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NORTHERN TECHNOLOGIES INTERNATIONAL CORP - 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 NTIC's financial condition and results of operations. Statements that are not historical are forward-looking and involve risks and uncertainties discussed under the heading "Part I. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations-Forward-Looking Statements." The following discussion of the results of the operations and financial condition of NTIC should be read in conjunction with NTIC's consolidated financial statements and the related notes thereto included under the heading "Part I. Item 1. Financial Statements." Business Overview NTIC develops and markets proprietary environmentally beneficial products and services in over 60 countries either directly or via a network of joint ventures, independent distributors and agents. NTIC's primary business is corrosion prevention marketed mainly under the ZERUST® brand. NTIC has been selling these proprietary ZERUST® products and services to the automotive, electronics, electrical, mechanical, military and retail consumer markets for over 35 years, and more recently, has expanded its target market to include the oil and gas industry. NTIC also sells a portfolio of bio-based and biodegradable (compostable) polymer resin compounds and finished products marketed under the Natur-Tec® brand. These products are intended to reduce NTIC's customers' carbon footprint and provide environmentally sound waste disposal options. NTIC's ZERUST® rust and corrosion inhibiting products include plastic and paper packaging, liquids and coatings, rust removers and cleaners, diffusers and variations of these products designed specifically for the oil and gas industry. NTIC's also offers worldwide on-site technical consulting for rust and corrosion prevention issues. NTIC's technical service consultants work directly with the end users of NTIC's ZERUST® rust and corrosion inhibiting products to analyze their specific needs and develop systems to meet their technical requirements. In North America, NTIC sells its ZERUST® corrosion prevention solutions through a direct sales force as well as a network of independent distributors and agents. Internationally, NTIC sells its ZERUST® corrosion prevention solutions through its majority owned subsidiary in Brazil, Zerust Prevenção de Corrosão S.A. (Zerust Brazil), its majority owned joint venture holding company for NTIC's joint venture investments in the Association of Southeast Asian Nations (ASEAN) region, and joint venture arrangements in North America, Europe and Asia. One of NTIC's strategic initiatives is to expand into and penetrate other markets for its ZERUST® corrosion prevention solutions. Consequently, for the past several years, NTIC has focused its sales and marketing efforts on the oil and gas industry, as the infrastructure that supports that industry is typically constructed using metals that are highly susceptible to corrosion. NTIC believes that its ZERUST® corrosion prevention solutions will minimize maintenance downtime on critical oil and gas industry infrastructure, extend the life of such infrastructure and reduce the risk of environmental pollution due to corrosion leaks. NTIC markets and sells its ZERUST® rust and corrosion prevention solutions to customers in the oil and gas industry across several countries either directly, through Zerust Brazil or through NTIC's joint venture partners and other strategic partners. The sale of ZERUST® corrosion prevention solutions to customers in the oil and gas industry has typically involved a long sales cycle, often including a one- to multi-year trial period with each customer and a slow integration process thereafter. Natur-Tec® bio-based and biodegradable plastics are manufactured using NTIC's patented and/or proprietary technologies and are intended to replace conventional petroleum-based plastics. The Natur-Tec® biopolymer resin compound portfolio include formulations that have been optimized for a variety of applications including blown-film extrusion, extrusion coating, injection molding, and engineered plastics. These resin compounds are fully biodegradable in a composting environment and are currently being used to produce finished products including shopping and grocery bags, lawn and leaf bags, can liners, pet waste collection bags, cutlery, packaging foam and coated paper products. In North America, NTIC markets its Natur-Tec® resin compounds and finished products primarily through a network of regional and national distributors as well as independent agents. NTIC continues to see significant opportunities for finished bioplastic products and, therefore, continues to strengthen and expand its North American distribution network for finished Natur-Tec® bioplastic products. Internationally, NTIC sells its Natur-Tec® resin compounds and finished products both directly and through its recently formed majority owned subsidiary in India, Northern Technologies India Private Limited (NTI India), and certain joint ventures. 16--------------------------------------------------------------------------------NTIC's Joint Venture Network NTIC participates in 21 active joint venture arrangements in North America, Europe and Asia. Each of these joint ventures generally manufactures and markets products in the geographic territory to which it is assigned. While most of NTIC's joint ventures exclusively sell rust and corrosion inhibiting products, some of the joint ventures sell NTIC's Natur-Tec® resin compounds. NTIC has historically funded its investments in joint ventures with cash generated from operations. NTIC's receipt of funds from its joint ventures is dependent upon fees for services that NTIC provides to its joint ventures, based primarily on the revenues of the joint ventures, and NTIC's receipt of dividend distributions from the joint ventures. NTIC receives fees for services provided to its joint ventures based primarily on the net sales of the individual joint ventures. The fees for services provided to joint ventures are determined based on either a flat fee or a percentage of sales depending on local laws and tax regulations. With respect to NTIC's primary joint venture in Germany (EXCOR), NTIC recognizes an agreed upon quarterly fee for such services. NTIC recognizes equity income from its joint ventures based on the overall profitability of its joint ventures. Such profitability is subject to variability from quarter to quarter which, in turn, subjects NTIC's earnings to variability from quarter to quarter. The profits of NTIC's joint ventures are shared by the respective joint venture owners in accordance with their respective ownership percentages. NTIC typically directly or indirectly owns 50% or less of each of its joint venture entities and thus does not control the decisions of these entities regarding whether to pay dividends and, if paid, how much they should be in a given year. The payment of a dividend by an entity is determined by a joint vote of the owners and is not at the sole discretion of NTIC. NTIC accounts for the investments and financial results of its 21 joint ventures in its financial statements utilizing the equity method of accounting. The results of Zerust Brazil, NTI India and NTI Asean are fully consolidated in NTIC's consolidated financial statements. NTIC holds 85% of the equity and 85% of the voting rights of Zerust Brazil. Beginning in the first quarter of fiscal 2013, NTIC consolidated the results of NTI Asean, which effective as of September 1, 2012 is a majority owned subsidiary of NTIC. NTIC holds 60% of the equity and 60% of the voting rights of NTI Asean. NTI Asean holds investments in eight entities that operate in the following eight territories located in the ASEAN region: China, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand. As of February 28, 2014 NTIC consolidated the results of NTI India, which effective as of December 1, 2013 is a majority owned subsidiary. NTIC holds 90% of the equity and 90% of the voting rights of NTI India NTIC considers EXCOR and China to be individually significant to NTIC's consolidated assets and income; and therefore, provides certain additional information regarding EXCOR and China in the notes to NTIC's consolidated financial statements and in this section of this report. Financial Overview NTIC's management, including its chief executive officer who is NTIC's chief operating decision maker, reports and manages NTIC's operations in two reportable business segments based on products sold, customer base and distribution center: ZERUST® products and services and Natur-Tec® products. NTIC's consolidated net sales increased 18.5% and 18.9% during the three and six months ended February 28, 2014, respectively, compared to the three and six months ended February 28, 2013. These increases were primarily a result of increased demand for ZERUST® rust and corrosion inhibiting packaging products and services and Natur-Tec® products. During the three and six months ended February 28, 2014, 89.3% and 90.2% of NTIC's consolidated net sales, respectively, were derived from sales of ZERUST® products and services, which increased 17.9% and 18.9% to $5,555,051 and $11,304,064 during the three and six months ended February 28, 2014, respectively, compared to $4,710,412 and $9,505,695 during the three and six months ended February 28, 2013, respectively, due to increased demand from both new and existing customers. NTIC has focused its sales efforts of ZERUST® products and services by strategically targeting customers with specific corrosion issues in new market areas, including the oil and gas industry and other industrial sectors that offer sizable growth opportunities. NTIC's consolidated net sales for the six months ended February 28, 2014 included $792,720 of sales made to customers in the oil and gas industry compared to $374,790 for the prior fiscal year period. Overall demand for ZERUST® products and services depends heavily on the overall health of the markets in which NTIC sells its products, including the automotive market in particular. 17-------------------------------------------------------------------------------- During the three and six months ended February 28, 2014, 10.7% and 9.8%, of NTIC's consolidated net sales were derived from sales of Natur-Tec® products compared to 10.2% and 9.8% during the three and six months ended February 28, 2013, respectively. Net sales of Natur-Tec® products increased 23.9% and 18.6% during the three and six months ended February 28, 2014 compared to the three and six months ended February 28, 2013, respectively. These increases were primarily due to finished product sales through NTIC's newly formed majority owned subsidiary in India, Northern Technologies India Private Limited (NTI India). Cost of goods sold as a percentage of net sales decreased to 65.2% during the three months ended February 28, 2014 compared to 69.3% during the three months ended February 28, 2013 and decreased to 65.5% during the six months ended February 28, 2014 compared to 69.5% during the prior fiscal year period. These decreases were primarily as a result of start-up costs associated with a new customer recognized during the prior fiscal year period. NTIC's equity in income of joint ventures increased 22.6% and 23.1% to $1,395,451 and $2,823,199, respectively, during the three and six months ended February 28, 2014 compared to $1,138,438 and $2,292,734 during the three and six months ended February 28, 2013, which increases were primarily a result of increases in sales at the joint ventures. NTIC recognized a 16.2% and 15.2% increase in fees for services provided to joint ventures during the three and six months ended February 28, 2014 compared to the three and six months ended February 28, 2013, respectively. These increases were primarily a result of increases in sales at the joint ventures as fees for services provided are a function of the net sales of NTIC's joint ventures, which were $28,389,158 and $58,050,376 during the three and six months ended February 28, 2014 compared to $26,722,201 and $54,247,135 for the three and six months ended February 28, 2013. Total net sales of NTIC's joint ventures appear to be slightly improving from the depressed sales levels experienced as a result of the European economic slowdown over the past few years. NTIC's total operating expenses increased 11.8%, or $861,644, to $8,141,229 during the six months ended February 28, 2014 compared to the six months ended February 28, 2013. This increase was primarily the result of an increase in selling expenses, general and administrative expenses and expenses incurred in support of joint ventures, and overall reflected NTIC's efforts to support its new business efforts. NTIC expenses all costs related to product research and development as incurred. NTIC incurred $2,237,865 and $1,850,599 of expense during the six months ended February 28, 2014 and 2013, respectively, in connection with its research and development activities. These represent net amounts after being reduced by reimbursements related to certain research and development contracts. Such reimbursements totaled $45,788 and $137,364 for the six months ended February 28, 2014 and 2013, respectively. NTIC anticipates that it will spend between $3,800,000 and $4,000,000 in total during fiscal 2014 on research and development activities related to its new technologies. This estimate is a net range after being reduced by anticipated reimbursements related to certain research and development contracts. Net income attributable to NTIC increased 136.0%, to $1,025,044, or $0.22 per diluted common share, for the three months ended February 28, 2014 compared to $434,410, or $0.10 per diluted common share, for the three months ended February 28, 2013. Net income attributable to NTIC increased 128.6%, to $1,883,630, or $0.41 per diluted common share, for the six months ended February 28, 2014 compared to $824,032, or $0.18 per diluted common share, for the six months ended February 28, 2013. These increases were primarily the result of increases in gross profit of NTIC's North American businesses and increases in joint venture operations. NTIC anticipates that its quarterly net income will remain subject to significant volatility primarily due to the financial performance of its joint ventures and sales of its ZERUST® products and services into the oil and gas industry and Natur-Tec® bioplastics products, which sales fluctuate more on a quarterly basis than the traditional ZERUST® business. 18--------------------------------------------------------------------------------NTIC's working capital was $17,690,903 at February 28, 2014, including $6,996,127 in cash and cash equivalents compared to $13,270,452 at August 31, 2013, including $4,314,258 in cash and cash equivalents. Results of Operations The following tables set forth NTIC's results of operations for the three and six months ended February 28, 2014 and 2013. Three Months Ended February 28, % of February 28, % of $ % 2014 Net Sales 2013 Net Sales Change Change Net sales, excluding joint ventures $ 5,527,366 88.9 % $ 4,485,203 85.5 % $ 1,042,163 23.2 % Net sales, to joint ventures 691,642 11.1 % 761,147 14.5 % (69,505 ) (9.1 )% Cost of goods sold 4,051,833 65.2 % 3,633,913 69.3 % 417,920 11.5 % Equity in income of joint ventures 1,395,451 22.4 % 1,138,438 21.7 % 257,013 22.6 % Fees for services provided to joint ventures 2,057,671 33.1 % 1,770,881 33.8 % 286,790 16.2 % Selling expenses 1,291,316 20.8 % 1,174,065 22.4 % 117,251 10.0 % General and administrative expenses 1,209,933 19.5 % 1,143,987 21.8 % 65,946 5.8 % Expenses incurred in support of joint ventures 366,469 5.9 % 321,456 6.1 % 45,013 14.0 % Research and development expenses 1,099,345 17.7 % 912,393 17.4 % 186,952 20.5 % Six Months Ended February 28, % of February 28, % of $ % 2014 Net Sales 2013 Net Sales Change Change Net sales, excluding joint ventures $ 11,132,384 88.9 % $ 9,255,590 87.8 % $ 1,876,794 20.3 % Net sales, to joint ventures 1,395,724 11.1 % 1,282,507 12.2 % 113,217 8.8 % Cost of goods sold 8,209,864 65.5 % 7,324,885 69.5 % 884,979 12.1 % Equity in income of joint ventures 2,823,199 22.5 % 2,292,734 21.8 % 530,465 23.1 % Fees for services provided to joint ventures 4,167,319 33.3 % 3,617,158 34.3 % 550,161 15.2 % Selling expenses 2,610,202 20.8 % 2,345,160 22.3 % 265,042 11.3 % General and administrative expenses 2,597,429 20.7 % 2,392,683 22.7 % 204,746 8.6 % Expenses incurred in support of joint ventures 695,733 5.6 % 691,143 6.6 % 4,590 0.7 % Research and development expenses 2,237,865 17.9 % 1,850,599 17.6 % 387,266 20.9 % Net Sales. NTIC's consolidated net sales increased 18.5% and 18.9% to $6,219,008 and $12,528,108, respectively, during the three and six months ended February 28, 2014 compared to the three and six months ended February 28, 2013. NTIC's consolidated net sales excluding NTIC's joint ventures increased 23.2% and 20.3% to $5,527,366 and $11,132,384, respectively, during the three and six months ended February 28, 2014 compared to the same respective prior fiscal year periods. These increases were primarily a result of increased demand and sales of ZERUST® rust and corrosion inhibiting packaging products and services and Natur-Tec® products. Net sales to joint ventures decreased 9.1% and increased 8.8% to $691,642 and $1,395,724 during the three and six months ended February 28, 2014, respectively, compared to the same respective prior fiscal year periods. These changes were primarily due to timing differences with orders placed with our joint ventures. The following table sets forth NTIC's net sales by product category for the three and six months ended February 28, 2014 and 2013 by segment: Three Months Ended Six Months Ended February 28, February 28, February 28, February 28, 2014 2013 2014 2013 ZERUST® sales $ 5,555,051 $ 4,710,412 $ 11,304,064 $ 9,505,695 Natur-Tec® sales 663,957 535,938 1,224,044 1,032,402 Total net sales $ 6,219,008 $ 5,246,350 $ 12,528,108 $ 10,538,097 19-------------------------------------------------------------------------------- During the three and six months ended February 28, 2014, 89.3% and 90.2% of NTIC's consolidated net sales, respectively, were derived from sales of ZERUST® products and services, which increased 17.9% and 18.9% to $5,555,051 and $11,304,064 during the three and six months ended February 28, 2014, respectively, compared to $4,710,412 and $9,505,695 during the three and six months ended February 28, 2013, respectively, due to increased demand from existing customers and the addition of new customers. NTIC has strategically focused its sales efforts for ZERUST® products and services on customers with sizeable corrosion problems in industry sectors that offer sizable growth opportunities, including the oil and gas sector. The following table sets forth NTIC's net sales of ZERUST® products for the three and six months ended February 28, 2014 and 2013: Three Months Ended February 28, February 28, $ % 2014 2013 Change Change ZERUST® industrial net sales $ 4,463,169 $ 3,705,937 $ 757,232 20.4 % ZERUST® joint venture net sales 689,772 758,382 (68,610 ) (9.0 )% ZERUST® oil & gas net sales 402,110 246,093 156,017 63.4 % Total ZERUST® net sales $ 5,555,051 $ 4,710,412 $ 844,639 17.9 % Six Months Ended February 28, February 28, $ % 2014 2013 Change Change ZERUST® industrial net sales $ 9,120,008 $ 7,851,163 $ 1,268,845 16.2 % ZERUST® joint venture net sales 1,391,336 1,279,742 111,594 8.7 % ZERUST® oil & gas net sales 792,720 374,790 417,930 111.5 % Total ZERUST® net sales $ 11,304,064 $ 9,505,695 $ 1,798,369 18.9 % NTIC anticipates that its sales of ZERUST® products and services into the oil and gas industry will remain subject to significant volatility from quarter to quarter as sales are recognized. During the three and six months ended February 28, 2014, 10.7% and 9.8% of NTIC's consolidated net sales, respectively, were derived from sales of Natur-Tec® products, which increased 23.9% and 18.6% to $663,957 and $1,224,044 during the three and six months ended February 28, 2014, respectively, compared to the three and six months ended February 28, 2013. These increases were due primarily to increased sales to NTIC's Natur-Tec® distributors in the United States. Additionally, NTIC continues to target key regional and national retailers through independent sales agents. Demand for Natur-Tec® products depends primarily on market acceptance and the reach of NTIC's distribution network. Because of the typical size of individual orders and overall size of NTIC's net sales derived from sales of Natur-Tec® products, the timing of one or more orders can affect materially NTIC's quarterly sales of Natur-Tec® products and the comparisons to prior fiscal year quarters. Cost of Goods Sold. Cost of goods sold increased 11.5% and 12.1% for the three and six months ended February 28, 2014, respectively, compared to the three and six months ended February 28, 2013 primarily as a result of increased net sales as described above. Cost of goods sold as a percentage of net sales decreased to 65.2% during the three months ended February 28, 2014 compared to 69.3% the three months ended February 28, 2013 and decreased to 65.5% during the six months ended February 28, 2014 compared to 69.5% during the six months ended February 28, 2013. These decreases were primarily the result of start-up costs associated with a new customer incurred during the prior fiscal year periods. Equity in Income of Joint Ventures. NTIC's equity in income of joint ventures increased 22.6% and 23.1% to $1,395,451 and $2,823,199 during the three and six months ended February 28, 2014, respectively, compared to equity in income of joint ventures of $1,138,438 and $2,292,734 during the three and six months ended February 28, 2013, respectively, primarily as a result of increases in sales at the joint ventures. Of the total equity in income of joint ventures, NTIC had equity in income of joint ventures of $1,881,705 attributable to EXCOR during the six months ended February 28, 2014 compared to $1,631,125 attributable to EXCOR during the six months ended February 28, 2013. Of the total equity in income of joint ventures, NTIC had equity in income of joint ventures of $276,948 attributable to NTIC's joint venture in China during the six months ended February 28, 2014 compared to $262,148 attributable to NTIC's joint venture in China during the six months ended February 28, 2013. NTIC had equity in income of all other joint ventures of $664,546 during the six months ended February 28, 2014 compared to $399,461 during the six months ended February 28, 2013. 20 -------------------------------------------------------------------------------- Fees for Services Provided to Joint Ventures. NTIC recognized fee income for services provided to joint ventures of $2,057,671 and $4,167,319 during the three and six months ended February 28, 2014, respectively, compared to $1,770,881 and $3,617,158 during the three and six months ended February 28, 2013, respectively, representing an increase of 16.2% and 15.2%, respectively. Fee income for services provided to joint ventures are a function of the sales made by the various joint ventures of $28,389,158 and $58,050,376 during the three and six months ended February 28, 2014 compared to $26,722,201 and $54,247,135 for the three and six months ended February 28, 2013, respectively. Total net sales of NTIC's joint ventures for the prior fiscal year periods were adversely affected in part by the European economic slowdown, which NTIC believes also adversely affected net sales of certain of NTIC's other non-European joint ventures, as well as the weakening of the EURO and other currencies compared to the U.S. dollar. Sales of NTIC's joint ventures are not included in NTIC's product sales and are not combined with NTIC's sales in NTIC's consolidated financial statements or in any description of NTIC's sales. Of the total fee income for services provided to joint ventures, fees of $527,111 were attributable to EXCOR during the six months ended February 28, 2014 compared to $492,213 attributable to EXCOR during the six months ended February 28, 2013. Fees of $1,111,633 were attributable to NTIC's joint venture in China during the six months ended February 28, 2014 compared to $943,897 during the six months ended February 28, 2013. Selling Expenses. NTIC's selling expenses increased 10.0% and 11.3% for the three and six months ended February 28, 2014 compared to the same respective periods in fiscal 2014 due to increases in compensation and employee benefits, lab testing related expenses, commission expenses, travel and related expenses, and consulting expenses. Selling expenses as a percentage of net sales decreased slightly to 20.8% and 20.8% for the three and six months ended February 28, 2014, from 22.4% and 22.3% and during the three and six months ended February 28, 2013. General and Administrative Expenses. NTIC's general and administrative expenses increased 5.8% and 8.6% for the three and six months ended February 28, 2014 compared to the same respective periods in fiscal 2013 due to increases in consulting expenses to support new business development. As a percentage of net sales, general and administrative expenses decreased to 19.5% and 20.7% for the three and six months ended February 28, 2014 from 21.8% and 22.7% for the three and six months ended February 28, 2013. Expenses Incurred in Support of Joint Ventures. Expenses incurred in support of NTIC's joint ventures were $366,469 and $695,733 during the three and six months ended February 28, 2014, respectively, compared to $321,456 and $691,143 during the three and six months ended February 28, 2013, respectively, representing an increase of 14.0% and 0.7%, respectively. These increases were due primarily to increased headcount to support anticipated expanding operations and anticipated sales growth. Research and Development Expenses. NTIC's research and development expenses increased 20.5% for the three months ended February 28, 2014 compared to the same period in fiscal 2013 and increased 20.9% for the six months ended February 28, 2014 compared to the same period in fiscal 2014 primarily as a result of increased spending on headcount and field development associated with the new businesses. Interest Income. NTIC's interest income decreased to $2,570 and $4,359 during the three and six months ended February 28, 2014, respectively, compared to $22,288 and $47,634 during the three and six months ended February 28, 2013, respectively. Interest Expense. NTIC's interest expense increased to $11,976 during the three months ended February 28, 2014 compared to $6,988 during the three months ended February 28, 2013 and increased to $25,646 during the six months ended February 28, 2014 compared to $13,462 during the six months ended February 28, 2013. These increases were primarily due to higher average outstanding debt levels during the most recent periods. 21 -------------------------------------------------------------------------------- Income Before Income Tax Expense. Income before income tax expense increased to $1,643,828 and $3,146,246 for the three and six months ended February 28, 2014, respectively, compared to $985,155 and $1,877,691 for the three and six months ended February 28, 2013, respectively. Income Tax Expense. Income tax expense was $259,759 and $457,759 during the three and six months ended February 28, 2014, respectively, compared $240,000 and $374,000 during the three and six months ended February 28, 2013, respectively. Income tax expense was calculated based on management's estimate of NTIC's annual effective income tax rate. NTIC's annual effective income tax rate during the three and six months ended February 28, 2014 and 2013 was lower than the statutory rate primarily due to NTIC's equity in income of joint ventures being recognized based on after-tax earnings of these entities. To the extent undistributed earnings of NTIC's joint ventures are distributed to NTIC, it is not expected to result in any material additional income tax liability after the application of foreign tax credits. NTIC records a tax valuation allowance when it is more likely than not that some portion or all of its deferred tax assets will not be realized to reduce deferred tax assets to the amount expected to be realized. NTIC determined based on all available evidence, including historical data and projections of future results, that it is more likely than not that all of its deferred tax assets, except for its foreign tax credit carryforwards and Minnesota state research and development credit carryforwards, will be fully realized. In addition, NTIC determined based upon all available evidence, including new IRS guidance, historical results, projected future taxable income and foreign tax credit utilization, that it was not more likely than not that the federal research and development credits would be utilized during the carryforward period and as a result, a valuation allowance was recorded against all of NTIC's federal research and development credits. In addition, NTIC continues to believe that its deferred tax asset related to foreign tax credit carryforwards will not be realized due to insufficient federal taxable income within the carryforward period and the fact that for ordering purposes the foreign tax credit carryforwards are not allowed to be used until after any current year foreign tax credits are utilized. NTIC considers the earnings of certain foreign joint ventures to be indefinitely invested outside the United States on the basis of estimates that future domestic cash generation will be sufficient to meet NTIC's future domestic cash needs. As a result, U.S. income and foreign withholding taxes have not been recognized on the cumulative undistributed earnings of $20,232,259 and $22,281,510 at February 28, 2014 and August 31, 2013, respectively. To the extent undistributed earnings of NTIC's joint ventures are distributed in the future, they are not expected to result in any material additional income tax liability after the application of foreign tax credits Other Comprehensive Income - Foreign Currency Translations Adjustment. The volatility of the foreign currency translations adjustment was due to the volatility of the U.S. dollar compared to the Euro and other foreign currencies during the three and six months ended February 28, 2014 compared to the same respective periods in fiscal 2013. Liquidity and Capital Resources Sources of Cash and Working Capital. As of February 28, 2014, NTIC's working capital was $17,690,903, including $6,996,127 in cash and cash equivalents, compared to $13,270,452 at August 31, 2013, including $4,314,258 in cash and cash equivalents. This increase was due primarily to dividends received from joint ventures, including primarily EXCOR, and was offset in part by the use of $933,414 in cash to pay off in full NTIC's term loan that was obtained in connection with the purchase of NTIC's corporate headquarters in September 2006. As of February 28, 2014, NTIC had a revolving line of credit with PNC Bank of $3,000,000, with no amounts outstanding. The line of credit is evidenced by an amended and restated committed line of credit note in the principal amount of up to $3,000,000. The line of credit has a $1,200,000 standby letter of credit subfacility, with any standby letters of credit issued thereunder being at the sole discretion of PNC Bank. Any standby letters of credit issued under the subfacility are subject to customary fees and charges payable by NTIC. At the option of NTIC, outstanding advances under the line of credit bear interest at either (a) an annual rate based on LIBOR plus 2.15% for the applicable LIBOR interest period selected by NTIC or (b) at the rate publicly announced by PNC Bank from time to time as its prime rate. Interest is payable in arrears (a) for the portion of advances bearing interest under the prime rate on the last day of each month during the term thereof and (b) for the portion of advances bearing interest under the LIBOR option on the last day of the respective LIBOR interest period selected for such advance. Any unpaid interest is payable on the maturity date. As of February 28, 2014, the interest rate on the line of credit was 2.70%. 22 -------------------------------------------------------------------------------- The line of credit is governed under a loan agreement, which contains standard covenants, including affirmative financial covenants, such as the maintenance of a minimum fixed charge coverage ratio, and negative covenants, which, among other things, limit the incurrence of additional indebtedness, loans and equity investments, disposition of assets, mergers and consolidations and other matters customarily restricted in such agreements. Under the loan agreement, NTIC is subject to a minimum fixed charge coverage ratio of 1.10:1.00. As of February 28, 2014, NTIC was in compliance with all loan agreement covenants and expects to remain in compliance with all loan agreement covenants during the remainder of fiscal 2014. On December 31, 2013, PNC Bank extended the maturity date of the line of credit from January 8, 2014 to January 7, 2015. All other terms of the line of credit and the loan agreement and other documents evidencing the line of credit remain the same. It is anticipated that, as historically has been the practice, the line of credit will be renewed each year for one additional year for the immediate foreseeable future. NTIC believes that a combination of its existing cash and cash equivalents, forecasted cash flows from future operations, anticipated distributions of earnings, anticipated fees to NTIC for services provided to its joint ventures, and funds available through existing or anticipated financing arrangements, will be adequate to fund its existing operations, investments in new or existing joint ventures, capital expenditures, debt repayments and any stock repurchases for at least the next 12 months. During the remainder of fiscal 2014, NTIC expects to continue to invest in research and development and in marketing efforts and resources into the application of its corrosion prevention technology into the oil and gas industry and its Natur-Tec® bio-plastics business. In order to take advantage of such new product and market opportunities to expand its business and increase its revenues, NTIC may decide to finance such opportunities by borrowing under its revolving line of credit or raising additional financing through the issuance of debt or equity securities. There is no assurance that any financing transaction will be available on terms acceptable to NTIC or at all, or that any financing transaction will not be dilutive to NTIC's current stockholders. NTIC traditionally has used the cash generated from its operations, distributions of earnings and fees for services provided to its joint ventures to fund NTIC's new technology investments and capital contributions to new and existing joint ventures. NTIC's joint ventures traditionally have operated with little or no debt and have been self-financed with minimal initial capital investment and minimal additional capital investment from their respective owners. Therefore, NTIC believes it is not likely that there exists any exposure to debt by NTIC's joint ventures that could materially impact their respective operations and/or liquidity. Uses of Cash and Cash Flows. Net cash used in operating activities during the six months ended February 28, 2014 was $1,464,042, which resulted principally from NTIC's equity in income from joint ventures and increases in receivables, inventories and prepaid expenses and a decrease in accrued liabilities and income taxes payable, partially offset by NTIC's net income, expensing of fair value of stock options vested, depreciation and amortization. Net cash used in operating activities during the six months ended February 28, 2013 was $3,445,681, which resulted principally from NTIC's equity in income from joint ventures and increases in receivables, inventories and prepaid expenses and a decrease in accounts payables, accrued liabilities and income taxes payable, partially offset by NTIC's net income, depreciation and amortization. NTIC's cash flows from operations are impacted by significant changes in certain components of NTIC's working capital, including inventory turnover and changes in receivables. NTIC considers internal and external factors when assessing the use of its available working capital, specifically when determining inventory levels and credit terms of customers. Key internal factors include existing inventory levels, stock reorder points, customer forecasts and customer requested payment terms, and key external factors include the availability of primary raw materials and sub-contractor production lead times. NTIC's typical contractual terms for trade receivables excluding joint ventures are traditionally 30 days and for trade receivables from its joint ventures are 90 days. Before extending unsecured credit to customers, excluding NTIC's joint ventures, NTIC reviews customers' credit histories and will establish an allowance for uncollectible accounts based upon factors surrounding the credit risk of specific customers and other information. Accounts receivable over 30 days are considered past due for most customers. NTIC does not accrue interest on past due accounts receivable. If accounts receivables in excess of the provided allowance are determined uncollectible, they are charged to selling expense in the period that determination is made. Accounts receivable are deemed uncollectible based on NTIC exhausting reasonable efforts to collect. NTIC's typical contractual terms for receivables for services provided to its joint ventures are 90 days. NTIC records receivables for services provided to its joint ventures on an accrual basis, unless circumstances exist that make the collection of the balance uncertain in which case the fee income will be recorded on a cash basis until there is consistency in payments. This determination is handled on a case by case basis. 23 -------------------------------------------------------------------------------- NTIC experienced an increase in receivables and inventory as of February 28, 2014 compared to August 31, 2013 due to the increase in net sales and a desire to stock more products to shorten lead times and anticipate customer demand. Trade receivables excluding joint ventures as of February 28, 2014 increased $69,584 compared to August 31, 2013, primarily related to the increase in NTIC's net sales. Outstanding trade receivables excluding joint ventures balances as of February 28, 2014 decreased three days to an average of 53 days from balances outstanding from these customers as of August 31, 2013. Outstanding trade receivables from joint ventures as of February 28, 2014 decreased $322,902 compared to August 31, 2013 primarily due to the timing of payments. There was a decrease of outstanding balances from trade receivables from joint ventures as of February 28, 2014 of 50 days from an average of 120 days from balances outstanding from these customers compared to August 31, 2013. The significant average days outstanding of trade receivables from joint ventures as of February 28, 2014 were primarily due to the receivable balance at NTIC's joint venture in India, Korea and China. Outstanding receivables for services provided to joint ventures as of February 28, 2014 increased $370,026 compared to August 31, 2013, which resulted in a decrease of one day of fees receivable outstanding as of February 28, 2014 to an average of 123 days compared to August 31, 2013. Net cash provided by investing activities for the six months ended February 28, 2014 was $5,017,070, which was comprised primarily of $5,217,878 in dividends received from joint ventures. These amounts were partially offset by additions to property and equipment and additions to patents. Net cash provided by investing activities for the six months ended February 28, 2013 was $4,349,062, which was comprised primarily of dividends received from joint ventures, partially offset by additions to property and equipment and additions to patents. Net cash used in financing activities for the six months ended February 28, 2014 was $873,643, which resulted from principal payments on the bank loan for NTIC's corporate headquarters buildings, partially offset by proceeds from NTIC's employee stock purchase plan and, to a lesser extent, stock option exercises. Net cash used in financing activities for the six months ended February 28, 2013 was $779,147, which resulted from a dividend received from a controlling interests and principal payments on the bank loan for NTIC's corporate headquarters buildings, partially offset by proceeds from NTIC's employee stock purchase plan and, to a lesser extent, stock option exercises. Capital Expenditures and Commitments. NTIC spent $325,051 on capital expenditures during the six months ended February 28, 2014 and expects to spend an aggregate of approximately $600,000 to $1,000,000 on capital expenditures during fiscal 2014. Such anticipated capital expenditures for fiscal 2014 relate primarily to the possible additional expansion of its laboratory facilities and purchase of equipment in Circle Pines, Minnesota. NTIC has a lease agreement for approximately 17,000 square feet of office, manufacturing, laboratory and warehouse space in Beachwood, Ohio, requiring monthly payments of $17,500, which are adjusted annually according to the annual consumer price index, through November 2014. NTIC had no other material lease or other material capital commitments as of February 28, 2014. 24 --------------------------------------------------------------------------------Off-Balance Sheet Arrangements NTIC has no relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet financial arrangements. As such, NTIC is not materially exposed to any financing, liquidity, market or credit risk that could arise if NTIC had engaged in such arrangements. Inflation and Seasonality Inflation in the U.S. and abroad historically has had little effect on NTIC. NTIC's business has not historically been seasonal. Market Risk NTIC is exposed to some market risk stemming from changes in foreign currency exchange rates, commodity prices and interest rates. Because the functional currency of NTIC's foreign operations and investments in its foreign joint ventures is the applicable local currency, NTIC is exposed to foreign currency exchange rate risk arising from transactions in the normal course of business. NTIC's principal exchange rate exposure is with the Euro, the Japanese yen, Indian Rupee, Chinese yuan, Korean won and the English pound against the U.S. dollar. NTIC's fees for services provided to joint ventures and dividend distributions from these foreign entities are paid in foreign currencies and thus fluctuations in foreign currency exchange rates could result in declines in NTIC's reported net income. Since NTIC's investments in its joint ventures are accounted for using the equity method, any changes in foreign currency exchange rates would be reflected as a foreign currency translation adjustment and would not change NTIC's equity in income of joint ventures reflected in its consolidated statements of income. NTIC does not hedge against its foreign currency exchange rate risk. Some raw materials used in NTIC's products are exposed to commodity price changes. The primary commodity price exposures are with a variety of plastic resins. At the option of NTIC, outstanding advances under NTIC's $3,000,000 revolving line of credit with PNC Bank bear interest at either (a) an annual rate based on LIBOR plus 2.15% for the applicable LIBOR interest period selected by NTIC or (b) at the rate publicly announced by PNC Bank from time to time as its prime rate, and thus may subject NTIC to some market risk on interest rates. As of February 28, 2014, NTIC had no borrowings under the line of credit. Critical Accounting Policies and Estimates There have been no material changes to NTIC's critical accounting policies and estimates from the information provided in "Part II. Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies", included in NTIC's annual report on Form 10-K for the fiscal year ended August 31, 2013, other than the policy described below: Principles of Consolidation NTIC evaluates its voting and variable interests in entities on a qualitative and quantitative basis. NTIC consolidates entities in which it concludes it has the power to direct the activities that most significantly impact an entity's economic success and has the obligation to absorb losses or the right to receive benefits that could be significant to the entity. All such relationships are evaluated on an ongoing basis. The consolidated financial statements include the accounts of Northern Technologies International Corporation, its wholly owned subsidiary, Northern Technologies Holding Company, LLC, and NTIC's majority owned subsidiary in Brazil, Zerust Prevenção de Corrosão S.A., NTIC's majority owned holding company, NTI Asean LLC, and NTIC's majority owned subsidiary in India, Northern Technologies India Private Limited. NTIC's consolidated financial statements do not include the accounts of any of its joint ventures. 25 --------------------------------------------------------------------------------Forward-Looking Statements This quarterly report on Form 10-Q contains not only historical information, but also forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the safe harbor created by those sections. In addition, NTIC or others on NTIC's behalf may make forward-looking statements from time to time in oral presentations, including telephone conferences and/or web casts open to the public, in press releases or reports, on NTIC's Internet web site or otherwise. All statements other than statements of historical facts included in this report or expressed by NTIC orally from time to time that address activities, events or developments that NTIC expects, believes or anticipates will or may occur in the future are forward-looking statements including, in particular, the statements about NTIC's plans, objectives, strategies, the outcome of contingencies such as legal proceedings, and prospects regarding, among other things, NTIC's financial condition, results of operations and business. NTIC has identified some of these forward-looking statements in this report with words like "believe," "may," "could," "would," "might," "forecast," "possible," "potential," "project," "will," "should," "expect," "intend," "plan," "predict," "anticipate," "estimate," "approximate" "outlook" or "continue" or the negative of these words or other words and terms of similar meaning. The use of future dates is also an indication of a forward-looking statement. Forward-looking statements may be contained in the notes to NTIC's consolidated financial statements and elsewhere in this report, including under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements are based on current expectations about future events affecting NTIC and are subject to uncertainties and factors that affect all businesses operating in a global market as well as matters specific to NTIC. These uncertainties and factors are difficult to predict and many of them are beyond NTIC's control. The following are some of the uncertainties and factors known to us that could cause NTIC's actual results to differ materially from what NTIC has anticipated in its forward-looking statements: · The effect of current worldwide economic conditions, the European sovereign debt crisis and turmoil and disruption in the global credit and financial markets on NTIC's business; · The health of the U.S. automotive industry on NTIC's business; · NTIC's dependence on the success of its joint ventures and fees and dividend distributions that NTIC receives from them; · NTIC's relationships with its joint ventures and its ability to maintain those relationships, especially in light of anticipated succession planning issues; · NTIC's dependence upon sales by Zerust Brazil to Petroleo Brasileiro S.A. (Petrobras), an oil company located in Brazil, and the effect of such sales on NTIC's quarterly operating results, including in particular its net sales and margins; · The variability in NTIC's sales of ZERUST® products and services into oil and gas industry and Natur-Tec® products and NTIC's equity income of joint ventures, which variability in sales and equity in income of joint venture in turn, subject NTIC's earnings to quarterly fluctuations; · Risks associated with NTIC's international operations and exposure to fluctuations in foreign currency exchange rates and import duties and taxes; · Fluctuations in the cost and availability of raw materials, including resins and other commodities; · The success of and risks associated with NTIC's emerging new businesses and products and services, including in particular NTIC's ability and the ability of NTIC's joint ventures to sell ZERUST® products and services into oil and gas industry and Natur-Tec® products and the often lengthy and extensive sales process involved in selling such products and services; 26--------------------------------------------------------------------------------· NTIC's ability to introduce new products and services that respond to changing market conditions and customer demand; · Market acceptance of NTIC's existing and new products, especially in light of existing and new competitive products; · Maturation of certain existing markets for NTIC's ZERUST® products and services and NTIC's ability to grow market share and succeed in penetrating other existing and new markets; · Increased competition, especially with respect to NTIC's ZERUST® products and services, and the effect of such competition on NTIC's and its joint ventures' pricing, net sales and margins; · NTIC's reliance upon and its relationships with its distributors, independent sales representatives and joint ventures; · NTIC's reliance upon suppliers, including in particular its single supply source for its base bioplastics resins; · The costs and effects of complying with laws and regulations and changes in tax, fiscal, government and other regulatory policies, including rules relating to environmental, health and safety matters; · The transition of the manufacturing of certain select ZERUST® rust and corrosion inhibiting products in house at NTIC's corporate headquarters location in Circle Pines, Minnesota; · Unforeseen product quality or other problems in the development, production and usage of new and existing products; · Unforeseen production expenses incurred in connection with new customers and new products; · Loss of or changes in executive management or key employees; · Ability of management to manage around unplanned events; · NTIC's reliance on its intellectual property rights and the absence of infringement of the intellectual property rights of others; · Fluctuations in NTIC's effective tax rate; · NTIC's reliance upon its management information systems; and · NTIC's ability to maintain effective internal control over financial reporting and comply with its other U.S. public reporting company obligations, especially in light of its upcoming transition from a "smaller reporting company" to an "accelerated filer" under federal securities laws, and anticipated increased costs and diversion of management's time and attention associated with such compliance activities. For more information regarding these and other uncertainties and factors that could cause NTIC's actual results to differ materially from what NTIC has anticipated in its forward-looking statements or otherwise could materially adversely affect its business, financial condition or operating results, see NTIC's annual report on Form 10-K for the fiscal year ended August 31, 2013 under the heading "Part I. Item 1A. Risk Factors." 27-------------------------------------------------------------------------------- All forward-looking statements included in this report are expressly qualified in their entirety by the foregoing cautionary statements. NTIC wishes to caution readers not to place undue reliance on any forward-looking statement that speaks only as of the date made and to recognize that forward-looking statements are predictions of future results, which may not occur as anticipated. Actual results could differ materially from those anticipated in the forward-looking statements and from historical results, due to the uncertainties and factors described above, as well as others that NTIC may consider immaterial or does not anticipate at this time. Although NTIC believes that the expectations reflected in its forward-looking statements are reasonable, NTIC does not know whether its expectations will prove correct. NTIC's expectations reflected in its forward-looking statements can be affected by inaccurate assumptions NTIC might make or by known or unknown uncertainties and factors, including those described above. The risks and uncertainties described above are not exclusive and further information concerning NTIC and its business, including factors that potentially could materially affect its financial results or condition, may emerge from time to time. NTIC assumes no obligation to update, amend or clarify forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements. NTIC advises you, however, to consult any further disclosures NTIC makes on related subjects in its annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K NTIC files with or furnishes to the Securities and Exchange Commission. |