Edgar Filing: KADANT INC

kaiform10q3q2012.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 September 29, 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 October 26, 2012
		Common Stock, $.01 par value			11,319,096

PART 1 – FINANCIAL INFORMATION

Item 1 – Financial Statements

KADANT INC.

Condensed Consolidated Balance Sheet

(Unaudited)

Assets

	September 29,		December 31,
(In thousands)	2012		2011

Current Assets:
Cash and cash equivalents	$	53,339	$	46,950
Restricted cash (Note 2)		67		700
Accounts receivable, less allowances of $2,370 and $2,308 (Note 2)		60,511		59,492
Inventories (Note 4)		43,561		50,527
Unbilled contract costs and fees		6,937		3,244
Other current assets		14,796		11,703
Assets of discontinued operation		1,642		1,675
Total Current Assets		180,853		174,291

Property, Plant, and Equipment, at Cost		106,794		105,671
Less: accumulated depreciation and amortization		68,920		65,576
		37,874		40,095

Other Assets		36,359		38,053

Goodwill		107,218		105,959

Total Assets	$	362,304	$	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

	September 29,			December 31,
(In thousands, except share amounts)	2012			2011

Current Liabilities:
Current maturities of long-term obligations	$	500		$	500
Accounts payable		22,843			28,624
Accrued payroll and employee benefits		15,871			17,687
Customer deposits		13,906			18,627
Other current liabilities		26,270			26,722
Liabilities of discontinued operation		1,460			3,632
Total Current Liabilities		80,850			95,792

Other Long-Term Liabilities		27,601			27,226

Long-Term Obligations (Note 6)		11,375			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		94,362			93,701
Retained earnings		220,763			198,706
Treasury stock at cost, 3,305,063 and 2,983,717 shares		(69,464	)		(62,118	)
Accumulated other comprehensive items		(4,628	)		(7,955	)
Total Kadant Shareholders’ Investment		241,179			222,480
Noncontrolling interest		1,299			1,150
Total Shareholders’ Investment		242,478			223,630

Total Liabilities and Shareholders’ Investment	$	362,304		$	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
	September 29,			October 1,
(In thousands, except per share amounts)	2012			2011

Revenues	$	86,601		$	84,358

Costs and Operating Expenses:
Cost of revenues		49,005			48,347
Selling, general, and administrative expenses		26,171			26,080
Research and development expenses		1,511			1,408
Other income (Note 8)		–			(2,282	)
		76,687			73,553

Operating Income		9,914			10,805

Interest Income		63			122
Interest Expense		(219	)		(254	)

Income from Continuing Operations Before Provision for Income Taxes		9,758			10,673
Provision for Income Taxes		2,055			774

Income from Continuing Operations		7,703			9,899
Income (Loss) from Discontinued Operation (net of income tax expense of $520 and income tax benefit of $224)		844			(1,156	)

Net Income		8,547			8,743

Net Income Attributable to Noncontrolling Interest		(86	)		(95	)

Net Income Attributable to Kadant	$	8,461		$	8,648

Amounts Attributable to Kadant:
Income from Continuing Operations	$	7,617		$	9,804
Income (Loss) from Discontinued Operation		844			(1,156	)
Net Income Attributable to Kadant	$	8,461		$	8,648

Earnings per Share from Continuing Operations Attributable to Kadant (Note 3):
Basic	$	.67		$	.81
Diluted	$	.66		$	.80

Earnings per Share Attributable to Kadant (Note 3):
Basic	$	.75		$	.71
Diluted	$	.74		$	.70

Weighted Average Shares (Note 3):
Basic		11,341			12,155

Diluted		11,491			12,276

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

KADANT INC.

Condensed Consolidated Statement of Income

(Unaudited)

	Nine Months Ended
	September 29,			October 1,
(In thousands, except per share amounts)	2012			2011

Revenues	$	253,696		$	238,495

Costs and Operating Expenses:
Cost of revenues		141,430			130,685
Selling, general, and administrative expenses		77,804			76,374
Research and development expenses		4,436			4,123
Other expense (income) (Note 8)		307			(2,282	)
		223,977			208,900

Operating Income		29,719			29,595

Interest Income		231			343
Interest Expense		(624	)		(810	)

Income from Continuing Operations Before Provision for Income Taxes		29,326			29,128
Provision for Income Taxes (Note 5)		7,898			5,974

Income from Continuing Operations		21,428			23,154
Income (Loss) from Discontinued Operation (net of income tax expense of $467 and income tax benefit of $229)		780			(1,165	)

Net Income		22,208			21,989

Net Income Attributable to Noncontrolling Interest		(151	)		(246	)

Net Income Attributable to Kadant	$	22,057		$	21,743

Amounts Attributable to Kadant:
Income from Continuing Operations	$	21,277		$	22,908
Income (Loss) from Discontinued Operation		780			(1,165	)
Net Income Attributable to Kadant	$	22,057		$	21,743

Earnings per Share from Continuing Operations Attributable to Kadant (Note 3):
Basic	$	1.85		$	1.87
Diluted	$	1.83		$	1.85

Earnings per Share Attributable to Kadant (Note 3):
Basic	$	1.91		$	1.78
Diluted	$	1.90		$	1.76

Weighted Average Shares (Note 3):
Basic		11,523			12,248

Diluted		11,633			12,387

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						Nine Months Ended
	September 29,			October 1,			September 29,			October 1,
(In thousands)	2012			2011			2012			2011

Net Income	$	8,547		$	8,743		$	22,208		$	21,989

Other Comprehensive Items:
Foreign Currency Translation Adjustment		4,542			(6,852	)		2,881			1,084
Pension and Other Post-Retirement Liability Adjustments,net (net of income tax of $67 and $205 in the three andnine months ended September 29, 2012, respectively, and $48 and $139 in the three and nine months ended October 1, 2011, respectively)		110			97			361			(696	)
Deferred Gain (Loss) on Hedging Instruments (net of income tax of $49 and $50 in the three and nine months ended September 29, 2012, respectively, and tax benefit of $(157) and $(126) in the three and nine months ended October 1, 2011, respectively)		93			(403	)		83			(196	)
		4,745			(7,158	)		3,325			192
Comprehensive Income		13,292			1,585			25,533			22,181
Comprehensive Income Attributable to Noncontrolling Interest		(128	)		(21	)		(149	)		(300	)
Comprehensive Income Attributable to Kadant	$	13,164		$	1,564		$	25,384		$	21,881

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

KADANT INC.

Condensed Consolidated Statement of Cash Flows

(Unaudited)

	Nine Months Ended
	September 29,			October 1,
(In thousands)	2012			2011

Operating Activities:
Net income attributable to Kadant	$	22,057		$	21,743
Net income attributable to noncontrolling interest		151			246
(Income) loss from discontinued operation		(780	)		1,165
Income from continuing operations		21,428			23,154
Adjustments to reconcile income from continuing operations to net cash provided by operating activities:
Depreciation and amortization		6,419			5,947
Stock-based compensation expense		3,560			2,921
Provision for losses on accounts receivable		65			1,013
Gain on the sale of property, plant, and equipment		(209	)		(2,323	)
Other items, net		1,144			(713	)
Changes in current assets and liabilities, net of effects of acquisitions:
Accounts receivable		(563	)		(4,778	)
Unbilled contract costs and fees		(3,934	)		(1,014	)
Inventories		7,398			(14,465	)
Other current assets		(980	)		(720	)
Accounts payable		(5,890	)		(1,089	)
Other current liabilities		(9,981	)		12,241
Contributions to pension plan		(720	)		(675	)
Net cash provided by continuing operations		17,737			19,499
Net cash (used in) provided by discontinued operation		(1,359	)		111
Net cash provided by operating activities		16,378			19,610

Investing Activities:
Purchases of property, plant, and equipment		(1,514	)		(5,473	)
Proceeds from sale of property, plant, and equipment		370			2,329
Acquisitions, net of cash acquired		113			(15,358	)
Dividend paid to minority shareholder		–			(579	)
Other, net		(10	)		58
Net cash used in continuing operations for investing activities		(1,041	)		(19,023	)

Financing Activities:
Purchases of Company common stock		(9,799	)		(9,445	)
Change in restricted cash		632			(1,188	)
Proceeds from issuance of long-term obligations		5,000			5,000
Repayments of short- and long-term obligations		(5,375	)		(10,892	)
Net proceeds from issuance of Company common stock		359			149
Other, net		(517	)		7
Net cash used in continuing operations for financing activities		(9,700	)		(16,369	)

Exchange Rate Effect on Cash and Cash Equivalents from Continuing Operations		752			828

Increase (Decrease) in Cash and Cash Equivalents from Continuing Operations		6,389			(14,954	)
Cash and Cash Equivalents at Beginning of Period		46,950			61,805
Cash and Cash Equivalents at End of Period	$	53,339		$	46,851

Non-cash Investing Activities:
Fair value of assets acquired	$	–		$	21,808
Cash paid for acquired business		–			(15,849	)
Liabilities assumed of acquired business	$	–		$	5,959

Non-cash Financing Activities:
Issuance of Company common stock	$	1,967		$	2,009

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 September 29, 2012, and its results of operations and comprehensive income for the three and nine month periods ended September 29, 2012 and October 1, 2011, and cash flows for the nine month periods ended September 29, 2012 and October 1, 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 contained in the Company’s Annual Report on Form 10-K. The condensed consolidated financial statements and related notes are presented as permitted by the Securities and Exchange Commission (SEC) rules and regulations for 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 SEC.

2.	Restricted Cash and Notes Receivable

As of September 29, 2012 and December 31, 2011, the Company had restricted cash of $67,000 and $700,000, respectively. This cash served as collateral for bank guarantees primarily associated with providing assurance to customers in China that the Company would fulfill certain customer obligations entered into in the normal course of business. All the bank guarantees expired by September 30, 2012.

As of September 29, 2012 and December 31, 2011, the Company had $9,853,000 and $15,901,000, respectively, of notes receivable, included in accounts receivable in the accompanying condensed consolidated balance sheet. These represent banker's acceptance bills from banks in China that have been presented by various customers in China as payment for their trade accounts receivable. The notes receivable are non-interest bearing and mature within six months. The Company has the ability to sell the notes receivable at a discount or transfer the notes receivable in settlement of current accounts payable prior to the scheduled maturity date.

3. Earnings per Share

Basic and diluted earnings per share are calculated as follows:

	Three Months Ended					Nine Months Ended
	September 29,		October 1,			September 29,		October 1,
(In thousands, except per share amounts)	2012		2011			2012		2011

Amounts Attributable to Kadant:
Income from Continuing Operations	$	7,617	$	9,804		$	21,277	$	22,908
Income (Loss) from Discontinued Operation		844		(1,156	)		780		(1,165	)
Net Income	$	8,461	$	8,648		$	22,057	$	21,743

Basic Weighted Average Shares		11,341		12,155			11,523		12,248
Effect of Stock Options, Restricted Stock Units and Employee Stock Purchase Plan		150		121			110		139
Diluted Weighted Average Shares		11,491		12,276			11,633		12,387

Basic Earnings per Share:
Continuing Operations	$	.67	$	.81		$	1.85	$	1.87
Discontinued Operation	$	.07	$	(.10	)	$	.07	$	(.10	)
Net Income	$	.75	$	.71		$	1.91	$	1.78

Diluted Earnings per Share:
Continuing Operations	$	.66	$	.80		$	1.83	$	1.85
Discontinued Operation	$	.07	$	(.09	)	$	.07	$	(.09	)
Net Income	$	.74	$	.70		$	1.90	$	1.76

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

3. Earnings per Share (continued)

Options to purchase approximately 164,400 and 81,600 shares of the Company’s common stock for the third quarters of 2012 and 2011, respectively, and 145,300 and 62,800 shares of the Company’s common stock for the first nine 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 43,000 shares of common stock for the third quarter of 2011, and 38,000 and 60,000 shares of common stock for the first nine 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:

	September 29,		December 31,
(In thousands)	2012		2011

Raw Materials and Supplies	$	19,914	$	20,218
Work in Process		7,952		9,383
Finished Goods		15,695		20,926
	$	43,561	$	50,527

5. Income Taxes

The provision for income taxes was $7,898,000 and $5,974,000 in the first nine months of 2012 and 2011, respectively, and represented 27% and 21% of pre-tax income. The effective tax rate of 27% in the first nine months of 2012 was lower than the Company’s statutory rate primarily due to the expected utilization of foreign tax credits in the U.S. that were fully reserved in prior periods and the distribution of worldwide earnings. The increase in the expected utilization of foreign tax credits was due to an increase in estimated current year income and foreign source income in the U.S. For the full year 2012, the Company estimates that it will be able to utilize approximately $2,709,000 of foreign tax credit carryforwards. The effective tax rate of 21% in the first nine months of 2011 was lower than the Company’s statutory rate primarily due to the inclusion of a discrete tax benefit of $1,890,000 from the recognition of previously unrecognized tax benefits that resulted primarily from the favorable settlement of a tax audit in a non-U.S. jurisdiction, as well as the expiration of statutes of limitations in various jurisdictions. Also contributing to the effective tax rate of 21% in the first nine months of 2011 was the expected utilization of foreign tax credits that were fully reserved in prior periods and the favorable geographic distribution of worldwide earnings.

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, “Income Taxes”, 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 September 29, 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 September 29, 2012 as a result of certain foreign subsidiaries being in a three-year cumulative loss position and the uncertainty of future profitability.

KADANT INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

6. Long-Term Obligations

Long-term obligations are as follows:

	September 29,			December 31,
(In thousands)	2012			2011

Revolving Credit Facility, due 2017	$	5,000		$	–
Revolving Credit Facility, due 2013		–			5,000
Variable Rate Term Loan, due from 2012 to 2016		6,875			7,250
Total Long-Term Obligations		11,875			12,250
Less: Current Maturities		(500	)		(500	)
Long-Term Obligations, less Current Maturities	$	11,375		$	11,750

The weighted average interest rate for the Company’s long-term obligations was 5.5% as of September 29, 2012.

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. The 2012 Credit Agreement also includes an uncommitted unsecured incremental borrowing facility of up to an additional $50,000,000. 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 in the 2012 Credit Agreement. For this purpose, total debt is defined as total debt less up to $25,000,000 of unrestricted domestic cash.

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 unsecured revolving credit facility entered into in February 2008, 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 $25,000,000, 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. As of September 29, 2012, the Company was in compliance with these covenants.

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

As of September 29, 2012, the Company had $89,937,000 of borrowing capacity available under the committed portion of its 2012 Credit Agreement. The amount the Company is able to borrow under the 2012 Credit Agreement is the total borrowing capacity less any outstanding borrowings, letters of credit and multi-currency borrowings issued under the 2012 Credit Agreement.

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:

	Nine Months Ended			Nine Months Ended
(In thousands)	September 29, 2012			October 1, 2011

Balance at beginning of period	$	4,129		$	3,778
Provision		1,128			1,373
Usage		(1,171	)		(1,563	)
Acquired		–			86
Currency translation		34			77
Balance at end of period	$	4,120		$	3,751

8. Restructuring and Other Expense (Income)

Other Expense (Income)

In the first nine 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. Other income in the three and nine month periods ended October 1, 2011 consisted of a pre-tax gain of $2,282,000 from the sale of real estate in China.

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 (Income) (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		(191	)
Currency translation		2
Balance at September 29, 2012	$	219

2008 Restructuring Plan
Balance at December 31, 2011	$	354
Payments		(141	)
Currency translation		2
Balance at September 29, 2012	$	215

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						Nine Months Ended
	September 29,			October 1,			September 29,			October 1,
(In thousands)	2012			2011			2012			2011

Revenues:
Papermaking Systems	$	85,211		$	82,883		$	245,322		$	230,038
Fiber-based Products		1,390			1,475			8,374			8,457
	$	86,601		$	84,358		$	253,696		$	238,495

Income from Continuing Operations Before Provision for Income Taxes:
Papermaking Systems	$	14,385		$	14,573		$	38,261		$	38,343
Corporate and Fiber-based Products (a)		(4,471	)		(3,768	)		(8,542	)		(8,748	)
Total Operating Income		9,914			10,805			29,719			29,595
Interest Expense, Net		(156	)		(132	)		(393	)		(467	)
	$	9,758		$	10,673		$	29,326		$	29,128

Capital Expenditures:
Papermaking Systems	$	578		$	1,371		$	1,339		$	5,281
Corporate and Fiber-based Products		95			138			175			192
	$	673		$	1,509		$	1,514		$	5,473

(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 $1,298,000 and $1,019,000 in the third quarters of 2012 and 2011, respectively, and $3,560,000 and $2,921,000 in the first nine 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 $5,578,000 at September 29, 2012, and will be recognized over a weighted average period of 1.6 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 (adjusted 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% and 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 nine months of 2012, the Company recognized compensation expense based on the probable number of RSUs expected to vest, which was 135% 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)	September 29, 2012						October 1, 2011
	Pension Benefits			Other Benefits			Pension Benefits			Other Benefits

Components of Net Periodic Benefit Cost:
Service cost	$	243		$	34		$	209		$	51
Interest cost		331			56			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			4
Net periodic benefit cost	$	341		$	104		$	295		$	123

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

Discount rate		4.28	%		4.43	%		5.25	%		5.05	%
Expected long-term return on plan assets		6.25	%		–			6.25	%		–
Rate of compensation increase		4.00	%		3.45	%		4.00	%		3.24	%

	Nine Months Ended						Nine Months Ended
(In thousands)	September 29, 2012						October 1, 2011
	Pension Benefits			Other Benefits			Pension Benefits			Other Benefits

Components of Net Periodic Benefit Cost:
Service cost	$	748		$	107		$	645		$	141
Interest cost		982			171			975			174
Expected return on plan assets		(1,208	)		–			(1,071	)		–
Recognized net actuarial loss		474			25			326			21
Amortization of prior service cost		42			17			42			3
Net periodic benefit cost	$	1,038		$	320		$	917		$	339

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

Discount rate		4.28	%		4.43	%		5.25	%		5.03	%
Expected long-term return on plan assets		6.25	%		–			6.25	%		–
Rate of compensation increase		4.00	%		3.46	%		4.00	%		3.14	%

The Company made cash contributions of $720,000 to its Kadant Solutions division’s noncontributory defined benefit retirement plan in the first nine months of 2012 and expects to make cash contributions of $240,000 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 September 29, 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 2012 Credit Agreement, or any agreement that amends or replaces the 2012 Credit Agreement in which the counterparty is a member, and the Company is unable to cure the default. An event of default under the 2012 Credit Agreement includes customary events of default and failure to comply with financial covenants, including a maximum consolidated leverage ratio of 3.5 to 1, a maximum annual capital expenditure of $25,000,000, and a minimum consolidated interest coverage ratio of 3 to 1. As of September 29, 2012, the Company was in compliance with these covenants. The unrealized loss of $1,181,000 as of September 29, 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 $14,000 and a gain of $10,000 in the third quarters of 2012 and 2011, respectively, and a loss of $39,000 and a gain of $91,000 in the first nine 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:

		September 29, 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	$	14		$	425	$	22		$	421
Derivatives in a Liability Position:
Forward currency-exchange contracts	Other Current Liabilities	$	(501	)	$	6,253	$	(462	)	$	6,635
Interest rate swap agreement	Other Current Liabilities	$	(56	)	$	5,000	$	–		$	–
Interest rate swap agreements	Other Long-Term Liabilities	$	(1,125	)	$	6,875	$	(1,401	)	$	12,250

Derivatives Not Designated as Hedging Instruments:
Derivatives in a Liability Position:
Forward currency-exchange contracts	Other Current Liabilities	$	(40	)	$	1,535	$	(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 nine 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 September 29, 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)		(244	)		13		(231	)
Loss recognized in OCI		103			45		148
Unrealized loss, net of tax, at September 29, 2012	$	1,025		$	325	$	1,350

(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 September 29, 2012, $591,000 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 September 29, 2012
(In thousands)	Level 1		Level 2		Level 3		Total

Assets:
Money market funds and time deposits	$	15,647	$	–	$	–	$	15,647
Forward currency-exchange contracts	$	–	$	14	$	–	$	14

Liabilities:
Forward currency-exchange contracts	$	–	$	541	$	–	$	541
Interest rate swap agreements	$	–	$	1,181	$	–	$	1,181

	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 nine 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:

	September 29, 2012				December 31, 2011
	Carrying		Fair		Carrying		Fair
(In thousands)	Value		Value		Value		Value

Long-term debt obligations	$	11,375	$	11,375	$	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

Discontinued Operation

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. To participate in the settlement, eligible settlement class members were required to file a proof of claim on or before September 10, 2012. The claim administrator is currently reviewing claims and will complete payment to eligible claimants by December 14, 2012. In the third quarter of 2012, the Company reduced the accrual for the payment of claims by $1,513,000 based on the claims submitted to date. As of September 29, 2012, the Company has accrued $1,064,000 for the payment of claims. 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.

General

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. For legal proceedings in which a loss is probable and estimable, the Company accrues a loss based on the low end of the range of estimated loss when there is no better estimate within the range. For legal proceedings in which a loss is neither probable nor remote, the Company is unable to determine an estimate, or range of estimates, of potential losses based on the information currently available. If the Company were found to be liable for any of the claims or counterclaims against it, the Company would incur a charge against earnings for amounts in excess of legal accruals.

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; and doctoring, cleaning, and filtration. The doctoring, cleaning, and filtration product line was formerly presented separately as the doctoring and water-management product lines.

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; and

Doctoring, Cleaning, and Filtration: 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; profiling systems that control moisture, web curl, and gloss during paper converting; and 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. To participate in the settlement, eligible settlement class members were required to file a proof of claim on or before September 10, 2012. The claim administrator is currently reviewing claims and will complete payment to eligible claimants by December 14, 2012. In the third quarter of 2012, we reduced the accrual for the payment of claims by $1.5 million based on the claims submitted to date. As of September 29, 2012, we have accrued $1.1 million for the payment of claims. If the actual claims submitted and approved under the settlement agreement exceed the amount of this reserve, we will reflect the amount of the additional claims in the results of the discontinued operation in future periods, up to a maximum of $5.0 million.

International Sales

During the first nine months of 2012 and 2011, approximately 61% and 63%, 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.

KADANT INC.

Overview (continued)

Industry and Business Outlook

Our products are primarily sold to the global pulp and paper industry. In North America, although the economic recovery has been sluggish, the paper industry has performed relatively well and analysts expect paper producer margins to remain fairly stable in the near term. In addition, input costs appear to be under control and inventories are fairly low. However, our bookings in North America were down 10% sequentially and 24% in the third quarter of 2012 compared to the prior year period reflecting a general slowdown in activity, particularly for capital orders. In Europe, the increasing uncertainty resulting primarily from sovereign debt issues continues to impact the economy and the region has slipped into a recession going into 2013. This macro environment has impacted the demand for paper products, and as a result has affected the demand for our products. Our bookings in Europe were down 25% sequentially and 48% in the third quarter of 2012 compared to the prior year period due to the economic uncertainty in Europe, as well as the timing of capital orders. In China, while the economy has continued to slow, our bookings increased 31% sequentially in the third quarter of 2012 and more than doubled compared to a relatively weak third quarter of 2011. Although the rate of growth has slowed, the economy continues to absorb the capacity that has recently come online. While we believe some producers are beginning to make plans for capacity expansion, the timing of orders remains uncertain. Some of our customers in China have delayed new projects in response to these market conditions. In emerging markets, such as Brazil and India, we believe the long-term business outlook is promising, with growth in paper production projected by RISI (Resource Information Systems Inc.) to be nearly 6% annually from a base year of 2010 through 2016.

For the fourth quarter of 2012, we expect to achieve diluted earnings per share (EPS) from continuing operations of $0.35 to $0.37, on revenues of $77 to $79 million. For the full year 2012, we expect to achieve diluted EPS from continuing operations of $2.18 to $2.20 on revenues of $331 to $333 million, revised from our previous guidance from continuing operations of $2.05 to $2.10 on revenues of $325 to $330 million.

Results of Operations

Third Quarter 2012 Compared With Third 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 third fiscal quarters of 2012 and 2011. The results of operations for the fiscal quarter ended September 29, 2012 are not necessarily indicative of the results to be expected for the full fiscal year.

	Three Months Ended
	September 29,			October 1,
	2012			2011

Revenues		100	%		100	%

Costs and Operating Expenses:
Cost of revenues		57			57
Selling, general, and administrative expenses		30			31
Research and development expenses		2			2
Other income		–			(3	)
		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		2			1

Income from Continuing Operations		9	%		12	%

KADANT INC.

Results of Operations (continued)

Revenues

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

	Three Months Ended
	September 29,		October 1,
(In thousands)	2012		2011

Revenues:
Papermaking Systems	$	85,211	$	82,883
Fiber-based Products		1,390		1,475
	$	86,601	$	84,358

Papermaking Systems Segment. Revenues increased $2.3 million to $85.2 million in the third quarter of 2012 from $82.9 million in the third quarter of 2011, including a $3.6 million decrease from the unfavorable effects of currency translation. Revenues in our doctoring, cleaning, and filtration product line increased $2.5 million, or 10%, due to increased demand for our capital products at our Chinese and European operations.

Fiber-based Products. Revenues decreased $0.1 million, or 6%, to $1.4 million in the third quarter of 2012 from $1.5 million in the third quarter of 2011 due to decreased 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 third quarters of 2012 and 2011, and the changes in revenues by product line between the third 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 third quarter of 2012 revenues in local currency into U.S. dollars at the third quarter of 2011 exchange rates, and then comparing this result to the actual revenues in the third 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 more complete 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)	September 29, 2012		October 1, 2011		Increase (Decrease)			Currency Translation

Papermaking Systems Product Lines:
Stock-Preparation	$	34.5	$	33.0	$	1.5		$	2.7
Doctoring, Cleaning, and Filtration (a)		27.1		24.6		2.5			3.5
Fluid-Handling		23.6		25.3		(1.7	)		(0.3	)
	$	85.2	$	82.9	$	2.3		$	5.9

(a) New product line presentation in the third quarter of 2012. Information was formerly presented separately as doctoring, water-management, and other product lines. Prior period amounts have been recasted to conform to the current presentation.

Revenues in our stock-preparation product line in the third quarter of 2012 increased $2.7 million, or 8%, excluding a $1.2 million unfavorable effect of currency translation, compared to the third quarter of 2011, due to increased sales of our capital products at our North American and European operations, offset in part by a decrease at our Chinese operations. Revenues from our doctoring, cleaning, and filtration product line in the third quarter of 2012 increased $3.5 million, or 14%, excluding a $1.0 million unfavorable effect of currency translation, compared to the prior year period primarily due to increased demand for

KADANT INC.

Results of Operations (continued)

capital products at our Chinese and European operations. In our fluid-handling product line, revenues in the third quarter of 2012 decreased $0.3 million, or 1%, excluding a $1.4 million unfavorable effect of currency translation, compared to the prior year period primarily due to decreased demand for our parts and consumables products at our European operations, offset in part by increased sales of our capital products in other regions.

Gross Profit Margin

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

	Three Months Ended
	September 29,			October 1,
	2012			2011

Gross Profit Margin:
Papermaking Systems		43.6	%		42.8	%
Fiber-based Products		30.4			36.5
		43.4	%		42.7	%

Papermaking Systems Segment. The gross profit margin in the Papermaking Systems segment increased to 43.6% in the third quarter of 2012 from 42.8% in the third quarter of 2011. This increase resulted primarily from higher gross profit margins in our stock-preparation product line due to higher margins on several large projects in North America and China. This increase was offset in part by an increase in the third quarter of 2012 in the proportion of lower-margin capital products to total revenues compared to the third quarter of 2011.

Fiber-based Products. The gross profit margin in our Fiber-based Products business decreased to 30.4% in the third quarter of 2012 from 36.5% in the third quarter of 2011 as a result of decreased manufacturing efficiency due to lower sales volumes.

Operating Expenses

Selling, general, and administrative expenses as a percentage of revenues were 30% and 31% in the third quarters of 2012 and 2011, respectively. Selling, general, and administrative expenses increased $0.1 million to $26.2 million in the third quarter of 2012 from $26.1 million in the third quarter of 2011, including a $1.0 million decrease from the favorable effect of currency translation.

Total stock-based compensation expense was $1.3 million and $1.0 million in the third 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 September 29, 2012, unrecognized compensation cost related to stock-based compensation was approximately $5.6 million, which will be recognized over a weighted average period of 1.6 years.

Research and development expenses were $1.5 million and $1.4 million in the third quarters of 2012 and 2011, respectively, and represented 2% of revenues in both periods.

Other Income

Other income was $2.3 million in the third quarter of 2011 associated with a gain from the sale of real estate in China.

Interest Income

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

Interest Expense

Interest expense decreased $0.1 million, or 14%, to $0.2 million in the third quarter of 2012 from $0.3 million in the third quarter of 2011 primarily due to lower outstanding borrowings in the 2012 period, offset in part by a higher average effective interest rate compared to the 2011 period.

KADANT INC.

Results of Operations (continued)

Provision for Income Taxes

Our provision for income taxes was $2.1 million and $0.8 million in the third quarters of 2012 and 2011, respectively, and represented 21% and 7% of pre-tax income. The effective tax rate of 21% in the third quarter of 2012 was lower than our statutory rate primarily due to the expected utilization of foreign tax credits in the U.S. that were fully reserved in prior periods and the distribution of worldwide earnings. The increase in the expected utilization of foreign tax credits was due to an increase in estimated current year income and foreign source income in the U.S. For the full year 2012, we estimate that we will be able to utilize approximately $2.7 million of foreign tax credit carryforwards. The effective tax rate of 7% in the third quarter of 2011 was lower than our statutory rate primarily due to the inclusion of a discrete tax benefit of $2.1 million from the recognition of previously unrecognized tax benefits that resulted primarily from the favorable settlement of a tax audit in a non-U.S. jurisdiction, as well as the expiration of statutes of limitations in various jurisdictions. Also contributing to the effective tax rate of 7% in the third quarter of 2011 was the expected utilization of foreign tax credits that were fully reserved in prior periods and the favorable geographic distribution of worldwide earnings.

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, “Income Taxes”, 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 September 29, 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 September 29, 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 $2.2 million to $7.7 million in the third quarter of 2012 from $9.9 million in the third quarter of 2011. This decrease was primarily due to a decrease in operating income of $0.9 million and a $1.3 million increase in our provision for income taxes (see Revenues, Gross Profit Margin, Other Income, and Provision for Income Taxes discussed above). The decrease in operating income of $0.9 million in the third quarter of 2012 compared to the prior year period was due to a $2.3 million gain on the sale of real estate in the third quarter of 2011, offset in part by an increase in gross margins.

Income (Loss) from Discontinued Operation

Income from the discontinued operation was $0.8 million in the third quarter of 2012 compared to a loss of $1.2 million in the third quarter of 2011. The results in both periods were primarily due to adjustments associated with the reserve for the payment of claims related to the Composites LLC class action settlement.

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.

KADANT INC.

Results of Operations (continued)

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.

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 Nine Months 2012 Compared With First Nine 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 nine months of 2012 and 2011. The results of operations for the first nine months of 2012 are not necessarily indicative of the results to be expected for the full fiscal year.

	Nine Months Ended
	September 29,			October 1,
	2012			2011

Revenues		100	%		100	%

Costs and Operating Expenses:
Cost of revenues		56			55
Selling, general, and administrative expenses		30			32
Research and development expenses		2			2
Other expense (income)		–			(1	)
		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		3			2

Income from Continuing Operations		9	%		10	%

KADANT INC.

Results of Operations (continued)

Revenues

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

	Nine Months Ended
	September 29,		October 1,
(In thousands)	2012		2011

Revenues:
Papermaking Systems	$	245,322	$	230,038
Fiber-based Products		8,374		8,457
	$	253,696	$	238,495

Papermaking Systems Segment. Revenues increased $15.3 million, or 7%, to $245.3 million in the first nine months of 2012 from $230.0 million in the first nine months of 2011, including a $7.9 million decrease from the unfavorable effects of currency translation. Revenues in our doctoring, cleaning, and filtration product line increased $10.8 million, or 16%, primarily due to higher demand for capital products. Revenues in our stock-preparation product line increased $7.2 million, or 8%, 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 nine months of 2012 and 2011, and the changes in revenues by product line between the first nine 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 nine months of 2012 revenues in local currency into U.S. dollars at the first nine months of 2011 exchange rates, and then comparing this result to the actual revenues in the first nine months of 2011. The presentation of the changes in revenues by product line excluding the effect of currency translation is a non-GAAP measure. We believe this non-GAAP measure helps investors gain a more complete 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.

	Nine Months Ended				Increase Excluding Effect of
(In millions)	September 29, 2012		October 1, 2011		Increase (Decrease)		Currency Translation

Papermaking Systems Product Lines:
Stock-Preparation	$	95.9	$	88.7	$	7.2	$	9.3
Doctoring, Cleaning, and Filtration (a)		79.7		68.9