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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

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

KAYDON CORPORATION

Registrant’s telephone number, including area code (734) 747-7025

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

Common Stock Outstanding at October 25, 2002 — 30,032,469 shares, $.10 par value.

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KAYDON CORPORATION FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 28, 2002

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ITEM 1. FINANCIAL STATEMENTS
KAYDON CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS

See accompanying notes to consolidated condensed financial statements.

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KAYDON CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(UNAUDITED)

See accompanying notes to consolidated condensed financial statements.

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KAYDON CORPORATION CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)

See accompanying notes to consolidated condensed financial statements.

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KAYDON CORPORATION

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(1)		The accompanying unaudited consolidated condensed financial statements of Kaydon Corporation and subsidiaries (“Kaydon” or the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included, and such adjustments are of a normal recurring nature. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2001.
		The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” This pronouncement amends the accounting for goodwill and intangible assets. SFAS No. 142 no longer permits amortization of goodwill and indefinite-lived intangible assets. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. In addition, SFAS No. 142 establishes a new method of testing goodwill for impairment by using a fair-value approach. The amortization provisions of SFAS No. 142 apply to goodwill and intangible assets acquired after June 30, 2001. With respect to goodwill and intangible assets acquired prior to July 1, 2001, Kaydon, as required, adopted the pronouncement in the fiscal year beginning January 1, 2002. Please refer to Notes to Consolidated Condensed Financial Statements (Note 9) in this quarterly report Form 10-Q for additional information on the implementation status of SFAS No. 142 at Kaydon.
(2)		Inventories are summarized as follows:

(3)

Comprehensive income reflects the change in equity of a business enterprise during a period from transactions and other events, and from circumstances involving nonowner sources. For the Company, comprehensive income consists of net income, foreign currency translation adjustments, minimum pension liability adjustments and unrealized loss on derivative financial instruments. Other comprehensive income (loss), net of tax, was approximately $(.4) million and $1.6 million, resulting in comprehensive income (loss) of $7.9 million and $(22.8) million for the quarters ended September 28, 2002 and September 29,

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		2001. For the first three quarters, other comprehensive income (loss), net of tax, was approximately $2.0 million and $(.6) million, resulting in year to date comprehensive income (loss) of $5.5 million and $(8.1) million for the first three quarters ended September 28, 2002 and September 29, 2001.
(4)		The following table reconciles the numerators and denominators used in the calculation of basic and diluted earnings per share from continuing operations for the periods presented.

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		Options to purchase 439,300 shares of common stock at prices ranging from $24.25 to $33.3125 per share were outstanding during the third quarter of 2002, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares during that period. Options to purchase 414,200 shares of common stock at prices ranging from $24.25 to $33.3125 per share were outstanding during the third quarter of 2001, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares during that period.
		In accordance with the provisions of Statement of Financial Accounting Standards No. 128, “Earnings Per Share”, potential dilutive shares resulting from stock option plans used in the calculation of dilutive earnings per share are based on an average of the potential dilutive shares resulting from stock option plans for the periods presented.
(5)		The Company operates through individual operating units for which separate financial information is available, and for which operating results are evaluated regularly by the Company’s chief operating decision maker in determining resource allocation and assessing performance (“operating segments”). The Company’s operating segments manufacture complex and standard metal products that are sold primarily to equipment manufacturers and other assemblers or integrators. Certain of the operating segments have similar long-term average gross margins and all of them exhibit other common attributes, including the nature of the products and production processes, distribution patterns and classes of customers. As a result, based upon current and expected future long-term financial performance, the Company aggregates its operating segments into three continuing reportable segments. Prior to the fourth quarter of 2001 the Company aggregated its operating segments into a single

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		reportable segment referred to as Custom-Engineered Products. Due to changes in economic conditions affecting certain operating segments, during the fourth quarter of 2001 the Company changed the way it aggregates operating segments for purposes of reporting segment information. Prior year amounts have been reclassified to reflect the current year presentation.
		The Company has three continuing reportable segments and one discontinued reportable segment engaged in the manufacture and sale of the following:
		Specialty Metal Formed Products — complex metal products used in specialized industrial and aerospace equipment applications. Products include anti-friction bearings, split roller bearings, specialty balls, industrial shock absorbers and metal retaining devices.
		Ring, Seal and Filtration Products — complex and standard ring, seal and filtration products used in demanding industrial, aerospace, medical, electronic and marine equipment applications. Products include engine rings, sealing rings, shaft seals, slip-rings, slip-ring assemblies, fiber optic rotary joints, filter elements and filtration systems.
		Fluid Power Products — standard and custom-made hydraulic cylinders used in heavy industrial equipment applications. The Fluid Power Products business was sold on December 31, 2001. Its results have been presented separately in the consolidated financial statements in accordance with the requirements of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”
		Other Metal Products- metal alloys, machine tool components, presses, dies and benders used in a variety of industrial applications.
		The accounting policies of the operating segments are the same as those of the Company. Segment performance is evaluated based on segment operating income (which includes an estimated provision for state income taxes) and segment assets.
		Items not allocated to segment operating income include depreciation of corporate fixed assets, certain amortization and corporate administrative expenses, and other amounts. Corporate assets consist of cash and cash equivalents, fixed assets and certain prepaid expenses. The selling price for transfers between operating segments and geographic areas is generally based on cost plus a mark-up.

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(6)		At September 28, 2002, borrowings under the Company’s revolving credit facility totaled $72.2 million. The revolving credit facility permits the Company to borrow under several different interest rate options. The interest rate on borrowings equaled a weighted average 2.3 percent during the third quarter of 2002 based on the London Interbank Offered Rate (LIBOR). The revolving credit facility contains certain restrictive covenants. The Company is in compliance with all restrictive covenants contained in the revolving credit facility at September 28, 2002. After consideration of the facility’s covenants, the Company has additional available credit under its revolving credit facility of $95.6 million at September 28, 2002.
(7)		On March 1, 2001, the Company purchased for $70.6 million, all of the outstanding stock of ACE Controls, Inc. and its affiliated company ACE Controls International, Inc. (collectively, “ACE”) headquartered in Farmington Hills, Michigan, with additional facilities in Germany, the United Kingdom and Japan. ACE manufacturers a wide range of linear deceleration products serving various industrial markets. The Company utilized its revolving credit facility to finance the acquisition. The acquisition has been accounted for using the purchase method of accounting and accordingly the results of operations have been included in the financial statements since the effective acquisition date.
		On a pro forma, unaudited basis, as if the ACE acquisition had occurred as of January 1, 2001, net sales, income from continuing operations, basic earnings per share from continuing operations and diluted earnings per share from continuing operations for the first three quarters of 2001 would have been $225.0 million, $24.4 million, $.82 and $.82.
(8)		As previously reported, the Company, along with certain other companies, is a defendant in a lawsuit filed in 1995 and pending in the United States District Court for the Southern District of New York captioned Richard A. Lippe, et al. v. Bairnco Corporation, et al. (the “Transactions Lawsuit”). The Transactions Lawsuit seeks damages alleged by plaintiffs to be an amount of $700 million, plus interest and punitive damages against the defendants collectively. The

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		current status of the Transactions Lawsuit is that fact depositions and discovery were completed during April 2002, and expert discovery was completed in May 2002. On July 15, 2002, the Company filed a motion for summary judgment dismissing all the claims against it. This motion will not be fully briefed before November 29, 2002. The Court has set March 31, 2003 as the trial date for the entire action. Management continues to believe that it has meritorious defenses to the claims pending against it in this litigation. Accordingly, no provision has been reflected in the consolidated financial statements for any alleged damages. Expenditures to litigate this matter equaled $0.9 million in 1999, $2.8 million in 2000, $3.9 million in 2001, and $3.9 million during the first three quarters of 2002. During the second quarter of 2002, a $7.5 million provision was recorded in order to support the Company’s most current and best estimate of the cost to continue to litigate the Transactions Lawsuit. The change in the estimate during the second quarter resulted from recent spending levels and new information regarding forecasted spending levels to complete the trial phase. As of September 28, 2002, a $8.1 million accrual is recorded as a current liability in the consolidated financial statements, reflecting the estimated costs to litigate this matter through the trial phase. While management currently believes the amount of the ultimate liability, if any, with respect to this action will not materially affect the financial condition, results of operations, or liquidity of the Company, management realizes that the ultimate outcome of this litigation is uncertain. Were an unfavorable outcome to occur, the impact could be material to the Company.
		As previously reported, in April 2001, the Company reached a settlement with the U.S. government regarding its grand jury investigation of inspection and product certification procedures at the Company’s Muskegon, Michigan facility. The settlement included the payment of $7.5 million to the U.S. government, including a $1.0 million fine. The payment to the U.S. government was completed during April 2001 and was offset by previously recorded provisions without any impact on year 2001 earnings. In addition to the U.S. government settlement, Kaydon entered into a three-year agreement with the U.S. Department of Navy, on behalf of the U.S. Department of Defense, which confirms that Kaydon is presently eligible to contract with the U.S. government, insures that Kaydon has, and will continue to have, a program of acceptable contracting policies and procedures, and establishes and implements a program of compliance reviews, audits and reports.
		As previously reported, in July 2001, Kaydon, Kaydon’s insurance provider and the plaintiff agreed to a settlement of a lawsuit which involved one of Kaydon’s subsidiaries as the defendant, with the settlement payment to the plaintiff being shared between Kaydon and Kaydon’s insurance provider. Kaydon’s portion of the settlement payment was offset by amounts previously recorded to litigate this legal matter. The Company believes that the loss sustained in the settlement of the lawsuit is covered under Kaydon’s commercial general liability policy, and that the ultimate resolution of the litigation related to this matter between Kaydon and Kaydon’s insurance provider will not have a material effect on the Company’s consolidated financial statements.

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		In August 2000, an accident involving a MH53E helicopter manufactured by Sikorsky Aircraft Corporation, resulted in four deaths and two injuries during a military training mission. The Company manufactures and sells swashplate bearings used on MH53E helicopters. In May 2002, the Company, along with Sikorsky Aircraft Corporation, The Armoloy Corporation, Armoloy of Illinois, Inc., Armoloy of Connecticut, Inc. and Investment Holdings, Inc., was named as a defendant in a lawsuit filed by the relatives and the estates of the four deceased individuals, and by the two injured individuals, in the United States District Court for the Southern District of Texas. Currently, the Company’s insurance provider is in the process of responding to the claim. The Company believes that the alleged damages claimed in this lawsuit, and the associated legal costs, will be fully covered under the Company’s insurance policy. Further, the Company believes it has meritorious defenses to these claims including, but not limited to, the fact that the bearing utilized in the helicopter involved in the accident was inspected and approved prior to shipment by both U.S. government inspectors and Sikorsky Aircraft Corporation. Accordingly, an accrual is not recorded in the consolidated financial statements related to this legal action.
		Various other claims, lawsuits and environmental matters arising in the normal course of business are pending against the Company. An accrual is recorded in the consolidated financial statements equal to the Company’s most current and best estimates to litigate these legal actions.
(9)		As required, on January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets.” As a result, Kaydon is no longer amortizing goodwill and indefinite-lived intangible assets beginning in 2002, but is required to subject these assets to an annual impairment analysis. During the first quarter of 2002, intangible assets deemed to have indefinite useful lives were tested for impairment as of January 1, 2002, with no impairment loss being realized.
		During the second quarter of 2002, the Company completed the first step of the two-step transitional goodwill impairment test required by SFAS No. 142. Step one is designed to identify potential impairment by comparing the fair value of the Company’s reporting units, as that term is defined by SFAS No. 142, with the reporting unit’s carrying amount. As required by SFAS No. 142, the comparison was done as of January 1, 2002. Fair values of the reporting units were estimated using the expected present value of future cash flows. As a result of completing step one, the Company identified two reporting units whose carrying amount exceeded their fair value, which indicates potential goodwill impairment. Both reporting units are part of the Company’s “Other Metal Products” reporting segment. The aggregate total carrying amount of goodwill at these two reporting units was $19.3 million as of January 1, 2002.
		During the third quarter of 2002, the Company engaged a valuation specialist to assist it in completing step two of the transitional goodwill impairment test, which measures the amount of any impairment loss by comparing the implied fair value

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		of the reporting unit’s goodwill with the carrying amount of that goodwill. As a result of completing step two of the transitional goodwill impairment test, the Company determined that the implied fair value of the goodwill of the two aforementioned reporting units equaled $2.5 million. Therefore, under SFAS No. 142, the Company incurred a pre-tax, non-cash goodwill impairment loss of $16.8 million as of January 1, 2002. The two reporting units are expected to generate positive future cash flows, but under the provisions of SFAS No. 142 the present values of those cash flows (reporting unit fair value) resulted in the implied fair value of goodwill being significantly less than the carrying amount. Under previous guidance, specifically Accounting Principles Board Opinion No. 17, goodwill was tested for impairment using an undiscounted cash flow (recoverability) approach. In accordance with SFAS No. 142, the $16.8 million goodwill impairment loss ($13.2 million or $.44 per share on an after tax, diluted basis) was recognized as the cumulative effect of a change in accounting principle as of January 1, 2002. Therefore, previously reported quarter and cumulative year-to-date results have been restated to reflect the goodwill impairment loss.
		During the second quarter of 2002 the Company acquired the net assets of a small, privately-held manufacturing company for $4.4 million, of which $0.2 million was assigned to a patent acquired and $1.8 million was recognized as goodwill. The patent is being amortized over its estimated useful life of 10 years. The goodwill is being reported as part of the Company’s “Ring, Seal and Filtration Products” reporting segment, and will not be amortized, but will be subject to annual impairment testing.

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The changes in the carrying amount of goodwill for the first three quarters ended September 28, 2002, are as follows:

For comparability purposes, the following table is presented as if goodwill and indefinite lived intangible assets were no longer amortized as January 1, 2001: