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MOCON INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis provides material historical and prospective disclosures intended to enable investors and other users to assess our financial condition and results of operations. Statements that are not historical are forward-looking and involve risks and uncertainties discussed below under the caption "Forward-Looking Statements." The following discussion of the results of operations and financial condition of MOCON should be read in conjunction with our consolidated financial statements and the related notes thereto included elsewhere in this report. Overview Description of Business MOCON, Inc. designs, manufactures, markets and services products and provides consulting and testing services primarily in the measurement and analytical instrument and services markets. Our products include instruments that detect, measure and monitor gases and chemical compounds. We continually seek growth opportunities through technological and product improvement, by developing new products, and by acquiring new companies, new product lines, or rights to technologies. We have two primary operating locations in the United States - Minnesota and Colorado - and we have foreign offices and laboratories in Germany, Denmark, France, Italy, Spain and China. We use a mix of a direct sales force and independent sales representatives to market our products and services in the United States, Canada, Europe and China, and we use a network of independent sales representatives to market and service our products and services in most other foreign countries. Historically, a significant portion of our sales has come from international customers. The international portion of our consolidated sales has increased from recent historical trends since the acquisition of Dansensor as the principal portion of their sales are to European customers. Our ongoing plans for growth include continued substantial funding for research and development to drive new product development, together with strategic acquisitions and investments where appropriate. Our purchase of PBI-Dansensor A/S of Ringsted, Denmark (Dansensor) is directly in line with our stated strategy of seeking opportunities to grow our business in part through strategic acquisitions and investments. This manufacturer of specialized instruments and control systems for the Modified Atmosphere Packaging (MAP) market world-wide is an excellent fit for our products, services, and distribution channels. We continue, with this acquisition, to grow our offerings to food, beverage, pharmaceutical, health care and other companies who are concerned about the quality, safety and extended shelf-life of their packaged products for consumers. During the third quarter 2012, we increased the number of reporting segments from one to three to reflect the integration of Dansensor's operations. These are classified as Permeation Products and Services ("Permeation"), Package Testing Products and Services ("Package Testing"), and Industrial Analyzer Products and Services and Other ("Industrial Analyzers and Other") for financial reporting purposes. Products and Services Permeation Products and Services Our permeation products consist of systems and services that measure the rate at which various gases and vapors transmit through a variety of materials. These products perform measurements under precise temperature, pressure and relative humidity conditions. The principal market for these products consists of manufacturers of packaging materials, including manufacturers of papers, plastic films, 17 -------------------------------------------------------------------------------- Table of Contents coatings and containers and the users of such packaging materials, such as companies in the food, beverage, pharmaceutical and consumer product industries. Other customers include manufacturers of flat panel displays, solar panels, electronics, and many other sophisticated materials. We also provide certain laboratory testing services to companies that have a need for permeation data. These services consist primarily of testing film and package permeation for companies that: † wish to outsource their testing needs to us; † are interested in evaluating our instrumentation prior to purchase; or † have purchased our products but have a need for additional capacity. Permeation instruments that we currently manufacture include OX-TRAN® systems for oxygen transmission rates, PERMATRAN-W® systems for water vapor transmission rates, and PERMATRAN-C® systems for carbon dioxide transmission rates. Our AQUATRAN® ultra-high sensitivity, trace moisture permeation analyzer has been increasingly accepted as the standard test instrument of choice in the flat panel, solar cell and electronics industries. Our systems are available in a wide range of options for our customers, including high or low throughput, price, sensitivity and ease of use. They are primarily marketed to research and development departments, as well as production and quality assurance groups. Package Testing Products and Services We manufacture and sell three primary products in this group: headspace analyzers, leak detection equipment and gas mixers. Our headspace analyzer products are used to analyze the amount and type of gas present in the headspace of flexible and rigid packages, as applied to gas flushing in modified or controlled atmosphere packaging. The principal market for these products consists of packagers of foods, beverages and pharmaceuticals. Our headspace analyzer products include the PAC CHECK®, CheckMateTM and CheckPointTM series of off-line headspace analyzers and the MAP Check 3TM series of on-line analyzers for continuous and intermittent monitoring of modified atmosphere packaging (MAP) and other gas flushing operations. Our leak detection products detect leaks in sterile medical trays, food pouches, blister packs and a wide range of other sealed packages. We currently manufacture three types of leak detection instruments. The first type is a non-destructive leak detector that senses small amounts of carbon dioxide escaping from a package or tray. The second type of instrument detects leaks and checks for seal integrity by applying and measuring pressure within a package. The third type pulls a vacuum on a package and looks for vacuum or gas flow changes. The principal markets for these products are packagers of sterile medical items, pharmaceuticals and food products. Our leak detection products include the LeakMatic IITM and LeakPointer IITM series of instruments. Our gas mixers are used in the food production environment to assure that the package has been properly flushed with the correct mixture of gases. Our gas mixer products include the MAP Mix Provectus and MAP Mix 9001 on-line instruments. Industrial Analyzer Products and Services and Other Sales at our Baseline-MOCON, Inc. (Baseline) subsidiary located near Boulder, Colorado comprise the majority of sales in this segment. Baseline offers advanced gas analysis and monitoring instrumentation used in applications such as oil and gas exploration, process gas analysis, industrial hygiene and safety, environmental air monitoring and indoor air quality. In this group, we manufacture and sell two types of gas analyzer instruments: gas chromatographs (GCs) and total hydrocarbon analyzers (THAs). These instruments are typically installed in fixed locations at the monitoring sites and perform their functions of detecting and measuring various 18 -------------------------------------------------------------------------------- Table of Contents hydrocarbons continually or at regular intervals. We also make gas sensors and detectors which are sold to original equipment manufacturers (OEMs) of mobile gas safety equipment. Our industrial analyzer products, sensors and detectors are for use in industrial hygiene (detection of hazardous gases in the workplace), hydrocarbon gas analysis for oil and gas exploration, contaminant detection in the manufacture of specialty gases, and environmental monitoring (tracking the release, or the presence, of toxic substances). Our newest GC offering measures trace levels of contaminants in beverage grade carbon dioxide which is used to carbonate soft drinks, beer and water. We market some of these products under the names BEVALERT®, PETROALERT®, and piD-TECH®. Microbial Detection Products Our microbial detection products are designed to rapidly detect microbial growth in food and beverage samples. Using the total viable count (TVC) method, our GreenLight® series of instruments perform rapid and precise measurements to determine the presence or absence of aerobic bacteria in food products or ingredients. There are two models of the GreenLight product line currently available. Results of Operations The following table sets forth the relationship between various components of our results of operations, stated as a percent of sales, for the three-month periods ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 Sales 100.0 100.0 Cost of sales 44.8 36.8 Gross profit 55.2 63.2Selling, general and administrative expenses 38.8 41.1 Research and development expenses 7.7 8.0 Operating income 8.7 14.1 Other income (expense), net (0.7 ) 0.2 Income before income taxes 8.0 14.3 Income tax expense 2.0 5.4 Net income 6.0 8.9 Comparison of Financial Results for the Three-Month Periods Ended March 31, 2013 and 2012 Sales Sales for the three-month period ended March 31, 2013 were $14,447,000, up 57% compared to $9,183,000 for the same period in 2012. We experienced significant growth in our Package Testing segment due to the addition of sales from Dansensor, which includes on-line and off-line analyzers, leak detection instruments and gas mixers. Sales of Dansensor are not included in our first quarter 2012 numbers. Our consolidated organic sales increased by 2% mainly due to growth in our Industrial Analyzer and Other segment. The Package Testing segment accounted for 46% of total consolidated sales for the quarter ended March 31, 2013 compared to 13% for the same period in 2012. The Permeation segment accounted for 34% of consolidated sales for the quarter ended March 31, 2013, and was down 15% from the same period last year as European demand continued to be soft. The Industrial Analyzers and Other segment accounted for 20% of consolidated sales for the current quarter and increased 35% over the 19 -------------------------------------------------------------------------------- Table of Contents same quarter in 2012 as strong shipments to the oil and gas exploration and environmental monitoring markets drove the growth. Total consolidated sales to foreign customers increased 67% in the current quarter compared to the same quarter last year as Dansensor's primary markets are in Europe, and domestic sales increased 42% between the two periods. The domestic growth came primarily from sales of gas chromatographs for oil and gas drilling applications and from improved permeation instrument shipments. Domestic and foreign sales accounted for 35% and 65%, respectively, of our consolidated first quarter sales in 2013, and 39% and 61% of our consolidated sales, respectively, for the same period in 2012. The following table summarizes total sales by reporting segments for the three-month periods ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 Permeation $ 4,877,660 $ 5,755,710 Package Testing 6,611,632 1,229,738Industrial Analyzers and Other 2,957,886 2,197,883 Total sales $ 14,447,178 $ 9,183,331 The following table sets forth the relationship between various components of domestic and foreign sales for the three-month periods ended March 31, 2013 and 2012: Three Months Ended March 31, 2013 2012 Domestic sales $ 5,055,070 $ 3,571,950 Foreign sales: Europe 6,189,908 2,274,515 Asia 2,226,345 2,391,099 Other 975,855 945,767 Total foreign sales 9,392,108 5,611,381 Total sales $ 14,447,178 $ 9,183,331 Permeation Testing Products and Services - Sales in our Permeation segment declined 15% for the three months ended March 31, 2013 compared to the same period in the prior year, and accounted for 34% and 63% of our consolidated first quarter sales in 2013 and 2012, respectively. Foreign sales comprised 62% of the shipments in this segment in the first quarter 2013, compared to 75% in the same period in the prior year. This decline was most evident in our European markets as economic concerns in many countries have influenced capital equipment purchases. Domestic sales accounted for 38% of the shipments in this segment and increased 32% in the current quarter compared to same period in the prior year. Package Testing Products and Services - Sales in our Package Testing segment, which accounted for 46% and 13% of our consolidated first quarter sales in 2013 and 2012, respectively, increased by $5.4 million in the first quarter 2013 compared to the same period in 2012. This group consists of headspace analyzers, leak detection instruments and gas mixers, and includes the total sales of Dansensor, which accounts for the large increase reported in the first quarter 2013 compared to the same period in 2012. Organic sales in this segment were up 21% in the first quarter 2013 over the prior year. Sales of our recently upgraded LeakMatic and LeakPointer series of leak detection instruments accounted for a significant portion of the overall sales growth. We also experienced growth in our online 20 -------------------------------------------------------------------------------- Table of Contents gas analyzer and gas mixer product lines represented by the MAP Check 3 and MAP Mix Provectus instruments, respectively. Recently, we have realized some sales to Eastern Europe, primarily Russia, as they become more aware of the benefits of MAP technology. Industrial Analyzer Products and Services and Other - Sales in our Industrial Analyzers and Other segment, which accounted for 20% and 24% of our consolidated first quarter sales in 2013 and 2012, respectively, increased 35% during the first quarter 2013 compared to the same period in 2012. Sales in this segment are comprised mainly of instruments and service provided by our Baseline subsidiary. Sales of gas chromatographs to the oil and gas exploration and environmental monitoring markets, as well as sales of OEM sensors and detectors for worker safety applications, accounted for the majority of the increase. Gross Profit The consolidated gross profit margin was 55% for the first quarter ended March 31, 2013 compared to 63% in the same period in 2012. The decrease in the first quarter 2013 is primarily due to lower sales of permeation instruments which carry a higher margin and amortization of intangible assets of approximately $201,000 related to the acquisition of Dansensor. The margins in the Permeation segment were lower in the current quarter as a result of lower sales volume as well as some select customer discounts. The margins in the Package Testing segment improved slightly in the current period primarily due to the integration of the traditional leak detection and headspace analysis products with the MAP product line from Dansensor. This resulted in the elimination of some of the slower moving, lower volume instruments from the overall product line. The overall gross profit margin varies from quarter to quarter depending on product mix and other factors. Selling, General and Administrative Expenses Selling, general and administrative (SG&A) expenses were $5,603,000, or 39% of consolidated sales, in the three-month period ended March 31, 2013, compared to $3,778,000, or 41% of consolidated sales, in the same period of 2012. The increase in the current quarter was primarily related to the SG&A expenses of Dansensor totaling $1,698,000 being included in our financial results for 2013. The remainder of the increase of $127,000 or 3% relates primarily to domestic representative commissions due to increased Industrial Analyzer sales and a 5% increase in employee headcount. Research and Development Expenses Research and development (R&D) expenses were $1,119,000 in the first quarter 2013, compared to $734,000 in the same period of 2012. The current period expense is higher than the previous year due primarily to the R&D expenses of Dansensor, which totaled $342,000 being included in our financial results for 2013. The remainder of the increase of $43,000 is within our planned level of spending which we project to be between 6% to 8% of sales each year. Other Income (Expense) Other income (expense) for the three-month periods ended March 31, 2013 and 2012 was as follows: 21 -------------------------------------------------------------------------------- Table of Contents Three Months Ended March 31, 2013 2012 Interest income $ 3,814 $ 31,119 Foreign currency exchange loss (20,374 ) (11,088 ) Interest expense (89,700 ) - Other 1,881 (2,523 ) $ (104,379 ) $ 17,508 The year-to-date amount in foreign currency exchange loss was primarily related to revaluing the foreign currency forward contract and Seller Note to fair value at March 31, 2013. Income Tax Expense Our provision for income tax expense was 24.7% and 37.6% of income before income taxes for the first quarters ended March 31, 2013 and 2012, respectively. The rate in the first quarter 2013 was positively impacted by tax law changes related to research and development credits. These tax law changes became effective in the first quarter 2013 such that the benefits are recorded in this quarter. Additionally, the effective rate on Dansensor's income is lower than our historical effective rate due to lower statutory rates in the jurisdictions in which it operates. The 2012 provision was higher than normal due primarily to the non-deductibility of certain expenses incurred in relation to the acquisition of Dansensor. In addition, the projected credit for research and development was not factored into the calculation because Congress had not yet extended the credit for 2012. Based on current projected annual operating results and current income tax rates, we expect the effective tax rate for the remainder of 2013 to increase somewhat from the rate noted above. This rate fluctuates over time based on the income tax rates in the various jurisdictions in which we operate, and also the level of profits in those jurisdictions. Net Income Net income was $867,000 in the first quarter 2013, compared to $821,000 in the first quarter 2012. Diluted net income per share was $0.15 and $0.14 in the first quarters of 2013 and 2012, respectively. Liquidity and Capital Resources Total cash, cash equivalents and marketable securities decreased $1,142,000 to $6,979,000 during the three-month period ended March 31, 2013, compared to $8,121,000 at December 31, 2012. Included in the March 31, 2013 total, there was $2,900,000 held outside of the United States. The year-to-date decrease in cash, cash equivalents and marketable securities was primarily due to net paydowns on our revolving lines of credit and term debt totaling $939,000 and dividend payments of $580,000. At March 31, 2013, we had $4.6 million outstanding on the revolving lines of credit. The four-year term note is payable in monthly principal installments of $72,917 plus interest at 3.46% per annum. The four-year seller note is payable in semi-annual installments of $891,000, including interest, at 3.46% per annum. The U.S. revolving line of credit accrues interest at 1.75% over the one-month LIBOR rate, which totaled 2.00% at March 31, 2013. The term note and the revolving line of credit related to our U.S. borrowings are due on March 28, 2016, and we are subject to certain financial and restrictive covenants. As of March 31, 2013, the Company was not in compliance with one of these financial covenants with the Bank which relates to the Bank borrowings totaling approximately $6.3 million. The Company has obtained a waiver of this violation for the period ended March 31, 2013, and currently expects to be in compliance with such covenant in future periods. Our working capital as of March 31, 2013 was $10,200,000, a decrease of $219,000 compared to $10,419,000 at December 31, 2012. This decrease is primarily related to the reduction in cash, cash equivalents and marketable securities as noted above, partially offset by a reduction in our revolving 22 -------------------------------------------------------------------------------- Table of Contents lines of credit and accrued compensation and related expenses. One of our strategic objectives is, as market and business conditions warrant, to consider acquisitions of, or investments in, businesses, products and/or technologies. If we wish to pursue one or more additional acquisition opportunities, this may require the consent of the Bank under the credit agreement we have executed, and we may need to fund such activities with a portion of our cash balances and debt or equity financing. If we need to raise additional capital, an equity-based or equity-linked financing may be used which could be dilutive to existing shareholders. If we raise additional funds by issuing debt, we may be subject to additional restrictive covenants that could limit our operational flexibility and higher interest expense could dilute earnings per share. We invest a large portion of our available cash in highly liquid marketable securities consisting primarily of certificates of deposits, municipal bonds, and money market funds. Our investment policy is to manage these assets to preserve principal, maintain adequate liquidity at all times, and maximize returns subject to investment guidelines we maintain. We believe that a combination of our existing cash, cash equivalents and marketable securities, funds available under the revolving credit facility, and an expected continuation of cash flow from operations, will continue to be adequate to fund our operations and working capital, capital expenditures, required payments on indebtedness and dividend payments. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate the funds related to those earnings for U.S. operations. Cash Flow Cash Flow from Operating Activities Historically, our primary source of funds has been cash provided by operating activities. In the first three months of 2013, cash provided by operations totaled approximately $755,000 due primarily to net income of $867,000, non-cash depreciation and amortization of $559,000, an increase in deferred revenue of $313,000, increased accrued income taxes of $222,000, and a reduction of trade accounts receivable of $195,000. These increases in cash from operating activities were partially offset by reductions in accounts payable of $909,000 and accrued compensation and related expenses of $396,000. Cash used in operations of approximately $202,000 in the first three months of 2012 was due primarily to a reduction in accrued compensation of $740,000, a reduction in deferred revenue of $367,000, increased trade accounts receivable of $284,000, and increased prepaid expenses of $262,000. These uses of cash from operating activities were partially offset by net income of $821,000, an increase in accounts payable of $548,000, and non-cash depreciation and amortization of $166,000. Cash Flow from Investing Activities Cash provided from investing activities totaled approximately $1,966,000 in the first three months of 2013 due primarily to the receipt of proceeds from maturities of marketable securities of $2,204,000, partially offset by cash paid for intangible assets and fixed asset additions of $237,000. Cash provided from investing activities in the first three months of 2012 of $382,000 consisted of net proceeds from marketable securities transactions of $1,109,000, partially offset by cash paid for intangible assets and fixed asset additions of $808,000. Cash Flow from Financing Activities Cash used in financing activities in the first three months of 2013 totaled approximately $1,414,000 due primarily to a net reduction in our revolving lines of credit of $717,000, a reduction of our term notes 23 -------------------------------------------------------------------------------- Table of Contents payable of $223,000 and dividends paid of $580,000. These uses of cash were partially offset by the receipt of proceeds from stock option exercises of $103,000. Cash generated from financing activities totaled approximately $7,267,000 in the first three months of 2012 due primarily to the proceeds of $7,500,000 from bank borrowings and seller financed note payable, partially offset by dividend payments in the amount of $544,000. Although we have repurchased shares of our common stock in the past, we currently are not authorized by our Board of Directors to make repurchases of our common stock and are prohibited from doing so under the credit agreement with the Bank unless we obtain the Bank's approval. Contractual Obligations We refer you to our Annual Report on Form 10-K for the year ended December 31, 2012 for a summary of our contractual obligations related to operating leases, purchase obligations and financing arrangements. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, as defined by the rules and regulations of the SEC, that have or are reasonably likely to have a material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. As a result, we are not materially exposed to financing, liquidity, market or credit risk that could arise if we had engaged in these arrangements. Recently Issued Accounting Guidance Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity In March 2013, the FASB issued guidance that resolves the diversity in practice as it applies to the release of the cumulative translation adjustment into net income when a parent company either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets within a foreign entity. This update is effective for the Company beginning on or after January 1, 2014. We do not expect this guidance to have a material impact on our consolidated financial statements. Critical Accounting Policies Our most critical accounting policies, which are those that require significant judgment, include policies related to revenue recognition, allowance for doubtful accounts, accrual for excess and obsolete inventories, recoverability of long-lived assets, accrued product warranties and income taxes. An in-depth description of these can be found in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. Management has not changed the method of calculating and using estimates and assumptions in preparing our condensed consolidated financial statements in accordance with generally accepted accounting principles. There have been no changes in the policies for our accounting estimates for the quarter ended March 31, 2013. Forward-Looking Statements This report contains forward-looking statements that involve future events, our future performance and our future operations and actions. In some cases you can identify forward-looking statements by the use of words such as "may," "should," "anticipate," "believe," "expect," "plan," "future," "intend," "could," 24 -------------------------------------------------------------------------------- Table of Contents "estimate," "predict," "hope," "potential," "continue," or the negative of these terms or other similar expressions. These forward-looking statements are only our predictions and involve numerous assumptions, risks and uncertainties. These forward-looking statements may be contained in the notes to our consolidated financial statements and elsewhere in this report, including under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations." Some of the factors known to us that could cause our actual results to differ materially from what we have anticipated in our forward-looking statements are described below. † Failure to effectively integrate the operations of Dansensor with ours; † Decline in overall economic or business conditions; † Ability to meet our debt obligations in a timely manner; † The impact of complying with our bank covenants; † Failure to successfully upgrade our ERP system without interruption; † Impairment of our investment in Luxcel due to adverse operating results as compared to plan; † Increases in prices for raw materials; † Risks inherent in operating internationally and selling and shipping our products and purchasing our products and components internationally; † Fluctuations in foreign currency exchange rates and interest rates; † Failure to develop new products and technologies, delays in new product introduction and lack of market acceptance of new products; † Exposure to assertions of intellectual property claims and failure to protect our intellectual property; † Disruption in our ability to manufacture our products or the ability of our key suppliers to provide us products or components or raw materials for products resulting in our inability to supply market demand for our products; † Reliance on independent sales distributors and sales associates to market and sell our products; † Highly competitive nature of the markets in which we sell our products and the introduction of competing products; † Loss of customers; † Failure to retain senior management or replace lost senior management; † Reliance on our management information systems for inventory management, distribution, accounting and other functions; † Effects of any potential litigation; † Failure to comply with applicable laws and regulations and adverse changes in applicable laws or regulations; or † Changes in generally accepted accounting principles |