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KMG CHEMICALS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) We manufacture, formulate and distribute specialty chemicals globally. We operate businesses engaged in electronic chemicals and industrial wood treating chemicals. Our electronic chemicals are sold to the semiconductor industry, where they are used primarily to clean and etch silicon wafers in the production of semiconductors. Our wood treating chemicals, pentachlorophenol ("penta") and creosote are used by our industrial customers primarily to extend the useful life of utility poles and railroad crossties. Sale of the Animal Health Business On March 1, 2012, we sold certain assets of our animal health business to Bayer Healthcare, LLC for a purchase price of approximately $10.2 million, including $1.0 million held in escrow. The escrowed amount is being held pending final acceptance by the United States Environmental Protection Agency of certain studies being performed at its request on tetrachlorvinphos. We retained the real estate and building at our facility in Elwood, Kansas, and we operate it to manufacture products for the buyer under a transition services agreement for one year, subject to two six-month extensions. Results of Operations Three Month Period Ended October 31, 2012 compared with Three Month Period Ended October 31, 2011 Segment Data Segment data is presented for our two reportable segments for the three month periods ended October 31, 2012 and 2011. The segment data should be read in conjunction with our condensed consolidated financial statements and related notes thereto included elsewhere in this report. Our animal health business was sold in March 2012, and results of that former segment are included as discontinued operations. Prior year information has been reclassified to conform to the current period presentation. Three Months Ended October 31, 2012 2011 (Amounts in thousands) Sales Electronic chemicals $ 39,507 $ 38,378 Wood treating chemicals 25,700 33,161 Total sales for reportable segments $ 65,207 $ 71,539 Net Sales Segment net sales decreased $6.3 million, or 8.9%, to $65.2 million in the first quarter of fiscal year 2013 as compared to $71.5 million for the same period of the prior year. Although net sales in our electronic chemicals segment were up $1.1 million in the first quarter of fiscal year 2013 over the prior year period, that increase was offset by a $7.5 million decline in net sales in our wood treating chemicals segment. In the first quarter of fiscal year 2013, the electronic chemicals segment had net sales of $39.5 million, an increase of $1.1 million, or 2.9%, as compared to $38.4 million for the prior year period. The first quarter sales for fiscal year 2013 were affected by weakening demand, particularly in Europe. We expect demand for our electronic chemicals products to decline in the second quarter of fiscal 2013 from first quarter levels before strengthening in the second half of the fiscal year in calendar 2013. 15 -------------------------------------------------------------------------------- Table of Contents Net sales of wood treating chemicals decreased $7.5 million, or 22.5%, to $25.7 million in the first quarter of fiscal year 2013 as compared to $33.2 million for the prior year period. The decrease in net sales for the quarter was due to a decrease in creosote sales volume. Creosote sales volume in the first quarter of fiscal 2013 was adversely impacted by customers pre-treating railroad ties with boron solutions as a way of reducing the amount of creosote needed. Some customers have adopted that practice as a way of holding down costs in response to higher creosote pricing. We anticipate further weakening of demand for wood treating chemicals in the second fiscal quarter before strengthening in the second half of fiscal 2013. Gross Profit Gross profit increased by $1.4 million, or 7.6%, to $20.1 million in the first quarter of fiscal year 2013 from $18.7 million in the same quarter of the prior year. Gross profit as a percentage of sales increased to 30.7% in the first quarter of fiscal year 2013 from 26.1% in the first quarter of fiscal year 2012. The increase in aggregate gross profit for the quarter was due to the completed integration of our fiscal 2010 acquisition in the electronic chemicals segment, and due to the reduced weighting of creosote in our overall product portfolio. Creosote is our lowest gross margin product, and sales of that product decline as a percentage of our total revenue, the decline has the effect of increasing our overall gross profit margin. Other companies may include certain of the costs that we record in cost of sales as distribution expenses or selling, general and administrative expenses, and may include certain of the costs that we record in distribution expenses or selling, general and administrative expenses as a component of cost of sales, resulting in a lack of comparability between our gross profit and that reported by other companies. Distribution Expenses Distribution expenses increased to $7.1 million in the first quarter of fiscal year 2013 from $6.1 million in the prior year period, a 16.2% increase. Distribution expenses were approximately 10.8% and 8.5% of net sales for the first quarter of fiscal years 2013 and 2012, respectively. The increase in distribution expenses was primarily attributable to an increase in average freight costs and a decline in tender of performance by our lowest cost carrier. Selling, General and Administrative Expenses Selling, general, and administrative expenses increased $317,000, or 5.6%, to $5.9 million in the first quarter of fiscal year 2013 from $5.6 million in the same quarter of fiscal year 2012. Those expenses were 9.1% and 7.8% of net sales in the first quarter of fiscal years 2013 and 2012, respectively. The increase in the current period was due to $577,000 of additional project costs primarily for consulting and professional services. Interest Expense, net Interest expense was $411,000 and $550,000 in the first quarter of fiscal years 2013 and 2012, respectively. The decrease was due to lower borrowings on our loan facility in fiscal year 2013 as compared to the same period of the prior year, in part because we paid off the outstanding balance on our term loan under that facility in the first quarter of fiscal year 2012. Income Taxes Our effective tax rate for continuing operations was 36.7% and 39.3% in the first quarter of fiscal years 2013 and 2012, respectively. Our Mexico subsidiary has undistributed earnings. It is our intention to continue to remain permanently reinvested in Mexico on its prior year cumulative undistributed earnings. Additionally, any undistributed earnings of the Italian subsidiary are considered to be permanently reinvested. Accordingly, no provision for United States income taxes has been provided with respect to undistributed earnings. Upon repatriation of those earnings, we will be subject to both United States income taxes (subject to an adjustment for foreign tax credits) and potentially withholding taxes payable to the foreign country. Discontinued Operations Discontinued operations reflected a loss, before income taxes, of $102,000 and $526,000 for the first quarter of fiscal year 2013 and 2012, respectively. We sold our animal health business in March 2012. In the first quarter of fiscal year 2013, we had certain post-closing adjustments related to that sale, and the loss in fiscal year 2012 included a first quarter loss of $483,000 from that business. We also incurred expense in each of the periods in connection with the dismantling of the production facility related to the agricultural chemical segment that was discontinued in fiscal year 2008. 16 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Cash Flows Net cash provided by operating activities was $6.3 million for the first three months of fiscal year 2013 as compared to $13.6 million for the comparable period in 2012. Net income adjusted for depreciation and amortization increased cash by $5.9 million in fiscal year 2013 as compared to $5.3 million over the same period of the prior year. Cash flows from operating activities during the current period were favorably impacted by $2.7 million due to a reduction in trade accounts receivable from lower sales in our electronic chemicals segment in the first quarter of fiscal year 2013 versus the fourth quarter of fiscal year 2012, and also favorably impacted by $1.9 million of increased accounts payable from the timing of payments and inventory purchases in our wood treating segment. Operating cash flows were unfavorably impacted by a $5.0 million increase in inventories primarily due to the timing of creosote purchases and, to a lesser extent, higher inventories in our electronic chemicals segment. Net cash used by investing activities in the first quarter of fiscal 2013 was $1.5 million as compared to $1.8 million in the prior year period, in each case for additions to property, plant and equipment. Net cash used in financing activities was $2.3 million in the first quarter of fiscal year 2013 as compared to $8.4 million in the prior year period. In the first three months of fiscal year 2013, we made payments of $2.0 million on our revolving loan. In the prior year period we made principal payments of $11.3 million on the term loan indebtedness to pay it off entirely, borrowed $6.1 million on our revolving loan, and cleared the book overdraft outstanding at July 31, 2011 of $2.9 million. The book overdraft represented the amount in excess of the bank cash balance necessary to fund the checks that were paid but not yet cleared. In the three month periods ended October 31, 2012 and 2011, we paid dividends of $342,000 and $283,000, respectively. It is our policy to pay dividends from available cash after taking into consideration our profitability, capital requirements, financial condition, growth, business opportunities and other factors which our board of directors may deem relevant. Working Capital We have a revolving line of credit under an amended and restated credit agreement. At October 31, 2012, we had $2.0 million outstanding under that revolving facility. Management believes that our current credit facility, combined with cash flows from operations, will adequately provide for our working capital needs for current operations for the next twelve months. Long Term Obligations To finance the acquisition of the electronic chemicals business in December 2007, we entered into a credit agreement and a note purchase agreement with Wachovia Bank, National Association, a subsidiary of Wells Fargo & Co., Bank of America, N.A., The Prudential Insurance Company of America, and Pruco Life Insurance Company. The credit facility included a revolving loan facility and a term loan facility. We amended the credit agreement in November 2011, raising the maximum amount that may be borrowed under the revolving loan facility from $50.0 million to $60.0 million, extending the maturity date of the credit agreement to December 31, 2016 and allowing advances under the revolving loan facility without reference to a borrowing base restriction. The financial covenant for debt to capitalization was replaced by a current ratio minimum of 1.5 to 1.0. During the first quarter of fiscal year 2012 we paid off all outstanding advances under the credit facility's term loan commitment, and in the November 2011 amendment, that aspect of the facility was deleted. Advances under the revolving loan mature December 31, 2016. They each bear interest at varying rate of LIBOR plus a margin based on our funded debt to EBITDA, as described below. Ratio of Funded Debt to EBITDA Margin Equal to or greater than 3.0 to 1.0 2.75 % Equal to or greater than 2.5 to 1.0, but less than 3.0 to 1.0 2.50 % Equal to or greater than 2.0 to 1.0, but less than 2.5 to 1.0 2.25 % Equal to or greater than 1.5 to 1.0, but less than 2.0 to 1.0 2.00 % Less than 1.5 to 1.0 1.75 % Advances under the revolving loan bear interest at 2.11% as of October 31, 2012 (LIBOR plus 2.00%). At October 31, 2012, $2.0 million was outstanding on the revolving facility. 17 -------------------------------------------------------------------------------- Table of Contents Before the term loan facility was paid off in October 2011, and removed from the credit facility, the term facility required principal payments of $458,333 per month for the first 24 months, then beginning January 2010 principal payments became $666,667 per month for the balance of the term prior to maturity. On March 2, 2012, we repaid $10.0 million of the balance on the revolving loan facility from proceeds received from the sale of the animal health business. The financing for the acquisition of the electronic chemicals business in fiscal year 2008 included a $20.0 million note purchase agreement with the Prudential Insurance Company of America. Advances under the note purchase agreement mature December 31, 2014, and bear interest at 7.43% per annum. Principal is payable at maturity. At October 31, 2012, $20.0 million was outstanding under the note purchase agreement. Loans under the amended and restated credit facility and the note purchase agreement are secured by our assets, including inventory, accounts receivable, equipment, intangible assets and real property. The credit facility and the note purchase agreement have restrictive covenants, including that we must maintain a fixed charge coverage ratio of 1.5 to 1.0, a ratio of funded debt to EBITDA of 3.0 to 1.0, and a current ratio of at least 1.5 to 1.0. For purposes of calculating these financial covenant ratios, we use a pro forma EBITDA. On October 31, 2012, we were in compliance with all of our debt covenants. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements, such as financing or unconsolidated variable interest entities, other than operating leases. Disclosure Regarding Forward Looking Statements We are including the following discussion to inform our existing and potential security holders generally of some of the risks and uncertainties that can affect us and to take advantage of the "safe harbor" protection for forward-looking statements that applicable federal securities law affords. From time to time, our management or persons acting on our behalf make forward-looking statements to inform existing and potential security holders about our company. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as "anticipate," "believe," "estimate," "intend," "plan," "project," "forecast," "may," "should," "budget," "goal," "expect," "probably" or similar expressions, we are making forward-looking statements. Many risks and uncertainties may impact the matters addressed in these forward-looking statements. Our forward-looking statements speak only as of the date made and we will not update forward-looking statements unless the securities laws require us to do so. Some of the key factors which could cause our future financial results and performance to vary from those expected include: • the loss of primary customers; • our ability to implement productivity improvements, cost reduction initiatives or facilities expansions; • market developments affecting, and other changes in, the demand for our products and the entry of new competitors or the introduction of new competing products; • availability or increases in the price of energy, our primary raw materials and active ingredients; • the timing of planned capital expenditures; • our ability to identify, develop or acquire, and market additional product lines and businesses necessary to implement our business strategy and our ability to finance such acquisitions and development; • the condition of the capital markets generally, which will be affected by interest rates, foreign currency fluctuations and general economic conditions; • cost and other effects of legal and administrative proceedings, settlements, investigations and claims, including environmental liabilities which may not be covered by indemnity or insurance; • the effects of weather, earthquakes, other natural disasters and terrorist attacks; • the ability to obtain registration and re-registration of our products under applicable law; • the political and economic climate in the foreign or domestic jurisdictions in which we conduct business; and • other United States or foreign regulatory or legislative developments which affect the demand for our products generally or increase the environmental compliance cost for our products or impose liabilities on the manufacturers and distributors of such products. 18 -------------------------------------------------------------------------------- Table of Contents The information contained in this report, including the information set forth under the heading "Risk Factors", identifies additional factors that could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report and the exhibits and other documents incorporated herein by reference, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved. |