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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2004

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 28, 2005, the aggregate market value of the Common Stock held by non-affiliates was approximately $681,347,573.

As of February 28, 2005, there were 24,497,559 shares of registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE: Portions of registrant’s definitive proxy statement for its annual meeting of stockholders to be held on May 23, 2005 are incorporated by reference into Part III of this Form 10-K.

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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, ceramics powders 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 both domestic and international markets.

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. Our sales also increased in 2004 because we purchased ESK Ceramics on August 23, 2004 and their operations have been consolidated with ours since September 1, 2004.

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

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 drive 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 through four operating segments: our Advanced Ceramic Operations division, our ESK Ceramics subsidiary, our Semicon Associates division and our Thermo Materials division. 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.

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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 were excellent electrical insulators and were 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 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. The current geopolitical climate, terrorist threats and heightened risk of international conflict have been the primary factors driving 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 have completed the renovation and relocation of 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.

In August 2004, we acquired ESK Ceramics, who has been a supplier to us for over 30 years of boron carbide powder, a key raw material used in the production of our largest product line, body armor. Since the acquisition, we have been consolidating inter-company profits from the inter-company sales and purchases of boron carbide thus reducing our cost of goods sold and increasing gross margins.

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 material’s 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. Our acquisition in May 2004 of the assets and business of Quest Technology, LP, a San Diego, California-based manufacturer of small, precision ceramic parts using an injection molding process, and the acquisition in August 2004 of ESK Ceramics, a German-based manufacturer of ceramic powders and components, have substantially contributed to our goal of broadening our product lines and the markets we serve.

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

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our customer product and market base by converting certain advanced technical ceramics, originally developed for defense applications, to industrial and commercial applications. A strategic reason for our acquisition of ESK Ceramics, a European based ceramics manufacturing company, was to diversify our non-defense revenue base.

Leveraging our Facilities and Technologies to Address New Products and Markets. Over the past two decades, we have designed and constructed 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. A strategic reason for our acquisition of ESK Ceramics was to expand our sales to customers located outside the United States. Since the consolidation of ESK Ceramics’ operations with ours commencing as of September 1, 2004, their sales to customers located outside the United States were approximately 79% of their total sales during the four month period ended December 31, 2004. ESK Ceramics has sales offices in Germany, France and China. 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 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 and other vehicles.

Boron Carbide Powders. We manufacture boron carbide powder that is used in the production of lightweight ceramic body armor. Our subsidiary and recent acquisition, ESK Ceramics, is one of leading suppliers of this material in the world. They have been a supplier to us for over 30 years and also supply our ceramic body armor competitors.

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.

Fluid Handling/Wear Parts. We also supply products made primarily of our EKasic^® silicon carbide, silicon nitride and boron carbide, which have excellent wear resistant properties, lightness, hardness, and can withstand extremely

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high temperatures. Products furnished are used in high performance pump seals, bearings for fluid handling, riser tubes, blast nozzles and chemical processing.

Boron Compounds & Metallurgy. Boron nitride powders are well known for their excellent release properties during forming and bending of glass. Furthermore, electro statically applied dry boron nitride powder serves as a lubricant for aluminum extrusion and is used as an additive in refractory materials for higher wear and corrosion resistance. EKatherm^® is our registered trademark for products made of silicon nitride. EKatherm^® foundry products are used by aluminum foundries for transportation of liquid aluminum for use in low and high pressure casting. They are also used in the dosing of liquid aluminum for different processes, temperature measurement and during the heating process of liquid aluminum. Our EKatherm^® products display excellent thermal shock resistance and temperature stability up to 1,200° Centigrade.

Evaporation Boats. Our TriMet^® evaporation boats are used in the metallization of various surfaces such as plastic, paper or glass. Metallization is a process based on the deposition of a metallic vapor under high vacuum to coat a substrate surface with a thin layer of aluminum, zinc, copper or silver. The preferred metal for the metallizing process is aluminum. Evaporation boats have direct contact with highly corrosive liquid metal alloys and are made out of a boron nitride/titanium diboride composite material. These products provide packaging manufactures the ability to apply molten aluminum to packaging material that as a finished product helps to preserve and maintain the shelf life of food products in the consumer packaging goods industry.

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.

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.

Neutron Absorption. Our TETRABOR^® boron carbide has a high cross-section for neutrons making it the ideal material for the management of neutron irradiation. Typical applications include the use in neutron absorbing parts, such as control rods in nuclear power plants with powders and pellets or nuclear shielding and transportation of nuclear waste materials using powders and tiles.

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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.

Wear-Resistant Functional and Frictional Coatings. We have been manufacturing our Ekagrip^® Foils for wear-resistant functional and frictional coatings utilizing entrapped hard particles either of diamonds or ceramics. This product line increases the static friction coefficient and minimizes the effects of vibration and allows more economic and efficient designs of engines, particularly in the auto industry. The textile industry also consumes this product.

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 (jointly owned by Ceradyne and 3M Unitek) 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.

Operating Divisions and Facilities

We serve our markets through four segments from manufacturing facilities in several locations across the United States and from two locations in Europe - Germany and France. The following table includes a summary of our facilities and products comprising our four operating segments.

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Sales, Marketing and Customers

Each of our four reporting segments maintains a separate sales and marketing force promoting its individual products. As of December 31, 2004, we had 67 employees directly involved in sales and marketing, including 14 sales and marketing personnel located outside the United States.

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 sales to customers located outside the United States represented approximately 20.5% of our net sales in 2004, 5.4% in 2003 and 10.9% in 2002.

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.

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 59.2% of our net sales in 2004, 53.7% in 2003 and 35.9% in 2002.

We sell our translucent ceramic orthodontic brackets only to 3M Unitek under an exclusive agreement that ends in 2007. Sales to 3M Unitek represented approximately 4.5% of our net sales in 2004, 8.9% in 2003 and 11.5% in 2002. 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

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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 our recently acquired subsidiary, ESK Ceramics, as well as 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.

Ceramic Powders (Boron Carbide TETRABOR^®, Titanium Diboride, Calcium Hexaboride, Zirconium Diboride). We purchase raw materials like carbon, boric acid and oxides from outside vendors. These raw materials are converted in high temperature processes using an arc furnace process. These products are then purified through a chemical treatment. The next process is the classification; various grain sizes are produced. The specific manufacturing processes result in a very high and constant quality with the resulting finished ceramic powder products used in a wide range of applications, such as ceramics and powders for abrasives, armor, neutron absorption and refractories.

Sintering and Reaction Bonding of Silicon Nitride (SRBSN). 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 some 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 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.

Functional coatings. The coatings result in the deposition of hard particles (typically diamonds) in a nickel layer on steel, aluminum or titanium. We purchase the hard particles—sized between nanometers and 60µm - from outside vendors and customize these raw materials through chemical treatment. Before being coated, the metal parts are chemically cleaned and deburred. The final product is manufactured by an electroless nickel coating process with simultaneous embedding of hard particle grains. The final step is the hardening of the nickel surface by a heat treatment process up to 660°F.

Evaporation Boats (LaserMet^®, DiMet^®, TriMet^®, FlashMet^®). Evaporation boats are ceramic sintered parts consisting of titanium diboride/boron nitride and other nitride compositions for our TriMet^® product. These components, in the form of ceramic powders, are milled and conditioned. The key forming process is hot pressing, which results in solid sintered billets. From these sintered billets, the evaporation boats are machined with proprietary processes to various types and shapes.

Sintered Parts. For the production of sintered parts, we either buy raw materials like silicon carbide from outside vendors or use our own ceramic powders like TETRABOR^® boron carbide. There are various types of ceramic powder materials, such as silicon carbide, silicon nitride, boron nitride, boron carbide and titanium diboride that are available in our standard product portfolio. With our specific developed processes, we condition the ceramic powders by additives, milling, and spray drying into ready-to-press powders. We then utilize the processing steps of forming, green machining, sintering and machining as the materials are transformed into various shapes. We utilize a broad range of technological processes and

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equipment to accomplish this. An example of these are cold isostatic pressing, axial dry pressing, injection molding, extrusion molding, pressure sintering, hot pressing and hot isostatic pressing.

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 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.

Injection Molding. Certain markets, like medical device components, require ceramic shapes that are small, highly configured and held to tight dimensional tolerances. Many of these can only be produced by the injection molding process. At the present time these powders tend to be oxide ceramics, primarily zirconia, alumina and/or blends thereof that we mix in house. The ceramic powder is then blended with organic ingredients that constitute a proprietary binder system. The resultant feedstock allows us to process the material through a standard injection-molding machine into a precision mold designed by us.

Raw Materials. The starting raw materials for our manufacturing operations are generally fine, synthetic powders available from several domestic and foreign sources, including our subsidiary, ESK Ceramics. During the year end December 31, 2004, we purchased $4.8 million of boron carbide materials from ESK Ceramics, an increase of $3.3 million, or 220.00%, compared to $1.5 million in the year end December 31, 2003. Other raw materials, such as Kevlar^™, graphite and metal components are procured from several commercial sources. A raw material, Spectra Shield^™, used in the production of armor is on allocation as determined by the U.S. Government. We believe this material will be available in sufficient quantity for our production requirements during 2005.

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.

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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. 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 $3.3 million in 2004, $2.1 million in 2003, and $2.1 million in 2002.

Competition

Our products compete with advanced technical ceramics products and powders from other companies, as well as with high strength steel alloys and plastic products. When competing with other advanced technical ceramics products and powders, 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, Cercom, CoorsTek, Kyocera’s Industrial Ceramics Group, Saint Gobain, UK Abrasives, Sintec, GE Advanced Ceramics, Ceramtec, Denka, HC Starck, Hitachi, Morgan, 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. 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 and other customary terms and conditions. As of December 31, 2004, we had backlog of approximately $199.9 million and $4,400 of unexercised options for orders. As of December 31, 2003, we had backlog of approximately $103.1million and $1.1 million of unexercised options for orders. We expect that substantially all of the firm scheduled orders as of December 31, 2004 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 21 U.S. patents and have 14 patents pending and have applied for corresponding foreign patents in various foreign countries. The earliest of these patents expires in 2006.

Of the number of patents indicated above, our subsidiary, ESK Ceramics, has been issued 14 U.S. patents, while 6 patents are pending and one new patent has been filed in 2004.

The proprietary coarse grained silicon carbide materials, including silicon carbide materials with graphite inclusions, are protected by patents in Europe, the United States, Canada and Japan. These patents expire in 2017. Other patents and one patent pending also relate to sintered silicon carbide materials, the earliest expiring 2010. Another 4 patents

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for evaporation boats have been issued in Europe, the United States, Canada and Japan. The earliest of these patents expires 2018. Two other patents are on Ekagrip^®, the friction enhancing coatings, which expire in 2019. Other patents relate to boron nitride materials and composite ceramic materials.

“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^™”. The ESK name and logo, and ESK Ceramics’ major product trademarks, including “TETRABOR^®”, “EKasic^®”, “DiMet^®”, “TriMet^®”, “MYCROSINT^®” and “EKagrip^®” are registered in Germany and many countries worldwide.

Employees

As of December 31, 2004, we had approximately 1,442 employees, including 50 employees with undergraduate or graduate degrees in ceramic engineering. Of these total employees, 1,090 were in manufacturing, 165 were in engineering and research, 67 were in sales and marketing, and 120 were in general management, finance and administration. We also use temporary labor in some of our production operations. We generally consider our relationship with employees to be excellent. None of our U.S.-based employees are represented by labor unions.

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. These statements can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” or other similar words. Our actual results may differ materially from the results projected in the forward-looking statements. While the risks described below are the ones we believe are most important for you to consider, these risks are not the only ones that we face. If any of the following risks actually occur, our business, financial condition, operating results or cash flows could be materially harmed.

A very substantial portion of our revenue is derived from the sale of defense related products. If we fail to obtain new government contracts or orders under existing contracts, if existing government contracts or orders are cancelled, or if federal budget appropriations involving our products are reduced, our revenue, profits and cash flows could decline.

Historically, a very substantial portion of our revenue 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 revenue 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. If the U.S. government were to cancel any of these government contracts, our revenue and profitability could be reduced.

Our business is highly sensitive to changes in national and international defense and budget priorities. For example, in 2003 and 2004, our revenue 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, 2004, we anticipate that revenue from the sale of these products will increase in 2005. However, unless we receive additional orders under existing contracts or are successful in winning new contracts for sales of these products, revenue from sales of these products will decline materially after 2005 from the levels we obtained in 2004 and we expect to obtain in 2005.

Our revenue 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. Our success depends upon our ability to successfully compete for and retain such government contracts. If we, or if prime contractors for which we are a subcontractor, fail to win any particular bid, or if we are unable to replace business lost upon cancellation, expiration or completion of a contract, our revenue and cash flows could be reduced.

A critical raw material used to make ceramic body armor is in limited supply. A delay or inability to obtain sufficient quantities of this material could limit the amount of body armor we can manufacture and therefore result in reduced revenue, profits and cash flows.

The ceramic body armor that we manufacture consists of a ceramic armor plate that we laminate with an ultra-high molecular weight polyethylene textile material, which is available in the United States only from Honeywell International, Inc., under the brand name Spectra Shield^®, and from Royal DSM N.V., under the brand name Dyneema^®. Due to the rapid escalation in the demand for ceramic body armor, the quantities of Spectra Shield and Dyneema materials are currently in limited supply and on allocation. Although we believe that sufficient quantities of these materials will be available to fulfill our projected needs for 2005, any delay or interruption in the supply of either of these materials could adversely affect our ability to fulfill our current orders for ceramic body armor. Moreover, if orders increase from our currently anticipated levels for ceramic body armor to be shipped during 2005, we may not be able to fulfill those additional orders if supplies of Spectra Shield and Dyneema materials are limited. In either case, if a delay or reduction in current supplies of Spectra Shield or Dyneema occurs, or if Honeywell or DSM do not increase their production capacity for those

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materials, we may not be able to ship all of our orders for ceramic body armor, which could result in reduced revenue, cash flows and profits.

Recent acquisitions may place a significant strain on our management and resources and we may be unable to effectively integrate and develop the acquired businesses, which could cause our business to suffer.

We have limited experience integrating remote operations into our organizational structure. Our acquisitions during 2004 of ESK Ceramics and Quest Technology require us to integrate the technology and operations of these businesses with our company. In the case of ESK Ceramics, the magnitude of the acquisition will also require us to make changes to our own management team by adding executive positions to assist in the management of ESK Ceramics and to assimilate its foreign workforce. In addition, our increasing international presence resulting from this acquisition may increase our exposure to foreign political, currency and tax risks. If we are unable to efficiently manage the integration of these acquisitions, we may incur additional expenses and experience production delays, which could result in reduced revenue and profits.

The risks we face as a result of these acquisitions include, but are not limited to:

If we are not able to successfully integrate and develop these two acquired businesses, our revenue and operating results may be negatively affected in future periods, which may cause our stock price to decline. We may incur liabilities from the acquired businesses, including liabilities for infringement of intellectual property rights or other claims, and we may not be successful in seeking indemnification for such liabilities or claims. In addition, as a result of the risks and uncertainties associated with these acquisitions, our ability to make predictions of our future revenue, costs and expenses and operating results may become more difficult.

Our acquisition of ESK Ceramics required us to obtain substantial debt financing. If we default under this loan, our business and stock price could suffer.

We financed a substantial portion of the purchase price for our acquisition of ESK Ceramics with $110 million of long-term debt borrowed under a new $160 million credit facility. Our obligations under this loan are secured by substantially all of the assets of Ceradyne and ESK Ceramics, other than real property. The loan requires that we maintain specified minimum financial statement ratios and imposes restrictive covenants that will limit our flexibility in how we operate our business. Our business must continue to generate sufficient cash flow to enable us to pay the interest on this debt and repay principal. If we fail to make payments when due or fail to perform other required covenants under this credit facility, the lenders could declare a default and the resulting consequences could substantially hurt our business and cause our stock price to decline.

Defects in our products could harm our reputation for quality products, increase our operating expenses, reduce sales of our products and impact cash flows.

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 reduce our sales and profits. For example, in March 2002, the U.S. government determined that several lots of our small arms protective inserts, called

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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.

We have recently made significant investments to increase our manufacturing capacity and improve our product yields in response to increased demand. If our efforts to bring our new plants to full functional usage are not successful, our gross margins, profitability and cash flows may suffer.

We experienced a sudden increase in demand for ceramic body armor for military personnel and cam rollers for diesel engines during 2002. This demand increased further in 2003 and 2004, and we anticipate the trend will continue in 2005. In the effort to meet the sudden increased demand for our products, in 2002 we suffered from manufacturing inefficiencies, including low product yields, which caused our gross profit margins on these products to suffer in 2002. These problems were reduced during 2003 and 2004 as we implemented a number of new programs and management initiatives to improve manufacturing efficiencies, and we experienced higher product yields and an increase in our gross profit margins on these products during 2003 and 2004.

In response to the increased demand, we made significant capital expenditures during 2003 and 2004 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 to expand production capacity for diesel engine components and ceramic body armor. We began producing diesel engine components in this new Lexington, Kentucky facility during the third quarter of 2004, and commenced production of ceramic body armor in this facility during the first quarter of 2005. During 2003, we leased an additional 47,000 square feet near Scottdale, Georgia, to provide additional manufacturing capacity for our Thermo Materials division. In April 2004, we leased an additional 23,000 square feet in Irvine, California to provide additional manufacturing capacity for our Advanced Ceramics Operations division.

Our increased production capacity may not, however, enable us to manufacture the required quantities of our products in a timely manner. Additionally, these plants may take longer than anticipated to bring up to full functional usage, thereby causing additional expense and time delay than originally estimated. Further, demand for cam rollers and ceramic armor may not remain at levels sufficient to justify these additional capital expenditures. As a result, the profit margins we ultimately achieve on sales of ceramic body armor and cam rollers may be lower than our historical profit margins. In order to satisfy customer demand for these products while achieving acceptable profit margins, we must:

Moreover, managing our expansion and relocation efforts will put pressures on our operational, financial and managerial resources. To effectively manage our expansion and relocation effort, we must:

We may not be able to complete the expansion or relocation in a timely manner or within our capital expenditure budgets. We may not realize anticipated cost savings, especially if energy costs in Kentucky, which are substantially lower than in California, do not remain at expected levels over time. The expansion and relocation could also disrupt our operations. Certain of our contracts contain punitive provisions for missed deadlines. If the expansion or relocation causes a disruption in our operations, we may miss deadlines and be required to make penalty payments under these contracts. Moreover, some of the capital equipment for our Kentucky facility is being specially designed and built to our

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requirements. This equipment is complex and has not been constructed previously. As a result, we may not be able to complete the construction of this equipment on time or within our budget and the equipment may not operate as planned. Any of these occurrences could result in an increase in our operating expenses and a reduction in our revenue as a result of delays in the production of our products. As a result, our gross margin and profitability may suffer.

Growth in our operations may strain our resources, and if we fail to successfully manage our growth, we could incur higher operating costs and delays in the production of our products, which could result in reduced revenue, profits and cash flows.

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:

Any failure to effectively manage growth could result in increased operating costs and delays in the development and production of our products. If this occurs, our revenue and profits could decline.

Our business is subject to the risks associated with doing business outside the United States.

Shipments to customers outside of the United States accounted for approximately 20.5% of our sales in 2004, 5.4% of our sales in 2003, and 10.9% in 2002. The big increase in 2004 was due primarily to our acquisition of ESK Ceramics in August 2004, whose operations have been consolidated with ours since September 1, 2004. ESK Ceramics’ operations are located in Germany and France; approximately 79.0% of its sales are to customers located outside of the United States. We anticipate that international shipments will account for a large 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 sales from the United States to customers in foreign countries in U.S. dollars. Consequently, if the U.S. dollar becomes more expensive relative to the currencies of our foreign customers, the price of our products that we export from the United States to 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

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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.

Our recently acquired subsidiary, ESK Ceramics, whose operations are located primarily in Germany and France, invoices approximately 67.0% of its sales in Euros; its sales to customers located in the United States are invoiced in U.S. dollars. If the Euro becomes more expensive relative to the currencies of ESK Ceramics’ customers located outside the European Union, the price of its products sold to customers in those countries will rise and its sales into those countries, or its profitability within those countries, may fall.

If we are unable to compete successfully against current and future competitors, our revenue could decline.

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, Cercom, CoorsTek, Kyocera’s Industrial Ceramics Group, Saint Gobain, UK Abrasives, Sintec, GE Advanced Ceramics, Ceramtec, Denka, HC Starck, Hitachi, Morgan, Spectra-Mat and Vesuvius. Many of our current or potential competitors have greater financial, marketing and technical resources than we do. If we fail to compete successfully against our current or future competitors, our revenue and profitability could decline.

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 if our sales to 3M Unitek decline, our overall revenue, profits and cash flows may also decline.

We sell our ceramic orthodontic brackets exclusively to 3M Unitek under an agreement, which expires in 2007. As a result, our revenue from this product is 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 a reduction in our revenue, 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, resulting in a decrease in our revenue, profits and cash flows.

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

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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. As a result, our revenue, profits and cash flows may also decline.

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 depends on the continued service of our management team and key personnel, including Joel P. Moskowitz, our Chairman and Chief Executive Officer and President; Jerrold J. Pellizzon, our Chief Financial Officer and Corporate Secretary; David P. Reed, our Vice President, and President of North American Operations; and Peter Hartl, the President of our recently acquired subsidiary, ESK Ceramics. Mr. Moskowitz was diagnosed with non-Hodgkin’s lymphoma. He completed chemotherapy treatments in January 2005, and his current prognosis is positive.

If Mr. Moskowitz becomes unable to continue working due to health reasons, or if one or more of these individuals 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, and we may have difficulty replacing any of these individuals. We do not have employment agreements or key person insurance on any of our executive employees.

Competition for skilled employees is intense and we may not be able to recruit and retain such personnel. If we are unable to retain our existing managers and employees or hire and integrate new employees, we may experience operating inefficiencies, production delays and reduced profitability.

We may not be able to increase market awareness and acceptance of advanced technical ceramics in new applications and products, which could limit our ability to increase revenue, profitability and cash flows in the future.

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 brought against us could result in payment of substantial damages, which would decrease our cash reserves and could harm our profitability and cash flows.

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 may not have adequate insurance to cover the payment of any potential claim related to such injuries or deaths. Insurance coverage may not continue to be available to us or, if available, may be at a significantly higher 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. Our accrual may not be adequate to cover actual claims. Third party or workers compensation claims brought against us that exceed our insurance coverage or accruals would likely be paid out of our cash reserves, increasing our need for cash and potentially harming our profitability.

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 reduce our revenue, profits and cash flows.

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. As a result, our revenue and profits could be reduced.

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If we fail to comply with environmental laws and regulations, we could incur an increase in our operating costs and a decrease in our profits and cash flows.

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.

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 may not, however, be able to 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 would decrease our cash reserves and could harm our profitability.

We may not be able to adequately safeguard our intellectual property rights from unauthorized use, and we may 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, these efforts may not be successful. 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, requires management attention and might not bring us timely and effective relief.

Furthermore, third parties may assert that our products or processes infringe their patent rights. 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 may not be able to obtain any such licenses on acceptable terms, if at all.

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Our stock price has been volatile, which may make it more difficult to realize a gain on your investment in our stock.

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:

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 paying any cash dividends on our common stock. Consequently, you will not earn any return on your investment in our common stock unless you are able to sell the shares of our stock that you hold at a higher price than you pay for them.

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. Additionally, our new credit facility may restrict the payment of dividends. Consequently, you will not earn any return on your investment in our common stock unless you are able to sell the shares of our stock that you hold at a higher price than you pay for them.

Delaware law may delay or prevent a change in control, which could inhibit your ability to receive a premium price for your shares.

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. These provisions of Delaware law may have the effect of delaying, deferring or preventing a change in control, and may discourage bids for our common stock at a premium over its market price.

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Operating Divisions and Facilities

We serve our markets through four segments from manufacturing facilities in several locations across the United States and in Europe. The following table includes a summary of our facilities included within each or our four reportable operating segments.

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 2004.

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EXECUTIVE OFFICERS OF CERADYNE

Our executive officers and directors and their ages as of March 1, 2005 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.

David P. Reed joined Ceradyne in November 1983, and has served as a Vice President since January 1988. In March 2005, Mr. Reed was appointed to the newly created position of President of North American Operations, with responsibility for all the company’s Advanced Ceramic Operations in Costa Mesa, Irvine and San Diego, California, as well as the new plant in Lexington, Kentucky; Ceradyne Thermo Materials, in Scottdale, Georgia; and Ceradyne Semicon Associates, in Lexington, Kentucky. Mr. Reed’s focus has been and will continue to be on lightweight ceramic armor systems. Prior to joining Ceradyne, 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.

Jerrold J. Pellizzon joined us in September 2002 and serves as our Chief Financial 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.

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Michael Kraft joined Ceradyne in March 2005 in the newly created position of Vice President of Sales, Marketing and Business Development. This position encompasses sales and marketing for all Ceradyne profit centers, including responsibility for the integration of Ceradyne’s 2004 acquisition of ESK Ceramics of Kempten, Germany. Prior to joining us, Mr. Kraft was Managing Director of BVI Capital Partners from 2003 through 2005, and President and Founder of KAM Solutions, LLC in 2003. From 2000 through 2002, Mr. Kraft was President, USA, for Rational AG and from 1993 through 2000, he held various management and marketing positions with Kulicke & Soffa Industries, Inc. Prior to 1993, Mr. Kraft held various management and marketing positions with General Electric Company. He holds degrees with honors from Michigan State University in electrical engineering and an MBA degree from Pennsylvania State University.

Dr. Peter Hartl joined Ceradyne as the result of the Company’s acquisition of the German technical ceramic company, ESK Ceramics GmbH & Co. KG, completed in August 2004. Dr. Hartl was elected a Vice President in November 2004, and is President of ESK Ceramics. He joined ESK Ceramics in 1998 as Vice President in charge of boron compounds. Prior to joining ESK, Dr. Hartl spent 11 years at ESK’s former parent company, Wacker Chemie, starting in Wacker’s research department and moving to the chemical regulations department as part of a management development project. He became technical support manager in Wacker’s silicone division and was later appointed regional manager for silicone sealants to establish sales, marketing, production, and service operations in Singapore.

Marc King joined Ceradyne in September 2004 as Vice President of Armor Operations in Washington, D.C. to support ongoing growth of the Company’s ceramic armor business, particularly in armor for ground-based military vehicles. Prior to joining Ceradyne, he was Vice President of Business Development for Mistral, Incorporated, where he developed strategies for marketing and sales to the U.S. government markets, including Department of Defense (DoD) and Homeland Security. Prior to Mistral, Mr. King was president of GMA Cover Corporation (USA), a supplier to the United States Army Tank-Automotive and Armaments Command and the Defense Logistics Agency. Before that, he was Vice President of Gichner Systems Group (GSG), and President of its refrigerated truck body division. Gichner supplied shelters, enclosures, and other troop-support equipment through the DoD. Prior to GSG, Mr. King was Director of Allied Defense Industries’ land systems and aerospace divisions, where he planned and directed the marketing of defense and defense-related equipment, including vehicle armor. Mr. King’s military experience includes responsibility for command, operations, and logistical support for U.S. Army ground and air troops and weapons and ground warfare systems deployment. He also was a Congressional coordinator for the Secretary of the Army and managed Congressional legislative directives to the Army. He completed his military career as a lieutenant colonel.

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 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.

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.

Our officers are appointed by and serve at the discretion of our Board of Directors.

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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 28, 2005, there were approximately 529 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, 2004 that were not registered under the Securities Act of 1933, other than shares of our common stock that we issued in May 2004 in connection with the purchase of the assets and business of Quest Technology, LP. This transaction was previously reported in our 10-Q Report for the quarter ended June 30, 2004.

All share prices in the table above have been adjusted to give retroactive effect to a 3-for-2 split of our common stock in the form of a 50% stock dividend distributed on April 7, 2004, and a second 3-for-2 split of our common stock in the form of a 50% stock dividend distributed on January 18, 2005.

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The following selected consolidated financial data as of December 31, 2000, 2001 and 2002 and for the years ended December 31, 2000 and 2001 are derived from our audited consolidated financial statements, which are not included in this report. The selected consolidated financial data as of December 31, 2003 and 2004 and for the years ended December 31, 2002, 2003 and 2004 are derived from our audited consolidated financial statements, which are included elsewhere in this report. 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, ceramic powders 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; various types of ceramic powders; evaporation boats; functional coatings; 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 through four segments. The following table includes a summary of our products by applications for our four segments.

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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 factors contributing to our recent growth in sales is increased demand by the U.S. military for ceramic body armor that protects soldiers and our acquisition of ESK Ceramics in 2004. ESK’s reported 2004 sales are $36.0 million since the inclusion of their results as of September 1, 2004. 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 ceramic body armor. We expect our shipments of ceramic body armor to be higher in fiscal year 2005 than in 2004. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2006 from levels we expect to achieve in 2005. 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.

In recent years, a substantial portion of our annual revenue has been derived from our order backlog as of the end of the preceding year. Our order backlog as of December 31, 2004 was approximately $199.9 million, and we had $4,400 of unexercised options for orders. As of December 31, 2003, we had backlog of approximately $103.1 million, and $1.1 million of unexercised options for orders. Orders for ceramic armor as of December 31, 2004 represented approximately $131.3 million, or 65.7% of the total backlog. This compares with orders for ceramic armor as of December 31, 2003 of approximately $86.6 million, or 84.0% of the total backlog at that time. We expect that substantially all of the firm scheduled orders as of December 31, 2004 will be shipped during 2005.

Our sales to customers located outside of the United States have varied, representing $44.3 million, or 21.0% of net sales in 2004, $5.5 million, or 5.4% in 2003, and $6.7 million, or 10.9% in 2002. As a result of our acquisition of ESK Ceramics in August 2004, our sales to customers located outside of the United States as a percentage of total sales increased substantially. ESK’s 2004 sales to customers located outside of the United States were $28.5 million, or 64.3% of the total $44.3 million 2004 export sales for us. We plan to increase our sales efforts in foreign countries, and our acquisition of ESK Ceramics will help us achieve this goal. We currently have sales offices in Germany, China, and England as well as commissioned independent sales representatives in other parts of Europe and Asia. Of our export sales, 62.7% were 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. These research and development funds, which have been relatively small in amount, have been recognized as revenue as we performed the research and development.

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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 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.

Energy costs are an integral and material cost of our product sales. For the year ended December 2004, electricity energy costs for us in the United States and Europe in connection with our manufacturing operations were $4.4 million, an increase of $1.4 million, or 46.7%, from $3.0 million of electricity energy costs in the prior year. Electricity energy consumed for the year ended December 31, 2004 was 47.3 million kilowatt hours, an increase of 13.1 million kilowatt hours, or 38.3%, from 34.2 million kilowatt hours in the prior year. Average costs per kilowatt hour for the year ended December 31, 2004 were $.0939, an increase of $.0077 per kilowatt hour, or 8.9%, compared to $.0862 in the prior year. For the year ended December 2004, natural gas and propane energy costs were $300,000, an increase of $89,000, or 42.2%, from $211,000 of natural gas and propane energy costs in the prior year. Natural gas and propane energy consumed in connection with the manufacturing operations for the year ended December 31, 2004 were 427,000 therms, an increase of 116,000 therms, or 37.3%, from 311,000 therms in the prior year. The average costs of a therm for the year ended December 31, 2004 was $0.76, an increase of $.05 per therm, or 7.0%, compared to $0.71 in the prior year.

We recently relocated part of our silicon nitride manufacturing operations from California to a new facility in Lexington, Kentucky because of lower energy and occupancy costs in Kentucky compared to California. Recently, the Company increased its manufacturing capacity for the production of body armor plates by adding a hot press line at this facility. We chose this facility for the location of the hot press expansion for the same reasons: lower costs of energy and occupancy.

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, 2004, 2003 and 2002 expressed as a percentage of net sales.

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Years Ended December 31, 2004 and 2003

Net Sales. Our net sales for the year ended December 31, 2004 were $215.6 million, an increase of $114.1million, or 112.4% from $101.5 million of net sales in the prior year.

Net sales for our Advanced Ceramic Operations division for the year ended December 31, 2004 were $159.8 million, an increase of $79.3 million, or 98.5% from $80.5 million of net sales in the prior year. The increase in net sales was mainly due to a $69.0 million or 117.8% increase in ceramic armor shipments for defense customers because of an increase in demand for body armor, a $6.7 million or 133.8% increase in shipments of automotive parts as more diesel cam roller parts were included in diesel truck engines, a $1.2 million or 28.1% increase in industrial wear parts, a $1.8 million or 361.4% increase in shipments to the medical industry, and a $0.7 million or 8.2% increase in shipments of ceramic orthodontic brackets. Of the $1.8 million shipped to the medical industry, $1.0 million was contributed by the business we acquired from Quest Technology in May 2004. Sales increases were offset by decreases in other product lines, mainly a $100,000 or 8.0% decrease in net sales of machined products and a $200,000 or 21.7% decrease in research grants.

We acquired our ESK Ceramics subsidiary on August 23, 2004, and began to consolidate and report their operations with ours as of September 1, 2004. For the four month period ended December 31, 2004 during which their operations were consolidated with ours, ESK Ceramics contributed $36.0 million to our consolidated net sales.

Our Semicon Associates division had net sales of $7.5 million for the year ended December 31, 2004, an increase of $0.6 million, or 8.7%, from $6.9 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 $12.3 million for the year ended December 31, 2004, a decrease of $1.8 million, or 12.8%, from $14.1 million of sales in the prior year. The decline in sales was attributable to a decrease of $4.0 million or 66.3% due to the completion of the PAC-3 defense facilities in 2003 that did not re-occur in 2004 and a decline of $0.5 million or 13.0% in the sales of fused silica rollers because of reduced shipments to China and reduced unit prices due to more competitive pricing. Sales decreases were offset by an increase of $1.8 million or 145.9% in shipments of ceramic crucibles used in the manufacture of photovoltaic solar energy cells and an increase of $0.8 million or 58.1% increase in sales of ceramic radomes used on the PAC-3 and Arrow missiles.

Gross Profit. Our gross profit for the year ended December 31, 2004 was $69.1 million, an increase of $39.8 million, or 135.8%, from $29.3 million in the prior year. As a percentage of net sales, gross profit was 32.0% for the year ended December 31, 2004 as compared to 28.9% of net sales in the prior year.

Our Advanced Ceramic Operations division had gross profit for the year ended December 31, 2004 of $56.8 million, an increase of $31.4 million, or 123.6%, from $25.4 million in the prior year. Gross profit for Advanced Ceramic Operations in 2004 was 35.5% of net sales, as compared to 31.6% of net sales in the prior year. The improvement in gross profit during the year ended December 31, 2004 was a result of increased armor sales, improvements in manufacturing techniques in our hot press operations, higher absorption of fixed operating expenses, better manufacturing efficiencies, increased productivity through a reduction in our workers’ compensation costs and an improved sales mix in armor parts 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 ESK Ceramics subsidiary had gross profit of $8.9 million, or 24.7% of net sales, for the four months of 2004, during which their operations were consolidated with ours. Included in ESK’s gross profit are $3.0 million of pre-tax expenses related to the amortization of backlog and the step up of inventory resulting from the application of purchase accounting in connection with the acquisition. These non-recurring expenses had an 8.3% of net sales negative impact on gross profit in 2004.

Our Semicon Associates division had gross profit for the year ended December 31,2004 of $1.4 million, an increase of $0.3 million, or 27.3%, from $1.1 million in the prior year. Gross profit for Semicon Associates for the year end December 31, 2004 was 19.2% of net sales, as compared to 16.7% of net sales in the prior year. The increase in gross profit as a percentage of net sales was caused by an improvement in gross margins for our cathodes for microwave tubes and a reduction in losses incurred in our magnet products, resulting in higher overall gross profit levels.

Our Thermo Materials division had gross profit of $2.0 million for the year end December 31, 2004, a decrease of $0.8 million, or 28.6%, from $2.8 million in the prior year. Gross profit for Thermo Materials for the year end December 31, 2004 was 16.3% of net sales, as compared to 19.6% of net sales in the prior year. The decrease was due to a

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reduction in the amount of sales causing a lower absorption of fixed costs, a change in the mix of products sold and a reduction in gross margins for crucibles and castables due to lower production yields and higher scrap rates.

Selling Expenses. Selling expenses were $8.3 million for the year ended December 31, 2004, an increase of $5.9 million or 245.8%, from $2.4 million in the prior year. Of the increase, $4.8 million was due to the acquisition of ESK Ceramics, as we included their financial results beginning September 1, 2004. The balance of the increase, $1.1 million, was due to salary, bonuses, personnel increases and additional commissions and travel. Selling expenses, as a percentage of net sales, increased from 2.4% for the year ended December 31, 2003 to 3.8% of net sales for the year ended December 31, 2004 due to the inclusion of ESK’s sales expenses since September 1, 2004. If ESK’s operations had not been included in our results, then selling expenses would have been $3.4 million or 1.9% as a percentage of net sales.

General and Administrative Expenses. General and administrative expenses were $14.1 million for the year ended December 31, 2004, an increase of $6.3 million, or 80.8%, from $7.8 million in the prior year. Of the increase, $1.3 million was due to the acquisition of ESK Ceramics, which was included in our results beginning September 1, 2004. The balance of the increase, $5.0 million, was due to increases in salaries, bonuses and personnel and $1.1 million for Sarbanes-Oxley compliance. General and administrative expenses, as a percentage of net sales, decreased from 7.7% for the year ended December 31, 2003 to 6.5% for the year ended December 31, 2004 due to the higher levels of net sales in 2004 when compared to 2003.

Research and Development Expenses. Research and development expenses were $3.3 million for the year ended December 31, 2004, an increase of $1.2 million, or 57.1%, from $2.1 million in the prior year. Of the increase, $1.0 million was due to the acquisition of ESK Ceramics, which was included in our results beginning September 1, 2004. Research and development expenses, as a percentage of net sales, decreased from 2.1% for the year ended December 31, 2003 to 1.5% for the year ended December 31, 2004 due to the higher levels of net sales in 2004 when compared to 2003. 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 $2.2 million for the year ended December 31, 2004, an increase of $1.9 million, or 585.4%, from $321,000 in the prior year. Part of the increase in other income was a gain of $1.9 million on forward foreign currency exchange contracts, offset by foreign currency transaction losses of $0.7 million. Other income also includes royalty income, which decreased by $5,000 from the prior year due to lower sales of orthodontic brackets by licensees, $100,000 proceeds from a class action lawsuit award and interest income which increased by $340,000 due to larger cash balances in the year ended December 2004 compared to the year ended December 2003. The balance of the increase, $300,000, was attributable to an increase in miscellaneous income as a result of a royalty audit on the sale of orthodontic brackets.

Interest Expense. Interest expense was $1.7 million for the year ended December 31, 2004, an increase of $1.7 million, compared to $32,000 in the prior year. This increase was due to the increase in borrowings to finance our purchase of ESK Ceramics that closed in August 2004.

Income before Taxes. Our consolidated income before taxes for the year ended December 31, 2004 was $43.9 million, an increase of $26.6 million, or 154.0%, from $17.3 million in the prior year. As a percentage of net sales, consolidated income before taxes was 20.4% for the year ended December 31, 2004 as compared to 17.0% of net sales in the prior year.

Our Advanced Ceramic Operations division had segment income before taxes for the year ended December 31, 2004 of $43.9 million, an increase of $27.7 million, or 171.0%, from $16.2 million in the prior year. Segment income before taxes for Advanced Ceramic Operations in 2004 was 27.5% of net sales, as compared to 20.1% of net sales in the prior year.

Our ESK Ceramics subsidiary had segment loss before taxes of $0.6 million, or - -1.7% of net sales, for the four months of 2004 during which their operations were consolidated with ours. Included in segment loss before taxes is other expense of $2.4 million, which includes interest expense of $1.7 million and losses on currency translation of $0.7 million. Also included in ESK’s segment loss before taxes are $3.0 million of pre-tax expenses related to the amortization of backlog and the step up of inventory resulting from the application of purchase accounting in connection with the acquisition. These non-recurring expenses had a negative impact on segment loss before income taxes in an amount equal to 8.3% of net sales.

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Our Semicon Associates division had segment income before taxes for the year ended December 31, 2004 of $533,000, an increase of $212,000, or 66.0%, from $321,000 in the prior year. Segment income before taxes for Semicon Associates for the year end December 31, 2004 was 7.1% of net sales, as compared to 4.7% of net sales in the prior year.

Our Thermo Materials division had segment income before taxes of $81,000 for the year end December 31, 2004, a decrease of $0.7 million, or 89.9%, from $0.8 million in the prior year. Segment income before taxes for Thermo Materials for the year end December 31, 2004 was 0.7% of net sales, as compared to 5.4% of net sales in the prior year.

Income Taxes. We used a combined federal and state tax rate of 37.2% for the twelve months ended December 31, 2004, resulting in a provision for taxes of $16.3 million, an increase of $10.2 million, or 167.2%, from $6.1 million in the corresponding prior year. The effective income tax rate for the year ended December 31, 2003 was 35.0%. The increase in the tax rate was a result of higher pre-tax income and the expiration of tax credits.

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 photovoltaic solar cell industry, and revenue from the construction of the facilities that we will use to manufacture the PAC-3 missile radomes.

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 ended December 31, 2003, which was unchanged from the prior year. Gross profit for Semicon Associates for the year ended 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 ended 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 ended 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.

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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 before Taxes. Our consolidated income before taxes for the year ended December 31, 2003 was $17.3 million, an increase of $13.2 million, or 322.0%, from $4.1 million in the prior year. As a percentage of net sales, consolidated income before taxes was 17.0% for the year ended December 31, 2003 as compared to 6.7% of net sales in the prior year.

Our Advanced Ceramic Operations division had segment income before taxes for the year ended December 31, 2003 of $16.2 million, an increase of $12.1 million, or 295.1%, from $4.1 million in the prior year. Segment income before taxes for Advanced Ceramic Operations in 2003 was 20.1% of net sales, as compared to 8.7% of net sales in the prior year.

Our Semicon Associates division had segment income before taxes for the year ended December 31, 2003 of $321,000, a decrease of $82,000, or 20.3%, from $403,000 in the prior year. Segment income before taxes for Semicon Associates for the year end December 31, 2003 was 4.7% of net sales, as compared to 6.77% of net sales in the prior year.

Our Thermo Materials division had segment income before taxes of $0.8 million for the year end December 31, 2003, an increase of $1.2 million from a loss of $403,000 in the prior year. Segment income before taxes for Thermo Materials for the year end December 31, 2003 was 5.4% of net sales, as compared to -5.1% of net sales in the prior year.

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.

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.

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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.

Sales Recognition. Sales are 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. Management is required to make judgments about whether or not collectibility is reasonably assured. The Company reduces 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. The Company does not record a warranty reserve on the sale of its products. For its largest product line, body armor, all of which is sold to the U.S. Government, each lot of body armor is tested at an independent laboratory and the lot cannot be released for shipment to the U.S. Government until positive test results are received by both the U.S. Government and the Company. For its non-body armor sales, the Company has experienced minimal claims from these types of sales. Additionally, due to the inherent nature, strength, durability and structural properties of ceramics, as well as a rigid quality control program that includes, for some of our customers, having the customer accept quality test results prior to shipment, we do not believe a warranty reserve is necessary.

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.

Accounting for Long-Lived Assets. In accordance with SFAS No. 144, long-lived assets and intangible assets with definite lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment indicators include, among other conditions, cash flow deficits, historic or anticipated declines in revenue or operating profit and adverse legal or regulatory developments. If it is determined that such indicators are present and the review indicates that the assets will not be fully recoverable, based on undiscounted estimated cash flows over the remaining amortization periods, their carrying values are reduced to estimated fair market value. Estimated fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. For the purposes of identifying and measuring impairment, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.

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 have been 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 during the second quarter ended June 30, 2003, there was a remaining warranty reserve amount of $148,000 that was credited to cost of product sales.

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

Normally, we do not record a warranty reserve on the sale of our products. For our largest product line, body armor, all of which is sold to the U.S. Government, a revised testing and acceptance procedure was instituted in 2002 as a result of the warranty claim described above. Each lot of body armor is now tested at an independent laboratory and the lot cannot be released for shipment to the U.S. Government until positive test results are received by both the U.S. Government and us. For our non-body armor sales, we have experienced minimal claims from these types of sales. Additionally, due to the inherent nature, strength, durability and structural properties of ceramics, as well as a rigid quality control program, which includes, for some of our customers, having the customer accept quality test results prior to shipment, we do not believe that a warranty reserve is necessary.

Liquidity and Capital Resources

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

Our net cash position decreased by $6.9 million during the year ended December 31, 2004, compared to an increase of $11.1 million during the year ended December 31, 2003. For the year ended December 31, 2004, cash flow provided by operating activities amounted to $32.8 million. The primary factors contributing to cash flow from operating activities were net income of $27.6 million, depreciation and amortization of $7.6 million, a $3.1 million reduction of income taxes payable due to the exercise of stock options, and increased levels of accounts payable, accrued expenses and income tax payable that added an aggregate of $16.8 million. These contributions were offset in part by increases in accounts receivable of $14.4 million due to higher amounts of sales over the previous year, and increased levels of inventories, production tooling and prepaid expenses that totaled $9.7 million.

Cash used in investing activities of $158.8 million was for acquisitions of businesses, net of cash acquired of $141.3 million, capital expenditures of $26.6 million, offset by redemptions of $9.1 million of 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 $4.2 million used to install a new hot press line and furnaces for the production of ceramic armor plates in Lexington, Kentucky that was partially complete at December 31, 2004. We estimate that we will spend another $1.0 million to complete it in 2005. Also included in total capital expenditures was $3.9 million used to expand and improve our hot press line and furnaces in Costa Mesa, California and $6.4 million to install new machinery, equipment and furnaces in Lexington, Kentucky.

Financing activities provided cash of $118.4 million, generated primarily from the net proceeds of $119.4 million borrowed from our $160.0 million credit facility. On August 18, 2004, we entered into a $160 million Credit Facility Agreement with Wachovia Bank, National Association, and a syndicate of banks and other institutional lenders. The obligations under the Credit Agreement are collateralized by substantially all of our assets, other than real property. The Credit Agreement provides for a term loan in the amount of $110 million and a revolving line of credit in the amount of $50 million. We borrowed the entire $110 million under the term loan on August 18, 2004. Principal under the term loan is payable in installments of $275,000 on the last day of each calendar quarter commencing December 31, 2004, with a balloon payment of $102,575,000 payable on August 18, 2011. Additional payments of principal are required annually in an amount equal to 50% of our “excess cash flow,” as defined in the Credit Agreement. Principal may be prepaid at any time, in whole or in part, without premium or penalty at our election. Accrued interest is payable with each installment of principal.

As of December 31, 2004, the balance due under our term loan was $109.7 million. The interest rate on $95.0 million of the $109.7 million term loan is currently based on the LIBOR rate for a fixed period of six months, at an effective interest rate equal to 3.94 percent per annum. The interest rate on the $14.7 million balance is comprised of a $13.0 million amount based on the LIBOR rate for a fixed period of three months, at an effective interest rate equal to 4.38 percent per annum and a $1.75 million amount based on the LIBOR rate for a fixed period of approximately two months, at an effective interest rate equal to 4.50 percent per annum.

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As of December 31, 2004, we borrowed a total of $9.7 million under the revolving line of credit. The interest rate on $5.0 million of the credit line is based on the U.S. LIBOR rate for a period of one month, at an effective rate equal to 4.19%. The interest rate on $2.0 million of the credit line is based on the prime rate plus a margin of one half of one percent, which equals 6.0%. The remaining balance of $2.7 million is based on the European LIBOR rate for a period of 5 days, at an effective rate equal to 4.19%.

Financing activities also provided $2.2 million in connection with the issuance of common stock upon the exercise of employee stock options under our stock option and stock purchase plans. Cash used in financing activities included $3.2 million used to pay for loan fees for our $160 million credit facility.

Our net cash position increased by $11.1 million during the twelve months ended December 31, 2003. An important component of this change was our completion of a public offering of 1,725,000 (3,881,250 adjusted for stock splits in 2004 and 2005) newly issued shares of our common stock at a price to the public of $17.50 per share ($7.78 per share split adjusted). We received net proceeds of approximately $27.9 million from this offering after deducting offering expenses of $0.5 million and underwriting discounts. We also made capital expenditures of $12.3 million and used $19.2 million to purchase marketable securities during the year ended December 31, 2003. Cash flow from operating activities for the year ended December 31, 2003 was $15.4 million. The primary factors contributing to 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.

Our cash, cash equivalents and short term investments totaled $14.6 million at December 31, 2004, compared to $30.7 million at December 31, 2003. At December 31, 2004, we had working capital of $78.4 million, compared to $60.5 million at December 31, 2003. We believe that our current cash and cash equivalents on hand, cash available from the sale of short term investments, cash available from additional borrowings under our revolving line of credit, 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.

Our material contractual obligations and commitments as of December 31, 2004 are as follows (amounts in thousand):

Off-Balance Sheet Arrangements

Ceradyne does not have any off-balance sheet arrangements.

New Accounting Pronouncements

In November 2004, Statement of Financial Accounting Standards No. 151, “Inventory Costs-an amendment of ARB No. 43, Chapter 4” (SFAS No. 151), was issued. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and

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wasted material (spoilage). SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not expect adoption of this standard to have a material impact on our consolidated financial statements.

In December 2004, the Financial Accounting Standards Board issued a revision of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123R). SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance and eliminates the alternative to use Opinion 25’s intrinsic value method of accounting that was provided in Statement 123 as originally issued. Under Opinion 25, issuing stock options to employees at market value generally resulted in recognition of no compensation cost. SFAS No. 123R requires entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (with limited exceptions). SFAS No. 123R is effective for the first interim or annual reporting period that begins after June 15, 2005. We have not quantified the potential effect of adoption of SFAS No. 123R. However, we believe adoption of SFAS No.123R will result in a decrease to our reporting earnings.

Interest Rate Risk

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio and our debt. We have not used derivative financial instruments in our investment portfolio. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk. Our investments in marketable securities consist primarily of high-grade corporate and government securities with maturities of less than three years. Investments purchased with an original maturity of three months or less are considered cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of stockholders’ equity. Average maturity of our investment portfolio is 34 months; therefore, the movement of interest rates should not have a material impact on our balance sheet or income statement.

At any time, a significant increase/decrease in interest rates will have an impact on the fair market value and interest earnings of our investment portfolio. We do not currently hedge this interest rate exposure. We have performed a sensitivity analysis as of December 31, 2004 and 2003, using a modeling technique that measures the change in the fair values arising from a hypothetical 50 basis points and 100 basis points adverse movement in the levels of interest rates across the entire yield curve, which are representative of historical movements in the Federal Funds Rate with all other variables held constant. The analysis covers our investment and is based on the weighted-average maturity of our investments as of December 31, 2004 and 2003. The sensitivity analysis indicated that a hypothetical 50 basis points adverse movement in interest rates would result in a loss in the fair values of our investment instruments of approximately $485,000 at December 31, 2004 and approximately $64,000 at December 31, 2003. Similarly a hypothetical 100 basis points adverse movement in interest rates would result in a loss in the fair values of our investments of approximately $969,000 at December 31, 2004 and approximately $480,000 at December 31, 2003.

Actual maturities may differ from contractual maturities because the issuer of the securities may have the right to repurchase such securities. We classify short-term investments in current assets, as all such investments are available for current operations.

We are exposed to market risks related to fluctuations in interest rates on our debt. Currently, we do not utilize interest rate swaps or other types of derivative financial instruments regarding our debt. 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, 2004. As of December 31, 2003, we did not have any debt outstanding.

We have performed a sensitivity analysis as of December 31, 2004, that measures the change in interest expenses due to a hypothetical 50 basis points and 100 basis points adverse movement in the levels of interest rates across the entire yield curve. The analysis covers our debt. The sensitivity analysis indicated that a hypothetical 50 basis points adverse movement in interest rates would result in an increase in our interest expense of approximately $596,000 at December 31, 2004. Similarly a hypothetical 100 basis points adverse movement in interest rates would result in an increase in our interest expense of approximately $1.2 million at December 31, 2004.

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Foreign Currency Fluctuations

We enter into foreign exchange forward contracts to reduce earnings and cash flow volatility associated with foreign exchange rate changes to allow our management team to focus its attention on its core business operations. Accordingly, we enter into contracts which change in value as foreign exchange rates change to economically offset the effect of changes in value of foreign currency assets and liabilities, commitments and anticipated foreign currency denominated sales and operating expenses. We enter into foreign exchange forward contracts in amounts between minimum and maximum anticipated foreign exchange exposures, generally for periods not to exceed one year. These derivative instruments are not designated as accounting hedges.

We measure the financial statements of our foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Translation adjustments resulting from this process are included in stockholders’ equity. Gains and losses from foreign currency transactions are included in other income miscellaneous.

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.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934) were effective.

Changes in Internal Control over Financial Reporting

Our management evaluated our internal control over financial reporting and there have been no changes during the fiscal quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our assessment, we have concluded that, as of December 31, 2004, the Company’s internal control over financial reporting was effective based on those criteria.

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We have excluded ESK Ceramics and its subsidiaries from our assessment of internal control over financial reporting as of December 31, 2004 because they were acquired by the Company in a purchase business combination during 2004. ESK Ceramics is a wholly owned subsidiary of the Company whose total assets and total revenues represent 56% and 17%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2004.

Ceradyne’s independent registered public accounting firm, PricewaterhouseCoopers LLP, audited our assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 as stated in their report which appears herein.

Not applicable.

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PART III

Information in response to this item (except for certain information concerning executive officers included in Part I of this report) is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.

Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.

Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.

Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.

Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.

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PART IV