UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 1-1520

 

GenCorp Inc.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code

(916) 355-4000

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

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

 

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

 

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

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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

 

 

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

 

The aggregate market value of the voting common equity held by nonaffiliates of the registrant as of May 31, 2006 was approximately $1.0 billion.

 

As of January 16, 2007, there were 55.9 million outstanding shares of the Company’s Common Stock, $0.10 par value.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the 2007 Proxy Statement of GenCorp Inc. relating to its annual meeting of shareholders scheduled to be held on March 28, 2007 are incorporated by reference into Part III of this Report.

 

 

GENCORP INC.

Annual Report on Form 10-K
For the Fiscal Year Ended November 30, 2006

Table of Contents

 

 

 

 

Unless otherwise indicated or required by the context, as used in this Annual Report on Form 10-K, the terms “we,” “our” and “us” refer to GenCorp Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America.

 

Certain information contained in this Annual Report on Form 10-K should be considered “forward-looking statements” as defined by Section 21E of the Private Securities Litigation Reform Act of 1995. All statements in this report other than historical information may be deemed forward-looking statements. These statements present (without limitation) the expectations, beliefs, plans and objectives of management and future financial performance and assumptions underlying, or judgments concerning, the matters discussed in the statements. The words “believe,” “estimate,” “anticipate,” “project” and “expect,” and similar expressions, are intended to identify forward-looking statements. Forward-looking statements involve certain risks, estimates, assumptions and uncertainties, including with respect to future sales and activity levels, cash flows, contract performance, the outcome of litigation and contingencies, environmental remediation and anticipated costs of capital. A variety of factors could cause actual results or outcomes to differ materially from those expected and expressed in our forward-looking statements. Some important risk factors that could cause actual results or outcomes to differ from those expressed in the forward-looking statements are described in the section “Risk Factors” in Item 1A of this Report.

 

The list of factors that may affect future performance and the accuracy of forward-looking statements described in the section “Risk Factors” in Item 1A of this Report is illustrative, but by no means exhaustive. Additional risk factors may be described from time to time in our future filings with the Securities and Exchange Commission (SEC). Accordingly, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty. All such risk factors are difficult to predict, contain material uncertainties that may affect actual results and may be beyond our control.

 

We are a technology-based manufacturer of aerospace and defense systems with a real estate business segment that includes activities related to the entitlement, sale, and leasing of our excess real estate assets. Our continuing operations are organized into two segments:

 

Aerospace and Defense — includes the operations of Aerojet-General Corporation, or Aerojet, which develops and manufactures propulsion systems for defense and space applications, armament systems for precision tactical weapon systems and munitions applications. We are one of the largest providers of propulsion systems in the United States (U.S.) and the only company that provides both solid and liquid propellant based systems. Primary customers served include major prime contractors to the United States government, the Department of Defense (DoD), and the National Aeronautics and Space Administration (NASA).

 

Real Estate — includes activities related to the re-zoning, entitlement, sale, and leasing of our real estate assets. Through our Aerojet subsidiary, we own approximately 12,600 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento (Sacramento Land). We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. We have filed applications with and submitted information to governmental and regulatory authorities for approvals necessary to re-zone over 6,400 acres of the Sacramento Land.

 

Our fiscal year ends on November 30 of each year. When we refer to a fiscal year, such as fiscal 2006, we are referring to the fiscal year ended on November 30 of that year.

 

We were incorporated in Ohio in 1915 and our principal executive offices are located at Highway 50 and Aerojet Road, Rancho Cordova, CA 95670. Our mailing address is P.O. Box 537012, Sacramento, CA 95853-7012 and our telephone number is 916-355-4000.

 

Our Internet website address is www.GenCorp.com. We have made available through our Internet website, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act) as soon as reasonably practicable after such materials are electronically filed with, or

furnished to, the Securities and Exchange Commission (SEC). We also make available on our Internet web site our corporate governance guidelines and the charters for each of the following committees of the Company’s Board of Directors: Audit; Corporate Governance & Nominating; Finance; and Organization & Compensation. Our corporate governance guidelines and such charters are also available in print to any shareholder who requests them.

 

Aerospace and Defense

 

For over 60 years, Aerojet has been an industry leader and pioneer in the development of critical products and technologies that have strengthened the U.S. military and enabled the exploration of space. Aerojet focuses on creating military defense systems, as well as military, civil and commercial space systems, that address the needs of two broad industry sectors: defense systems and space systems. Aerojet believes it is in a unique competitive position, due to the diversity of its propulsion technologies (solid, liquid, air-breathing and electric) and synergy of its product lines to offer its customers the most innovative and advanced solutions available in the domestic propulsion market. Aerojet has historically been able to capitalize on its strong technical capabilities to become a critical provider of components and systems for major propulsion programs. Aerojet propulsion systems have flown prominently on manned and unmanned missions for NASA and the DoD since the inception of the U.S. Space Program. Principal customers include the DoD, NASA, The Boeing Company (Boeing), Lockheed Martin Corporation (Lockheed Martin) and Raytheon Company (Raytheon).

 

 

Aerojet has been proactively engaged in the consolidation of the propulsion industry. In fiscal 2004, Aerojet acquired from Pratt & Whitney’s Chemical Systems Division (CSD) certain intellectual property and personal property associated with several solid rocket motor programs for a nominal amount. This transaction highlights a key event in the continuing consolidation of the propulsion industry because CSD has now exited the solid propulsion business. In fiscal 2003, Aerojet acquired substantially all of the assets of the propulsion business of Atlantic Research Corporation (ARC), a subsidiary of Sequa Corporation. This acquisition made Aerojet a leading supplier of solid rocket motors for tactical and missile defense applications and complements Aerojet’s capabilities for air-breathing and strategic systems. In fiscal 2002, Aerojet acquired the assets of the General Dynamics’ Ordnance and Tactical Systems Space Propulsion and Fire Suppression business (Redmond, Washington operations), a leading supplier of satellite propulsion systems for defense, civilian and commercial applications. These acquisitions have strengthened our market positions in both the defense and space propulsion systems industry sectors, and have provided leadership positions in the tactical and in-space propulsion market. Although we believe the major propulsion industry consolidation is over, our business strategy contemplates continued expansion of our Aerospace and Defense operations including growth through acquisitions that make both strategic and economic sense.

 

Industry Overview

 

While broad support continues for DoD and NASA budgets in the Government Fiscal Year (GFY) 2007 and beyond, the impact of the global war on terrorism, the cost of military support in Iraq and Afghanistan, the rising federal deficit, and the significant recovery costs of the 2005 hurricane season may impact these budgets in the near-term.

 

Department of Defense

 

Following a period of budget decreases in the post-Cold War era, the U.S. defense budget, as appropriated by Congress, has increased in recent years. The defense appropriations budget has risen to over $377 billion in GFY 2007 from $319 billion in GFY 2001 and comparable funding of $358 billion in GFY 2006. We expect the U.S. defense budgets for research, development, test and evaluation, and procurement — the primary funding sources for Aerojet’s programs — to grow as well, with annual forecasts continuing to show increases through GFY 2011. While the top line number continues to increase, the Pentagon has announced it favors reductions in the overall rate of growth. Although the ultimate distribution of the defense budget remains uncertain, Aerojet is well positioned to benefit from DoD investment in high priority transformational systems that address contemporary war fighting needs and requirements as well as the re-capitalization of weapon systems and equipment being expended during deployment.

 

In GFY 2006, the DoD released the Quadrennial Defense Review (QDR), a once-in-four-year review of U.S. military strategy and force structure. The QDR continued the military shift away from the static posture and heavy forces of the last century and towards highly mobile expeditionary forces. In general, there were no major new strategies recommended in the QDR, which was designed to support the Bush Administration’s GFY 2007 budget while providing strategic guidance for GFY 2008 and beyond. Aerojet will continue to align its new business capture and discretionary investment strategies to be consistent with the long range goals of the DoD.

 

NASA

 

Congress continues to support the new Vision for Space Exploration, unveiled by the Bush Administration in 2004, which renews commitments to space and planetary exploration. Congress approved a NASA budget of over $16.2 billion in GFY 2006. Congress has indicated that NASA’s budget for GFY 2007 will be subject to a continuing resolution limiting expenditures around GFY 2006 levels.

 

NASA has indicated that its primary objectives to implement the initial phases of the Vision for Space Explorations will be to complete construction of the International Space Station and retire the Space Shuttle by 2010 and develop Orion, a new (human-rated) Crew Exploration Vehicle, and the Commercial Orbital Transport System (COTS), which is designed to shuttle supplies to the International Space Station. The Orion prime contractor Lockheed Martin has selected Aerojet to develop and produce all in-space propulsion for the service and command modules. In addition, Orbital Sciences under contract to Lockheed Martin for the Orion Launch Abort System (LAS) has selected Aerojet for significant propulsion work on the LAS. Orion poses a significant opportunity to continue Aerojet’s legacy of providing mission-critical propulsion systems to NASA as it has since the inception of the U.S. manned space program.

 

In addition, we believe Aerojet is well-positioned to provide propulsion solutions in a few of NASA’s special interest areas: advanced propellant technology, reliable launch abort for crew survivability, attitude/reaction control systems, and robotic exploration propulsion. Furthermore, as a result of NASA’s intention to retire the Space Shuttle from service as early as 2010, we believe that NASA will focus on maneuvering and long-duration propulsion systems that are currently available and flight-proven, which will present additional opportunities for existing Aerojet product lines.

 

Competition

 

As the only domestic supplier of both solid and liquid propulsion systems, Aerojet believes it is in a unique competitive position. The diversity of its technologies and synergy of its product lines offer Aerojet customers the most innovative and advanced solutions available in the domestic propulsion market. The basis on which Aerojet competes in the Aerospace and Defense industry varies by program, but generally is based upon price, technology, quality and service. Although market competition is intensive, Aerojet believes it possesses innovative and advanced propulsion solutions, combined with adequate resources to continue to compete successfully.

 

Participation in the defense and space propulsion market is capital intensive requiring long research and development periods that represent significant barriers to entry. Aerojet may partner on various programs with its major customers or suppliers, some of whom are, from time to time, competitors on other programs.

 

The table below lists the primary participants in the propulsion market:

 

 

United Technologies Corporation acquired the Rocketdyne division of Boeing in 2005, forming Pratt & Whitney Rocketdyne, the largest liquid propulsion contractor in the U.S. domestic market. Both the domestic liquid and solid propulsion markets remained unchanged in 2006 with Aerojet in the number two position in both markets, behind Alliant Techsystems in solids and Pratt & Whitney Rocketdyne in liquids.

 

Major Customers

 

As a merchant supplier to the Aerospace and Defense industry, we do not align ourselves with any single prime contractor except on a project-by-project basis. We believe that our position as a merchant supplier has helped us become a trusted partner to our customers, enabling us to maintain strong long-term relationships with a variety of prime contractors. Under each of our contracts, we act either as a prime contractor, where we sell directly to the end user, or as a subcontractor, where we sell our products to other prime contractors.

 

The principal end user customers of our products and technology are agencies of the U.S. government, U.S. prime contractors and government agencies. Since a majority of Aerojet’s sales are, directly or indirectly, to the U.S. government, funding for the purchase of Aerojet’s products and services generally follows trends in U.S. defense spending. However, individual government agencies, which include the military services, the Defense Advanced Research Projects Agency (DARPA), NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within “budget top-line” limits. Therefore, sales to the U.S. government are not regarded as sales to one customer and, accordingly, each contracting agency is viewed as a separate customer. While we believe the DoD and NASA budgets are generally relevant to our business outlook, closer examination of the needs and priorities of the U.S. government agencies provides a better indication of product area stability and growth potential.

 

Customers that represented more than 10% of net sales for the fiscal years presented are as follows:

 

 

Direct sales to the U.S. government and its agencies, or government customers, and indirect sales to government customers via direct sales to prime contractors accounted for a total of approximately 84% of sales,

or approximately $523.5 million, in fiscal 2006. The following are approximate percentages of net sales by principal end user in fiscal 2006:

 

 

Major Programs

 

Defense systems — Aerojet believes it is in a unique competitive position due to the diversity of its propulsion technologies (solid, liquid, air-breathing, and electric), its complete warhead capabilities and the synergy of its product lines to offer its defense customers the most innovative and advanced solutions available in the domestic market. Key competitive wins on the Standard Missile-3 Block Throttling Divert and Attitude Control System (TDACS) and the Terminal High Altitude Air Defense (THAAD) Booster Fire Unit Fielding programs continue to strengthen our position and reputation as the propulsion leader in missile defense and tactical systems. A subset of our key defense systems programs are listed below:

 

 

Space Systems — Aerojet improved its already strong market position in the space systems market segment in fiscal 2006 by capturing important propulsion contracts on Orion and COTS, and a new hydrocarbon booster engine technology demonstrator for U.S. Air Force launch systems. Aerojet’s commitment to its space systems programs was reflected in 100% success on several space exploration and other critical missions using Aerojet’s products. These include NASA’s Pluto New Horizons spacecraft and Solar Terrestrial Relations Observatory (STEREO), the launch of two Space Shuttles, Discovery and Atlantis, and the launching of five Delta II vehicles, the latest marking Aerojet’s 253rd consecutive Delta mission, all with 100% success, reflect Aerojet’s commitment to quality and excellence in our space systems. In addition, two successful launches of the Atlas ^® V vehicle using Aerojet’s solid rocket boosters in fiscal 2006 and the renegotiation of our production contract helped return that program to a favorable cash flow position in December 2005. These successes strengthen our legacy of supplying mission critical propulsion systems to the DoD and NASA as we have since the inception of the U.S. civil and military space programs.

 

A subset of our key space systems programs is listed below:

 

 

Contract Types

 

Under each of its contracts, Aerojet acts either as a prime contractor, where it sells directly to the end user, or as a subcontractor, selling its products to other prime contractors. Research and development contracts are awarded during the inception stage of a program’s development. Production contracts provide for the production and delivery of mature products for operational use. Aerojet’s contracts are primarily categorized as either “cost-reimbursable” or “fixed-price.” During fiscal 2006, approximately 51% of our net sales were from fixed-price contracts and 40% from cost reimbursable contracts.

 

Cost-reimbursable contracts are typically (i) cost plus fixed fee, (ii) cost plus incentive fee, or (iii) cost plus award fee contracts. For cost plus fixed fee contracts, Aerojet typically receives reimbursement of its costs, to the extent the costs are allowable under contractual provisions, in addition to receipt of a fixed fee. For cost plus incentive fee contracts and cost plus award fee contracts, Aerojet receives adjustments in the contract fee, within designated limits, based on its actual results as compared to contractual targets for factors such as cost, performance, quality, and schedule.

 

Fixed-price contracts are typically (i) fixed-price, (ii) fixed-price-incentive, or (iii) fixed-price level of effort contracts. For fixed-price contracts, Aerojet performs work for a fixed price and realizes all of the profit or loss resulting from variations in costs of performance. For fixed-price-incentive contracts, Aerojet receives increased or decreased fees or profits based upon actual performance against established targets or other criteria. For fixed-price level of effort contracts, Aerojet generally receives a structured fixed price per labor hour, dependent upon the customer’s labor hour needs. All fixed-price contracts present the risk of unreimbursed cost overruns.

 

Many programs under contract have product lifecycles exceeding 10 years, such as the Delta, Standard Missile, and Tomahawk programs. It is typical for U.S. government propulsion contracts to be relatively small ($2.5 million a year on average) during development phases that can last from two to five years, followed by low-rate and then full-rate production, where annual funding can grow as high as $30 million a year over many years.

 

Backlog

 

As of November 30, 2006, contract backlog was $718 million compared to $696 million as of November 30, 2005. Funded backlog, which includes only the amount for which money has been directly authorized by the U.S. Congress, or for which a purchase order has been received from a commercial customer, was $565 million as of November 30, 2006, compared to funded backlog of $498 million as of November 30, 2005. Overall growth in backlog reflects increased funding in solid booster motors for missile defense and tactical missiles, partially offset by Atlas motor deliveries on the restructured contract.

 

Research and Development

 

Aerojet views its research and development efforts as critical to maintain its leadership position in markets in which it competes. We maintain an active research and development effort supported primarily by customer funding. Customer-funded research and development expenditures are funded under contract specifications, typically research and development contracts, several of which we believe will become key programs in the

future. Historically, over 90% of our research and development expenditures were customer funded. We believe customer-funded research and development activities are vital to our ability to compete for contracts and to enhance our technology base.

 

Aerojet’s company-funded research and development efforts include expenditures for technical activities that are vital to the development of new products, services, processes or techniques, as well as those expenses for significant improvements to existing products or processes.

 

The following table summarizes Aerojet’s research and development expenses during the past three fiscal years:

 

 

Aerojet’s strong portfolio of advanced propulsion technologies, across the liquid, solid, air-breathing and electric propulsion spectrum, has enabled steady growth in our research and development business. A ramp up of several motor development activities, including THAAD, PAC-3, and Standard Missile, contributed to increases in customer-funded research and development expenditures in fiscal 2006 compared to fiscal 2005.

 

Suppliers, Raw Materials and Seasonality

 

Availability of raw materials and supplies to Aerojet is generally sufficient. Aerojet is sometimes dependent, for a variety of reasons, upon sole-source suppliers for procurement requirements but has experienced no significant difficulties in meeting production and delivery obligations because of delays in delivery or reliance on such suppliers.

 

We closely monitor sources of supply to assure that adequate raw materials and other supplies needed in our manufacturing processes are available. As a U.S. government contractor, we are frequently limited to procuring materials and components from sources of supply that meet rigorous customer and/or government specifications. In addition, as business conditions, DoD budgets, and Congressional allocations change, suppliers of specialty chemicals and materials sometimes consider dropping low-volume items from their product lines. This may require us to qualify new suppliers for raw materials on key programs. Current suppliers of some raw materials used in the manufacturing of rocket nozzles, composite cases and explosives have announced plans to close their plants and discontinue certain product lines. These materials, which include a tar pitch material, a resin (ERL-4221) and High Melting eXplosive (HMX), are used industry-wide and, therefore, are key to many of our motor and warhead programs. We have started qualifying new suppliers and materials for these materials and we expect that such new materials can be available in time to meet our future production needs. In some situations, increased costs related to new suppliers may not be recoverable under our contracts. The supply of ammonium perchlorate, a principal raw material used in solid propellant, is limited to a single source that supplies the entire domestic solid propellant industry. This single source, however, maintains two separate manufacturing lines a reasonable distance apart which mitigates the likelihood of a fire, explosion, or other problem impacting production. The industry also currently relies on one primary supplier for graphite fiber, which is used in the production of composite materials. This supplier has multiple manufacturing lines for such material. Although other sources of graphite fiber exist, the addition of a new supplier would require us to qualify the new source for use. As of November 30, 2006, there is no indication that the availability of these key materials is in jeopardy.

 

We are also impacted, as is the rest of the industry, by increases in the prices and lead-times of raw materials used in production on various fixed-price contracts. We have seen an increase in the price and lead-times of commodity metals, primarily steel, titanium and aluminum. Aerojet monitors the price and supply of these materials and works closely with suppliers to schedule purchases far enough in advance and in the most economical means possible to reduce program impact.

 

Aerojet’s business is not subject to predictable seasonality. Primary factors affecting the timing of Aerojet’s sales include the timing of government awards, the availability of U.S. government funding, contractual product delivery requirements and customer acceptances.

 

Intellectual Property

 

Where appropriate, Aerojet obtains patents in the U.S. and other countries covering various aspects of the design and manufacture of its products. We consider these patents to be important to Aerojet as they illustrate Aerojet’s innovative design ability and product development capabilities. We do not believe the loss or expiration of any single patent would have a material adverse effect on the business or financial results of Aerojet or on our business as a whole.

 

Real Estate

 

Through our Aerojet subsidiary, we own approximately 12,600 acres of land in the Sacramento metropolitan area (Sacramento Land). The property is located 15 miles northeast of downtown Sacramento, along U.S. Highway 50, a key growth corridor in the region. We believe our land has competitive business advantages over other land in the area, including being one of the largest single-owner land tracts suitable for development in the Sacramento region, having a very low cost basis, and being a desirable “in-fill” location surrounded by developing residential and business properties.

 

The Sacramento Land was acquired by Aerojet in the early 1950s for the manufacture and testing of propulsion products. Most of the Sacramento Land was never used for production or testing purposes, rather it was used to provide safe buffer zones for propulsion products. As a result of changes and relocations of certain propulsion activities, Aerojet has determined that some portions of the Sacramento Land are no longer necessary for Aerojet’s mission in Sacramento. Our plan is to continue to reposition the Sacramento Land for higher and better uses optimizing the land value. Currently, we have entitlement requests pending for the re-zoning of approximately 6,400 acres of the Sacramento Land. Our efforts regarding entitlement re-zoning changes for this approximately 6,400 acres are expected to increase the value of this land over its current value.

 

In conjunction with our entitlements efforts, we will continue to explore real estate structures (or transactions) that may further enhance the value of our Sacramento Land, including outright sales, and/or joint ventures with real estate developers, residential builders or other third parties.

 

The Sacramento Land(1) acreage is comprised of the following:

 

 

 

 

Land Currently Undergoing Entitlement and Re-zoning

 

Easton is the brand name that identifies the approximate 6,400 acres of Sacramento Land for which we are currently seeking entitlement. Our plans for Easton reflect our efforts to make Easton one of the finest master-planned communities in the region. Easton will include a broad range of housing as well as office, industrial, retail and recreational uses. The entitlement process in California is long and uncertain with numerous approvals required from various authorities, including the US Army Corps of Engineers and the United States Department of Interior,

Fish and Wildlife Service. The Company continues to work with these authorities providing data and input such that the entitlements may be obtained expediently.

 

The table below summarizes acreage for the various projects within Easton and based on information available our current best estimates of when we believe approvals and/or entitlements may be achieved:

 

 

The environmentally restricted acreage described above is subject to restrictions imposed by state and/or federal regulatory agencies because of Aerojet’s historical propulsion activities, even though most of the land was never used for propulsion production and testing. We are actively working with the various regulatory agencies that control the environmental restrictions to have those restrictions removed as early as practicable. Since 1997, we have successfully removed restrictions on approximately 3,800 acres of which approximately 1,100 acres were sold in 2001.

 

Following is a discussion of the various projects within Easton and a description of the environmental restrictions on each of the projects:

 

Rio Del Oro — In 2002, we filed an application with the County of Sacramento (County) for a general plan amendment and request for re-zoning of an approximate 2,700 acre project called Rio Del Oro. In 2003, this application was transferred to the newly incorporated City of Rancho Cordova (Rancho Cordova). Our application was submitted in conjunction with an application by a regional homebuilder for the property the homebuilder owns west and adjacent to the Rio Del Oro land. In 2001, we granted this regional homebuilder the right to purchase 400 acres of our Rio Del Oro property, for which the purchase price is fixed at $10 million. The homebuilder is obligated to pay costs associated with the entitlements for our portion of Rio Del Oro as well as its other land.

 

The Draft Rio Del Oro Specific Plan, dated September 7, 2005 (Plan) includes our 2,700 acres and the homebuilder’s 1,100 acres. The plan calls for 22 different proposed land uses with estimated land areas for each use. The Plan combines these land uses into four categories with estimated land acreage for each category as follows:

 

 

The Plan does not separate our portion of the Plan from the homebuilder’s portion. Our estimate for our 2,700 acres is as follows: Residential, 1,484 acres; Village Services and Employment, 184 acres; Education, 65 acres; and Open Space and Public, 983 acres. These are only estimated land uses and there are no assurances that Rancho Cordova will approve any plan and if it approves a plan, that the final plan will conform to these uses and areas.

 

Rio Del Oro is subject to certain state environmental restrictions which we are working with state regulators to remove. We believe the first portions of the Rio Del Oro land should have environmental restrictions lifted within the next year. The project also has extensive wetland conservation areas and preserved habitat for certain species on the Federal Endangered Species List. We are working on a conservation plan that will be a part of the approval of the land use application by Rancho Cordova.

 

In accordance with the California Environmental Quality Act (CEQA) and the National Environmental Policy Act (NEPA), Rancho Cordova staff and the applicants have been working to complete the EIR/EIS since mid-2005. On December 8, 2006, we achieved a significant milestone on our Rio Del Oro project with the publication of the draft EIS and the draft EIR. Rancho Cordova will also seek a 404 Permit under the Clean Water Act from the U.S. Army Corp of Engineers to allow development to occur on the property. In addition, Rancho Cordova will also obtain a Biological Opinion, which is the Fish and Wildlife Services document that states the applicant’s requirements to ensure it is in compliance with the Endangered Species Act.

 

In order to receive approvals, the following steps are necessary: Complete the Public hearings process, Approval of Specific Plan and related documents, Approval of EIR / EIS, Approval of Federal 404 permit, and issuance of Biological Opinion.

 

Glenborough and Easton Place — In 2004, we announced plans for an approximate 1,400 acre master planned community called Glenborough and Easton Place and filed applications with the County for a general plan amendment and changes in zoning. Easton Place will take full advantage of its location on the Highway 50 corridor, the new light rail station within Easton Place and the existing Aerojet employment base. The Glenborough and Easton Place projects have been well received by the County. The general categories of land use and their currently estimated acreage are as follows:

 

 

There are no assurances that the County will approve any plan and if it approves a plan that the final plan will conform to these uses and areas. Approximately 330 acres in Glenborough are subject to federal environmental restrictions. A portion of those 330 acres is also a closed landfill. Before these 330 acres, as well as other portions of Glenborough, can be sold or developed, the landfill must be removed and/or the existing federal environmental restrictions removed. We have submitted proposals to the appropriate agencies regarding remedial activities necessary to have the landfill removed and the restrictions lifted. We do not believe the necessary approvals will delay the County’s approval for our application. Significant areas will remain subject to environmental restrictions for a period of time after receipt of County approval of our entitlements application. However, we do not expect any delays in the overall project schedule because the sale of those portions of the project is not expected to begin for several years. The County began preparation of the EIR for Glenborough and Easton Place in June 2005. This project has a considerable habitat for the Valley Elderberry Long-horned Beetle (VELB), a protected species on the Federal Endangered Species List. We are working with USFWS to develop a comprehensive mitigation plan that will provide suitable mitigation for the impact caused by the project. This mitigation plan will be part of the approval of the land use application by the County.

 

In order to receive approvals, the following steps are necessary: Release EIR for public review and comment, Public hearings process, Approval of Land Use Master Plan (Specific Plan) and related documents, Approval of EIR, Approval of Federal 404 permit, and issuance of Biological Opinion.

 

Westborough — In 2004, we filed an application with Rancho Cordova for a general plan amendment for an approximate 1,650 acre project named Westborough. The Westborough application will be completed in two phases. In June 2005, we submitted an updated general plan amendment and a re-zoning application for approximately 1,100 acres as the initial phase of Westborough. Of the approximate 550 acres in the second phase of Westborough, a portion of the land is within the Rancho Cordova and a portion is in the County. Consequently, over the next few years, we will be working with the County and Rancho Cordova to reach agreement on the terms

and conditions for annexation of the County land into Rancho Cordova. Once an agreement is achieved, we will file an application for the second phase. Rancho Cordova has retained a consultant to prepare the EIR for phase one.

 

In 2004, we contracted with a regional homebuilder to sell 100 acres of Westborough for $3.1 million. As partial consideration for this purchase agreement, the regional homebuilder also agreed to remove a restriction on residential development of Westborough extending through 2009 that had been granted to such developer pursuant to a 2001 transaction.

 

Approximately 280 acres of the second phase is subject to federal environmental clean-up restrictions which we do not expect to be removed for several years. We do not anticipate delays in our overall project schedule because those portions of the project are part of phase two that will not be entitled for several years. This project also has extensive habitat for the VELB. We are working with USFWS to develop a comprehensive mitigation plan that will provide suitable mitigation for the impact caused by the project. This mitigation plan will be part of the approval of the land use application by Rancho Cordova.

 

In order to receive approvals, the following steps are necessary: Release EIR for public review and comment, Public hearings process, Approval of Specific Plan and related documents, Approval of EIR, Approval of Federal 404 permit, and issuance of Biological Opinion.

 

Folsom Sphere of Influence — Approximately 625 acres of the Sacramento Land is within a larger area designated as the City of Folsom Sphere of Influence (SOI). Aerojet, in cooperation with the other landowners in the SOI, is working with Folsom to satisfy the conditions of annexation of the entire SOI, including our 625 acres, to Folsom. The proposed land uses for the 625 acres include residential, office, and retail. The annexation process is expected to be complex and lengthy.

 

Office Park and Auto Mall — In March 2003, we entered into a joint venture with Panattoni Development Company to develop an office park. An office park is consistent with the existing zoning for the property. We are working with the County and the U.S. Army Corps to obtain the necessary approvals.

 

In 2006, we obtained the approval from the County for a thirty-acre auto mall on Folsom Boulevard. We sold approximately 20 acres to two automobile dealers in fiscal 2003 for $5.9 million.

 

Land Available for Future Entitlements

 

We believe it will be several years before any of the 1,003 acres of available land will be processed for a change in entitlements. Some of this land is outside the current Urban Services Boundary established by the County and all of it is far from existing infrastructure, making it uneconomical to attempt to develop it at this time.

 

Aerojet Operations Land

 

We believe that the land currently available for Aerojet’s operations is more than adequate for its long-term needs. As a result, additional land may become available for re-zoning in the future.

 

Sacramento Real Estate Market

 

The rate of new home sales for the Sacramento region has continued its slowdown from historically high levels. We believe that this downturn does not change the long-term prospects for the Sacramento region, which still remains an attractive and affordable alternative to the San Francisco Bay area and other large metropolitan areas of California. The Sacramento Land is positioned in one of the strongest growth corridors of the region, and it commands a unique location advantage. We believe the compelling Sacramento area demographic and real estate fundamentals support our objective of creating value by re-zoning a substantial portion of the Sacramento Land.

 

Water Supply

 

In California, all applications for a change in land use must include a source of water to serve the proposed project. We addressed this critical issue with our 2003 water settlement agreement with the County for Rio and Westborough. We are currently negotiating with the City of Folsom on water issues for Glenborough. Pursuant to that agreement, Aerojet transferred all of the remediated groundwater to the County. Subject to conditions and

limitations in the agreement, including all required approvals under CEQA, the County assumed the responsibility for providing replacement water to those water purveyors who have lost wells as a result of groundwater contamination. If the amount of Aerojet’s transferred remediated groundwater is in excess of the replacement water actually provided to the impacted water purveyors, the County has committed to make such excess water available to Aerojet to satisfy the requirements for the Easton project. The County has requested modifications to our existing agreement. We are currently considering their requests.

 

Other

 

Aerojet owns approximately 400 acres of land in Chino Hills, California. This property was used for the manufacture and testing of ordnance. With the sale of its ordnance business in the mid-1990s, Aerojet closed this facility and commenced clean-up of the site. At this time, Aerojet continues to work with state regulators and the City of Chino Hills to complete those efforts. Once the remediation is complete and based on the certification of use from the state, Aerojet will work with the City of Chino Hills to maximize the value of the site.

 

In addition to the projects described above, we currently lease to third parties approximately 330,000 square feet of office space and 10 acres of land. These leasing activities generated $6.5 million in revenue in fiscal 2006.

 

Although, we are actively working with various governmental and regulatory agencies to obtain the necessary entitlements and to lift environmental restrictions, we may not be able to obtain these required approvals in a timely manner, or at all. For a discussion of the risks related to our real estate activities, please see Item 1A, Risk Factors.

 

Environmental Matters

 

Our current and legacy business operations are subject to, and affected by, federal, state, local and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation and remediation of certain materials, substances and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations and management of environmental matters. We believe our current operations are in substantial compliance with all applicable environmental laws and regulations.

 

Operation and maintenance costs associated with environmental compliance and management of contaminated sites are a normal, recurring part of our operations. These costs are not significant relative to total operating costs and most of such costs are incurred by our Aerospace and Defense segment and are generally allowable costs under contracts with the U.S. government.

 

Under existing U.S. environmental laws, a Potentially Responsible Party (PRP) is jointly and severally liable, and therefore we are potentially liable to the government or third parties for the full cost of remediating the contamination at our facilities or former facilities or at third-party sites where we have been designated as a PRP by the Environmental Protection Agency or a state environmental agency. The nature of environmental investigation and cleanup activities often makes it difficult to determine the timing and amount of any estimated future costs that may be required for remediation measures. However, we review these matters and accrue for costs associated with environmental remediation when it becomes probable that a liability has been incurred and the amount of the liability, usually based on proportionate sharing, can be reasonably estimated. These liabilities have not been discounted to their present value as the timing of cash payments is not fixed or reliably determinable. See Management’s Discussion and Analysis in Part II, Item 7 of this Report for additional information.

 

Employees

 

As of November 30, 2006, 16% of our 3,144 employees were covered by collective bargaining agreements which are due to expire in the summer of 2008. We believe that our relations with our employees are good.

 

Executive Officers of the Registrant

 

See Part III, Item 10 of this Report for information about Executive Officers of the Company.

 

Set forth below are the risks that we believe are material to our investors. This section contains forward-looking statements. You should refer to the explanation of the qualifications and limitations on forward-looking statements set forth at the beginning of Item 1 of this Report.

 

The cancellation or material modification of one or more significant contracts could have a material adverse effect on our ability to realize anticipated sales and profitability.

 

Sales, directly and indirectly, to the U.S. government and its agencies accounted for approximately 84% of our total net sales in fiscal 2006. Our contracts typically permit the U.S. government to unilaterally modify or terminate a contract or to discontinue funding for a particular program at any time. The cancellation of one or more significant contracts could have a material adverse effect on our ability to realize anticipated sales and profits. The cancellation of a contract, if terminated for cause, could also subject us to liability for the excess costs incurred by the U.S. government in procuring undelivered items from another source. If terminated for convenience, our recovery of costs would be limited to amounts already incurred or committed, and our profit would be limited to work completed prior to termination.

 

Future reductions or changes in U.S. government spending could negatively affect our sales and profitability.

 

Our primary aerospace and defense customers include the DoD and its agencies, the government prime contractors that supply products to these customers, and NASA. As a result, we rely on particular levels of U.S. government spending on propulsion systems for defense and space applications and armament systems for precision tactical weapon systems and munitions applications, and our backlog depends, in a large part, on continued funding by the U.S. government for the programs in which we are involved. These spending levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general political support for this type of spending. Although the DoD currently forecasts continued defense budget increases through its fiscal year 2011, which is the remainder of the DoD’s detailed forecast period, future levels of defense spending may not increase and could decrease. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, Congress usually must approve funds for a given program each government fiscal year and may significantly reduce or eliminate funding for a program. A decrease in U.S. military expenditures, or the elimination or curtailment of a material program in which we are involved, could negatively affect our sales and profitability.

 

A significant percentage of our sales are generated from fixed-price contracts. If we experience cost overruns on these contracts, we would have to absorb the excess costs and our profitability would be adversely affected.

 

Our aerospace and defense contracts generally can be categorized as either “fixed-price” or “cost-reimbursable” contracts. Under fixed-price contracts, we agree to perform specified work for a fixed price and realize all of the profit or loss resulting from variations in the costs of performing the contract. As a result, all fixed-price contracts involve the inherent risk of unreimbursed cost overruns. To the extent we were to incur unanticipated cost overruns on a program or platform subject to a fixed-price contract, our profitability would be adversely affected. Future profitability is subject to risks including the ability of suppliers to deliver components of acceptable quality on schedule and the successful implementation of automated tooling in production processes.

 

During fiscal 2006, approximately 51% of our net sales were from fixed-price contracts and 40% from cost reimbursable contracts.

 

Our success and growth in our Aerospace and Defense segment depends on our ability to secure contracts. We face significant competition, including from competitors with greater resources than ours, which may adversely effect our market share.

 

We encounter intense competition in bidding for contracts. Many of our competitors have financial, technical, production, and other resources substantially greater than ours. Although the downsizing of the defense industry in

the early 1990s has resulted in a reduction in the aggregate number of competitors, the consolidation has also strengthened the capabilities of some of the remaining competitors resulting in an increasingly competitive environment. The U.S. government also has its own manufacturing capabilities in some areas. We may be unable to compete successfully with our competitors and our inability to do so could result in a decrease in revenues that we historically have generated from these contracts. Further, the U.S. government may open to competition programs on which we are currently the sole supplier, which could also adversely affect our sales.

 

Our Aerospace and Defense segment is subject to procurement and other related laws and regulations inherent in contracting with the U.S. government, non-compliance with which could have a material adverse effect on our business.

 

In the performance of contracts with the U.S. government, we are subject to complex and extensive procurement and other related laws and regulations. Possible consequences of a failure to comply, even inadvertently, with these laws and regulations include civil and criminal fines and penalties, in some cases, double or triple damages, and suspension or debarment from future government contracts and exporting of goods for a specified period of time.

 

These laws and regulations provide for ongoing audits and reviews of incurred costs as well as contract procurement, performance and administration. The U.S. government may, if appropriate, conduct an investigation into possible illegal or unethical activity in connection with these contracts. Investigations of this nature are common in the aerospace and defense industry, and lawsuits may result. In addition, the U.S. government and its principal prime contractors periodically investigate the financial viability of its contractors and subcontractors as part of its risk assessment process associated with the award of new contracts. If the U.S. government or one or more prime contractors were to determine that we were not financially viable, our ability to continue to act as a government contractor or subcontractor would be impaired.

 

Our inability to adapt to rapid technological changes could impair our ability to remain competitive.

 

The aerospace and defense industry has undergone rapid and significant technological development over the last few years. Our competitors may implement new technologies before we are able to, allowing them to provide more effective products at more competitive prices. Future technological developments could:

 

 

We may experience warranty claims for product failures, schedule delays or other problems with existing or new products and systems, all of which could result in increased costs and loss of sales.

 

Many of the products we develop and manufacture are technologically advanced systems that must function under demanding operating conditions. Even though we believe that we employ sophisticated and rigorous design, manufacturing and testing processes and practices, we may not be able to successfully launch or manufacture our products on schedule or our products may not perform as intended.

 

Some of our contracts require us to forfeit a portion of our expected profit, receive reduced payments, provide a replacement product or service or reduce the price of subsequent sales to the same customer if our products fail to perform adequately. Performance penalties may also be imposed if we fail to meet delivery schedules or other measures of contract performance. We do not generally insure against potential costs resulting from any required remedial actions or costs or loss of sales due to postponement or cancellation of scheduled operations or product deliveries.

 

Our operations and properties are currently the subject of significant environmental claims, and the numerous environmental and other government regulations to which we are subject may become more stringent in the future and may reduce our profitability.

 

We are subject to federal, state and local laws and regulations that, among other things, require us to obtain permits to operate and install pollution control equipment and regulate the generation, storage, handling, transportation, treatment, and disposal of hazardous and solid wastes. We may also be subject to fines and penalties relating to the operation of our existing and formerly owned businesses, and are subject to toxic tort and asbestos lawsuits as well as other third-party lawsuits, due to either our past or present use of hazardous substances or the alleged on-site or off-site contamination of the environment through past or present operations. We may incur material costs in defending these proceedings or claims. Any adverse judgment or cash outlay could reduce our profitability and leave us with less cash available to service our debt.

 

For additional discussion of legal and environmental matters, please see the discussion in Note 13 in Notes to Consolidated Financial Statements.

 

Although some of our environmental costs may be recoverable and we have established reserves, given the many uncertainties involved in assessing liability for environmental claims, our reserves may not be sufficient.

 

Under an agreement with the U.S. government, the U.S. government recognizes as allowable for government contract cost purposes up to 88% of environmental expenses at our Sacramento and former Azusa sites and other sites environmental expenses are treated under the normal rules of cost allowability. Aerojet’s mix of contracts can affect the actual reimbursement made by the U.S. government. Because these costs are recovered through forward pricing arrangements, our ability to continue recovering these costs from the U.S. government depends on Aerojet’s sustained business volume under U.S. government contracts and programs and the relative size of Aerojet’s commercial business.

 

As of November 30, 2006, we had established reserves of $266.0 million, which we believe to be sufficient to cover our future remediation costs that could be incurred by us over the contractual term or next fifteen years of the estimated remediation. However, given the many uncertainties involved in assessing liability for environmental claims, our reserves may prove to be insufficient. We continually evaluate the adequacy of those reserves, and they could change. In addition, the reserves are based only on known sites and the known contamination at those sites. It is possible that additional sites needing remediation will be identified in the future or that unknown contamination at previously identified sites will be discovered. It is also possible that the regulatory agencies may change clean-up standards for chemicals of concern such as ammonium perchlorate and trichloroethylene. This could lead us to have additional expenditures for environmental remediation in the future and given the many uncertainties involved in assessing liability for environmental claims, our reserves may prove to be insufficient.

 

For additional discussion of environmental matters, please see the environmental discussion in Note 13 in Notes to Consolidated Financial Statements.

 

The release or explosion of dangerous materials used in our business could disrupt our operations and cause us to incur additional costs and liability.

 

Our business operations involve the handling and production of potentially explosive materials and other dangerous chemicals, including materials used in rocket propulsion and explosive devices. Despite our use of specialized facilities to handle dangerous materials and intensive employee training programs, the handling and production of hazardous materials could result in incidents that temporarily shut down or otherwise disrupt our manufacturing operations and could cause production delays. It is possible that a release of these chemicals or an explosion could result in death or significant injuries to employees and others. Material property damage to us and third parties could also occur. The use of these products in applications by our customers could also result in liability if an explosion or fire were to occur. Any release or explosion could expose us to adverse publicity or liability for damages or cause production delays, any of which could have a material adverse effect on our reputation and profitability.

 

Future reductions in airbag propellant volume could adversely affect our profitability.

 

One of our plants produces large volumes of propellants used in automobile airbags sold to a single customer. These products are subject to cost competition from other potential domestic and foreign suppliers. The loss of significant volume could affect fixed cost absorption for the plant and negatively impact profitability on other products.

 

Disruptions in the supply of key raw materials and difficulties in the supplier qualification process, as well as increases in prices of raw materials, could adversely impact our operations.

 

We closely monitor sources of supply to assure that adequate raw materials and other supplies needed in our manufacturing processes are available. As a U.S. government contractor, we are frequently limited to procuring materials and components from sources of supply that meet rigorous customer and/or government specifications. In addition, as business conditions, DoD budgets, and Congressional allocations change, suppliers of specialty chemicals and materials sometimes consider dropping low-volume items from their product lines, which may require us to qualify new suppliers for raw materials on key programs.

 

Current suppliers of some raw materials used in the manufacturing of rocket nozzles, composite cases and explosives have announced plans to close their plants and discontinue certain product lines. These materials, which include a tar pitch material, a resin (ERL-4221) and HMX, are used industry-wide and, therefore, are key to many of our motor and warhead programs. We have started qualifying new suppliers and materials for these materials and we expect that such new materials can be available in time to meet our future production needs. In some situations, increased costs related to new suppliers may not be recoverable under our contracts.

 

The supply of ammonium perchlorate, a principal raw material used in solid propellant, is limited to a single source that supplies the entire domestic solid propellant industry. This single source, however, maintains two separate manufacturing lines a reasonable distance apart which helps mitigate the likelihood of a fire, explosion, or other problem impacting supply. The industry also currently relies on one primary supplier for graphite fiber, which is used in the production of composite materials. This supplier has multiple manufacturing lines for such material. Although other sources of graphite fiber exist, the addition of a new supplier would require us to qualify the new source for use. As of November 30, 2006, there is no indication that the availability of these key materials is in jeopardy.

 

We are also impacted, as is the rest of the industry, by increases in the prices and lead-times of raw materials used in production on various fixed-price contracts. We have seen an increase in the price and lead-times of commodity metals, primarily steel, titanium and aluminum. We monitor the price and supply of these materials and work closely with suppliers to schedule purchases far enough in advance and in the most economical means possible to reduce program impact. Additionally, whenever possible, we have negotiated with our customers economic and/or price adjustment clauses tied to commodity indices. Our past success in negotiating these terms is no indication of our ability to continue to do so.

 

Prolonged disruptions in the supply of any of our key raw materials, difficulty qualifying new sources of supply, implementing use of replacement materials or new sources of supply, and/or a continuing increase in the prices of raw materials could have a material adverse effect on our operating results, financial condition and/or our cash flows.

 

Substantially all of our real estate is located in Sacramento County, California making us vulnerable to changes in economic and other conditions in that particular market.

 

As a result of the geographic concentration of our properties, our long-term performance and the value of our properties will depend upon conditions in the Sacramento region, including:

 

 

 

If unfavorable economic or other conditions occur in the region, our plans and business strategy could be adversely affected.

 

The real estate business is inherently risky.

 

Our real estate business activities may subject us to various risks including the following:

 

 

We have limited experience in real estate activities.

 

While we have owned our Sacramento real estate for over 50 years, we have limited real estate experience. Therefore, we do not have substantial history from which you can draw conclusions about our ability to execute our real estate business plans.

 

We have a substantial amount of debt, and the cost of servicing that debt could adversely affect our ability to take actions or our liquidity or financial condition.

 

We have a substantial amount of debt for which we are required to make interest and principal payments. As of November 30, 2006, we had $462.4 million of debt. Subject to the limits contained in some of the agreements governing our outstanding debt, we may incur additional debt in the future.

 

Our level of debt places significant demands on our cash resources, which could:

 

 

 

If we are unable to generate sufficient cash flow to service our debt and fund our operating costs, our liquidity may be adversely affected.

 

We are obligated to comply with financial and other covenants outlined in our debt indentures and agreements that could restrict our operating activities and the failure to comply could result in defaults that accelerate the payment of our debt.

 

Our debt instruments generally contain various restrictive covenants which include, among others, provisions restricting our ability to:

 

 

Our secured debt also contains other customary covenants, including, among others, provisions:

 

 

In addition, certain covenants in our bank facilities require us and our subsidiaries to maintain certain financial ratios. Any of the covenants described in this risk factor may restrict our operations and our ability to pursue potentially advantageous business opportunities. Our failure to comply with these covenants could also result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our debt.

 

If our operating subsidiaries do not generate sufficient cash flow or if they are not able to pay dividends or otherwise distribute their cash to us, or if we have insufficient funds on hand, we may not be able to service our debt.

 

All of the operations of our Aerospace and Defense and Real Estate businesses are conducted through subsidiaries. Consequently, our cash flow and ability to service our debt obligations will be largely dependent upon the earnings and cash flows of our operating subsidiaries and the distribution of those earnings to us, or upon loans, advances or other payments made by these subsidiaries to us. The ability of our subsidiaries to pay dividends or make other payments or advances to us will depend upon their operating results and cash flows and will be subject to applicable laws and any contractual restrictions contained in the agreements governing their debt, if any.

 

We are from time to time subject to significant litigation, the outcome of which may have a material adverse effect on our financial performance, cash flow and liquidity.

 

From time to time, we and our subsidiaries are subject to material litigation. We may be unsuccessful in defending or pursuing these lawsuits or claims. Regardless of the outcome, litigation can be very costly and can divert management’s efforts. Adverse outcomes in litigation, including toxic tort claims pending against Aerojet and any appeals of the unfair labor claims brought by former employees of the Company’s Snappon SA subsidiary in France could have a material adverse effect on our financial performance, cash flow and liquidity. See Item 3, Legal Proceedings and Note 13 in Notes to Consolidated Financial Statements for more detailed information on legal proceedings.

 

We may expand our operations through acquisitions, which may divert management’s attention and expose us to unanticipated liabilities and costs. We may experience difficulties integrating any acquired operations, and we may incur costs relating to acquisitions that are never consummated.

 

Our business strategy may include continued expansion of our Aerospace and Defense operations through future acquisitions that make both strategic and economic sense. However, our ability to consummate any future acquisitions on terms that are favorable to us may be limited by the number of attractive acquisition targets, internal demands on our resources and our ability to obtain financing. Our success in integrating newly acquired businesses will depend upon our ability to retain key personnel, avoid diversion of management’s attention from operational matters, integrate general and administrative services and key information processing systems and, where necessary, requalify our customer programs. In addition, future acquisitions could result in the incurrence of additional debt, costs and contingent liabilities. We may also incur costs and divert management attention to acquisitions that are never consummated. Integration of acquired operations may take longer, or be more costly or disruptive to our business, than originally anticipated. It is also possible that expected synergies from future acquisitions may not materialize.

 

Although we undertake a diligence investigation of each business that we have or may acquire, there may be liabilities of the acquired companies that we fail to, or are unable to, discover during the diligence investigation and for which we, as a successor owner, may be responsible. In connection with acquisitions, we generally seek to minimize the impact of these types of potential liabilities through indemnities and warranties from the seller. However, these indemnities and warranties, if obtained, may not fully cover the liabilities due to limitations in scope, amount or duration, financial limitations of the indemnitor or warrantor or other reasons.

 

We have recently focused our operations through divestitures. We may incur additional costs related to these divestitures, which may negatively impact our profitability.

 

In connection with our divestitures of the Fine Chemicals and GDX Automotive (GDX) businesses in 2005 and 2004, respectively, we have incurred and may incur additional costs, including costs related to the closure of a manufacturing facility in Chartres, France. As part of these and other divestitures, we have provided customary indemnification to the purchasers for such matters as claims arising from the operation of the businesses prior to disposition, and liability to investigate and remediate environmental contamination existing prior to disposition. These additional costs and the indemnification of the purchasers of our former businesses may require additional cash expenditures, which will have a material adverse effect on our operating results, financial condition and/or our cash flows.

 

A strike or other work stoppage, or our inability to renew collective bargaining agreements on favorable terms, could have a material adverse effect on our cost structure and ability to run our facilities and produce our products.

 

As of November 30, 2006, 16% of our 3,144 employees were covered by collective bargaining agreements which are due to expire in the summer of 2008. If we are unable to negotiate acceptable new agreements with the unions representing our employees upon expiration of the existing contracts, we could experience strikes or work stoppages. Even if we are successful in negotiating new agreements, the new agreements could call for higher wages or benefits paid to union members, which would increase our operating costs and could adversely affect our

profitability. If our unionized workers were to engage in a strike or other work stoppage, or other non-unionized operations were to become unionized, we could experience a significant disruption of operations at our facilities or higher ongoing labor costs. A strike or other work stoppage in the facilities of any of our major customers could also have similar effects on us.

 

Due to the nature of our business, our sales levels may fluctuate causing our quarterly operating results to fluctuate.

 

Changes in our operating results from quarter to quarter may result in volatility in the market price of our common stock. Our quarterly and annual sales are affected by a variety of factors that may lead to significant variability in our operating results:

 

 

Investment returns on pension plan assets and the discount rate used to determine pension liabilities may have a material adverse effect on our shareholders’ deficit.

 

In the event pension liabilities exceed pension assets on the annual measurement date as a result of the investment returns on such assets and/or the discount rate used to measure pension liabilities, we would record a material charge which will cause an increase to our shareholders’ deficit. See Note 20 in Notes to Consolidated Financial Statements for more detailed information on the impact of the adoption of Statement of Financial Accounting Standards No. 158 Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.

 

A loss of key personnel or highly skilled employees could disrupt our operations.

 

Our executive officers are critical to the management and direction of our businesses. Our future success depends, in large part, on our ability to retain these officers and other capable management personnel. In general, we do not enter into employment agreements with our executive officers. We have entered into severance agreements with our executive officers that allow those officers to terminate their employment under particular circumstances following a change of control of the Company. Although we believe that we will be able to attract and retain talented personnel and replace key personnel should the need arise, our inability to do so could disrupt our operations. In addition, because of the complex nature of many of our products and programs, we are generally dependent on an educated and highly-skilled engineering staff and workforce. Our operations could be disrupted by a shortage of available skilled employees.

 

Failure to maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act could negatively impact the market price of our stock price.

 

If, in the future, we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could negatively impact the market price of our common stock.

 

None.

 

Significant operating, manufacturing, research, design, and/or marketing facilities are set forth below.

 

Facilities

 

Corporate Headquarters

 

GenCorp Inc.

Highway 50 and Aerojet Road

Rancho Cordova, California 95670

 

Mailing address:

P.O. Box 537012

Sacramento, California 95853-7012

 

Manufacturing/Research/Design/Marketing Locations

 

 

 

 

We believe each of the facilities is adequate for the business conducted at that facility. The facilities are suitable and adequate for their intended purpose and taking into account current and future needs. A portion of Aerojet’s property in California, and its Redmond, Washington facility are encumbered by a deed of trust or mortgage. In addition, we own and lease properties (primarily machinery and warehouse and office facilities) in various locations for use in the ordinary course of our business.

 

The following information pertains to legal proceedings, including proceedings relating to environmental matters, which are discussed in detail in Notes 13(b) and 13(c) in Notes to Consolidated Financial Statements.

 

Groundwater Cases

 

Sacramento Litigation

 

Aerojet was sued by eleven individual plaintiffs residing in the vicinity of Aerojet’s facilities near Sacramento, California. Haynes et al. v. Aerojet-General Corporation, Case No. O6AS04555, Sacramento County (CA) Superior Court (the Sacramento litigation), served December 15, 2006.

 

In the Sacramento litigation, the plaintiffs allege that Aerojet contaminated groundwater provided by water purveyors as drinking water, which plaintiffs consumed causing illness, death and economic injury. Plaintiffs seek judgment against Aerojet for unspecified general, special, and punitive damages.

 

Orange County Water Case

 

Orange County Water District v. Northrop Corporation, et al., Case No. O4CC00715, Orange County (CA) Superior Court, served December 29, 2004. Aerojet and other defendants were sued by the Orange County Water District, a public entity with jurisdiction over groundwater resources and water supplies in Orange County, California. The plaintiff alleges that groundwater in Orange County is contaminated with chlorinated solvents that were allegedly released to the environment by Aerojet and other industrial defendants causing it to incur unspecified response costs and other damages. The plaintiff seeks declaratory relief and recovery of past costs in connection with the investigation and remediation of groundwater resources. Discovery is ongoing.

 

Water Entity Cases

 

South El Monte Operable Unit (SEMOU) Related Cases

 

In October 2002, Aerojet, along with approximately 65 other individual and corporate defendants, was served with four civil suits filed in the U.S. District Court for the Central District of California pursuant to which plaintiff water purveyors seek recovery of costs allegedly incurred in response to the contamination present at the SEMOU of the San Gabriel Valley Superfund site. The cases are denominated as follows:

 

San Gabriel Valley Water Company v. Aerojet-General Corporation, et al., Case No. CV-02-6346 ABC (RCx), U.S. District Court, Central District of CA, served October 30, 2002.

 

San Gabriel Basin Water Quality Authority v. Aerojet-General Corporation, et al., Case No. CV-02-4565 ABC (RCx), U.S. District Court, Central District of CA, served October 30, 2002.

 

Southern California Water Company v. Aerojet-General Corporation, et al., Case No. CV-02-6340 ABC (RCx), U.S. District Court, Central District of CA, served October 30, 2002.

 

The City of Monterey Park v. Aerojet-General Corporation, et al., Case No. CV-02-5909 ABC (RCx), U.S. District Court, Central District of CA, served October 30, 2002.

 

The cases have been coordinated for ease of administration by the court. Plaintiffs allege that groundwater in the SEMOU is contaminated with chlorinated solvents and ammonium perchlorate that were released into the environment by Aerojet and other defendants, causing plaintiffs to incur unspecified response costs and other damages.

 

Aerojet has filed third-party complaints against several water entities on the basis that they introduced perchlorate-containing Colorado River water to the basin. Those water entities have filed motions to dismiss Aerojet’s complaints. The motions as well as discovery have been stayed pending efforts to resolve the litigation through mediation.

 

Vinyl Chloride Litigation

 

The following table sets forth information related to our vinyl chloride litigation:

 

 

Legal and administrative fees for the vinyl chloride cases for fiscal years 2006, 2005, and 2004 were $0.4 million for each period.

 

Asbestos Litigation

 

The following table sets forth information related to our asbestos litigation:

 

 

 

 

Legal and administrative fees for the asbestos cases for fiscal years 2006, 2005, and 2004 were $0.5 million, $0.5 million, and $1.0 million, respectively.

 

Snappon SA Wrongful Discharge Claims

 

In November 2003, we announced the closing of a GDX Automotive manufacturing facility in Chartres, France owned by Snappon SA, a subsidiary of the Company. The decision resulted primarily from declining sales volumes with French automobile manufacturers. In accordance with French law, Snappon SA negotiated with the local works’ council regarding the implementation of a social plan for the employees. Following the implementation of the social plan, approximately 188 of the 249 former Snappon employees sued Snappon SA in the Chartres Labour Court alleging wrongful discharge. Snappon SA is vigorously defending these claims. The claims have been heard in two groups. On April 11, 2006, the Labour Court rejected most of the claims of the first group of 44 former employees and held Snappon SA responsible for €12,000 as damages. This first group of former employees has appealed this decision. In March 2006, the Labour Court held a hearing with respect to a second group of 136 former employees, which group claimed damages in excess of €12.7 million. On June 27, 2006, the Labour Court

dismissed the claims filed by 15 of the second group of former employees who had been seeking in excess of €1.3 million. The Labour Court could not reach a decision on the remaining claims filed by the 121 other former employees so the Court held a hearing in front of a new judge in October 2006. On December 19, 2006, the judge dismissed the claims by the 121 former employees. No hearing date has been set for the remaining 8 former employees who have brought wrongful discharge claims.

 

Other Legal Proceedings

 

We are subject to other legal actions, governmental investigations, and proceedings relating to a wide range of matters in addition to those discussed above. While there can be no certainty regarding the outcome of any litigation, investigation, or proceeding, after reviewing the information that is currently available with respect to such matters, we believe that any liability that may ultimately be incurred with respect to these matters is not expected to materially affect our consolidated financial condition. It is possible that amounts incurred could be significant in any particular reporting period.

 

None.

 

Our common stock is quoted on the New York Stock Exchange under the trading symbol “GY.” The following table lists, on a per share basis for the periods indicated, the high and low sale prices for the common stock as reported by the New York Stock Exchange:

 

 

As of January 16, 2007, there were 9,059 holders of record of the common stock. On January 16, 2007, the last reported sale price of our common stock on the New York Stock Exchange was $13.75 per share.

 

Beginning in December 2004, our Senior Credit Facility (described in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption “Liquidity and Capital Resources”) restricted the payment of dividends and we do not anticipate paying cash dividends in the foreseeable future.

 

Information concerning long-term debt, including material restrictions relating to payment of dividends on our common stock appears in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption “Liquidity and Capital Resources” and in Part II, Item 8. Consolidated Financial Statements and Supplementary Data at Note 11 in Notes to Consolidated Financial Statements, which is incorporated herein by reference. Information concerning securities authorized for issuance under our equity

compensation plans appears in Part III, Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters under the caption “Equity Compensation Plan Information,” which is incorporated herein by reference.

 

The following selected financial data is qualified by reference to and should be read in conjunction with the Consolidated Financial Statements, including the Notes thereto in Item 8. Consolidated Financial Statements and Supplementary Data, and Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

 

 

 

We begin Management’s Discussion and Analysis of Financial Condition and Results of Operations with an overview of our business and operations. This is followed by a discussion of our results of operations, including results of our operating segments, for the past two fiscal years. We then provide an analysis of our liquidity and capital resources, including discussions of our cash flows, debt arrangements, sources of capital and financial commitments. In the next section, we discuss the critical accounting policies that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results.

 

The following discussion should be read in conjunction with the other sections of this Report, including the Consolidated Financial Statements and Notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations.

 

Overview

 

We are a technology-based manufacturer of aerospace and defense systems with a real estate business segment that includes activities related to the entitlement, sale, and leasing of our excess real estate assets. Our continuing operations are organized into two segments:

 

Aerospace and Defense — includes the operations of Aerojet-General Corporation, or Aerojet, which develops and manufactures propulsion systems for defense and space applications, armament systems for precision tactical weapon systems and munitions applications. We are one of the largest providers of propulsion systems in the United States (U.S.) and the only company that provides both solid and liquid propellant based systems. Primary customers served include major prime contractors to the United States government, the Department of Defense (DoD), and the National Aeronautics and Space Administration (NASA).

 

Real Estate — includes activities related to the re-zoning, entitlement, sale, and leasing of our real estate assets. Through our Aerojet subsidiary, we own approximately 12,600 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento (Sacramento Land). We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. We have filed applications with and submitted information to governmental and regulatory authorities for approvals necessary to re-zone over 6,400 acres of the Sacramento Land.

 

For all periods presented, we have classified the results of operations of GDX, Fine Chemicals, and the Turbo product line as discontinued operations in the Consolidated Statements of Operations. The assets and liabilities remaining related to the GDX operations after the sale to Cerberus Capital Management, L.P. (Cerberus) on August 31, 2004 have been classified as Assets of Discontinued Operations and Liabilities of Discontinued Operations in the Consolidated Balance Sheet as of November 30, 2006 (see Note 17 in Notes to Consolidated Financial Statements).

 

Business Outlook

 

Aerospace and Defense — Overall, sales are anticipated to grow further in fiscal 2007, with new awards in space exploration and solid booster motors for missile defense and tactical missiles leading the way. For fiscal 2007, sales on the Atlas V contract are expected to remain at fiscal 2006 levels, with Titan sales rebounding in fiscal 2007 as final close-out activities are conducted.

 

Real Estate — We expect to actively work with governmental authorities to effect entitlement changes and to lift environmental restrictions for approximately 6,400 acres of the Sacramento Land as soon as practicable. In conjunction with these efforts, we will continue to explore real estate structures (or transactions) that may further enhance the value of our real estate assets, including outright sales, and/or joint ventures with real estate developers, residential builders or other third parties.

 

Retirement Benefits Related Items — We estimate that our net periodic benefit expense will be approximately $21 million in fiscal 2007. The significant decrease in net periodic benefit expense is primarily due to (i) our decision to increase the discount rate in 2006 used to determine benefit obligations, due to higher market interest rates, and (ii) a diminishing actuarial loss base due to the recognition of prior year’s losses over five years. In addition, we estimate the adoption of Financial Accounting Standards (FASB) SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans in the fourth quarter of fiscal 2007 will increase our postretirement liability and shareholders’ deficit by approximately $66 million to $122 million.

 

Results of Operations

 

 

Net Sales

 

Consolidated net sales decreased to $621.1 million in fiscal 2006 compared to $622.4 million in fiscal 2005. Revenue growth in missile defense, tactical motors, and space propulsion programs was offset by volume declines in the Atlas V ($30.1 million) and Titan ($35.7 million) programs.

 

Consolidated net sales increased to $622.4 million in fiscal 2005 compared to $495.4 million in fiscal 2004. The increase in sales in fiscal 2005 was primarily due to the following programs: Atlas V, Standard Missile, and Terminal High-Altitude Area Defense (THAAD).

 

The following customers represented more than 10% of net sales:

 

 

Sales in fiscal 2006, fiscal 2005, and fiscal 2004 directly and indirectly to the U.S. government and its agencies, including sales to the Company’s significant customers discussed above, totaled $523.5 million, $500.8 million, and $419.9 million, respectively.

 

During fiscal 2006, approximately 51% of our net sales were from fixed-price contracts and 40% from cost reimbursable contracts.

 

Loss from Continuing Operations Before Income Taxes and Cumulative Effect of Changes in Accounting Principles

 

For fiscal 2006, we reported a loss from continuing operations before income taxes and cumulative effect of changes in accounting principles of $43.7 million compared to $235.7 million for fiscal 2005. The decrease in the loss reported was primarily due to the following:

 

 

These were partially offset by the following:

 

 

For fiscal 2005, we reported a loss from continuing operations before income taxes of $235.7 million compared to a loss from continuing operations of $57.3 million for fiscal 2004. The increased loss was primarily due to the following:

 

 

These were partially offset by the following:

 

 

 

Segment Results

 

We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance, which is a non-GAAP financial measure, represents net sales from continuing operations less applicable costs, expenses and provisions for unusual items relating to the segment operations. Segment performance excludes corporate income and expenses, commercial legacy income or expenses, provisions for unusual items not related to the segment operations, interest expense, and income taxes. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. Specifically, we believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance.

 

 

 

 

Aerospace and Defense

 

Fiscal 2006

 

Net sales decreased to $614.6 million in fiscal 2006 compared to $615.8 million in fiscal 2005. Revenue growth in missile defense, tactical motors, and space propulsion programs was offset by volume declines in the Atlas V ($30.1 million) and Titan ($35.7 million) programs.

 

For fiscal 2006, segment performance was income of $10.5 million compared to a loss of $137.5 million in fiscal 2005. Excluding the effect of environmental remediation provision adjustments, retirement benefit plan expense and unusual items, segment performance was $61.2 million (10.0% of sales) in fiscal 2006 compared to loss of $109.2 in fiscal 2005. Significant factors impacting the change in segment performance compared to the prior year were: (i) a $169.4 million write-down of inventory associated with the Atlas V program in fiscal 2005 which was charged to cost of products sold; (ii) the completion of high margin Titan launch support activities in fiscal 2005; and, (iii) a variety of other changes in fiscal 2006 sales that positively impacted mix and performance.

 

Fiscal 2005

 

Sales for fiscal 2005 increased 26% to $615.8 million compared to $489.1 million in fiscal 2004. Included in these amounts were Atlas sales of $83.9 million in fiscal 2005 and $12.8 million in fiscal 2004. Excluding Atlas sales, fiscal 2005 sales increased 12% to $531.9 million compared to $476.3 million in fiscal 2004. The fiscal 2005 sales improvements excluding Atlas include net increases in most of Aerojet’s product areas with individual program increases of greater than $10.0 million related to Standard Missile, THAAD, and Tomahawk.

 

Segment performance was a loss of $137.5 million in fiscal 2005 compared to income of $29.6 million in fiscal 2004. Excluding the effect of retirement benefit plan expense, environmental remediation provision adjustments, and unusual items, segment performance was a loss of $109.2 million in fiscal 2005 compared to income of $39.5 million in fiscal 2004. Significant factors impacting the change in segment performance compared to the prior year were: (i) a $169.4 million and $16.0 million write-down of inventory associated with the Atlas V program in fiscal 2005 and fiscal 2004, respectively, which were charged to cost of products sold; and (ii) changes in product mix that resulted in lower margins during fiscal 2005.

 

Real Estate

 

Fiscal 2006

 

Real Estate sales and segment performance for fiscal 2006 were $6.5 million and $2.3 million, respectively, compared to $6.6 million and $3.9 million, respectively, for fiscal 2005. Results for fiscal 2006 and 2005 consist of rental property operations and there were no significant sales of real estate assets. The decrease in segment performance was driven primarily by additional expenditures, including costs associated with the exploration of potential real estate joint ventures with third parties.

 

Fiscal 2005

 

Real Estate sales and segment performance for fiscal 2005 were $6.6 million and $3.9 million, respectively, compared to $15.1 million and $12.3 million, respectively, for fiscal 2004. The fiscal 2004 results included revenue from a property usage agreement and an exclusive mining rights agreement. Results for fiscal 2005 consist of rental property operations and there were no significant sales of real estate assets.

 

Corporate and Other Expenses

 

Corporate and other expenses increased to $20.6 million in fiscal 2006 compared to $17.7 million in fiscal 2005. The increase in spending was primarily due to higher expenses related to the election of the Company’s directors and a $1.7 million charge for the Company’s estimated share of future environmental remediation costs, following a July 2006 ruling in a lawsuit with Olin Corporation.

 

Corporate and other expenses decreased to $17.7 million in fiscal 2005 compared to $37.8 million in fiscal 2004. The decrease in spending was primarily due to lower corporate costs as a result of personnel reductions and

resource redeployment to Aerojet to adjust for the reduction in operations as a result of the divesture of GDX in August 2004.

 

Corporate and other expenses include costs associated with commercial legacy business matters, including legal and environmental costs.

 

Retirement Benefit Plans

 

Expense from pension and medical and life retirement benefit plans is as follows:

 

 

The decreased cost of benefit plans in fiscal 2006 compared to fiscal 2005 was primarily due to favorable investment returns during the past two years and a diminishing actuarial loss base due to the recognition of prior year’s losses over five years. The increased cost of benefit plans in fiscal 2005 compared to fiscal 2004 is primarily due to the deferred recognition of the underperformance of the U.S. pension plan assets in prior years and a decrease in the discount rate used to determine benefit obligations.

 

Unusual Items

 

Charges and gains associated with unusual items are summarized as follows:

 

 

In the second quarter of fiscal 2006, we recorded a charge of $8.5 million related to a $25 million settlement of a group of environmental toxic tort cases that had been pending in Sacramento Superior Court since 1997.

 

In fiscal 2005, we recorded a charge of $2.0 million related to a legal settlement of the San Gabriel Valley and Chino Hills toxic tort cases. In addition, we recorded an unusual gain of $11.8 million, $2.8 million of which related to a settlement with our insurance providers and $9.0 million of which related to an adjustment of reserves established in fiscal 2001 for customer reimbursements of tax recoveries that had been settled. We recorded a charge of $29.1 million related to the Olin legal matter. We also recorded a charge of $18.1 million as a result of the redemption of $52.5 million of principal of the 91/2% Notes, repayment of $59.9 million of principal of the 53/4% Notes, and the termination of the Company’s former Credit Facility.

 

In fiscal 2004, we incurred an $8.8 million charge as a result of the repayment of $70.3 million of principal of the 53/4% Notes.

 

Environmental Matters

 

Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation.

 

Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of the remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long periods of time over which most remediation efforts take place. In accordance with the American Institute of Certified Public Accountants’ Statement of Position 96-1 (SOP 96-1), Environmental Remediation Liabilities, and Staff Accounting Bulletin No. 92 (SAB 92), Accounting and Disclosure Relating to Loss Contingencies, we:

 

 

Expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations was $7.1 million in fiscal 2006, $11.2 million in fiscal 2005, and $12.8 million in fiscal 2004.

 

Reserves

 

We review on a quarterly basis estimated future remediation costs that could be incurred by us over the contractual term or next fifteen years of the expected remediation. We have an established practice of estimating environmental remediation costs over a fifteen year period; except for those environmental remediation costs whose contractual terms are sufficiently specific to allow reasonable costs estimates to be developed beyond a fifteen year period. As the period for which estimated environmental remediation costs increases, the reliability of such estimates decrease. These estimates consider the investigative work and analysis of our engineers, our outside environmental consultants, and the advice of our legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum is used. The timing of payment for estimated future environmental costs depends on the timing of regulatory approvals for planned remedies and the construction and completion of the remedies.

 

A summary of the environmental reserve activity is shown below:

 

 

As of November 30, 2006, the Aerojet reserves include $164.5 million for the Sacramento site, $75.0 million for the Baldwin Park Operable Unit (BPOU) site, and $17.0 million for other Aerojet sites.

 

The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be accurately predicted due to the uncertainty concerning both the amount and timing of future expenditures and due to regulatory or technological changes. We believe, on the basis of presently available information, that the resolution of environmental matters and our obligations for environmental remediation and compliance will not have a material adverse effect on our results of operations, liquidity or financial condition. We

will continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from insurance coverage and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies.

 

Estimated Recoveries

 

On January 12, 1999, Aerojet and the U.S. government implemented the October 1997 Agreement in Principle (Global Settlement) resolving certain prior environmental and facility disagreements, with retroactive effect to December 1, 1998. The Global Settlement covered all environmental contamination at the Sacramento and Azusa sites. Under the Global Settlement, Aerojet and the U.S. government resolved disagreements about an appropriate cost-sharing ratio. The Global Settlement provides that the cost-sharing ratio will continue for a number of years.

 

Pursuant to the Global Settlement covering environmental costs associated with Aerojet’s Sacramento site and its former Azusa site, the Company can recover up to 88% of its environmental remediation costs for these sites through the establishment of prices for Aerojet’s products and services sold to the U.S. government. Allowable environmental costs are charged to these contracts as the costs are incurred. Aerojet’s mix of contracts can affect the actual reimbursement made by the U.S. government. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet to continue recovering these costs from the U.S. government depends on Aerojet’s sustained business volume under U.S. government contracts and programs and the relative size of Aerojet’s commercial business.

 

In conjunction with the sale of Electronics and Information Systems (EIS), Aerojet entered into an agreement with Northrop Grumman Corporation (Northrop) whereby Aerojet is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement. Amounts reimbursed are subject to annual limitations, with excess amounts carried over to subsequent periods, the total of which will not exceed $190 million over the term of the agreement, which ends in 2028. As of November 30, 2006, $139.5 million in potential future reimbursements were available over the remaining life of the agreement. As of November 30, 2006, we had a $33.0 million receivable from Northrop.

 

As part of the acquisition of the Atlantic Research Corporation (ARC) propulsion business, Aerojet entered into an agreement with ARC pursuant to which Aerojet is responsible for up to $20 million of costs (Pre-Close Environmental Costs) associated with environmental issues that arose prior to Aerojet’s acquisition of the ARC propulsion business, of which $16.4 million remains as of November 30, 2006. Pursuant to a separate agreement with the U.S. government which was entered into prior to the closing of the ARC acquisition, these Pre-Close Environmental Costs are treated under the normal rules of cost allowability and are not subject to the 88% limitation under the Global Settlement, and are recovered through the establishment of prices for Aerojet’s products and services sold to the U.S. government.

 

In conjunction with the ARC acquisition, Aerojet signed a Memorandum of Understanding with the U.S. government agreeing to key assumptions and conditions that preserved the original methodology used in recalculating the percentage split between Aerojet and Northrop. Aerojet presented a proposal to the U.S. government based on the Memorandum of Understanding and expects to complete an agreement in the near term.

 

In conjunction with our review of environmental reserves discussed above, we revised our estimate of recoverable costs under the Global Settlement. The estimate of recoverable costs is based on business expected to be conducted under contracts with the U.S. government and our agencies in the future. In fiscal 2006, the increase to the reserve of $50.2 million resulted in a corresponding increase to the receivable and a charge to operations of $9.2 million. In fiscal 2005, the increase to the reserve of $14.4 million resulted in a corresponding increase to the receivable and a charge to operations of $5.1 million. The recovery of costs under the Global Settlement is based in part on the relative size of Aerojet’s commercial business base, which has historically included the Fine Chemicals’ operating segment because it was previously a division of Aerojet. As a result of the plan to sell the Fine Chemicals business, we revised our estimated recovery of costs under the Global Settlement during fiscal 2004. As a result, we increased our estimated recoveries by $37.8 million and recorded $16.4 million of income in fiscal 2004.

 

Income Tax (Benefit) Provision

 

Our income tax benefit in fiscal 2006 reflects a $6.0 million benefit from continuing operations for the carryback of current year losses resulting in refunds of previously paid taxes, offset by state tax expense and reserve adjustments, including interest.

 

Our income tax benefit in fiscal 2005 reflects a $29.3 million benefit from continuing operations for the carryback of current and prior year losses resulting in refunds of previously paid taxes. In fiscal 2004, a tax provision for continuing operations of $29.2 million was recorded consisting of $34.1 million primarily to reflect the uncertainty of realizing tax benefits, given historical losses, offset by a $4.9 million benefit primarily related to research tax credit refund claims.

 

At November 30, 2006, we had a federal net operating loss carryforward of approximately $224.9 million of which $61.3 million expire in fiscal 2024 and $163.6 million expire in fiscal 2025, if not utilized. Approximately $8.3 million of the net operating loss carryforward relates to the exercise of stock options, the benefit of which will be credited to equity when realized. In addition, we also have federal and state capital loss carryforwards of approximately $153.1 million and $60.5 million, respectively, most of which expire in fiscal 2009. For state tax purposes, we have approximately $202.0 million in net operating loss carryforwards of which $35.6 million expire in fiscal 2014, $134.0 million expire in fiscal 2015, and $32.4 million expire in fiscal 2016, if not utilized.

 

We also have a federal research credit carryforward of $5.7 million which begins expiring in fiscal 2021; and a California manufacturing investment credit carryforward of $2.7 million which begins expiring in fiscal 2009; and a foreign tax credit carryforward of $5.9 million which begins expiring in fiscal 2010, if not utilized. These tax carryforwards are subject to examination by the tax authorities.

 

Income (Loss) from Discontinued Operations

 

During the third quarter of fiscal 2006, we classified our Turbo product line as a discontinued operation as a result of our plans to sell the product line. The product line was not core to the Aerospace and Defense segment and required increased management oversight and costs because of increased competition and investments for on-going maintenance. On November 17, 2006, we completed the sale of our Turbo product line to Aerosource Inc. for $1.1 million, subject to adjustment. The loss on the sale of the Turbo product line during fiscal 2006 was $0.4 million.

 

During fiscal 2004, we classified the Fine Chemicals business as a discontinued operation as a result of our plans to sell the business. This plan was a result of management’s decision to focus our capital and resources on our Aerospace and Defense and Real Estate operating segments. On November 30, 2005, we completed the sale of the Fine Chemicals business to American Pacific Corporation (AMPAC) for $114.0 million, subject to adjustment, consisting of $88.5 million of cash, an unsecured subordinated seller note of $25.5 million, and the assumption by the buyer of certain liabilities. Additionally, AMPAC may be required to pay us up to $6.0 million based on the Fine Chemical business achieving specified earnings targets in the twelve month period ended September 30, 2006. In December 2006, we were notified by AMPAC that the earnings targets for the twelve month period ended September 30, 2006 had been achieved. We recorded a full allowance on the $25.5 million seller note in fiscal 2005 and $6.0 million earnings targets receivable in fiscal 2006. On January 17, 2007, AMPAC announced that it intends to refinance its senior debt. In addition, on January 17, 2007, we entered into an earn-out and seller note repayment agreement (Repayment Agreement) with AMPAC. The Repayment Agreement will result in us receiving $29.7 million and the release of certain liabilities related to the divestiture during the first quarter of fiscal 2007 in consideration for the seller note, including interest, and the earnings targets payment, only if AMPAC successfully completes the refinancing of its senior debt and receipt of any required consents of holders of its senior debt. Income will be recorded in the future on the seller note of $25.5 million and the earnings targets payment when realized. The loss on the sale of the Fine Chemicals business during fiscal 2005 was $28.7 million. An additional loss of $0.1 million was recorded in fiscal 2006 to reflect the net assets of the Fine Chemicals business and management’s estimate of the proceeds from the sale.

 

On August 31, 2004, we completed the sale of our GDX Automotive business (GDX) which developed and manufactured vehicle sealing systems for automotive original equipment manufacturers, including substantially all

of our assets that were used in the GDX business and substantially all of our worldwide subsidiaries that were engaged in the GDX business, to Cerberus for $147 million, subject to adjustment. In June 2006, we entered into a Final Settlement and Release Agreement with Cerberus related to the sale of GDX which resulted in a $2.9 million income tax benefit and $2.0 million gain that was recorded during the second quarter of fiscal 2006. The loss on the sale of the GDX business during fiscal 2004 was $279.0 million.

 

In November 2003, we announced the closing of a GDX manufacturing facility in Chartres, France. The decision resulted primarily from declining sales volumes with French automobile manufacturers. In June 2004, we completed the legal process for closing the facility and establishing a social plan. In fiscal 2004, an expense of approximately $14.0 million related to employee social costs was recorded in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. An expense of $1.0 million was recorded during fiscal 2005 primarily related to employee social costs that became estimable in fiscal 2005 and is included as a component of discontinued operations. We have not yet recorded expenses associated with certain social benefits due to the uncertainty of these costs. These additional social costs may result in an additional pre-tax expense of up to $2.0 million and may be incurred over the next few years.

 

We adjusted certain pre-acquisition obligations during the second quarter of fiscal 2006 associated with our purchase of the Draftex group in December 2000 which resulted in a $1.7 million pre-tax charge. During the third quarter of fiscal 2006, we reached a settlement on certain pre-acquisition obligations associated with the purchase of the Draftex group which resulted in $1.3 million of pre-tax income.

 

Summarized financial information for discontinued operations is set forth below:

 

 

Cumulative Effect of Changes in Accounting Principles

 

As of December 1, 2005, we adopted SFAS No. 123(R), Share-Based Payment (SFAS 123(R)), which requires companies to recognize in the statement of operations the grant-date fair value of stock awards issued to employees and directors. We adopted SFAS 123(R) using the modified prospective transition method. In accordance with the modified prospective transition method, our Consolidated Financial Statements for prior periods have not been restated to reflect the impact of SFAS 123(R). As a result of applying SFAS 123(R), the loss from continuing operations before the cumulative effect of changes in accounting principles for fiscal 2006 was increased by $0.6 million. In addition, we recognized an increase to our net loss of $0.7 million related to the cumulative effect of a change in accounting principle as of December 1, 2005 (see Note 14(c) in Notes to Consolidated Financial Statements).

 

As of November 30, 2006, we adopted FASB Interpretation No. 47 (FIN 47), Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS No. 143, Accounting for Asset Retirement Obligations. FIN 47 requires that the fair value of a liability for a conditional asset retirement obligation be recognized in the period in which it is incurred and the settlement date is estimable, and is capitalized as part of the carrying amount of the related tangible long-lived asset. The adoption of FIN 47 resulted in our recording conditional asset retirement obligations in the amount of $10.2 million. Of this amount, $1.4 million was recorded as an incremental cost of the underlying property, plant and equipment, less $0.8 million of accumulated depreciation. We also recorded an asset of $8.4 million which represents the amount of the conditional asset retirement obligation that is estimated to be recoverable under U.S. government contracts. As of November 30, 2006, the cumulative effect related to the accretion of the liability and depreciation of the asset net of the amount recoverable under U.S. government contracts was $1.2 million (see Note 13(e) in Notes to Consolidated Financial Statements).

 

Liquidity and Capital Resources

 

Liquidity Requirements

 

Short-term liquidity requirements consist primarily of normal recurring operating expenses; costs associated with legacy business matters, including costs related to our retirement benefit plans; capital expenditures; and debt service requirements. We expect to meet these requirements through available cash, the generation of cash from our Aerospace and Defense segment, and our Senior Credit Facility. See discussion of our Senior Credit Facility under the caption “Borrowing Activity and Senior Credit Facility” below.

 

As of November 30, 2006, long-term liquidity requirements consist primarily of obligations under our long-term debt obligations. We expect to meet long-term liquidity requirements through cash provided from operations and, if necessary, with long-term borrowings and other financing alternatives. The availability and terms of any such financing will depend upon market and other conditions at the time.

 

Net Cash Provided by (Used in) Operating, Investing, and Financing Activities

 

Cash and cash equivalents decreased by $30.5 million during the year ended November 30, 2006. The change in cash and cash equivalents is summarized as follows:

 

 

Net Cash Used in Operating Activities

 

Continuing Operations

 

Fiscal 2006 versus 2005 — Continuing operations generated cash of $0.6 million in fiscal 2006 compared to cash usage of $81.2 million in fiscal 2005. The year over year change consists of: (i) improved cash flows from the Aerospace and Defense segment; (ii) generation of cash from income tax related items; (iii) a payment in fiscal 2005 of approximately $30 million for the Olin judgment; and (iv) timing of payables and receivables and working capital increases, partially offset by payments associated with the settlement of the environmental toxic tort cases.

 

Fiscal 2005 versus 2004 — Continuing operations used cash of $81.2 million in fiscal 2005 compared to generating cash of $5.2 million in fiscal 2004. The year over year change consists of: (i) timing of payables and receivables and working capital increases reflecting sales growth in our Aerospace and Defense segment; (ii) no real estate asset sales in fiscal 2005 versus collection of a $20 million note receivable and real estate sales in fiscal 2004; and (iii) a payment in fiscal 2005 of approximately $30 million for the Olin judgment, partially offset by lower interest and corporate costs.

 

Discontinued Operations

 

Discontinued operations used cash of $13.7 million in fiscal 2006 primarily due to payments associated with the Fine Chemicals business divestiture, including purchase price adjustments and transaction costs, and the Final Settlement and Release Agreement we entered into with Cerberus in June 2006 related to the sale of our GDX Automotive business. Discontinued operations used cash of $2.6 million in fiscal 2005 and $35.0 million in fiscal 2004.

 

Net Cash (Used In) Provided by Investing Activities

 

Continuing Operations

 

Restricted Cash — As of November 30, 2006, we designated $19.8 million as restricted cash related to the cash collateralization of our 53/4% Convertible Subordinated Notes (53/4% Notes). As of November 30, 2004, we designated $201.1 million as restricted cash, consisting of a portion of the proceeds from the GDX Automotive sale and the proceeds from an equity offering completed in fiscal 2004. This restricted cash was used to repay debt in early fiscal 2005.

 

Fiscal 2006 — Continuing operations used cash of $37.7 million consisting of $19.0 million in capital expenditures and $19.8 million of restricted cash; offset by $1.1 million of proceeds from the sale of the Turbo product line.

 

Fiscal 2005 — Continuing operations provided cash of $289.7 million consisting of $108.3 million of proceeds from the sale of the Fine Chemicals business and $201.1 million of restricted cash; offset by $19.7 million in capital expenditures.

 

Fiscal 2004 — Continuing operations used cash of $78.2 million consisting of $140.0 million of proceeds from the sale of the GDX Automotive business, and $4.0 million of proceeds from the sale of certain assets acquired with the ARC acquisition; offset by $201.1 million designated as restricted cash as of fiscal year end 2004, and $21.1 million in capital expenditures.

 

Discontinued Operations

 

Discontinued operations used cash of $38.5 million in fiscal 2005 for capital expenditures in the Fine Chemicals business, of which approximately $17 million was reimbursed pursuant to the amended Fine Chemicals purchase agreement. Cash of $41.3 million in fiscal 2004 was used for capital expenditures in both the GDX and Fine Chemicals businesses.

 

Net Cash Provided by (Used in) Financing Activities

 

Fiscal 2006 — Cash of $20.3 million was generated primarily from the net issuances of approximately $18.5 million of debt. See discussion of our debt activity under the caption “Borrowing Activity and Senior Credit Facility” below.

 

Fiscal 2005 — Cash of $143.6 million was used primarily reflecting the completion of our recapitalization initiated in November 2004. We redeemed $264.6 million of outstanding debt including redemption costs, offset by $66.4 million from the issuance of our additional 21/4% Debentures and $55.7 million from the issuance of Term Loans under our Senior Credit Facility. In addition, we incurred $6.0 million in debt issuance costs and received $4.9 million in other equity transactions.

 

Fiscal 2004 — Cash of $157.4 million was generated reflecting the recapitalization completed in fiscal 2005, and other borrowings and debt repayments. We generated net cash proceeds of $130.5 million from the issuance of 8.6 million shares of common stock for $16 per share, and $80.0 million from the issuance of our 21/4% Debentures with net proceeds used to repurchase $78.8 million of the outstanding 53/4% Notes including redemption costs. We also issued $125.0 million of 4% Convertible Subordinated Notes (4% Notes) and had net debt repayments of $96.9 million. We paid $8.1 million in debt issuance costs, received $8.4 million in other equity transactions, and paid $2.7 million in dividends on our common stock.

 

Our Board of Directors eliminated the payment of quarterly dividends effective the third quarter of fiscal 2004. Beginning in December 2004, the Senior Credit Facility restricted the payment of dividends.

 

Borrowing Activity and Senior Credit Facility:

 

Our borrowing activity in fiscal 2006 and our debt balances as of November 30, 2005 and 2006 were as follows:

 

 

In December 2004, we entered into a credit facility (Senior Credit Facility) with a syndicate of lenders. The Senior Credit Facility was originally a $180.0 million facility, consisting of an $80.0 million revolving credit facility (Revolver) maturing in December 2009, and a $100.0 million credit-linked facility maturing in December 2010. As of May 31, 2006, the amount of the credit-linked facility was $98.5 million, consisting of a $44.2 million letter of credit subfacility and a $54.3 million term loan subfacility. In June 2006, this credit-linked facility was replaced with a new $154.5 million facility consisting of an $80.0 million letter of credit subfacility and a $74.5 million term loan subfacility on terms and conditions substantially similar to the existing facility. In addition, the senior lenders also modified the maximum covenants (see discussion below). The Revolver borrowing limit of $80.0 million was not amended.

 

As of November 30, 2006, the borrowing limit and availability under the Revolver was $80.0 million. The Company had $73.7 million outstanding under the term loan subfacility and $70.5 million outstanding letters of credit issued under the $80.0 million letter of credit subfacility at November 30, 2006.

 

Interest rates are based on LIBOR borrowings or Alternate Base Rate borrowings, as defined in the amended credit agreement. The interest rate on the Revolver is currently LIBOR plus 225 basis points, or Alternate Base Rate plus 125 basis points, subject to adjustment based on our senior leverage ratio, to a maximum of LIBOR plus 300 basis points, or the Alternate Base Rate plus 200 basis points. The interest rate on the term loan is LIBOR plus 325 basis points, or the Alternate Base Rate plus 225 basis points, subject to a 50 basis point increase in the event that our senior secured debt ratings are lowered to certain levels. The fees on the letter of credit subfacility are 335 basis points plus any shortfall from LIBOR earned on the credit-linked deposits, subject to a 50 basis point increase in the event that our senior secured debt ratings are lowered to certain levels. The Revolver commitment fee is 50 basis points per annum on the unused balance of the Revolver.

 

The Senior Credit Facility is secured by substantially all of our assets, including the stock and assets of our material domestic subsidiaries that are guarantors of this facility. We are subject to certain limitations including the ability to: incur additional debt or sell assets, with restrictions on the use of proceeds; make certain investments and

acquisitions; grant liens; and make restricted payments. We are also subject to financial covenants, as amended, which are as follows: