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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2003

For the transition period from                      to                     

Commission file number 000-13059

CERADYNE, INC.

(Exact name of registrant as specified in its charter)

(714) 549-0421

(Registrant’s telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Securities Exchange Act Rule 12b-2).

YES x NO ¨

As of February 20, 2004, the aggregate market value of the Common Stock held by non-affiliates was approximately $335,335,414.

As of February 20, 2004, there were 10,626,669 shares of registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE: None

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PART I

FORWARD-LOOKING STATEMENTS

This annual report on Form 10-K contains forward-looking statements including statements concerning the future of our industry, product development, business strategy, continued acceptance of our products, market growth, and dependence on significant customers. These statements can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” or other similar words. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this report, including, in particular, those discussed in the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The risk factors and other factors noted throughout this report could cause our actual results to differ significantly from those contained in any forward-looking statement. Except as required by law, we undertake no obligation to update publicly any forward-looking statements contained in this report to conform these statements to actual results or to changes in our expectations.

Introduction

We develop, manufacture and market advanced technical ceramic products and components for defense, industrial, automotive/diesel and commercial applications. Our competitive advantage results from our expertise in ceramic material science as well as our vertically integrated approach of designing much of our key equipment and controlling the manufacturing process from raw material powders to finished product. This allows us to design and manufacture precision, high quality advanced technical ceramic products to meet demanding customer specifications. Our customers include the U.S. government, prime government contractors and large industrial and commercial manufacturers.

In many high performance applications, products made of advanced technical ceramics meet specifications that similar products made of metals, plastics or traditional ceramics cannot achieve. Advanced technical ceramics can withstand extremely high temperatures, combine hardness with light weight, are highly resistant to corrosion and wear, and often have excellent electrical insulation capabilities, special electronic properties and low friction characteristics.

Our primary products include:

The principal factor contributing to our recent growth in sales is increased demand by the U.S. military for ceramic body armor that protects soldiers. The ongoing adoption of ceramic body armor by the military is driven by a growing recognition of the technical advancement of materials available and the life saving benefits of lightweight ceramic body armor. Recent military conflicts in Afghanistan and Iraq, as well as an increasingly unstable geopolitical climate and the heightened risk of international conflicts, have resulted in increased orders for these products. Ceramic armor contracts generally are awarded in an open competitive bidding process. Our future level of sales of ceramic body armor will depend on our ability to successfully compete for this business.

We have also developed other products that could have a significant impact on our long-term growth, including:

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To meet increasingly higher performance standards, advanced technical ceramics have stringent technical manufacturing requirements. We have designed and customized our facilities and capital equipment to enhance our advanced technical ceramic manufacturing processes. We recently implemented lean manufacturing initiatives to lower costs and achieve further efficiencies in our manufacturing processes, and are expanding our facilities to add manufacturing capacity.

Our goal is to profitably develop, manufacture and sell advanced technical ceramic components to customers and markets where there is a need for new materials that will increase the efficiency, productivity and life of our customers’ end products. Key elements of our strategy for achieving this goal include:

We conduct our operations primarily from our three domestic manufacturing locations. Our principal executive offices are located at 3169 Red Hill Avenue, Costa Mesa, California 92626, and our telephone number is (714) 549-0421. We maintain a web site at www.ceradyne.com. The reference to our web site address does not constitute incorporation by reference into this report of the information contained at that site. We are organized as a Delaware corporation.

Industry Background

Evolving customer requirements in industrial processing, military systems, microwave electronics, automotive/diesel engine products and orthodontics have generated a demand for high performance materials with properties not readily available in metals, plastics or traditional ceramics. In some high performance applications, this demand has been met by products made of advanced technical ceramics.

The following table compares favorable typical properties of selected advanced technical ceramics with those of other selected materials.

Ceramics such as earthenware, glass, brick and tile have been made for centuries and are still in common use today. The inertness and lasting qualities of ceramics are illustrated by artifacts uncovered intact in modern times. Almost all traditional ceramics, including those of ancient times, were based on clay. In the last fifty years, significant advances have been made in ceramic technology by applying specialized manufacturing processes to produce synthetic ceramic powders. Developments in aluminum oxide and other oxides provided ceramics that are excellent electrical insulators and are capable of withstanding high temperatures. In addition, industry advancements in ceramic material science have led to the development of a class of ceramics that are generally non-oxides, such as carbides, borides and nitrides. These materials generally have mechanical properties that exceed those of oxide ceramics developed in prior periods. Collectively, these developments resulted in the ability to manufacture ceramics with great strength at elevated

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temperatures and reduced brittleness, historically a primary limitation of ceramics. The products that have emerged from these advances are known as advanced technical (or structural) ceramics.

The properties of advanced technical ceramics present a compelling case for their use in a wide array of modern applications. However, to meet increasingly higher performance standards, advanced technical ceramics have stringent technical manufacturing requirements. The specialized equipment required to manufacture advanced technical ceramics must often be custom designed and is not readily available, requiring a significant investment in capital equipment and facilities to allow volume production. Manufacturing costs associated with the production of these materials are generally higher than the materials they replace. A portion of these costs is related to the need for diamond grinding finished components to exacting tolerances. To accelerate the use of advanced technical ceramics as a direct replacement for metals, plastics or other ceramics, these manufacturing costs need to be reduced. Cost reduction efforts include the production of blanks or feed stock to “near net shape” configurations in order to reduce the amount of diamond grinding needed. Manufacturers are also seeking to reduce costs through the use of high volume automated processing and finishing equipment and techniques, and to achieve economies of scale in areas such as powder processing, blank fabrication, firing, finishing and inspection.

Our Solution

We develop, manufacture and market advanced technical ceramic products and components for defense, industrial, automotive/diesel and commercial applications. Our competitive advantage results from our expertise in ceramic material science as well as our vertically integrated approach of designing much of our key equipment and controlling the manufacturing process from raw material powders to finished product. This allows us to design and manufacture precision, high quality advanced technical ceramic products to meet demanding customer specifications.

The following table illustrates some of the solutions we have designed to meet market opportunities and demands.

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Our Business Strategy

Our goal is to profitably develop, manufacture and sell advanced technical ceramic components to customers and markets where there is a need for new materials that will increase the efficiency, productivity and life of our customers’ end products. Key elements of our strategy for achieving this goal include:

Capitalizing on Opportunities in the Defense Market. We expect that the current geopolitical climate, terrorist threats and heightened risk of international conflict will continue to drive demand for our defense products. Our defense marketing and sales efforts will emphasize sales of ceramic armor and missile radomes (nose cones) to the U.S. government and, with the authorization of the U.S. government, to foreign allies of the United States. We intend to expand our lightweight ceramic armor products to address new applications in military boats, vehicles and aircraft.

Investing to Improve our Gross Margins and Manufacturing Efficiencies. We will continue to implement lean manufacturing initiatives such as Demand Flow^® Technology to reduce inventories and queue times and to increase productivity in order to improve gross profit margins. We intend to expand our in-line production efficiency by using automation and dedicated work cells. We anticipate that as we increase production volumes, we will further implement productivity-enhancing automation.

We are currently renovating, and plan to relocate some of our high energy-utilization manufacturing processes to a 115,000 square foot building that we recently purchased near our Lexington, Kentucky facility where, in addition to other benefits, electricity costs, which are a material part of our cost of product sales, can be reduced significantly. We intend to establish strategic manufacturing relationships in certain international markets, including joint ventures or acquisitions, particularly in low cost manufacturing areas such as Mexico and China. We plan to develop strategic relationships with other manufacturing companies or key customers whose expertise or financial resources can assist us in accomplishing our objectives.

Identifying New Products and Markets. We intend to identify new products and markets to meet evolving customer requirements for high performance materials. Often our customers may have a materials problem, or need, and may not be familiar or comfortable with the advantages of our advanced technical ceramics. We are committed to educating our current and potential customers and assisting them in developing new technical ceramic components for existing or new products and applications. We seek to educate our customers through technical paper presentations and product literature, by participating in technical or trade show meetings and exhibitions and by maintaining a highly qualified technical sales and marketing staff.

Continuing to Diversify our Non-Defense Revenue Base. We currently depend on the U.S. government for a substantial portion of our revenues. We will continue to grow our customer base, primarily through promoting existing products to new customers and developing new products for new and existing customers. We intend to further diversify our customer product and market base by converting certain advanced technical ceramics, originally developed for defense applications, to industrial and commercial applications.

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Leveraging our Facilities and Technologies to Address New Products and Markets. Over the past two decades, we have designed, constructed and refined a substantial array of highly specialized and customized facilities and equipment for the manufacture of a series of advanced technical ceramics. In conjunction with these manufacturing facilities, we have designed equipment and developed processes that we believe allows us to enter new markets. We intend to leverage our equipment and technology to rapidly respond to new product and market opportunities as we identify them.

Increasing our Export Sales. In recent years we established sales offices in China and England, in addition to commissioned sales representatives in Italy, Germany, Israel, Japan, South Korea, Taiwan and Scandinavia to allow us to better market our products outside the United States. Furthermore, we intend to leverage our existing customer relationships by marketing our products to foreign companies which are affiliated with U.S. companies with whom we are currently doing business. To accomplish each of these goals, we intend to continue to participate in trade shows outside the United States and to further train our export sales and marketing group (both direct employees and independent manufacturing representatives) through training sessions and annual corporate meetings.

Market Applications and Products

Our products are sold into four principal markets: defense, industrial, automotive/diesel and commercial. The following is a description of our principal products by market application:

Defense

Lightweight Ceramic Armor. We have developed and currently manufacture lightweight ceramic armor capable of protecting against threats as great as 12.7mm armor piercing machine gun bullets. Compared to traditional steel armor plates, our ceramic armor systems offer weight savings as great as 40%. Using hot pressed Ceralloy^® ceramic, our armor plates are laminated with either Kevlar^™, Spectra Shield^™, fiberglass, zylon or custom hybrid laminates and formed into a wide variety of shapes, structures and components. Initially, our manufactured ceramic armor was used principally for military helicopter crew seats and airframe panels. We are now also a major supplier of lightweight ceramic body armor for the U.S. military, and we believe we are a leading producer of lightweight ceramic armor for military helicopters. We are also developing products to address similar ballistic protection needs in boats, aircraft and other vehicles.

Missile Radomes (Nose Cones). We manufacture conical shaped, precision machined ceramic radomes which are designed for the front end of defensive missiles. These radomes are used where missile velocities are high and operating environments are severe, and the thermal shock and erosion resistance, high strength and microwave transparency properties of advanced technical ceramics are required. We expect that our ceramic radomes will be used on the PAC-3 (Patriot Advanced Capability) and the Arrow Missile.

Industrial

Industrial Wear Components. Our industrial wear components are made primarily of our Ceralloy^® 147 sintered reaction bonded silicon nitride (SRBSN). These SRBSN ceramic components are generally incorporated in high wear areas of industrial machinery where severe abrasive conditions would otherwise wear out vital components. Our wear resistant parts are used to replace parts made of materials such as tungsten carbide or ceramics such as aluminum oxide. Applications include paper making equipment, abrasive blasting nozzles, metal cutting tool inserts as well as custom products.

Semiconductor Equipment Components. The advanced equipment used to process silicon wafers creates harsh process environments that limit the life of traditional ceramic and metal components and produce particulate contamination that lowers wafer yields. We offer the industry advanced technical ceramics that have exceptional corrosion resistance, high thermal conductivity and other key properties that are essential to the manufacture of high quality semiconductors at acceptable yields.

Tempered Glass Furnace Components and Metallurgical and Industrial Tooling. Fused silica ceramic does not, to any material extent, expand when heated or contract when cooled. This material is therefore used for industrial tooling components and molds where complicated shapes and dimensions are maintained over a wide range of temperatures. Such applications include forming and shaping titanium metal used in aircraft manufacture. Other applications take advantage of fused silica’s excellent thermal shock resistance and inertness when in contact with glass. We produce fused silica ceramic rollers up to 14 feet in length used in glass tempering furnaces.

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Ceramic-Impregnated Dispenser Cathodes. We manufacture ceramic-impregnated dispenser cathodes for microwave tubes used in radar, satellite communications, electronic countermeasures and other applications. Dispenser cathodes, when heated, provide the stream of electrons which are magnetically focused into an electron beam. Microwave dispenser cathodes are primarily composed of a porous tungsten matrix impregnated with ceramic oxide compounds. The use of ceramic-impregnated cathodes reduces the amount of energy necessary to create a high level of electron emissions. Our ceramic-impregnated cathodes are also used in ion lasers and cathode ray tubes.

Samarium Cobalt Permanent Magnets. We manufacture and market our samarium cobalt magnets as components primarily for microwave tube applications. Electron beams in microwave tubes generated by the dispenser cathodes described above can be controlled by the magnetic force provided by these powerful permanent magnets. The magnets are generally small sub-components of microwave traveling wave tubes.

Precision Ceramics. We manufacture a variety of hot pressed Ceralloy^® ceramic compositions that are precision diamond ground to exacting tolerances, primarily for microwave tube applications. The interior cavities of microwave tubes often require microwave absorbing ceramic components capable of operating at elevated temperatures and in high vacuums.

Fused Silica Ceramic Crucibles. We manufacture fused silica ceramic crucibles, or receptacles, which are used in the fabrication of polycrystal silicon for photovoltaic cells that convert sunlight into electricity. These crucibles are designed to withstand high temperatures and thermal shock when in contact with molten silicon, without contaminating the melt.

Automotive/Diesel

Diesel Engine Components. We have been manufacturing ceramic cam rollers for heavy-duty diesel engines since 1999, and now have production contracts to supply cam rollers to two major engine companies. We also have a supply contract with a fuel systems manufacturer for components for a diesel fuel pump. In addition, we are engaged in development projects with a number of other diesel engine and fuel systems manufacturers worldwide for various ceramic components.

Ceramic Armor System Components for Civilian Vehicles. We have been selected by Ford Motor Company to manufacture and supply lightweight ceramic armor system components for incorporation into the Lincoln Town Car Ballistic Protection Series (BPS). Our components will incorporate technology and ballistic protection similar to that which we developed for several defense related applications. This product has been in development for the past two years and was introduced in January 2003. Ford is expected to release the vehicle for sale in the second quarter of 2004.

Commercial

Ceramic Orthodontic Brackets. In orthodontics, to correct a patient’s tooth alignment, a small stainless steel bracket is attached to each tooth. These brackets provide a guide to the archwire, which is the wire that sets into each bracket. The cosmetic appearance of this metal is often considered unattractive. Together with 3M Unitek, we have developed a patented ceramic bracket which 3M Unitek markets to orthodontists under the brand name Clarity^™. The translucency of this ceramic bracket, together with the classic ceramic properties of hardness, chemical inertness and imperviousness, result in a cosmetic substitute for traditional stainless steel brackets. These brackets reveal the natural color of the patient’s teeth while performing the structural functions of traditional stainless steel brackets.

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Operating Divisions and Facilities

We serve our markets from manufacturing facilities in three locations across the United States. The following table includes a summary of our facilities and manufacturing structure.

The financial information for all segments is presented within footnote 6 in our consolidated financial statements included in this report.

Sales, Marketing and Customers

Each of our three manufacturing locations maintains an autonomous sales and marketing force promoting its individual products. As of December 31, 2003, we had 15 employees directly involved in sales and marketing, including a marketing manager located in England, and a sales manager located in China.

We also have agreements with manufacturers’ representatives in foreign countries who are compensated as a percent of sales in their territory. We are focusing much of our marketing effort outside the United States through direct involvement of senior management personnel from our U.S. facilities. Revenues from export sales represented approximately 5.4% of our net sales in 2003, 10.9% in 2002 and 15.9% in 2001.

We continue to explore various domestic, international and other relationships to increase our sales and market penetration. We seek long-term relationships such as multi-year agreements or exclusive relationships with our customers to promote a smoother, more predictable flow of orders and shipments.

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We sell products and components to the U.S. government and government agencies, as well as to government contractors, original equipment manufacturers and to end users. The U.S. government and government agencies collectively represented approximately 53.7% of our net sales in 2003, 35.9% in 2002 and 17.0% in 2001.

We sell our translucent ceramic orthodontic brackets only to 3M Unitek under an exclusive agreement. Sales to 3M Unitek represented approximately 8.9% of our net sales in 2003, 11.5% in 2002 and 17.6% in 2001. In March 1986, we entered into a joint development and supply agreement with 3M Unitek for the development of a translucent ceramic bracket for orthodontic appliances, commonly known as braces. 3M Unitek is a major manufacturer of stainless steel orthodontic brackets and, early in our relationship, shared with us the functional specifications and properties which ceramic brackets would be required to satisfy. With this information and our experience with translucent ceramics in defense applications, we developed, and in 1987 began manufacturing, translucent ceramic brackets. 3M Unitek may or may not continue to actively market our ceramic orthodontic brackets, and our agreement with 3M Unitek does not require it to maintain any level of commitment to our products.

Manufacturing

We employ a number of advanced technical ceramics manufacturing processes that enable us to deliver high quality products designed to meet specific customer requirements. These processes are described below.

Hot Pressing. Our hot pressing process is generally used to fabricate ceramic shapes for lightweight ceramic armor and semiconductor equipment components. We have designed and constructed induction heated furnaces capable of operating at temperatures exceeding 4,000°F in inert atmospheres at pressures up to 5,000 pounds per square inch. With this equipment, we can fabricate parts more than 26 inches in diameter, which is considered large for advanced technical ceramics. Using multiple cavity dies and special tooling, we can produce a number of parts in one furnace during a single heating and pressing cycle.

Our raw materials are fine powders procured from several outside suppliers. After we process them, the powders are either loaded directly into the hot pressing molds or are shaped into pre-forms prior to loading into the hot pressing molds. The powders are placed in specially prepared graphite tooling, most of which we machine to shape. Heat and pressure are gradually applied to the desired level, carefully maintained and finally reduced. The furnace is removed from the press while cooling to permit the press to be used with another furnace. For most products, this cycle takes approximately 20 hours. The resultant ceramic product generally has mechanical, chemical and electrical properties of a quality approaching theoretical limits. Almost all products, other than armor, are then finished by diamond grinding to meet precise dimensional specifications.

Sintering and Reaction Bonding of Silicon Nitride. The sintering of reaction bonded silicon nitride results in our Ceralloy^® 147 SRBSN, which is used in industrial and automotive/diesel applications. This SRBSN process begins with relatively inexpensive high purity elemental silicon (Si) powders, which contrasts sharply with most other competitors’ manufacturing techniques which start with relatively more expensive silicon nitride (Si₃N₄) powders.

After additives are incorporated by milling and spray drying, the silicon powders are formed into shapes through conventional ceramic processing such as dry pressing. These shapes are then fired in a nitrogen atmosphere which converts the silicon part to a silicon nitride part. At this step (reaction bonding), the silicon nitride is pressure sintered in an inert atmosphere increasing the strength of the component threefold. As a result of SRBSN processing, the ceramic crystals grow in an intertwining “needle-like” fashion which we have named NeedleLok^™. The NeedleLok^™ structure results in a tough, high fracture energy part. This process is relatively economical due to the low cost of the starting powders and can be used to produce extremely high production volumes of parts due to the use of conventional pressing processes.

Fabrication of Translucent Ceramics (Transtar^®). We produce translucent aluminum oxide (Transtar^®) components primarily for use as orthodontic ceramic brackets. We purchase the high purity powders from outside vendors and process them using dedicated conventional ceramic mechanical dry presses. The formed blanks are then fired in a segregated furnace in a hydrogen atmosphere at over 3,000°F until the ceramics enter into a mechanically strong, translucent condition. These fired aesthetic brackets then have certain critical features diamond ground into them. The next step is a proprietary treatment of the bonding side in order to permit a sound mechanical seal when bound to the patient’s teeth. In the final step we furnace braze a stainless steel channel into each archwire slot which has been previously diamond ground into the bracket.

Diamond Grinding. Many of our advanced technical ceramic products must be finished by diamond grinding because of their extreme hardness. Our finished components typically are machined to tolerances of ±.001 inch and

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occasionally are machined to tolerances up to ±.0001 inch. To a limited extent, we also perform diamond grinding services for customers independently of our other manufacturing processes to specifications provided by the customer. Our diamond grinding facilities can perform surface grinding, diameter grinding, ultrasonic diamond grinding, diamond lapping, diamond slicing and honing. The equipment includes manual, automatic and computer numerically controlled (CNC) grinders. We have specially adapted the CNC grinders for precision grinding of ceramic contours to exacting tolerances.

Sintering of Fused Silica Ceramics. Sintering of fused silica ceramics is the process we use to fabricate fused silica ceramic shapes for applications in glass tempering furnaces, metallurgical tooling, missile radomes (nose cones) and other industrial uses. To fabricate fused silica ceramic shapes, fused silica powders are made into unfired shapes through slip casting or other ceramic compaction processes. These unfired “green” shapes are fired as they move through a continuously operated 150 foot long tunnel kiln at temperatures up to 2,500°F. The final shapes are often marketed in the “as fired” condition or, in some cases, precision diamond ground to achieve specific dimensional tolerances or surface finishes required by certain customers.

Ceramic-Impregnated Dispenser Cathode Fabrication. Ceramic-impregnated dispenser cathode fabrication is used to produce cathodes for microwave power tube applications. To produce ceramic-impregnated dispenser cathodes, both tungsten metal powders and ceramic powders are used. The tungsten metal powders are isostatically pressed in polymer tooling, removed and fired in special atmospheres at temperatures in excess of 4,000°F. The tungsten billets are machined into precision shapes with exacting tolerances. The tungsten machined shapes are impregnated with a ceramic composite and fired at high temperatures in special atmospheres. The ceramic impregnated components are assembled and furnace brazed.

Final processing includes the insertion of a metal heating element within a ceramic insulating compound and the addition of an extremely thin layer of precious metals to the surface. Our final quality inspection often includes a test of the cathode’s electron emitting capabilities at normal operating temperatures.

Fabrication of Samarium Cobalt Permanent Magnets. The fabrication of samarium cobalt permanent magnets results in various magnet shapes which are primarily used in microwave tube applications. We procure premixed samarium cobalt powder either as SmCo₅ or Sm₂Co₁₇ compositions. The powders are then milled and formed into the final configuration by pressing in a magnetic field using a specially designed magnet press. These “pre-fire” or “green” magnets are then sintered at 2,000°F in helium or a vacuum. The magnets may then be subsequently diamond ground and measured and sorted by each individual magnet’s strength.

Raw Materials. The starting raw materials for our manufacturing operations are generally fine, synthetic powders available from several domestic and foreign sources. Other raw materials, such as Kevlar^™, Spectra Shield^™, graphite and metal components are readily available from several commercial sources.

Quality Control. We make our products to a number of exacting specifications. In order to meet both internal quality criteria and customer requirements, we implement a number of quality assurance and in-process statistical process control programs. We implement these quality programs separately at each of our three manufacturing locations. Our Advanced Ceramic Operations and Thermo Materials facilities have received ISO 9001 Certification. Ceradyne Semicon Associates is ISO 9000 compliant.

Engineering and Research

Our engineering and research efforts consist of application engineering in response to customer requirements, in addition to new materials and product development performed by our Research and Development Department. Our efforts create new products, modify existing products to fit specific customer needs and result in developing enhanced ceramic processes.

We allocate costs associated with application engineering and research between cost of product sales and research and development expense. Application engineering efforts devoted to specific customer orders generally are recognized as cost of product sales, while the balance of engineering and research costs is included in research and development and expensed as incurred. Our research and development expenses were approximately $2.1 million in 2003, $2.1 million in 2002, and $1.1 million in 2001.

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Competition

Our products compete with advanced technical ceramics products from other companies, as well as with high strength steel alloys and plastic products. When competing with other advanced technical ceramics products, we believe the principal competitive factors are price, product performance, material specifications, application engineering capabilities, customer support and reputation. Some of our competitors include Armor Holdings, ArmorWorks, United Defense Industries, CoorsTek, Kyocera’s Industrial Ceramics Group, Saint Gobain Advanced Ceramics, Spectra-Mat and Vesuvius. Many of our current or potential competitors have greater financial, marketing and technical resources than we do. We cannot guarantee that we will be able to compete successfully against our current or future competitors. If we fail to compete successfully, there could be material adverse effects on our business, financial condition, results of operations and cash flows. In many applications we also compete with manufacturers of non-ceramic materials. When competing with high strength steel alloys and plastic products, we may not be able to compete effectively when price is a primary consideration, because our products are typically more expensive.

Backlog

We record an item as backlog when we receive a contract, purchase order or other notification indicating the number of units to be purchased, the purchase price, specifications, delivery date and other customary terms and conditions. As of December 31, 2003, we had backlog of approximately $103.1 million and $1.1 million of unexercised options for orders. As of December 31, 2002, we had backlog of approximately $34.3 million and $1.4 million of unexercised options for orders. We expect that substantially all of the firm scheduled orders as of December 31, 2003 will be shipped within the next twelve months.

Patents, Licenses and Trademarks

We rely primarily on trade secrecy to protect compositions and processes that we believe are proprietary. In certain cases, the disclosure of information concerning such compositions or processes in issuing a patent could be competitively disadvantageous. However, our management believes that patents are important for technologies where trade secrecy alone is not a reliable source of protection. Accordingly, we have applied for, or have been granted, several U.S. patents relating to compositions, products or processes that our management believes are proprietary, including lightweight ceramic armor.

We have been issued two U.S. patents relating to translucent ceramics for orthodontic brackets. The earliest of these patents expires in 2007. We co-invented and co-own these patents with 3M Unitek. Together with 3M Unitek, we have granted licenses to companies whose ceramic orthodontic brackets infringe our joint patents. These companies pay both of us royalties based on sales of their orthodontic ceramic brackets for the remaining life of the patents.

In addition to the above, we have been issued 8 U.S. patents and have seven patents pending and have applied for corresponding foreign patents in various foreign countries. The earliest of these patents expires in 2006.

“Ceralloy^®,” the name of our technical ceramics, “Ceradyne^®” and the Ceradyne logo, comprising the stylized letters “CD^®,” are our major trademarks registered in the United States and various foreign countries. We also have other trademarks, including “Transtar^®,” “Semicon^®,” “Thermo^®,” “Netshape^®,” “Defender^®,” “NeedleLok^™,” and “Ramtech^™.”

Employees

As of December 31, 2003, we had approximately 500 employees, including 21 employees with undergraduate or graduate degrees in ceramic engineering. Of these total employees, 375 were in manufacturing, 53 were in engineering and research, 16 were in sales and marketing, and 35 were in general management, finance and administration. We also use temporary labor in some of our production operations. We consider our relationship with employees to be excellent. None of our employees are represented by a labor union.

Availability of SEC Filings

We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission. You can read our SEC filings over the Internet at the SEC’s website at http://www.sec.gov. We also make our SEC filings available free of charge through our Internet website as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. Our website address is www.ceradyne.com. The reference to our website address does not constitute incorporation by reference into this report of the information contained at that site.

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RISK FACTORS

This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our actual results may differ materially from the results projected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, the following:

A very substantial portion of our revenues is derived from the sale of defense related products, and our failure to obtain new government contracts, the cancellation of government contracts, or a reduction in federal budget appropriations involving our products could materially adversely affect our revenues.

Historically, a very substantial portion of our revenues has been derived from the sale of defense related products, such as ceramic body armor, either directly or indirectly to the U.S. government. We anticipate that a substantial portion of our revenues for the foreseeable future will continue to come from such sales. These contracts typically may be cancelled at any time without penalty, other than our right to be reimbursed for certain expenses. Any cancellations of these government contracts could have material adverse effects on our business, operating results and financial condition.

Our business is highly sensitive to changes in national and international defense and budget priorities. For example, in 2003, our revenues from the sale of ceramic body armor increased significantly due to the U.S. military’s acceleration of its program to equip its soldiers with ceramic body armor systems because of the war in Iraq. Demand for ceramic body armor may decline when the number of body armor systems shipped is sufficient to equip front-line troops, if conflicts in the Middle East and other high risk areas subside, or if U.S. defense budget appropriations are reduced.

Many defense contracts are awarded in an open competitive bidding process, and our past success in winning government contracts does not guarantee that we will win any new contracts in the future. Based upon our backlog for ceramic body armor as of December 31, 2003, we anticipate that revenues from the sale of these products will increase in 2004. However, unless we receive additional orders under existing contracts or are successful in winning new contracts for sales of these products, revenues from sales of these products may decline materially in 2005 from the levels we expect to obtain in 2004.

Our revenues and cash flows from the sale of defense related products could also be reduced if a significant number of our government contracts are delayed or cancelled due to cutbacks in defense, homeland security or other federal agency budgets or other reasons. In addition, our failure to successfully compete for and retain such government contracts could have an adverse effect on our revenues and cash flows. We cannot guarantee that we, or if we are a subcontractor that the prime contractor, will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract.

Defects in our products could harm our business and adversely affect our operating results.

Our products have in the past contained, and may in the future contain, errors or defects that may be detected at any point in the life of the products. Detection of such errors could result in delays in shipping and sales during the period required to correct such errors. Real or perceived defects in our products may result in product returns, loss of sales, delays in market acceptance, injury to our reputation and increased warranty costs, which could have an adverse effect on our business, operating results and financial condition. For example, in March 2002, the U.S. government determined that several lots of our small arms protective inserts (SAPI) for lightweight ceramic body armor failed to pass ballistics reverification tests. As a result, we stopped production of our SAPI product, modified the design of our product and resumed shipping approximately four months later. In addition, we agreed to correct or replace at our expense all supplies of our SAPI product sales that did not meet the original contractual requirements. As a result, we recorded a warranty reserve of $650,000 in the second quarter of 2002 against cost of product sales.

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We are making significant investments to increase our manufacturing capacity and improve our product yields in response to increased demand. If these efforts are not successful, our gross margins and profitability may suffer.

We experienced a sudden increase in demand for ceramic body armor for military personnel and cam rollers for diesel engines during 2002, and this demand increased further in 2003. In the effort to meet the sudden increased demand for our products, we suffered from manufacturing inefficiencies, including low product yields, which caused our gross profit margins on these products to suffer in 2002.

In response to the increased demand, we made significant capital expenditures during 2003 to increase our production capacity for these products. We paid $3.4 million in June 2003 to purchase a 41,000 square foot manufacturing facility in Irvine, California, which we previously had leased. In October, 2003, we purchased a 115,000 square foot facility in Lexington, Kentucky for $2.4 million, which we are converting into manufacturing and office space. During 2003, we leased an additional 47,000 square feet near Scottdale, Georgia, which will provide additional manufacturing capacity for our Thermo Materials division. We plan to make significant additional capital expenditures during 2004 for building improvements, capital equipment, and to relocate some of our California operations to our new Kentucky facility.

We cannot assure you, however, that our increased production capacity will enable us to manufacture the required quantities of our products in a timely manner. Further, we cannot assure you that demand for cam rollers and ceramic armor will remain at levels sufficient to justify these additional capital expenditures. In addition, in order to satisfy customer demand for these products while achieving acceptable profit margins, we must:

There can be no assurance that the profit margins we ultimately achieve on higher volumes of ceramic body armor and cam rollers will be comparable to our historical profit margins. Moreover, managing this expansion and relocation effort will put pressures on our operational, financial and managerial resources. We cannot assure you that we will be able to complete the expansion or relocation in a timely manner or within our capital expenditure budgets. We cannot assure you that we will realize anticipated cost savings or that energy costs in Kentucky, which are substantially lower than in California, will remain at expected levels over time. Any delay in completion of the expansion and relocation, budget overruns or an increase in energy costs in Kentucky could adversely affect our profitability.

The expansion and relocation could disrupt our operations. Certain of our contracts contain punitive provisions for missed deadlines. We cannot guarantee that the expansion or relocation will not cause a disruption in our operations that results in missed deadlines and payments of penalties under these contracts. Moreover, some of the capital equipment for our Kentucky facility will be specially designed and built to our requirements. This equipment is complex and has not been constructed previously. As a result, we cannot assure you that it will operate as planned or that we will be able to complete the construction of this equipment on time or within our budget.

To effectively manage this expansion and relocation effort, we must:

Any failure to effectively manage this expansion and relocation effort could have material adverse effects on our business, operating results and financial condition.

Growth in our operations may strain our resources, and if we fail to successfully manage our growth, our business could be harmed.

The increase in orders for ceramic body armor for military personnel and cam rollers for diesel engines, as well as the introduction of new products, is placing, and will continue to place, a significant strain on our operational, financial and managerial resources and personnel. To effectively manage our growth, we must:

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Any failure to effectively manage growth could have material adverse effects on our business, operating results and financial condition.

Our failure to compete successfully against current and future competitors could adversely affect our business.

Our products compete with advanced technical ceramics products from other companies, as well as with high strength steel alloys and plastic products.

When competing with other advanced technical ceramics products, we believe the principal competitive factors are:

When competing with high strength steel alloys and plastic products, we may not be able to compete effectively when price is a primary consideration, because our products are typically more expensive.

Some of our competitors include Armor Holdings, ArmorWorks, United Defense Industries, CoorsTek, Kyocera’s Industrial Ceramics Group, Saint Gobain Advanced Ceramics, Spectra-Mat and Vesuvius. Many of our current or potential competitors have greater financial, marketing and technical resources than we do. We cannot guarantee that we will be able to compete successfully against our current or future competitors. If we fail to compete successfully, there could be material adverse effects on our business, financial condition and results of operations.

All of our sales of ceramic orthodontic brackets are sold to 3M Unitek pursuant to an exclusive agreement that prohibits us from selling to other parties. A material portion of our revenue and profits is derived from this agreement, and a decrease in our sales to 3M Unitek could have an adverse effect on our revenues and profits.

We sell our ceramic orthodontic brackets exclusively to 3M Unitek under an agreement which expires in 2007. As a result, our revenues from this product are entirely dependent upon 3M Unitek. 3M Unitek also offers traditional stainless steel orthodontic brackets. We cannot guarantee that 3M Unitek will devote substantial marketing efforts to the sale of our ceramic orthodontic brackets, or that 3M Unitek will not reassess its commitment to our product. If 3M Unitek fails to actively market our ceramic orthodontic brackets or decides to promote a competing product over ours, this could cause the sales of our ceramic orthodontic brackets to decline and could have an adverse effect on our revenues, profits and cash flows.

In addition, the future success of our ceramic orthodontic brackets depends on our ability to maintain and increase market acceptance for our product compared to other competitive solutions, including traditional stainless steel brackets and newer products such as transparent plastic orthodontic aligners, synthetic sapphire brackets and other ceramic brackets. If demand for our product declines, or if competitive products gain market share, the sales of our ceramic orthodontic brackets may decline, which could have an adverse effect on our revenues, profits and cash flows.

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Moreover, the first of our two patents for our ceramic orthodontic brackets, which we jointly own with 3M Unitek, expires in 2007. Upon expiration of the patent, we may not be able to prevent third parties from manufacturing and selling competitive ceramic orthodontic brackets. Ceramic orthodontic brackets manufactured and sold by third parties may be less expensive than ours and may cause sales of our ceramic orthodontic brackets to decline either as a result of pricing pressure or loss of market share, which could have an adverse effect on our revenues, profits and cash flows.

Our ability to operate effectively could be impaired if we were to lose the services of Joel P. Moskowitz or our other key personnel, or if we are unable to recruit qualified managers and key personnel in the future.

Our success largely depends on the continued service of our management team and key personnel. If one or more of these individuals, particularly Joel P. Moskowitz, our Chairman, Chief Executive Officer and President, were to resign or otherwise terminate their employment with us, we could experience a loss of sales, delays in new product development and diversion of management resources.

Competition for skilled employees is intense and there can be no assurance that we will be able to recruit and retain such personnel. If we are unable to retain our existing managers and employees or hire and integrate new managers and employees, we could suffer material adverse effects on our business, operating results and financial condition.

To increase our revenues and profitability, we must increase market awareness and acceptance of advanced technical ceramics in new applications and products.

The future prospects of our business depend in part on the increased acceptance by our target markets of advanced technical ceramics to replace materials such as steel alloys, plastics and other ceramics. While advanced technical ceramics have certain advantages over other materials, such as the ability to withstand extremely high temperatures and combining hardness with light weight, they are generally significantly more expensive to produce. As a result, the market for advanced technical ceramics products may be limited to high-end applications where price is not the critical competitive factor. Moreover, because the market for advanced technical ceramics is relatively limited to applications where the characteristics of advanced technical ceramics may justify the higher costs compared to other materials, the market for our products may not grow as we anticipate.

Uninsured losses arising from third party claims could have a material adverse effect on our business.

Our products are used in applications where the failure to use our products properly or their malfunction could result in serious bodily injury or death. We cannot assure you that we have adequate insurance to cover the payment of any potential claim related to such injuries or deaths. We also cannot assure you that insurance coverage will continue to be available or, if available, that we will be able to obtain it at a reasonable cost. In addition, we are self-insured against workers compensation claims in an amount that exceeds our accrual for such claims. Our accrual is based on our historical experience with these claims, and we have excess liability insurance to cover losses beyond a specified amount. We cannot assure you that our accrual will be adequate to cover actual claims, and if actual claims are higher, our operating results will be adversely affected. Any material uninsured losses from third party claims could have a material adverse effect on our business, financial condition and results of operations.

We are subject to extensive government regulation, and our failure or inability to comply with these regulations could subject us to penalties and result in a loss of our government contracts, which could adversely affect our revenues.

We must comply with and are affected by various government regulations that impact our operating costs, profit margins and our internal organization and operation of our business. Furthermore, we have production contracts with governmental entities and are subject to additional rules, regulations and approvals applicable to government contractors. We are also subject to routine audits to assure our compliance with these requirements. Our failure to comply with these regulations, rules and approvals could result in the impositions of penalties and the loss of our government contracts and disqualification as a U.S. government contractor, which could adversely affect our revenues.

We are subject to risks associated with environmental laws and regulations, which expose us to potential liability.

We are subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous materials used to manufacture our products. Authorities could impose fines, suspend production, alter our manufacturing processes, or stop our operations if we do not comply with these regulations.

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In the past, we produced certain products using beryllium oxide, which is highly toxic in powder form. This powder, if inhaled, can cause chronic beryllium disease in a small percentage of the population. We have been sued in the past by former employees and by employees of one of our customers and by their family members alleging that they had contracted chronic beryllium disease as a result of exposure to beryllium oxide powders used in our products. All of these claims have been dismissed without incurring material liability. We cannot guarantee that we will avoid future liability to persons who may allege that they contracted chronic beryllium disease as a result of exposure to the beryllium oxide we used in prior years.

Any failure to comply with current or subsequently enacted environmental statutes and regulations could subject us to liabilities, fines or the suspension of production. Furthermore, any claims asserted against us in the future related to exposure to beryllium oxide powder may not be covered by insurance. Even if covered, the amount of insurance may be inadequate to cover any adverse judgment.

Fines and other punishments imposed on us for environmental violations and expenses we incur to remedy or comply with environmental regulations and future liability for incidences of chronic beryllium disease contracted by employees or employees of customers could have material adverse effects on our business, operating results and financial condition.

Our export sales are subject to the risks associated with doing business outside the United States.

Shipments to customers outside of the United States accounted for approximately 5.4% of our sales in 2003, 10.9% in 2002 and 15.9% in 2001. We anticipate that international shipments will account for a portion of our sales for the foreseeable future. Therefore, the following risks associated with international business activities could have material adverse effects on our performance:

We have traditionally invoiced our foreign sales in U.S. dollars. Accordingly, we do not currently engage in foreign currency hedging transactions that could protect us against the risk of currency fluctuations. If the U.S. dollar becomes more expensive relative to the currencies of our foreign customers, the price of our products in those countries will rise and our sales into those countries, or our profitability within those countries, may fall. In addition, in the future, we may be required to denominate foreign sales in the local currencies of our customers. In that case, if the U.S. dollar were to become more expensive relative to the currencies of our foreign customers, we would receive fewer U.S. dollars for each unit of foreign currency that we receive when our customers pay us. Therefore, a more expensive U.S. dollar would cause us to incur losses upon the conversion of accounts receivable denominated in foreign currencies. Such losses could harm our results of operations.

We cannot export some of our products to certain foreign countries without an export license obtained from the U.S. government. In the past, we have had difficulty in obtaining licenses to export our products to certain countries. We cannot guarantee that similar difficulties will not arise again in the future. If any of the above risks emerge, there may be material adverse effects on our business, operating results and financial condition.

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We may be adversely affected if we are unable to adequately safeguard our intellectual property rights from unauthorized use, or if we become subject to claims that we infringe on others’ intellectual property rights.

We rely on a combination of patents, trade secrets, trademarks, and other intellectual property law, nondisclosure agreements and other protective measures to preserve our proprietary rights to our products and production processes. These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States.

Although we implement protective measures and intend to defend our proprietary rights, there can be no assurance that these efforts will succeed. We may have to litigate within the United States or abroad to enforce our issued or licensed patents, to protect our trade secrets and know-how or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. Enforcing or defending our proprietary rights could be expensive and might not bring us timely and effective relief.

Furthermore, there can be no assurance that our products or processes are not in violation of the patent rights of third parties. Our patents may be challenged, invalidated or circumvented. Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief, which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we cannot guarantee that any such licenses could be obtained on acceptable terms, if at all.

If we fail to adequately protect our intellectual property, or if we face claims for infringement on the intellectual property of third parties, there may be material adverse effects on our business, operating results, and financial condition.

Evolving regulation of corporate governance and public disclosure may result in additional expenses and continuing uncertainty.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules are creating uncertainty for companies such as ours. These new or changed laws, regulations and standards are subject to varying interpretations in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, our reputation may be harmed.

Our stock price is volatile.

The market price and trading volume of our common stock has been subject to significant volatility, and this trend may continue. The value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:

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Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the market price of our common stock are beyond our control. The market price of our common stock at any particular time may not remain the market price in the future. In the past, securities class action litigation has been instituted against companies following periods of volatility in the market price of their securities. Any such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.

We do not anticipate declaring any cash dividends on our common stock.

We have never declared or paid cash dividends on our common stock and do not plan to pay any cash dividends in the near future. Our current policy is to retain all funds and earnings for use in the operation and expansion of our business.

Delaware law may delay or prevent a change in control.

We are subject to the provisions of section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular a stockholder owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless this stockholder receives board approval for the transaction or 66 2/3% of the shares of voting stock not owned by the stockholder approve the merger or transaction.

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Operating Divisions and Facilities

We serve our markets from manufacturing facilities in three locations across the United States. The following table includes a summary of our facilities and manufacturing structure.

We are involved in legal proceedings incidental to our business from time to time. There are no material actions currently pending.

No matters were submitted to a vote of security holders during the fourth quarter of 2003.

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PART II

Our common stock is traded on the Nasdaq National Market under the symbol “CRDN.” The following table shows the high and low closing sale prices for our common stock as reported by the Nasdaq National Market during the calendar quarters indicated:

As of February 20, 2004, there were approximately 326 holders of record of our common stock.

We have never declared or paid cash dividends on our common stock and do not plan to pay any cash dividends in the near future. Our current policy is to retain all funds and earnings for use in the operation and expansion of our business.

We did not sell any equity securities during the year ended December 31, 2003 that were not registered under the Securities Act of 1933.

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The following selected consolidated financial data as of December 31, 1999, 2000 and 2001 and for the years ended December 31, 1999 and 2000 are derived from our audited consolidated financial statements, which are not included in this report. The selected consolidated financial data as of December 31, 2002 and 2003 and for the years ended December 31, 2001, 2002 and 2003 are derived from our audited consolidated financial statements, which are included elsewhere in this report. Our consolidated financial statements as of December 31, 1999, 2000 and 2001 and for the years ended December 31, 1999, 2000 and 2001 were audited by Arthur Andersen LLP, independent public accountants. Our consolidated financial statements as of December 31, 2002 and 2003, and for the years ended December 31, 2002 and 2003 were audited by PricewaterhouseCoopers LLP, independent auditors. Our historical results are not necessarily indicative of the results of operations for future periods. The following data is qualified in its entirety by and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes relating to those statements appearing elsewhere in this report.

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The following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data” and our consolidated financial statements and related notes included in this report. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. We base these statements on assumptions that we consider reasonable. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those discussed in “Risk Factors,” “Forward-Looking Statements” and elsewhere in this report.

Overview

We develop, manufacture and market advanced technical ceramic products and components for defense, industrial, automotive/diesel and commercial applications. Our primary products include lightweight ceramic armor for soldiers and military helicopters; ceramic orthodontic brackets; ceramic diesel engine components; ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes; and ceramic industrial components for erosion and corrosion resistant applications. Our customers include the U.S. government, prime government contractors and large industrial and commercial manufacturers.

We conduct our operations primarily in three locations. The following table includes a summary of our products by applications for our three divisions.

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We categorize our products into four market applications. The table below shows the percentage contribution to our total sales of each market application in the different time periods.

The principal factor contributing to our recent growth in sales is increased demand by the U.S. military for ceramic body armor that protects soldiers. Recent military conflicts in Afghanistan and Iraq, as well as an increasingly unstable geopolitical climate and the heightened risk of international conflicts, have resulted in increased orders for these products. We expect our shipments of ceramic body armor to be higher in fiscal year 2004 than in 2003. However, unless we are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor may decline materially in 2005 from levels we expect to achieve in 2004. For the next several quarters, and perhaps longer, fluctuations in sales of ceramic body armor are likely to be the biggest factor affecting our sales.

Although we expect demand for ceramic body armor to continue for many years, the quantity and timing of government orders depends on a number of factors outside of our control, such as the amount of U.S. defense budget appropriations and the level of international conflicts. Moreover, ceramic armor contracts generally are awarded in an open competitive bidding process. Therefore, our future level of sales of ceramic body armor will depend on our ability to successfully compete for this business.

Other existing products which we believe could have a significant impact on our growth over the long term include ceramic components for heavy-duty diesel truck engines and ceramic radomes (nose cones) for missiles.

Our largest diesel engine components customer informed us in May 2003 that it will triple the number of our ceramic cam rollers, from six to 18, that it uses in each heavy-duty diesel truck engine. We began shipping these additional components in the fourth quarter of 2003.

In May 2003, the prime government contractor for the PAC-3 (Patriot Advanced Capability) missile selected Ceradyne to manufacture the technical ceramic radome blank, diamond grind the radome blank to precise tolerances and assemble and test the radome components for incorporation on the PAC-3 missile. Previously, the prime contractor made the ceramic radome blank and we performed only the diamond grinding. The prime contractor has and will continue to provide us with funds to purchase most of the equipment and tooling required for this program, which we are installing in 25,000 square feet of the total 47,000 square foot facility that we lease in Clarkston, Georgia. Depending on the level of government funding for this program, we expect revenues from sales of radomes for the PAC-3 missile to increase from our historic levels and to continue for several years, if not longer.

Also in May 2003, we were selected to make radomes for the Arrow Missile. We will manufacture the technical ceramic radome blank, diamond grind the radome blank to precise tolerances and assemble and test the radome components. We expect revenues from the sales of the radomes for this system to begin in 2004 and continue for several years.

Our export sales have varied, representing $5.5 million, or 5.4% of our net sales in 2003, $6.7 million, or 10.9% in 2002, and $7.2 million, or 15.9% in 2001. Our export sales consist primarily of defense related products purchased by U.S. allies, and ceramic glass tempering rolls. We plan to increase our sales efforts in foreign countries, and we currently have sales offices in China and England, as well as commissioned independent sales representatives in other parts of Europe and Asia. All of our export sales are currently denominated in U.S. dollars.

Net Sales. Our net sales consist primarily of revenue from the sale of products, which we recognize when the product is shipped to the customer. In the past we have also received research and development funds from the U.S. government under Small Business Innovation Research grants, and from the Ford Motor Company pursuant to a joint development agreement. These research and development funds, which have been relatively small in amount, have been recognized as revenue as we performed the research and development.

Cost of Product Sales. Our cost of product sales includes the cost of materials, direct labor expenses and manufacturing overhead expenses. Our business requires us to maintain a relatively high fixed manufacturing overhead. As a result, our gross profit, in absolute dollars and as a percentage of net sales, is greatly impacted by our sales volume and the corresponding absorption of fixed manufacturing overhead expenses. Additionally, because many of our products are

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customized, we are frequently required to devote resources to sustaining engineering expenses, which we also include in cost of product sales and expense as incurred.

Selling Expenses. Our selling expenses consist primarily of salaries and benefits for direct sales and marketing employees, commissions for direct sales employees and for independent sales representatives, trade show expenses, rent for our sales offices, product literature, and travel and entertainment expenses.

General and Administrative Expenses. General and administrative expenses consist primarily of employee salaries and benefits, employee bonuses, which are computed quarterly and accrued in the quarter earned, professional service fees, rent for facilities and expenses for information technology.

Research and Development Expenses. Our research and development expenses consist primarily of employee salaries and benefits, materials and supplies related to ongoing application engineering in response to customer requirements, and the research and development of new materials technology and products. These costs are expensed as incurred.

Results of Operations

The following table sets forth certain income and expense items from our financial statements for the years ended December 31, 2003, 2002 and 2001 expressed as a percentage of net sales.

Years Ended December 31, 2003 and 2002

Net Sales. Our net sales for the year ended December 31, 2003 were $101.5 million, an increase of $40.3 million, or 65.7%, from $61.2 million of net sales in the prior year.

Net sales for our Advanced Ceramic Operations division for the year ended December 31, 2003 were $80.5 million, an increase of $33.2 million, or 70.1%, from $47.3 million of net sales in the prior year. The increase in net sales was mainly due to a $32.2 million or 122.8% increase in ceramic armor shipments for defense customers and a $2.0 million increase in shipments of ceramic orthodontic brackets. Sales increases were offset by decreases in other product lines, mainly a $0.5 million decrease in net sales of machined products and a $0.5 million decrease in net sales of automotive/diesel engine components.

Our Semicon Associates division had net sales of $6.9 million for the year ended December 31, 2003, an increase of $0.9 million, or 13.6%, from $6.0 million of sales in the prior year. This increase was mainly due to an increase in customers’ demand for dispenser cathodes, which are used in microwave tubes for radar and satellite communications.

Our Thermo Materials division had net sales of $14.1 million for the year ended December 31, 2003, an increase of $6.2 million, or 79.0%, from $7.9 million of sales in the prior year. The increase in sales was attributable to an increase in demand for ceramic radomes used on the PAC-3 missile, an increase in shipments of ceramic crucibles to accommodate growth in the photo voltaic solar cell industry, and revenue from the construction of the facilities that we will use to manufacture the PAC- 3 missile radomes.

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Gross Profit. Our gross profit for the year ended December 31, 2003 was $29.3 million, an increase of $16.2 million, or 124.4%, from $13.1 million in the prior year. As a percentage of net sales, gross profit was 28.9% for the year ended December 31, 2003, as compared to 21.4% of net sales in the prior year.

Our Advanced Ceramic Operations division had gross profit for the year ended December 31, 2003 of $25.4 million, an increase of $14.6 million, or 135.2%, from $10.8 million in the prior year. Gross profit for Advanced Ceramic Operations in 2003 was 31.6% of net sales, as compared to 22.8% of net sales in the prior year. The improvement in gross profit during the year ended December 31, 2003 was a result of increased armor sales, improved absorption of fixed operating expenses, better manufacturing efficiencies, increased productivity and an improved sales mix when compared to last year. Also favorably impacting gross profit margins were higher volumes of parts and higher capacity utilization resulting in economies of scale.

Our Semicon Associates division had gross profit of $1.1 million for the year end December 31, 2003, which was unchanged from the prior year. Gross profit for Semicon Associates for the year end December 31, 2003 was 16.7% of net sales, as compared to 18.7% of net sales in the prior year. The decrease in gross profit as a percentage of net sales was due to a change in sales mix and losses incurred in our magnet products, resulting in lower overall gross profit levels.

Our Thermo Materials division had gross profit of $2.8 million for the year end December 31, 2003, an increase of $1.6 million, or 130.2%, from $1.2 million in the prior year. Gross profit for Thermo Materials for the year end December 31, 2003 was 19.6% of net sales, as compared to 15.2% of net sales in the prior year. The increase was attributable to higher production volume causing better absorption of fixed manufacturing costs. Also, increases in shipments of ceramic radomes with higher gross profit margins contributed to the increases, as did higher shipments of ceramic rolls with higher gross margins and reducing certain process control problems in fused silica products.

Selling Expenses. Selling expenses were $2,440,000 for the year ended December 31, 2003, an increase of $371,000, or 17.9%, from $2,069,000 in the prior year. The increase of $371,000 was due to salary, bonuses, personnel increases, commissions and travel. Selling expenses, as a percentage of net sales, decreased from 3.4% for the year ended December 31, 2002 to 2.4% of net sales for the year ended December 31, 2003 due to the higher levels of net sales in 2003 when compared to 2002.

General and Administrative Expenses. General and administrative expenses were $7.8 million for the year ended December 31, 2003, an increase of $2.8 million, or 57.1%, from $5.0 million in the prior year. Salary, bonuses and personnel increases accounted primarily for the increased expenses. General and administrative expenses, as a percentage of net sales, decreased from 8.1% for the year ended December 31, 2002 to 7.7% for the year ended December 31, 2003 due to the higher levels of net sales in 2003 when compared to 2002.

Research and Development Expenses. Research and development expenses were $2.1 million for the year ended December 31, 2003, which were unchanged from the previous year. Research and development expenses, as a percentage of net sales, decreased from 3.4% for the year ended December 31, 2002 to 2.1% for the year ended December 31, 2003 due to the higher levels of net sales in 2003 when compared to 2002. In both years, the expenses relate to wages for engineering, technicians and production personnel, materials, outside services, small tools and travel.

Other Income. Other income was $321,000 for the year ended December 31, 2003, an increase of $56,000, or 21.1%, from $265,000 in the prior year. Other income includes royalty income, which decreased by $65,000 from the prior year due to lower sales of orthodontic brackets by licensees. Interest income increased by $122,000 due to larger cash balances resulting from the follow-on offering of shares of our common stock in July 2003 and increased net cash flow from operations.

Interest Expense. Interest expense was $32,000 for the year ended December 31, 2003, a decrease of $70,000, or 68.7%, compared to $102,000 in the prior year. Interest expense, as a percentage of sales, was insignificant. This decrease was due to the reduction of borrowings on our line of credit, which was paid in full during the year from part of the proceeds of the follow-on offering completed in July 2003.

Income Taxes. We had a combined federal and state tax rate of 35% for the twelve months ended December 31, 2003, resulting in a provision for taxes of $6.1 million, an increase of $4.7 million, or 318.2%, from $1.4 million in the corresponding prior year. The effective income tax rate was also 35% in 2002.

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Years Ended December 31, 2002 and 2001

Net Sales. Our net sales for the year ended December 31, 2002 were $61.2 million, an increase of $15.9 million, or 35.1%, from $45.3 million of net sales in the prior year.

Net sales for our Advanced Ceramic Operations division for the year ended December 31, 2002 were $47.3 million, an increase of $16.3 million, or 52.6%, from $31.0 million of net sales in the prior year. The increase in net sales was mainly due to a $13.8 million or 110.4% increase in ceramic armor shipments for defense customers, a $4.2 million or 457.9% increase in the diesel engine components business compared to the year ago period, and a $1.0 million increase in research and development contracts awarded by the Department of Defense. Sales increases were offset by decreases in other product lines, mainly a $0.9 million decrease in net sales of ceramic orthodontic brackets and a $1.7 million decrease in net sales of industrial wear products.

Our Semicon Associates division had net sales of $6.0 million for the year ended December 31, 2002, a decrease of $1.7 million, or 22.1%, from $7.7 million of sales in the prior year. This decrease was mainly due to a slow down in our customers’ demand for dispenser cathodes, which are used in microwave tubes for radar and satellite communications.

Our Thermo Materials division had net sales of $7.9 million for the year ended December 31, 2002, an increase of $1.3 million, or 19.7%, from $6.6 million of sales in the prior year. The increase in sales was attributable to an increase in demand for fused silica products domestically by the glass, steel and aluminum making industries.

Gross Profit. Our gross profit for the year ended December 31, 2002 was $13.1 million, an increase of $0.6 million, or 4.8%, from $12.5 million in the prior year. As a percentage of net sales, gross profit was 21.4% for the year ended December 31, 2002, as compared to 27.5% of net sales in the prior year.

Our Advanced Ceramic Operations division had gross profit for the year ended December 31, 2002 of $10.8 million, an increase of $1.6 million, or 17.4%, from $9.2 million in the prior year. Gross profit for Advanced Ceramic Operations in 2002 was 22.8% of net sales, as compared to 29.7% of net sales in the prior year. Gross profit as a percentage of sales was negatively impacted by a number of factors, including a $650,000 warranty reserve for SAPI armor plates that was recorded in the second quarter of 2002, declines in net sales of ceramic orthodontic brackets and industrial wear products, as well as a significant increase in net sales of diesel engine components which did not contribute to gross profit margins. Gross margins on diesel components and ceramic body armor in particular were adversely affected by manufacturing and production inefficiencies as production capacities were being increased to meet rising demand for these products.

Our Semicon Associates division had gross profit of $1.1 million for the year end December 31, 2002, a decrease of $1.3 million, or 54.2%, from $2.4 million in the prior year. Gross profit for Semicon Associates for the year end December 31, 2002 was 18.2% of net sales, as compared to 31.2% of net sales in the prior year. The decrease is due to lower plant overhead absorption because of lower sales and production.

Our Thermo Materials division had gross profit of $1.2 million for the year end December 31, 2002, an increase of $0.3 million, or 33.3%, from $0.9 million in the prior year. Gross profit for Thermo Materials for the year end December 31, 2002 was 15.2% of net sales, as compared to 13.6% of net sales in the prior year. The increase was attributable to higher production volume and eliminating certain process control problems in fused silica products. We corrected the process control concern by diligently testing raw materials.

Selling Expenses. Selling expenses were $2,069,000 for the year ended December 31, 2002, an increase of $33,000, or 1.6%, from $2,036,000 in the prior year. Selling expenses, as a percentage of net sales, decreased from 4.5% for the year ended December 31, 2001 to 3.4% of net sales for the year ended December 31, 2002. The increase of $33,000 was due to salary and personnel increases, commissions and travel.

General and Administrative Expenses. General and administrative expenses were $5.0 million for the year ended December 31, 2002, an increase of $0.1 million, or 2.0%, from $4.9 million in the prior year. General and administrative expenses, as a percentage of net sales, decreased from 10.8% for the year ended December 31, 2001 to 8.1% for the year ended December 31, 2002. Salary and personnel increases accounted primarily for the increased expenses.

Research and Development Expenses. Research and development expenses were $2.1 million for the year ended December 31, 2002, an increase of $1.0 million, or 90.9%, from $1.1 million in the prior year. Research and development expenses, as a percentage of net sales, increased from 2.4% for the year ended December 31, 2001 to 3.4% for the year

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ended December 31, 2002. This increase resulted from our increased investment toward developing future ceramic technology and new products. In both years, the expenses relate to wages for engineering, technicians and production personnel, materials, outside services, small tools and travel.

Other Income. Other income was $265,000 for the year ended December 31, 2002, a decrease of $127,000, or 32.4%, from $392,000 in the prior year. Other income includes royalty income, which increased by $50,000 over the prior year due to greater demand for orthodontic brackets. Interest income decreased by $172,000 due to lower cash balances resulting from increases in inventory levels relating to ceramic armor and diesel engine component product lines while miscellaneous income decreased by $4,000.

Interest Expense. Interest expense was $102,000 for the year ended December 31, 2002, an increase of $76,000, or 292.3%, compared to $26,000 in the prior year. Interest expense, as a percentage of sales, was insignificant. This increase was attributable to higher inventory levels for which we increased borrowing from our line of credit.

Income Taxes. We used a combined federal and state tax rate of 35% for the twelve months ended December 31, 2002, resulting in a provision for taxes of $1.4 million, an increase of $0.6 million, or 75.0%, from $0.8 million in the corresponding prior year. The effective income tax rate of 35% for the year ended December 31, 2002 increased from 17% for the year ended December 31, 2001 as a result of releasing of valuation allowances in the prior year.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of financial condition and results of operations, as well as disclosures included elsewhere in this report are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Preparing these consolidated financial statements requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingencies. We believe that the critical accounting policies that most impact the consolidated financial statements are as described below. A summary of our significant accounting policies is included in Note 1 to our consolidated financial statements which is included in Item 15 of this Form 10-K.

In applying these policies, estimates and judgments affect the amounts at which accounts receivable and inventory and certain liabilities are recorded and the useful lives of property and equipment. We apply our accounting policies on a consistent basis. As circumstances change, they are considered in our estimates and judgments. Future changes in circumstances could result in changes in amounts at which assets and liabilities are recorded. Future changes could also affect the estimated useful levels of property and equipment, which could result in changes in depreciation expense or write offs or write downs of such assets.

Revenue Recognition. Sales are generally recorded when all of the following have occurred: an agreement of sale exists, product delivery and acceptance has occurred or services have been rendered, and collection is reasonably assured. We are required to make judgments about whether or not collectibility is reasonably assured. We reduce our revenue with reserves for estimated price concessions and sales returns. Allowances, which are recorded at the time revenue is recognized, in accordance with SFAS No, 48, “Revenue Recognition When Right of Return Exists,” are based upon historical price concessions and sales returns.

Accounts Receivable. We review our trade accounts receivables and our estimates of the allowance for doubtful accounts each period. The allowance for doubtful accounts includes our estimate of the amount we expect to be uncollectable on specific accounts and unidentified accounts included in accounts receivable. In estimating the potential losses on specific accounts, we rely on in-house prepared analysis, historical experience and a review of other available information. The amounts we will ultimately realize could differ materially from the amounts assumed in arriving at the allowance for doubtful accounts in the accompanying financial statements.

Inventories. Inventories are valued at the lower of cost (first-in, first-out) or market. The write down of inventory for obsolete items is based on our estimate of the amount considered obsolete based on specific reviews of inventory items. In estimating the allowance, we rely on our knowledge of the industry as well as our current inventory levels. The amounts we will ultimately realize could differ from the estimated amounts. Inventory costs include the cost of material, labor and manufacturing overhead.

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Production Tooling. Our production tooling primarily consists of graphite tooling used in the manufacturing and furnace processes. This tooling is being amortized over its estimated useful life of three to nine months.

Warranty Reserve. The U.S. government Defense Logistics Agency (DLA) notified us on March 27, 2002, that three lots of our small arms protective inserts (SAPI) for light weight ceramic armor shipped in January 2002 failed to pass ballistics reverification tests by the government’s designated independent commercial testing laboratory. During the period of December 2001 through March 27, 2002, we had shipped approximately $5.1 million under our existing contract with the DLA. Subsequent to March 27, 2002, the DLA directed the independent testing laboratory to perform reverification testing and $3.4 million of the shipments were not in testing compliance.

When we first were notified of these issues on March 27, 2002, we voluntarily stopped producing our original SAPI design and thereafter actively worked with the government to understand the quality and testing issues and to resolve the status and disposition of the SAPI plates in question. We completed the development of a modified design for our ceramic SAPI armor plates. Independently performed tests by the government’s designated testing laboratory of the modified design were successful and the “first article” (initial production parts) of this modified design was approved in June 2002.

On August 7, 2002, we signed an amendment to our contract with the government for certain of the SAPI plates shipped in December 2001 and the first quarter 2002. The amendment required that we correct or replace at our expense all supplies of the product that did not meet the original contractual requirements. The warranty items were delivered between October 2002 and June 2003. We estimated the cost to rework and upgrade the SAPI plates at approximately $650,000 and set up a warranty reserve in that amount, recorded in the second quarter ended June 30, 2002 against cost of product sales. Upon completion of the cost to rework and upgrade the SAPI plates, there was a remaining warranty reserve amount of $148,000 that was credited to cost of product sales during the second quarter ended June 30, 2003.

Changes in the product warranty accrual for the year ended December 31, 2003 were as follows:

Liquidity and Capital Resources

We generally have met our operating and capital requirements with cash flow from operating activities, borrowings under our line of credit, and proceeds from the sale of shares of our common stock.

Our net cash position increased by $11.1 million during the year ended December 31, 2003, compared to a decrease of $667,000 during the year ended December 31, 2002. For the year ended December 31, 2003, cash flow provided by operating activities amounted to $15.4 million. The primary factors contributing to the increase in cash flow from operating activities were net income of $11.2 million, depreciation and amortization of $3.3 million, a $2.7 million reduction of income taxes payable due to the exercise of stock options, and increased levels of accounts payable and accrued expenses that added an aggregate of $7.5 million. These contributions were offset in part by increases in accounts receivable of $7.1 million due to higher amounts of sales over the previous year, and increased levels of inventories, production tooling and prepaid expenses that totaled $2.4 million.

Cash used in investing activities of $31.5 was for capital expenditures of $12.3 million and $19.2 used to purchase marketable securities. A majority of our capital expenditures were for equipment to gain additional capacity and improve operations. Also included in the total capital expenditures was $3.4 million used to purchase a plant in Irvine, California, that we formerly leased and where we produce the ceramic orthodontic brackets and machine grind diesel engine parts, and $2.4 million used to acquire a plant in Lexington, Kentucky that we are now renovating to increase our production capacity for ceramic components for heavy-duty diesel truck engines. We plan to spend an additional $2.6 million in 2004 for renovation costs. We also plan to spend approximately $3.2 million in 2004 to purchase machinery, equipment and furnaces, primarily for the new plant in Kentucky.

Financing activities provided cash of $27.2 million generated from the net proceeds of $27.9 million from the issuance of common stock in our public offering, described below, and $1.4 million in connection with the issuance of common stock upon the exercise of employee stock options under the stock option and stock purchase plans. Cash used in

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financing activities included $2.4 million used to reduce our bank line of credit and $158,000 used to reduce long-term debt.

Our net cash position decreased by $0.7 million during the twelve months ended December 31, 2002. An important component of this change was our investment of $5.6 million for the purchase of machinery, equipment and leasehold improvements. These capital expenditures served to fund the expansion of production capacity primarily at our Advanced Ceramic Operations division. Cash flow from operations for the year ended December 31, 2002 was $1.9 million. This was due to net income plus depreciation and amortization and deferred taxes offset by changes in operating assets and liabilities of $5.3 million. Inventories and accounts receivable increased by $4.8 million due to the higher volumes of business compared to the year earlier period.

In May 2002, we increased our revolving bank line of credit from $4.0 million to $7.5 million. The bank line of credit balance of $2.4 million at December 31, 2002 was fully repaid in July 2003 with a portion of the net proceeds from our recent public offering described below. We established a new unsecured line of credit with a new bank in August 2003, which expires in August 2005. The amount available under the terms of the new line of credit is $10.0 million and bears interest at 1.75 percentage points in excess of the LIBOR rate for a period selected by Ceradyne. The LIBOR rates for the periods that could be selected ranged from approximately 1.12 percent to 1.46 percent at December 31, 2003. The bank line of credit did not have an outstanding balance at December 31, 2003.

We entered into a $500,000 capital equipment loan agreement during the third quarter of 1999. The term of this loan was 60 months, with a prepayment penalty, and interest accrued at a fixed rate of 8.18%. In July 2003, we repaid the entire balance due with a portion of the net proceeds from our public offering.

During July 2003, we completed a public offering of 1,725,000 newly issued shares of our common stock at a price to the public of $17.50 per share. We received net proceeds of approximately $27.9 million from this offering after deducting offering expenses of $0.5 million and underwriting discounts.

Our cash, cash equivalents and short term investments totaled $30.7 million at December 31, 2003, compared to $350,000 at December 31, 2002. At December 31, 2003, we had working capital of $60.5 million, compared to $24.8 million at December 31, 2002. We believe that our current cash and cash equivalents on hand, cash available from the sale of short term investments, and cash we expect to generate from operations will be sufficient to finance our anticipated capital and operating requirements for at least the next 12 months. We also may utilize cash from time to time to acquire other businesses, technologies or product lines that compliment our existing business, although we have no present commitments or agreements to do so.

The Company’s contractual obligations are for non-cancelable operating leases and are as follows (amounts in thousands):

Off-Balance Sheet Arrangements

Ceradyne does not have any off-balance sheet arrangements.

New Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51. This Interpretation addresses consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics: (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity, and (ii) the equity investors lack an essential characteristic of a controlling financial interest. It applies to all variable interest entities established after January

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31, 2003 and is effective July 1, 2003 for any variable interest entity acquired prior to February 1, 2003. The application of FIN 46 did not have a significant impact on the Company’s consolidated financial statements.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities. This statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. It amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. SFAS 149 amends SFAS 133 for decisions made as part of the Derivatives Implementation Group process that effectively required amendments to SFAS 133, in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative. The application of this statement did not have an impact on the Company’s consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes standards for how a company clarifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires a company to classify such instruments as liabilities, whereas they previously may have been classified as equity. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise was effective July 1, 2003. The application of this statement did not have an impact on the Company’s consolidated financial statements.

Ceradyne is exposed to market risks related to fluctuations in interest rates on our debt. Currently, we do not utilize interest rate swaps, forward or option contracts on foreign currencies or commodities, or other types of derivative financial instruments. The purpose of the following analysis is to provide a framework to understand our sensitivity to hypothetical changes in interest rates as of December 31, 2003.

As of December 31, 2003, we did not have any debt outstanding. We have an unsecured line of credit with a bank in the amount of $10 million. The bank line of credit interest rate is charged at 1.75 percentage points in excess of the LIBOR rate for a period selected by us. The LIBOR rates for the periods that could be selected ranged from approximately 1.12 percent to 1.46 percent at December 31, 2003.

The Consolidated Financial Statements and Supplementary Data commence at page F-1 of this report and an index thereto is included in Part IV, Item 15 of this report.

Not applicable.

We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of Ceradyne’s disclosure controls and procedures as of December 31, 2003, pursuant to Rule 13a-15 under the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that those disclosure controls and procedures were adequate to ensure that information required to be disclosed in this report is recorded, processed, summarized and reported in a timely basis.

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PART III

Our executive officers and directors and their ages as of March 1, 2004 are as follows:

Joel P. Moskowitz co-founded our predecessor company in 1967. He served as our President from 1974 until January 1987, and has served as our President since September 1987. In addition, Mr. Moskowitz has served as our Chairman of the Board and Chief Executive Officer since 1983. Mr. Moskowitz currently serves on the Board of Trustees of Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from Alfred University in 1961 and an M.B.A. from the University of Southern California in 1966.

Earl E. Conabee joined us in July 1985, and has served as a Vice President since June 1986. Mr. Conabee also serves as Director of Marketing for our Thermo Materials division, where he is responsible for the overall marketing and sales effort for fused silica ceramics. Prior to joining us, Mr. Conabee served as General Manager of Ceramatec, a manufacturer of technical ceramics from 1983 to 1985, and as Director of Refinery Operations for Englehard Minerals Corporation from 1973 to 1983. Mr. Conabee obtained a B.S. in Ceramic Engineering from Alfred University in 1960.

Jerrold J. Pellizzon joined us in September 2002 and serves as our Chief Financial Officer, Chief Administrative Officer and Corporate Secretary. Prior to joining us, Mr. Pellizzon was Chief Executive Officer of DrSoy Nutrition, Inc., from 2000 until 2002. From 1994 through 2000, Mr. Pellizzon served as Chief Operating Officer and Chief Financial Officer of Met-Rx Substrate Technologies. From 1984 to 1993, Mr. Pellizzon was Chief Financial Officer for Breton Construction, Inc., and served on their executive committee and board of directors. Prior to 1984, Mr. Pellizzon held executive and management positions at Duke Timber Construction/Tobin Steel Company and was employed as a C.P.A. in public accounting. Mr. Pellizzon obtained his B.S. in Economics from UCLA in 1975.

David P. Reed joined us in November 1983, and has served as a Vice President since January 1988. Mr. Reed is responsible for the operations, finances and marketing of our Costa Mesa, California operations. Prior to joining us, Mr. Reed served as Manager, Process Engineering for the Industrial Ceramic Division of Norton Co. from 1980 to 1983. Mr. Reed obtained a B.S. in Ceramic Engineering from Alfred University in 1976 and an M.S. in Ceramic Engineering from the University of Illinois in 1978.

Bruce Lockhart joined our Thermo Materials division as its President in September of 2001 after 16 years of varied experience in the ceramic industry, the majority of which was with Thermal Ceramics Inc. in Augusta, Georgia. Mr. Lockhart was elected as a Vice President in February 2003. Prior to joining us, Mr. Lockhart’s past experiences included positions as a development engineer, senior R & D engineer, production manager, product marketing manager, and manufacturing manager. Mr. Lockhart received a B.S. in Ceramic Engineering from Clemson University in 1985 and a M.B.A. from Clemson University in 1990.

Jeff Waldal joined our Semicon Associates division in 1995 as a quality manager, and was promoted to manufacturing manager in 1997 and to President of Semicon in 1999. Mr. Waldal was elected as a Vice President in February 2003. He is currently responsible for the operations, finances and marketing at Semicon Associates. Mr. Waldal

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began his career as senior materials technician at United Technologies – Pratt & Whitney Aircraft. Mr. Waldal was employed for eight years at Ladish Company, Inc. as quality supervisor and quality manager. Mr. Waldal currently serves on the board of directors as Treasurer for Kentucky Manufacturing Assistance Center and is a member of the University of Kentucky College of Engineering Dean’s Advisory Council. Mr. Waldal obtained a degree in Non-Destructive Testing from Hutchinson Technology Institute in 1984, a B.A. in Business Management from the University of Kentucky in 1995, and an M.B.A. from Eastern Kentucky University in 1998.

Richard A. Alliegro has served on our board of directors since 1992. Mr. Alliegro retired from Norton Company in 1990 after 33 years, where his last position was Vice President, Refractories and Wear, for Norton’s Advanced Ceramics operation. He served as President of Lanxide Manufacturing Co., a subsidiary of Lanxide Corporation, from May 1990 to February 1993. Mr. Alliegro currently is the owner of AllTec Consulting, Inc., a ceramic technology consulting firm. Mr. Alliegro obtained B.S. and M.S. degrees in Ceramic Engineering from Alfred University in 1951 and 1952, respectively, and previously served as a member of the Board of Trustees of that university.

Eduard Bagdasarian was appointed to our board of directors on February 25, 2002 to fill the vacancy created by the resignation of Leonard Allenstein. He is Managing Director and Chief Operating Officer of the investment banking firm of Barrington Associates, where he has been employed since 1989. Mr. Bagdasarian chairs Barrington Associates’ Executive Committee and serves on its Board of Directors. Mr. Bagdasarian is a registered General and Financial Principal with the NASD. Mr. Bagdasarian obtained a B.A. degree in Business/Economics from UCLA in 1987.

Frank Edelstein has served on our board of directors since 1984. Mr. Edelstein has been a Vice President of Stone Creek Capital, Inc., an investment banking firm, since November 1986. From 1979 to November 1986, he was Chairman of the Board of International Central Bank & Trust Company, which was acquired by Continental Insurance Co. in July 1983. Mr. Edelstein is currently a director of Arkansas Best Corp. and IHOP Corp. Mr. Edelstein obtained a B.A. degree in Mathematics from NYU in 1948.

Wilford D. Godbold, Jr. has served on our board of directors since July 2000. Mr. Godbold is currently a private investor. From 1982 to 1998, Mr. Godbold was employed by Zero Corporation, a manufacturer of packaging systems for the electronics industry, where he served as Chief Executive Officer and President from 1984 to 1998. From 1966 to 1982, he was engaged in the private practice of law with Gibson Dunn & Crutcher, specializing in mergers and acquisitions, corporate finance and general corporate law. Mr. Godbold holds an A.B. degree in Political Science from Stanford University, and obtained a J.D. from UCLA Law School in 1966. Mr. Godbold is a director of Sempra Energy and K2 Inc.

Milton L. Lohr served on our board of directors from 1986 until early 1988, when he resigned to accept a position as Deputy Undersecretary of Defense for Acquisitions. He held that position until May 1989 and was re-elected to our board of directors in July 1989, and has served on our board of directors since July 1989. Mr. Lohr is currently a partner of L. F. Global Investments, LLC, a San Diego based financial firm with activities in money management funds, venture capital and asset management companies. He served as the first Deputy Undersecretary for Acquisitions in both the Reagan and Bush administrations, with responsibility to assist in overseeing the Department of Defense’s major acquisition programs as well as exercising oversight of international programs and U.S. Arms Control Compliance activities. He also served as U.S. Acquisition Representative to the NATO Conference of National Armament Directors and provided leadership guiding U.S. armament cooperative programs, and in developing and establishing policy initiatives aimed at promoting cooperation on major weapon systems and technology among the NATO Allies. He also served on the Four Power Group with members from the U.K., France, Germany and the United States. Mr. Lohr previously held the position of President of Defense Development Corporation, a defense-related research and development company from 1990 to 1993. Mr. Lohr also held the position of Senior Vice President of Titan Systems, a defense-related research and development company, from 1986 to 1988, and was founder and CEO of Defense Research Corporation, a defense consulting firm, from 1983 to 1986. Mr. Lohr served from 1969 to 1983 as Executive Vice-President of Flight Systems, Inc., a firm engaged in aerospace and electronic warfare systems. Mr. Lohr has over thirty-five years experience in government positions and aerospace and defense management. He served as a panel member on both the President’s Science Advisory Committee (2 years) and the Defense Science Board (15 years), and as a member of the Army Science Board (8 years), as well as other ad hoc government related assignments. Mr. Lohr obtained a B.E. degree in Engineering from USC in 1949 and a M.S. degree from UCLA in 1964.

Directors are elected annually and hold office until the next annual meeting of stockholders and until their successors have been elected and qualified. Officers are appointed by and serve at the discretion of the Board of Directors.

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Audit Committee

Ceradyne’s Board of Directors has established a standing audit committee, which is currently comprised of the following directors: Eduard Bagdasarian, Frank Edelstein, Wilford D. Godbold, Jr. and Milton L. Lohr. All members of the audit committee are non-employee directors and satisfy the current standards with respect to independence, financial expertise and experience established by rules of The Nasdaq Stock Market, Inc. Our Board of Directors has determined that Mr. Godbold meets the Securities and Exchange Commission’s definition of “audit committee financial expert.”

Code of Ethics

Ceradyne has not yet adopted a formal, written code of ethics, as such term is defined in Item 406(b) of Regulation S-K under the Securities Exchange Act of 1934. Ceradyne intends to prepare and adopt a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Once adopted, we will file the code of ethics as an exhibit to our Annual Report on Form 10-K, post it on our website, or do both.

Compliance with Section 16(a) of the Securities Exchange Act of 1934

Section 16(a) of the Securities Exchange Act of 1934 requires Ceradyne’s directors and executive officers, and persons who own more than ten percent of a registered class of our equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of our common stock and other equity securities. Officers, directors and greater than ten percent shareholders are required by SEC regulations to furnish Ceradyne with copies of all Section 16(a) forms they file.

To our knowledge, based solely on a review of the copies of such reports furnished to us and written representations that no other reports were required during the fiscal year ended December 31, 2003, our officers, directors and greater than ten percent beneficial owners complied with all Section 16(a) filing requirements except as follows:

Mr. Richard A. Alliegro filed one late Form 4, reporting late one transaction involving the grant of stock options to him.

Mr. Earl E. Conabee filed two late Form 4’s, reporting late a total of three transactions. One transaction involved the grant of stock options to him and the other two transactions involved the sale of common stock.

Mr. Frank Edelstein filed two late Form 4’s, each reporting late one transaction. One transaction involved a bona fide gift of common stock and one transaction involved the grant of stock options to him.

Mr. Bruce Lockhart filed one late Form 4, reporting late one transaction involving the grant of stock options to him.

Mr. Milton L. Lohr filed one late Form 4, reporting late one transaction involving the grant of stock options to him.

Mr. Joel P. Moskowitz filed two late Form 4’s, reporting late a total of three transactions. One transaction involved the grant of stock options to him, and two transactions involved the sale of common stock.

Mr. Jerrold J. Pellizzon filed one late Form 4, reporting late one transaction involving the grant of stock options to him.

Mr. David P. Reed filed two late Form 4’s, reporting late a total of three transactions. One transaction involved the grant of stock options to him, one transaction involved the exercise of stock options and one transaction involved the sale of common stock.

Mr. Jeff Waldal filed one late Form 4, reporting late one transaction involving the grant of stock options to him.

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Summary Compensation Table

The following table shows certain information concerning the compensation of our Chief Executive Officer and the four other most highly compensated executive officers of Ceradyne whose aggregate compensation for services in all capacities rendered during the year ended December 31, 2003 exceed $100,000 (collectively, the “Named Executive Officers”):

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Option Grants in Last Fiscal Year

The following table sets forth certain information concerning grants of options to each of the Named Executive Officers during the year ended December 31, 2003. In addition, in accordance with the rules and regulations of the Securities and Exchange Commission, the following table sets forth the hypothetical gains or “option spreads” that would exist for the options. Such gains are based on assumed rates of annual compound stock appreciation of 5% and 10% from the date on which the options were granted over the full term of the options. The rates do not represent Ceradyne’s estimate or projection of future common stock prices, and no assurance can be given that any appreciation will occur or that the rates of annual compound stock appreciation assumed for the purposes of the following table will be achieved.

Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values

The following table sets forth certain information regarding option exercises during the year ended December 31, 2003 by the Named Executive Officers, the number of shares covered by both exercisable and unexercisable options as of December 31, 2003 and the value of unexercised in-the-money options held by the Named Executive Officers as of December 31, 2003: