X annual report pursuant to section 13 or 15(d) of the securities exchange act of 1934


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Backlog

 

In recent years, our customers have increasingly demanded shorter order lead times and “just-in-time” delivery performance.  While we have many multi-year contracts with our major aerospace customers, most of these contracts specify the proportion of the customers’ requirements that will be supplied by us and the terms under which the sales will occur, not the specific quantities to be

 

 

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procured.  Our industrial customers have always desired to order their requirements on as short a lead-time as possible.  As a result, twelve-month order backlog is not a meaningful trend indicator for us, and therefore, we do not monitor it in the management of our business.

 

Raw Materials and Production Activities

 

Our manufacturing operations are vertically integrated.  We produce carbon fibers, industrial fabrics, composite materials and composites structures as well as sell these materials to third-party customers for their use in the manufacture of their products.

 

We manufacture high performance carbon fiber from polyacrylonitrile (“PAN”) precursor produced at our Decatur, Alabama facility.  The primary raw material for PAN is acrylonitrile.  All the PAN we produce is for internal carbon fiber production.  We consume approximately 55% by value of the carbon fiber we produce and sell the remainder of our output to third-party customers.  However, as one of the world’s largest consumers of carbon fiber, we purchase significantly greater quantities of carbon fiber than we produce for our own use.  The sources of carbon fiber we can use in any product or application are sometimes dictated by its customer qualifications or certifications, otherwise we select a fiber based on performance, price and availability.  With the increasing demand for carbon fiber, particularly in aerospace applications, the supply of carbon fiber started to tighten in 2005.  In response to increasing demand, the majority of carbon fiber manufacturers have announced plans to increase their manufacturing capacity over the next two to three years.  In 2005, we announced our plans to expand our PAN and carbon fiber capacity by about 50% to serve the growing needs of our customers and our own downstream products.   The first of the fiber lines was completed at the end of 2006 and production began in the first quarter of 2007.  The second line, a greenfield site near Madrid, Spain, was essentially completed in December 2007 and will begin production by end of the  first quarter of 2008.  In October 2007, we announced another 70% increase in PAN and carbon fiber capacity, which will increase our nameplate capacity to a total of about 16 million pounds of carbon fiber by 2010.  After a new line starts production, it can take over a year to be certified for aerospace qualifications.  However, these lines can start supplying fiber for many industrial and recreational applications in a very short time period.

 

We purchase glass yarn from a number of suppliers in the United States, Europe and Asia. Aramid and high strength fibers are produced by only a few companies, and during periods of high demand, can be in short supply.  In addition, epoxy and other specialty resins, aramid paper and aluminum specialty foils are used in the manufacture of composite products. When entering into multi-year contracts with aerospace customers, the business attempts to get back-to-back commitments from key raw material suppliers.

 

Our manufacturing activities are generally based on a combination of “make-to-order” and “make-to-forecast” production requirements. We coordinate closely with key suppliers in an effort to avoid raw material shortages and excess inventories. However, many of the key raw materials we consume are available from relatively few sources, and in many cases the cost of product qualification makes it impractical to develop multiple sources of supply. The lack of availability of these materials could under certain circumstances have a material adverse effect on our consolidated results of operations.

 

Research and Technology; Patents and Know-How

 

Research and Technology (“R&T”) departments support our businesses worldwide. Through R&T activities, we maintain expertise in precursor and carbon fiber, chemical and polymer formulation and curatives, fabric forming and textile architectures, advanced composite structures, process engineering, application development, analysis and testing of composite materials, computational design, and other scientific disciplines related to our worldwide business base.

 

Our products rely primarily on our expertise in materials science, textiles, process engineering and polymer chemistry.  Consistent with market demand, we have been placing more emphasis on cost effective product design and lean manufacturing in recent years while seeking to improve the consistency of our products.  Towards this end, we have entered into formal and informal alliances, as well as licensing and teaming arrangements, with several customers, suppliers, external agencies and laboratories.  We believe that we possess unique capabilities to design, develop and manufacture composite materials and structures.  We have over 400 patents and pending applications worldwide, have licensed many key technologies, and have granted technology licenses and patent rights to several third parties in connection with joint ventures and joint development programs.  It is our policy to actively enforce our proprietary rights.  We believe that the patents and know-how rights currently owned or licensed by Hexcel are adequate for the conduct of our business.

 

We spent $34.2 million, $29.7 million, and $24.8 million for R&T in 2007, 2006, and 2005, respectively.  We increased our R&T spending in 2007 to support new product development and qualification activities particularly in relation to commercial aircraft applications.  These expenditures were expensed as incurred.

 

Environmental Matters

 

We are subject to federal, state, local and foreign laws and regulations designed to protect the environment and to regulate the discharge of materials into the environment.  We believe that our policies, practices, and procedures are properly designed to prevent unreasonable risk of environmental damage and associated financial liability.  To date, environmental control regulations have not had a significant adverse effect on our overall operations.

 

Our aggregate environmental related accruals at December 31, 2007 and 2006 were $3.2 million and $5.3 million, respectively.  As of December 31, 2007 and December 31, 2006, $2.1 million and $2.4 million, respectively, were included in other current accrued

 

 

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liabilities, with the remainder included in other non-current liabilities.  As related to certain of our environmental matters, our accruals were estimated at the low end of a range of possible outcomes since there was no better point within the range.  If we had accrued for these matters at the high end of the range of possible outcomes, our accruals would have been $4.6 million and $2.7 million higher at December 31, 2007 and 2006, respectively.  Environmental remediation spending charged directly to our reserve balance for 2007, 2006, and 2005, was $2.7 million, $2.8 million, and $1.4 million, respectively.  In addition, our operating costs relating to environmental compliance were $8.2 million, $8.0 million, and $6.5 million, for 2007, 2006, and 2005, respectively, and were charged directly to expense.  Capital expenditures for environmental matters approximated $2.3 million, $0.8 million and $1.1 million for 2007, 2006 and 2005, respectively.

 

These accruals can change significantly from period to period due to such factors as additional information on the nature or extent of contamination, the methods of remediation required, changes in the apportionment of costs among responsible parties and other actions by governmental agencies or private parties, or the impact, if any, of Hexcel being named in a new matter.  A discussion of environmental matters is contained in Item 3, “Legal Proceedings,” and in Note 16 to the accompanying consolidated financial statements included in this Annual Report on Form 10-K.

 

Sales and Marketing

 

A staff of salaried market managers, product managers and sales personnel sell and market our products directly to customers worldwide.  We also use independent distributors and manufacturer representatives for certain products, markets and regions.  In addition, we operate various sales representation offices in the United States, Europe and Asia Pacific.

 

Competition

 

In the production and sale of advanced composites, we compete with a number of U.S. and international companies on a worldwide basis.  The broad markets for composites are highly competitive, and we have focused on both specific submarkets and specialty products within markets.  In addition to competing directly with companies offering similar products, we compete with producers of substitute composites such as structural foam, infusion technology, wood and metal.  Depending upon the material and markets, relevant competitive factors include approvals, database of usage, technology, product performance, delivery, service, price and customer preference for sole sourcing.

 

Employees

 

As of December 31, 2007, we employed 4,081 full-time employees, 2,212 in the United States and 1,869 in other countries.  The number of full-time employees as of December 31, 2006 and 2005 was 4,459 and 4,460, respectively.

 

Other Information

 

Our internet website is www.hexcel.com. We make available, free of charge through our website, our Form 10-Ks, 10-Qs and 8-K’s, and any amendments to these forms, as soon as reasonably practicable after filing with the Securities and Exchange Commission.

 

ITEM                  1A. Risk Factors

 

An investment in our common stock or debt securities involves risks and uncertainties.  You should consider the following risk factors carefully, in addition to the other information contained in this Annual Report on Form 10-K, before deciding to purchase any of our securities.

 

The markets in which we operate can be cyclical, and downturns in them may adversely affect the results of our operations.

 

Some of the markets in which we operate have been, to varying degrees, cyclical and have experienced downturns.  We are currently in an upturn of demand in the commercial aerospace and wind energy industries. However, a downturn in these markets could occur at any time, and in the event of a downturn, we have no way of knowing if, when and to what extent there might be a recovery. Any deterioration in any of the cyclical markets we serve could adversely affect our financial performance and operating results.

 

While Boeing and Airbus increased their production and deliveries of commercial aircraft in 2007, have had three years in a row of record orders and have announced further increases for 2008, any significant reduction in demand could result in reduced net sales for our commercial aerospace products and could reduce our operating margins. Approximately 53% of our net sales for 2007 were derived from sales to the commercial aerospace industry. Reductions in demand for commercial aircraft or a delay in deliveries could result from many factors, including a terrorist event similar to that which occurred on September 11, 2001 and any subsequent military response, changes in the propensity for the general public to travel by air, a rise in the cost of aviation fuel, consolidation and liquidation of airlines and slower macroeconomic growth.  Both Boeing and Airbus have experienced various delays in their newest aircraft programs, including the Boeing 787 and the Airbus A380 and A350.  These delays have or could have delayed our expected growth.  Future delays in these or other major Boeing or Airbus programs could similary impact our results.

 

In addition, our customers continue to emphasize the need for improved yield in the use of our products and cost reduction throughout the supply chain.  In response to these pressures, we may be required to reduce the price of some products in the future. Where possible, we seek to offset or mitigate the impact of such price reductions by productivity improvements and reductions in the

 

 

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costs of the materials and services we procure.

 

A significant decline in business with Boeing, EADS, Vestas, or other significant customers could materially impact our business, operating results, prospects and financial condition.

 

We have concentrated customers in the commercial aerospace, space and defense, and wind energy markets.  In the commercial aerospace market, approximately 74%, and in the space and defense market, approximately 36%, of our 2007 net sales were made to Boeing and EADS (including Airbus) and their related subcontractors.  In addition, for the years ended December 31, 2007 and December 31, 2006, approximately 25% of our total consolidated net sales was made to Boeing and its related subcontractors for both years, and approximately 22% and 23% of our total consolidated net sales, respectively, was made to EADS, including Airbus and its related subcontractors.  A significant portion of our total sales (but less than 10%) in 2007 and 2006 was made to Vestas in our wind energy market.  Significant changes in the demand for our customers’ end products, the share of their requirements that is awarded to us or changes in the design or materials used to construct their products could result in a significant loss of business with these customers.  The loss of, or significant reduction in purchases by, Boeing, EADS and Vestas or any of our other significant customers could materially impair our business, operating results, prospects and financial condition.  The level of purchases by our customers is often affected by events beyond their control, including general economic conditions, demand for their products, business disruptions, disruptions in deliveries, strikes and other factors.

 

Reductions in space and defense spending could result in a decline in our net sales.

 

The growth in military aircraft production that has occurred in recent years may not be sustained, individual programs important to Hexcel may be cancelled, production may not continue to grow nor may the increased demand for replacement helicopter blades continue. The production of military aircraft depends upon defense budgets and the related demand for defense and related equipment. Approximately 22% of our net sales in 2007 were derived from space and defense industries.

 

Changes to the capital expansion plans could materially impact our operating results and financial condition.

 

The company has significantly increased its capital expenditures in recent years, including capital expenditure spending of $120.6 million in 2007, $117.9 million in 2006 and $64.3 million in 2005.  During that period, major projects completed include carbon fiber lines in Salt Lake City, Utah and Spain, the precursor line in Decatur, Alabama, satellite prepreg plants in Germany and France and additional wind energy capacity in Austria.  In October 2007 we announced an additional $180 million carbon fiber capacity to be completed by the end of 2009.  Based on expected growth estimates, the company anticipates that it will continue a high level of capital expenditures for additional capacity for carbon fiber and other products through investing in existing and new facilities. Our 2008 capital expenditures are estimated to be $150 million, including the announced carbon fiber expansion.  As noted above, we operate in markets which historically have been cyclical and our business is concentrated in a few large customers and our growth is highly dependent on the sucess of their programs.  Our capacity expansion plans could cost more than we anticipated, take longer to complete than scheduled, or fail to produce the quantity or quality of product to meet the requirements of customers.  This could result in our not achieving the growth in business that our capital expenditure plans were designed to deliver, resulting in much higher manufacturing and capital expenditure costs, pressure on our capital structure and a material adverse impact on our financial statements. In addition, these capital expansions are dependent on our ability to generate cash and have access to financing on a timely and cost effective basis.

 
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