Overview

We provide proprietary, value-added products to a diverse customer base covering a broad spectrum of industries. This strategic customer diversification means that demand for our products depends, in part, upon certain general economic conditions, which affect our markets in varying ways from year to year. Similar to 2006 and 2007, in the first half of 2008 the Company continued to benefit from a strong manufacturing economy. At the end of the third quarter of 2008 business conditions worldwide grew weaker and appreciably worsened during the fourth quarter of 2008 as customers reacted to adverse market conditions, which affected each of the Company's businesses. While business conditions weakened at the end of 2008, the Company achieved a full year sales record of $522.4 million as a result of the strong start in the first half of the year, the continuing growth in the wind energy and military markets, and the full year results of Avon Bearings Corporation ("Avon") acquired in October 2007. Benefiting from the record sales, the Company generated net income of $67.1 million, and cash flow from operating activities of $57.9 million during 2008. Despite the strong cash flow from operations, cash and cash equivalents and short-term investments decreased $54.0 million during the year as the Company invested $59.5 million in net capital expenditures, $35.9 million for stock repurchases, $11.9 million to partially fund its qualified pension plans, and increased its common stock dividend. The total order book for 2008 equaled $596.0 million, compared to $505.5 million in 2007, and $405.3 million in 2006. Our 2008 year-end backlog of $312.6 million provides a firm foundation for operating performance in 2009. However, with recessionary pressures building in the United States and Europe and slowing growth in China and India, the near term will be challenging. Also, the worst investment conditions in more than half a century resulted in a substantial decline in our pension fund assets which will contribute to an increase in 2009 pension expense of more than $8.0 million compared to 2008. Our investable balances provided significant interest income in 2007 and early 2008, but no longer are providing income due to interest rates that are now near zero percent.

During 2008 the Company continued its wind energy capacity expansion program and also successfully integrated Avon into the Friction Control Products segment. Avon is a custom designer and manufacturer of high precision large diameter turntable bearings. Avon also remanufactures bearings and sells replacement bearings. The Company acquired all of the outstanding stock of Avon in October 2007 in a cash transaction valued at $54.4 million, net of $0.5 million of working capital adjustments recorded in 2008.

In the third quarter of 2008, the Company completed the conversion of its $200.0 million of 4% Contingent Convertible Senior Subordinated Notes due 2023 (the "Notes"). The Notes were converted into a total of 6,858,683 shares of the Company's common stock, which were issued from treasury stock. As a result the Company is now debt-free.

The Company continues to focus on programs intended to reduce costs, improve capacity utilization, increase efficiencies, and grow market share and cash flow, thereby positioning the Company to capitalize on future opportunities in targeted markets. The Company expects to complete its capacity expansion program to provide performance-critical specialty bearings to serve the rapidly growing wind energy market in the first half of 2009. The Company also continued its Lean Sigma effort and its investments in lean manufacturing and information systems to strengthen the Company's operational excellence.

Maintaining the Company's strong balance sheet and financial flexibility remains a key strategy of the Company. The Company's current cash and cash equivalent balances and its $300.0 million revolving credit facility provide liquidity and additional financial strength to support the Company's objectives, including strategic acquisitions.

In summary, in the future the Company expects to benefit from the growth of key markets, principally the wind energy market. The Company is also well positioned to take full advantage of both internal growth initiatives and strategic acquisition opportunities that become available. However, the current adverse worldwide economic conditions are challenging. Because many of these factors are external to the Company, it is difficult to predict the specific impact they may have on the Company's future operating results. Due to current economic conditions, coupled with the lagged effect of recent economic stimulus, the Company expects shipments to be more weighted towards the latter half of 2009 than in past years.

The discussion which follows should be reviewed in conjunction with the consolidated financial statements and the related Notes to consolidated financial statements contained in Item 8 of this Annual Report to assist in understanding the Company's results of operations, its financial condition, cash flows, capital structure and other relevant financial information.

8 KAYDON CORPORATION FORM 10K

Analysis of 2008 Operations Compared to 2007 Operations

Selected Data For The Year 2008 Compared With The Year 2007


                                                                                 For the Years Ended
                                                                                    December 31,

                                                                          2008                         2007

                                                                      (In thousands, except per share amounts)

Results from operations:
Net sales                                                         $             522,374         $           451,382
Gross profit                                                      $             192,180         $           184,300
Gross profit margin                                                                36.8 %                      40.8 %
Selling, general and administrative expenses                      $              86,669         $            73,037
Operating income                                                  $             105,511         $           111,263
Operating margin                                                                   20.2 %                      24.6 %
Interest expense                                                  $              (6,223 )       $            (9,552 )
Interest income                                                   $               4,860         $            18,051
Net income                                                        $              67,071         $            77,707
Earnings per share - diluted                                      $                2.09         $              2.41

Net sales of $522.4 million in 2008 increased $71.0 million or 15.7 percent compared to 2007's net sales of $451.4 million. Specifically, the Friction Control Products reporting segment achieved sales of $326.0 million during 2008, up $64.3 million or 24.6 percent compared to 2007 sales of $261.7 million. Sales of custom-engineered bearings to the wind energy market increased $47.6 million, to the military market increased $8.0 million, to the medical market increased $4.8 million, and to the heavy equipment market increased $6.3 million, which benefited from the inclusion of a full year of sales from Avon. Sales of split roller bearings increased $5.4 million compared to 2007. Sales of custom-engineered bearings to the machinery market declined $4.2 million and to the specialty electronics market declined $2.4 million compared to the prior year. Our Velocity Control Products reporting segment achieved sales of $69.6 million during 2008, up $5.7 million, or 8.9 percent from 2007 sales of $63.9 million, reflecting increased sales of gas springs, hydraulic dampers, and other products, particularly in Germany and other European countries, including the favorable effects of foreign currency translation. Our Sealing Products reporting segment sales totaled $45.0 million during 2008, a decline of 3.6 percent from 2007 sales of $46.7 million, due to lower demand in the defense and railroad markets. Demand in the petroleum processing market was flat. Our other businesses achieved sales of $81.8 million during 2008, up $2.7 million or 3.4 percent from 2007 sales of $79.1 million primarily due to growth in our liquid and air filtration businesses, and due to higher pricing in our metal alloys business when metal prices spiked in the middle of 2008.

Gross profit for 2008 equaled $192.2 million or 36.8 percent of sales as compared to $184.3 million or 40.8 percent of sales for 2007. Higher gross profit was attributable to increased demand for our products in many of our business segments. Lower gross margin was due to the combined effects of product mix shifts, the incurrence of costs to ramp up our wind energy expansion, and the inclusion of Avon.

Selling, general and administrative expenses totaled $86.7 million and equaled 16.6 percent of sales. Selling, general and administrative expenses in 2007 totaled $73.0 million, which included the $5.0 million positive effect of the gain on the sale of a component of the Friction Control Products reporting segment, and equaled 16.2 percent of sales. Selling, general and administrative expenses increased during 2008 in support of higher sales, particularly in the expansion of the Company's sales force, and due to higher intangible amortization associated with the Avon acquisition.

Operating income totaled $105.5 million or 20.2 percent of sales compared to $111.3 million or 24.6 percent of sales during 2007, including the aforementioned $5.0 million gain.

On a reporting segment basis, operating income from the Friction Control Products reporting segment was $73.9 million during 2008 as compared to $77.0 million during 2007. The decrease is the result of the absence of the prior year $5.0 million gain on the sale of a component of this reporting segment only partly offset by the benefit of increased sales of the segment.

The Velocity Control Products reporting segment contributed $18.0 million to our consolidated operating income during 2008 as compared to $16.2 million during 2007 due principally to the benefit of higher sales. The Sealing Products reporting segment contributed $5.0 million to our consolidated operating income during 2008 as compared to $8.7 million during 2007 due to the decrease in sales, adverse product mix changes, and property and equipment impairment charges totaling $0.8 million.

Our other businesses contributed $10.5 million to our consolidated operating income during 2008 as compared to $11.1 million during 2007 due principally to an increase in product costs.

During 2008, $6.0 million of interest and amortization of issuance costs related to our $200.0 million of 4% Contingent Convertible Senior Subordinated Notes (the "Notes") was charged to interest expense prior to the conversion of the Notes in the third quarter of 2008. In 2007, $9.3 million of interest and amortization of issuance costs related to the Notes was charged to interest expense.

Interest income declined to $4.9 million in 2008 compared to $18.1 million in 2007. The decline was due to substantially lower market interest rates which on

average were almost 300 basis points lower than in 2007. The Company also had lower cash and short-term investment balances due to investments in property, plant, and equipment for capacity expansion, the acquisition of Avon, share repurchases, pension contributions, and increased dividend payments. In addition, during 2008, the Company incurred losses totaling $1.7 million recorded as a reduction to interest income related to the decline in value of an enhanced cash investment as more fully described in Notes to Consolidated Financial Statements (Note 1 and 12) in this Annual Report.

The effective tax rate for 2008 was 35.6 percent compared to 35.1 percent in 2007. We expect the effective tax rate for 2009 to be approximately 35-36 percent.

Our net income for 2008 totaled $67.1 million or $2.09 per share on a diluted basis, based on 34.0 million common shares outstanding. Net income for 2007, which included the $3.1 million, or $0.09 per share, after tax gain on the sale of a component of a reporting segment, was $77.7 million or $2.41 per share on a diluted basis, based on 34.7 million common shares outstanding.

Analysis of 2007 Operations Compared to
2006 Operations

Selected Data For The Year 2007 Compared With The Year 2006


                                                                                 For the Years Ended
                                                                                    December 31,

                                                                          2007                         2006

                                                                      (In thousands, except per share amounts)

Results from operations:
Net sales                                                         $             451,382         $           403,992
Gross profit                                                      $             184,300         $           167,426
Gross profit margin                                                                40.8 %                      41.4 %
Selling, general and administrative expenses                      $              73,037         $            68,746
Operating income                                                  $             111,263         $            98,680
Operating margin                                                                   24.6 %                      24.4 %
Interest expense                                                  $              (9,552 )       $            (9,554 )
Interest income                                                   $              18,051         $            16,253
Net income                                                        $              77,707         $            69,508
Earnings per share - diluted                                      $                2.41         $              2.17

Net sales of $451.4 million in 2007 increased $47.4 million or 11.7 percent compared to 2006's net sales of $404.0 million. Specifically, the Friction Control Products reporting segment achieved sales of $261.7 million during 2007, up $27.6 million or 11.8 percent compared to 2006 sales of $234.0 million. The increase was principally the result of increases in sales in 2007 compared to 2006 in the following markets: custom-engineered bearings to the wind energy market increased $11.7 million, the machinery market increased $7.4 million, the $4.3 million of sales from Avon Bearings Corporation acquired in October 2007, and higher sales of split roller bearings, which increased $10.7 million. Sales to the specialty electronics market declined $5.7 million compared to the prior year. Our Velocity Control Products reporting segment achieved sales of $63.9 million during 2007, up $7.2 million, or 12.7 percent from 2006 sales of $56.7 million, reflecting increased sales of gas springs, hydraulic dampers, and other products, particularly in Germany and other European countries. Our Sealing Products reporting segment achieved sales of $46.7 million during 2007, an increase of $4.7 million, or 11.2 percent from 2006 sales of $42.0 million, as demand increased in aerospace, defense, and railroad markets. Demand in the petroleum processing market continued to be strong. Our other businesses achieved sales of $79.1 million during 2007, up $7.9 million or 11.1 percent from 2006 sales of $71.2 million, primarily due to growth in our liquid and air filtration businesses.

Gross profit for 2007 equaled $184.3 million or 40.8 percent of sales as compared to $167.4 million or 41.4 percent of sales for 2006. Higher gross profit was attributable to increased demand for our products in all business segments. Lower gross margin was due to the combined effects of product mix shifts, costs to ramp up our wind energy expansion, and higher costs associated with the reconfiguration of a portion of our Sealing Products business.

Selling, general and administrative expenses totaled $73.0 million, including the $5.0 million positive effect of the gain on the sale of a component of the Friction Control Products reporting segment, and equaled 16.2 percent of sales. Selling, general and administrative expenses in 2006 totaled $68.7 million or 17.0 percent of sales. Selling, general and administrative expenses increased in support of higher sales, particularly in the expansion of the Company's sales force, and also because of accelerated amortization of stock awards associated with the retirements of two executive officers during 2007.

Operating income, including the aforementioned $5.0 million gain, equaled $111.3 million during 2007, compared to $98.7 million in 2006, with operating margins of 24.6 percent and 24.4 percent in 2007 and 2006.

On a reporting segment basis, operating income from the Friction Control Products reporting segment was $77.0 million during 2007 as compared to $70.5 million during 2006. The increase was the result of higher sales of custom-engineered bearings to the wind energy and machinery equipment markets, and of split roller bearing products used globally in various industrial markets, and the $5.0 million gain on the sale of a component of this reporting segment.

The Velocity Control Products reporting segment contributed $16.2 million to our consolidated operating income during 2007 as compared to $13.0 million during 2006. The Sealing Products reporting segment contributed $8.7 million to our

10 KAYDON CORPORATION FORM 10K

consolidated operating income during 2007 as compared to $6.5 million during 2006. The increased operating income in both of these segments was due primarily to higher sales in 2007.

Our other businesses contributed $11.1 million to our consolidated operating income during 2007 as compared to $6.7 million during 2006. Each of our other businesses generated increased operating income in 2007 compared with 2006, primarily as a result of higher sales, particularly of our liquid and air filtration products.

During both 2007 and 2006, $9.3 million of interest and amortization of issuance costs related to our $200.0 million of 4% Contingent Convertible Senior Subordinated Notes was charged to interest expense.

Because of higher investment interest rates and higher average cash and cash equivalent, and short-term investment balances, interest income increased to $18.1 million during 2007, compared with $16.3 million during 2006.

The effective tax rate for 2007 was 35.1 percent compared to 34.0 percent in 2006. The effective tax rate for 2006 reflects reductions to the tax provision related to deductions recognized for financial reporting purposes, after examinations by certain taxing authorities, or after the expiration of applicable review periods, totaling $1.7 million.

Our net income for 2007, including the $3.1 million after tax gain on the sale of a component of a reporting segment, was $77.7 million or $2.41 per share on a diluted basis, based on 34.7 million common shares outstanding, compared with net income for 2006 of $69.5 million or $2.17 per share on a diluted basis, based on 34.8 million common shares outstanding.

Liquidity, Working Capital, and Cash Flows

One of our financial strategies is to maintain an adequate level of liquidity supported by strong cash flow. Historically, we have generated significant cash flows from operating activities to fund capital expenditures, dividends and other operating requirements. Cash flow generation has been enhanced by our continuing efforts to improve operating efficiencies, cost reductions and the management of working capital requirements. We continued to follow this strategy in 2008, despite worsening economic conditions. Net cash from operating activities equaled $57.9 million in 2008, $74.3 million in 2007, and $89.9 million in 2006. Net cash from operating activities in 2008 declined compared to 2007 due to decreased net income and increased investment in working capital associated with sales growth, which more than offset the benefits of decreased contributions to our qualified pension plans. Net cash from operating activities for 2007 declined compared to 2006 due to a significant contribution to fund our qualified pension plans in 2007 and investment in working capital associated with sales growth, which were only partially offset by increased net income. Net capital expenditures to expand productive capacity, improve quality, and reduce costs equaled $59.5 million in 2008, $54.1 million in 2007 and $26.3 million in 2006. The increase in capital expenditures in each of these years was driven principally by the wind energy growth initiative first announced in 2006 and expanded in 2007. During 2008 and 2007, capital expenditures for the wind energy growth initiative totaled $33.7 million and $29.1 million, respectively. During 2009 we expect to invest approximately $30 million in net capital expenditures. The Company paid common stock dividends totaling $18.2 million in 2008, $14.4 million in 2007 and $13.5 million in 2006. The dividend payments in 2006, and through the third quarter 2007, were at a quarterly rate of $0.12 per share. The dividend declared in July 2007, and paid early in the fourth quarter 2007, and the dividend payments in the first three quarters of 2008, were at a quarterly rate of $0.15 per share. The dividend declared in July 2008, paid early in the fourth quarter 2008, was at a quarterly rate of $0.17 per share.

The Company has a senior credit facility with a syndicate of lenders providing for a $300.0 million senior unsecured revolving credit facility. The credit facility provides for borrowings and issuances of letters of credit by the Company and its subsidiaries in various currencies for general corporate purposes, including acquisitions. The credit facility matures on July 12, 2010 and is guaranteed by the Company and certain of the Company's domestic subsidiaries. Interest expense incurred on borrowings under the revolving credit facility will be based on the London Interbank Offered Rate. The revolving credit facility contains restrictive financial covenants on a consolidated basis including leverage and coverage ratios, utilizing measures of earnings and interest expense as defined in the revolving credit facility agreement. The Company is in compliance with all restrictive covenants contained in the revolving credit facility at December 31, 2008. After consideration of the facility's covenants and $4.9 million of letters of credit issued under the facility, the Company has available credit under its revolving credit facility of $295.1 million at December 31, 2008.

Fees related to the revolving credit facility of approximately $1.2 million are being amortized as a component of interest expense over a five-year period. Revolving credit facility fees included in other assets in the Consolidated Balance Sheet as of December 31, 2008, equaled $0.4 million.

The Company continues its corporate development efforts to complement internal growth through the acquisition of additional companies that meet Kaydon's well-disciplined criteria. In October 2007, the Company acquired Avon Bearings Corporation for $54.4 million, net of working capital adjustments recorded in 2008. An independent appraiser was engaged to assist management in determining the fair values of separately recognized intangible assets of Avon. After allocating cost to other assets acquired and liabilities assumed based on their estimated fair values,

the excess cost of the acquisition, equal to $27.4 million, was recognized as goodwill at December 31, 2007. Purchase price adjustments totaling $1.1 million were recorded to goodwill in 2008 associated with the Avon acquisition.

The Company's payments to various taxing authorities were $27.4 million, $25.1 million, and $28.9 million during 2008, 2007, and 2006. Tax payments are expected to be approximately $30 million during 2009.

In 2003, the Company issued $200.0 million of 4% Contingent Convertible Senior Subordinated Notes due 2023 (the "Notes"). The Notes were convertible into shares of Company common stock provided certain contingencies were met. During the second quarter of 2008, holders of $11.5 million of the Notes converted their Notes into 394,375 shares of Company common stock, which were issued from treasury stock. On August 21, 2008, the Company announced that it was exercising its right to redeem all of the remaining outstanding Notes. On September 19, 2008, the Company announced that it had completed its redemption of the Notes as the holders of all of the outstanding Notes exercised their rights to convert their Notes into shares of Company common stock at a conversion price of $29.16 per share. The Company issued a total of 6,858,683 shares from treasury stock in 2008 in satisfaction of the conversions in 2008. The Company had provided a deferred tax liability for the additional interest deduction for tax purposes on the Notes as the deductibility of the additional interest would have been recaptured if the Notes were redeemed or surrendered for conversion at an amount less than the tax accreted value. As the Notes were converted into the Company's common stock in 2008 at amounts higher than the tax accreted value, the deferred tax liability provided for through the date of conversion of $21.6 million was eliminated through an adjustment to the Company's shareholders' equity. The elimination of this deferred tax liability did not affect current tax expense.

Interest expense on the Notes totaled $5.4 million, $8.0 million, and $8.0 million, in 2008, 2007, and 2006. Included in the 2008 interest expense was accrued but unpaid interest through the conversion date of the Notes which equaled $2.3 million. The holders of the Notes forfeited their rights to the interest upon the conversion of their Notes. The $2.3 million accrued interest liability at the date of the respective Note conversions was reclassified to additional paid in capital in accordance with Emerging Issues Task Force Issue No. 85-17, "Accrued Interest upon Conversion of Convertible Debt." Note issuance costs of approximately $6.5 million were amortized over a five-year period and the final $0.2 million of amortization was recorded during the second quarter of 2008. Amortization of Note issuance costs was recorded as a component of interest expense. There were no unamortized Note issuance costs at December 31, 2008. Unamortized Note issuance costs included in other assets equaled $0.5 million at December 31, 2007.

We repurchased 937,941 shares of our common stock in 2008 for $35.9 million compared to 601,974 shares of our common stock in 2007 for $30.1 million and 96,355 shares in 2006 for $3.4 million. In 2005, the Company's Board of Directors authorized a share repurchase program of up to 5,000,000 shares. Of the 5,000,000 shares currently authorized by the Board of Directors for repurchase 1,656,770 shares have been repurchased as of December 31, 2008. We will continue to make opportunistic stock repurchases during 2009, the amount of which will depend on the market for our common stock and our financial position and liquidity.

We believe our current cash and cash equivalent balances and future cash flows from operations, along with our borrowing capacity and access to financial markets are adequate to fund our strategies for future growth, including working . . .