- Selling and administrative 24,914 32.6 19,570 27.1 Research and technical services 1,493 2.0 1,138 1.6 Amortization of intangibles 1,570 2.1 1,593 2.2 Other charges (income), net 330 -- (87) -- ----------- --------- ----------- ----------- Total operating expenses 28,307 37.0 22,214 30.8 Operating income 8,104 10.6 10,917 15.1 Interest expense, net 4,972 6.5 5,451 7.6 ----------- --------- ----------- ----------- Income before provision for income taxes 3,132 4.1 5,466 7.6 Provision for income taxes 850 1.1 454 0.6 ----------- --------- ----------- ----------- Net income 2,282 3.0 5,012 6.9 =========== ========= =========== =========== EBITDA $ 12,607 16.5 $ 15,080 20.9 =========== ========= =========== ===========

Net Sales. Net sales in the three months ended June 30, 2002 increased 6.0% to $76.4 million from $72.1 million in the three months ended June 30, 2001. The increase in sales was primarily driven by the recent acquisitions and improvement in the Specialty Composites segment. The Safety Products segment net sales in the three months ended June 30, 2002 increased 4.0% to $55.0 million from $52.9 million in the three months ended June 30, 2001. The weakness of the U.S. dollar had the impact of increasing sales by $0.5 million in the three months ended June 30, 2002 as compared to the three months ended June 30, 2001. The Safety Products segment sales for the three months ended June 30, 2002 included $1.8 million of sales due to the acquisition of Leader Industries on January 22, 2002. The Safety Prescription Eyewear - 15 - segment net sales in the three months ended June 30, 2002 increased 10.4% to $11.1 million from $10.0 million in the three months ended June 30, 2001. The Safety Prescription Eyewear segment sales for the three months ended June 30, 2002 included $1.1 million of sales due to the acquisitions of Iron Age Vision on December 14, 2001 and Chesapeake Optical on May 7, 2002. The Specialty Composites segment net sales in the three months ended June 30, 2002 increased 12.2% to $10.3 million from $9.2 million in the three months ended June 30, 2001. The increase was primarily driven by volume in the electronics segment of the precision equipment market, which includes computers and personal communications system (PCS) applications. Gross Profit. Gross profit in the three months ended June 30, 2002 increased 9.9% to $36.4 million from $33.1 million in the three months ended June 30, 2001. The increase in gross profit is primarily due to increased productivity and acquisitions. Gross profit as a percentage of net sales in the three months ended June 30, 2002 increased to 47.6% from 45.9% in the three months ended June 30, 2001. The improvement in gross profit as a percentage of net sales is primarily due to increased productivity and the positive impacts resulting from the 2001 restructuring plan partially offset by a less favorable product mix. Operating Expenses. Operating expenses in the three months ended June 30, 2002 increased 27.3% to $28.3 million from $22.2 million in the three months ended June 30, 2001. The increase was primarily driven by an increase in selling and administrative expenses and other charges, net. Selling and administrative expenses in the three months ended June 30, 2002 included approximately $1.0 million of incremental expenses due to acquisitions as well as increased spending for brand support. For the three months ended June 30, 2001, operating expenses were lower due to salary reductions, deferral of the Company's 401k match and other discretionary spending cuts made to offset the impact of the weak economy in the last half of fiscal 2001. The increase in other charges, net was primarily driven by foreign exchange losses in the three months ended June 30, 2002 as compared to foreign exchange gains in the three months ended June 30, 2001. Operating Income. As a result of the factors mentioned above, operating income decreased 25.8% to $8.1 million in the three months ended June 30, 2002 from $10.9 million in the three months ended June 30, 2001. Operating income as a percentage of net sales in the three months ended June 30, 2002 decreased to 10.6% as compared to 15.1% in the three months ended June 30, 2001. Interest Expense, Net. Interest expense, net in the three months ended June 30, 2002 decreased 8.8% to $5.0 million from $5.5 million in the three months ended June 30, 2001. The decrease is attributed to lower weighted average interest rates in effect for the three months ended June 30, 2002 as compared to the three months ended June 30, 2001. Provision For Income Taxes. The provision for income taxes increased to $0.9 million in the three months ended June 30, 2002 from $0.5 million in the three months ended June 30, 2001. Certain of the Company's foreign subsidiaries had taxable income in their foreign jurisdictions while the Company's domestic subsidiaries generated a net operating loss. The domestic subsidiaries have net operating loss carry-forwards for income tax purposes. Due to the uncertainty of realizing these tax benefits, the tax benefits generated by the net operating losses have been fully reserved with a valuation allowance. Net Income. For the three months ended June 30, 2002, the Company had net income of $2.2 million as compared to $5.0 million for the three months ended June 30, 2001. EBITDA. EBITDA is defined by the Company as earnings before interest, taxes, depreciation, amortization, and non-operating income or expense. Non-operating income or expense is further defined as extraordinary gains or losses, or gains or losses from sales of assets other than in the ordinary course of business. While the Company believes EBITDA is a useful indicator of its ability to service debt, - 16 - EBITDA should not be considered as a substitute for net income determined in accordance with GAAP as an indicator of operating performance or as an alternative to cash flow as a measure of liquidity. Investors should be aware that EBITDA as presented below may not be comparable to similarly titled measures presented by other companies and comparisons could be misleading. EBITDA Calculation Three Months Ended June 30, 2002 (Dollars in Thousands) (Unaudited) Three Months Ended Change June 30, Favorable (Unfavorable) ----------------------------- ------------------------ 2002 2001 Amount Percent -------------- -------------- ----------- ------------ Operating Income $ 8,104 $ 10,917 $ (2,813) (25.8%) Add Backs: Depreciation 2,868 2,574 294 11.4 Amortization of intangibles 1,570 1,593 (23) (1.4) Non-operating costs, net 65 (4) 69 -- ---------- ---------- --------- ------------- EBITDA $ 12,607 $ 15,080 $ (2,473) (16.4%) ========== ========== ========= ============= By Segment Safety Products $ 10,940 $ 11,367 $ (427) (3.8%) Safety Prescription Eyewear 484 650 (166) (25.5) Specialty 1,468 408 1,060 -- Reconciling Items (285) 2,655 (2,940) -- ---------- ---------- --------- ------------- EBITDA $ 12,607 $ 15,080 $(2,473) (16.4%) ========== ========== ========= =============

EBITDA for the three months ended June 30, 2002 decreased 16.4% to $12.6 million from $15.1 million in the three months ended June 30, 2001. EBITDA as a percentage of net sales in the three months ended June 30, 2002 was 16.5% as compared to 20.9% in the three months ended June 30, 2001. The decrease in EBITDA is primarily attributed to higher operating expenses as compared to the prior period which benefited from salary reductions, deferral of the Company's 401k match and other discretionary spending cuts that were taken to offset the unfavorable impact of foreign currencies and the weak economy. These actions impacted each of the Company's three operating segments. The Safety Products segment EBITDA in the three months ended June 30, 2002 decreased 3.8% to $10.9 million from $11.4 million in the three months ended June 30, 2001. This decrease was primarily due to higher operating expenses due to last year's actions as mentioned above and increased brand support. The Safety Prescription Eyewear segments EBITDA in the three months ended June 30, 2002 decreased 25.5% to $0.5 from $0.7 million in the three months ended June 30, 2001. This decrease was primarily driven by higher operating expenses due to last year's actions as mentioned above, product mix and higher distribution costs. The Specialty Composites segments EBITDA for the six months ended June 30, 2002 increased 259.8% to $1.5 million from $0.4 million in the three months ended June 30, 2001. This increase was primarily driven by improved sales volume and the positive impacts of productivity improvements partially offset by the relative increase in operating expenses due to last year's actions as mentioned above. - 17 - Results of Operations -- Nine Months Ended June 30, 2002 Compared to Nine Months Ended June 30, 2001 Results of Operations (Dollars in Thousands) (Unaudited) Nine Months Ended June 30, ------------------------------------------ 2002 % 2001 % ------------- -------- ----------- ------ Net Sales Safety Products $ 150,417 72.1 $ 155,149 72.3 Safety Prescription Eyewear 30,662 14.7 29,716 13.9 Specialty Composites 27,682 13.2 29,677 13.8 ----------- ------ ----------- ------ Total net sales 208,761 100.0 214,542 100.0 Cost of Sales 110,312 52.8 115,676 53.9 Gross profit 98,449 47.2 98,866 46.1 Operating Expenses- Selling and administrative 68,602 32.9 65,664 30.6 Research and technical services 4,251 2.0 3,987 1.9 Amortization of intangibles 4,686 2.2 4,882 2.3 Other charges, net 368 0.2 437 0.2 ----------- ------ ----------- ------ Total operating expenses 77,907 37.3 74,970 34.9 Operating income 20,542 9.8 23,896 11.1 Interest expense, net 15,018 7.2 17,131 8.0 ----------- ------ ----------- ------ Income before provision for income taxes 5,524 2.6 6,765 3.2 Provision for income taxes 1,936 0.9 1,105 0.5 ----------- ------ ----------- ------- Net income 3,588 1.7 5,660 2.6 =========== ====== =========== ======= EBITDA $ 33,473 16.0 $ 36,358 16.9 =========== ====== =========== ======= Net Sales. Net sales in the nine months ended June 30, 2002 decreased 2.7% to $208.8 million from $214.5 million in the nine months ended June 30, 2001. The favorable impact of acquisitions was not sufficient enough to offset the unfavorable impact of the significant slowdown in the manufacturing sector of the economy in which the Company markets its products that was exacerbated by the impact of the terrorist events of September 11, 2001 and the strong U.S. dollar. The Safety Products segment net sales in the nine months ended June 30, 2002 decreased 3.0% to $150.4 million from $155.1 million in the nine months ended June 30, 2001. This decrease was primarily driven by the continued effects of a weak economy as mentioned above. The strength of the U.S. dollar had the impact of reducing sales by $1.1 million in the nine months ended June 30, 2002 as compared to the nine months ended June 30, 2001. The Safety Products segment sales for the nine months ended June 30, 2002 included $3.3 million of sales due to the acquisition of Leader Industries on January 22, 2002. The Safety Prescription Eyewear segment net sales in the nine months ended June 30, 2002 increased by 3.2% to $30.7 million from $29.7 million in the nine months ended June 30, 2001. The Safety Prescription Eyewear segment sales for the - 18 - nine months ended June 30, 2002 included $1.5 million of sales due to the acquisitions of Iron Age Vision on December 14, 2001 and Chesapeake Optical on May 7, 2002. The Specialty Composites segment net sales in the nine months ended June 30, 2002 decreased 6.7% to $27.7 million from $29.7 million in the nine months ended June 30, 2001. The decrease was primarily driven by volume declines in the industrial equipment markets due to the weak economy. Gross Profit. Gross profit in the nine months ended June 30, 2002 decreased 0.4% to $98.5 million from $98.9 million in the nine months ended June 30, 2001. The slight decline in gross profit is primarily due to lower sales volumes caused by the events of September 11, 2001 and the weak economy offset by strong ongoing productivity improvements within the manufacturing plants. Gross profit as a percentage of net sales in the nine months ended June 30, 2002 improved to 47.2% as compared to 46.1% in the nine months ended June 30, 2001. The increase in the Gross Profit percentage of net sales is primarily due to continued productivity improvements in manufacturing operations and the positive impact of the restructuring plan announced on September 30, 2001 partially offset by unfavorable product mix, lower capacity utilization and a stronger U.S. dollar. Operating Expenses. Operating expenses in the nine months ended June 30, 2002 increased 3.9% to $77.9 million from $75.0 million in the nine months ended June 30, 2001. The increase in operating expenses was primarily driven by higher selling and administrative expenses. Selling and administrative expenses in the nine months ended June 30, 2002 included approximately $1.6 million of incremental expenses due to acquisitions as well as increased spending for brand support. For the nine months ended June 30, 2001, operating expenses were lower due to salary reductions, deferral of the Company's 401k match and other discretionary spending cuts made to offset the impact of the weak economy in the last half of fiscal 2001. Selling and administrative expenses as a percentage of net sales increased to 32.9% in the nine months ended June 30, 2002 as compared to 30.6% in the nine months ended June 30, 2001. Operating Income. As a result of the factors mentioned above, operating income decreased 14.0% to $20.5 million in the nine months ended June 30, 2002 from $23.9 million in the nine months ended June 30, 2001. Operating income as a percentage of net sales in the nine months ended June 30, 2002 decreased to 9.8% as compared to 11.1% in the nine months ended June 30, 2001. Interest Expense, Net. Interest expense, net in the nine months ended June 30, 2002 decreased 12.4% to $15.0 million from $17.1 million in the nine months ended June 30, 2001. The decrease is attributed to lower weighted average interest rates in effect for the nine months ended June 30, 2002 as compared to the nine months ended June 30, 2001. Provision For Income Taxes. The provision for income taxes increased to $1.9 million in the nine months ended June 30, 2002 from $1.1 million in the nine months ended June 30, 2001. Certain of the Company's foreign subsidiaries had taxable income in their foreign jurisdictions while the Company's domestic subsidiaries generated a net operating loss. The domestic subsidiaries have net operating loss carry-forwards for income tax purposes. Due to the uncertainty of realizing these tax benefits, the tax benefits generated by the net operating losses have been fully reserved for by a valuation allowance. Net Income. For the nine months ended June 30, 2002 the Company had net income of $3.6 million as compared to $5.7 million for the nine months ended June 30, 2001. EBITDA. EBITDA is defined by the Company as earnings before interest, taxes, depreciation, amortization, and non-operating income or expense. Non-operating income or expense is further defined as extraordinary gains or losses, or gains or losses from sales of assets other than in the ordinary course of business. While the Company believes EBITDA is a useful indicator of its ability to service debt, EBITDA should not be considered as a substitute for net income determined in accordance with GAAP as an indicator of operating performance or as an alternative to cash flow as a measure of liquidity. - 19 - Investors should be aware that EBITDA as presented below may not be comparable to similarly titled measures presented by other companies and comparisons could be misleading. EBITDA Calculation Nine Months Ended June 30 (Dollars in Thousands) (Unaudited) Nine Months Ended Change June 30, Favorable(Unfavorable) --------------------- ---------------------- 2002 2001 Amount Percent ---------- ---------- ----------- ---------- Operating Income $ 20,542 $ 23,896 $ (3,354) (14.0%) Add Backs: Depreciation 7,976 7,695 281 3.7 Amortization of intangibles 4,686 4,882 (196) (4.0) Non-operating costs, net 269 (115) 384 -- ---------- ---------- --------- --------- EBITDA $ 33,473 $ 36,358 $ (2,885) (7.9%) ========== ========== ========= ========== By Segment Safety Products $ 29,122 $ 28,953 $ 169 0.6% Safety Prescription Eyewear 1,484 1,724 (240) (13.9) Specialty 2,452 1,622 830 51.2 Reconciling Items 415 4,059 (3,644) (89.8) ---------- --------- --------- --------- EBITDA $ 33,473 $ 36,358 $ (2,885) (7.9%) ========== ========== ========= ========= EBITDA for the nine months ended June 30, 2002 decreased 7.9% to $33.5 million from $36.4 million for the nine months ended June 30, 2001. EBITDA as a percentage of net sales in the nine months ended June 30, 2002 was 16.0% as compared to 16.9% in the nine months ended June 30, 2001. The decrease in EBITDA is primarily attributed to higher operating expenses as compared to the prior period which benefited from salary reductions, deferral of the Company's 401k match and other discretionary spending cuts that were taken to offset the unfavorable impact of foreign currencies and the weak economy. These actions impacted each of the Company's operating segments. The Safety Products segment EBITDA in the nine months ended June 30, 2002 increased 0.6% to $29.1 million from $29.0 million in the nine months ended June 30, 2001. This increase was primarily driven by improved gross margin due to productivity improvements and the acquisition of Leader Industries on January 22, 2002 partially offset by increased operating expenses due to the actions mentioned above. The Safety Prescription Eyewear segment EBITDA in the nine months ended June 30, 2002 decreased 13.9% to $1.5 million from $1.7 million in the nine months ended June 30, 2001. This decrease was primarily driven by higher operating expenses due to last year's actions as mentioned above, product mix and higher distribution costs. The Specialty Composites segment EBITDA for the nine months ended June 30, 2002 increased 51.2% to $2.5 million from $1.6 million in the nine months ended June 30, 2001. This increase was primarily driven by productivity improvements and the positive impacts of the 2001 restructuring plan partially offset by lower sales volume. Effects of Changes in Exchange Rates In general, the Company's results of operations are affected by changes in exchange rates. Subject to market conditions, the Company prices its products in Europe and Canada in local currencies. While - 20 - many of the Company's selling and distribution costs are also denominated in these currencies, a large portion of product costs are U.S. Dollar denominated. As a result, a decline in the value of the U.S. Dollar relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the U.S. Dollar relative to these other currencies can have a negative effect on the profitability of the Company. As a result of the acquisition of Peltor, the Company's operations are also affected by changes in exchange rates relative to the Swedish Krona. In contrast to the above, a decline in the value of the Krona relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the Krona relative to other currencies can have a negative impact on the profitability of the Company. The Company utilizes forward foreign currency contracts and other hedging instruments to mitigate the effects of changes in foreign currency rates on profitability. Effects of Inflation In recent years, inflation has been modest and has not had a material impact upon the results of the Company's operations. Effects of Economic Conditions Softening of the North American economy began during the first fiscal quarter of 2001. Since that time the overall economic downturn has resulted in many companies announcing layoffs which has also had an impact on overall consumer confidence. The announced layoffs have had a significant impact on the number of employed industrial workers. As a result of this it is expected that the Company will continue to operate in a challenging sales environment. Liquidity and Capital Resources The Company's sources of funds have consisted primarily of operating cash flow and debt financing. The Company's uses of those funds consist principally of debt service, capital expenditures and acquisitions. The Company's debt structure includes: (a) $98.0 million of Senior Subordinated Notes (Notes) due 2005, which are publicly held and are redeemable at the option of the Company, in whole or in part, at various redemption prices, and (b) up to an aggregate of $135.0 million under a Credit Agreement with various banks to provide Senior Bank Facilities comprised of (i) a secured term loan facility consisting of loans providing for up to $100.0 million of term loans (collectively the Term Loans) with a portion of the Term Loans denominated in foreign currencies, (ii) a secured revolving credit facility (Revolving Credit Facility) providing for up to $30.0 million of revolving loans for general corporate purposes, and (iii) a U.K. overdraft facility of up to an equivalent of $5.0 million in Great Britain Pounds for working capital requirements as needed. The amount outstanding on the Term Loans at June 30, 2002, was approximately $95.6 million. No amounts were outstanding under the Revolving Credit Facility or the U.K. overdraft facility. Under the terms of both the Senior Bank Facilities and the Notes indenture, Aearo Company is required to comply with certain financial covenants and restrictions. Aearo Company was in compliance with all financial covenants and restrictions at June 30, 2002. On October 17, 2001 the Company executed a First Amendment to the Credit Agreement, which allowed the Company the option to purchase, on or before December 21, 2001, up to $10.0 million of the Notes at or below par. Prior to December 21, 2001, the Company purchased and retired $2.0 million of the Notes. Maturities under the Company's Term Loans are: $2.1 million for the remainder of fiscal 2002, $12.4 million in fiscal 2003, and $81.0 million thereafter. Other than upon a change of control or as a result of certain asset sales, or in the event that certain excess funds exist at the end of a fiscal year, the Company - 21 - will not be required to make additional principal payments in respect of the Term Loans until maturity in 2005. The Company is required to make interest payments with respect to both the Senior Bank Facilities and the Notes. The Company's Revolving Credit Facility and Term Loans mature in March 2005. The Company's net cash provided by operating activities for the nine months ended June 30, 2002 totaled $14.9 million as compared to $13.9 million for the nine months ended June 30, 2001. The increase of $1.0 million was primarily due to a $2.6 million net change in assets and liabilities partially offset by a $1.7 million decrease in net income adjusted for non cash charges (depreciation, amortization, deferred taxes and other). The Company's net changes in assets and liabilities was primarily driven by a $6.4 million increase in accounts payable and accrued liabilities and other, net, partially offset by a $3.7 million reduction of cash from accounts receivables and inventory compared to a $0.1 million increase in cash from accounts receivable and inventory for the nine months ended June 30, 2001. Net cash used by investing activities was $13.2 million for the nine months ended June 30, 2002 as compared to $5.8 million for the nine months ended June 30, 2001. The increase of $7.4 million in net cash used by investing activities is primarily attributed to the acquisitions of Iron Age Vision for $0.7 million in December 2001, the acquisition of Leader Industries for $3.6 million in January 2002 and the acquisition of Chesapeake Optical for $3.0 million in May 2002. Net cash used by financing activities for the nine months ended June 30, 2002 was $8.5 million compared with net cash used by financing activities for the nine months ended June 30, 2001 of $1.5 million. The change of $7.0 million is primarily due to no borrowings from the Revolving Credit Facility during the nine months ended June 30, 2002, as compared to a net draw of $11.8 million during the nine months ended June 30, 2001, partially offset by a decrease in Term Loans and Notes repayments of $5.2 million. The Company has no financing arrangements involving special purpose entities. The Company has a substantial amount of indebtedness. The Company relies on internally generated funds, and to the extent necessary, on borrowings under the Revolving Credit Facility (subject to certain customary drawing conditions) to meet its liquidity needs. The Company anticipates that operating cash flow will be adequate to meet its operating and capital expenditure requirements for the next several years, although there can be no assurances that existing levels of sales and normalized profitability, and therefore cash flow, will be maintained. In particular, during fiscal 2001 and the nine months ended June 30, 2002, the Company was affected by the significant slowdown in the manufacturing sector of the economies in which the Company markets its products that began in earnest during the first fiscal quarter of fiscal 2001, exacerbated by the impact of the terrorist events of September 11, 2001. As a result, it is expected that the Company will continue to operate in a challenging sales environment. The Company expects to arrange for new financing of both the Senior Bank Facilities and the Notes before the maturity of the Senior Bank Facilities in March 2005. There can be no assurances that any additional financing or other sources of capital will be available to the Company at acceptable terms, or at all. The inability to obtain additional financing would have a material adverse effect on the Company's business, financial condition and results of operations. - 22 - Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company is exposed to market risks related to changes in foreign currencies, interest rates and commodity pricing. The Company uses derivatives to mitigate the impact of changes in foreign currencies and interest rates. All derivatives are for purposes other than trading. The Company adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" on October 1, 2000. The Company has formally documented its hedging relationships, including identification of hedging instruments and the hedge items, as well as its risk management objectives. Foreign Currency Risk The Company's results of operations are subject to risks associated with operating in foreign countries, including fluctuations in currency exchange rates. While many of the Company's selling and distribution costs are denominated in Canadian and European currencies, a large portion of product costs are U.S. Dollar denominated. As a result, a decline in the value of the U.S. Dollar relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the U.S. Dollar relative to these other currencies can have a negative effect on the profitability of the Company. As a result of the acquisition of Peltor, the Company's operations are also affected by changes in exchange rates relative to the Swedish Krona. In contrast with the above, a decline in the value of the Krona relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the Krona relative to other currencies can have a negative impact on the profitability of the Company. The Company executes two hedging programs, one for transaction exposures, and the other for cash flow exposures in European operations. The Company has utilized forward foreign currency contracts for transaction and cash flow exposures. During the nine months ended June 30, 2002, net transaction losses were $0.1 million and there were no cash flow hedge gains or losses. In addition, the Company limits foreign exchange impact on the balance sheet with foreign denominated debt in Great Britain Pound Sterling, Euros and Canadian dollars. SFAS No. 133 requires that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. As a result of forward foreign currency contracts, the Company has recorded a derivative payable of $0.6 million as of June 30, 2002. The forward foreign currency contracts will expire over the next 3 months. Interest Rates The Company is exposed to market risk changes in interest rates through its debt. The Company utilizes interest rate instruments to reduce the impact of either increases or decreases in interest rates on its floating rate debt. As a result of the current economic slowdown and corresponding interest rate reductions, the Company entered into an interest rate collar arrangement in October 2001 to protect $25.0 million of the outstanding variable rate term loan debt from future interest rate volatility. The collar floor is set at 2% LIBOR (London Interbank Offering Rate) and cap at 6.25% LIBOR. The collar was not designated as a hedge under SFAS No. 133 and accordingly, the fair value of gains or losses were charged to earnings. The Company is of the opinion that it is well positioned to manage interest exposures in the short term. The Company continues to monitor interest rate movements and has mitigated the risks of potential interest rate fluctuations through the use of the aforementioned interest rate instruments. - 23 - Commodity Risk The Company is subject to market risks with respect to industry pricing in paper and crude oil as it relates to various commodity items. The Company is also exposed to market risks for electricity, fuel oil and natural gas consumed in its operations. Items with potential impact are paperboard, packaging films, nylons, resins, propylene, ethylene, plasticizer and freight. The Company manages pricing exposures on larger volume commodities such as polycarbonate, polyols and polyvinyl chloride via price negotiations utilizing alternative supplier competitive pricing. The Company sources some products and parts from Far East sources where resource availability, competition, and infrastructure stability has provided a favorable purchasing environment. The Company does not enter into derivative instruments to manage commodity risks. - 24 - PART II - OTHER INFORMATION Item 1. Legal Proceedings Contingencies. Various lawsuits and claims arise against the Company in the ordinary course of its business. Most of these lawsuits and claims are product liability matters that arise out of the use of safety eyewear and respiratory product lines manufactured by the Company as well as products purchased for resale. In addition, the Company may be contingently liable with respect to numerous lawsuits involving respirators sold by its predecessors, American Optical Corporation and Cabot Corporation, arising out of agreements entered into when the AOSafety(R) Division was sold by American Optical Corporation to Cabot in April 1990 and when later sold by Cabot to the Company in 1995. These lawsuits typically involve plaintiffs alleging that they suffer from asbestosis or silicosis, and that such condition results in part from respirators which were negligently designed or manufactured. The defendants in these lawsuits are often numerous, and include, in addition to respirator manufacturers, employers of the plaintiffs and manufacturers of sand (used in sand blasting) and asbestos. Responsibility for legal costs, as well as for settlements and judgments, is shared contractually by the Company, Cabot, American Optical Corporation and a prior owner of American Optical Corporation. Liability is allocated among the parties based on the number of years each company owned the AOSafety Division and the alleged years of exposure of the individual plaintiff. The Company's share of the contingent liability is further limited by an agreement entered into between the Company and Cabot whereby, so long as the Company pays to Cabot an annual fee of $400,000, Cabot will retain responsibility and liability for, and indemnify the Company against, asbestos and silicosis related legal claims asserted after July 11, 1995 (the date of the Company's formation) alleged to arise out of the use of respirators manufactured prior to July 11, 1995. This annual fee was negotiated as part of the 1995 agreement between the Company and Cabot. To date, the Company has elected to pay the annual fee. The Company could potentially be liable for these exposures if the Company elects to discontinue its participation in this arrangement, or if Cabot is no longer able to meet its obligations in these matters. With these arrangements in place, however, the Company's potential liability is limited to exposures alleged to arise from the use of respirators manufactured after July 11, 1995. The Company may also be responsible for certain claims of acquired companies other than the AOSafety(R) Division that are not covered by, and are unrelated to, the agreement with Cabot. At June 30, 2002, the Company has reserved approximately $5.0 million for product liabilities including those arising from asbestosis or silicosis litigation. The reserve is reevaluated periodically and may result in additional charges to operations if additional information becomes available. As is standard in the insurance industry, the Company's product liability insurance excludes asbestos and silicosis related respiratory claims. Therefore, the Company's accrual has not been reduced for estimated insurance recoveries. Consistent with the general environment experienced by other companies involved in asbestos-related litigation, there has been an increase in the number of asserted legal claims that could potentially involve the Company. Since the Company, until recently, has not been directly named in the lawsuits, it has very little available information regarding specific numbers of claims that affect the Company directly. Various factors increase the difficulty in determining the Company's potential liability, if any, in such claims, including the fact that the defendants in these lawsuits are often numerous and the claims generally do not specify the amount of damages sought. Additionally, the bankruptcy filings of other companies with asbestos-related litigation could affect the Company's cost over time. However, it is management's opinion, taking into account currently available information, historical experience, uncertainties, the Cabot agreement and the Company's reserve, that these suits and claims should not result in final judgments or settlements that, in the aggregate, would have a material effect on the Company's financial condition or results of operation. - 25 - Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K None. - 26 - SIGNATURES 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. Date: August 14, 2002 AEARO CORPORATION /s/ Jeffrey S. Kulka --------------------------------------- Jeffrey S. Kulka Vice President, Chief Financial Officer, Treasurer,and Secretary (Principal Financial and Accounting Officer) - 27 - CERTIFICATIONS In connection with the Quarterly Report of the Company on Form 10-Q for the period ending June 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Michael A. McLain, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C ss.1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: 1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and 2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company /s/Michael A. McLain --------------------------------------- Michael A. Mclain Chief Executive Officer, President, and Chairman of the Board of Directors In connection with the Quarterly Report of the Company on Form 10-Q for the period ending June 30, 2002 as filed with the Securities and Exchange Commission on the date hereof, I, Jeffrey S. Kulka, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C ss.1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: 1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and 2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company /s/ Jeffrey S. Kulka -------------------------------------- Jeffrey S. Kulka Vice President, Chief Financial Officer, Treasurer, and Secretary (Principal Financial and Accounting Officer) - 28 - EXHIBIT INDEX EXHIBITS DESCRIPTION --------- ------------

December 31, September 30, 2001 2001 ----------- ------------ Unaudited) CURRENT ASSETS: Cash and cash equivalents $ 20,016 $ 18,233 Accounts receivable (net of reserve for doubtful accounts of $1,022 and $831 respectively) 35,164 42,428 Inventories 30,752 29,564 Deferred and prepaid expenses 3,126 2,325 -------- -------- Total current assets 89,058 92,550 -------- -------- PROPERTY, PLANT AND EQUIPMENT, NET 48,100 47,003 INTANGIBLE ASSETS, NET 116,667 118,200 OTHER ASSETS 3,267 3,549 -------- -------- Total assets $257,092 $261,302 ======== ========

December 31, September 30, 2001 2001 ------------ ------------ (Unaudited) CURRENT LIABILITIES: Current portion of long-term debt $ 9,338 $ 8,393 Accounts payable and accrued liabilities 34,226 37,896 Accrued interest 5,636 2,691 U.S. and foreign income taxes 1,873 2,265 --------- --------- Total current liabilities 51,073 51,245 --------- --------- LONG-TERM DEBT 189,477 193,836 DEFERRED INCOME TAXES 486 383 OTHER LIABILITIES 6,159 5,982 --------- --------- Total liabilities $ 247,195 $ 251,446 --------- --------- COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value- (Redemption value of $99,826 and $96,801, respectively) Authorized--200,000 shares Issued and outstanding--45,000 shares -- -- Common stock, $.01 par value- Authorized--200,000 shares Issued and outstanding--102,088 shares 1 1 Additional paid-in capital 32,357 32,374 Accumulated deficit (3,205) (2,494) Accumulated other comprehensive loss (19,256) (20,025) --------- --------- Total stockholders' equity 9,897 9,856 --------- --------- Total liabilities and stockholders' equity $ 257,092 $ 261,302 ========= =========

For the Three Months Ended December 31, ------------------------------- -------------- ------------- 2001 2000 CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (711) $ (2,387) Adjustments to reconcile net loss to cash provided by operating activities- Depreciation 2,375 2,529 Amortization of intangible assets and deferred financing costs 1,866 1,988 Deferred income taxes 96 (75) Other, net 15 16 Changes in assets and liabilities-(net of effects of Iron Age Vision purchase) Accounts receivable 7,443 3,131 Inventories (1,073) (1,454) Accounts payable and accrued liabilities (1,017) 367 Other, net (890) (680) -------- -------- Net cash provided by operating activities 8,104 3,435 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (1,811) (1,595) Cash paid for Iron Age Vision (730) -- Proceeds provided by disposals of property, plant and equipment -- 33 -------- -------- Net cash used by investing activities (2,541) (1,562) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolving credit facility, net -- 3,700 Repayment of bonds (2,000) Repayment of term loans (2,017) (4,409) Repayment of capital lease obligations (13) -- Proceeds (repayment) of long-term debt (35) 30 Other (16) (20) -------- -------- Net cash used by financing activities (4,081) (699) -------- -------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 301 (752) -------- -------- INCREASE IN CASH AND CASH EQUIVALENTS 1,783 422 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 18,233 3,495 -------- -------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 20,016 $ 3,917 ======== ======== NON-CASH INVESTING AND FINANCING ACTIVITIES: Capital lease obligations $ 1,285 $ -- ======== ======== CASH PAID FOR: Interest $ 1,698 $ 2,423 ======== ======== Income taxes $ 433 $ 433 ======== ========

Three Months Ended December 31, ------------------------------------------------------------- 2001 % 2000 % ----------- ------------ ----------- ------------ Net Sales Safety Products $ 45,006 73.0 $ 49,178 71.9 Safety Prescription Eyewear 8,994 14.6 8,941 13.1 Specialty Composites 7,643 12.4 10,246 15.0 ----------- ----------- ----------- ----------- Total net sales 61,643 100.0 68,365 100.0 Cost of Sales 32,928 53.4 37,553 54.9 Gross profit 28,715 46.6 30,812 45.1 Operating Expenses- Selling and administrative 20,856 33.8 24,183 35.4 Research and technical services 1,369 2.2 1,484 2.2 Amortization of intangibles 1,559 2.5 1,655 2.4 Other charges, net 9 -- 9 -- ----------- ----------- ----------- ----------- Total operating expenses 23,793 38.6 27,331 40.0 Operating income 4,922 8.0 3,481 5.1 Interest expense, net 5,110 8.3 5,801 8.5 ----------- ----------- ----------- ----------- Loss before provision for income taxes (188) (0.3) (2,320) (3.4) Provision for income taxes 523 0.8 67 0.1 ----------- ----------- ----------- ----------- Net loss (711) (1.2) (2,387) (3.5) EBITDA $ 8,864 14.4 $ 7,659 $ 11.2 =========== =========== =========== ===========

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