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KMG CHEMICALS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the "Selected Financial Data" section of this report and our consolidated financial statements and the related notes and other financial information included elsewhere in this report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under the section entitled "Risk Factors" and elsewhere in this report. Introduction We manufacture, formulate and globally distribute specialty chemicals. We operate specialty chemical businesses selling 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, penta and creosote, are used by industrial customers primarily to extend the useful life of utility poles and railroad crossties. In fiscal year 2014, approximately 71.8% of our revenues were from electronic chemicals and 28.2% were from industrial wood preservation chemicals. Our results of operations are impacted by various competitive and other factors including: • fluctuations in sales volumes; • raw material pricing and availability; • our ability to acquire and integrate new products and businesses; and • the difference between prices received by us for our specialty chemical products and the costs to produce those products. Acquisition On May 31, 2013, we completed our acquisition of the ultra pure chemicals ("UPC") business subsidiaries of OM Group, with facilities located in the United States, the United Kingdom, France and Singapore. The final purchase price for the acquisition was $63.2 million. The subsidiaries sell high purity and ultra purity, wet process chemicals to the semiconductor industry. See Note 2 to the consolidated financial statements included in this report. Restructuring and Realignment of Operations In October 2013, we announced that, as part of a global restructuring of our electronic chemicals operations, we would close our Fremont, California manufacturing site acquired in the UPC acquisition, and shift production primarily to our Hollister, California and Pueblo, Colorado facilities. We ceased production at the Fremont facility, and completed site decommissioning by the end of fiscal year 2014. In November 2013, we announced that we would close a facility in Milan, Italy, and shift production to our facilities in France and the United Kingdom. We will continue to operate a warehouse facility in Milan. We have begun decommissioning certain manufacturing equipment in Milan, and are transitioning products from there to other sites in Europe. Our global restructuring remains on schedule. Total costs related to restructuring incurred for fiscal year 2014 was $3.9 million and an additional $2.4 million related to accelerated depreciation. We estimate that restructuring charges, exclusive of accelerated depreciation, will range between $7.0 million and $9.0 million cumulatively over fiscal years 2014 and 2015, and that accelerated depreciation with respect to the Fremont and Milan facilities will be approximately $4.0 million over those two fiscal years. See Note 14 to the financial statements included in this report. On October 13, 2014, we announced a realignment of our hydrofluoric acid business. We will not renew the toll manufacturing agreement with Chemtrade Logistics ("Chemtrade") under which it produces hydrofluoric acid for us at its Bay Point, California facility (the tolling agreement had formerly been with General Chemical). We will instead obtain our requirements for hydrofluoric acid products under supply agreements with other producers. We acquired certain manufacturing equipment at the Bay Point facility in our purchase of the electronic chemicals business of General Chemical in March 2010. Under the toll manufacturing agreement with Chemtrade, we are to pay or reimburse Chemtrade for certain costs associated with the cessation of operations at Bay Point, including certain employee costs and the decommissioning, dismantling and removal of our manufacturing equipment at the site. Operations are expected to cease by March 2015. We estimate that we will incur realignment charges of $2.5 -$4.0 million for decontamination, decommissioning and dismantling, and $2.5 -$2.8 million for accelerated depreciation. Additionally, we are obligated to pay certain employee costs that we are unable to estimate at this time. In fiscal year 2014, we established an asset retirement obligation of $3.7 million for decontamination, decommissioning and dismantling at Bay Point and recorded depreciation expense of $1.0 million against that obligation, and the Company recognized $0.8 million of accelerated depreciation. In addition, we have recognized an impairment charge of $2.7 million in fiscal year 2014 with respect to certain manufacturing equipment at Bay Point that is unrelated to hydrofluoric acid production. We have held certain assets at Bay Point for redeployment to other facilities. Although some of those assets have been redeployed, management has now determined to dispose of the remaining assets, and we have recognized the impairment loss. See Note 15 to the financial statements included in this report. 16-------------------------------------------------------------------------------- Table of Contents Sale of the Animal Health Business On March 1, 2012, we sold 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 EPA of certain studies being performed on tetrachlorvinphos. We retained the real estate and building at our facility in Elwood, Kansas, but that facility has since been leased through February 28, 2015 to another manufacturer in the animal health business who took over operations there, including the hiring of our employees. The tenant has an option to purchase the facility. Results of Operations Segment Data Segment data is presented for our two reportable segments for the three fiscal years ended July 31, 2014, 2013 and 2012. The segment data should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Year Ended July 31, 2014 2013 2012 (Amounts in thousands) Sales: Electronic chemicals $ 253,754 $ 165,755 $ 159,451 Wood treating chemicals 99,514 97,185 113,034 Total sales for reportable segments $ 353,268 $ 262,940 $ 272,485 Segment Sales In fiscal year 2014, net sales from electronic chemicals were $253.8 million, an increase of $88.0 million, or 53.1%, over net sales of $165.8 million in fiscal year 2013. In fiscal year 2013, net sales in the electronic chemicals segment increased $6.3 million, or 4.0%, over net sales of $159.5 million in fiscal year 2012. In both fiscals year 2014 and 2013, the increase in net sales from the prior year came primarily from the acquisition of the UPC business subsidiaries of OM Group on May 31, 2013. Net sales of wood treating chemicals increased by $2.3 million, or 2.4%, to $99.5 million in fiscal year 2014 from $97.2 million in fiscal year 2013. Net sales of wood treating chemicals in fiscal year 2013 decreased by $15.8 million, or 14.0%, from $113.0 million in fiscal year 2012. The increase in fiscal year 2014 in wood treating products net sales came mostly from an increase in penta block sales to customers, offset by lower creosote volume. The decrease in fiscal year 2013 in wood treating products net sales came from a reduction in creosote demand as customers pre-treated railroad ties with a borate solution, resulting in a reduced amount of creosote used in each tie. Segment Income from Operations Income from operations of the electronic chemicals segment was $14.1 million in fiscal year 2014, as compared to $14.0 million in fiscal year 2013 and $13.4 million in fiscal year 2012. Income from operations of electronic chemicals increased by $100,000 in fiscal year 2014 as compared to the prior year period, and increased by $600,000, or 4.5%, in fiscal year 2013 as compared to the prior year period. The fiscal year 2014 improvement in income from operations in electronic chemicals was primarily due to the effect of the acquisition of the UPC business net of integration expense of approximately $1.2 million and additional depreciation and amortization of $5.4 million. Integration expenses in fiscal year 2014 were primarily for consulting, professional services and travel expenses, including first year Sarbanes-Oxley implementation and testing at the acquired UPC subsidiaries. In fiscal year 2013, income from operations in electronic chemicals was burdened by approximately $577,000 for acquisition and integration expenses, primarily for consulting services and travel expenses, benefited by approximately $900,000 from the acquisition of the UPC business. Depreciation expense for the electronic chemicals segment for fiscal year 2014 includes accelerated depreciation of assets of $261,000 at our Fremont, California facility, $0.8 million at the Bay Point, California facility, and $2.1 million at our Milan, Italy facility, as well as depreciation related to asset retirement obligations at Bay Point of $1.0 million. We ceased operations at Fremont in fiscal year 2014, and have announced that we will exit from our toll manufacturing arrangement and cease operations at the Bay Point facility in March 2015. We have also announced that we will close a portion of our Milan facility. These decisions resulted in a reassessment of the useful lives of certain equipment at each facility and in accelerated depreciation. In addition, we recognized an impairment loss in fiscal year 2014 of $2.7 million on certain long-lived assets at the Bay Point facility that are no longer in service and management has concluded will be disposed of. 17-------------------------------------------------------------------------------- Table of Contents In fiscal year 2014, income from operations of the wood treating segment was $8.4 million as compared to $10.5 million in fiscal year 2013 and $15.6 million in fiscal year 2012. Income from operations for the wood treating segment decreased by $2.1 million, or 20.0%, in fiscal year 2014 and decreased by $5.1 million, or 32.7%, in fiscal year 2013 as compared to the respective prior year period. In fiscal year 2014, creosote and penta volume improved approximately 3.6% and 9.4%, respectively, but operating income in wood treating chemicals was down due to lower pricing of the hydrochloric acid that is a byproduct of penta production, higher raw material costs for penta and creosote and lower creosote pricing. In fiscal year 2013, income from operations in the wood treating segment suffered from a 16.3% decline in creosote sales volume, primarily because of the move by many customers to pre-treat railroad crossties with borate as a way to extend the service life of such crossties. The treatment of railroad ties with a combination of borates and creosote results in a reduced amount of creosote used to treat each crosstie. Net Sales and Gross Profit Net Sales and Gross Profit for Fiscal Year 2014 vs. Fiscal Year 2013 Net sales increased $90.1 million, or 34.2% in fiscal year 2014 to $353.4 million from $263.3 million in fiscal year 2013. Net sales for fiscal year 2014 increased over the prior year period primarily because of the UPC acquisition. That acquisition has allowed us to expand our global presence, and expand our ability to serve a broader spectrum of our semiconductor customers' requirements. Gross profits increased by $27.0 million, or 35.3%, to $103.5 million compared to $76.5 million in fiscal year 2013. The increase in gross profit was the result of sales attributable to the UPC acquisition. Gross profit as a percent of sales increased in fiscal 2014 to 29.3% from 29.0% in fiscal 2013. Because other companies may include certain of the costs that we record in cost of sales in 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 cost of sales, our gross profit may not be comparable to that reported by other companies. Net Sales and Gross Profit for Fiscal Year 2013 vs. Fiscal Year 2012 Net sales decreased $9.4 million, or 3.4% in fiscal year 2013 to $263.3 million from $272.7 million in fiscal year 2012. Despite an increase of $6.3 million in net sales from our electronic chemicals segment, net sales were down in the aggregate because of weak demand in North America beginning in the second quarter for electronic chemicals and a decline of approximately $15.8 million in net sales from our wood treating chemicals segment. Gross profits decreased by $595,000, or 0.8%, to $76.5 million compared to $77.1 million in fiscal year 2012. The decrease in gross profit was the result of the decline in revenue offset by a small increase in the average gross profit margin. Gross profit as a percent of sales increased in fiscal 2013 to 29.0% from 28.3% in fiscal 2012. The small improvement was due to a shift in the weighted average composition of revenues. Distribution and Selling, General and Administrative Expenses Distribution and Selling, General and Administrative for Fiscal Year 2014 vs. Fiscal Year 2013 Distribution expenses increased to approximately $50.3 million in fiscal year 2014 from $30.3 million in fiscal year 2013, an increase of about $20.0 million, or 66.0%. Distribution expense is heavily concentrated in our electronic chemicals business. The electronic chemicals segment incurred approximately 89%, 82% and 79% of our distribution expense in fiscal years 2014, 2013 and 2012, respectively. The increase in distribution expense in fiscal year 2014 reflected a greater volume of shipments from UPC-related sales. Distribution expense was 14.2% of consolidated net sales in fiscal year 2014 and 11.5% in fiscal year 2013. The increase in distribution expense as a percent of net sales in fiscal year 2014 was predominantly due to the effect of our Total Chemical Management personnel costs included in distribution expense from the Singapore UPC business acquired from OM Group. Selling, general and administrative expenses increased to $38.4 million in fiscal year 2014 from $29.0 million in fiscal year 2013, an increase of $9.4 million, or 32.4%. As a percentage of net sales, those expenses were 10.9% and 11.0% in fiscal years 2014 and 2013, respectively. The increase in fiscal year 2014 over the prior year was primarily because of the OM Group acquisition and employee-related costs, including stock-based compensation, and professional services. 18 -------------------------------------------------------------------------------- Table of Contents Distribution and Selling, General and Administrative for Fiscal Year 2013 vs. Fiscal Year 2012 Distribution expenses increased to approximately $30.3 million in fiscal year 2013 from $26.8 million in fiscal year 2012, an increase of about $3.5 million, or 13.2%. The increase in distribution expense was due solely to the acquired electronic chemicals business. Distribution expense as a percent of sales historically has been significantly higher for a newly acquired electronic chemicals business as compared with the current electronic chemicals business. Distribution expense was 11.5% of net sales in fiscal year 2013 and 9.8% in fiscal year 2012. The increase in distribution expense as a percent of net sales in fiscal year 2013 was predominantly due to distribution expense in the UPC business acquired from OM Group. Selling, general and administrative expenses increased to $29.0 million in fiscal year 2013 from $24.9 million in fiscal year 2012, an increase of $4.1 million, or 16.6%. As a percentage of net sales, those expenses were 11.0% and 9.1% in fiscal years 2013 and 2012, respectively. The increase in fiscal year 2013 over the prior year was primarily because of transaction related expenses for our UPC acquisition of $2.1 million, for our integration of that acquisition of $577,000 and for expenses associated with the departure of our former President and CEO, J. Neal Butler of $1.5 million. Adjusted EBITDA, Adjusted Net Income and Adjusted Earnings Per Share In fiscal year 2014 adjusted EBITDA, which excludes the effect of acquisition-related restructuring, the realignment of the hydrofluoric acid business, integration and CEO transition expenses, was $30.6 million, an increase of $1.2 million, or 4%, as compared to $29.4 million in fiscal year 2013. The improvement in fiscal 2014 adjusted EBITDA reflects operational synergies and commercial benefits related to the UPC acquisition and subsequent rationalization of our North American electronic chemicals assets, partially offset by reduced margins related to our creosote product in our wood treating chemicals segment. In fiscal year 2014 adjusted earnings per share was $0.81, compared to $1.11 in fiscal year 2013. The decrease in fiscal 2014 in adjusted earnings per share primarily reflects increased depreciation and amortization expenses primarily due to the UPC acquisition and higher corporate expenses including costs incurred for audit and other professional services. We provide non-GAAP financial information to complement reported GAAP results with adjusted EBITDA, adjusted net income and adjusted diluted earnings per share. We believe that analysis of our financial performance is enhanced by an understanding of these non-GAAP financial measures. We believe that they aid in evaluating the underlying operational performance of our business, and facilitate comparisons between periods. Non-GAAP financial information, such as adjusted EBITDA, is used externally by users of our consolidated financial statements, such as analysts and investors. A similar calculation of adjusted EBITDA is utilized internally for executives' compensation and by our lenders for a key debt compliance ratio. We define adjusted EBITDA as earnings from continuing operations before interest, taxes, depreciation, amortization, acquisition and integration expenses, restructuring and realignment charges and other nonrecurring items. Adjusted EBITDA is a primary measurement of cash flows from operations and a measure of our ability to invest in our operations and provide shareholder returns. Adjusted EBITDA is not intended to represent U.S. GAAP definitions of cash flow from operations or net income (loss). Adjusted net income adjusts net income for acquisition and integration expenses, restructuring and realignment charges and other nonrecurring items, while diluted adjusted earnings per share is adjusted net income divided by diluted shares outstanding. Adjusted EBITDA, adjusted net income and diluted adjusted earnings per share should be viewed as supplements to, and not substitutes for, U.S. GAAP measures of performance. The table below provides a reconciliation of operating income to adjusted EBITDA. Year Ended July 31, 2014 2013 2012 (Amounts in thousands) Operating income $ 3,951 $ 17,180 $ 25,437 Other income/(expense) (831 ) (208 ) (269 ) Depreciation and amortization 18,327 8,295 7,018 EBITDA 21,447 25,267 32,186 Acquisition and integration expenses 1,249 2,637 - CEO transition costs 1,280 1,516 - Restructuring charges, excluding accelerated depreciation 3,925 - - Impairment charges 2,741 - - Adjusted EBITDA $ 30,642 $ 29,420 $ 32,186 19 -------------------------------------------------------------------------------- Table of Contents The table below provides a reconciliation of net income/(loss) to adjusted net income and diluted adjusted earnings per share. Year Ended July 31, 2014 2013 2012 (Amounts in thousands, except per share) Net income/(loss) $ (988 ) $ 9,348 $ 13,825 Items impacting pre-tax income, net of tax: Restructuring and realignment charges 7,069 - - Acquisition and integration expenses 812 2,446 - CEO transition costs 832 1,014 - Restructuring income tax expense 1,725 - - Adjusted net income including discontinued operations $ 9,450 $ 12,808 $ 13,825 Diluted adjusted earnings per share (1) $ 0.81 $ 1.11 $ 1.20 Weighted average diluted shares outstanding 11,644 11,578 11,528 (1) Potentially dilutive shares are included in the weighted average diluted shares outstanding for the computation of diluted adjusted earnings per share. Interest Expense Interest expense was $2.9 million in fiscal year 2014, $1.8 million in fiscal year 2013, and $2.1 million in fiscal year 2012. We increased borrowings under our revolving credit facility to complete the OM Group acquisition in May 2013. In fiscal year 2014, we paid $25.0 million towards our revolving loan facility and reduced the debt from $85.0 million at the beginning of the fiscal year to $60.0 million at July 31, 2014. Income Taxes We had income tax expense from continuing operations of $1.3 million, $5.7 million and $8.8 million in fiscal years 2014, 2013 and 2012, respectively. Our effective tax rate was 471.4% in fiscal 2014, 37.6% in fiscal year 2013 and 37.9% in fiscal year 2012. In general, differences between these effective tax rates and the United States statutory rate of 35.0% are primarily due to statutory rates in our foreign jurisdictions, valuation allowances recorded against our current and prior year period operating losses for our Italian subsidiary as a result of restructuring of those operations and a deemed dividend related to a Mexico receivable, offset by the tax benefit from adjustments of foreign operations. Discontinued Operations Discontinued operations reflected a loss before income taxes of $203,000 and $711,000 for fiscal years 2013 and 2012, respectively. In fiscal year 2008, we discontinued operations of our herbicide product line that had comprised the agricultural chemical segment. We incurred costs of $121,000 and $599,000 in the fiscal years ended July 31, 2013 and 2012, respectively, for dismantling the herbicide facility and for medical and other expenses associated with an accident that occurred in fiscal year 2012 while the facility was being dismantled. On March 1, 2012, we sold the business that had comprised our animal health segment to Bayer Healthcare LLC. For the fiscal years ended July 31, 2013 and 2012, $82,000 and $112,000 was reported as a loss from discontinued operations before income taxes. In fiscal year 2013 the loss included $57,000 for a post-closing inventory adjustment that was recognized as loss on sale of the business in the first fiscal quarter, and in fiscal year 2012 the loss included the gain on sale of approximately $90,000. Liquidity and Capital Resources Cash Flows Net cash provided by operating activities was $40.4 million in fiscal year 2014, $20.3 million in fiscal year 2013 and $25.2 million in fiscal year 2012. In fiscal year 2014, operating cash flows increased significantly due to improvements in KMG's cash conversion cycle. Trade accounts receivable decreased $2.1 million primarily in our electronic chemicals business in North America, and inventories decreased $7.9 million primarily in wood treating due to lower creosote volumes. Accrued liabilities increased by $7.8 million in part due to restructuring and realignment accruals. Overall, fiscal year 2014 cash flows increased due to the UPC acquisition. 20-------------------------------------------------------------------------------- Table of Contents In fiscal year 2013, operating cash flows were favorably impacted by a $5.3 million increase in accounts payable, primarily from the timing of creosote inventory purchases and by a $1.8 million decrease in trade accounts receivable. Trade accounts receivable decreased because of lower electronic chemical sales in the fourth quarter of fiscal year 2013 as compared to the same period in the prior year. Operating cash flow was unfavorably impacted by an increase in accounts receivable-other of $2.6 million, primarily from payments of estimated income taxes for the current period. In fiscal year 2012, cash flows from operating activities were favorably impacted by a decrease in accounts receivable of $6.8 million, primarily due to lower sales of creosote during the fourth quarter of fiscal year 2012 as compared to the prior year fourth fiscal quarter, and to a lesser extent because of the sale of the animal health business and currency translation adjustments of our Italian subsidiary's accounts receivable balance on lower currency exchange rates. Cash flows were also favorably impacted by an increase in accrued liabilities and a decrease in other receivables of $1.9 million and $2.2 million, respectively. The increase in accrued liabilities was mainly due to a higher employee incentive accrual of approximately $1.1 million, while the decrease in other receivables included a reduction in income taxes receivable applied to the current period tax payments. Cash flows from operating activities were unfavorably impacted by a decrease in our trade accounts payable and an increase in inventories of $2.8 million and $5.5 million, respectively. The decrease in accounts payable was due primarily to the timing of payments on our creosote purchases and lower freight accruals, while the increase in inventories was attributable to our creosote inventories due to the combination of higher quantities, higher average cost and material in transit at the end of the current year. We also had higher inventories in our electronic chemicals segment due to increased raw material purchases at the end of fiscal year 2012. All results reported were net of the sale of our animal health business which reduced our working capital requirements. In fiscal year 2014, cash used in investing activities was $9.3 million, compared to cash used in investing activities of $68.1 million in fiscal year 2013. The fiscal year 2014 investing activities were for the additions to property, plant and equipment, of which $7.0 million was for electronic chemicals and $2.0 million related to our global project to implement a comprehensive financial/enterprise management software solution with SAP. In fiscal year 2013, cash used in investing activities was $68.1 million compared to cash provided by investing activities of $4.0 million in fiscal year 2012. In fiscal year 2013, $62.6 million was used to acquire the UPC business of the OM Group, which was net of cash acquired, and $5.5 million was invested in property, plant and equipment, about $4.2 million of which was invested in our legacy electronic chemicals business. The rest of the capital expenditure was primarily for various equipment and additions across our other facilities. Net cash provided by investing activities was $4.0 million in fiscal year 2012. In fiscal year 2012, we made $5.2 million of additions to property, plant and equipment, approximately $4.3 million of which was for electronic chemicals production and distribution equipment. The remainder of our additions to property was capital expenditures for normal equipment and system upgrades and purchases at our different locations. We received $10.2 million of proceeds for the sale of our animal health business during fiscal year 2012. In fiscal year 2014, $25 million of net cash was used in financing activities to pay down debt on our revolving credit facility. In fiscal year 2013, net cash from financing activities was $60.0 million including $61.0 million of net borrowings on our revolving credit facility to finance the purchase of the UPC business. In fiscal year 2012, net cash used in financing activities was $29.3 million. We reduced our revolving facility by $13.9 million and paid $11.3 million to pay off our term loan. We paid dividends of $1.4 million in each of fiscal years 2014 and 2013, and paid dividends of $1.2 million in fiscal year 2012. Working Capital We refinanced and amended the loan facility we had in place at July 31, 2014 with our New Credit Facility, but as of July 31, 2014 we had $40.0 million outstanding under a then existing revolving line of credit of $110.0 million. The maximum borrowing capacity under that revolving loan was $46.6 million, after giving effect to a reduction of $3.4 million for unused letters of credit. The amount available under that revolving facility at July 31, 2014 was limited, however, to approximately $35.0 million, because of a loan covenant restriction respecting funded debt to pro-forma earnings before interest, taxes and depreciation. On October 9, 2014, we refinanced our revolving loan facility and entered into the New Credit Facility. The initial advance under the new credit agreement was used to repay in full the $20.0 million outstanding indebtedness under our note purchase agreement with The Prudential Insurance Company of America and Pruco Life Insurance Company, and to pay the $38.0 million then outstanding on our existing revolving loan facility. Management believes that our New Credit Facility, combined with cash flows from operations, will adequately provide for our working capital needs for current operations for the next twelve months. 21 -------------------------------------------------------------------------------- Table of Contents Long Term Obligations Our long-term debt and current maturities as of July 31, 2014 and July 31, 2013 consisted of the following (in thousands): July 31, July 31, 2014 2013Senior Secured Debt: Note Purchase Agreement, maturing on December 31, 2014, interest rate of 7.43% $ 20,000 $ 20,000 Revolving Loan Facility, maturing on April 30, 2018, variable interest rates based on LIBOR plus 2.0% and 1.50% at July 31, 2014 and 2013, respectively 40,000 65,000 Total debt 60,000 85,000 Current maturities of long-term debt - - Long-term debt, net of current maturities $ 60,000 $ 85,000 In December 2007 we entered into an amended and restated credit agreement and a note purchase agreement, which was subsequently amended. Advances under the revolving loan, as amended, bore interest at 2.155% and 1.69% as of July 31, 2014 and 2013, respectively. The amount outstanding on the revolving loan facility was $40.0 million at July 31, 2014. The note purchase agreement was for $20.0 million. Advances under the note purchase agreement bore interest at 7.43% per annum. At July 31, 2014, $20.0 million was outstanding under the note purchase agreement. We refinanced our existing revolving loan facility and entered into the New Credit Facility on October 9, 2014. The New Credit Facility is with Wells Fargo Bank, National Association, Bank of America, N.A., HSBC Bank USA, National Association, and JPMorgan Chase Bank, N.A. The initial advance under the New Credit Facility was used to repay in full the $20.0 million outstanding indebtedness under our note purchase agreement with The Prudential Insurance Company of America and Pruco Life Insurance Company, and to pay the $38.0 million then outstanding on our existing revolving loan facility. The New Credit Facility provides for a revolving loan up to $150 million, including an accordion feature that allows for an additional revolving loan increase of up to $100 million with approval from our lenders. The amount available under the New Credit Facility at October 9, 2014 was limited, however, to approximately $44.2 million, because of a loan covenant restriction respecting funded debt to EBITDA. The maturity date for the New Credit Facility is October 9, 2019. The revolving loan under the New Credit Facility bears interest at varying rate of LIBOR plus a margin based on funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA"), as described in the table. Ratio of Funded Debt to EBITDA Margin Equal to or greater than 3.0 to 1.0 1.875% Equal to or greater than 2.75 to 1.0, but less than 3.0 to 1.0 1.625% Equal to or greater than 2.50 to 1.0, but less than 2.75 to 1.0 1.500% Equal to or greater than 2.25 to 1.0, but less than 2.50 to 1.0 1.375% Equal to or greater than 2.00 to 1.0, but less than 2.25 to 1.0 1.250% Equal to or greater than 1.50 to 1.0, but less than 2.00 to 1.0 1.125% Less than 1.50 to 1.0 1.000% We also incur an unused commitment fee on the unused amount of commitments under the revolving loan facility from 0.30% to 0.15% based on ratio of funded debt to EBITDA. Advances under the New Credit Facility are secured by our assets, including stock in subsidiaries, inventory, accounts receivable, equipment, intangible assets, and real property. The New Credit Facility has restrictive covenants, including requirements that we must maintain a fixed charge coverage ratio of 1.5 to 1.0, a ratio of funded debt to EBITDA (as adjusted for non-cash and unusual, non-recurring, and certain acquisition and integration costs) of 3.25 to 1.0 (with a step-up to 3.5 to 1.0 during an acquisition period with lender consent) and a current ratio of at least 1.5 to 1.0. After considering the New Credit Facility, at July 31, 2014, principal payments due under our long-term debt agreements as of July 31, 2014 for the fiscal years ended July 31 were as follows (in thousands): Total 2015 2016 2017 2018 2019 Thereafter Long-term debt $ 60,000 $ - $ - $ - $ - $ - $ 60,000 22 -------------------------------------------------------------------------------- Table of Contents Environmental Expenditures Our capital expenditures and operating expenses for environmental matters, excluding testing, data submission and other costs associated with our product task force participation, were approximately $2.7 million in fiscal year 2014, $1.3 million in fiscal year 2013 and $2.2 million in fiscal year 2012. We expensed approximately $667,000 for testing, data submission and other costs associated with our participation in product task forces in fiscal year 2014, and approximately $522,000 and $802,000 in fiscal years 2013 and 2012, respectively. We estimate that we will continue to incur additional testing, data submission and other costs of approximately $586,000 in fiscal year 2015. Since environmental laws have traditionally become increasingly stringent, costs and expenses relating to environmental control and compliance may increase in the future. While we do not believe that the incremental cost of compliance with existing or future environmental laws and regulations will have a material adverse effect on our business, financial condition or results of operations, we cannot assure that costs of compliance will not exceed current estimates. Contractual Obligations Our obligations to make future payments under contracts as of July 31, 2014 are summarized in the following table (in thousands): Payments Due by Period (in thousands) Total 1 Year 2-5 Years More than 5 Years Long-term debt (1) $ 60,000 $ - $ - $ 60,000 Estimated interest payments on debt (2) 4,340 1,102 3,109 129 Operating leases 17,512 5,333 9,253 2,926 Other long-term liabilities (3) 2,421 224 1,021 1,176 Purchase obligations (4) 129,146 56,087 73,059 - Total $ 213,419 $ 62,746 $ 86,442 $ 64, 231 (1) On October 9, 2014, we refinanced amounts outstanding under our existing revolving credit agreement and the Prudential term notes with the New Credit Facility. (2) Estimated payments are based on interest rates in effect as of the end of July 2014. (3) Includes postretirement benefit obligations for a supplemental executive retirement plan for one of our former United States executives and in connection with benefit obligations of our foreign subsidiary; and estimated unused commitment fees on our revolving credit facility. (4) Consists primarily of raw materials purchase contracts. These are typically not fixed prices arrangements. The prices are based on the prevailing prices. Outlook for Fiscal Year 2015 Our electronic chemicals business is closely tied to global semiconductor production. In calendar 2014, the global semiconductor market has benefited from relative strength in the mobile, industrial and automotive markets, while the personal computer market has shown signs of stabilization in Western Europe and North America. According to industry forecasts, the global semiconductor market is anticipated to grow approximately 6% in calendar 2014, followed by more moderate growth of 3% in calendar 2015. Within our wood treating chemicals segment, we expect solid market demand for utility poles treated with penta, as utilities in the Western United States continue upgrading their distribution infrastructure, and as poles near the end of their service life are regularly replaced. However, the railroad crosstie market is likely to remain challenged by increased competition for the hardwood timbers used for crossties. In addition, Class I railroads continue to specify that wood crossties be treated with borates, thus reducing the amount of creosote used to treat each crosstie. These factors are likely to contribute to excess creosote supply and exert downward pressure on prices in fiscal 2015. Overall, we project consolidated net sales in fiscal year 2015 will be essentially flat as compared to fiscal year 2014, with the likelihood of moderate sales growth in our electronic chemicals business being offset by weakness in our wood treating chemicals segment due to continued challenges in the rail tie market. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements, such as financing or unconsolidated variable interest entities, other than operating leases. 23-------------------------------------------------------------------------------- Table of Contents Recent Accounting Standards We have considered all recently issued accounting standards updates and SEC rules and interpretive releases, and none of them are expected to have a material impact on our financial statements. See Note 1 to the financial statements included in this report. Critical Accounting Policies Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires the use of estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting principles that we believe are the most important to aid in fully understanding our financial results are the following: Revenue Recognition - Our chemical products are sold in the open market and revenue is recognized when risk of loss and title to the products transfers to customers. In general, risk of loss transfers upon shipment to customers. We also recognize service revenue in connection with technical support services and chemicals delivery and handling at customer facilities. Revenue is recognized as those services are provided. Allowance for Doubtful Accounts - We record an allowance for doubtful accounts to reduce accounts receivable where we believe accounts receivable may not be collected. A provision for bad debt expense recorded to selling, general and administrative expenses increases the allowance. Accounts receivable that are written off decrease the allowance. The amount of bad debt expense recorded each period and the resulting adequacy of the allowance at the end of each period are determined using a customer-by-customer analyses of accounts receivable balances each period and subjective assessments of future bad debt exposure. Historically, write offs of accounts receivable balances have been insignificant. The allowance was $272,000 and $224,000 at July 31, 2014 and 2013, respectively. Goodwill - The carrying value of goodwill is reviewed at least annually, and if this review indicates that it will not be recoverable, our carrying value of goodwill will be adjusted to fair value. Based on an assessment of qualitative factors it was determined that there were no events or circumstances that would lead us to a determination that is more likely than not that the fair value of the applicable reporting unit was less than the carrying value as of July 31, 2014 and 2013. Accordingly, we determined that as of July 31, 2014 and 2013, goodwill was not impaired. We perform a similar assessment for intangible assets with indefinite lives. Based on that assessment, we determined that there was no impairment of these intangible assets during fiscal years 2014, 2013 and 2012. Impairment of Long-Lived Assets - Long-lived assets, including property, plant and equipment, and intangible assets, with defined lives, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset or its disposition. The measurement of an impairment loss for long-lived assets, where management expects to hold and use the asset, are based on the asset's estimated fair value. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value. In conjunction with its decision to cease operations at its Bay Point, California facility in fiscal year 2015, the Company recognized an impairment loss in fiscal year 2014 of $2.7 million on certain long-lived assets at that facility. Asset Retirement Obligations - We measure asset retirement obligations based upon the applicable accounting guidance, using certain assumptions including estimates for decommissioning, dismantling and disposal costs. In the event that operational or regulatory issues vary from our estimates, we could incur additional significant charges to income and increases in cash expenditures related to those costs. Certain conditional asset retirement obligations related to facilities have not been recorded in the consolidated financial statements due to uncertainties surrounding the ultimate settlement date and estimate of fair value related to a legal obligation to perform an asset retirement activity. When a reasonable estimate of the ultimate settlement can be made, an asset retirement obligation is recorded and such amounts may be material to the consolidated financial statements in the period in which they are recorded. In conjunction with its decision to exit the Bay Point facility, in fiscal year 2014 the Company recognized $3.7 million in asset retirement obligations related to the decommissioning, decontamination, and dismantling costs. See Note 15 to the consolidated financial statements included in item 8 of Part II of this report. Income Taxes - Deferred income taxes and liabilities are determined using the asset and liability method in accordance with accounting principles generally accepted in the United States of America. We have deferred tax assets that are reviewed periodically for recoverability. These assets are evaluated by using estimates of future taxable income streams. Valuations related to tax accruals and assets could be impacted by changes to tax codes, changes in the statutory tax rates and our future taxable income levels. With the consolidation of our European manufacturing facilities, it is more likely than not that our subsidiary in Italy will not generate a sufficient profit in the near future to recover restructuring charges. The impact on our Italian subsidiary's tax provision was approximately $1.7 million, and was recorded in the second quarter of fiscal year 2014. Our subsidiary in Italy is currently under examination for the period ended July 31, 2009 respecting certain registration tax assessments. See Note 8 to the financial statements included in this report. Inventory- Inventories are valued at the lower of cost or market. For certain products, cost is generally determined using the first-in, first-out ("FIFO") method. For certain other products we utilize a weighted-average cost. We record inventory obsolescence as a reduction in inventory when considered unsellable. We review inventories periodically to ensure the valuation of these assets is recorded at the lower of cost or market and to record an obsolescence reserve when inventory is considered unsellable. During the fiscal years ended July 31, 2014 and 2013, we recognized inventory valuation (gain)/loss of $634,000 and $(355,000), respectively. As of July 31, 2014 and 2013, we had $290,000 and $180,000, respectively, of reserves for inventory obsolescence. 24 -------------------------------------------------------------------------------- Table of Contents Disclosure Regarding Forward Looking Statements This report includes "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. 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; • our ability to realize the anticipated benefits of business acquisitions and to successfully integrate previous or future business acquisitions; • 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. 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. 25-------------------------------------------------------------------------------- Table of Contents |