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NATIONAL PRESTO INDUSTRIES INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 8, 2014

Forward-looking statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations, elsewhere in this Form 10-Q, in the Company's 2013 Annual Report to Shareholders, in the Proxy Statement for the annual meeting held May 20, 2014, and in the Company's press releases and oral statements made with the approval of an authorized executive officer are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. There are certain important factors that could cause results to differ materially from those anticipated by some of the statements made herein. Investors are cautioned that all forward-looking statements involve risks and uncertainty. In addition to the factors discussed herein and in the notes to consolidated financial statements, among the other factors that could cause actual results to differ materially are the following: consumer spending and debt levels; interest rates; continuity of relationships with and purchases by major customers; product mix; the benefit and risk of business acquisitions; competitive pressure on sales and pricing; increases in material, freight/shipping, or production cost which cannot be recouped in product pricing; delays or interruptions in shipping or production from machine issues; work or labor disruptions stemming from a unionized work force; changes in government requirements and funding of government contracts; failure of subcontractors or vendors to perform as required by contract; the efficient start-up and utilization of capital equipment investments; and political actions of federal and state governments which could have an impact on everything from the value of the U.S dollar vis-À-vis other currencies to the availability of affordable labor and energy. Additional information concerning these and other factors is contained in the Company's Securities and Exchange Commission filings.

Comparison of Second Quarter 2014 and 2013

Readers are directed to Note D to the Consolidated Financial Statements, "Business Segments," for data on the financial results of the Company's three business segments for the quarters ended June 29, 2014 and June 30, 2013.

On a consolidated basis, sales decreased by $13,084,000 (13%), gross profit decreased by $2,269,000 (12%), selling and general expenses increased by $1,014,000 (19%), intangibles amortization increased by $3,215,000 (1,937%) and other income increased by $1,000 (1%). Earnings before the provision for income taxes decreased by $6,497,000 (50%), as did net earnings by $4,130,000 (50%). Details concerning these changes can be found in the comments by segment below.

Housewares/Small Appliance net sales decreased by $2,540,000 from $24,489,000 to $21,949,000, or 10%, primarily reflecting a decrease in shipments. Defense net sales decreased by $8,149,000 from $58,516,000 to $50,367,000, or 14%, primarily related to reduced shipments of 40mm ammunition and cartridge cases. Absorbent Products net sales decreased by $2,395,000 from $18,391,000 to $15,996,000, or 13%, and was largely attributable to a reduction of shipments due to the ongoing shift in the segment's customer base.

Housewares/Small Appliance and Defense segments' gross profits were essentially flat. Absorbent Products gross profit decreased $1,835,000 from a $369,000 profit to a $1,466,000 loss, primarily reflecting the decrease in sales mentioned above, increased material costs, and costs associated with the installation and startup of new capital equipment.

Selling and general expenses for the Housewares/Small Appliance segment increased $208,000, primarily reflecting increased benefit and self insurance accruals. Defense segment selling and general expenses increased by $606,000, primarily reflecting ongoing operational costs associated with the acquisition of substantially all of the assets from Chemring Energetic Devices, Inc.'s business, as described in Note H to the Consolidated Financial Statements in Part I of this Form 10-Q ("Tech Ord"), and increased employee compensation and benefit costs. Absorbent Products segment selling and general expenses increased $200,000, primarily reflecting the absence of the prior period's favorable adjustments to the segment's provision for bad debts and expenses classified as administrative that related to a royalty arrangement with an independent manufacturing facility. A description of the Company's relationship with the facility can be found in Note S to the Company's Consolidated Financial Statements for the year ended December 31, 2013 on Form 10-K.

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Intangibles amortization increased by $3,215,000, primarily reflecting the amortization of the customer contract intangible asset corresponding to the quarter's shipment of a portion of the backlog acquired from DSE, Inc., one of the Company's competitors in the Defense segment. The asset acquisition is described in Note Q to the Company's 2013 Consolidated Financial Statements on Form 10-K. For the quarter ended June 29, 2014, the Company recorded amortization expense of $3,179,000 associated with the customer contract intangible asset.

The above items were responsible for the change in operating profit.

Earnings before provision for income taxes decreased $6,497,000 from $12,966,000 to $6,469,000. The provision for income taxes decreased from $4,665,000 to $2,298,000, primarily reflecting a decrease in taxable earnings. Net earnings decreased $4,130,000 from $8,301,000 to $4,171,000, or 50%.

Comparison of First Six Months 2014 and 2013

Readers are directed to Note D to the Consolidated Financial Statements, "Business Segments," for data on the financial results of the Company's three business segments for the first six months ended June 29, 2014 and June 30, 2013.

On a consolidated basis, sales decreased by $9,720,000 (5%), gross profit decreased by $2,758,000 (8%), selling and general expenses increased by $1,625,000 (15%), intangibles amortization increased by $5,491,000 (1,649%) and other income decreased by $43,000 (12%). Earnings before the provision for income taxes decreased by $9,917,000 (42%), as did net earnings by $6,294,000 (42%). Details concerning these changes can be found in the comments by segment below.

Housewares/Small Appliance net sales decreased by $8,066,000 from $49,378,000 to $41,312,000, or 16%, primarily reflecting a decrease in shipments. Defense net sales increased by $1,189,000 from $97,467,000 to $98,656,000, or 1%, reflecting increases in unit sales of non 40mm ammunition, offset by decreases in sales of 40mm ammunition and cartridge cases. Absorbent Products net sales decreased by $2,843,000 from $37,741,000 to $34,898,000, or 8%, and was largely attributable to the ongoing shift in the segment's customer base.

Housewares/Small Appliance gross profit decreased $834,000 from $9,031,000 to $8,197,000, or 9%, primarily reflecting the decrease in sales mentioned above, offset in part by an adjustment to the warranty accrual. Defense gross profit increased $971,000 from $23,534,000 to $24,505,000, or 4%, primarily attributable to the increase in sales mentioned above, augmented by an improved product mix. Absorbent Products gross profit decreased $2,895,000 from a $2,055,000 profit to an $840,000 loss, primarily reflecting the decrease in sales mentioned above, increased material costs, cost associated with the installation of new capital equipment, and the absence of the prior year's insurance settlement of $553,000.

Selling and general expenses for the Housewares/Small Appliance segment increased $154,000, primarily reflecting increased benefits cost and self insurance accruals. Defense segment selling and general expenses increased by $1,207,000, primarily reflecting ongoing operational costs associated with the acquisition of Tech Ord mentioned above and increased employee compensation and benefits costs. Absorbent Products segment selling and general expenses increased $264,000, primarily reflecting the absence of the prior period's favorable adjustments to the segment's expenses classified as administrative that related to a royalty arrangement with an independent manufacturing facility. A description of the Company's relationship with the facility can be found in Note S to the Company's Consolidated Financial Statements for the year ended December 31, 2013 on Form 10-K.

Intangibles amortization increased by $5,491,000, primarily reflecting the amortization of the customer contract intangible asset corresponding to the first six months' shipment of a portion of the backlog acquired from DSE, Inc., one of the Company's competitors in the Defense segment. The asset acquisition is described in Note Q to the Company's 2013 Consolidated Financial Statements on Form 10-K. For the six months ended June 29, 2014, the Company recorded amortization expense of $5,398,000 associated with the customer contract intangible asset.

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The above items were responsible for the change in operating profit.

Earnings before provision for income taxes decreased $9,917,000 from $23,532,000 to $13,615,000. The provision for income taxes decreased from $8,377,000 to $4,754,000, primarily reflecting a decrease in taxable earnings. Net earnings decreased $6,294,000 from $15,155,000 to $8,861,000, or 42%.

Liquidity and Capital Resources

Net cash provided by operating activities was $33,667,000 and $1,113,000 for the six months ended June 29, 2014 and June 30, 2013, respectively. The principal factors contributing to the increase can be found in the changes in the components of working capital within the Consolidated Statements of Cash Flows. Of particular note during the first six months of 2014 were net earnings of $8,861,000, which included total non-cash depreciation and amortization expenses of $10,537,000, a decrease in accounts receivable levels stemming from cash collections on customer sales, and a decrease in deposits made with raw material suppliers included in other current assets. These were partially offset by a decrease in payable and accrual levels and an increase in inventory levels. Of particular note during the first six months of 2013 were net earnings of $15,155,000, which included total non-cash depreciation and amortization expenses of $4,514,000; increases in inventory levels and deposits made with raw material suppliers included in other current assets, partially offset by a decrease in accounts receivable levels stemming from cash collections on customer sales, and a net decrease in payable and accrual levels.

Net cash used in investing activities was $2,007,000 during the first six months of 2014 compared to $2,918,000 used in investing activities during the first six months of 2013. The change in investing activity cash flow is primarily attributable to the acquisition of substantially all of the assets from Chemring Energetic Devices, Inc.'s business located in Clear Lake, South Dakota and the real property owned by Technical Ordnance Realty, LLC during the first quarter of 2014 mentioned above; an increase in net proceeds from marketable securities activity; and a decrease in the acquisition of property, plant, and equipment.

Cash flows from financing activities for the first six months of 2014 and 2013 primarily differed as a result of an accelerated payment made in late December 2012 of the annual 2013 dividend. The acceleration was occasioned by the uncertainty over the federal income tax rates that would be in effect in 2013. In contrast, the annual 2014 dividend payment was made during the first quarter of 2014.

Working capital decreased by $24,350,000 during the first six months of 2014 to $185,493,000 at June 29, 2014 for the reasons stated above. The Company's current ratio was 5.3 to 1.0 at June 29, 2014 and 4.9 to 1.0 at December 31, 2013.

The Company expects to continue to evaluate acquisition opportunities that align with its business segments and will make further acquisitions, as well as continue to make capital investments in these segments per existing authorized projects and for additional projects if the appropriate return on investment is projected.

The Company has substantial liquidity in the form of cash and cash equivalents and marketable securities to meet all of its anticipated capital requirements, to make dividend payments, and to fund future growth through acquisitions and other means. The bulk of its marketable securities are invested in the tax exempt variable rate demand notes described above and in municipal bonds that are pre-refunded with escrowed U.S. Treasuries. The Company intends to continue its investment strategy of safety and short-term liquidity throughout its investment holdings.

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Critical Accounting Policies

The preparation of the consolidated financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the amount of reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and revenues and expenses during the periods reported. Actual results may differ from those estimates. The Company reviewed the development and selection of the critical accounting policies and believes the following are the most critical accounting policies that could have an effect on the Company's reported results. These critical accounting policies and estimates have been reviewed with the Audit Committee of the Board of Directors.

Inventories

New Housewares/Small Appliance product introductions are an important part of the Company's sales to offset the morbidity rate of other Housewares/Small Appliance products and/or the effect of lowered acceptance of seasonal products due to weather conditions. New products entail unusual risks and have occasionally in the past resulted in losses related to obsolete or excess inventory as a result of low or diminishing demand for a product. There were no such obsolescence issues that had a material effect during the current period, and accordingly, the Company did not record a reserve for obsolete product. In the future should product demand issues arise, the Company may incur losses related to the obsolescence of the related inventory. Inventory risk for the Company's other segments is not deemed to be significant, as products are largely built pursuant to customers' specific orders.

Self-Insured Product Liability and Health Insurance The Company is subject to product liability claims in the normal course of business and is self-insured for health care costs, although it does carry stop loss and other insurance to cover claims once a health care claim reaches a specified threshold. The Company's insurance coverage varies from policy year to policy year, and there are typically limits on all types of insurance coverage, which also vary from policy year to policy year. Accordingly, the Company records an accrual for known claims and incurred but not reported claims, including an estimate for related legal fees in the Company's consolidated financial statements. The Company utilizes historical trends and other analysis to assist in determining the appropriate accrual. There are no known claims that would have a material adverse impact on the Company beyond the reserve levels that have been accrued and recorded on the Company's books and records. An increase in the number or magnitude of claims could have a material impact on the Company's financial condition and results of operations.

Sales and Returns Sales are recorded net of discounts and returns. The latter pertain primarily to warranty returns, returns of seasonal items, and returns of those newly introduced products sold with a return privilege. The calculation of warranty returns is based in large part on historical data, while seasonal and new product returns are primarily developed using customer provided information.

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