Edgar Filing: KADANT INC

kaiform10q2q2012.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

____________________________________________________

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2012

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

For the transition period from ________ to _________

Commission file number 1-11406

KADANT INC.

(Exact name of registrant as specified in its charter)

Delaware		52-1762325
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

One Technology Park Drive
Westford, Massachusetts		01886
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (978) 776-2000

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 ¨

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

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

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

Smaller reporting company o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


Class	Outstanding at July 27, 2012
Common Stock, $.01 par value		11,363,273

PART 1 – FINANCIAL INFORMATION

Item 1 – Financial Statements

KADANT INC.

Condensed Consolidated Balance Sheet

(Unaudited)

Assets

	June 30,		December 31,
(In thousands)	2012		2011

Current Assets:
Cash and cash equivalents	$	42,031	$	46,950
Restricted cash (Note 2)		68		700
Accounts receivable, less allowances of $2,078 and $2,308		57,134		59,492
Inventories (Note 4)		49,167		50,527
Unbilled contract costs and fees		10,662		3,244
Other current assets		11,127		11,703
Assets of discontinued operation		1,661		1,675
Total Current Assets		171,850		174,291

Property, Plant, and Equipment, at Cost		105,014		105,671
Less: accumulated depreciation and amortization		66,959		65,576
		38,055		40,095

Other Assets		36,329		38,053

Goodwill		104,912		105,959

Total Assets	$	351,146	$	358,398

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

KADANT INC.

Condensed Consolidated Balance Sheet (continued)

(Unaudited)

Liabilities and Shareholders’ Investment

	June 30,			December 31,
(In thousands, except share amounts)	2012			2011

Current Liabilities:
Short-term obligations and current maturities of long-term obligations	$	5,500		$	500
Accounts payable		25,645			28,624
Accrued payroll and employee benefits		13,143			17,687
Customer deposits		21,330			18,627
Other current liabilities		19,896			26,722
Liabilities of discontinued operation		2,847			3,632
Total Current Liabilities		88,361			95,792

Other Long-Term Liabilities		27,327			27,226

Long-Term Obligations (Note 6)		6,500			11,750

Shareholders’ Investment:
Preferred stock, $.01 par value, 5,000,000 shares authorized; none issued		–			–
Common stock, $.01 par value, 150,000,000 shares authorized; 14,624,159 shares issued		146			146
Capital in excess of par value		93,223			93,701
Retained earnings		212,302			198,706
Treasury stock at cost, 3,264,886 and 2,983,717 shares		(68,553	)		(62,118	)
Accumulated other comprehensive items		(9,331	)		(7,955	)
Total Kadant Shareholders’ Investment		227,787			222,480
Noncontrolling interest		1,171			1,150
Total Shareholders’ Investment		228,958			223,630

Total Liabilities and Shareholders’ Investment	$	351,146		$	358,398

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

KADANT INC.

Condensed Consolidated Statement of Income

(Unaudited)

	Three Months Ended
	June 30,			July 2,
(In thousands, except per share amounts)	2012			2011

Revenues	$	82,982		$	82,457

Costs and Operating Expenses:
Cost of revenues		46,684			44,751
Selling, general, and administrative expenses		25,490			25,821
Research and development expenses		1,393			1,403
		73,567			71,975

Operating Income		9,415			10,482

Interest Income		74			122
Interest Expense		(196	)		(299	)

Income from Continuing Operations Before Provision for Income Taxes		9,293			10,305
Provision for Income Taxes		2,705			2,927

Income from Continuing Operations		6,588			7,378
Loss from Discontinued Operation (net of income tax benefit of $4 and $2)		(3	)		(5	)

Net Income		6,585			7,373

Net Income Attributable to Noncontrolling Interest		(42	)		(69	)

Net Income Attributable to Kadant	$	6,543		$	7,304

Amounts Attributable to Kadant:
Income from Continuing Operations	$	6,546		$	7,309
Loss from Discontinued Operation		(3	)		(5	)
Net Income Attributable to Kadant	$	6,543		$	7,304

Earnings per Share from Continuing Operations Attributable to Kadant (Note 3):
Basic	$	.57		$	.59
Diluted	$	.56		$	.59

Earnings per Share Attributable to Kadant (Note 3):
Basic	$	.57		$	.59
Diluted	$	.56		$	.59

Weighted Average Shares (Note 3):
Basic		11,575			12,321

Diluted		11,679			12,477

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

KADANT INC.

Condensed Consolidated Statement of Income

(Unaudited)

	Six Months Ended
	June 30,			July 2,
(In thousands, except per share amounts)	2012			2011

Revenues	$	167,095		$	154,137

Costs and Operating Expenses:
Cost of revenues		92,425			82,338
Selling, general, and administrative expenses		51,633			50,294
Research and development expenses		2,925			2,715
Other expense (Note 8)		307			–
		147,290			135,347

Operating Income		19,805			18,790

Interest Income		168			221
Interest Expense		(405	)		(556	)

Income from Continuing Operations Before Provision for Income Taxes		19,568			18,455
Provision for Income Taxes (Note 5)		5,843			5,200

Income from Continuing Operations		13,725			13,255
Loss from Discontinued Operation (net of income tax benefit of $53 and $5)		(64	)		(9	)

Net Income		13,661			13,246

Net Income Attributable to Noncontrolling Interest		(65	)		(151	)

Net Income Attributable to Kadant	$	13,596		$	13,095

Amounts Attributable to Kadant:
Income from Continuing Operations	$	13,660		$	13,104
Loss from Discontinued Operation		(64	)		(9	)
Net Income Attributable to Kadant	$	13,596		$	13,095

Earnings per Share from Continuing Operations Attributable to Kadant (Note 3):
Basic	$	1.18		$	1.07
Diluted	$	1.17		$	1.05

Earnings per Share Attributable to Kadant (Note 3):
Basic	$	1.17		$	1.07
Diluted	$	1.16		$	1.05

Weighted Average Shares (Note 3):
Basic		11,614			12,294

Diluted		11,704			12,442

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

KADANT INC.

Condensed Consolidated Statement of Comprehensive Income

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
(In thousands)	2012			2011			2012			2011

Net Income	$	6,585		$	7,373		$	13,661		$	13,246

Other Comprehensive Items:
Foreign Currency Translation Adjustment		(5,463	)		1,786			(1,661	)		7,936
Pension and Other Post-Retirement Liability Adjustments, net (net of income tax of $70 and $138 in the three and six months ended June 30, 2012, respectively, and $47 and $91 in the three and six months ended July 2, 2011, respectively)		146			84			251			(793	)
Deferred (Loss) Gain on Hedging Instruments (net of income tax of $(85) and $1 in the three and six months ended June 30, 2012, respectively, and $24 and $31 in the three and six months ended July 2, 2011, respectively)		(174	)		1			(10	)		207
		(5,491	)		1,871			(1,420	)		7,350
Comprehensive Income		1,094			9,244			12,241			20,596
Comprehensive Loss (Income) Attributable to Noncontrolling Interest		36			(106	)		(21	)		(279	)
Comprehensive Income Attributable to Kadant	$	1,130		$	9,138		$	12,220		$	20,317

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

KADANT INC.

Condensed Consolidated Statement of Cash Flows

(Unaudited)

	Six Months Ended
	June 30,			July 2,
(In thousands)	2012			2011

Operating Activities:
Net income attributable to Kadant	$	13,596		$	13,095
Net income attributable to noncontrolling interest		65			151
Loss from discontinued operation		64			9
Income from continuing operations		13,725			13,255
Adjustments to reconcile income from continuing operations to net cash provided by operating activities:
Depreciation and amortization		4,272			3,847
Stock-based compensation expense		2,262			1,902
(Benefit) provision for losses on accounts receivable		(225	)		314
Gain on the sale of property, plant, and equipment		(106	)		(18	)
Other items, net		779			689
Changes in current assets and liabilities, net of effects of acquisitions:
Accounts receivable		2,098			(1,373	)
Unbilled contract costs and fees		(7,612	)		(1,609	)
Inventories		1,081			(15,294	)
Other current assets		461			(1,360	)
Accounts payable		(2,600	)		1,494
Other current liabilities		(9,123	)		5,809
Contributions to pension plan		(480	)		(450	)
Net cash provided by continuing operations		4,532			7,206
Net cash (used in) provided by discontinued operation		(835	)		5
Net cash provided by operating activities		3,697			7,211

Investing Activities:
Purchases of property, plant, and equipment		(841	)		(3,964	)
Proceeds from sale of property, plant, and equipment		262			35
Acquisitions, net of cash acquired		(25	)		(15,358	)
Dividend paid to minority shareholder		–			(579	)
Other, net		–			58
Net cash used in continuing operations for investing activities		(604	)		(19,808	)

Financing Activities:
Purchases of Company common stock		(8,377	)		–
Change in restricted cash (Note 2)		632			(2,173	)
Repayments of short- and long-term obligations		(250	)		(5,767	)
Net proceeds from issuance of Company common stock		138			149
Other, net		125			21
Net cash used in continuing operations for financing activities		(7,732	)		(7,770	)

Exchange Rate Effect on Cash and Cash Equivalents from Continuing Operations		(280	)		2,474

Decrease in Cash and Cash Equivalents from Continuing Operations		(4,919	)		(17,893	)
Cash and Cash Equivalents at Beginning of Period		46,950			61,805
Cash and Cash Equivalents at End of Period	$	42,031		$	43,912

Non-cash Investing Activities:
Fair value of assets acquired	$	–		$	21,844
Cash paid for acquired business		–			(15,849	)
Liabilities assumed of acquired business	$	–		$	5,995

Non-cash Financing Activities:
Issuance of Company common stock	$	1,829		$	1,855

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

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. General

The interim condensed consolidated financial statements and related notes presented have been prepared by Kadant Inc. (also referred to in this document as “we,” “Kadant,” “the Company,” or “the Registrant”), are unaudited, and, in the opinion of management, reflect all adjustments of a normal recurring nature necessary for a fair statement of the Company’s financial position at June 30, 2012, and its results of operations and comprehensive income for the three and six month periods ended June 30, 2012 and July 2, 2011, and cash flows for the six month periods ended June 30, 2012 and July 2, 2011. Interim results are not necessarily indicative of results for a full year or for any other interim period.

The condensed consolidated balance sheet presented as of December 31, 2011 has been derived from the consolidated financial statements that have been audited by the Company’s independent registered public accounting firm. The condensed consolidated financial statements and related notes are presented as permitted by Form 10-Q and do not contain certain information included in the annual consolidated financial statements and related notes of the Company. The condensed consolidated financial statements and notes included herein should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the Securities and Exchange Commission.

2.	Restricted Cash

As of June 30, 2012 and December 31, 2011, the Company had restricted cash of $68,000 and $700,000, respectively. This cash serves as collateral for bank guarantees primarily associated with providing assurance to customers in China that the Company will fulfill certain customer obligations entered into in the normal course of business. All the bank guarantees will expire by September 30, 2012.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

3. Earnings per Share

Basic and diluted earnings per share are calculated as follows:

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
(In thousands, except per share amounts)	2012			2011			2012			2011

Amounts Attributable to Kadant:
Income from Continuing Operations	$	6,546		$	7,309		$	13,660		$	13,104
Loss from Discontinued Operation		(3	)		(5	)		(64	)		(9	)
Net Income	$	6,543		$	7,304		$	13,596		$	13,095

Basic Weighted Average Shares		11,575			12,321			11,614			12,294
Effect of Stock Options, Restricted Stock Units and Employee Stock Purchase Plan		104			156			90			148
Diluted Weighted Average Shares		11,679			12,477			11,704			12,442

Basic Earnings per Share:
Continuing Operations	$	.57		$	.59		$	1.18		$	1.07
Discontinued Operation	$	–		$	–		$	(.01	)	$	–
Net Income	$	.57		$	.59		$	1.17		$	1.07

Diluted Earnings per Share:
Continuing Operations	$	.56		$	.59		$	1.17		$	1.05
Discontinued Operation	$	–		$	–		$	(.01	)	$	–
Net Income	$	.56		$	.59		$	1.16		$	1.05

Options to purchase approximately 164,400 and 81,600 shares of the Company’s common stock for the second quarters of 2012 and 2011, respectively, and 135,700 and 53,400 shares of the Company’s common stock for the first six months of 2012 and 2011, respectively, were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price for the common stock during the period and the effect of their inclusion would have been anti-dilutive. Unvested restricted stock units equivalent to approximately 2,000 shares of common stock for the second quarter of 2012, and 57,000 and 68,000 shares of common stock for the first six months of 2012 and 2011, respectively, were not included in the computation of diluted earnings per share because either the effect of their inclusion would have been anti-dilutive, or for unvested performance-based restricted stock units, the performance conditions had not been met as of the end of the reporting period.

4. Inventories

The components of inventories are as follows:

	June 30,		December 31,
(In thousands)	2012		2011

Raw Materials and Supplies	$	19,475	$	20,218
Work in Process		10,001		9,383
Finished Goods		19,691		20,926
	$	49,167	$	50,527

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

5. Income Taxes

The provision for income taxes was $5,843,000 and $5,200,000 in the first six months of 2012 and 2011, respectively, and represented 30% and 28% of pre-tax income. The effective tax rates were lower than the Company’s statutory rate primarily due to the distribution of worldwide earnings and the expected utilization of foreign tax credits in the U.S. that were fully reserved in prior periods, due to an increase in estimated current year income in the U.S. The increase in the effective tax rate between the first six months of 2011 and 2012 was primarily due to increases in the U.S. tax cost of the Company’s foreign operations, net unrecognized tax benefits, and non-deductible expenses outside of the U.S.

The Company has established valuation allowances related to certain domestic and foreign deferred tax assets and tax credits. The valuation allowance as of December 31, 2011 was $21,014,000, consisting of $8,096,000 in the U.S. and $12,918,000 in foreign jurisdictions. Compliance with Accounting Standards Codification (ASC) 740 requires the Company to periodically evaluate the necessity of establishing or adjusting a valuation allowance for deferred tax assets depending on whether it is more likely than not that a related tax benefit will be recognized in future periods. When assessing the need for a valuation allowance in a tax jurisdiction, the Company evaluates the weight of all available evidence to determine whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. As part of this evaluation, the Company considers its cumulative three-year history of earnings before income taxes, taxable income in prior carryback years, future reversals of existing taxable temporary differences, prudent and feasible tax planning strategies, and expected future results of operations. As of June 30, 2012, the Company has maintained a valuation allowance in the U.S. primarily against certain of its foreign tax credits due to the uncertainty of income beyond 2012. The Company’s full valuation allowance in certain foreign jurisdictions was maintained as of June 30, 2012 as a result of certain foreign subsidiaries being in a three-year cumulative loss position and the uncertainty of future profitability.

6. Short- and Long-Term Obligations

Short- and long-term obligations are as follows:

	June 30,			December 31,
(In thousands)	2012			2011

Revolving Credit Facility, due 2013	$	5,000		$	5,000
Variable Rate Term Loan, due from 2012 to 2016		7,000			7,250
Total Short- and Long-Term Obligations		12,000			12,250
Less: Short-Term Obligations and Current Maturities		(5,500	)		(500	)
Long-Term Obligations, less Current Maturities	$	6,500		$	11,750

The weighted average interest rate for the Company’s short- and long-term obligations was 5.29% as of June 30, 2012.

As of June 30, 2012, the Company had $69,193,000 of borrowing capacity available under the committed portion of its five-year unsecured revolving credit facility entered into on February 13, 2008 (2008 Credit Agreement). The amount the Company is able to borrow under the 2008 Credit Agreement is the total borrowing capacity less any outstanding borrowings, letters of credit and multi-currency borrowings issued under the 2008 Credit Agreement.

See Note 16 for information related to the repayment and termination of the 2008 Credit Agreement and the Company’s execution of a new credit agreement effective August 3, 2012.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

7. Warranty Obligations

The Company provides for the estimated cost of product warranties at the time of sale based on the actual historical occurrence rates and repair costs. The Company typically negotiates the terms regarding warranty coverage and length of warranty depending on the products and applications. While the Company engages in extensive product quality programs and processes, the Company’s warranty obligation is affected by product failure rates, repair costs, service delivery costs incurred in correcting a product failure, and supplier warranties on parts delivered to the Company. Should actual product failure rates, repair costs, service delivery costs, or supplier warranties on parts differ from the Company’s estimates, revisions to the estimated warranty liability would be required.

The changes in the carrying amount of accrued warranty costs included in other current liabilities in the accompanying condensed consolidated balance sheet are as follows:

	Six Months Ended
(In thousands)	June 30, 2012

Balance at December 31, 2011	$	4,129
Provision		486
Usage		(841	)
Currency translation		(41	)
Balance at June 30, 2012	$	3,733

8. Restructuring and Other Expense

Other Expense

In the first six months of 2012, other expense consisted of accelerated depreciation of $307,000 associated with the anticipated disposal of equipment in China related to a facility consolidation.

2011 Restructuring Plan

The Company recorded total restructuring costs of $408,000 in the fourth quarter of 2011 in its Papermaking Systems segment consisting of severance and associated costs related to the reduction of 73 employees in China to adjust our cost structure and streamline the Company’s operations.

2008 Restructuring Plan

The Company recorded total restructuring costs of $4,515,000, including severance and associated costs of $4,130,000 and facility-related costs of $385,000, in prior periods associated with its 2008 Restructuring Plan. These restructuring costs related to the reduction of 329 employees in China, North America, Latin America, and Europe, all in its Papermaking Systems segment. These actions were taken to adjust the Company’s cost structure and streamline its operations in response to the weak economic environment at the time.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

8. Restructuring and Other Expense (continued)

A summary of the changes in accrued restructuring costs related to the Company’s 2008 and 2011 Restructuring Plans is as follows:

(In thousands)	Severance Costs

2011 Restructuring Plan
Balance at December 31, 2011	$	408
Payments		(178	)
Currency translation		3
Balance at June 30, 2012	$	233

2008 Restructuring Plan
Balance at December 31, 2011	$	354
Payments		(123	)
Currency translation		3
Balance at June 30, 2012	$	234

The Company expects to pay the remaining accrued restructuring costs from 2012 to 2016.

9. Business Segment Information

The Company has combined its operating entities into one reportable operating segment, Papermaking Systems, and a separate product line, Fiber-based Products. In classifying operational entities into a particular segment, the Company aggregated businesses with similar economic characteristics, products and services, production processes, customers, and methods of distribution.

	Three Months Ended						Six Months Ended
	June 30,			July 2,			June 30,			July 2,
(In thousands)	2012			2011			2012			2011

Revenues:
Papermaking Systems	$	79,961		$	79,621		$	160,111		$	147,155
Fiber-based Products		3,021			2,836			6,984			6,982
	$	82,982		$	82,457		$	167,095		$	154,137

Income from Continuing Operations Before Provision for Income Taxes:
Papermaking Systems	$	11,772		$	13,073		$	23,876		$	23,770
Corporate and Fiber-based Products (a)		(2,357	)		(2,591	)		(4,071	)		(4,980	)
Total Operating Income		9,415			10,482			19,805			18,790
Interest Expense, Net		(122	)		(177	)		(237	)		(335	)
	$	9,293		$	10,305		$	19,568		$	18,455

Capital Expenditures:
Papermaking Systems	$	503		$	2,746		$	761		$	3,910
Corporate and Fiber-based Products		80			54			80			54
	$	583		$	2,800		$	841		$	3,964

(a) Corporate primarily includes general and administrative expenses.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

10. Stock-Based Compensation

Stock-based compensation expense of $1,188,000 and $1,078,000 in the second quarters of 2012 and 2011, respectively, and $2,262,000 and $1,902,000 in the first six months of 2012 and 2011, respectively, was recognized within selling, general, and administrative expenses in the accompanying condensed consolidated statement of income. Unrecognized compensation expense related to stock-based compensation totaled approximately $6,554,000 at June 30, 2012, and will be recognized over a weighted average period of 1.8 years.

On March 7, 2012, the Company granted to executive officers of the Company performance-based restricted stock units (RSUs), which represented, in aggregate, the right to receive 66,299 shares (the target RSU amount), subject to adjustment, with a grant date fair value of $21.91 per share. The RSUs are subject to adjustment based on the achievement of the performance measure selected for the 2012 fiscal year, which is a specified target for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) generated from continuing operations for the 2012 fiscal year. The RSUs are adjusted by comparing the actual adjusted EBITDA for the performance period to the target adjusted EBITDA. Actual adjusted EBITDA between 50% and 100% of the target adjusted EBITDA results in an adjustment of 50% to 100% of the RSU amount. Actual adjusted EBITDA between 100% and 115% of the target adjusted EBITDA results in an adjustment using a straight-line linear scale between 100% to 150% of the RSU amount. If actual adjusted EBITDA is below 50% of the target adjusted EBITDA for the 2012 fiscal year, all RSUs will be forfeited. In the first six months of 2012, the Company recognized compensation expense based on the probable number of RSUs expected to vest, which was 113% of the target RSU amount. Following the adjustment, the RSUs will be subject to additional time-based vesting, and will vest in three equal annual installments on March 10 of 2013, 2014, and 2015, provided that the executive officer is employed by the Company on the applicable vesting dates. In March 2012, the Company granted time-based RSUs representing 93,198 shares to its employees and non-employee directors. Also in March 2012, the Company granted options to purchase 82,717 shares of common stock to its executive officers.

11. Employee Benefit Plans

The Company sponsors a noncontributory defined benefit retirement plan for the benefit of eligible employees at its Kadant Solutions division and its corporate office (included in the table below in “Pension Benefits”). In addition, employees at certain of the Company’s subsidiaries participate in defined benefit retirement and post-retirement welfare benefit plans (included in the table below in “Other Benefits”). The components of the net periodic benefit cost for the pension benefits and other benefits plans are as follows:

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

11. Employee Benefit Plans (continued)

	Three Months Ended						Three Months Ended
(In thousands)	June 30, 2012						July 2, 2011
	Pension Benefits			Other Benefits			Pension Benefits			Other Benefits

Components of Net Periodic Benefit Cost:
Service cost	$	243		$	34		$	209		$	52
Interest cost		331			57			324			61
Expected return on plan assets		(407	)		–			(359	)		–
Recognized net actuarial loss		160			8			107			7
Amortization of prior service cost		14			6			14			6
Net periodic benefit cost	$	341		$	105		$	295		$	126

The weighted average assumptions used to determine net periodic benefit cost are as follows:

Discount rate		4.28	%		4.44	%		5.25	%		5.05	%
Expected long-term return on plan assets		6.25	%		–			6.25	%		–
Rate of compensation increase		4.00	%		3.44	%		4.00	%		3.22	%

	Six Months Ended						Six Months Ended
(In thousands)	June 30, 2012						July 2, 2011
	Pension Benefits			Other Benefits			Pension Benefits			Other Benefits

Components of Net Periodic Benefit Cost:
Service cost	$	505		$	73		$	436		$	90
Interest cost		651			115			651			113
Expected return on plan assets		(801	)		–			(712	)		–
Recognized net actuarial loss		314			17			219			14
Amortization of prior service cost (income)		28			11			28			(1	)
Net periodic benefit cost	$	697		$	216		$	622		$	216

The weighted average assumptions used to determine net periodic benefit cost are as follows:

Discount rate		4.28	%		4.43	%		5.25	%		5.02	%
Expected long-term return on plan assets		6.25	%		–			6.25	%		–
Rate of compensation increase		4.00	%		3.46	%		4.00	%		3.08	%

The Company made cash contributions of $480,000 to its Kadant Solutions division’s noncontributory defined benefit retirement plan in the first six months of 2012 and expects to make cash contributions of $480,000 over the remainder of 2012. For the remaining pension and post-retirement welfare benefits plans, the Company does not expect to make cash contributions other than to fund current benefit payments.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

12. Derivatives

The Company uses derivative instruments primarily to reduce its exposure to changes in currency exchange rates and interest rates. When the Company enters into a derivative contract, the Company makes a determination as to whether the transaction is deemed to be a hedge for accounting purposes. For a contract deemed to be a hedge, the Company formally documents the relationship between the derivative instrument and the risk being hedged. In this documentation, the Company specifically identifies the asset, liability, forecasted transaction, cash flow, or net investment that has been designated as the hedged item, and evaluates whether the derivative instrument is expected to reduce the risks associated with the hedged item. To the extent these criteria are not met, the Company does not use hedge accounting for the derivative. The changes in the fair value of a derivative not deemed to be a hedge are recorded currently in earnings. The Company does not hold or engage in transactions involving derivative instruments for purposes other than risk management.

ASC 815, “Derivatives and Hedging,” requires that all derivatives be recognized on the balance sheet at fair value. For derivatives designated as cash flow hedges, the related gains or losses on these contracts are deferred as a component of accumulated other comprehensive items. These deferred gains and losses are recognized in the period in which the underlying anticipated transaction occurs. For derivatives designated as fair value hedges, the unrealized gains and losses resulting from the impact of currency exchange rate movements are recognized in earnings in the period in which the exchange rates change and offset the currency gains and losses on the underlying exposures being hedged. The Company performs an evaluation of the effectiveness of the hedge both at inception and on an ongoing basis. The ineffective portion of a hedge, if any, and changes in the fair value of a derivative not deemed to be a hedge are recorded in the condensed consolidated statement of income.

Interest Rate Swaps

The Company entered into interest rate swap agreements in 2008 and 2006 to hedge its exposure to variable-rate debt and has designated these agreements as cash flow hedges. On February 13, 2008, the Company entered into a swap agreement (2008 Swap Agreement) to hedge the exposure to movements in the three-month LIBOR rate on future outstanding debt. The 2008 Swap Agreement has a five-year term and a $15,000,000 notional value, which decreased to $5,000,000 on December 30, 2011. Under the 2008 Swap Agreement, on a quarterly basis the Company receives a three-month LIBOR rate and pays a fixed rate of interest of 3.265% plus the applicable margin. The Company entered into a swap agreement in 2006 (the 2006 Swap Agreement) to convert a portion of the Company’s outstanding debt from a floating to a fixed rate of interest. The swap agreement has the same terms and quarterly payment dates as the corresponding debt, and reduces proportionately in line with the amortization of the debt. Under the 2006 Swap Agreement, the Company receives a three-month LIBOR rate and pays a fixed rate of interest of 5.63% plus an applicable margin. The fair values for these instruments as of June 30, 2012 are included in liabilities, with an offset to accumulated other comprehensive items (net of tax) in the accompanying condensed consolidated balance sheet. The Company has structured these interest rate swap agreements to be 100% effective and as a result, there is no current impact to earnings resulting from hedge ineffectiveness. Management believes that any credit risk associated with the swap agreements is remote based on the Company’s financial position and the creditworthiness of the financial institution issuing the swap agreements.

The counterparty to the swap agreement could demand an early termination of the swap agreement if the Company is in default under the 2008 Credit Agreement, or any agreement that amends or replaces the 2008 Credit Agreement in which the counterparty is a member, and the Company is unable to cure the default. An event of default under the 2008 Credit Agreement includes customary events of default and failure to comply with financial covenants, including a maximum consolidated leverage ratio of 3.5 and a minimum consolidated fixed charge coverage ratio of 1.2. As of June 30, 2012, the Company was in compliance with these covenants. The unrealized loss of $1,252,000 as of June 30, 2012 represents the estimated amount that the Company would pay to the counterparty in the event of an early termination.

Forward Currency-Exchange Contracts

The Company uses forward currency-exchange contracts primarily to hedge exposures resulting from fluctuations in currency exchange rates. Such exposures result primarily from portions of the Company’s operations and assets and liabilities that are denominated in currencies other than the functional currencies of the businesses conducting the operations or holding the assets and liabilities. The Company typically manages its level of exposure to the risk of currency-exchange fluctuations by hedging a portion of its currency exposures anticipated over the ensuing 12-month period, using forward currency-exchange contracts that have maturities of 12 months or less.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

12. Derivatives (continued)

Forward currency-exchange contracts that hedge forecasted accounts receivable or accounts payable are designated as cash flow hedges. The fair values for these instruments are included in other current assets for unrecognized gains and in other current liabilities for unrecognized losses, with an offset in accumulated other comprehensive items (net of tax). For forward currency-exchange contracts that are designated as fair value hedges, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item are recognized currently in earnings. The fair values of forward currency-exchange contracts that are not designated as hedges are recorded currently in earnings. The Company recognized a loss of $23,000 and a gain of $84,000 in the second quarters of 2012 and 2011, respectively, and a loss of $25,000 and a gain of $81,000 in the first six months of 2012 and 2011, respectively, included in selling, general, and administrative expenses, associated with forward currency-exchange contracts that were not designated as hedges. Management believes that any credit risk associated with forward currency-exchange contracts is remote based on the Company’s financial position and the creditworthiness of the financial institutions issuing the contracts.

The following table summarizes the fair value of the Company’s derivative instruments designated and not designated as hedging instruments, the notional values of the associated derivative contracts, and the location of these instruments in the condensed consolidated balance sheet:

		June 30, 2012					December 31, 2011
	Balance Sheet	Asset			Notional		Asset			Notional
(In thousands)	Location	(Liability) (a)			Amount (b)		(Liability) (a)			Amount
Derivatives Designated as Hedging Instruments:
Derivatives in an Asset Position:
Forward currency-exchange contracts	Other Current Assets	$	9		$	643	$	22		$	421
Derivatives in a Liability Position:
Forward currency-exchange contracts	Other Current Liabilities	$	(578	)	$	6,440	$	(462	)	$	6,635
Interest rate swap agreement	Other Current-Liabilities	$	(88	)	$	5,000	$	–		$	–
Interest rate swap agreements	Other Long-Term Liabilities	$	(1,164	)	$	7,000	$	(1,401	)	$	12,250

Derivatives Not Designated as Hedging Instruments:
Derivatives in a Liability Position:
Forward currency-exchange contracts	Other Current Liabilities	$	(23	)	$	979	$	(82	)	$	1,775

(a)	See Note 13 for the fair value measurements related to these financial instruments.

(b)	The total notional amount is indicative of the level of the Company’s derivative activity during the first six months of 2012.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

12. Derivatives (continued)

The following table summarizes the activity in accumulated other comprehensive items (OCI) associated with the Company’s derivative instruments designated as cash flow hedges as of and for the period ended June 30, 2012:

(In thousands)	Interest Rate Swap Agreements			Forward Currency-Exchange Contracts		Total
Unrealized loss, net of tax, at December 31, 2011	$	1,166		$	267	$	1,433
(Loss) gain reclassified to earnings (a)		(163	)		5		(158	)
Loss recognized in OCI		68			100		168
Unrealized loss, net of tax, at June 30, 2012	$	1,071		$	372	$	1,443

(a) Included in interest expense for interest rate swap agreements and in revenues for forward currency-exchange contracts in the accompanying condensed consolidated statement of income.

As of June 30, 2012, $282,000 of the net unrealized loss included in OCI is expected to be reclassified to earnings over the next twelve months.

13. Fair Value Measurements

Fair value measurement is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy is established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

•

Level 1—Quoted prices in active markets for identical assets or liabilities.

•

Level 2—Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly.

•

Level 3—Unobservable inputs based on the Company’s own assumptions.

The following table presents the fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis:

	Fair Value as of June 30, 2012
(In thousands)	Level 1		Level 2		Level 3		Total

Assets:
Money market funds and time deposits	$	13,762	$	–	$	–	$	13,762
Forward currency-exchange contracts	$	–	$	9	$	–	$	9

Liabilities:
Forward currency-exchange contracts	$	–	$	601	$	–	$	601
Interest rate swap agreements	$	–	$	1,252	$	–	$	1,252

	Fair Value as of December 31, 2011
(In thousands)	Level 1		Level 2		Level 3		Total

Assets:
Money market funds and time deposits	$	13,983	$	–	$	–	$	13,983
Forward currency-exchange contracts	$	–	$	22	$	–	$	22

Liabilities:
Forward currency-exchange contracts	$	–	$	544	$	–	$	544
Interest rate swap agreements	$	–	$	1,401	$	–	$	1,401

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

13. Fair Value Measurements (continued)

The Company uses the market approach technique to value its financial assets and liabilities, and there were no changes in valuation techniques during the first six months of 2012. The Company’s financial assets and liabilities carried at fair value include cash equivalents and derivative instruments used to hedge the Company’s foreign currency and interest rate risks. The Company’s cash equivalents are comprised of money market funds and time deposits that are highly liquid and easily tradable. These investments are fair valued using inputs observable in active markets. The fair values of the Company’s interest rate swap agreements are based on LIBOR yield curves at the reporting date. The fair values of the Company’s forward currency-exchange contracts are based on quoted forward foreign exchange rates at the reporting date. The forward currency-exchange contracts and interest rate swap agreements are hedges of either recorded assets or liabilities or anticipated transactions. Changes in values of the underlying hedged assets and liabilities or anticipated transactions are not reflected in the table above.

The carrying value and fair value of the Company’s long-term debt obligations are as follows:

	June 30, 2012				December 31, 2011
	Carrying		Fair		Carrying		Fair
(In thousands)	Value		Value		Value		Value

Long-term debt obligations	$	6,500	$	6,500	$	11,750	$	11,750

The carrying value of long-term debt obligations approximates fair value as the obligations bear variable rates of interest, which adjust quarterly based on prevailing market rates.

14. Recent Accounting Pronouncements

Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. In July 2012, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2012-02, “Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” The guidance in this ASU gives the Company the option to first perform a qualitative assessment to determine whether it is more likely than not (a likelihood of more than 50%) that an indefinite-lived intangible asset is impaired. If the Company determines that it is more likely than not that the fair value of such an asset exceeds its carrying amount, it would not need to calculate the fair value of the asset in that year. However, if the Company concludes otherwise, it must calculate the fair value of the asset, compare that value with its carrying amount, and record an impairment charge, if any. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, although early adoption is permitted. The Company is currently evaluating when it will adopt this ASU, but such adoption is not expected to have a material effect on its consolidated financial statements.

Comprehensive Income. In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” The new guidance eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity. Instead, the new rule requires an entity to present net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate but consecutive statements. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. In addition, in December 2011, the FASB issued an amendment to this accounting standard which defers the requirement to present certain components of reclassifications of other comprehensive income on the face of the income statement for all periods presented. During the deferral, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the issuance of this amendment. This new guidance is effective for interim and annual periods beginning after December 15, 2011. The Company adopted this ASU in the first quarter of 2012 and has revised its presentation of comprehensive income in the accompanying condensed consolidated financial statements.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

14. Recent Accounting Pronouncements (continued)

Fair Value Measurements. In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRSs).” ASU No. 2011-04 establishes a number of new requirements for fair value measurements. These include: (1) a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; (2) an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and (3) a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used and qualitative details about the sensitivity of the measurements. In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed. This ASU is effective for interim and annual periods beginning after December 15, 2011. The Company adopted this ASU in the first quarter of 2012, which did not have an impact on its condensed consolidated financial statements.

15. Litigation

In 2005, the Company’s Kadant Composites LLC subsidiary (Composites LLC) sold substantially all of its assets to a third party. Through the sale date of October 21, 2005, Composites LLC offered a standard limited warranty to the owner of its decking and roofing products, limited to repair or replacement of the defective product or a refund of the original purchase price. Under the terms of the asset purchase agreement, Composites LLC retained certain liabilities associated with the operation of the business prior to the sale, including the warranty obligations associated with products manufactured prior to the sale date. Composites LLC retained all of the cash proceeds received from the asset sale and continued to administer and pay warranty claims from the sale proceeds into the third quarter of 2007. On September 30, 2007, Composites LLC announced that it no longer had sufficient funds to honor warranty claims, was unable to pay or process warranty claims, and ceased doing business. All activity related to this business is classified in the results of the discontinued operation in the accompanying condensed consolidated financial statements.

On October 24, 2011, the Company, Composites LLC, and other co-defendants entered into an agreement to settle a nationwide class action lawsuit related to allegedly defective composites decking building products manufactured by Composites LLC between April 2002 and October 2003, which was filed and approved in Connecticut state court. As of June 30, 2012, the Company has accrued $2,577,000 for the payment of claims under the settlement. If the actual claims submitted and approved under the settlement agreement exceed the amount of this reserve, the Company will reflect the amount of the additional claims in the results of the discontinued operation in future periods, up to a maximum of $5,000,000 as agreed in the settlement agreement. In in the second quarter of 2012, the Company paid $710,000 in legal fees and incentives as agreed to in the settlement agreement.

From time to time, the Company is subject to various other claims and legal proceedings covering a range of matters that arise in the ordinary course of business. Such litigation may include claims and counterclaims by and against the Company for breach of contract, canceled contracts, or alleged breaches of warranty and other contract commitments. The Company believes such claims to be without merit and intends to continue its practice of vigorously defending these claims and cases. At this time, the Company believes that a loss regarding these legal proceedings is neither probable nor remote, and based on the information currently available, the Company is unable to determine an estimate, or range of estimates, of potential losses. If the Company was found to be liable for any of the claims or counterclaims against it, the Company would incur a charge against earnings.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

16. Subsequent Event

On August 3, 2012, the Company entered into a five-year unsecured revolving credit facility (2012 Credit Agreement) in the aggregate principal amount of up to $100,000,000, of which $5,000,000 is subject to future joinder by a foreign bank. The 2012 Credit Agreement also includes an uncommitted unsecured incremental borrowing facility of up to an additional $50,000,000. The Company can borrow up to $100,000,000 under the 2012 Credit Agreement. The principal on any borrowings made under the 2012 Credit Agreement is due on August 3, 2017. Interest on any loans outstanding under the 2012 Credit Agreement accrues and is payable quarterly in arrears at one of the following rates selected by the Company: (i) the highest of (a) the federal funds rate plus 0.50% plus an applicable margin of 0% to 1%, (b) the prime rate, as defined, plus an applicable margin of 0% to 1%and (c) the Eurocurrency rate, as defined, plus 0.50% plus an applicable margin of 0% to 1% or (ii) the Eurocurrency rate, as defined, plus an applicable margin of 1% to 2%. The applicable margin is determined based upon the ratio of the Company’s total debt to EBITDA, as defined. For this purpose, total debt is defined as total debt less unrestriced domestic cash of up to $25,000,000.

Contemporaneously with the execution of the 2012 Credit Agreement, the Company borrowed $5,000,000 under the 2012 Credit Agreement and applied the proceeds to pay off its existing outstanding debt under the 2008 Credit Agreement, which was then terminated.

The obligations of the Company under the 2012 Credit Agreement may be accelerated upon the occurrence of an event of default under the 2012 Credit Agreement, which includes customary events of default including without limitation payment defaults, defaults in the performance of affirmative and negative covenants, the inaccuracy of representations or warranties, bankruptcy- and insolvency-related defaults, defaults relating to such matters as the Employment Retirement Income Security Act (ERISA), unsatisfied judgments, the failure to pay certain indebtedness, and a change of control default. In addition, the 2012 Credit Agreement contains negative covenants applicable to the Company and its subsidiaries including financial covenants requiring the Company to comply with a maximum consolidated leverage ratio of 3.5 to 1, a maximum annual capital expenditure of $25 million, and a minimum consolidated interest coverage ratio of 3 to 1, and restrictions on liens, indebtedness, fundamental changes, dispositions of property, making certain restricted payments (including dividends and stock repurchases), investments, transactions with affiliates, sale and leaseback transactions, swap agreements, changing its fiscal year, arrangements affecting subsidiary distributions, entering into new lines of business, and certain actions related to the discontinued operation.

Loans under the 2012 Credit Agreement are guaranteed by certain domestic subsidiaries of the Company pursuant to the Guarantee Agreement, effective August 3, 2012.

KADANT INC.

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q includes forward-looking statements that are not statements of historical fact, and may include statements regarding possible or assumed future results of operations. Forward-looking statements are subject to risks and uncertainties and are based on the beliefs and assumptions of our management, using information currently available to our management. When we use words such as “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates,” “seeks,” “should,” “likely,” “will,” “would,” “may,” “continue,” “could,” or similar expressions, we are making forward-looking statements.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties, and assumptions. Our future results of operations may differ materially from those expressed in the forward-looking statements. Many of the important factors that will determine these results and values are beyond our ability to control or predict. You should not put undue reliance on any forward-looking statements. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events, or otherwise. For a discussion of important factors that may cause our actual results to differ materially from those suggested by the forward-looking statements, you should read carefully the section captioned “Risk Factors” in Part II, Item 1A, of this Report.

Overview

Company Background

We are a leading supplier of equipment used in the global papermaking and paper recycling industries and a manufacturer of granules made from papermaking byproducts. Our continuing operations are comprised of one reportable operating segment: Papermaking Systems, and a separate product line, Fiber-based Products. Through our Papermaking Systems segment, we develop, manufacture, and market a range of equipment and products for the global papermaking, paper recycling, and process industries. We have a large customer base that includes most of the world’s major paper manufacturers. We believe our large installed base provides us with a spare parts and consumables business that yields higher margins than our capital equipment business.

Through our Fiber-based Products business, we manufacture and sell granules derived from pulp fiber for use as carriers for agricultural, home lawn and garden, and professional lawn, turf and ornamental applications, as well as for oil and grease absorption.

Papermaking Systems Segment

Our Papermaking Systems segment consists of the following product lines: stock-preparation, fluid-handling, doctoring, and water-management.

Stock-preparation: custom-engineered systems and equipment, as well as standard individual components, for pulping, de-inking, screening, cleaning, and refining primarily recycled fiber for preparation for entry into the paper machine; recausticizing and evaporation equipment and systems used in the production of virgin pulp;

Fluid-handling: rotary joints, precision unions, steam and condensate systems, components, and controls used primarily in the dryer section of the papermaking process and during the production of corrugated boxboard, metals, plastics, rubber, textiles, chemicals, and food;

Doctoring: doctoring systems and related consumables that continuously clean rolls to keep paper machines running efficiently; doctor blades made of a variety of materials to perform functions including cleaning, creping, web removal, flaking, and the application of coatings; and profiling systems that control moisture, web curl, and gloss during paper converting; and

Water-management: systems and equipment used to continuously clean paper machine fabrics and rolls, drain water from pulp mixtures, form the sheet or web, and filter the process water for reuse.

KADANT INC.

Overview (continued)

Fiber-based Products

We produce biodegradable, absorbent granules from papermaking byproducts for use primarily as carriers for agricultural, home lawn and garden, and professional lawn, turf and ornamental applications, as well as for oil and grease absorption.

Discontinued Operation

In 2005, our Kadant Composites LLC subsidiary (Composites LLC) sold substantially all of its assets to a third party. Under the terms of the asset purchase agreement, Composites LLC retained certain liabilities associated with the operation of the business prior to the sale, including the warranty obligations related to products manufactured prior to the sale date. All activity related to this business is classified in the results of the discontinued operation in the accompanying condensed consolidated financial statements.

On October 24, 2011, we, our Composites LLC subsidiary, and other co-defendants entered into an agreement to settle a nationwide class action lawsuit related to defective composites decking building products manufactured by Composites LLC between April 2002 and October 2003. For more information regarding litigation arising from these claims, see Part II, Item 1A, “Risk Factors.”

International Sales

During the first six months of 2012 and 2011, approximately 59% and 60%, respectively, of our sales were to customers outside the United States, principally in Europe and China. We generally seek to charge our customers in the same currency in which our operating costs are incurred. However, our financial performance and competitive position can be affected by currency exchange rate fluctuations affecting the relationship between the U.S. dollar and foreign currencies. We seek to reduce our exposure to currency fluctuations through the use of forward currency exchange contracts. We may enter into forward contracts to hedge certain firm purchase and sale commitments denominated in currencies other than our subsidiaries’ functional currencies. These contracts hedge transactions principally denominated in U.S. dollars.

Application of Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of our condensed consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Our actual results may differ from these estimates.

Critical accounting policies are defined as those that reflect significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. We believe that our most critical accounting policies, upon which our financial condition depends and which involve the most complex or subjective decisions or assessments, are those described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the section captioned “Application of Critical Accounting Policies and Estimates” in Part I, Item 7, of our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, filed with the Securities and Exchange Commission (SEC). There have been no material changes to these critical accounting policies since fiscal year-end 2011 that warrant disclosure.

Industry and Business Outlook

Our products are primarily sold to the global pulp and paper industry. In North America, containerboard grades showed some strength with operating rates climbing to 96% in June and several major producers announcing a $50 per ton price increase, which will take effect in August. Operating rates for tissue also remained strong through the first half of 2012, although the forecast for writing and newsprint grades continues to be weak. In general, we believe that higher mill operating rates lead to increased demand for our parts and consumables products. In Europe, the increasing uncertainty resulting primarily from sovereign debt issues continues to impact the economy and demand for paper products. We have seen reduced demand for our products in Europe and projects in Europe have been delayed. In China, we continue to see relatively weak market conditions as the market absorbs the large amount of capacity that has come on line over the past year and the pace of economic growth slows. Some of our customers in China have delayed new projects or deferred shipments for orders in our backlog in response to these market conditions. However, we believe the business outlook in emerging markets is more promising with growth in paper production projected to be nearly 6% annually from a base year of 2010 through 2016.

KADANT INC.

Overview (continued)

For the third quarter of 2012, we expect to achieve diluted earnings per share (EPS) from continuing operations of $0.49 to $0.51, on revenues of $80 to $82 million. For the full year 2012, we expect to achieve diluted EPS from continuing operations of $2.05 to $2.10 on revenues of $325 to $330 million, revised from our previous guidance from continuing operations of $2.10 to $2.20 on revenues of $335 to $345 million.

Results of Operations

Second Quarter 2012 Compared With Second Quarter 2011

The following table sets forth our unaudited condensed consolidated statement of income expressed as a percentage of total revenues from continuing operations for the second fiscal quarters of 2012 and 2011. The results of operations for the fiscal quarter ended June 30, 2012 are not necessarily indicative of the results to be expected for the full fiscal year.

	Three Months Ended
	June 30,			July 2,
	2012			2011

Revenues		100	%		100	%

Costs and Operating Expenses:
Cost of revenues		56			54
Selling, general, and administrative expenses		31			31
Research and development expenses		2			2
		89			87

Operating Income		11			13

Interest Income		–			–
Interest Expense		–			–

Income from Continuing Operations Before Provision for Income Taxes		11			13
Provision for Income Taxes		3			4

Income from Continuing Operations		8	%		9	%

Revenues

Revenues for the second quarters of 2012 and 2011 from our Papermaking Systems segment and Fiber-based Products business are as follows:

		Three Months Ended
		June 30,		July 2,
(In thousands)		2012		2011

Revenues:
Papermaking Systems	$	79,961	$	79,621
Fiber-based Products		3,021		2,836
	$	82,982	$	82,457

KADANT INC.

Results of Operations (continued)

Papermaking Systems Segment. Revenues increased $0.4 million to $80.0 million in the second quarter of 2012 from $79.6 million in the second quarter of 2011, including a $3.5 million decrease from the unfavorable effects of currency translation. Revenues in our water-management product line increased $4.6 million, or 53%, due to a $2.4 million increase from Kadant M-Clean, acquired in May 2011, and higher demand for our capital products. Revenues in our stock-preparation product line decreased $3.6 million, or 11%, due to decreased demand for capital products at our Chinese operations, offset in part by an increase at our North American operations.

Fiber-based Products. Revenues increased $0.2 million, or 7%, to $3.0 million in the second quarter of 2012 from $2.8 million in the second quarter of 2011 primarily due to increased demand for our biodegradable granular products.

Papermaking Systems Segment by Product Line. The following table presents revenues for our Papermaking Systems segment by product line, the changes in revenues by product line between the second quarters of 2012 and 2011, and the changes in revenues by product line between the second quarters of 2012 and 2011 excluding the effect of currency translation. The increase (decrease) in revenues excluding the effect of currency translation represents the increase (decrease) resulting from the conversion of second quarter of 2012 revenues in local currency into U.S. dollars at the second quarter of 2011 exchange rates, and then comparing this result to the actual revenues in the second quarter of 2011. The presentation of the changes in revenues by product line excluding the effect of currency translation is a non-GAAP (generally accepted accounting principles) measure. We believe this non-GAAP measure helps investors gain a better understanding of our underlying operations especially when comparing such results to prior periods. This non-GAAP measure should not be considered superior to or a substitute for the corresponding GAAP measure.

	Three Months Ended				Increase (Decrease) Excluding Effect of
(In millions)	June 30, 2012		July 2, 2011		Increase (Decrease)			Currency Translation

Papermaking Systems Product Lines:
Stock-Preparation	$	28.7	$	32.3	$	(3.6	)	$	(2.8	)
Fluid-Handling		23.7		24.5		(0.8	)		0.6
Doctoring		14.0		13.7		0.3			0.9
Water-Management		13.1		8.5		4.6			5.2
Other		0.5		0.6		(0.1	)		–
	$	80.0	$	79.6	$	0.4		$	3.9

Revenues in our stock-preparation product line in the second quarter of 2012 decreased $2.8 million, or 9%, excluding a $0.8 million unfavorable effect of currency translation, compared to the second quarter of 2011, due to decreased demand for capital products at our Chinese operations, offset in part by an increase at our North American operations. In our fluid-handling product line, revenues in the second quarter of 2012 increased $0.6 million, or 2%, excluding a $1.4 million unfavorable effect of currency translation, compared to the prior year period primarily due to higher demand for our products at our North American operations and parts and consumables products at our European operations. Revenues from our doctoring product line in the second quarter of 2012 increased $0.9 million, or 7%, excluding a $0.6 million unfavorable effect of currency translation, compared to the prior year period primarily due to increased demand for parts and consumables products at our North American operations. Revenues from our water-management product line in the second quarter of 2012 increased $5.2 million, or 61%, excluding a $0.6 million unfavorable effect of currency translation, compared to the prior year period due to a $2.8 million increase from Kadant M-Clean, acquired in May 2011, and an increase in demand for capital products at our North American and Chinese operations.

KADANT INC.

Results of Operations (continued)

Gross Profit Margin

Gross profit margins for the second quarters of 2012 and 2011 are as follows:

	Three Months Ended
	June 30,	July 2,
	2012	2011

Gross Profit Margin:
Papermaking Systems	43.4%	45.3%
Fiber-based Products	52.8	56.6
	43.7%	45.7%

Papermaking Systems Segment. The gross profit margin in the Papermaking Systems segment decreased to 43.4% in the second quarter of 2012 from 45.3% in the second quarter of 2011. This decrease resulted from lower gross profit margins, primarily in our stock-preparation product line, due to lower margins on capital products. This decrease was offset in part by higher gross profit margins in our doctoring product line, primarily in North America and China.

Fiber-based Products. The gross profit margin in our Fiber-based Products business decreased to 52.8% in the second quarter of 2012 from 56.6% in the second quarter of 2011 as a result of decreased manufacturing efficiency due to lower production volumes.

Operating Expenses

Selling, general, and administrative expenses as a percentage of revenues were 31% in both the second quarters of 2012 and 2011. Selling, general, and administrative expenses decreased $0.3 million, or 1%, to $25.5 million in the second quarter of 2012 from $25.8 million in the second quarter of 2011, including a $1.1 million decrease from the favorable effect of currency translation and a $0.9 million increase from Kadant M-Clean, acquired in May 2011.

Total stock-based compensation expense was $1.2 million and $1.1 million in the second quarters of 2012 and 2011, respectively, and is included in selling, general, and administrative expenses in the accompanying condensed consolidated statement of income. As of June 30, 2012, unrecognized compensation cost related to stock-based compensation was approximately $6.6 million, which will be recognized over a weighted average period of 1.8 years.

Research and development expenses were $1.4 million in the second quarters of 2012 and 2011, and represented 2% of revenues in both periods.

Interest Income

Interest income was $0.1 million in the second quarters of 2012 and 2011.

Interest Expense

Interest expense decreased $0.1 million, or 34%, to $0.2 million in the second quarter of 2012 from $0.3 million in the second quarter of 2011 primarily due to lower outstanding borrowings in the 2012 period.

KADANT INC.

Results of Operations (continued)

Provision for Income Taxes

Our provision for income taxes was $2.7 million and $2.9 million in the second quarters of 2012 and 2011, respectively, and represented 29% and 28% of pre-tax income. The effective tax rates were lower than our statutory rate primarily due to the distribution of worldwide earnings and the expected utilization of foreign tax credits in the U.S. that were fully reserved in prior periods, due to an increase in estimated current year income in the U.S.

We have established valuation allowances related to certain domestic and foreign deferred tax assets and tax credits. The valuation allowance as of December 31, 2011 was $21.0 million, consisting of $8.1 million in the U.S. and $12.9 million in foreign jurisdictions. Compliance with Accounting Standards Codification 740 requires us to periodically evaluate the necessity of establishing or adjusting a valuation allowance for deferred tax assets depending on whether it is more likely than not that a related tax benefit will be recognized in future periods. When assessing the need for a valuation allowance in a tax jurisdiction, we evaluate the weight of all available evidence to determine whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. As part of this evaluation, we consider our cumulative three-year history of earnings before income taxes, taxable income in prior carryback years, future reversals of existing taxable temporary differences, prudent and feasible tax planning strategies, and expected future results of operations. As of June 30, 2012, we have maintained a valuation allowance in the U.S. primarily against certain of its foreign tax credits due to the uncertainty of income beyond 2012. Our full valuation allowance in certain foreign jurisdictions was maintained as of June 30, 2012 as a result of certain foreign subsidiaries being in a three-year cumulative loss position and the uncertainty of future profitability.

Income from Continuing Operations

Income from continuing operations decreased $0.8 million to $6.6 million in the second quarter of 2012 from $7.4 million in the second quarter of 2011. This decrease was primarily due to a decrease in operating income of $1.1 million offset in part by a $0.2 million decrease in our provision for income taxes. (see Revenues, Gross Profit Margin, and Provision for Income Taxes discussed above).

Loss from Discontinued Operation

Loss from the discontinued operation was $3 thousand and $5 thousand in the second quarters of 2012 and 2011, respectively.

Recent Accounting Pronouncements

Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. In July 2012, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2012-02, “Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” The guidance in this ASU gives us the option to first perform a qualitative assessment to determine whether it is more likely than not (a likelihood of more than 50%) that an indefinite-lived intangible asset is impaired. If we determine that it is more likely than not that the fair value of such an asset exceeds its carrying amount, we would not need to calculate the fair value of the asset in that year. However, if we conclude otherwise, we must calculate the fair value of the asset, compare that value with its carrying amount, and record an impairment charge, if any. This guidance is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, although early adoption is permitted. We are currently evaluating when we will adopt this ASU, but such adoption is not expected to have a material effect on our consolidated financial statements.

Comprehensive Income. In June 2011, the FASB issued ASU No. 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income”. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity. Instead, the new rule requires an entity to present net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate but consecutive statements. While the new guidance changes the presentation of comprehensive income, there are no changes to the components that are recognized in net income or other comprehensive income under current accounting guidance. In addition, in December 2011, the FASB issued an amendment to this accounting standard which defers the requirement to present certain components of reclassifications of other comprehensive income on the face of the income statement for all periods presented. During the deferral, entities should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the issuance of this amendment. This new guidance is effective for interim and annual periods beginning after December 15, 2011. We adopted this ASU in the first quarter of 2012 and have revised our presentation of comprehensive income in the accompanying condensed consolidated financial statements.

KADANT INC.

Results of Operations (continued)

Fair Value Measurements. In May 2011, the FASB issued ASU No. 2011-04, “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRSs)”. ASU No. 2011-04 establishes a number of new requirements for fair value measurements. These include: (1) a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; (2) an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and (3) a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used and qualitative details about the sensitivity of the measurements. In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed. This ASU is effective for interim and annual periods beginning after December 15, 2011. We adopted this ASU in the first quarter of 2012, which did not have an impact on our condensed consolidated financial statements.

First Six Months 2012 Compared With First Six Months 2011

The following table sets forth our unaudited condensed consolidated statement of income expressed as a percentage of total revenues from continuing operations for the first six months of 2012 and 2011. The results of operations for the first six months of 2012 are not necessarily indicative of the results to be expected for the full fiscal year.

	Six Months Ended
	June 30,			July 2,
	2012			2011

Revenues		100	%		100	%

Costs and Operating Expenses:
Cost of revenues		55			53
Selling, general, and administrative expenses		31			33
Research and development expenses		2			2
Other expense		–			–
		88			88

Operating Income		12			12

Interest Income		–			–
Interest Expense		–			–

Income from Continuing Operations Before Provision for Income Taxes		12			12
Provision for Income Taxes		4			3

Income from Continuing Operations		8	%		9	%

Revenues

Revenues for the six months of 2012 and 2011 from our Papermaking Systems segment and Fiber-based Products business are as follows:

		Six Months Ended
		June 30,		July 2,
(In thousands)		2012		2011

Revenues:
Papermaking Systems	$	160,111	$	147,155
Fiber-based Products		6,984		6,982
	$	167,095	$	154,137

KADANT INC.

Results of Operations (continued)

Papermaking Systems Segment. Revenues increased $13.0 million, or 9%, to $160.1 million in the first six months of 2012 from $147.1 million in the first six months of 2011, including a $4.3 million decrease from the unfavorable effects of currency translation. Revenues in our water-management product line increased $8.6 million, or 56%, primarily due to a $4.0 million increase from Kadant M-Clean, acquired in May 2011, and higher demand for capital products at our North American operations. Revenues in our stock-preparation product line increased $5.8 million, or 10%, due to higher demand for capital products at our North American operations, and to a lesser extent, our European operations. Partially offsetting these increases was a decrease in demand for capital products at our Chinese operations.

Papermaking Systems Segment by Product Line. The following table presents revenues for our Papermaking Systems segment by product line, the changes in revenues by product line between the first six months of 2012 and 2011, and the changes in revenues by product line between the first six months of 2012 and 2011 excluding the effect of currency translation. The increase in revenues excluding the effect of currency translation represents the increase resulting from the conversion of first six months of 2012 revenues in local currency into U.S. dollars at the first six months of 2011 exchange rates, and then comparing this result to the actual revenues in the first six months of 2011. The presentation of the changes in revenues by product line excluding the effect of currency translation is a non-GAAP (generally accepted accounting principles) measure. We believe this non-GAAP measure helps investors gain a better understanding of our underlying operations especially when comparing such results to prior periods. This non-GAAP measure should not be considered superior to or a substitute for the corresponding GAAP measure.

	Six Months Ended				Increase Excluding Effect of
(In millions)	June 30, 2012		July 2, 2011		Increase (Decrease)			Currency Translation

Papermaking Systems Product Lines:
Stock-Preparation	$	61.4	$	55.6	$	5.8		$	6.6
Fluid-Handling		46.1		47.1		(1.0	)		0.7
Doctoring		27.6		27.8		(0.2	)		0.7
Water-Management		23.9		15.3		8.6			9.3
Other		1.1		1.3		(0.2	)		–
	$	160.1	$	147.1	$	13.0		$	17