Item 1. Condensed Financial Statements
 
IKONICS CORPORATION
CONDENSED BALANCE SHEETS  
                 
    September 30     December 31  
    2007     2006  
    (unaudited)          
ASSETS
                
 
                
CURRENT ASSETS:
                
Cash and cash equivalents
   $ 4,531,100     $ 3,428,186  
Trade receivables, less allowance of $55,000 in 2007 and $70,000 in 2006
     2,097,867       1,976,893  
Inventories (Note 2)
     2,006,608       2,494,876  
Deposits, prepaid expenses and other assets
     186,702       232,255  
Deferred income taxes
     88,000       97,000  
 
            
Total current assets
     8,910,277       8,229,210  
 
            
 
                
PROPERTY, PLANT, AND EQUIPMENT, at cost:
                
Land and building
     1,597,516       1,500,271  
Machinery and equipment
     2,727,529       2,396,867  
Office equipment
     866,669       817,406  
Vehicles
     219,965       203,816  
 
            
 
     5,411,679       4,918,360  
Less accumulated depreciation
     4,082,399       3,926,440  
 
            
 
     1,329,280       991,920  
 
            
 
                
INTANGIBLE ASSETS, less accumulated amortization of $199,633 in 2007 and $159,351 in 2006
     485,074       485,421  
 
                
DEFERRED INCOME TAXES
     48,000       48,000  
 
                
INVESTMENTS IN NON-MARKETABLE EQUITY SECURITIES
     855,201       988,910  
 
            
 
 
   $ 11,627,832     $ 10,743,461  
 
            
 
                
LIABILITIES AND STOCKHOLDERS’ EQUITY
                
 
                
CURRENT LIABILITIES:
                
Accounts payable
   $ 452,955     $ 288,449  
Accrued compensation
     239,863       324,082  
Other accrued liabilities
     251,511       172,381  
Income taxes payable
     1,568       94,450  
 
            
Total current liabilities
     945,897       879,362  
 
            
 
                
STOCKHOLDERS’ EQUITY:
                
Preferred stock, par value $.10 per share; authorized 250,000 shares; issued none
                
Common stock, par value $.10 per share; authorized 4,750,000 shares; issued and outstanding 2,042,961 shares in 2007 and 2,010,861 in 2006
     204,296       201,086  
Additional paid-in capital
     2,106,214       1,979,012  
Retained earnings (Note 9)
     8,371,425       7,684,001  
 
            
Total stockholders’ equity
     10,681,935       9,864,099  
 
            
 
   $ 11,627,832     $ 10,743,461  
 
            
See notes to condensed financial statements.

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IKONICS CORPORATION
CONDENSED STATEMENTS OF OPERATIONS (Unaudited)
                                 
    Three Months     Nine Months  
    Ended September 30     Ended September 30  
    2007     2006     2007     2006  
NET SALES
   $ 4,016,923     $ 3,673,830     $ 11,899,367     $ 11,145,304  
 
                                
COSTS AND EXPENSES:
                                
Cost of goods sold
     2,186,892       1,975,667       6,794,437       6,197,398  
Selling, general, and administrative
     1,158,735       1,122,399       3,601,132       3,410,574  
Research and development
     186,295       196,493       582,503       561,496  
 
                        
 
     3,531,922       3,294,559       10,978,072       10,169,468  
 
                        
 
                                
INCOME FROM OPERATIONS
     485,001       379,271       921,295       975,836  
 
                                
GAIN ON SALE OF NON-MARKETABLE EQUITY SECURITIES
     —       —       55,159       —  
 
                                
INTEREST INCOME
     40,616       32,492       110,247       82,639  
 
                        
 
                                
INCOME BEFORE INCOME TAXES
     525,617       411,763       1,086,701       1,058,475  
 
                                
INCOME TAX EXPENSE
     171,692       126,810       262,277       327,751  
 
                        
 
                                
NET INCOME
   $ 353,925     $ 284,953     $ 824,424     $ 730,724  
 
                        
 
                                
EARNINGS PER COMMON SHARE:
                                
Basic
   $ 0.17     $ 0.14     $ 0.41     $ 0.37  
 
                        
 
                                
Diluted
   $ 0.17     $ 0.14     $ 0.40     $ 0.36  
 
                        
 
                                
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING :
                                
Basic
     2,042,113       2,010,861       2,029,110       1,996,363  
 
                        
 
                                
Diluted
     2,074,569       2,043,981       2,061,400       2,029,732  
 
                        
See notes to condensed financial statements.

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IKONICS CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS (Unaudited)  
                 
    Nine Months  
    Ended September 30  
    2007     2006  
CASH FLOWS FROM OPERATING ACTIVITIES:
                
Net income
   $ 824,424     $ 730,724  
Adjustments to reconcile net income to net cash provided by operating activities:
                
Depreciation
     203,981       181,120  
Amortization
     40,282       18,532  
Excess tax benefit from share-based payment arrangement
     (31,997 )     (36,712 )
Tax benefit from stock option exercise
     12,508       14,055  
Stock based compensation
     14,185       19,021  
Gain on sale of vehicles
     (7,341 )     —  
Gain on sale of non-marketable equity securities
     (55,159 )     —  
Deferred income taxes
     9,000       —  
Changes in working capital components:
                
Trade receivables
     (120,974 )     (317,999 )
Inventories
     488,268       94,865  
Prepaid expenses and other assets
     45,553       (23,987 )
Accounts payable
     164,506       158,426  
Accrued liabilities
     (142,089 )     (64,842 )
Income taxes payable
     (60,885 )     24,216  
 
            
Net cash provided by operating activities
     1,384,262       797,419  
 
            
 
                
CASH FLOWS FROM INVESTING ACTIVITIES:
                
Purchases of property and equipment
     (545,500 )     (92,542 )
Proceeds from sale of vehicles
     11,500       —  
Purchase of intangibles
     (39,935 )     (23,314 )
Purchase of non-marketable equity securities
     (63,750 )     (414,370 )
Proceeds from sales of non-marketable equity securities
     252,618       83,979  
 
            
 
                
Net cash used in investing activities
     (385,067 )     (446,247 )
 
            
 
                
CASH FLOWS FROM FINANCING ACTIVITIES:
                
Excess tax benefit from share-based payment arrangement
     31,997       36,712  
Proceeds from exercise of stock options
     71,722       186,335  
 
            
Net cash provided by financing activities
     103,719       223,047  
 
            
 
                
NET INCREASE IN CASH AND CASH EQUIVALENTS
     1,102,914       574,219  
 
                
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
     3,428,186       3,412,072  
 
            
 
                
CASH AND CASH EQUIVALENTS AT END OF PERIOD
   $ 4,531,100     $ 3,986,291  
 
            
 
                
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
                
Cash paid for income taxes
   $ 342,653     $ 289,480  
 
            
See notes to condensed financial statements.

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IKONICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
 
(Unaudited)
1.   Basis of Presentation

The balance sheet of IKONICS Corporation (the “Company”) as of September 30, 2007, and the related statements of operations for the three and nine months ended September 30, 2007 and 2006, and cash flows for the nine months ended September 30, 2007 and 2006, have been prepared without being audited.
 
    In the opinion of management, these statements reflect all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of IKONICS Corporation as of September 30, 2007, and the results of operations and cash flows for all periods presented.
 
    Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. Therefore, these statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2006.
 
    The results of operations for interim periods are not necessarily indicative of results that will be realized for the full fiscal year.
 
2.   Inventory

The major components of inventory are as follows:
 
                 
    Sep 30, 2007     Dec 31, 2006  
Raw materials
   $ 1,149,143     $ 1,577,165  
Work-in-progress
     314,510       225,033  
Finished goods
     1,096,954       1,227,806  
Reduction to LIFO cost
     (553,999 )     (535,128 )
 
            
 
                
Total Inventory
   $ 2,006,608     $ 2,494,876  
 
            
3.   Earnings Per Common Share (EPS)
 
    Basic EPS is calculated using net income divided by the weighted average common shares outstanding. Diluted EPS is similar to Basic EPS except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares, such as options, had been issued.

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    Shares used in the calculation of diluted EPS are summarized below:
                 
    Three Months Ended
    Sep 30, 2007   Sep 30, 2006
Weighted average common shares outstanding
     2,042,113       2,010,861  
Dilutive effect of stock options
     32,456       33,120  
 
                
Weighted average common and common equivalent shares outstanding
     2,074,569       2,043,981  
 
                
                 
    Nine Months Ended
    Sep 30, 2007   Sep 30, 2006
Weighted average common shares outstanding
     2,029,110       1,996,363  
Dilutive effect of stock options
     32,290       33,369  
 
                
Weighted average common and common equivalent shares outstanding
     2,061,400       2,029,732  
 
                
    Options to purchase 55,622 and 88,222 shares of common stock were outstanding as of September 30, 2007 and 2006, respectively.
 
4.   Stock-Based Compensation
 
    The Company has a stock incentive plan for the issuance of up to 342,750 shares of common stock. The plan provides for granting eligible participants stock options or other stock awards, as provided by the plan, at option prices ranging from 85% to 110% of fair market value at date of grant. Options granted expire up to seven years after the date of grant. Such options generally become exercisable over a one to three year period. A total of 56,173 shares of common stock are reserved for additional grants of options under the plan at September 30, 2007.
 
    The Company accounts for this plan under FAS 123(R), “Share-Based Payment”, using the modified-prospective-transition method. Under the modified-prospective-transition method, FAS 123(R) applies to new awards and to awards that were outstanding on January 1, 2006 that are subsequently modified, repurchased, or cancelled. Under this method compensation cost in 2007 and 2006 includes cost for options granted in 2007 and 2006 and options granted prior to but not vested as of December 31, 2005.
 
    The Company charged compensation cost of $4,700 against income for the three months ended September 30, 2007 and $4,600 for the three months ended September 30, 2006. For the first nine months of 2007, the Company charged compensation cost of approximately $14,200 against income compared to $13,300 for the same period in 2006. As of September 30, 2007 there was approximately $20,000 of unrecognized compensation cost related to unvested share-based compensation awards granted. That cost is expected to be recognized over the next three years.
 
    The Company receives a tax deduction for certain stock option exercises during the period in which the options are exercised, generally for the excess of the market price at the time the stock options are exercised over the exercise price of the options, which increased the APIC pool. This is the amount that represents the pool of excess tax benefits available to absorb tax shortages. For the nine months ended September 30, 2007, $31,997 of excess tax benefits were reported as operating and financing cash flows compared to $36,712 for the nine months ended September 30, 2006. The Company’s APIC pool totaled $71,709 and $39,712 at September 30, 2007 and December 31, 2006, respectively.
 
    Proceeds from the exercise of stock options were $71,722 and $186,335 for the nine months ended September 30, 2007 and 2006, respectively. There were no options granted during the nine months ending September 30, 2007.

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    Stock option activity during the nine months ended September 30, 2007 was as follows:
                 
            Weighted
            Average
            Exercise
    Shares   Price
Outstanding at December 31, 2006
     88,222     $ 3.33  
Granted
     —       —  
Exercised
     (32,100 )     2.23  
Expired and forfeited
     (500 )     4.32  
 
                
Outstanding at September 30, 2007
     55,622       3.95  
 
                
    The aggregate intrinsic value of all options outstanding and for those exercisable at September 30, 2007 was $282,251 and $263,675, respectively.
 
5.   Intangible Assets
 
    Intangible assets consist primarily of patents, licenses and covenants not to compete arising from business combinations. Intangible assets are amortized on a straight-line basis over their estimated useful lives or terms of their agreements. Amortization expense for each of the next five years is estimated to be $54,000 annually. In connection with license agreements, the Company has agreed to pay royalties ranging from 3% to 5% on the future sales of products subject to the agreements.
 
6.   Comprehensive Income
 
    Comprehensive income includes unrealized gains and losses on the Company’s available for sale marketable securities. There were no marketable securities available for sale at December 31, 2006 or September 30, 2007 and the impact of foreign exchange was not material. Total comprehensive income was $353,925 and $284,953 for the three months ended September 30, 2007 and 2006, respectively. Total comprehensive income was $824,424 and $731,620 for the nine months ended September 30, 2007 and 2006, respectively.
 
7.   Purchase of Assets
 
    On December 29, 2006, the Company acquired certain assets of Franklin International Inc. related to the image mate® product line. If the acquisition had occurred on January 1, 2006, the unaudited pro forma impact on revenues would have been to increase revenues by approximately $150,000 for the three months ended September 30, 2006 and $450,000 for the nine months ended September 30, 2006. The unaudited pro forma effect on net income and earnings per common share would not have been significant to the amounts reported in the Company’s income statement for the both the three and nine months ended September 30, 2006.
 
8.   Segment Information
 
    The Company’s reportable segments are strategic business units that offer different products and have a varied customer base. There are three reportable segments: Domestic, Export, and IKONICS Imaging. Domestic sells screen printing film, emulsions, and inkjet receptive film which is sold to distributors located in the United States and Canada. IKONICS Imaging sells photo resistant film, art supplies, glass, metal medium and related abrasive etching equipment to end user customers located in the United States and Canada. It is also entering the market for etched ceramics, glass and silicon wafers; and is developing and selling proprietary inkjet technology. Export sells primarily the same products as Domestic and IKONICS Imaging to foreign customers.

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    The accounting policies applied to determine the segment information are the same as those described in the summary of significant accounting policies included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2006.
 
    Management evaluates the performance of each segment based on the components of divisional income, and with the exception of accounts receivable, does not allocate assets and liabilities to segments. Financial information with respect to the reportable segments follows:
 
    For the three months ended September 30, 2007:
                                         
                    IKONICS              
    Domestic     Export     Imaging     Other     Total  
Net Sales
   $ 1,741,960     $ 1,267,710     $ 1,007,253     $ —     $ 4,016,923  
 
                                        
Cost of good sold
     946,154       777,616       463,122       —       2,186,892  
Selling, general and administrative*
     288,455       93,382       348,110       428,788       1,158,735  
Research and Development*
     —       —       —       186,295       186,295  
 
                              
 
     1,234,609       870,998       811,232       615,083       3,531,922  
 
                              
 
                                        
Income from operations
   $ 507,351     $ 396,712     $ 196,021     $ (615,083 )   $ 485,001  
 
                              
    For the three months ended September 30, 2006:
                                         
                    IKONICS              
    Domestic     Export     Imaging     Other     Total  
Net Sales
   $ 1,419,000     $ 1,115,328     $ 1,139,502     $ —     $ 3,673,830  
 
                                        
Cost of good sold
     715,065       690,319       570,283       —       1,975,667  
Selling, general and administrative*
     241,967       89,337       363,470       427,625       1,122,399  
Research and Development*
     —       —       —       196,493       196,493  
 
                              
 
     957,032       779,656       933,753       624,118       3,294,559  
 
                              
 
                                        
Income from operations
   $ 461,968     $ 335,672     $ 205,749     $ (624,118 )   $ 379,271  
 
                              
    For the nine months ended September 30, 2007:
                                         
                    IKONICS              
    Domestic     Export     Imaging     Other     Total  
Net Sales
   $ 4,933,275     $ 3,637,174     $ 3,328,918     $ —     $ 11,899,367  
 
                                        
Cost of good sold
     2,764,261       2,465,928       1,564,248       —       6,794,437  
Selling, general and administrative*
     850,825       334,182       1,081,295       1,334,830       3,601,132  
Research and Development*
     —       —       —       582,503       582,503  
 
                              
 
     3,615,086       2,800,110       2,645,543       1,917,333       10,978,072  
 
                              
 
                                        
Income from operations
   $ 1,318,189     $ 837,064     $ 683,375     $ (1,917,333 )   $ 921,295  
 
                              
    For the nine months ended September 30, 2006:
                                         
                    IKONICS              
    Domestic     Export     Imaging     Other     Total  
Net Sales
   $ 4,313,129     $ 3,398,526     $ 3,433,649     $ —     $ 11,145,304  
 
                                        
Cost of good sold
     2,326,156       2,252,004       1,619,238       —       6,197,398  
Selling, general and Administrative*
     730,918       292,778       1,135,764       1,251,114       3,410,574  
Research and Development*
     —       —       —       561,496       561,496  
 
                              
 
     3,057,074       2,544,782       2,755,002       1,812,610       10,169,468