UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

x                              Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the fiscal year ended December 31, 2006.

o                                 Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period from              to             

Commission File Number 0-15760

HARDINGE INC.

(Exact name of registrant as specified in its charter)

 

Registrant’s telephone number, including area code:
(607) 734-2281

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

Securities pursuant to section 12(g) of the Act:

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d). Yes o  No x

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 and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether registrant is a shell company (as defined by Exchange Act Rule 12b-2). Yes o  No x

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2006 was $124.1 million, based on the closing price of common stock on the NASDAQ stock exchange on June 30, 2006. Shares of common stock held by each officer and director and by the Company’s benefit plans have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for any other purpose.

The number of shares outstanding of the issuer’s common stock as of February 1, 2007: Common Stock, $.01 par value 8,833,457 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Hardinge Inc.’s Proxy Statement for its 2007 Annual Meeting of Shareholders to be filed with the Commission on or about March 30, 2007 are incorporated by reference to Part III of this Form 10K.

PART I

ITEM 1.—BUSINESS

General

Hardinge Inc.’s principal executive office is located at One Hardinge Drive, Elmira, New York 14902-1507; telephone (607) 734-2281. The principal executive office is located in Chemung County, New York, which is on the south-central border of upstate New York.

The Company’s website is www.hardinge.com. Hardinge’s website provides links to all of the Company’s filings with the Securities and Exchange Commission. A copy of the 10-K is available on the website or can be obtained by contacting the Investor Relations Department at the Company’s principal executive office. Alternatively, such reports may be accessed at the Internet address of the SEC, which is www.sec.gov or at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information about the operation of the SEC’s Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.

The Company has eight wholly owned subsidiaries.

 

The Company has manufacturing facilities located in Chemung County, New York; St. Gallen, Switzerland; Biel, Switzerland; Nan Tou City, Taiwan; and Shanghai, People’s Republic of China. Hardinge manufactures the majority of the products it sells.

References to Hardinge Inc., the “Company”, or “Hardinge” are to Hardinge Inc. and its predecessors and subsidiaries, unless the context indicates otherwise. The Company changed its name in 1995 from Hardinge Brothers, Inc. to Hardinge Inc.

Products

The Company designs, manufactures, distributes and markets computer-numerically controlled metal-cutting lathes, machining centers, grinding machines, collets, chucks, indexing fixtures, and other industrial products. It considers its products to be among the world’s best in terms of accuracy, reliability, durability and value. The wide variety of machines manufactured by the Company allows it to be a sole source supplier for many of its customers.

The Company has been a manufacturer of industrial-use Super-Precision® and general precision turning machine tools since 1890. Turning machines, or lathes, are power-driven machines used to remove material from a rough-formed part by moving multiple cutting tools against the surface of a part rotating at very high speeds in a spindle mechanism. The multi-directional movement of the cutting tools allows the part to be shaped to the desired dimensions. On parts produced by Hardinge machines, those dimensions are often measured in ten-thousandths of inches. Hardinge considers itself to be a leader in the field of producing machines capable of consistently and cost-effectively producing parts to those dimensions in production environments.

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Grinding is a machining process where a surface is shaped to closer tolerances or a finer surface finish with a rotating abrasive wheel or tool moving against a part. Grinding machines can be used to finish parts of various shapes and sizes. The grinding machines of the Company’s Kellenberger subsidiary are used to grind the outside and inside diameters of cylindrical parts. Such grinding machines are typically used to provide a more exact finish on a part, which has been partially completed on a lathe. Kellenberger machines are generally purchased by the same type of customers as other Hardinge equipment and further the ability of the Company to be a sole source supplier for its customers.

Hardinge acquired HTT Hauser Tripet Tschudin AG in 2000 to expand its grinding machine product line. Hauser jig grinding machines are used to make demanding contour components, primarily for tool and mold making applications. Tripet and Tschudin product technology is focused on the specialized internal and external cylindrical grinding needs of high volume production customers.

Machining centers or milling machines are designed to remove material from stationary, prismatic (box-like) parts of various shapes with rotating tools that are capable of milling, drilling, tapping, reaming and routing. The multi-directional movement of the spindle holding the cutting tool and the table holding the part allows the part to be shaped to the desired dimension. Machining centers have mechanisms that automatically change tools based on commands from a built-in computer control without the assistance of an operator. The Company produces a broad line of machining centers addressing a range of sizes, speeds and powers.

Most models of Hardinge’s machines are computer numerically controlled (“CNC”) and use commands from an integrated computer to control the movement of cutting tools, grinding wheels, part positioning, and in the case of turning and grinding machines, the rotation speeds of the part being shaped. The computer control enables the operator to program operations such as part rotation, tooling selection and tooling movement for a specific part and then store that program in memory for future use. The machines are able to produce parts while left unattended when connected to automatic bar-feeding, robotics equipment, or other material handling devices designed to supply raw materials.

On November 3, 2004, the Company acquired the name, trademarks, copyrights, designs, patents, know-how, and all other intangibles associated with the former Bridgeport Machine company throughout the world. Hardinge also acquired certain operating assets from the court appointed receiver of the former Bridgeport operations in the U.K. to allow it to carry on Bridgeport’s sales, service and support operations in Europe.

The Bridgeport name has long been associated with a full range of quality machining centers. The Company uses this brand name for all of its machining center lines. The products of Bridgeport, which are being sourced from Taiwan, expanded the line of machines available from the Company in this segment to include horizontal machining centers and 5-axis machining capabilities. Also, the operations in the U.K. have been combined with the Company’s U.K. subsidiary to provide sales and service support for the complete line of Hardinge company products.

Hardinge obtained the rights to manufacture and distribute Bridgeport manually controlled milling machines (called knee mills) in 2002, and parts and support services functions for both knee mills and vertical machining centers previously produced by the Connecticut operations of Bridgeport Machines, Inc. under a licensing arrangement with BPT IP, LLC.

In January 2006, the Company executed its option to purchase the technical information of the Bridgeport knee-mill machine tools, related accessories and spare parts from BPT IP, LLC (“BPT”). BPT had granted the Company the exclusive right to manufacture and sell certain versions of the knee-mill machine tools, accessories and spare parts under Alliance Agreements dated October 29, 2002 and November 3, 2004. Per the Alliance Agreements, the Company had agreed to pay to BPT royalties based on a percentage of net sales attributable to the products, accessories and spare parts.

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The purchase price for the technical information was $5.0 million and it will be amortized over a ten-year period. The technical information purchased includes, but is not limited to, blueprints, designs, schematics, drawings, specifications, computer source and object code, customer lists and proprietary rights and assets of a similar nature. Subsequent to the purchase, no further royalties will be paid to BPT for products shipped thereafter. Royalty expense under these agreements was less than $0.1 million, $1.3 million, and $1.2 million during the years ended December 31, 2006, 2005, and 2004, respectively.

On December 27, 2005, the Company entered into a Share Purchase Agreement with a group of selling shareholders pursuant to which those selling shareholders agreed to sell their shares in Hardinge Taiwan Limited (“Hardinge Taiwan”) to the Company. Pursuant to a Joint Venture Agreement dated March 16, 1999, the Company owned 51% of Hardinge Taiwan and the selling shareholders owned 49% of Hardinge Taiwan. The Company now owns 100% of Hardinge Taiwan, making it a wholly-owned subsidiary of the Company.

The purchase price of the shares was NT$298.8 million, which was equivalent to approximately $9.0 million at December 28, 2005. The purchase price was primarily recorded against the liability for equity of minority interest on the balance sheet. The purchase price was subject to adjustment based on the final audited balance sheet of Hardinge Taiwan as of December 31, 2005. Based on the final audited balance sheet of Hardinge Taiwan, the purchase price adjustment was NT$3.9 million, which was equivalent to approximately $0.1 million when it was paid in  March 2006.

On December 27, 2005, Hardinge Taiwan entered into a Share Purchase Agreement with U-Sung Co. Ltd. (“U-Sung), a company in the Republic of China pursuant to which Hardinge Taiwan purchased 100% of the shares of U-Sung. U-Sung owns the land and building in Nan Tou City, Taiwan, Republic of China that is occupied and leased by Hardinge Taiwan. The purchase price of U-Sung was NT$234.8 million, which is equivalent to approximately $7.0 million, which substantially reflects the fair market value of the land and building acquired. No goodwill was recorded. Under an operating lease agreement, Hardinge Taiwan previously paid rent to U-Sung. Rent expense under that lease was $0.9 million and $0.6 million during the years ended December 31, 2005, and 2004, respectively. Hardinge Taiwan now owns U-Sung so any rent expense or income in 2006 was eliminated in their consolidation.

New product development is important to the Company’s growth. Products are introduced each year to take advantage of new technologies available to the Company. These technologies generally allow the machine to run at higher speeds and with more power, thus increasing its efficiency. Customers routinely replace old machines with newer machines that can produce parts faster and with less time to set up the machine when converting from one type of part to another.

Multiple options are available on a broad range of the Company’s machines, which allow customers to customize their machines for the specific purpose, and cost objective they require. The Company produces machines for stock with popular option combinations for immediate delivery, as well as machines made to specific customer orders. In addition to its machines, the Company provides the necessary computer programming and tooling, as well as robotics and other parts handling equipment manufactured by it or others.

Generally Hardinge machines can be used to produce parts from all of the standard ferrous and non-ferrous metals, as well as plastics, composites and exotic materials.

The sale of repair parts is important to the business of the Company. Certain parts on machines wear over time or break through misuse. Customers will buy parts from the Company through the life of the machine, which is several years. There are thousands of machines in operation in the world for which the Company provides those repair parts, in many cases exclusively.

In addition to its machine lines, the Company offers the most extensive line of workholding devices available in the industry, which may be used on both its machines and those produced by others. The

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Company considers itself to be a worldwide leader in the design and manufacture of workholding devices for machine tools.

The Company offers various warranties on its equipment and considers post-sales support to be a critical element of its business. Warranties on machines typically extend for twelve months after purchase. Services provided include operation and maintenance training, in-field maintenance, and in-field repair. The Company, where practical, provides readily available replacement parts. The Company offers these post sales support services on a paid basis throughout the life of the machine.

Markets and Distribution

The Company markets its products in most industrialized countries of the world through a combination of distributors, agents and manufacturers’ representatives. In certain areas of the United States, Canada, China, Germany, and the United Kingdom, the company also uses a direct sales force. Generally, distributors have exclusive rights to sell the Company’s products in a defined geographic area.

Certain of the Company’s distributors operate independent businesses, purchase products from the Company at discounted prices and maintain inventories of these products for their customers, while agents and representatives sell products on behalf of the Company and receive commissions on sales. The Company’s commission schedule is adjusted to reflect the level of marketing and aftermarket support offered by its distributors. The Company’s direct sales personnel earn a fixed salary plus commission.

Sales through distributors are made only on standard commercial open account terms or through letters of credit and are not included in the Company’s financing programs discussed below. Distributors take title to products upon shipment from the Company’s facilities and do not have any special return privileges.

In the past the Company provided financing terms of up to seven years for qualified end user customers to purchase equipment, primarily in the United States and Canada. These contracts were backed by liens and security agreements.

The Company discontinued providing financing itself for North America in 2002 and began outsourcing long-term customer financing to third party leasing companies. However, the Company continues to offer long term customer financing for some of its foreign operations. Further, the Company occasionally offers special interest rates to customers as part of its marketing efforts. The amount of the charge from the third party financing company for these special programs is treated as a discount to sales at the time of the contract. There are no repurchase or remarketing agreements with these third parties.

The Company’s non-machine products are mainly sold in the United States through telephone orders to a toll-free “800” telephone number, which is linked to an on-line computer order entry system maintained by the Company at its Elmira headquarters. In most cases, the Company is able to package and ship in-stock tooling and repair parts within 24 hours of receiving orders. The Company can package and ship items with heavy demand within several hours. In other parts of the world, these products are sold through distributor arrangements associated with machine sales.

The Company promotes recognition of its products in the marketplace through advertising in trade publications and participation in industry trade shows. In addition, the Company markets its non-machine products through publication of general catalogues and other targeted catalogues, which it distributes to existing and prospective customers. The Company has a substantial presence on the internet at www.hardinge.com where customers can obtain information about the Company’s products and place orders for workholding products.

A substantial portion of the Company’s sales are to small and medium-sized independent job shops, which in turn sell machined parts to their industrial customers. Industries directly and indirectly served by

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the Company include aerospace, automotive, construction equipment, defense, energy, farm equipment, medical equipment, recreational equipment, telecommunications, and transportation.

No single customer accounted for more than 5% of consolidated sales in 2006. In 2005, one customer accounted for approximately 6% of consolidated sales and in 2004, no single customer accounted for more than 5% of consolidated sales.

The Company operates in a single business segment, industrial machine tools.

Competitive Conditions

The primary competitive factors in the marketplace for the Company’s machine tools are reliability, price, delivery time, service and technological characteristics. There are many manufacturers of machine tools in the world. They can be categorized by the size of material their products can machine and the precision level they can achieve. In the size and precision level the Company addresses with its turning machines and machining centers, the primary competition comes from several Japanese, German, Taiwanese and Korean manufacturers. Kellenberger, Hauser, Tripet and Tschudin grinding machines compete with machines from Japanese, German and other Swiss manufacturers. Management considers its segment of the industry to be extremely competitive. The Company believes that it brings superior quality, reliability, value, availability, capability and support to its customers.

Sources and Availability of Raw Materials

The Company manufactures and assembles its lathes, knee-mills, and related industrial products at its Elmira, New York plant. Kellenberger grinding machines and related products are manufactured at its St. Gallen, Switzerland plant and HTT products are produced at its Biel, Switzerland facility. Hardinge produces machining centers and a line of lathes at its plants in Taiwan and China. Some of the machining center products are sourced from manufacturers in Taiwan. Products are manufactured by the Company from various raw materials, including cast iron, sheet metal, and bar steel. The Company purchases a number of components from outside suppliers, including the computer and electronic components for its CNC lathes, grinding machines and machining centers. There are multiple suppliers for virtually all of the Company’s raw material and components and the Company has not experienced a serious supply interruption in past years. The Company did experience supply constraints with a Taiwanese contract manufacturer for milling products. This has been remediated as of January 2007.

A major component of the Company’s CNC machines is the computer and related electronics package. The Company purchases a majority of these components from Fanuc Limited, a large Japanese electronics company. The Company also purchases those components from Siemens and Heidenhain, both substantial German manufacturers, for some of its machine lines. A disruption in supply of the computer controls from one of its suppliers could cause the Company to experience a substantial disruption of its operations, depending on the circumstances at the time. The Company purchases parts from these suppliers under normal trade terms. There are no agreements with these suppliers to purchase minimum volumes per year.

Research and Development

The Company’s ongoing research and development program involves creating new products, modifying existing products to meet market demands and redesigning existing products to add both new functionality and reduce the cost of manufacturing. The research and development departments throughout the world are staffed with experienced design engineers with varying levels of education, from technical through doctoral degrees.

The worldwide cost of research and development, all of which has been charged to cost of goods sold, amounted to $9.8 million, $9.1 million and $7.9 million, in 2006, 2005, and 2004 respectively.

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Patents

Although the Company holds several patents with respect to certain of its products, it does not believe that its business is dependent to any material extent upon any single patent or group of patents.

Seasonal Trends and Working Capital Requirements

The Company’s business and that of the machine tool industry in general is cyclical. It is not subject to significant seasonal trends. However, the Company’s quarterly results are subject to fluctuation based on the timing of its shipments of machine tools, which are largely dependent upon customer delivery requirements. Traditionally, the Company has experienced reduced activity during the third quarter of the year, largely as a result of vacations scheduled at its U.S. and European customers’ plants and the Company’s policy of closing its New York and Switzerland facilities for two weeks during the third quarter. As a result, the Company’s third-quarter net sales, income from operations and net income typically have been the lowest of any quarter during the year.

The ability to deliver products within a short period of time is an important competitive criterion. The Company must have inventory on hand to meet customers’ delivery expectations, which for standard machines typically are between immediate to four weeks deliveries. Meeting this requirement is especially difficult with products made in Taiwan, where delivery is extended due to ocean travel times, depending on the location of the customer. This creates a situation where the Company must have inventory of finished machines available in its major markets.

The Company delivers many of its machine products within one to two months after the order. Some orders, especially multiple machine orders, are delivered on a turnkey basis with the machine or group of machines configured to make certain parts for the customer. This type of order often includes the addition of material handling equipment, tooling and specific programming. In those cases the customer usually observes and inspects the parts being made on the machine at the Company’s facility before it is shipped and the timing of the sale is dependent upon the schedule of the customer. Therefore, sales from quarter to quarter can vary depending upon the timing of those customers’ acceptances and the significance of those orders.

The Company feels it is important, where practical, to provide readily available workholding and replacement parts for the machines it sells. The Company carries inventory at levels to meet these customer requirements.

Backlog

The Company’s order backlog was $99.6 million at December 31, 2006, compared to an adjusted backlog of $78.2 million at December 31, 2005.

Orders for most products are subject to cancellation by the customer prior to shipment. On large orders for specialized equipment, there are generally cancellation charges associated. The level of unfilled orders at any given date during the year may be materially affected by the timing of the Company’s receipt of orders, the speed with which those orders are filled and the timing of customer acceptance of specialized equipment. Accordingly, the Company’s backlog is not necessarily indicative of actual shipments or sales for any specific future quarterly period, and period-to-period comparisons may not be meaningful.

Governmental Regulations

The Company believes that its current operations and its current uses of property, plant and equipment conform in all material respects to applicable laws and regulations.

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Environmental Matters

The Company’s operations are subject to extensive federal and state legislation and regulation relating to environmental matters.

Certain environmental laws can impose joint and several liability for releases or threatened releases of hazardous substances upon certain statutorily defined parties regardless of fault or the lawfulness of the original activity or disposal. Activities at properties owned by the Company and on adjacent areas have resulted in environmental impacts.

In particular, the Company’s New York manufacturing facility is located within the Kentucky Avenue Wellfield on the National Priorities List of hazardous waste sites designated for cleanup by the United States Environmental Protection Agency (“EPA”) because of groundwater contamination. The Kentucky Avenue Wellfield site encompasses an area of approximately three square miles which includes sections of the Town of Horseheads and the Village of Elmira Heights in Chemung County, New York. In February 2006, the Company received a Special Notice Concerning a Remedial Investigation/Feasibility Study for the Koppers Pond portion of the Kentucky Avenue Wellfield site. The EPA has documented the release and threatened release of hazardous substances into the environment at the Kentucky Avenue Well Field Superfund site, including releases into and in the vicinity of the Koppers Pond (the “Pond”). The hazardous substances, including metals and polychlorinated biphenyls, have been detected in sediments in the Pond.

A substantial portion of the Pond is located on the Company’s property. The Company, along with Beazer East, Inc., the Village of Horseheads, the Town of Horseheads, the County of Chemung, CBS Corporation, and Toshiba America, Inc., have agreed to voluntarily participate in the Remedial Investigation and Feasibility Study (“RI/FS”) by signing an Administrative Settlement Agreement and Order on Consent on September 29, 2006. On September 29, 2006, the Director of Emergency and Remedial Response Division of the U.S. Environmental Protection Agency, Region II, approved and executed the Agreement on behalf of the EPA. The PRPs also signed a PRP Member Agreement, agreeing to share the cost of the RI/FS study on a per capita basis. The cost of the RI/FS has been estimated to be between $250,000 and $800,000. The PRPs are currently developing the model for the RI/FS with the consultant that they have retained.

Until receipt of this notice, the Company had never been named as a potentially responsible party at the site or received any requests for information from EPA concerning the site. Environmental sampling on the Company’s property within this site under supervision of regulatory authorities has identified off-site sources for such groundwater contamination and sediment contamination in the Pond and has found no evidence that the Company’s property is contributing to the contamination. Since the RI/FS has not commenced, the Company has not established a reserve for any potential costs relating to this site, as it is too early in the process to determine the Company’s responsibility as well as to estimate any potential costs to remediate. The Company did notify all appropriate insurance carriers and is actively cooperating with them, but whether coverage will be available has not yet been determined and possible insurance recovery cannot now be estimated with any degree of certainty.

Employees

As of December 31, 2006 the Company employed 1,457 persons, 612 of who were located in the United States. None of the Company’s employees are covered by collective bargaining agreements. Management believes that relations with the Company’s employees are good.

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Foreign Operations and Export Sales

Information related to foreign and domestic operations and sales is included in Note 7 to the Consolidated Financial Statements contained in this Annual Report. The Company believes that its manufacturing subsidiaries operate in countries in which the economic climate is relatively stable.

The strategy of the Company has been to diversify its sales and operations geographically so that the impact of economic trends in different regions can be balanced. The rapid growth in the manufacturing activity in Asia has been significant to the Company’s growth over the past few years.

ITEM 1A.—RISK FACTORS

The various risks related to the Company’s business include the risks described below. The business, financial condition or results of operations of Hardinge Inc. could be materially adversely affected by any of these risks. The risks and uncertainties described below or elsewhere in the Form 10-K are not the only ones to which Hardinge Inc. is exposed. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also adversely affect our business and operations. If any of the matters included in the following risks were to occur, our business, financial condition, results of operations, cash flows or prospects could be materially adversely affected.

Cyclical nature of the business could cause fluctuations in operating results.

The Company’s business is cyclical in nature, following the strength and weakness of the manufacturing economies in the geographic markets in which the Company serves. As a result of this cyclicality, the Company has experienced, and in the future can be expected to experience, significant fluctuations in sales and operating income, which may affect the Company’s financial condition.

Competitive position and prospects for growth may be diminished if the Company is unable to develop and introduce new and enhanced products on a timely basis that are accepted in the market.

The machine tool industry is subject to technological change, evolving industry standards, changing customer requirements and improvements in and expansion of product offerings, especially with respect to computer controlled products. The Company’s ability to anticipate changes in technology, industry standards, customer requirements and product offerings by competitors, and to develop and introduce new and enhanced products on a timely basis that are accepted in the market, will be significant factors in its competitive position and prospects for growth. Moreover, if technologies or standards used in its products become obsolete or fail to gain widespread commercial acceptance, its business would be materially adversely affected. Although the Company believes that it has the technological capabilities to remain competitive, developments by others may render its products or technologies obsolete or noncompetitive. Failure to effectively introduce new products or product enhancements on a timely basis could materially adversely affect the Company’s business, operating results and financial condition.

The Company may face trade barriers that could have a material adverse effect on its results of operations and result in a loss of customers or suppliers.

Trade barriers erected by the United States or other countries may interfere with the Company’s ability to offer its products in those markets. The Company manufactures a substantial portion of its products overseas and sells its products throughout the world. The Company cannot predict whether the United States or any other country will impose new quotas, tariffs, taxes or other trade barriers upon the importation or exportation of its products or supplies, any of which could have a material adverse effect on its results of operations and financial condition. Competition and trade barriers in those countries could require the Company to reduce prices, increase spending on marketing or product development, withdraw or not enter certain markets or otherwise take actions adverse to us.

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In all jurisdictions in which the Company operates, it is also subject to the laws and regulations that govern foreign investment and foreign trade, which may limit its ability to repatriate cash as dividends or otherwise to the United States.

The Company competes with larger companies that have greater financial resources, and our business could be harmed by competitive inroads.

The markets in which the Company’s machine and non-machine products are sold are extremely competitive and highly fragmented. In marketing its products, the Company competes with other manufacturers primarily on quality, reliability, price, value, delivery time, service and technological characteristics. The Company competes with a number of U.S., European and Asian competitors, many of which are larger, have substantially greater financial resources, and are supported by governmental or financial institution subsidies. While the Company believes its product lines compete effectively in their markets, they may not continue to do so.

If the Company were unable to access financial markets on favorable terms, its liquidity, businesses and results of operations could be adversely affected.

The ability to raise financial capital, either in public or private markets, or through commercial banks, is critical to the Company’s current business and future growth. The Company’s business is generally working capital intensive requiring a fairly long cash out to cash in cycle. Also, the Company will rely on the availability of longer term debt financing or equity financing to make investments in new opportunities. The Company’s access to the financial markets could be adversely impacted by various factors including the following:

·       Changes in credit markets that reduce available credit or the ability to renew existing facilities on acceptable terms;

·       A deterioration in its financial situation that would violate current covenants and/or prohibit the Company from obtaining capital from banks, financial institutions, or investors;

·       Extreme volatility in credit markets that increase margin or credit requirements; or

·       Volatility in the Company’s results that would substantially increase the cost of its capital.

The Company’s operations and growth prospects would be adversely impacted if the Company were unable to attract and retain skilled employees to work at its manufacturing facilities.

The Company conducts substantially all of its manufacturing operations in relatively small urban areas, with the exception of our Shanghai facility. The Company’s continued success depends on its ability to attract and retain a skilled labor force at these locations. If the Company is not able to attract and retain the personnel it requires, it may be unable to develop, manufacture and market its products and expand its operations in a manner that best exploits market opportunities and capitalizes on its investment in its business. This would materially adversely affect the Company’s business, operating results and financial condition.

Prices of some raw materials, especially steel and iron products, fluctuate which can adversely affect the Company’s sales, costs, and profitability.

The Company manufactures products with a high iron castings or steel content, commodities for which worldwide prices have increased significantly. The availability of and prices for these and other raw materials are subject to volatility due to worldwide supply and demand forces, speculative actions, inventory levels, exchange rates, production costs, and anticipated or perceived shortages. In some cases, those cost increases can be passed on to customers in the form of price increases; in other cases they cannot. If raw materials prices increase and the Company is not able to charge its customers higher prices to compensate, it would adversely affect the Company’s business, financial condition and results of operations.

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Due to future technological changes, changes in market demand, or changes in market expectations, portions of the Company’s inventory may become obsolete or excess.

The technology within the Company’s products changes and generally new versions of machines are brought to market in three to five year cycles. The phasing out of an old product involves both estimating the amount of inventory to hold to satisfy the final demand for those machines as well as to satisfy future repair part needs. Based on changing customer demand and expectations of delivery times for repair parts, the Company may find that it has either obsolete or excess inventory on hand. Because of unforeseen changes in technology, market demand, or competition, the Company may have to write off unusable inventory at some time in the future, which may adversely affect its results of operations and financial condition.

The Company has made and expects to continue to make acquisitions that could disrupt its operations and harm its operating results.

The Company’s strategy involves increasing its product offerings and the markets it serves through acquisitions of other companies, product lines, technologies and personnel. Acquisitions involve numerous risks, including the following:

·       Difficulties in integrating the operations, technologies, products and personnel of the acquired companies;

·       Diversion of management’s attention from normal daily operations of the business;

·       Potential difficulties in completing projects associated with in-process research and development;

·       Difficulties in entering markets in which the Company has no or limited direct prior experience and where competitors in such markets have stronger market positions;

·       Initial dependence on unfamiliar supply chains or relatively small supply partners;

·       Insufficient revenues to offset increased expenses associated with acquisitions; and

·       The potential loss of key employees of the acquired companies.

Acquisitions may also cause the Company to:

·       Issue common stock that would dilute the Company’s current shareholders’ percentage ownership;

·       Assume liabilities;

·       Record goodwill and non-amortizable intangible assets that will be subject to impairment testing on a regular basis and potential periodic impairment charges;

·       Incur amortization expenses related to certain intangible assets;

·       Incur large and immediate write-offs, and restructuring and other related expenses; or

·       Become subject to litigation.

Mergers and acquisitions of companies are inherently risky, and no assurance can be given that the Company’s previous or future acquisitions will be successful and will not materially adversely affect its business, operating results or financial condition. Failure to manage and successfully integrate acquisitions the Company makes could harm its business and operating results in a material way. Prior acquisitions have resulted in a wide range of outcomes, from successful introduction of new products, technologies, facilities and personnel to an inability to do so. Even when an acquired company has already developed and marketed products, there can be no assurance that product enhancements will be made in a timely

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fashion or that pre-acquisition due diligence will have identified all possible issues that might arise with respect to such products.

Risks related to new product development also apply to acquisitions. Please see the risk factor above entitled, “Due to future technological changes, changes in market demand, or changes in market expectations, portions of the Company’s inventory may become obsolete or excess” for additional information.

Fluctuations in the exchange rates between the U.S. dollar and any of several foreign currencies could increase the Company’s costs or decrease its revenue.

The Company’s international operations generate sales in a number of foreign currencies, particularly Swiss Francs, Chinese RMB, British pounds sterling, Canadian dollars, Taiwanese dollars, and the Euro. Therefore, its results of operations and financial condition are affected by fluctuations in exchange rates between these currencies and the U.S. dollar. In addition, the Company’s purchases of components in yen, Euro, Taiwanese dollars, Swiss francs, and Chinese RMB are affected by inter-currency fluctuations in exchange rates.

Major changes in the economic situation of our customer base could require the Company to write-off significant parts of its receivables from customers.

In difficult economic periods, our customers lose work and find it difficult if not impossible to pay for products purchased from the Company. Although appropriate credit reviews were done at the time of sale, rapidly changing economic conditions can have sudden impacts on customers’ ability to pay.  The Company was especially exposed to this bad debt risk when it sold a substantial percentage of its products on time payment contracts supported by Hardinge. This practice was discontinued in 2002, however the Company still runs the risk of bad debts on existing time payment contracts and open accounts. If the Company writes off significant parts of its customer accounts or notes receivable because of unforeseen changes in their business condition, it would adversely affect the Company’s results of operations and financial condition.

Some components and products are purchased from a single supplier or a limited number of suppliers. The loss of any of these suppliers may cause the Company to incur additional costs, result in delays in manufacturing and delivering its products or cause the Company to carry excess or obsolete inventory.

While components and supplies are generally available from a variety of sources, the Company currently depends on a limited number of suppliers for certain components for its products. Some components are purchased from a single supplier or a limited number of suppliers. For example, a large Japanese company and two European companies supply the computer and related electronics package used in the Company’s CNC machines. The Company’s purchases from these suppliers are not made pursuant to long-term contracts and are subject to the additional risks associated with purchasing products internationally, including risks associated with potential import restrictions and exchange rate fluctuations, as well as changes in tax laws, tariffs and freight rates. Although the Company believes that its relationship with these suppliers is good, there can be no assurance that the Company will be able to obtain these products from these suppliers on satisfactory terms indefinitely.

The Company believes that design changes could be made to its machines to allow sourcing from several other suppliers; however, a disruption in the supply of the components from any of these three suppliers could cause the Company to experience a material adverse effect on its operations.

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The unplanned loss of current members of the Company’s senior management team and other key personnel may adversely affect its operating results.

The unplanned loss of senior management or other key personnel could impair the Company’s ability to carry out its business plan. The Company believes that its future success will depend in part on its ability to attract and retain highly skilled and qualified personnel. The loss of senior management or other key personnel may adversely affect  operating results as the Company would incur costs to replace the departed personnel and potentially lose opportunities in the transition of important job functions.

The Company expenditures for post-retirement pension obligations could be materially higher than predicted if underlying assumptions prove to be incorrect or the Company is required to use different assumptions.

The Company provides defined benefit pension plans to eligible employees. The Company’s pension expense, the funded status of its plans and related charges to equity for the amount of under funding, and its required contributions to its pension plans are directly affected by the value of plan assets, the projected rate of return on plan assets, the actual rate of return on plan assets and the actuarial assumptions the Company uses to measure its defined benefit pension plan obligations, including the rate at which future obligations are discounted to a present value, or the discount rate. For pension accounting purposes in the U.S. based plan, which is the largest of the Company plans, an 8.50% rate of return was assumed on pension plan assets for consideration of contributions for future years. The discount rate was 6.02% at December 31, 2006, the new plan measurement date, compared to 5.85% at September 30, 2005, and 6.00% at September 30, 2004, the old measurement dates.

Lower investment performance of pension plan assets resulting from a decline in the stock market could significantly impact the plan assets and future growth of the plan assets. Should the assets earn an average return less than 8.50% over time, it is likely that future pension expenses and funding requirements would increase. Investment earnings in excess of 8.50% may reduce future pension expenses.

The discount rate used to determine the present value of the projected and accumulated benefit obligation at the end of each year is based upon the available market rates for high quality, fixed income investments. A change in the discount rate would impact the funded status of the Company’s plans. An increase to the discount rate would reduce the future pension expense and conversely, a lower discount rate would raise the future pension expense.

Based on current guidelines, assumptions and estimates, including stock market prices and interest rates, the Company anticipates that it may be required to make a cash contribution of approximately $1.5 million to the U.S. pension plan in 2007 and approximately $2.2 million to the foreign plans in 2007. If the Company’s current assumptions and estimates are not correct, a contribution in years beyond 2007 may be greater than the projected 2007 contribution.

In addition, the Company cannot predict whether changing market or economic conditions, regulatory changes or other factors will increase its pension expenses or its funding obligations, diverting funds it would otherwise apply to other uses. At December 31, 2006, the excess of consolidated projected benefit obligations over plan assets was $24.9 million and the excess of consolidated accumulated benefit obligations over plan assets was $13.1 million.

In 2004, the Company made the decision that people hired by the U.S. Company after March 1, 2004 will no longer be eligible for the defined benefit plan.  The U.K. defined benefit plan was closed to new entrants in April of 2005. These employees will be provided a company subsidized 401(k) plan instead.

Item 1B.—UNRESOLVED STAFF COMMENTS

None.

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ITEM 2.—PROPERTIES

Pertinent information concerning the principal properties of the Company and its subsidiaries is as follows:

				Acreage (Land)
				Square Footage
Location		Type of Facility		(Building)
Owned Properties
Horseheads, New York		Manufacturing, Engineering, Turnkey Systems, Marketing, Sales, Demonstration, Service and Administration		80 acres 515,000 sq. ft.
St. Gallen, Switzerland		Manufacturing, Engineering, Turnkey Systems, Marketing, Sales, Demonstration, Service and Administration		8 acres 162,924 sq. ft.
Nan Tou, Taiwan		Manufacturing, Engineering, Marketing, Sales, Service, Demonstration and Administration		3 acres 123,204 sq. ft.
Biel, Switzerland		Manufacturing, Engineering, Turnkey Systems		4 acres 41,500 sq. ft.
Exeter, England		Sales, Marketing, Demonstration, Service, Turnkey Systems and Administration		2 acres 27,500 sq. ft.

 

						Lease
						Expiration
Location		Type of Facility		Square Footage		Date
Leased Properties
Elmira, New York		Warehouse		55,999 sq. ft.		3/31/09
Shanghai, People’s Republic of China		Product Assembly, Marketing, Engineering, Turnkey Systems, Sales, Service, Demonstration and Administration		53,529 sq. ft.		2/28/09
Biel, Switzerland		Engineering, Marketing, Sales, Service, and Administration		44,369 sq. ft.		6/30/08
Horseheads, New York		Warehouse		40,000 sq. ft.		12/31/07
Leicester, England		Sales, Marketing, Engineering, Turnkey Systems, Demonstration, Service, and Administration		30,172 sq. ft.		1/31/15
St. Gallen, Switzerland		Manufacturing		14,208 sq. ft.		8/02/11
Raamsdonksveer, Netherlands		Sales, Service, Demonstration and Administration		10,226 sq. ft.		9/15/11
Krefeld, Germany		Sales, Service, Demonstration and Administration		10,172 sq. ft.		7/31/10
Coventry, England		Storage		2,906 sq. ft.		8/29/09
Santa Ana, California		Sales		2,900 sq. ft.		7/31/07
Xian, People’s Republic of China		Sales		1,913 sq. ft.		8/31/07
Chongqing, People’s Republic of China		Sales		947 sq. ft.		10/23/07
Beijing, People’s Republic of China		Sales		1,399 sq. ft.		2/29/08

 

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ITEM 3.—LEGAL PROCEEDINGS

The Company is from time to time involved in routine litigation incidental to its operations. None of the litigation in which the Company is currently involved, individually or in the aggregate, is anticipated to be material to its financial condition, results of operations, or cash flows.

ITEM 4.—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter of 2006, no matters were submitted to a vote of security holders.

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PART II

ITEM 5.—MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The following table reflects the highest and lowest values at which the stock traded in each quarter of the last two years. Hardinge Inc. common stock trades on The Nasdaq Stock Market under the symbol “HDNG.” The table also includes dividends per share, by quarter.

		2006											2005
		Values											Values
		High			Low			Dividends					High			Low			Dividends
Quarter Ended
March 31		$	18.20		$	14.24			$	0.03			$	15.27		$	13.00			$	0.03
June 30		17.17			14.00				0.03				16.75			12.30				0.03
September 30		16.00			12.68				0.03				17.00			12.65				0.03
December 31		15.72			12.85				0.05				19.00			14.01				0.03

 

At March 12, 2007, there were 2,930 holders of record of common stock.

Issuer Purchases of Equity Securities

The following tables provides information about issuer repurchases of the Company’s common stock by month for the quarter ended December 31, 2006:

Issuer Purchases of Equity Securities
Period				Total Number of Shares Purchased				Average Price Paid per Share
October 1—October 31, 2006					311				$	14.38
November 1—November 30, 2006					128				$	15.60
December 1—December 31, 2006					—				N/A
Total					439				$	14.74

 

The above shares were repurchased as part of the Company’s Incentive Compensation Plan to satisfy tax withholding obligations in connection with the exercise of stock options by employees.

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Performance Graph

The graph below compares the five-year cumulative total return for Hardinge Inc. Common Stock with the comparable returns for the NASDAQ Stock Market (U.S.) Index and a group of eight peer issuers selected for their presence in the machine tool industry. Said peer group includes Circor International Inc., Flow International Corp., Hurco Companies Inc., Kadant Inc., Kaydon Corp., Magnetek Inc., NN Inc., and Sun Hydraulics Corp. Cumulative total return represents the change in stock price and the amount of dividends received during the indicated period, assuming reinvestment of dividends. The graph assumes an investment of $100 on December 31, 2001. The stock performance shown in the graph is included in response to SEC requirements and is not intended to forecast or to be indicative of future performance.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Hardinge, Inc., The NASDAQ Composite Index
And A Peer Group

*                   $100 invested on 12/31/01 in stock or index-including reinvestment of dividends.
Fiscal year ending December 31.

		12/01		12/02		12/03		12/04		12/05		12/06
Hardinge, Inc.		100.00		87.25		122.63		141.45		185.46		162.72
NASDAQ Composite		100.00		71.97		107.18		117.07		120.50		137.02
Peer Group		100.00		81.38		109.77		129.19		136.39		174.48

 

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ITEM 6.—SELECTED FINANCIAL DATA

The following selected financial data is derived from the audited consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes and other information included herein (dollar amounts in thousands except per share data).

		2006			2005			2004			2003			2002
STATEMENT OF OPERATIONS DATA
Net sales		$	326,621		$	289,925		$	232,054		$	185,302		$	169,014
Cost of sales		226,470			199,642			162,376			130,698			117,403
Gross profit		100,151			90,283			69,678			54,604			51,611
Selling, general andadministrative expense		77,054			74,723			57,184			47,731			46,448
Operating income		23,097			15,560			12,494			6,873			5,163
Interest expense		5,294			4,284			2,660			2,917			3,978
Interest (income)		(713		)	(569		)	(533		)	(500		)	(496		)
Income before income taxes, minority interest in (profit) of consolidated subsidiary, and profit (loss) in investment of equity company		18,516			11,845			10,367			4,456			1,681
Income taxes (benefits)(1)		4,566			2,373			3,542			14,667			(868		)
Minority interest in (profit) of consolidated subsidiary		—			(2,466		)	(2,433		)	(1,257		)	(566		)
Profit in investment of equity company		—			—			—			184			17
Net income (loss)(1)		$	13,950		$	7,006		$	4,392		$	(11,284	)	$	2,000
PER SHARE DATA:
Weighted average number of
Common shares Outstanding—basic		8,770			8,761			8,745			8,708			8,687
Basic earnings (loss) per share		$	1.59		$	0.80		$	0.50		$	(1.30	)	$	0.23
Weighted average number of
Common shares Outstanding—diluted		8,809			8,822			8,773			8,708			8,687
Diluted earnings (loss) per share		$	1.58		$	0.79		$	0.50		$	(1.30	)	$	0.23
Cash dividends declared per share		$	0.14		$	0.12		$	0.03		$	0.02		$	0.10
BALANCE SHEET DATA
Working capital		$	156,994		$	126,421		$	122,181		$	103,280		$	103,864
Total assets		330,660			300,276			286,311			245,707			256,285
Total debt		77,861			67,114			42,868			23,301			42,002
Shareholders’ equity		157,109			138,993			150,000			139,086			145,786

(1)          2003 results include a non-cash charge for income tax expense of $12,905 to provide a valuation allowance for the Company’s U.S. deferred tax assets as required by FAS 109.

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ITEM 7. - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview.   The Company’s primary business is designing, manufacturing, and distributing high-precision computer controlled metal-cutting turning, grinding and milling machines and related accessories. The Company is geographically diversified with manufacturing facilities in the U.S., Switzerland, Taiwan, and China and with sales to most industrialized countries. Approximately 64% of its 2006 sales were to customers outside of North America, 57% of its 2006 products were manufactured outside of North America, and 58% of its employees are outside of North America.

The Company’s machine products are considered to be capital goods and are part of what has historically been a highly cyclical industry. The Company’s management believes that a key performance indicator is its order level as compared to industry measures of market activity levels.

The U.S. market activity metric most closely watched by management has been metal-cutting machine orders as reported by the Association of Manufacturing Technology (AMT), the primary industry group for U.S. machine tool manufacturers. In 2006, industry-wide orders for metal cutting machine tools increased 29% versus 2005. In 2005, orders increased by 9% versus 2004. The AMT’s statistics include metal-cutting machines of all types and sizes, including segments where the Company does not compete. The Company does use this metric as an indication of overall market trends. While more detailed information regarding types of machines is not publicly available, the Company is able to obtain more detailed information because of its membership in the organization to determine market trends for the types of machines it distributes.

Similar information regarding machine tool consumption (domestic production plus imports, less exports) in foreign countries is published in various trade journals. In China, the largest market, consumption increased by 20% in 2006 versus 2005, and increased by 15% in 2005 versus 2004. In Germany, the fourth largest market, consumption measured in local currencies decreased by 6% in 2006 versus 2005, and it increased by 6% when comparing 2005 to 2004.   In the United Kingdom, machine tool consumption measured in pound sterling increased by 9% in 2006 versus 2005, and decreased by 1% in 2005 versus 2004.

Other closely followed U.S. market indicators are tracked to determine activity levels in U.S. manufacturing plants that might purchase the Company’s products. One such measurement is the PMI (formerly called the Purchasing Manager’s Index), as reported by the Institute for Supply Management. This measurement has indicated continued expansion in the manufacturing sector. Another measurement is capacity utilization for manufacturing companies, as reported by the Federal Reserve Board. This measurement has been on an upward trend, but has not yet reached the levels that have historically preceded a strong level of capital spending by manufacturers. The Company’s management is not aware of comparably reliable measures of foreign demand or customer activity.

Non-machine sales which includes collets, accessories, repair parts, and service revenue have typically accounted for between 26% to 30% of overall sales and are an important part of the Company’s business, especially in the U.S. where Hardinge has an installed base of thousands of machines. Sales of these products do not vary on a year-to-year basis as significantly as capital goods, but demand does typically track the direction of the related machine metrics.

Other key performance indicators are geographic distribution of net sales and orders, gross profit as a percent of net sales, income from operations, working capital changes, and debt level trends. In an industry where constant product technology development has led to an average model life of three to five years, effectiveness of technological innovation and development of new products are also key performance indicators.

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The Company’s management believes currency exchange rate changes are significant to reported results for several reasons. The Company’s primary competitors, particularly for the most technologically advanced products are now, largely, manufacturers in Japan, Germany, and Switzerland, which causes the worldwide valuation of the yen, Euro, and Swiss franc to be central to competitive pricing in all of the Company’s markets. Also, the Company translates the results of its Swiss, Taiwanese, Chinese, English, German and Canadian subsidiaries into U.S. dollars for consolidation and reporting purposes. Period to period changes in the exchange rate between their local currency and the U.S. dollar may affect comparative data significantly. The Company also purchases computer controls and other components from suppliers throughout the world, with purchase costs reflecting currency changes.

In January 2006, the Company executed its option to purchase the technical information of the Bridgeport knee-mill machine tools, related accessories and spare parts from BPT IP, LLC (“BPT”). BPT had granted the Company the exclusive right to manufacture and sell certain versions of the knee-mill machine tools; accessories and spare parts under an Alliance Agreement dated November 3, 2004. Per the Alliance Agreement, the Company had agreed to pay BPT royalties based on a percentage of net sales attributable to the products, accessories and spare parts.

The purchase price for the technical information was $5.0 million and it will be amortized over a ten-year period. The technical information purchased includes, but is not limited to, blueprints, designs, schematics, drawings, specifications, computer source and object code, customer lists and proprietary rights and assets of a similar nature. Subsequent to the purchase, no further royalties will be earned by BPT. Royalty expense under this agreement was less than $0.1 million in 2006 and $1.3 million and $1.2 million during the years ended December 31, 2005, and 2004, respectively.

Results of Operations

2006 Compared to 2005

The following table summarizes certain financial data for 2006 and 2005:

 

Net Sales.   Net sales were $326.6 million in 2006, compared to $289.9 million in 2005. The increase in net sales of $36.7 million, or 12.7%, included increases in all three sales regions, as shown below:

 

North American sales increase of 11.6% was driven by market demand, primarily in turning and milling products. European sales were flat in the first half of the year, but demonstrated 17.8% growth in

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the second half of the 2006 versus the same period in the prior year, averaging 9.2% growth on the full year. Sales in Asia and Other grew at 20.2% as the company continues to penetrate this market.

Sales growth by product line is as follows: Turning grew 36% with strong market demand for North American produced lathes; Grinding grew 4% on the year with 16% growth in the second half of 2006; Workholding at 3%; and  Milling increased by 1%, with significant growth in North America offset by declines in the rest of the world. Total milling had been constrained by manufacturing capacity with a Taiwanese contract manufacturer. As of January 2007, this supplier has expanded milling manufacturing capacity with a new production line.

Under U.S. accounting standards, income statement items of foreign subsidiaries are translated into U.S. dollars at the average exchange rate during the periods presented. The net of these foreign currency transactions relative to the U.S. dollars had a favorable impact on sales of $1.4 million. Excluding the impact of foreign currency translation, sales for 2006 increased $35.3 million or 12.2%.

The geographic mix of sales as a percentage of total net sales is shown in the table below:

 

Machine sales represented 73.3% of 2006 net sales, as compared to 71.3% of 2005 net sales. Sales of non-machine products and services, primarily repair parts and accessories, made up the balance.

Orders and Backlog:   The Company’s new orders rose 19.8% to $347.8 million in 2006 compared to $290.4 million in 2005, as shown in the table below:

 

The $57.4 million, or 19.8% increase in new orders was driven by strength in all markets, and growth in all product lines, demonstrating underlying strength in the industry.

The Company’s December 31, 2006 backlog of $99.6 million was 27.4% above the adjusted December 31, 2005 backlog of $78.2 million. This was driven by strong order performance in the second half of the year.

Gross Profit.   Gross profit was $100.2 million, or 30.7% of net sales in 2006, compared to $90.3 million, or 31.1% of net sales in 2005. The reduction in gross margin for 2006 resulted from differences in product mix, market mix, and distribution channels.

Selling, General, and Administrative Expense.   Selling, general and administrative (“SG&A”) expense for the year 2006 was $77.1 million, or 23.6% of net sales, compared to $74.7 million, or 25.8% of net sales, in 2005. The $2.4 million increase was primarily due to commission expenses of $1.4 million on higher volume, and $2.4 million, or a 3.2% increase related to continued expansion of the company’s sales and support functions to manage growth in worldwide operations. This was partially offset by a reduction in bad debt expense of $1.4 million for customer notes receivable provisions that did not reoccur to the same levels in 2006.

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Income from Operations.   Income from operations increased by 48.4% to $23.1 million, or 7.1% of net sales in 2006 from $15.6 million, or 5.4% of net sales in 2005 primarily due to the increased sales level.

Interest Expense & Interest Income.   Interest expense includes interest payments under the Company’s credit facility, unrealized and realized gains or losses on our interest rate swap agreement and amortization of deferred financing costs associated with our credit facility.

Interest expense for the year 2006 was $5.3 million, an increase from $4.3 million in 2005. The increase was primarily due to higher average borrowings incurred to finance the purchase of the 49% minority interest in Hardinge Taiwan Limited, in December 2005, and the purchase of the technical information of the Bridgeport knee-mill machine tool business, in January 2006, as reported by the Company in prior filings with the Securities and Exchange Commission.

Interest income, primarily derived from previous years’ internally financed customer sales, was $0.7 million in 2006 and $0.6 million in 2005.

Income Tax/Benefit.   Income tax expense in 2006 was $4.6 million compared to $2.4 Million in 2005. The effective tax rate was 24.7% in 2006 and 20.0% in 2005. The increase in the effective rate is primarily due to the non-reoccurrence of the $0.4 million reduction in the tax valuation allowance in 2005 primarily in the U.K. as well as a change in the mix of profits by country. The 2006 effective tax rate was favorably affected by 3.7 percentage points due to a reduction in the tax rate at one of the Company’s Swiss entities. This reduction resulted in revaluing previous deferred taxes. The income tax expense fundamentally represents tax expense on profits in the Company’s foreign subsidiaries.

There is no tax benefit recorded on losses in the U.S. and Canada in accordance with the provisions of Statement of Financial Accounting Standards No. 109 (SFAS 109). As specified in SFAS 109, the Company regularly reviews recent results and projected future results of its operations, as well as other relevant factors, to reconfirm the likelihood that existing deferred tax assets in each tax jurisdiction would be fully recoverable. In the case of the U. S. operations, this recoverability had been based largely on the likelihood of future taxable income.

Minority Interest In (Profit) of Consolidated Subsidiary.   Until December 27, 2005, the Company owned a 51% interest in Hardinge Taiwan Precision Machinery Limited, an entity that is recorded as a consolidated subsidiary. There is no minority interest reduction to consolidated net income for 2006, compared to a reduction of $2.5 million in 2005. This represented the minority stockholders’ 49% share in the joint venture’s net income.

Net Income (Loss).   Net income for 2006 was $14.0 million or 4.3% of net sales, compared to $7.0 million, or 2.4% of net sales in 2005. Basic and diluted earnings per share for 2006 were $1.59 and $1.58, respectively, compared to basic and diluted earnings per share of $0.80 and $0.79 in 2005. The increase was the result of the factors described above.

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Results of Operations
2005 Compared to 2004

The following table summarizes certain financial data for 2005 and 2004:

 

Net Sales.   Net sales were $289.9 million in 2005, an increase of $57.9 million or 24.9% compared to $232.1 million in 2004. Sales increased due to the addition of Bridgeport products, which were acquired in November 2004, and due to increased shipments of the Company’s other product lines. Sales of Bridgeport products were approximately $48.3 million in 2005 and $3.1 million in the part of 2004 after the acquisition.

The table below summarizes our 2005 net sales by geographical region, with comparisons to 2004. Net sales in all three geographical regions increased in 2005 as compared to 2004.

 

Sales to customers in North America, Europe and Asia and Other increased due to sales of the Bridgeport products in addition to increased sales of the Company’s other product lines.

Under U.S. accounting standards, income statement items of foreign subsidiaries are translated into U.S. dollars at the average exchange rate during the periods presented. The net of these foreign currency translations relative to the U.S. dollar had a favorable impact on sales of $0.5 million. Excluding the impact of foreign currency translation, sales for 2005 increased $57.4 million or 24.7%.

The geographic mix of sales  as a percentage of total net sales is shown below:

 

Sales of machines accounted for approximately 71.3% of net sales for 2005, as compared to 70.2% of net sales in 2004. Sales of non-machine products and services, consist of workholding, repair parts, services and accessories.

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Orders and Backlog:   The Company’s orders by geographical region are below:

 

Orders for 2005 were $290.4 million, an increase of $34.7 million or 13.6% compared to $255.7 million in 2004.        The increase is primarily due to orders for our new Bridgeport products, which were acquired in November 2004. Orders for the new Bridgeport products were $55.0 million in 2005 and $21.7 million in 2004.

The increase in orders in North America and Europe are due to the Bridgeport products. Orders in the Asia and Other region decreased due to the acquisition of Bridgeport in November 2004. That acquisition resulted in the conversion of $13.6 million in orders from Bridgeport to Hardinge for the Asia and Other region, resulting in a one-time increase in new orders for 2004. Our consolidated adjusted backlog at December 31, 2005 was $78.2 million.

Gross Profit.   Gross profit for 2005 was $90.3 million, an increase of $20.6 million or 29.6% compared to $69.7 million in 2004. The increased gross profit is primarily due to the increased net sales. In addition, gross profit percentage for 2005 was 31.1% of net sales compared to 30.0% of net sales in 2004. The increased gross profit percentage reflects changes in product mix and better utilization of manufacturing operations.

Selling, General, and Administrative Expense.   Selling, general and administrative (“SG&A”) expense was $74.7 million, or 25.8% of net sales for 2005, an increase of $17.5 million or 30.6% compared to $57.2 million, or 24.6% of net sales, in 2004. The increase in SG&A for the full year includes the following: $8.8 million was due to the addition of two new sales, service and technical centers located in the U.K. and Holland to support the Bridgeport acquisition, $0.8 million resulted from increased commission expense due to higher sales, $1.9 million was driven by increased promotional and support costs in China. Additionally, bad debt expense increased by $1.4 million. The increase is due to additional reserves for the Company’s customer notes receivables. Each quarter, the Company reviews the sufficiency of its allowance for bad debts, based upon its recent experience, prior years experience and the makeup and aging of its current accounts and notes receivables, and adjusts the allowance for bad debts accordingly.  The Company discontinued issuing notes in 2002. The remainder of the expense increase resulted primarily from expansion of the Company’s sales and support functions to manage the growth in worldwide operations.

Income from Operations.   Income from operations was $15.6 million, or 5.4% of net sales for 2005, compared to $12.5 million, or 5.4% of net sales in 2004. The increase in income from operations is primarily due to the increase in net sales.

Interest Expense & Interest Income.   Interest expense includes interest payments under the Company’s credit facilities, realized gains or losses on the interest rate swap agreement and amortization of deferred financing costs associated with the Company’s credit facilities. Interest expense was $4.3 million for 2005 compared to $2.7 million in 2004. The increase was due to higher average borrowings, which is primarily attributable to the acquisition of the Bridgeport business, and an increase in working capital to support the increase in net sales.   Interest income was $0.6 million in 2005 and $0.5 million in 2004.

Income Tax Expense/Benefit.   Income tax expense was $2.4 million in 2005, compared to $3.5 million in 2004. The effective tax rate was 20.0% in 2005 and 34.2% in 2004. The decrease in the effective rate is due to non-cash reductions in certain income tax valuation allowances, primarily in the U.K., and accruals

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in the amount of $1.1 million and to changes in the mix of profits in various countries, offset by not recording a tax benefit for losses in the U.S which resulted in an increase in our valuation allowance of $0.3 million. Our income tax expense primarily represents tax expense on profits in the Company’s foreign subsidiaries. There is no tax benefit recorded on losses in the U.S. in accordance with the provisions of Statement of Financial Accounting Standards No. 109 (SFAS 109). As specified in SFAS 109, the Company regularly reviews recent results and projected future results of its operations, as well as other relevant factors, to reconfirm the likelihood that existing deferred tax assets in each tax jurisdiction would be fully recoverable. In the case of the U. S. operations, this recoverability had been based largely on the likelihood of future taxable income.

Minority Interest In (Profit) of Consolidated Subsidiary.   Until December 27, 2005, the Company had a 51% interest in Hardinge Taiwan Precision Machinery Limited, an entity that is recorded as a consolidated subsidiary. In 2005, $2.5 million of reductions in consolidated net income were recorded, compared to $2.4 million in 2004. This represents the minority stockholders’ 49% share in the joint venture’s net income. This elimination of the minority interest in this consolidated subsidiary was consistent in both years due to the comparable profits at that subsidiary’s operations.

Net Income.   Net income for 2005 was $7.0 million or 2.4% of net sales, compared to $4.4 million, or 1.9% of net sales in 2004. Basic earnings per share were $0.80 and diluted earnings per share were $0.79 for 2005, compared to $0.50 per basic and diluted earnings per share for 2004.

Liquidity and Capital Resources

The Company’s principal capital requirements are to fund its operations, including working capital, the purchase and funding of improvements to its facilities, machines and equipment and to fund acquisitions.

At December 31, 2006, cash and cash equivalents were $6.8 million, compared to $6.6 million at December 31, 2005. The current ratio at December 31, 2006 was 3.22:1 compared to 2.65:1 at December 31, 2005.

Cash Flows from Operating Activities:

As shown in the Consolidated Statements of Cash Flows, cash from operating activities was $6.7 million in 2006 compared to a use of funds of $5.8 million in 2005. This represents an increase in cash flows of $12.6 million.

The table below shows the changes in cash flows from operating activities by component:

 

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In 2006, cash was provided by net income, depreciation and amortization, notes receivable and accounts payable. Cash was used in provision for deferred taxes, accounts receivable, inventories, accrued expenses, other assets and other operating activities. Increased net income is due primarily to higher net sales. The increased receivables, inventory levels and accrued expenses are due to increased production and sales levels.

Cash Used In Investing Activities:

The table below shows the changes in cash flows from investing activities by component:

 

Net cash used in investing activities was $15.8 million for 2006, compared to $15.3 million in 2005. Capital expenditures for 2006 were $3.6 million. Capital expenditures in 2006 included modest retooling, reconfiguration and replacement of manufacturing equipment.

Capital expenditures for 2005 were $4.8 million. Capital expenditures for 2005 included leasehold improvement costs to outfit the new demonstration and technical center, which houses the activities of Bridgeport operations in the U.K and for routine replacements of other equipment.

Cash used in investing activities during 2006 was primarily related to the $5.1 million payment for the purchase of U-Sung Co., Ltd., which owned the land and building previously leased by Hardinge Taiwan; the purchase of the technical information of the Bridgeport knee-mill machine tool business in the first quarter of 2006 for $5.0 million; the purchase of other assets for $2.0 million, and a payment of $0.1 million on the purchase of the 49% interest in Hardinge Taiwan which was acquired in the fourth quarter of 2005.

Cash used in investing activities during 2005 included the purchase of 49% shares of Hardinge Taiwan for $9.0 million. Pursuant to a Joint Venture Agreement, the Company owned 51% of Hardinge Taiwan and other minority shareholders owned 49% of Hardinge Taiwan. On December 27, 2005, the Company purchased the remaining 49% of Hardinge Taiwan, making it a wholly owned subsidiary of the Company.

Cash used in investing activities during 2005 also included a partial payment for the purchase of U-Sung, Ltd. for $1.4 million, net of cash acquired. U-Sung owned the land and building in Nan Tou City, Taiwan, Republic of China that was occupied and previously leased by Hardinge Taiwan.

Cash Provided by Financing Activities:

Net cash provided by financing activities for 2006 and 2005 are summarized in the table below:

 

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Cash provided by financing activities was $8.8 million for 2006, compared to $23.8 million for 2005. Debt, including notes payable, provided cash of $10.1 million in 2006 compared to $24.7 million in 2005. The additional debt level is due to the increase in working capital to support increased sales and the purchases of U-Sung Co., Ltd., and the technical information of the Bridgeport knee-mill machine tool business. Payment of dividends used $1.2 million in 2006 compared to $1.1 million in 2005. In December 2006, the Company increased its dividend payout to $0.05 per share for the quarter compared to $0.03 per share paid in the first three quarters of 2006 and all four quarters of 2005.

In January 2005, the Company negotiated a revised loan agreement with a group of U.S. banks and amended the Company’s existing agreements. The amended agreement provided for a revolving loan facility allowing for borrowing of up to $40.0 million through January 2010 and a term loan of $30.0 million with quarterly principal payments of $1.2 million through December 2006 and quarterly principal payments of $1.3 million from March 2007 through March 2011. These loans were secured by substantially all of the Company’s U.S. assets, other than real estate, and a pledge of 65% of the Company’s investment in its major subsidiaries. Interest charged on this debt was based on LIBOR plus a spread that varied depending on the Company’s debt to EBITDA ratio. A variable commitment fee of 0.175% to 0.375%, based on the Company’s debt to EBITDA ratio, was payable on the unused portion of the revolving loan facility.

In December 2005, the Company executed an amendment to the loan agreement described above which provided the Company with an additional $20.0 million on the revolving loan facility. This amendment was a temporary facility and in June 2006 the expiration was extended to December 29, 2006. This amendment was arranged through the same bank group as the original facility discussed above. It also has the same security and similar financial covenants as provided under the loan agreements described above. At December 31, 2005, the outstanding balance on the amended revolving loan facility was $30.9 million. At December 31, 2005, the outstanding balance on the term loan was $25.2 million.

In November 2006, the Company executed its Second Amended and Restated Revolving Credit and Term Loan Agreement. The amendment increased the revolving loan facility from $40.0 million to $70.0 million with a portion of the increase used to pay off the temporary facility described above. The amendment also increased the permitted debt to EBITDA ratio for certain portions of the term of the facility, lowered the variable commitment fee and borrowing rates at certain debt to EBITDA ratios, and provided for permitted annual acquisitions up to a certain amount. Additionally, mandatory prepayment of the term loans upon equity issuance and the fixed charge coverage ratio were both eased. Other terms and conditions remain essentially the same as the prior agreement. At December 31, 2006, the outstanding balance on the amended revolving loan facility was $43.2 million. At December 31, 2006, the outstanding balance on the term loan was $20.4 million.

The Company has an $8.0 million unsecured short-term line of credit from a bank with interest based on the prime rate. At December 31, 2006, the outstanding balance on this line was $0.6 million. There was no outstanding balance on this line at December 31, 2005. The agreement is negotiated annually and requires no commitment fee.

The Company maintains a $1.6 million standby letter of credit, which expires March 31, 2007, for potential liabilities pertaining to self-insured workers compensation exposure. This standby letter of credit is renewed annually.

The Company’s Kellenberger AG (“Kellenberger”) subsidiary maintains a loan agreement with a Swiss bank providing for borrowing of up to 7.5 million Swiss francs, which is equivalent to approximately $6.2 million at December 31, 2006. This agreement is secured by the real property owned by Kellenberger. At December 31, 2006, borrowings under this facility were $2.9 million. At December 31, 2005, borrowings under this facility were $5.7 million.

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During 2005, Kellenberger entered into an amended unsecured overdraft facility with a commercial bank that permitted borrowings of up to 7.5 million Swiss Francs, which is equivalent to approximately $6.2 million at December 31, 2006. This replaced the previous overdraft facility that permitted borrowing of up to 6.5 million Swiss Francs. These lines provide for interest at competitive short-term interest rates and carry no commitment fees on unused funds. At December 31, 2006 the outstanding balance under this facility was $0.3 million. At December 31, 2005, there were no borrowings outstanding under this facility.

The Company’s HTT subsidiary maintains a loan agreement with a Swiss bank providing for borrowings of up to 4.0 million Swiss Francs, which is equivalent to approximately $3.3 million at December 31, 2006. This agreement is secured by real property owned by HTT. There were no borrowings under this agreement at December 31, 2006. Borrowings under this agreement were $1.5 million at December 31, 2005.

HTT also maintains an unsecured overdraft facility with a commercial bank that permits borrowings of up to 8.8 million Swiss Francs, which is equivalent to approximately $7.2 million at December 31, 2006. These lines provide for interest at competitive short-term interest rates and carry no commitment fees on unused funds. Borrowings under these lines were $3.7 million and $2.3 million at December 31, 2006 and December 31, 2005 respectively.

The Company’s Hardinge Machine Tools, Ltd. subsidiary maintains an overdraft facility that allows for borrowing up to 0.4 million pounds sterling, which is equivalent to approximately $0.7 million at December 31, 2006. There were no borrowings under this facility at December 31, 2006 or 2005. Hardinge Machine Tool, Ltd. also has a mortgage agreement with total remaining loan balances of $1.6 million and $1.5 million, at December 31, 2006 and 2005, respectively.

In June 2006, the Company’s Taiwan subsidiary negotiated a mortgage loan with a bank secured by the real property owned by the Taiwan subsidiary which provides borrowings up to 180.0 million New Taiwanese dollars which is equivalent to approximately $5.5 million. At December 31, 2006 borrowings under this agreement were $5.2 million. Principal on the mortgage loan is repaid quarterly in the amount of 4.5 million New Taiwanese dollars, which is equivalent to approximately $0.1 million.

Certain of these debt agreements require, among other things, that the Company maintain specified levels of tangible net worth, working capital, and specified ratios of debt to EBITDA, and EBITDA minus capital expenditures to fixed charges.

These facilities, along with other short-term credit agreements, provide for access of up to $128.8 million. Based on our most restrictive covenants, the Company had actual additional borrowing availability of $37.0 million at December 31, 2006. Total consolidated outstanding borrowings at December 31, 2006 were $77.9 million.

The Company was in compliance with all covenants at December 31, 2006 and 2005.

During September 2006, the Securities and Exchange Commission declared the Company’s shelf registration statement on Form S-3 effective, registering $50 million of the Company’s common stock. The filing of this shelf registration statement could facilitate the Company’s ability to raise capital, should the Company decide to do so, in the future. The amount, price and other terms of the common stock will be determined at the time of any particular transaction.

The Company conducts some of its manufacturing, sales and service operations from leased space, with lease terms up to 20 years, and uses certain data processing equipment under lease agreements expiring at various dates. Rent expense under these leases totaled $2.2 million, $3.0 million, and $2.0 million, during the years ended December 31, 2006, 2005, and 2004, respectively.

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The following table shows our future commitments in effect as of December 31, 2006 (in thousands):

 

The Company believes that the currently available funds and credit facilities, along with internally generated funds, will provide sufficient financial resources for ongoing operations throughout 2007.

Off Balance Sheet Arrangements

The Company does not have any off balance sheet arrangements.

Market Risk

The following information has been provided in accordance with the Securities and Exchange Commission’s requirements for disclosure of exposures to market risk arising from certain market risk sensitive instruments.

The Company’s earnings are affected by changes in short-term interest rates as a result of its floating interest rate debt. However, due to its purchase of interest rate swap agreements, the effects of interest rate changes are limited. If market interest rates on debt subject to floating interest rates were to have increased by 2% over the actual rates paid in that year, interest expense would have increased by $1.6 million in 2006 and $1.0 million in 2005, after considering the effect of the interest rate swap agreements. These amounts are determined by considering the impact of hypothetical interest rates on the Company’s borrowing cost and interest rate swap agreements.

The Company’s operations consist of manufacturing and sales activities in foreign jurisdictions. The Company currently manufactures its products in the United States, Switzerland, Taiwan and China using production components purchased internationally, and sells the products in those markets as well as other worldwide markets. The U.S. parent company purchases grinding machines manufactured in Switzerland by its two Swiss subsidiaries. Likewise, it purchases machining centers and other machines manufactured in Taiwan by its  Taiwanese subsidiary and other Taiwanese manufacturers. The Company’s subsidiaries in the U.K., Germany, Switzerland and Canada sell products in local currency to customers in those countries. The Company’s Taiwanese subsidiary sells products to foreign purchasers in U.S. dollars. As a result of these sales in various currencies and in various countries of the world, the Company’s financial results could be significantly affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which the Company distributes its products. The Company’s operating results are exposed to changes in exchange rates between the U.S. dollar, Canadian dollar, U.K. pound, Swiss franc, Euro, New Taiwan Dollar, and Japanese yen. To mitigate the short-term effect of changes in currency exchange rates on the Company’s functional currency based purchases and sales, the Company occasionally hedges by entering into foreign exchange forward contracts for amounts less than its projected three to six months of such purchase and sales transactions.

Discussion of Critical Accounting Policies

The preparation of the Company’s financial statements requires the application of a number of accounting policies which are described in the notes to the financial statements. These policies require the use of assumptions or estimates, which, if interpreted differently under different conditions or circumstances, could result in material changes to the reported results. Following is a discussion of those

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accounting policies, which were reviewed with the Company’s audit committee, and which the Company feels are most susceptible to such interpretation.

Accounts and Notes Receivable.   The Company assesses the collectibility of its trade accounts and notes receivable using a combination of methods. It reviews large individual accounts for evidence of circumstances that suggest a collection problem might exist. Such situations include, but are not limited to, the customer’s past history of payments, its current financial condition as evidenced by credit ratings, financial statements or other sources, and recent collection activities. The Company offers long term customer financing in the form of notes receivable at some of its foreign operations. The Company’s notes receivable in North America are limited to machine sales to end-user customers for years prior to 2003, and a security interest is normally maintained in the equipment sold under terms of the notes. In cases where repossession may be likely, the Company estimates the probable resale potential of the assets to be repossessed net of repossession, refurbishment and resale costs, and provides a reserve for the remaining receivable balance after realization of such proceeds. The Company provides a reserve for losses based on current payment trends in the economies where it holds concentrations of receivables and provides a reserve for what it believes to be the most likely risk of uncollectibility. In order to make these allowances, the Company relies on assumptions regarding economic conditions, equipment resale values, and the likelihood that previous performance will be indicative of future results.

Inventories.   The Company uses a number of assumptions and estimates in determining the value of its inventory. An allowance is provided for the value of inventory quantities of specific items that are deemed to be excessive based on an annual review of past usage and anticipated future usage. While the Company feels this is the most appropriate methodology for determining excess quantities, the possibility exists that customers will change their buying habits in the future should their own requirements change. Changes in metal-cutting technology can render certain products obsolete or reduce their market value. The Company continually evaluates changes in technology and adjusts its products and inventories accordingly, either by write-off or by price reductions. However, the possibility exists that a future technological development, currently unanticipated, might affect the marketability of specific products produced by the Company.

The Company includes in the cost of its inventories a component to cover the estimated cost of manufacturing overhead activities associated with production of its products.

The Company believes that being able to offer immediate delivery on many of its products is critical to its competitive success. Likewise, it believes that maintaining an inventory of service parts, with a particular emphasis on purchased parts, is especially important to support its policy of maintaining serviceability of its products. Consequently, it maintains significant inventories of repair parts on many of its machine models, including some, which are no longer in production.  The Company’s ability to accurately determine which parts are needed to maintain this serviceability is critical to its success in managing this element of its business.

Intangible Assets.   The Company has acquired other machine tool companies or assets of companies. When doing so, it has used outside specialists to assist it in determining the value of assets acquired, and has used traditional models for establishing purchase price based on EBITDA multiples and present value of future cash flows. Consequently, the value of goodwill and other purchased intangible assets on the Company’s balance sheet has been affected by the use of numerous estimates of the value of assets purchased and of future business opportunity.

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Net Deferred Tax Assets.   As specified in Statement of Financial Accounting Standards No. 109 (SFAS 109), the Company annually reviews the recent results and projected future results of its operations, as well as other relevant factors, to reconfirm the likelihood that existing deferred tax assets in each tax jurisdiction would be fully recoverable. In the Company’s case, this recoverability had been based largely on the likelihood of future taxable income.

During the third quarter of 2003, it was determined that it was unlikely that the Company’s U.S. operations would return to profitability by the end of the year, as had been previously expected. SFAS 109 stipulates that when a Company is relying largely on future taxable income, considerably greater positive evidence is necessary to conclude that deferred tax assets do not warrant a valuation allowance. The Company did not feel that this high standard for positive evidence could be fully met and the valuation allowance was established. During 2005, the Company reduced the valuation allowance related to the deferred tax assets in the U.K. In 2006, the Company continues to record a valuation allowance in the U.S. and Canada.

Retirement Plans.   The Company sponsors various defined benefit pension plans and one postretirement benefit plan, all as described in Note 10 of the Consolidated Financial Statements. The calculation of the Company’s plan expenses and liabilities require the use of a number of critical accounting estimates. Changes in the assumptions can result in different plan expense and liability amounts, and actual experience can differ from the assumptions. The Company believes that the most critical assumptions are the discount rate and the expected rate of return on plan assets.

The Company annually reviews the discount rate to be used for retirement plan liabilities, considering rates of return on high quality, long term corporate bonds that receive highest ratings by recognized rating agencies. The Company discounted its future plan liabilities for its U.S. plan using a rate of 6.02% at its new plan measurement date of December 31, 2006 and 5.85% at its previous plan measurement date of September 30, 2005. The Company discounted its future plan liabilities for its foreign plans using rates appropriate for each country, which resulted in a blended rate of 3.25% and 3.41% at their measurement dates of December 31, 2006 and 2005, respectively. A change in the discount rate can have a significant effect on retirement plan expense. For example, a decrease in the discount rate of a quarter of a percentage point would increase U.S. pension expense by approximately $0.3 million and would change foreign pension expenses and postretirement expenses by lesser amounts.

The expected rate of return on plan assets varies based on the investment mix of each particular plan and reflects the long-term average rate of return expected on funds invested or to be invested in each pension plan to provide for the benefits included in the pension liability. The Company reviews its expected rate of return annually based upon information available to the Company at that time, including the historical returns of major asset classes, the expected investment mix of the plans’ assets, and estimates of future long-term investment returns. The Company used an expected rate of return of 8.50% at its new plan measurement date of December 31 2006 and at its previous measurement date of September 30, 2005 for its U.S. plan. The Company used rates of return appropriate for each country for its foreign plans which resulted in a blended expected rate of return of 4.94% and 5.28% at their measurement dates of December 31, 2006 and 2005, respectively. A change in the expected return on plan assets can also have a significant effect on retirement plan expense. For example, a decrease of a quarter of a percentage point would increase U.S. pension expense by approximately $0.2 million and would change foreign pension plan expenses by lesser amounts.

New Accounting Standards

On January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 151, “Inventory Costs - An Amendment of ARB No. 43, Chapter 4” (SFAS 151). This statement amends

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ARB No. 43, Chapter 4, Inventory Pricing, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current-period charges. Additionally, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The adoption of SFAS 151 did not have a material impact on the consolidated financial statements of the Company.

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (SFAS 123R), which required the Company to measure all employee stock-based compensation awards using a fair value method and record the related expense in the financial statements. The Company elected to use the modified prospective transition method, which requires that compensation cost be recognized in the financial statements for all awards granted after the date of adoption as well as for existing awards for which the requisite service has not been rendered as of the date of adoption and requires that prior periods not be restated. All periods presented prior to January 1, 2006 were accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). Accordingly, no compensation cost was recognized for fixed stock options prior to January 1, 2006 because the exercise price of the stock options equaled the market value of the Company’s common stock at the date of grant, which is the measurement date. The Company did not issue any new stock options during the year ended December 31, 2006. In addition, all previously awarded stock option grants were fully vested at the date of the adoption of FAS 123R, therefore, the Company did not recognize any share-based compensation expense in 2006 based on stock options. See Note 1 to the Consolidated Financial Statements for more information regarding the implementation of SFAS 123R.

In July 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 “Accounting for Income Taxes.”  FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating the impact of FIN 48, and although the evaluation is not complete, the Company does not expect FIN 48 to have a material impact on its consolidated results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in applying generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 is not expected to have a material impact on the Company’s consolidated results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - An amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158). SFAS 158 requires an employer to recognize the funded status of each defined benefit post employment plan on the balance sheet. The funded status of all overfunded plans are aggregated and recognized as a non-current asset on the balance sheet. The funded status of all underfunded plans are aggregated and recognized as a current liability, a non-current liability, or a combination of both on the balance sheet. A current liability is the amount by which the benefit obligation payable in the next 12 months exceeds the fair value of plan assets, and is determined on a plan-by-plan basis. SFAS 158 also requires the measurement date of a plan’s assets and its obligations to be the employer’s fiscal year-end date. All of the plans consolidated within this disclosure already complied with

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the December 31, 2006 measurement date except for the U.S. Pension Plan. The Company early adopted this requirement and changed the measurement date for the Company’s domestic Pension Plan from September 30, 2006 to December 31, 2006. The 2006 net periodic benefit cost was determined using the alternative transition method outlined in paragraph 19 of SFAS 158. Under this approach, the 2006 periodic benefit cost was set equal to twelve-fifteenths of the net periodic benefit cost determined for the period October 1, 2005 through December 31, 2006. The remaining three-fifteenths of the net periodic benefit cost for the period October 1, 2005 through December 31, 2006 was charged as a $0.5 million reduction to retained earnings. This measurement date change resulted in a liability reduction of $2.2 million. Additionally, SFAS 158 requires an employer to recognize changes in the funded status of a defined benefit post employment plan in the year in which the change occurs. SFAS 158 is effective for the Company as of December 31, 2006. The incremental effect of applying FAS 158 to the Company’s Consolidated Balance Sheet as of December 31, 2006 was to increase retirement-related liabilities by $13.1 million, non-current deferred tax assets by $1.2 million, and to decrease accumulated other comprehensive income (loss) by $11.9 million. See Note 10 to the Consolidated Financial Statements for more information regarding the implementation of SFAS 158.

This report contains statements of a forward-looking nature relating to the financial performance of Hardinge Inc. Such statements are based upon information known to management at this time. The Company cautions that such statements necessarily involve uncertainties and risk and deal with matters beyond the Company’s ability to control, and in many cases the Company cannot predict what factors would cause actual results to differ materially from those indicated. Among the many factors that could cause actual results to differ from those set forth in the forward-looking statements are fluctuations in the machine tool business cycles, changes in general economic conditions in the U.S. or internationally, the mix of products sold and the profit margins thereon, the relative success of the Company’s entry into new product and geographic markets, the Company’s ability to manage its operating costs, actions taken by customers such as order cancellations or reduced bookings by customers or distributors, competitors’ actions such as price discounting or new product introductions, governmental regulations and environmental matters, changes in the availability and cost of materials and supplies, the implementation of new technologies and currency fluctuations. Any forward-looking statement should be considered in light of these factors. The Company undertakes no obligation to revise its forward-looking statements if unanticipated events alter their accuracy.

ITEM 7A.—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The information required by this item is incorporated herein by reference to the section entitled “Market Risk” in Item 7, Management’s Discussion and Analysis of Results of Operations and Financial Condition, of this Form 10K.

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ITEM 8—FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

HARDINGE INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
December 31, 2006

 

All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted.

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Report of Ernst & Young, LLP, Independent Registered Public Accounting Firm

The Board of Directors and Shareholders
of Hardinge Inc.

We have audited the accompanying consolidated balance sheets of Hardinge Inc. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hardinge Inc. and Subsidiaries at December 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 1 to the consolidated financial statrements, on January 1, 2006, the Company changed its method of accounting for stock based compensation. In addition, as discussed in Note 10 to the consolidated financial statements, on December 31, 2006, the Company changed its method of accounting for defined benefit pension and other postretirement benefits.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hardinge Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2007 expressed an unqualified opinion thereon.

 

Buffalo, New York
March 15, 2007

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HARDINGE INC. and SUBSIDIARIES
Consolidated Balance Sheets
(In Thousands)

 

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HARDINGE INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(In Thousands)

 

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