Company Overview

IntriCon Corporation, (the "Company" or "IntriCon", "we", "us" or "our") is an international firm engaged in the designing, developing, engineering and manufacturing of body-worn devices and electronic products. The Company serves the body-worn device market by designing, developing, engineering and manufacturing micro-miniature injection-molded plastics, microelectronics, micro-mechanical assemblies and complete assemblies, primarily for bio-telemetry devices, medical equipment, hearing instruments, electronics, professional audio and telecommunications devices and computers.

Currently, the Company has two operating segments, its body-worn device segment and electronics products segment. Our expertise in body-worn devices is focused on three main markets within this segment: medical, hearing health, and professional audio. Within these chosen markets, we combine ultra-miniature mechanical and electronics capabilities with proprietary technology that enhances the performance of body-worn devices.

Business Highlights

On July 20, 2008, the Company entered into a strategic alliance with Dynamic Hearing, a designer of proprietary DSP firmware used in ULP DSP hardware platforms for the hearing health and professional audio market. Dynamic Hearing granted a license to the Company to use certain of Dynamic Hearing's technology, including DSP and ULP technology. IntriCon intends to use the license from Dynamic Hearing to develop new body-worn ULP-DSP applications and expand its hearing health and professional audio product portfolio.

Forward-Looking Statements

The following discussion and analysis of our financial condition and results of operations should be read together with the selected consolidated financial data and our financial statements and the related notes appearing in Item 6. and Item
8. of this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward- looking statements as a result of many factors, including but not limited to those under the heading "Risk Factors" in Item 1A of this Annual Report on Form 10-K.

Results of Operations: 2008 Compared with 2007

Consolidated Net Sales

Consolidated net sales for 2008 and 2007 were as follows (dollars in thousands):

Change 2008 2007 Dollars Percent Consolidated net sales $ 65,555 $ 68,983 $ 3,428 (5.0%)

Our net sales are comprised of four main markets: hearing health, medical, and professional audio (collectively our body-worn device segment) and electronics (our electronics products segment).

We experienced an increase of 7 percent in net sales in the medical equipment market in 2008 as a direct result of increased sales to existing original equipment manufacturer, or OEM, customers. We believe there is an industry-wide trend toward further miniaturization and ambulatory operation enabled by wireless connectivity, referred to as bio-telemetry, which resulted in further growth in our medical business. We have experienced solid growth in our most advanced biotelemetry device, a continuous wireless glucose monitor, which we manufacture for a major medical OEM. We are also working with our strategic partner, Advanced Medical Electronics, on proprietary biotelemetry technologies that will enable us to develop new devices that connect patients and care givers, providing critical information and feedback.

Net sales in our hearing health business declined 19 percent from 2007 primarily due to lower demand from our customers in this market and the completion of a one-time hearing health project in the 2007 third and fourth quarters, which the customer took in-house in 2008. We expect the softness in the market will continue into 2009. Despite the anticipated short-term softness, we believe our longer term prospects in our hearing health business remain strong as we continue to develop advanced technologies, such as our nanoDSP™, which will enhance the performance of hearing devices. In addition, we believe the market indicators in the hearing health industry, including the aging world population, suggest long-term industry growth.

Net sales to the professional audio communications market grew 21 percent over the prior year fueled by a full year of revenue from our May 2007 acquisition of ITC and higher demand for communication devices from new and existing customers. Our professional audio communication business serves customers in need of high-performance portable communication devices. For customers focusing on homeland security needs, the line includes several communication devices that are more portable and perform well in noisy or hazardous environments. These products are also well suited for applications in the fire, law enforcement, safety, aviation and military markets.

Net sales to the electronics product sector decreased 18 percent from prior year, primarily due to lower demand from one customer. In addition, management made an effort to eliminate lower margin revenue from non-strategic customers and reduce the electronics business' cost structure in attempt to maximize profit from this segment.

Gross Profit

Gross profit, both in dollars and as a percent of sales, for 2008 and 2007, were as follows (dollars in thousands):

2008 2007 Change Dollars Percent Dollars Percent Dollars Percent

Gross profit $ 16,046 24.5% $ 17,245 25.0% ($1,199 ) (7.0%)

In 2008, gross profit dollars decreased primarily due to lower sales volume; gross profit as a percentage of sales decreased primarily as a result of the conclusion of the one-time hearing health program in 2007, general softness in hearing health and the decline in our electronics product segment. We have various activities underway to increase our gross margins, such as transferring our microphone and receiver production from our Maine operation to our lower cost Singapore facility, increasing the percentage of IntriCon proprietary content in the devices we manufacture and significant investments to introduce Six Sigma lean manufacturing methods into key medical device product lines.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the years ended December 31,
2008 and 2007 were (dollars in thousands):


                                         2008                        2007                     Change
                                            Percent of                  Percent of
                                Dollars        Sales       Dollars        Sales         Dollars     Percent

Selling                         $  3,959         6.0 %     $  4,034         5.8 %      ($     75 )   (1.9 %)
Research and development           3,248         5.0 %        3,089         4.5 %       $    159      5.1 %
General and administrative         6,796        10.4 %        6,859         9.9 %      ($     63 )   (0.9 %)

The decreased selling expenses for 2008 as compared to the prior year were primarily driven by decreases in royalties and commissions as a result of lower revenues. The decrease in general and administrative expenses were driven by cost control measures taken by the Company in conjunction with the revenue decreases, as well as lower professional and legal fees compared to the prior year offset, in part by a $246,000 increase in stock based compensation expense. The 2007 expenses included significant costs related to the Energy Transportation Group, Inc. litigation and our acquisition of ITC. The increased research and development expenses as compared to the prior year were due to our continued emphasis on investing in research and development projects to develop new products and technology to further enhance our product portfolio.

Net Interest Expense

Net interest expense for 2008 was $682,000, a decrease of $211,000 from $893,000 in 2007. The decrease in net interest expense was due primarily to charges related to the refinancing of the credit facility that were incurred in 2007 in connection with the ITC acquisition and lower interest rates in effect on lower outstanding debt in 2008, offset in part by decreased interest income as a result of the lower balance of the note receivable.

Equity in Earnings of Partnerships

The equity in earnings of partnerships for 2008 was $4,000 compared to $158,000 in 2007.

The Company recorded a $145,000 decrease in the carrying amount of its investment in the Hearing Instrument Manufacturers Patent Partnership ("HIMPP") for 2008, reflecting amortization of the patents and other intangibles and the Company's portion of the partnership's operating results for the year ended December 31, 2008, compared to a $333,000 decrease in the carrying amount of the investment in 2007 for the amortization of the patents and other intangibles and the Company's portion of the partnership's operating results for the year ended December 31, 2007.

The Company recorded a $141,000 and $175,000 increase in the carrying amount of ITC's investment in a joint venture, reflecting the Company's portion of the joint venture's operating results for year ended December 31, 2008 and 2007, respectively.

Other

In 2008, other expense was $56,000 compared to $164,000 in 2007. The other expense for 2008 and 2007 primarily related to the losses on foreign currency exchange as a result of the exchange rate changes in the Singapore dollar and Euro.

Income Taxes

Income taxes were as follows (dollars in thousands):


                                2008    2007

Income tax expense             $  264   $ 181
Percentage of pre-tax income     20.3 %   8.8 %

The expense in 2008 and 2007 was primarily due to foreign taxes on German and Singapore operations. The Company is in a net operating loss position ("NOL") for federal income tax purposes and, consequently, minimal income tax expense from the current period domestic operations was recognized. Our deferred tax asset related to the NOL carryforwards has been offset by a full valuation allowance. We estimate we have approximately $13.5 million of NOL carryforwards available to offset future federal income taxes that begin to expire in 2022.

Results of Operations: 2007 Compared with 2006

Consolidated Net Sales

Consolidated net sales for 2007 and 2006 were as follows (dollars in thousands):

Change 2007 2006 Dollars Percent Consolidated net sales $ 68,983 $ 51,726 $ 17,257 33.4%

Net sales in our hearing health business grew 17 percent from 2006 fueled by increased demand for the latest technology advancements in hearing devices, including our advanced line of amplifier assemblies and systems based on our proprietary nanoDSP technology.

We experienced an increase of 122 percent in net sales in the medical equipment market in 2007 as a direct result of increased sales to existing OEM customers. Exclusive of net sales resulting from the ITC acquisition, medical net sales increased 101 percent from 2006.

Net sales to the professional audio device product sector grew 44 percent over the prior year due to additional sales of microphones to a specific customer and additional sales resulting from the acquisition of ITC. Excluding the results from ITC, professional audio device sales grew 11 percent from 2006.

Net sales to the electronics product sector decreased 10 percent from prior year, primarily due to lower demand from one customer.

Gross Profit

Gross profit, both in dollars and as a percent of sales, for 2007 and 2006, were as follows (dollars in thousands):

2007 2006 Change Dollars Percent Dollars Percent Dollars Percent

Gross profit $ 17,245 25.0% $ 12,422 24.0% $ 4,823 38.8%

In 2007, gross margin dollars increased due to the higher overall sales volume. Additionally, gross profit margin as a percentage of sales increased to 25 percent. Gross margin increase from 2006 was primarily due to increased IntriCon product content, proprietary technology and leverage gained on increased volume.

Selling, General and Administrative Expenses

Selling, general and administrative expenses for the years ended December 31,
2007 and 2006 were (dollars in thousands):


                                          2007                        2006                      Change
                                             Percent of                  Percent of                 Yr-over-yr
                                Dollars        Sales        Dollars        Sales        Dollars        Incr.

Selling                         $  4,034             5.8 %  $  3,410             6.6 %  $    624           18.3 %
Research and development           3,089             4.5 %     2,123             4.1 %  $    966           45.5 %
General and administrative         6,859             9.9 %     4,922             9.5 %  $  1,937           39.4 %

The increased selling, research and development and general and administrative expenses in 2007 as compared to the prior year were primarily driven by the expenses incurred to adequately support our growth and the May 22, 2007 acquisition of ITC. ITC operating expenses for the year were $1.0M. The Company made continued efforts to invest in strategic research and development opportunities in 2007.

Net Interest Expense

Net interest expense for 2007 was $893,000, an increase of $442,000 from $451,000 in 2006. The increase from the prior year's expense was primarily due to the higher outstanding debt balance, a prepayment penalty of $110,000 related to debt which was paid off early as a result of refinancing our debt at the time we acquired ITC, partly offset by a decrease in the average interest rate compared to the prior year. The higher outstanding debt balance was primarily driven by the debt related to the purchase of ITC.

Equity in Earnings of Partnerships

Equity in earnings of partnerships for 2007 resulted in a net loss of $158,000. This represents the Company's portion of the operating results of equity method investments, as well as amortization of of the excess of the HIMPP investment over the underlying partnership assets.

Other

In 2007, other expense was $164,000 compared to $102,000 in 2006. The other expense for 2007 and 2006 primarily related to the loss on foreign currency exchange.

Income Taxes

Income taxes were as follows (dollars in thousands):


                               2007     2006

Income tax expense             $ 181   $  174
Percentage of pre-tax income     8.8 %   12.3 %

The expense in 2007 and 2006 was primarily due to foreign taxes on German and Singapore operations. On February 22, 2006, the Company received approval from the Singapore Ministry of Trade and Industry to lower the effective tax rate in Singapore from 20% to 13%. This change was retroactive to September 2003. As such a $106,000 benefit was recognized in the first quarter of 2006.

Discontinued Operations

We recorded a loss from discontinued operations as follows (dollars in thousands):

2007 2006

Loss from discontinued Heat Technology Business $ - $ (78 )

Heat Technology Segment

The 2006 net loss of $(78,000), or $(0.01) per diluted share, was primarily due to a write-off of a portion of the note receivable recorded upon sale of the assets.

Liquidity and Capital Resources

Our primary sources of cash have been cash flows from operations, bank borrowings, and other financing transactions such as sale-leaseback transactions and capital leases. For the last three years, cash has been used for repayments of bank borrowings, the ITC acquisition, purchases of equipment, and working capital to support research and development.

As of December 31, 2008, we had approximately $0.2 million of cash on hand. Sources of our cash for the year ended December 31, 2008 have been from our operations, as described below.

Consolidated net working capital increased to $10.6 million at December 31, 2008 from $9.4 million at December 31, 2007. Our cash flows from operating, investing and financing activities, as reflected in the statement of cash flows at December 31, are summarized as follows (dollars in thousands):

                                                    2008       2007       2006
        Cash provided (used) by:
        Continuing operations                     $  2,452   $  3,534   $  1,656
        Discontinued operations                          -          -        (78 )
        Investing activities                           (98 )   (7,060 )     (565 )
        Financing activities                        (2,480 )    3,740     (1,308 )
        Effect of exchange rate changes on cash         (6 )        8         14

        Increase (decrease) in cash               $   (132 ) $    221   $   (281 )

Operating Activities. The most significant items that contributed to the $2.5 million of cash provided by continuing operations were net income of $1.0 million, depreciation of $2.4 million and changes in operating assets and liabilities of $(1.2) million. The change in operating assets and liabilities was primarily due to increases in accounts receivable and decreases in accounts payable and accrued expenses, partially offset by decreases in inventory and other assets. The change in accounts receivable and accounts payable are primarily due to the timing of sales, payments received from customers and payments made to vendors.

Investing Activities. The most significant items that contributed to the $0.1 million of cash used by investing activities were purchases of property, plant and equipment of $1.5 million partially offset by $1.1 million of net cash received from equipment sales and $0.2 million of dividends received.

Financing Activities. Net cash used by financing activities of $2.5 million was comprised primarily of net payments of debt of $2.3 million.

Cash generated from operations may be affected by a number of factors. See "Forward Looking Statements" and "Item 1A: Risk Factors" contained herein for a discussion of some of the factors that can negatively impact the amount of cash we generate from our operations.

We had the following bank arrangements at December 31, (dollars in thousands):

                                                     2008       2007

Total availability under existing facilities       $ 13,243   $ 13,623

Borrowings and commitments:
Domestic credit facility                              3,000      3,000
Domestic term loans                                   2,756      4,275
Foreign overdraft and letter of credit facility         605      1,071
Capital leases                                        1,330         94
Total borrowings and commitments                      7,691      8,440
Remaining availability under existing facilities   $  5,552   $  5,183

The Company and its subsidiaries, IntriCon, Inc., RTI Electronics, Inc. and IntriCon Tibbetts Corporation, referred to as the borrowers, entered into a credit facility with LaSalle Bank, National Association (now Bank of America), referred to as the lender, on May 22, 2007 replacing the prior credit facilities with M & I Business Credit (formerly known as Diversified Business Credit, Inc.). The credit facility provides for:

• a $10,000,000 revolving credit facility, with a $200,000 subfacility for letters of credit. Under the revolving credit facility, the availability of funds depends on a borrowing base composed of stated percentages of our eligible trade receivables and eligible inventory, less a reserve.

• a $4,500,000 term loan, which was used to fund the Tibbetts acquisition.

Loans under the new credit facility are secured by a security interest in substantially all of the assets of the borrowers including a pledge of the stock of the subsidiaries. All of the borrowers are jointly and severally liable for all borrowings under the new credit facility.

Proceeds from the new facility were used to repay amounts owed under the prior credit facilities of approximately $5.0 million and the $4.5 million purchase price to complete the Tibbetts asset acquisition.

Loans under the new credit facility bear interest, at the option of the Company, at:

• the London InterBank Offered Rate ("LIBOR") plus 1.90%, in the case of revolving line of credit loans, or LIBOR plus 2.15%, in the case of the term loan, or

• the base rate, which is the higher of (a) the rate publicly announced from time to time by the lender as its "prime rate" and (b) the Federal Funds Rate plus 0.5%.

Interest is payable monthly in arrears, except that interest on LIBOR based loans is payable at the end of the one, two or three month interest periods applicable to LIBOR based loans, or every three months in the case of LIBOR based loans with a six month interest period.

Weighted average interest on the domestic asset-based revolving credit facilities (including the prior credit facility) was 5.51% and 7.82% for 2008 and 2007, respectively.

The new credit facility will expire and all outstanding loans will become due and payable on June 30, 2012. The term loan requires quarterly principal payments, commencing on September 30, 2007, based on an increasing installment schedule, with any balance due on June 30, 2012. The principal balance of the term loan was $2,756,250 and $4,275,000 at December 31, 2008 and 2007, respectively. In 2008, we used proceeds of $1,013,000 from the equipment sale-leaseback described below to pay down the term loan.

The outstanding balance of the revolving credit facility was $3,000,000 at December 31, 2008 and 2007, respectively. The total remaining availability on the revolving credit facility was approximately $4,349,000 and $4,443,000 at December 31, 2008 and 2007, respectively.

The revolving facility carries a non-use fee equal to 0.25% per year of the unused portion of the revolving line of credit facility, payable quarterly in arrears.

The Company is subject to various covenants under the credit facility, including financial covenants relating to tangible net worth, funded debt to Earnings Before Interest, Taxes, Depreciation and Amortization, fixed charge coverage ratio and capital expenditures. Under the credit facility, except as otherwise permitted, the borrowers may not, among other things, incur or permit to exist any indebtedness; grant or permit to exist any liens or security interests on their assets or pledge the stock of any subsidiary; make investments; be a party to any merger or consolidation, or purchase of all or substantially all of the assets or equity of any other entity; sell, transfer, convey or lease all or any substantial part of its assets or capital securities; sell or assign, with or without recourse, any receivables; issue any capital securities; make any distribution or dividend (other than stock dividends), whether in cash or otherwise, to any of its equityholders; purchase or redeem any of its equity interests or any warrants, options or other rights in respect thereof; enter into any transaction with any of its affiliates or with any director, officer or employee of any borrower; be a party to any unconditional purchase obligations; cancel any claim or debt owing to it; enter into any agreement inconsistent with the provisions of the credit facility or other agreements and documents entered into in connection with the credit facility; engage in any line of business other than the businesses engaged in on the date of the credit facility and businesses reasonably related thereto; or permit its charter, bylaws or other organizational documents to be amended or modified in any way which could reasonably be expected to materially adversely affect the interests of the lender. Effective as of September 30, 2007, the credit facility was amended to change the tangible net worth covenant. Effective as of June 30, 2008, the credit facility was amended to correct an error in the amortization table set forth in the loan agreement. Effective as of December 31, 2008, the credit facility was amended to change the fixed charge coverage covenant to exclude payments made in connection with the June 2008 sale leaseback described below. As of December 31, 2008, the Company was in compliance with all financial covenants under the credit facility, as amended.

Upon the occurrence and during the continuance of an event of default (as defined in the credit facility), the lender may, among other things: terminate its commitments to the borrowers (including terminating or suspending its obligation to make loans and advances); declare all outstanding loans, interest and fees to be immediately due and payable; take possession of and sell any pledged assets and other collateral; and exercise any and all rights and remedies available to it under the Uniform Commercial Code or other applicable law. In the event of the insolvency or bankruptcy of any borrower, all commitments of the lender will automatically terminate and all outstanding loans, interest and fees will be immediately due and payable. Events of default include, among other things: failure to pay any amounts when due; material misrepresentation; default in the performance of any covenant, condition or agreement to be performed that is not cured within 20 days after notice from the lender; default in the payment of other indebtedness or other obligation with an outstanding principal balance of more than $50,000, or of any other term, condition or covenant contained in the agreement under which such obligation is created, the effect of which is to allow the other party to accelerate such payment or to terminate the agreements; the insolvency or bankruptcy of any borrower; the entrance of any judgment against any borrower in excess of $50,000, which is not fully covered by insurance; the occurrence of a change in control (as defined in the credit facility); certain collateral impairments; and a contribution failure with respect to any employee benefit plan that gives rise to a lien under ERISA.

The prior credit facility provided for:

• a $5,500,000 domestic revolving credit facility, bearing interest at an annual rate equal to the greater of 5.25%, or 0.5% over prime. Under the revolving credit facility, the availability of funds depended on a borrowing base composed of stated percentages of our eligible trade receivables and eligible inventory, less a reserve.

• a $1,000,000 domestic equipment term loan, bearing interest at an annual . . .