IKONICS Corporation
Annual Report 2006

Plain-text annual report

2 0 0 6 A N N U A L R E P O R T IKONMetal Brass Thru-Holes on Silicon Wafer Deep Etching on Alumina UPC Identification on Graphite Acquired December 2006 C O R P O R A T E P R O F I L E 2006 Net Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$14,888,912 Earnings per common share (diluted) . . . . . . . . . . . . . . . . . . .$0.55 Founded . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1952 Employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .70 NASDAQ Symbol . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .IKNX LETTER TO SHAREHOLDERS I am pleased to report sales and earnings for the year 2006. Net sales increased by 7% to $14,889,000 and earnings by 24% to $1,124,000 or $0.55 per diluted share. We remain financially very sound, with a strong balance sheet. In addition to a positive financial year we have laid the foundation for future growth. At the end of 2006 we acquired the image mate™ brand of screen print products from Franklin International. The products and distributor base complement our domestic and export screen print products, with a number of oppor- tunities for cross fertilization and a dual brand marketing strategy. For 2006, Franklin’s image mate estimated sales were $600,000. During 2006, we spent considerable effort bringing our abrasive etching technology to the industrial ceramics and electronic wafer markets. This effort is based on pro- prietary products (including our DuPont licensed RapidMask™ film), designed to meet specific industrial needs. Although this is a longer sales cycle than we are accustomed to and 2006 has been a learning year, we believe we now have significant business opportunities in sight. I anticipate this effort will be a contributor to future growth. Also, during the year we increased our investment in Imaging Technology International, recognized leaders in industrial digital inkjet technology. We have made the development of inkjettable fluids and fluid receptive sub- strates a priority for our R&D effort and capital expendi- tures. We have established a digital inkjet lab in Duluth and have made progress toward the commercialization of an advanced digital technology. Finally, in the second half of 2006, we improved the production process for IKONMetal™, and the product is being sold to both the signage and award/trophy markets. Our IKONBraille™ product has encountered similar production issues; but I believe we are well on our way to solving them. I anticipate that 2007 will be another successful year for IKONICS, with our core businesses continuing to grow and our new initiatives bringing increased revenues and profits while diversifying our customer base. I do, however, expect that compliance costs associated with Sarbanes Oxley Rule 404 will be a drag on earnings. BILL ULLAND CHAIRMAN, PRESIDENT & CEO For the Board of the Directors William C. Ulland Chairman, President and CEO The preceding letter contains statements regarding future financial results, new products, the success of acquisitions and other matters that involve risks and uncertainties. The Company's actual results could differ materially as a result of domestic and global economic conditions, competitive market conditions, acceptance of new products, the ability to identify, complete and successfully integrate suitable acquisitions, as well as the other factors described elsewhere in this Annual Report and in the Company's most recent Form 10-KSB and most recent Form 10-QSB on file with the SEC. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 2 FINANCIAL RESULTS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following management discussion and analysis focuses on those factors that had a material effect on the Company’s finan- cial results of operations and financial condition during 2006 and 2005 and should be read in connection with the Company’s audited financial statements and notes thereto for the years ended December 31, 2006 and 2005. Factors that May Affect Future Results Certain statements made in this Annual Report on Form 10-KSB, including those summarized below, are forward-looking statements within the meaning of the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934, as amend- ed, that involve risks and uncertainties, and actual results may differ. Factors that could cause actual results to differ include those identified below. The Company’s belief that costs related to Section 404 of the Sarbanes-Oxley Act of 2002 should be higher in 2007—This belief may be impacted by changes in law or regulation affecting the timing of the Company’s required compliance with Section 404 or unanticipated barriers to such compli- ance resulting from the Company’s internal controls or third party influences. The Company’s belief that the quality of its receivables is high and that strong internal controls are in place to maintain proper collections—This belief may be impacted by domestic economic conditions, by economic, political, regulatory or social conditions in foreign markets, or by the failure of the Company to properly implement or maintain internal controls. The belief that the Company’s current financial resources, cash generated from operations and the Company’s capacity for debt and/or equity financing will be sufficient to fund current and anticipated business operations and capital expenditures. The belief that the Company’s low debt levels and available line of credit make it unlikely that a decrease in product demand would impair the Company’s ability to fund operations—Changes in anticipated operating results, credit availability, equity market conditions or the Company’s debt levels may further enhance or inhibit the Company’s ability to maintain or raise appropriate levels of cash. The Company’s expectation that capital expenditures will be funded with cash generated from operating activities—This expectation may be affected by changes in the Company’s anticipated capital expenditure requirements resulting from unforeseen required maintenance or repairs. The funding of planned or unforeseen expenditures may also be affected by changes in anticipated operating results resulting from decreased sales or increased operating expenses. The Company’s belief that its vulnerability to foreign curren- cy fluctuations and general economic conditions in foreign countries is not significant—This belief may be impacted by economic, political and social conditions in foreign markets, changes in regulatory and competitive conditions, a change in the amount or geographic focus of the Company’s interna- tional sales, or changes in purchase or sales terms. TABLE OF CONTENTS Letter to Shareholders . . . . . . . . . . . . . . . . . . . . . . 2 Management Discussion & Analysis . . . . . . . . . 3-6 Management Report . . . . . . . . . . . . . . . . . . . . . . . . 6 Independent Auditor’s Report . . . . . . . . . . . . . . . . 6 Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Statements of Operations . . . . . . . . . . . . . . . . . . . 8 Statements of Stockholders’ Equity . . . . . . . . . . . 8 Statements of Cash Flows . . . . . . . . . . . . . . . . . . . 9 Notes to Financial Statements . . . . . . . . . . . . 10-14 Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . 14 Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 5-Year History . . . . . . . . . . . . . . . . . . . . Back Cover The Company’s plans to continue to invest in research and development efforts, expedite internal product development and invest in technological alliances, as well as the expected focus and results of such investments—These plans and expectations may be impacted by general market conditions, unanticipated changes in expenses or sales, delays in the development of new products, technological advances, the ability to find suitable and willing technology partners or other changes in competitive or market conditions. The Company’s efforts to grow its international business— These efforts may be impacted by economic, political and social conditions in current and anticipated foreign markets, regulatory conditions in such markets, unanticipated changes in expenses or sales, changes in competitive condi- tions or other barriers to entry or expansion. The Company’s belief as to future activities that may be undertaken to expand the Company’s business—Actual activ- ities undertaken may be impacted by general market conditions, competitive conditions in the Company’s indus- try, unanticipated changes in the Company’s financial position or the inability to identify attractive acquisition targets or other business opportunities. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 3 CRITICAL ACCOUNTING POLICIES The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. Therefore, the Company is required to make certain estimates, judgments and assumptions that the Company believes are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The accounting policies which IKONICS believes are the most critical to aid in fully under- standing and evaluating its reported financial results include the following: Accounts Receivable The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by review of the current credit information. The Company continu- ously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. While such credit losses have histori- cally been within expectations and the provisions established, the Company cannot guarantee that it will continue to experi- ence the same collection history that has occurred in the past. The general payment terms are net 30-45 days for domestic customers and net 60-90 days for foreign customers. Inventory Inventories are valued at the lower of cost or market value using the last in, first out (LIFO) method. The Company monitors its inventory for obsolescence and records reductions in cost when required. Deferred Tax Assets At December 31, 2006, the Company had approximately $145,000 of net deferred tax assets. The deferred tax assets result primarily from temporary differences in accrued expens- es, inventory reserves, intangible assets and property and equipment. The Company has recorded a $27,000 valuation allowance to reserve for items that more likely than not will not be realized. The Company has determined that it is more likely than not that the remaining deferred tax assets will be realized and that an additional valuation allowance for such assets is not currently required. Revenue Recognition The Company recognizes revenue on products when title passes which is usually upon shipment. Freight billed to customers is included in sales. Shipping costs are included in cost of goods sold. RESULTS OF OPERATIONS Year Ended December 31, 2006 Compared to Year Ended December 31, 2005 Sales The Company’s net sales increased 6.6% to $14.9 million in 2006, compared to net sales of $14.0 million in 2005. Sales increases were realized in both international and domestic markets. International shipments grew 10.1% mainly due to increased film shipments to Asia. The 5.1% domestic sales increase was driven by both higher film and glass shipments. FINANCIAL RESULTS Cost of Goods Sold Cost of goods sold was $8.2 million, or 55.0% of sales, in 2006 and $7.7 million, or 55.5% of sales, in 2005. The decrease in the cost of sales as a percentage of sales during 2006 reflects a more favorable product mix partially offset by rising raw material and transportation costs. Selling, General and Administrative Expenses Selling, general and administrative expenses increased to $4.5 million, or 30.2% of sales, in 2006 from $4.4 million, or 31.3% of sales, in 2005. The 2006 increase was due to $140,000 of addi- tional trade show and advertising expenses. Salary, insurance and pension costs also increased by $100,000. These cost increas- es were partially offset by a $80,000 decrease in travel costs and a $20,000 decrease in depreciation. The Company also incurred $40,000 in additional expenses related to Sarbanes-Oxley compli- ance in 2005 as compared to 2006. The Company anticipates that Sarbanes-Oxley compliance expenses will increase by $60,000 in 2007 as compared to 2006. Research and Development Expenses Research and development expenses were $742,000, or 5.0% of sales, in 2006 compared to $642,000, or 4.6% of sales, in 2005. The increase is due to an increase in spending on new product development, production trials, and additional research and development staff. Interest Income Interest income increased to $115,000 for 2006, compared to $58,000 for 2005. The increase was primarily due to increased interest rates and a larger average cash balance during the year. Income Taxes The income tax provision differs from the expected tax expense primarily due to the benefits of the foreign sales exclusion, state income taxes and federal tax credits for research and develop- ment. Income tax expense in 2006 was $466,000, or an effective rate of 29.3%. Income tax expense for 2005 was $348,000, or an effective rate of 27.7%. The lower effective rate for 2005 was partially due to a study performed by the Company during 2005 related to its research and development activities resulting in tax credits totaling $15,000. The Company also realized a larger benefit in 2005 related to the foreign sales exclusion. Liquidity and Capital Resources The Company has financed its operations principally with funds generated from operations. These funds have been sufficient to cover the Company’s normal operating expenditures, annual capi- tal requirements, and research and development expenditures. Cash and cash equivalents were $3,428,000 and $3,412,000 at December 31, 2006 and 2005, respectively. The Company gener- ated $1,076,000 in cash from operating activities during 2006 compared to $980,000 of cash generated from operating activities during 2005. Cash provided by operating activities is primarily the result of net income adjusted for non cash depreciation, amortization, stock based compensation, deferred taxes, and certain changes in working capital components discussed in the following paragraph. During 2006, trade receivables increased by $274,000. The increase in receivables is primarily related to higher sales. The Company believes that the quality of its receivables is high and that strong internal controls are in place to maintain proper T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 4 FINANCIAL RESULTS collections. Inventory levels increased by $34,000 due to higher raw material and finished goods inventory stock. Accounts payable decreased by $150,000, reflecting the timing of payments to suppliers. Income taxes payable increased by $74,000 as a result of the timing of estimated 2006 tax payments compared to the calculated 2006 tax liability. The Company used $1,283,000 and $423,000 in cash for invest- ing activities during 2006 and 2005, respectively. During 2006, the Company invested $538,000 in imaging Technology interna- tional Corporation ("iTi") to acquire 69,166 common shares. The Company owns 105,662 shares of iTi which represents 7% of the total outstanding common shares of iTi. iTi is a leader in the development of industrial production systems based on inkjet technology and the Company believes iTi's expertise fits strategi- cally with the Company's expertise in developing substrates for inkjet printing and the Company's plans to develop proprietary industrial inkjet technologies. On December 29, 2006, the Company acquired the image mate™ line of screen printing prod- ucts from Franklin International for $533,000. Unaudited image mate sales in 2006 were estimated to be $600,000. The acquisition included inventory, equipment, deposits under an agreement to purchase key raw materials from Franklin International and an agreement not to compete. The Company made $274,000 of prop- erty and equipment purchases during 2006. The purchases were comprised of plant and research equipment to improve efficiency and safety, reduce operating costs and update facilities, and two automobiles. The Company also incurred $28,000 in patent appli- cation costs that it recorded as an asset and amortizes upon successful completion of the application process. The Company received $84,000 during 2006 from the sale of marketable securi- ties and $6,000 from the sale of an automobile. During 2005, the Company invested $253,000 in iTi to acquire 36,496 common shares and warrants to purchase an additional 33,333 common shares of iTi. The Company made $211,000 of property and equipment purchases during 2005 and $12,000 in patent application costs. The Company received $43,000 during 2005 from the sale of marketable securities and $11,000 from the sale of automobiles. The Company realized $223,000 in cash from financing activ- ities during 2006 compared to $117,000 received in 2005. During 2006, the Company received $186,000 for the issuance of 48,324 shares of common stock issued upon the exercise of stock options compared to $233,000 received during 2005 for 57,491 shares of common stock issued upon the exercise of stock options. The Company also realized a $37,000 cash benefit during 2006 relat- ed to the excess tax benefit from the exercise of stock options. The Company repurchased 25,499 shares of its common stock at a cost of $116,000 during 2005. A bank line of credit provides for borrowings of up to $1,250,000. Borrowings under this line of credit are collateralized by accounts receivable and inventory and bear interest at 2.00 percentage points over the 30 day LIBOR rate. The Company did not utilize this line of credit during the year and there were no borrowings outstanding as of December 31, 2006. The line of credit was also not utilized during 2005 and there were no borrowings outstanding under this line as of December 31, 2005. The Company believes that current financial resources, its line of credit, cash generated from operations and the Company’s capacity for debt and/or equity financing will be sufficient to fund current and anticipated business operations. The Company also believes that its low debt levels and available line of credit make it unlikely that a decrease in demand for the Company’s products would impair the Company’s ability to fund operations. Capital Expenditures The Company spent $274,000 on capital expenditures during 2006. This spending included plant and research equipment upgrades to improve efficiency and safety, reduce operating costs, update facilities and vehicles. Plans for capital expenditures include ongoing manufactur- ing equipment upgrades, development equipment to modernize the capabilities and processes of IKONICS’ laboratory, research and development to improve measurement and quality control processes and vehicles. These commitments are expected to be funded with cash generated from operating activities. International Activity The Company markets its products to numerous countries in all regions of the world including North America, Europe, Latin America, and Asia. Foreign sales were approximately 30.4% of total sales during 2006 and 29.4% of total sales in 2005. Foreign sales in 2006 reflect increased shipments to Asia. Fluctuations in certain foreign currencies have not significantly impacted the Company’s operations because the Company’s foreign sales are not concentrated in any one region of the world. The Company believes its vulnerability to uncertainties due to foreign currency fluctuations and general economic conditions in foreign countries is not significant. The Company’s foreign transactions are primarily negotiated, invoiced and paid in U.S. dollars while a portion is transacted in Euros. IKONICS has not implemented an economic hedging strategy to reduce the risk of foreign currency translation expo- sures, which management does not believe to be significant based on the scope and geographic diversity of the Company’s foreign operations as of December 31, 2006. Future Outlook IKONICS has invested on average over 4% of its sales dollars for the past few years in research and development. The Company plans to maintain its efforts in this area and expedite internal product development, as well as form technological alliances with outside experts to ensure commercialization of new product opportunities. In addition to its traditional emphasis on domestic markets, the Company will continue efforts to grow its business interna- tionally by attempting to develop new markets and expanding market share where it has already established a presence. Other future activities undertaken to expand the Company’s business may include acquisitions, building expansion and addi- tions, equipment additions, new product development and marketing opportunities. Recent Accounting Pronouncements In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and tran- T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 5 sition. FIN 48 will be effective for the Company beginning in fiscal 2007. The Company does not expect this interpretation will have a material effect on its financial statements and related disclosures. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclo- sures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously conclud- ed in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for the Company beginning in fiscal year 2008. The Company is evaluating the statement to determine the effect on its financial statements and related disclosures. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES The Company’s Common Stock is traded on the Nasdaq Capital Market under the symbol IKNX. The following table sets forth, for the fiscal quarters indicated, the high and low bid prices for the Company’s Common Stock as reported on the Nasdaq Capital Market for the periods indicated. The quotations reflect inter- dealer prices without retail mark-up, mark-down or commission, and may not represent actual transactions. Fiscal Year Ended December 31, 2006: High First Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . $8.33 Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . 10.47 8.97 Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . 8.60 Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . Fiscal Year Ended December 31, 2005: High First Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . $7.35 7.00 Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . 6.99 Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . 8.99 Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . Low $6.26 7.06 7.15 7.02 Low $5.51 4.20 4.95 5.78 As of February 28, 2007, the Company had approximately 654 shareholders. The Company has never declared or paid any divi- dends on its Common Stock. The Company did not purchase shares of its equity securities during 2006. A total of 50,007 shares of Common Stock may yet be purchased under the repurchase program approved by the Company’s Board of Directors in February 2005. FINANCIAL RESULTS MANAGEMENT’S REPORT The financial statements of IKONICS Corporation have been prepared by company management who are responsible for their content. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, where appropriate, reflect estimates based on judgements of management. IKONICS maintains a system of internal controls. Our system provides reasonable assurance that assets are protected, transactions are appropriately reported, and established proce- dures are followed. The financial statements have been audited by McGladrey & Pullen LLP, an independent registered public accounting firm. The Audit Committee of the Board of Directors, comprised of outside directors, meets periodically with the independent audi- tors and management to discuss the company’s internal accounting controls and financial reporting matters. Our inde- pendent public accounting firm has unrestricted access to the Audit Committee, without management present, to discuss the results of their audit, the adequacy of internal accounting controls, and the quality of financial reports. William C. Ulland Chairman, President & CEO Jon Gerlach Chief Financial Officer REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Stockholders and Board of Directors IKONICS Corporation Duluth, Minnesota We have audited the balance sheets of IKONICS Corporation as of December 31, 2006 and 2005, and the related statements of operations, stockholders’ equity and comprehensive income and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial state- ments based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the finan- cial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluat- ing the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above pres- ent fairly, in all material respects, the financial position of IKONICS Corporation as of December 31, 2006 and 2005, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. As discussed in Note 1 to the financial statements, effective January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Shared-Based Payment.” /s/ McGladrey & Pullen, LLP Duluth, Minnesota March 21, 2007 T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 6 BALANCE SHEETS: DECEMBER 31, 2006 & 2005 ASSETS Current Assets: 2006 2005 Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,428,186 _ Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trade receivables, less allowance for doubtful accounts of $50,000 (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories (Notes 1 and 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits, prepaid expenses and other assets (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,976,893 2,494,876 232,255 97,000 8,229,210 Property, Plant, and Equipment, at cost: Land and building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,271 2,396,867 817,406 203,816 4,918,360 3,926,440 991,920 Intangible Assets, less accumulated amortization of $159,351 in 2006 and $134,642 in 2005 (Notes 3 and 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485,421 Deferred Income Taxes (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000 $3,412,072 84,875 1,702,608 2,364,056 65,747 99,000 7,728,358 1,479,824 2,531,734 1,280,149 174,803 5,466,510 4,514,945 951,565 279,086 61,000 Investments in Non-Marketable Equity Securities (Note 1) . . . . . . . . . . . . . . . . . . 988,910 $10,743,461 450,790 $9,470,799 LIABILITIES AND STOCKHOLDERS’ EQUITY 2006 2005 Current Liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $288,449 324,082 172,381 94,450 879,362 $438,597 279,042 217,912 56,743 992,294 Commitments and Contingencies (Note 4) Stockholders’ Equity: Preferred stock, par value $.10 per share; authorized 250,000 shares: issued none Common stock, par value $.10 per share; authorized 4,750,000 shares: issued and outstanding 2,010,861 shares in 2006 and 1,962,537 shares in 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See notes to financial statements. 201,086 1,979,012 7,684,001 _ 9,864,099 $10,743,461 196,254 1,721,119 6,560,236 896 8,478,505 $9,470,799 T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 7 STATEMENTS OF OPERATIONS: YEARS ENDED DECEMBER 31, 2006 & 2005 2006 2005 Net Sales (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,888,912 Costs and Expenses: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,181,814 4,490,381 742,406 13,414,601 $13,971,217 7,748,707 4,383,144 641,622 12,773,473 Income from Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,474,311 1,197,744 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,454 58,425 Income Before Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,589,765 1,256,169 Federal and State Income Taxes (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466,000 348,000 Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,123,765 $908,169 Earnings Per Common Share: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.56 $0.55 $ 0.47 $0.46 Weighted Average Common Shares: Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,017 2,027,916 1,944,330 1,986,885 See notes to financial statements. STATEMENTS OF STOCKHOLDERS’ EQUITY & COMPREHENSIVE INCOME: YEARS ENDED DECEMBER 31, 2006 & 2005 Common Stock Shares Amount 1,930,545 _ _ _ 57,491 (25,499) _ 1,962,537 _ _ _ 48,324 _ _ $193,055 _ _ _ 5,749 (2,550) _ 196,254 _ _ _ 4,832 _ _ Additional Paid-in Capital Accumulated Other Retained Comprehensive Income (Loss) Earnings $1,477,815 _ _ _ 227,042 (19,519) 35,781 1,721,119 _ _ _ 181,503 14,055 62,335 $5,745,662 908,169 _ _ _ (93,595) _ 6,560,236 1,123,765 _ _ _ _ _ $(2,316) _ 3,212 _ _ _ _ 896 _ (896) _ _ _ _ Total Stock- holders’ Equity $7,414,216 908,169 3,212 911,381 232,791 (115,664) 35,781 8,478,505 1,123,765 (896) 1,122,869 186,335 14,055 62,335 Balance at December 31, 2004 Net income Unrealized gain on available-for-sale securities Total comprehensive income Exercise of stock options Common stock repurchased Tax benefit resulting from stock option exercises Balance at December 31, 2005 Net income Unrealized loss on available-for-sale securities Total comprehensive income Exercise of stock options Tax benefit resulting from stock option exercises Stock based compensation and related tax benefit Balance at December 31, 2006 2,010,861 $201,086 $1,979,012 $7,684,001 $ _ $9,864,099 See notes to financial statements. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 8 STATEMENTS OF CASH FLOWS: YEARS ENDED DECEMBER 31, 2006 & 2005 2006 2005 Cash Flows from Operating Activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,123,765 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Excess tax benefit from share-based payment arrangement . . . . . . . . . . . . . . . . . . . . Tax benefit from stock option exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Gain) Loss on sale of vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in working capital components, net of effects of 242,833 24,710 (36,712) 14,055 25,623 (640) 15,000 business acquisition: Trade receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes payable Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . (274,285) 34,101 (16,508) (150,148) (491) 74,419 1,075,722 Cash Flows from Investing Activities: Purchases of property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds on sale of vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Business acquisition (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of non-marketable equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (273,548) 6,000 (532,921) (28,045) (538,120) 83,979 (1,282,655) Cash Flows from Financing Activities: Excess tax benefit from share-based payment arrangement . . . . . . . . . . . . . . . . . . . . Proceeds from exercise of stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Redemption of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,712 186,335 _ 223,047 $908,169 269,549 24,914 _ 35,781 _ 7,992 48,000 (59,704) (162,774) (8,402) (97,794) (12,258) 26,574 980,047 (211,276) 11,000 _ (11,651) (253,330) 42,695 (422,562) _ 232,791 (115,664) 117,127 Net Increase in Cash and Cash Equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,114 674,612 Cash and Cash Equivalents at Beginning of Year . . . . . . . . . . . . . . . . . . . . . . . . . . 3,412,072 2,737,460 Cash and Cash Equivalents at End of Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,428,186 $3,412,072 Supplemental Disclosure of Cash Flow Information Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $362,526 $237,645 See notes to financial statements. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 9 NOTES TO FINANCIAL STATEMENTS: YEARS ENDED DECEMBER 31, 2006 AND 2005 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business and Foreign Sales IKONICS Corporation (the Company) develops and manufac- tures high-quality photochemical imaging systems for sale primarily to a wide range of printers and decorators of surfaces. Customers’ applications are primarily screen printing and abra- sive etching. The Company’s principal markets are throughout the United States. In addition, the Company sells to Western Europe, Latin America, Asia, and other parts of the world. The Company extends credit to its customers, all on an unsecured basis, on terms that it establishes for individual customers. Foreign sales approximated 30.4% of total sales in 2006 and 29.4% of total sales in 2005. Thirty-nine percent and forty-four percent, respectively, of the Company’s accounts receivable at December 31, 2006 and 2005 are due from foreign customers. The foreign receivables are composed primarily of open credit arrange- ments with terms ranging from 45 to 90 days. No single customer represented greater than 10% of net sales in 2006 or in 2005. A summary of the Company’s significant accounting policies follows: Cash Equivalents The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Cash equivalents consist of putable variable rate municipal bonds backed by a letter of credit and money market funds in which the carrying value of both types of instruments approximate market value because of the short maturity of these instruments. Marketable Securities Marketable securities were classified as available-for-sale and consist primarily of municipal revenue bonds that were held for indefinite periods of time, including securities that may be sold in response to changes in market interest or prepayment rates, needs for liquidity, or changes in the availability or yield of alternative investments. These securities were carried at fair market value with changes in fair value, net of tax, recorded in other comprehensive income. There were no marketable securi- ties at December 31, 2006. Trade Receivables Trade receivables are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on an on-going basis. Management deter- mines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer’s financial condition, credit history, and current economic condi- tions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received. Accounts are considered past due if payment is not received according to agreed-upon terms. Inventories Inventories are stated at the lower of cost or market using the last-in, first-out (LIFO) method. If the first-in, first-out cost method had been used, inventories would have been approxi- mately $535,000 and $509,000 higher than reported at December 31, 2006 and 2005, respectively. The major compo- nents of inventories are as follows: 2006 Raw materials . . . . . . . . . . . . . . . . $1,577,165 225,033 Work-in-progress . . . . . . . . . . . . . 1,227,806 Finished goods . . . . . . . . . . . . . . . Reduction to LIFO cost . . . . . . . . (535,128) Total inventories . . . . . . . . . . . . . . $2,494,876 2005 $1,483,881 212,254 1,176,647 (508,726) $2,364,056 Depreciation Depreciation of property, plant and equipment is computed using the straight-line method over the following estimated useful lives: Years Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15-40 5-10 Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . 3-10 Office equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible Assets Intangible assets consist primarily of patents, licenses and covenants not to compete arising from business combinations. Intangible assets are amortized on a straight-line basis over their estimated useful lives or agreement terms. Remaining estimated useful lives on intangible assets range from 5 to 14 years. Intangible assets with finite lives are assessed for impair- ment whenever events or circumstances indicate the carrying value may not be fully recoverable by comparing the carrying value of the intangibles to their future undiscounted cash flows. To the extent there is impairment, analysis is performed based on several criteria, including, but not limited to, revenue trends, discounted operating cash flows and other operating factors to determine the impairment amount. Investments in Non-Marketable Equity Securities Investments in non-marketable equity securities consist of a $791,450 investment in Imaging Technology International ("iTi"). The Company acquired an additional 69,166 common shares of iTi during 2006. The Company currently owns 105,662 common shares of iTi which represents 7% of the total outstand- ing common shares of iTi. iTi is a leader in the development of industrial production systems based on inkjet technology and the Company believes iTi's expertise fits strategically with the Company's expertise in developing substrates for inkjet print- ing and its plan to develop proprietary industrial inkjet technology. The Company has a $197,460 equity investment in Apprise Technologies, Inc. As of December 31, 2006, the Company's ownership of Apprise's common and preferred stock represented approximately 4.95% of the outstanding shares of Apprise. The Company accounts for these investments by the cost method because the common stock of each corporation is unlisted and the criteria for using the equity method of account- ing are not satisfied. The Company reviews these investments for impairment annually and writes them down whenever the recorded amount exceeds estimated fair market value. During February 2007, Apprise was acquired by Eco Lab Incorporated for cash. The Company realized a gain of approximately $55,000 on the first payment from the transaction. The Company also expects to receive an additional $40,000 in 2008 at which time an additional gain will be recognized. Cash received in February 2007 was $253,000. Fair Value of Financial Instruments The carrying amounts of financial instruments, including cash, cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate fair value due to the short matu- rity of these instruments. The carrying value of the non-marketable equity securities approximated their estimated fair value based on management’s knowledge of recent sales prices of the non-marketable equity securities. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 10 NOTES TO FINANCIAL STATEMENTS: YEARS ENDED DECEMBER 31, 2006 AND 2005 Revenue Recognition The Company recognizes revenue on sales of products when title passes which is usually upon shipment. Freight billed to customers is included in sales. Shipping costs are included in cost of goods sold. Deferred Taxes Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The adoption of FAS 123(R) lowered net income by approxi- mately $25,600 for the year ended December 31, 2006, compared to accounting for share-based compensation under APB No. 25. The Company has elected the alternative (short-cut) method for calculating the pool of excess tax benefits (APIC Pool) available to absorb tax shortages recognized subsequent to the adoption of FAS 123(R). The Company’s calculation of the APIC windfall at January 1, 2006 was $3,000. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of FAS 123(R) during the period prior to its effective date. For the purposes of this pro forma disclosure, the value of the options is estimated using a Black-Scholes option-pricing model and amortized to expense over the vesting periods of the options. Year Ended December 31, 2005 Net income: Comprehensive Income The Company’s comprehensive income consists of net income and net unrealized holding gains and losses on marketable secu- rities, net of taxes. Earnings Per Common Share (EPS) Basic EPS is calculated using net income divided by the weight- ed average of common shares outstanding during the year. Diluted EPS is similar to Basic except that the weighted aver- age of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares, such as options, had been issued. As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $908,169 Deduct total stock-based employee compensation expense determined under fair value based method for all awards . . . . . . . 21,214 Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $886,955 Basic earnings per common share: As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per common share: . . . . . . . . . . . . As reported . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pro forma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.47 $0.46 $0.46 $0.45 Shares used in the calculation of diluted EPS are summarized below: Weighted average common shares outstanding . . . . . . . . . . . . Dilutive effect of stock options . . . . . . . . . . . . . . . . . Weighted average common and common equivalent shares outstanding . . . . . . . . . . . . 2006 2005 2,000,017 1,944,330 27,899 42,555 2,027,916 1,986,885 Options to purchase 88,222 and 130,285 shares of common stock were outstanding as of December 31, 2006 and 2005, respectively. Employee Stock Plan Effective January 1, 2006, the Company adopted Financial Accounting Standards Board Statement No. 123 (revised 2004), “Share-Based Payment,” (FAS 123(R)) using the modified-prospec- tive-transition method. Prior to the adoption of FAS 123(R), we accounted for stock option grants under APB Opinion No. 25, “Accounting for Stock Issued to Employees” (the intrinsic value method), and accordingly recognized no compensation expense for stock option grants. Under the modified-prospective-transition method, FAS 123(R) applies to new awards and to awards that were outstand- ing on January 1, 2006 that are subsequently modified, repurchased, or cancelled. Under this method compensation cost in 2006 includes cost for options granted prior to but not vested as of December 31, 2005, and options granted in 2006. Prior periods were not restated to reflect the impact of adopting the new standard. As of December 31, 2006, there was approximately $36,000 of unrecognized compensation cost related to unvested share- based compensation awards granted. That cost is expected to be recognized over the next three years. The Company receives a tax deduction for certain stock option exercises during the period in which the options are exer- cised, generally for the excess of the prices at which the option shares are sold over the exercise price of the options. Prior to the adoption of FAS 123(R), the Company reported all tax benefits relating to the exercise of stock options as operating cash flows in our statement of cash flows. In accordance with FAS 123(R), for the year ended December 31, 2006, we began reporting the excess tax benefits from the exercise of stock options as a reduc- tion of operating and an increase in financing cash flows. For the year ended December 31, 2006, $36,712 of excess tax benefits were reported in the statement of cash flows. Use of Estimates The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assump- tions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Foreign Currency Translation Foreign currency transactions and translation adjustments did not have a significant effect on the Statements of Stockholders’ Equity and Comprehensive Income and Cash Flows for 2006 and 2005. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 11 NOTES TO FINANCIAL STATEMENTS: YEARS ENDED DECEMBER 31, 2006 AND 2005 2. INCOME TAXES Income tax expense for the years ended December 31, 2006 and 2005 consists of the following: 2006 2005 Current: Federal . . . . . . . . . . . . . . . . . . . . $401,000 50,000 State . . . . . . . . . . . . . . . . . . . . . . 451,000 15,000 $466,000 Deferred . . . . . . . . . . . . . . . . . . . $262,000 38,000 300,000 48,000 $348,000 The expected provision for income taxes, computed by applying the U.S. federal income tax rate of 35% in 2006 and 2005 to income before taxes, is reconciled to income tax expense as follows: 2006 2005 Expected provision for federal income taxes . . . . . . . . . . . . $556,400 State income taxes, net of federal benefit . . . . . . . . . . . . Extraterritorial income exclusion . . Domestic manufacturers deduction . . Non-deductible meals and entertainment . . . . . . . . . . . . . . Tax-exempt interest . . . . . . . . . . . . . R&D Credit . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . 16,400 (39,000) (13,600) (30,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . $466,000 36,300 (49,400) (11,100) $439,700 25,700 (64,700) _ 13,600 (18,100) (29,000) (19,200) $348,000 Deferred tax assets consist of the following as of December 31, 2006 and 2005: 2006 2005 Property and equipment and other assets . . . . . . . . . . . . . . . . $38,000 19,000 Accrued vacation . . . . . . . . . . . . . . . 49,000 Other accrued expenses . . . . . . . . . . 12,000 Inventories . . . . . . . . . . . . . . . . . . . . 18,000 Allowance for doubtful accounts . . . 7,000 Allowance for sales returns . . . . . . . 10,000 Intangible assets . . . . . . . . . . . . . . . 27,000 Capital loss carryforward . . . . . . . . 180,000 (27,000) 153,000 Less valuation allowance . . . . . . . . $40,000 14,000 47,000 20,000 18,000 7,000 21,000 27,000 194,000 (27,000) 167,000 Deferred tax liabilities: Prepaid expenses . . . . . . . . . . . . . . . 8,000 $145,000 7,000 $160,000 The deferred tax amounts described above have been included in the accompanying balance sheet as of December 31, 2006 and 2005 as follows: 2006 Current assets . . . . . . . . . . . . . . . . . $97,000 48,000 Noncurrent assets . . . . . . . . . . . . . . $145,000 2005 $99,000 61,000 $160,000 3. PURCHASE OF ASSETS On December 29, 2006, the Company acquired certain assets of Franklin International Inc. (Franklin) related to the image mate™ line of screen printing products. The acquisition was accounted for under the purchase method of accounting. Accordingly, the assets acquired were recorded at their fair market value. The assets acquired include lab equipment, raw materials and finished goods inventory, and a non-compete agree- ment with Franklin. The costs allocated to the non-compete agreement will be amortized on a straight-line basis over its seven year term. In connection with the acquisition, the Company entered into an agreement to prepay for inventory purchases from Franklin, which are expected to be utilized over three years. The fair market value of the assets acquired resulted in the following purchase price allocation: Cash price paid for assets . . . . . . . . . . . . . . . . . . . . . $528,921 Acquisition costs incurred . . . . . . . . . . . . . . . . . . . . . 4,000 Total purchase price . . . . . . . . . . . . . . . . . . . . . . . . . $532,921 Purchase Price Allocation Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $164,921 150,000 Deposit for inventory purchases . . . . . . . . . . . . . . . . 15,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203,000 Noncompete agreement . . . . . . . . . . . . . . . . . . . . . . . $532,921 If the acquisition had occurred on January 1, 2005, the unaudit- ed pro forma impact on revenues would have been to increase revenues by approximately $600,000 for each of the years ended December 31, 2005 and 2006. The unaudited proforma net income and earnings per common share would not have been significant to the amounts reported in the Company’s financial statements for such years. 4. INTANGIBLE ASSETS Intangible assets consist primarily of patents, licenses and covenants not to compete arising from business combinations. Intangible assets are amortized on a straight-line basis over their estimated useful lives or terms of their agreement, whichever is shorter. During 2005, application costs for two patents with total capitalized costs of $30,341 were expensed as it was determined that these projects had no future value. No impairment adjustments to intangible assets were made during the year ended December 31, 2006. Intangible assets at December 31, 2006 and 2005 consist of the following: December 31, 2006 December 31, 2005 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Amortized intangible assets: Patents . . . . . . . . . . . . . . . . . . . $241,773 Licenses . . . . . . . . . . . . . . . . . . 100,000 Non-compete agreement . . . . . 303,000 $644,773 $(81,022) (35,000) (43,330) $(159,352) $213,728 100,000 100,000 $413,728 Aggregate amortization expense: 2006 For the year ended December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $24,710 $(71,102) (26,875) (36,664) $(134,642) 2005 $24,914 Estimated amortization expense for the year ended December 31: 2007 . . . . . $53,710 2008 . . . . .$53,710 2009 . . . . .$53,710 2010 . . . . .$53,710 2011 . . . . .$53,710 In connection with the license agreements, the Company has agreed to pay royalties ranging from 3% to 5% on the future sales of products subject to the agreements. The Company incurred $119,000 of expense under these agreements during 2006, and $108,000 during 2005. 5. RETIREMENT PLAN The Company has established a salary deferral plan under Section 401(k) of the Internal Revenue Code. Such deferrals accumulate on a tax-deferred basis until the employee withdraws the funds. The Company contributes 5% of each eligible employee’s compensation. Total retirement expense for the years ended December 31, 2006 and 2005 was approximately $163,000 and $150,000, respectively. T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 12 NOTES TO FINANCIAL STATEMENTS: YEARS ENDED DECEMBER 31, 2006 AND 2005 6. SEGMENT INFORMATION The Company's reportable segments are strategic business units that offer different products and have a varied customer base. There are three reportable segments: Domestic, Export, and IKONICS Imaging. Domestic sells screen printing film, emulsions, and inkjet receptive film which is sold to distributors located in the United States. IKONICS Imaging sells photo resistant film, art supplies, glass, metal medium and related abrasive etching equipment to end user customers located in the United States. It is also entering the market for etched ceramics, glass and silicon wafers; and is developing and selling proprietary inkjet technology. Export sells primarily the same products as Domestic and IKONICS Imaging to foreign customers. The account- ing policies applied to determine the segment information are the same as those described in the summary of significant accounting policies. Management evaluates the performance of each segment based on the components of divisional income, and with the exception for accounts receivable, does not allocate assets and liabilities to segments. Financial information with respect to the reportable segments follows: For the year ended December 31, 2006 Domestic Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,777,987 3,803,598 Cost of good sold . . . . . . . . . . . . . . . . . . . . . . 965,695 Selling, general and administrative* . . . . . . 842,144 Accounts receivable . . . . . . . . . . . . . . . . . . . For the year ended December 31, 2005 Domestic Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,512,880 3,071,175 Cost of good sold . . . . . . . . . . . . . . . . . . . . . . 935,424 Selling, general and administrative* . . . . . . 696,615 Accounts receivable . . . . . . . . . . . . . . . . . . . . Export** $4,531,605 2,955,011 395,619 780,599 Export** $4,115,198 2,669,605 445,852 748,002 IKONICS Imaging $4,579,320 2,143,205 1,479,464 384,748 Other $ _ _ 1,649,603 (30,598) IKONICS Imaging $4,343,139 2,007,927 1,381,117 290,305 Other $ _ _ 1,620,751 (32,314) Total $14,888,912 8,181,814 4,490,381 1,976,893 Total $13,971,217 7,748,707 4,383,144 1,702,608 *The company does not allocate all general and administrative expenses to its operating segments for internal reporting. **In 2006 and 2005, the Company marketed its products in various countries throughout the world. The Company is exposed to the risk of changes in social, political, and economic conditions inherent in foreign operations, and the Company’s results of operations are affected by fluctuations in foreign currency exchange rates. No single foreign country accounted for more than 10% of the Company’s net sales for 2006 and 2005. 30.4% and 29.4%, respectively, of the Company’s net sales at December 31, 2006 and 2005 are from foreign customers. 7. STOCK OPTIONS During 1995, the Company, with the approval of its shareholders, adopted a stock incentive plan for the issuance of up to 57,750 shares of common stock. In 1999, the Company, with the approval of its shareholders, increased the number of shares reserved for issuance under this plan to 305,250 shares and, in 2004, increased the number of shares reserved for issuance under this plan to 342,750 shares. The plan provides for granting eligible participants stock options or other stock awards, as described by the plan, at option prices ranging from 85% to 110% of fair market value at date of grant. Options granted expire up to seven years after the date of grant. Such options generally become exercisable over a one to three year period. A total of 55,673 shares of common stock are reserved for additional grants of options under the plan at December 31, 2006. Under the plan, the Company charged compensation cost of $25,623 against income and recognized a total income tax benefit in the income statement of $26,482 for 2006. No compensation cost or income tax benefit was recognized in the income statement for share-based compensation in 2005. The fair value of share-based payment awards was estimated using the Black-Scholes option pricing model with the following assumptions: Dividend yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expected life of option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk-free interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 0.0% 60.6 - 63.0% five years 4.8-5.0% 2005 0.0% 63.2% five years 3.9% A summary of the status of the Company’s stock option plan as of December 31, 2006 and changes during the year then ended is presented below: Weighted Average Weighted Average Remaining Aggregate Shares Options 130,285 Outstanding at January 1, 2006 7,250 Granted (48,324) Exercised (989) Expired and forfeited Outstanding at December 31, 2006 88,222 Vested or expected to vest at December 31, 2006 87,722 73,888 Exercisable at December 31, 2006 Exercise Price $3.27 8.03 3.86 4.50 3.33 3.33 $2.75 Contractual Term (years) Intrinsic Value 1.55 1.55 1.12 $392,710 $392,710 $370,356 The weighted-average grant-date fair value of options granted was $4.58 and $2.44 for the years ended December 31, 2006 and 2005, respectively. The total intrinsic value of options exercised was $227,175 and $109,345 for the years ended December 31, 2006 and 2005, respectively. The following table summarizes information about stock options outstanding at December 31, 2006: Range of Number Outstanding at Options Outstanding Weighted- Average Remaining Exercise Price December 31, 2006 Contractual Life (years) $2.00 - 2.99 3.00 - 3.99 4.00 - 4.99 7.00 - 7.99 58,222 11,250 9,250 9,500 88,222 0.89 1.59 3.32 3.79 1.55 Options Exercisable Weighted-Average Exercise Price $2.44 3.36 4.32 7.79 $3.33 Number Exercisable at Weighted-Average December 31, 2006 58,222 11,250 2,916 1,500 73,888 Exercise Price $2.44 3.36 4.32 7.01 $2.75 T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 13 NOTES TO FINANCIAL STATEMENTS: YEARS ENDED DECEMBER 31, 2006 AND 2005 8. CONCENTRATION OF CREDIT RISK The Company maintains its cash balances primarily in one financial institution. As of December 31, 2006, the balance exceeded the Federal Deposit Insurance Corporation coverage. The Company reduces its exposure to credit risk by maintaining such balances with financial institutions that have high credit ratings. Accounts receivable are financial instruments that also expose the Company to concentration of credit risk. The large number of customers comprising the Company’s customer base and their dispersion across different geographic areas limits such exposure. In addition, the Company routinely assesses the financial strength of its customers and maintains an allowance for doubtful accounts that management believes will adequately provide for credit losses. Concentration of credit risk with respect to trade receivables is not significant. No one customer accounted for more than 10% of total receivables as of December 31, 2006. 9. LEASE EXPENSE The Company leases buildings on a month-to-month basis and equipment as needed. Total rental expense for all equipment and building operating leases was $21,000 in 2006 and $30,000 in 2005. On February 1, 2007 the Company entered into a one year lease agreement for additional warehouse space at a cost of $5,750 per month or $69,000 per year. 10. LINE OF CREDIT The Company has a $1,250,000 bank line of credit that provides for working capital financing. This line of credit is subject to annual renewal on each May 1, is collateralized by trade receivables and inventory, and bears interest at 2.00 percentage points over 30- day LIBOR. There were no outstanding borrowings under this line of credit at December 31, 2006 and 2005. 11. ACCOUNTING PRONOUNCEMENTS In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 will be effective for the Company beginning in fiscal 2007. Management does not expect this interpretation will have material effect on the Company’s our financial statements and related disclosures. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establish- es a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for the Company beginning in fiscal year 2008. Management is evaluating the statement to determine the effect, if any, on the financial statements and related disclosures. BOARD OF DIRECTORS T R O P E R L A U N N A 6 0 0 2 N O I T A R O P R O C S C I N O K I 14 Charles H. Andresen Attorney Andresen & Butterworth P.A. Duluth, MN Director Since 1979 OFFICERS Rondi Erickson Co-Owner Nokomis Restaurant Duluth, MN Director Since 2000 David O. Harris President David O. Harris, Inc. Minneapolis, MN Director Since 1965 H. Leigh Severance President Severance Capital Management Denver, CO Director Since 2000 Gerald W. Simonson President Omnetics Connector Corporation Minneapolis, MN Director Since 1978 William C. Ulland Chairman, President & CEO IKONICS Corporation Duluth, MN Director Since 1972 Robert D. Banks Vice President, International Toshifumi Komatsu Vice President, Technology Jon Gerlach Vice President, Finance, CFO Claude Piguet Executive Vice President Parnell Thill Vice President, Marketing William C. Ulland Chairman, President & CEO ADDITIONAL FINANCIAL INFORMATION Stockholders of record automatically receive quarterly earnings information, and street name holders may do so upon written request. For a copy of the Form 10-KSB, as filed with the Securities and Exchange Commission, and other finan- cial information available at no charge to stockholders, please contact: ANNUAL MEETING The Company’s annual meeting will be held April 26, 2007 at 1:00 p.m. at the Kitchi Gammi Club, 831 East Superior Street, Duluth, MN. Jon Gerlach, Chief Financial Officer IKONICS Corporation 4832 Grand Avenue Duluth, MN 55807 Phone: 218-628-2217 E-mail: jgerlach@ikonics.com FIVE-YEAR HISTORY Net Sales Pretax Income Net Income Net Cash Provided by Operations Return on Sales Return on Assets Return on Avg. Stockholders' Equity Debt to Equity Diluted EPS Stock price: High Low Close Weighted Average Shares Outstanding Weighted Average Shares & Equivalent Total Assets Total Liabilities Total Stockholders’ Equity Capital Spending 2002 $11,797,279 $460,817 $359,817 $249,117 3.0% 5.6% 6.3% 9.3% $0.19 $3.40 $1.90 $2.20 2003 $12,105,127 $632,416 $503,416 $1,400,756 4.2% 7.0% 8.2% 13.0% $0.27 $5.56 $2.03 $4.20 2004 $13,682,449 $1,031,351 $758,351 $1,261,855 5.5% 8.9% 11.0% 14.5% $0.38 $8.30 $4.48 $7.35 2005 $13,971,217 $1,256,169 $908,169 $980,047 6.5% 9.6% 11.4% 11.7% $0.46 $8.99 $4.20 $6.35 2006 $14,888,912 $1,589,765 $1,123,765 $1,075,722 7.5% 10.5% 12.3% 8.9% $0.55 $10.47 $6.26 $7.53 1,878,030 1,872,190 1,906,771 1,944,330 2,000,017 1,879,213 $6,412,159 $545,496 $5,866,663 $250,366 1,895,106 $7,194,684 $826,334 $6,368,350 $244,573 1,982,814 $8,489,988 $1,075,772 $7,414,216 $270,089 1,986,885 $9,470,799 $992,294 $8,478,505 $211,276 2,027,916 $10,743,461 $879,362 $9,864,099 $273,548 Share & per share amounts have been adjusted for the 2004 three-for-two stock split. All share and per share information presented has been adjusted as if the stock split occurred on the earliest date presented. NET SALE S 20 02- 2006 NET INCOME 20 02- 2006 $ 1 6 , 0 0 0 , 0 0 0 $ 1 4 , 0 0 0 , 0 0 0 $ 1 2 , 0 0 0 , 0 0 0 $ 1 0 , 0 0 0 , 0 0 0 $8000,000 $6 0 00,000 $ 4 , 0 0 0 , 0 0 0 $ 2 , 0 0 0 , 0 0 0 $0 2002 2003 2004 2005 200 6 $ 1 , 2 0 0 , 0 0 0 $ 1 , 0 0 0 , 0 0 0 $ 8 0 0 , 0 0 0 $ 6 0 0 , 0 0 0 $ 4 0 0 , 0 0 0 $ 2 0 0 , 0 0 0 $ 0 2002 2003 2004 20 05 2 0 06 4832 Grand Avenue, Duluth, MN 55807 | toll free: 1-800-328-4261 | phone: 218-628-2217 | fax: 218-628-3245 | www.ikonics.com | info@ikonics.com ISO 9001 CERTIFIED NASDAQ LISTED: IKNX 070301 

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