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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 30, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission File Number: 1-7211
IONICS, INCORPORATED
(Exact name of registrant as specified in its charter)
Massachusetts 04-2068530
(State of incorporation) (IRS Employer Identification Number)
65 Grove Street
Watertown, Massachusetts 02472-2882
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (617) 926-2500
Former name, former address and former fiscal year,
if changed since last report: None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceeding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
At July 17, 2003 the Company had 17,620,231 shares of Common Stock, par value
$1.00 per share, outstanding.
IONICS, INCORPORATED
FORM 10-Q
FOR QUARTER ENDED JUNE 30, 2003
INDEX
PAGE
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements 2
Consolidated Statements of Operations
Three and Six Months Ended June 30, 2003 and 2002 2
Consolidated Balance Sheets
June 30, 2003 and December 31, 2002 3
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2003 and 2002 4
Notes to Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures about Market Risk 27
Item 4. Controls and Procedures 28
PART II - OTHER INFORMATION 30
Item 1. Legal Proceedings 30
Item 4. Submissions of Matters to a Vote of Securities Holders 30
Item 6. Exhibits and Reports on Form 8-K 31
SIGNATURES 32
EXHIBIT INDEX 33
Page -1-
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
IONICS, INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Amounts in thousands, except per share amounts)
Three months ended Six months ended
June 30, June 30,
------------------------- --------------------------
2003 2002 2003 2002
----------- ------------ ----------- -----------
Revenues: (as restated) (as restated)
Equipment Business Group $ 37,430 $ 35,944 $ 70,114 $ 70,992
Ultrapure Water Group 23,615 25,440 48,864 50,185
Consumer Water Group 10,006 8,726 20,821 19,279
Instrument Business Group 6,879 6,810 14,559 13,354
Affiliated companies 13,006 2,577 24,783 5,692
----------- ------------ ----------- -----------
90,936 79,497 179,141 159,502
----------- ------------ ----------- -----------
Costs and expenses:
Cost of sales of Equipment Business Group 28,554 26,579 52,017 52,176
Cost of sales of Ultrapure Water Group 18,078 18,613 36,866 37,611
Cost of sales of Consumer Water Group 6,753 4,874 14,268 11,704
Cost of sales of Instrument Business Group 3,010 2,584 6,123 5,337
Cost of sales to affiliated companies 11,166 2,279 21,383 5,316
Research and development 1,954 1,594 3,731 3,215
Selling, general and administrative 22,827 21,545 45,374 41,400
Impairment of long-lived assets 3,981 - 3,981 -
----------- ------------ ----------- -----------
96,323 78,068 183,743 156,759
----------- ------------ ----------- -----------
(Loss) income from operations (5,387) 1,429 (4,602) 2,743
Interest income 755 868 1,542 1,861
Interest expense (264) (376) (487) (936)
Equity (loss) income (2,742) 782 (2,843) 1,674
----------- ------------ ----------- -----------
(Loss) income before income taxes and minority interest expense(7,638) 2,703 (6,390) 5,342
Income tax (benefit) expense (2,902) 1,297 (2,428) 2,173
----------- ------------ ----------- -----------
(Loss) income before minority interest expense (4,736) 1,406 (3,962) 3,169
Minority interest expense 188 161 386 425
----------- ------------ ----------- -----------
Net (loss) income $ (4,924) $ 1,245 $ (4,348) $ 2,744
=========== ============ =========== ===========
Basic (loss) earnings per share $ (0.28) $ 0.07 $ (0.25) $ 0.16
=========== ============ =========== ===========
Diluted (loss) earnings per share $ (0.28) $ 0.07 $ (0.25) $ 0.15
=========== ============ =========== ===========
Shares used in basic (loss) earnings per share calculations 17,564 17,547 17,559 17,528
=========== ============ =========== ===========
Shares used in diluted (loss) earnings per share calculations 17,564 17,707 17,559 17,742
=========== ============ =========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
Page -2-
IONICS, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Amounts in thousands, except share and par value amounts)
June 30, December 31,
2003 2002
--------------- ---------------
ASSETS
Current assets:
Cash and cash equivalents $ 126,979 $ 136,044
Restricted cash - 4,250
Short-term investments 1,033 958
Accounts receivable, net 83,907 94,841
Notes receivable 7,092 6,662
Receivables from affiliated companies 47,491 23,642
Inventories:
Raw materials 20,197 19,837
Work in process 8,313 6,992
Finished goods 6,155 8,018
--------------- ---------------
34,665 34,847
Deferred income taxes 14,473 14,664
Other current assets 10,858 12,832
--------------- ---------------
Total current assets 326,498 328,740
Receivables from affiliated companies, long-term 17,935 11,740
Notes receivable, long-term 25,123 24,718
Investments in affiliated companies 19,078 22,618
Property, plant and equipment:
Land 6,213 6,077
Buildings 46,253 45,782
Machinery and equipment 282,943 273,442
Other, including furniture, fixtures and vehicles 32,701 32,307
--------------- ---------------
368,110 357,608
Less accumulated depreciation 188,573 177,694
--------------- ---------------
179,537 179,914
Goodwill 20,482 20,200
Deferred income taxes, long-term 12,591 12,591
Other assets 7,669 7,492
--------------- ---------------
Total assets $ 608,913 $ 608,013
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable and current portion of long-term debt $ 5,075 $ 4,134
Accounts payable 28,619 36,039
Deferred revenue and advances from affiliated companies 11,816 4,308
Income taxes payable 24,222 25,692
Other current liabilities 38,838 43,995
--------------- ---------------
Total current liabilities 108,570 114,168
Long-term debt and notes payable 9,421 9,670
Deferred income taxes 36,376 35,337
Deferred revenue from affiliated companies 3,916 4,662
Other liabilities 7,950 6,023
Commitments and contingencies
Stockholders' equity:
Common stock, par value $1.00, authorized
shares: 55,000,000 at June 30, 2003 and December 31, 2002;
issued: 17,616,731 at June 30, 2003 and 17,555,046 at December 31, 2002 17,617 17,555
Additional paid-in capital 191,651 190,417
Retained earnings 242,761 247,109
Accumulated other comprehensive loss (9,349) (16,928)
--------------- ---------------
Total stockholders' equity 442,680 438,153
--------------- ---------------
Total liabilities and stockholders' equity $ 608,913 $ 608,013
=============== ===============
The accompanying notes are an integral part of these consolidated financial statements.
Page -3-
IONICS, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Amounts in thousands)
Six months ended
June 30,
----------------------------------
2003 2002
--------------- ---------------
Operating activities: (as restated)
Net (loss) income $ (4,348) $ 2,744
Adjustments to reconcile net (loss) income to net cash
used in operating activities:
Depreciation 12,687 11,124
Amortization of intangibles 241 116
Impairment of long-lived assets 3,981 -
Provision for losses on accounts and notes receivable 981 332
Equity in losses (earnings) of affiliates 2,843 (1,674)
Changes in assets and liabilities:
Notes receivable 704 (1,884)
Accounts receivable 12,655 10,051
Receivables from affiliated companies (30,822) (7,121)
Inventories 1,208 (2,539)
Other current assets 2,166 329
Investments in affiliated companies 609 1,984
Deferred income taxes 295 510
Accounts payable and accrued expenses (12,992) (22,455)
Customer deposits (2,122) 2,605
Deferred revenue and advances from affiliated companies 7,508 (148)
Income taxes payable (2,313) (19,652)
Other (51) (822)
--------------- ---------------
Net cash used in operating activities (6,770) (26,500)
--------------- ---------------
Investing activities:
Additions to property, plant and equipment (11,991) (14,113)
Disposals of property, plant and equipment 55 546
Additional investments in affiliates (36) -
Acquisitions, net of cash acquired - (635)
Sales of short-term investments 1 184
--------------- ---------------
Net cash used in investing activities (11,971) (14,018)
--------------- ---------------
Financing activities:
Restricted cash 4,250 -
Principal payments on current debt (456) (53,374)
Proceeds from borrowings of current debt 1,051 48,618
Principal payments on long-term debt (684) (480)
Proceeds from borrowings of long-term debt - 1,135
Proceeds from issuance of common stock - 60
Proceeds from issuance of stock under stock option plans 1,181 1,654
--------------- ---------------
Net cash provided by (used in) financing activities 5,342 (2,387)
--------------- ---------------
Effect of exchange rate changes on cash 4,334 3,749
--------------- ---------------
Net change in cash and cash equivalents (9,065) (39,156)
Cash and cash equivalents at beginning of period 136,044 178,283
--------------- ---------------
Cash and cash equivalents at end of period $ 126,979 $ 139,127
=============== ===============
The accompanying notes are an integral part of these consolidated financial statements.
Page -4-
IONICS, INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The accompanying consolidated quarterly financial statements of Ionics,
Incorporated (the "Company") are unaudited; however, in the opinion of the
management of the Company, all adjustments have been made that are necessary for
a fair presentation of the Company's consolidated financial position, results of
operations and cash flows for each period presented. The consolidated results of
operations for the interim periods are not necessarily indicative of the results
of operations to be expected for the full year or any future period.
The accompanying financial statements have been prepared with the assumption
that users of the interim financial information have either read or have access
to the Company's financial statements for the year ended December 31, 2002.
Accordingly, footnote disclosures that would substantially duplicate the
disclosures contained in the Company's December 31, 2002 audited financial
statements have been omitted from these financial statements. These financial
statements have been prepared in accordance with the instructions to Form 10-Q
and the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such instructions, rules and regulations. These
financial statements should be read in conjunction with the Company's 2002
Annual Report as filed on Form 10-K (the "2002 Form 10-K") with the Securities
and Exchange Commission.
Certain prior year amounts have been reclassified to conform to the current year
presentations with no impact on net income.
2. Restatement of Quarterly Financial Statements
The Company's consolidated financial statements for the three months ended March
31, 2002 and June 30, 2002 and the six months ended June 30, 2002 were restated
in November 2002, primarily as a result of intercompany transactions including
transactions between the Company and its French subsidiary that were erroneously
recorded at the subsidiary level. The restatement resulted primarily from the
French subsidiary's failure to properly record intercompany adjustments
necessary to correct errors on its books, which became apparent to the Company's
corporate management during the preparation of the Company's consolidated
financial statements for the three-month and nine-month periods ended September
30, 2002. These adjustments primarily affected accounting entries related to
revenues from sales of spare parts and expenses related to project cost
overruns, sales support costs and severance costs. These adjustments, which
increased the historical pre-tax loss at the French subsidiary in the quarters
ended March 31, 2002 and June 30, 2002 and the forecast of the French
subsidiary's pre-tax losses for the year ended December 31, 2002, resulted in
the Company's determination that it was more likely than not that the Company
would not fully realize future tax benefits associated with the French
subsidiary's net operating losses. Accordingly, the Company's income tax expense
and its effective annual tax rate for the three months ended June 30, 2002 were
increased. In addition, the restatement reflected other adjustments that
primarily consisted of corrections to various otherwise immaterial accounting
errors that were identified during the preparation of the Company's consolidated
financial statements for the quarters ended March 31, 2002, June 30, 2002 and
September 30, 2002. The restatement did not materially impact any items on the
Company's consolidated balance sheets as of March 31, 2002 and June 30, 2002.
The following table presents a summary of the impact of the restatements on the
Company's consolidated statements of operations for the three and six months
ended June 30, 2002:
Page -5-
(Amounts in thousands, except per share amounts)
Three months ended June 30, 2002 Six months ended June 30, 2002
------------------------------------------------------------------------------
As originally As originally
reported As restated reported As restated
----------------- ----------------- ----------------- -----------------
Revenues $ 79,321 $ 79,497 $ 159,662 $ 159,502
Costs and expenses 77,303 78,068 155,639 156,759
Income from operations 2,018 1,429 4,023 2,743
Income before income taxes
and minority interest 3,292 2,703 6,622 5,342
Income tax expense 1,119 1,297 2,251 2,173
Minority interest in earnings 79 161 340 425
Net income 2,094 1,245 4,031 2,744
Basic earnings per share $ 0.12 $ 0.07 $ 0.23 $ 0.16
Diluted earnings per share $ 0.12 $ 0.07 $ 0.23 $ 0.15
3. Stock Plans
Options for the purchase of the Company stock are granted to officers, directors
and key employees under various stock option agreements. The Company applies the
recognition and measurement provisions of Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," and related interpretations
in accounting for its stock-based compensation plans. Accordingly, for options
with an exercise price less than the fair market value of the stock at the date
of grant, if any, stock-based compensation is measured as the difference between
the option exercise price and fair market value of the stock at the date of
grant and is charged to operations over the expected period of benefit to the
Company. For the three and six months ended June 30, 2003 and 2002, no
stock-based compensation expense is reflected in net income.
The following table illustrates the pro forma effect on net (loss) income and
basic and diluted (loss) earnings per share if the Company had applied the fair
value method of accounting for stock options and other equity instruments as
defined by Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation."
For the three months ended For the six months ended
(Amounts in thousands, except per share amounts) June 30, June 30,
---------------------------- ----------------------------
2003 2002 2003 2002
(as restated) (as restated)
------------- ------------- ------------- -------------
Net (loss) income, as reported $ (4,924) $ 1,245 $ (4,348) $ 2,744
Less: Stock-based employee compensation determined
under fair value method for all awards, net of related tax effects (1,069) (594) (1,869) (1,174)
------------- ------------- ------------- -------------
Pro forma net (loss) income $ (5,993) $ 651 $ (6,217) $ 1,570
============= ============= ============= =============
(Loss) earnings per basic share, as reported $ (0.28) $ 0.07 $ (0.25) $ 0.16
============= ============= ============= =============
(Loss) earnings per basic share, pro forma $ (0.34) $ 0.04 $ (0.35) $ 0.09
============= ============= ============= =============
(Loss) earnings per diluted share, as reported $ (0.28) $ 0.07 $ (0.25) $ 0.15
============= ============= ============= =============
(Loss) earnings per diluted share, pro forma $ (0.34) $ 0.04 $ (0.35) $ 0.09
============= ============= ============= =============
Since the options vest over several years and because additional option grants
are expected to be made in future years, the pro forma results are not
representative of the pro forma results for future periods.
The fair value of each option granted during the first six months of 2003 and
2002 is estimated on the date of grant using the Black-Scholes option-pricing
model with the following assumptions:
Page -6-
For the three months ended For the six months ended
June 30, June 30,
---------------------------- ---------------------------
2003 2002 2003 2002
------------ ------------ ----------- -----------
Expected term (years) 6 6 6 6
Volatility 40.8 42.2 40.8 42.2
Risk-free interest rate (zero coupon U.S. treasury note) 3.28% 5.05% 3.28% 4.91%
Dividend yield None None None None
4. Equity Income (Loss) in Affiliated Companies
The Company accounts for investments in affiliates that represent 20% to 50%
ownership of the equity securities of the affiliate under the equity method of
accounting. Under the equity method, the Company records its proportionate share
of the earnings or losses of the affiliates in equity income (loss). With
respect to the Company's investment in the Desalination Company of Trinidad and
Tobago Ltd. ("Desalcott"), in recognition of the fact that the Company has
provided all of the cash equity funding for Desalcott, the Company has concluded
that it would not be appropriate to recognize equity method losses based solely
on its ownership interest in Desalcott. The Company holds 200 ordinary shares of
Desalcott, representing a 40% ownership interest. The Company also loaned $10
million to Hafeez Karamath Engineering Services, Ltd. ("HKES"), the founder of
Desalcott and promoter of the Trinidad desalination project, to enable HKES to
acquire 200 ordinary shares of Desalcott and thereby raise its existing equity
interest in Desalcott from 100 to 300 ordinary shares. As a result, the Company
currently owns a 40% equity interest in Desalcott, and HKES currently owns a 60%
equity interest in Desalcott. In addition, the Company expects to finalize a $10
million loan to Desalcott in the third quarter of 2003 as an additional source
of long-term financing. Accordingly, based on its aggregate economic interests
in Desalcott, the Company records 100% of any net loss reported by Desalcott and
40% of any net income reported by Desalcott. In periods in which Desalcott has
an accumulated loss (as opposed to retained earnings), the Company records 100%
of any net income of Desalcott up to the amount of Desalcott's accumulated loss,
and 40% of any net income reported thereafter by Desalcott.
5. Income Taxes
For the six months ended June 30, 2003, the Company recorded income tax benefit
of $2.4 million on a consolidated pre-tax loss before minority interest expense
of $6.4 million, yielding an annual effective tax rate of 38%. For the six
months ended June 30, 2002, the Company recorded income tax expense of $2.2
million on consolidated pre-tax income before minority interest of $5.3 million,
yielding an annual effective tax rate of 40.7%. The change in the effective tax
rate for the six months ended June 30, 2003 compared to the six months ended
June 30, 2002 resulted from changes in the overall level of consolidated pre-tax
profit and the geographic mix of expected losses in several foreign subsidiaries
for which the Company may not be able to realize future tax benefits.
6. Commitments and Contingencies
Litigation
- ----------
The Company, its Chief Financial Officer and its former Chief Executive Officer
have been named as defendants in a class action lawsuit captioned Jerome Deckler
v. Ionics, Inc., et al., filed in the U.S. District Court, District of
Massachusetts in March 2003. Plaintiff alleges violations of the federal
securities laws relating to the restatement of the Company's financial
statements for the first and second quarters of 2002, announced in November
2002, and are seeking an unspecified amount of compensatory damages and their
costs and expenses, including legal fees. The Company believes the allegations
in the lawsuit are without merit and intends vigorously to defend the
litigation. While the Company believes that the litigation will have no material
adverse impact on its financial condition, results of operations or cash flows,
the litigation process is inherently uncertain and the Company can make no
assurances as to the ultimate outcome of this matter.
The Company and its wholly owned subsidiary, Sievers Instruments, Inc.
("Sievers"), have been named as defendants in a lawsuit captioned Aerocrine AB
v. Ionics, Inc. and Sievers Instruments, Inc., filed in the U.S. District Court,
District of Maine, in July 2003. Plaintiff alleges that the Company and Sievers
have infringed four patents owned by plaintiff relating to the measurement of
nitric oxide in exhaled breath for medical diagnostic purposes, as a result of
Sievers' manufacture and sale of an instrument for the detection of nitric
oxide. Plaintiff is seeking an injunction, an unspecified amount of damages, and
Page -7-
attorneys' fees and expenses. Plaintiff is also seeking to have two patents
owned by Sievers relating to nitric oxide detection declared invalid. The
Company believes that the activities carried out by Sievers do not infringe
plaintiff's patents and that its own patents are valid. The Company and the
plaintiff are currently engaged in discussions concerning a commercial
resolution of the matter. If these discussions are not effective, the Company
intends to defend this litigation. While the Company believes that the
litigation will have no material adverse impact on its financial condition,
results of operations or cash flows, the litigation process is inherently
uncertain and the Company can make no assurances as to the ultimate outcome of
this matter.
The Company was notified in 1992 that it is a potentially responsible party
(PRP) at a Superfund Site, Solvent Recovery Services of New England in
Southington, Connecticut. Ionics' share of assessments to date for site work and
administrative costs totals approximately $78,000. The United States
Environmental Protection Agency ("EPA") has not yet issued a decision regarding
clean-up methods and costs. However, based upon the large number of PRPs
identified, the Company's small volumetric ranking (approximately 0.5%) and the
identities of the larger PRPs, the Company believes that its liability in this
matter will not have a material effect on the Company's financial position,
results of operations or cash flows.
In 2002, Sievers Instruments, Inc. ("Sievers"), a wholly owned subsidiary of the
Company, filed a patent infringement suit in the United States District Court
for the District of Colorado against Anatel Corporation and against Anatel's
acquiring company, Hach Company ("Anatel"). The suit alleges that Anatel's
manufacture and sale of its Model 643 organic carbon analyzer unlawfully copied
and interfered with sales of Sievers' TOC 400 total organic carbon analyzer in
that the Model 643 infringes certain claims of Sievers' U.S. patents No.
5,976,468 and No. 6,271,043. The suit further asserts that the continuing sale
of calibration standards by Anatel constitutes infringement. The defendants have
raised certain defenses, withdrawn the accused product from the market, and
introduced a redesigned analyzer. Defendants have asked the Court to rule that
their redesigned analyzer does not infringe, and the Court has not yet issued
its decision.
The Company is involved in the normal course of its business in various other
litigation matters, some of which are in the pre-trial discovery stages. The
Company believes that none of the other pending matters will have an outcome
material to the Company's financial position, results of operations or cash
flows.
Other Commitments and Contingencies
- -----------------------------------
From time to time, the Company enters into joint ventures with respect to
specific projects, including the projects in Trinidad, Kuwait and Israel
described below. Each joint venture arrangement is independently negotiated
based on the specific facts and circumstances of the project, the purpose of the
joint venture company related to the project, as well as the rights and
obligations of the other joint venture partners. Generally, the Company has
structured its project joint ventures so that the Company's obligation to
provide funding to the underlying project or to the joint venture entity is
limited to its proportional capital contribution, which can take the form of
equity or subordinated debt. Except in situations that are negotiated with a
specific joint venture entity as discussed below, the Company has no other
commitment to provide for the joint venture's working capital or other cash
needs. In addition, the joint venture entity typically obtains third-party debt
financing for a substantial portion of the project's total capital requirements.
In these situations, the Company is typically not responsible for the repayment
of the indebtedness incurred by the joint venture entity. In connection with
certain joint venture projects, the Company may also enter into contracts for
the supply and installation of the Company's equipment during the construction
of the project, for the operation and maintenance of the facility once it begins
operation, or both. These commercial arrangements do not require the Company to
commit to any funding for working capital or any other requirements of the joint
venture company. As a result, the Company's exposure with respect to its joint
ventures is typically limited to its debt and equity investments in the joint
venture entity, the fulfillment of any contractual obligations it has to the
joint venture entity and the accounts receivable owing to the Company from the
joint venture entity.
Trinidad
- --------
In 2000, the Company acquired 200 ordinary shares of Desalination Company of
Trinidad and Tobago Ltd. ("Desalcott"), for $10 million and loaned $10 million
to Hafeez Karamath Engineering Services Ltd. ("HKES"), the founder of Desalcott
and promoter of the Trinidad desalination project, to enable HKES to acquire an
additional 200 ordinary shares of Desalcott. Prior to those investments, HKES
owned 100 ordinary shares of Desalcott. As a result, the Company currently owns
a 40% equity interest in Desalcott, and HKES currently owns a 60% equity
interest in Desalcott. In the second quarter of 2002, construction was completed
on the first four (out of five) phases of the Trinidad desalination facility
owned by Desalcott, and the facility commenced water deliveries to its customer,
the Water and Sewerage Authority of Trinidad and Tobago.
Page -8-
The Company's $10 million loan to HKES is included in notes receivable,
long-term in the Company's Consolidated Balance Sheets. The loan bears interest
at a rate equal to 2% above the London Interbank Offered Rate (LIBOR), with
interest payable (subject to availability of funds) starting October 25, 2002
and every six months thereafter and at maturity. Prior to maturity, accrued
interest (as well as principal payments) is payable only to the extent dividends
or other distributions are paid by Desalcott on the ordinary shares of Desalcott
owned by HKES and pledged to the Company. Principal repayment is due in 14 equal
installments commencing on April 25, 2004 and continuing semiannually
thereafter. The loan matures and is payable in full on April 25, 2011. The loan
is secured by a security interest in the shares of Desalcott owned by HKES and
purchased with the borrowed funds, which is subordinate to the security interest
in those shares in favor of the Trinidad bank that provided the financing for
Desalcott. In addition, any dividends or other distributions paid by Desalcott
to HKES on the pledged shares must be applied to loan payments to the Company.
In 2000, Desalcott entered into a "bridge loan" agreement with a Trinidad bank
providing $60 million in construction financing. Effective November 8, 2001, the
loan agreement was amended to increase maximum borrowings to $79.9 million. The
bridge loan of $79.9 million and the $20 million equity provided to Desalcott
did not provide sufficient funds to pay all of Desalcott's obligations in
completing construction and commissioning of the project prior to receipt of
long-term financing in the second quarter of 2003. Consequently, included in
Desalcott's obligations at March 31, 2003 was approximately $30.1 million
payable to the Company's Trinidad subsidiary for equipment and services
purchased in connection with the construction of the facility. However,
Desalcott had disputed certain amounts payable under the construction contract,
and the parties made their dispute subject to the dispute resolution procedures
of the contract.
In June 2003, Desalcott and the Company's Trinidad subsidiary resolved certain
disputes under the construction contract, and reached agreement as to the final
amount owing to the Company for completion of the first four phases of the
project. As a result of this agreement, the Company will not realize
approximately $2.7M of the deferred profit on the construction project, and
therefore reduced the related accounts receivable and deferred revenue balances
by $2.7 million each. In June 2003, Desalcott entered into a long-term loan
agreement with the Trinidad bank that had provided the bridge loan. In
connection with the funding of the loan, Desalcott paid the Company's Trinidad
subsidiary approximately $12 million of outstanding accounts receivable under
the construction contract in July 2003. In addition, pursuant to a previous
commitment made by the Company, the Company expects in the third quarter of 2003
to convert an additional $10 million of amounts owing under the construction
contract into a loan to Desalcott as an additional source of long-term project
financing. That loan will have a seven-year term and will be payable in 28
quarterly payments of principal and interest. The interest rate will be fixed at
two percent (2%) above the interest rate payable by Desalcott on the U.S. dollar
portion of its borrowings under its long-term loan agreement with the
Trinidadian bank (the initial annual rate on the U.S. dollar portion was 8
1/2%). In the event of a default by Desalcott, Desalcott's obligations to the
Company will be subordinated to Desalcott's obligations to the Trinidad bank.
As a result of the settlement of the construction contract dispute described
above and Desalcott's $12 million payment to the Company's Trinidad subsidiary,
together with the conversion of an additional $10 million of accounts receivable
into a long-term note receivable as described above, the remaining amount due to
the Company's Trinidad subsidiary from Desalcott for construction work on the
first four phases of the project is approximately $6 million. This amount will
be partially paid out of Desalcott's future cash flow from operations, and the
balance from loan proceeds upon completion by the Company of certain "punch
list" items, over a period of time estimated to be two years. In addition,
Desalcott and the Company agreed that the Company's Trinidad subsidiary would
complete the last phase (phase 5) of the project (which will increase water
production capacity by approximately 9%) for a fixed price of $7.7 million. Work
on phase 5 has commenced and is expected to be completed in the second quarter
of 2004.
Kuwait
- ------
During 2001, the Company acquired a 25% equity interest in a Kuwaiti project
company, Utilities Development Company W.L.L. ("UDC"), which was awarded a
concession agreement by an agency of the Kuwaiti government for the
construction, ownership and operation of a wastewater reuse facility in Kuwait.
During the second quarter of 2002, UDC entered into agreements for the long-term
financing of the project, and construction of the project commenced. At June 30,
2003, the Company had invested a total of $6.7 million as equity and
subordinated debt in UDC. The Company has commitments to make additional equity
investments or issue additional subordinated debt to UDC of approximately $12.0
million over the next two years.
Page -9-
Israel
- ------
In 2001, the Company entered into agreements with an Israeli cooperative society
and an Israeli corporation for the establishment of Magan Desalination Ltd.
("MDL") as an Israeli project company in which the Company has a 49% equity
interest. During the second quarter of 2003, the Israeli cooperative society
obtained the ownership interest in the Israeli corporation. On June 17, 2003,
MDL finalized a concession contract originally entered into in August 2002 with
a state-sponsored water company for the construction, ownership and operation of
a brackish water desalination facility in Israel. In June 2003, MDL secured $8
million of debt financing for the project from an Israeli bank, and the Company
has guaranteed repayment of 49% of the loan amount. In July 2003, the Company
through its Israeli subsidiary currently anticipates making an equity investment
of $1.3 million in MDL, for a 49% equity interest. This project is scheduled to
be completed in the first half of 2004.
In January 2002, the Company entered into agreements with two Israeli
corporations giving the Company the right to a one-third ownership interest in
an Israeli project company, Carmel Desalination Ltd. ("CDL"). On October 28,
2002, CDL was awarded a concession agreement by the Israeli Water Desalination
Agency ("WDA") (established by the Ministry of Finance and the Ministry of
Infrastructure) for the construction, ownership and operation of a major
seawater desalination facility in Israel. At December 31, 2002, the Company made
an equity investment of $0.2 million in CDL. Additionally, at June 30, 2003 the
Company had deferred costs of approximately $0.6 million relating to the
engineering design and development work on the project. If CDL obtains long-term
project financing, the Company has committed to make additional equity
investments to CDL of approximately $9.7 million. The timing and amount of such
investments will depend upon the terms of the long-term financing agreement. The
terms of the concession agreement originally required that long-term financing
be obtained by April 2003. CDL has been granted an extension to August 20, 2003
and has requested a further extension to obtain such financing. Although the
Company currently anticipates that CDL will obtain long-term financing for the
project, if CDL is unable to obtain such financing, the Company would expense
its deferred costs relating to the construction project and its investment in
CDL (estimated to be approximately $0.8 million by the time of the closing of
the long-term financing). Additionally, the Company could incur its one-third
proportionate share ($2.5 million) of liability under a $7.5 million performance
bond issued on behalf of CDL. In August 2003, the Company entered into an
agreement with the two other equity participants in CDL which would permit one
of them to withdraw from the project subject to the approval of the WDA. Should
the withdrawal of the partner be approved by the WDA, the Company's equity
interest in CDL would increase from one-third to 50%, proportionately increasing
its obligation under the performance bond, as well as increasing its required
equity investment in the project.
Guarantees and Indemnifications
- -------------------------------
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45 "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others an
interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB
Interpretation No. 34" ("FIN 45"). FIN 45 requires that a guarantor recognize,
at the inception of a guarantee, a liability for the fair value of the
obligation undertaken by issuing the guarantee and additional disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees it has issued. The accounting requirements
for the initial recognition of guarantees became applicable on a prospective
basis for guarantees issued or modified after December 31, 2002. The disclosure
requirements are effective for all guarantees outstanding, regardless of when
they were issued or modified as of December 15, 2002. The adoption of FIN 45 did
not have a material effect on the Company's consolidated financial statements.
The following is a summary of the Company's agreements that have determined to
be within the scope of FIN 45.
Under its By-laws, the Company has an obligation to indemnify its directors and
officers to the extent legally permissible against liabilities reasonably
incurred in connection with any action in which such individual may be involved
by reason of such individual being or having been a director or officer of the
Company. The Company has obtained director and officer liability insurance
policies that may limit its exposure and enable it to recover a portion of any
future amounts paid. As a result of this insurance policy coverage, the
estimated fair value of this indemnification is not material. This obligation to
indemnify its directors and officers is grandfathered under the provisions of
FIN 45 as it existed prior to December 31, 2002. Accordingly, the Company has
not recorded any liabilities for these obligations as of June 30, 2003.
Page -10-
In the normal course of business, the Company issues letters of credit to
customers, vendors and lending institutions as guarantees for payment,
performance or both under various commercial contracts into which it enters. Bid
bonds are also sometimes obtained by the Company as security for the Company's
commitment to proceed with a project if it is the successful bidder. Performance
bonds are typically issued for the benefit of the Company's customers as
financial security for the completion or performance by the Company of its
contractual obligations under certain commercial contracts. In the past, the
Company has not incurred significant liabilities or expenses as a result of the
use of these instruments. Approximately $128.5 million of these instruments were
outstanding at June 30, 2003. Based on the Company's experience with respect to
letters of credit, bid bonds and performance bonds, the Company believes the
estimated fair value of the instruments entered into during the first half of
2003 is not material. Accordingly, the Company has not recorded any liabilities
for these instruments as of June 30, 2003.
As part of past acquisitions and divestitures of businesses or assets, the
Company made a variety of warranties and indemnifications to the sellers and
purchasers that are typical for such transactions. The Company only provides
such warranties or indemnifications after considering the economics of the
transaction and the liquidity and credit risk of the other party in the
transaction. Typically, certain of the warranties and the indemnifications
expire after a defined period of time following the transaction, but others may
survive indefinitely. The warranty and indemnification obligations noted above
were grandfathered under the provisions of FIN 45 as they were in effect prior
to December 31, 2002. In addition, the Company has not made any similar warranty
or indemnification obligations during the second quarter of 2003. Accordingly,
the Company has not recorded any liabilities for these obligations as of June
30, 2003.
Warranty Obligations
- --------------------
The Company's products generally include warranty obligations and the related
estimated costs are included in cost of sales when revenue is recognized. While
the Company engages in extensive product quality programs and processes, the
Company's estimated costs to satisfy its warranty obligations are based upon
historical product failure rates and the costs incurred in correcting such
product failures. If actual product failure rates or the costs associated with
fixing such product failures differ from historical rates, adjustments to the
warranty obligations may be required in the period in which determined. The
changes in accrued warranty obligations for the six months ended June 30, 2003
are as follows:
(Amounts in thousands)
For the six months ended
June 30,
2003
-------------
Balance at December 31, 2002 $ 1,067
Accruals for warranties issued during the period 461
Accruals related to pre-existing warranties 78
Settlements made (in cash or in kind) during the period (511)
-------------
Balance at June 30, 2003 $ 1,095
=============
7. Earnings Per Share (EPS)
The effect of dilutive stock options excludes those stock options for which the
impact was antidilutive based on the exercise price of the options. The number
of options that were antidilutive for the three and six months ended June 30,
2002 were 1,409,767 and 635,250, respectively. All options outstanding are
antidilutive for the three and six months ended June 30, 2003 based on the
Company's net loss.
(Amounts in thousands, except per share amounts)
For the three months ended June 30,
----------------------------------------------------------------------------------------------
2003 2002
(as restated)
---------------------------------------------- --------------------------------------------
Net Per Share Net Per Share
(Loss) income Shares Amount Income Shares Amount
------------------------------ ------------ ------------ ------------- -------------
Basic EPS
Income available to
common stockholders $ (4,924) 17,564 $ (0.28) $ 1,245 17,547 $ 0.07
Effect of dilutive
stock options - - - - 160 -
-------------- ------------ ------------ ------------ ------------- -------------
Diluted EPS $ (4,924) 17,564 $ (0.28) $ 1,245 17,707 $ 0.07
============== ============ ============ ============ ============= =============
Page -11-
For the six months ended June 30,
----------------------------------------------------------------------------------------------
2003 2002
(as restated)
---------------------------------------------- --------------------------------------------
Net Per Share Net Per Share
Income Shares Amount Income Shares Amount
-------------- ------------ ------------ ------------ ------------- -------------
Basic EPS
Income available to
common stockholders $ (4,348) 17,559 $ (0.25) $ 2,744 17,528 $ 0.16
Effect of dilutive
stock options - - - - 214 (0.01)
-------------- ------------ ------------ ------------ ------------- -------------
Diluted EPS $ (4,348) 17,559 $ (0.25) $ 2,744 17,742 $ 0.15
============== ============ ============ ============ ============= =============
8. Comprehensive Income (Loss)
The Company has adopted SFAS No. 130, "Reporting Comprehensive Income," which
establishes standards for the reporting and display of comprehensive income and
its components. The table below sets forth comprehensive income (loss) as
defined by SFAS No. 130 for the three- and six-month periods ended June 30, 2003
and 2002.
(Amounts in thousands)
Three months ended Six months ended
June 30, June 30,
------------------------------- ------------------------------
2003 2002 2003 2002
(as restated) (as restated)
------------- --------------- ------------- ------------
Net (loss) income $ (4,924) $ 1,245 $ (4,348) $ 2,744
Other comprehensive income,
net of tax:
Change in value of foreign exchange
contracts designated as cash flow hedges 187 - 571 -
Translation adjustments 5,998 7,056 7,008 4,476
------------- ------------ ------------- ------------
Comprehensive income $ 1,261 $ 8,301 $ 3,231 $ 7,220
============= ============ ============= ============
9. Segment Information
The Company has four reportable segments corresponding to a "business group"
structure. The following table summarizes the Company's operations by the four
business group segments and "Corporate." Corporate includes legal and research
and development expenses not allocated to the business groups, certain corporate
administrative and insurance costs, foreign exchange gains and losses on
corporate assets, as well as the elimination of intersegment transfers.
For the three months ended June 30, 2003
------------------------------------------------------------
Equipment Ultrapure Consumer Instrument
Business Water Water Business
Group Group Group Group Corporate Total
--------- --------- --------- ---------- -------------------
(Amounts in thousands)
Revenue - unaffiliated $ 37,430 $ 23,615 $ 10,006 $ 6,879 $ - $ 77,930
Revenue - affiliated 12,886 - 75 45 - 13,006
Inter-segment transfers 1,960 328 - 678 (2,966) -
Gross profit - unaffiliated 8,876 5,537 3,253 3,869 - 21,535
Gross profit - affiliated 1,773 - 45 22 - 1,840
Impairment of long-lived assets - - 3,981 - - 3,981
Equity (loss) income (2,859) - 217 - (100) (2,742)
(Loss) income before interest, tax
and minority interest (954) (543) (4,745) 301 (2,188) (8,129)
Interest income 755
Interest expense (264)
(Loss) before income taxes
and minority interest (7,638)
Page -12-
For the three months ended June 30, 2002 (as restated)
------------------------------------------------------------
Equipment Ultrapure Consumer Instrument
Business Water Water Business
Group Group Group Group Corporate Total
--------- --------- --------- ---------- -------------------
(Amounts in thousands)
Revenue - unaffiliated $ 35,944 $ 25,440 $ 8,726 $ 6,810 $ - $ 76,920
Revenue - affiliated 2,575 - 2 - - 2,577
Inter-segment transfers 1,658 163 - 635 (2,456) -
Gross profit - unaffiliated 9,365 6,827 3,852 4,226 - 24,270
Gross profit - affiliated 297 - 1 - - 298
Equity income (loss) 689 9 265 - (181) 782
Income (loss) before interest, tax
and minority interest 2,578 642 (1,314) 1,237 (932) 2,211
Interest income 868
Interest expense (376)
Income before income taxes
and minority interest 2,703
For the six months ended June 30, 2003
------------------------------------------------------------
Equipment Ultrapure Consumer Instrument
Business Water Water Business
Group Group Group Group Corporate Total
--------- --------- --------- -------- --------- ------
(Amounts in thousands)
Revenue - unaffiliated $ 70,114 $ 48,864 $ 20,821 $ 14,559 $ - $ 154,358
Revenue - affiliated 24,612 - 92 79 24,783
Inter-segment transfers 3,945 717 4 1,113 (5,779) -
Gross profit - unaffiliated 18,097 11,998 6,553 8,436 - 45,084
Gross profit - affiliated 3,306 - 54 40 - 3,400
Impairment of long-lived assets - - 3,981 - - 3,981
Equity (loss) income (2,937) - 398 - (304) (2,843)
Income (loss) before interest, tax
and minority interest 936 (177) (5,091) 1,579 (4,692) (7,445)
Interest income 1,542
Interest expense (487)
(Loss) before income taxes
and minority interest (6,390)
Identifiable assets 335,586 138,629 97,664 32,760 (14,804) 589,835
Investments in affiliated companies 14,632 - 2,452 - 1,994 19,078
Goodwill 11,780 7,758 944 - - 20,482
Other intangible assets 1,072 670 63 309 - 2,114
For the six months ended June 30, 2002 (as restated)
------------------------------------------------------------
Equipment Ultrapure Consumer Instrument
Business Water Water Business
Group Group Group Group Corporate Total
--------- --------- --------- ---------- -------------------
(Amounts in thousands)
Revenue - unaffiliated $ 70,992 $ 50,185 $ 19,279 $ 13,354 $ - $ 153,810
Revenue - affiliated 5,690 - 2 - - 5,692
Inter-segment transfers 3,552 311 - 1,112 (4,975) -
Gross profit - unaffiliated 18,816 12,574 7,575 8,017 - 46,982
Gross profit - affiliated 375 - 1 - - 376
Equity income (loss) 1,345 7 503 - (181) 1,674
Income (loss) before interest, tax
and minority interest 4,323 (716) (2,747) 2,014 1,543 4,417
Interest income 1,861
Interest expense (936)
Income before income taxes
and minority interest 5,342
Page -13-
10. Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No.
143, "Accounting for Obligations Associated with the Retirement of Long-Lived
Assets." SFAS No. 143 provides the accounting requirements for retirement
obligations associated with tangible long-lived assets. SFAS No. 143 is
effective for financial statements for fiscal years beginning after June 15,
2002. The adoption of SFAS No. 143 did not have a material impact on the
Company's financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." SFAS No. 146 requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan and nullifies
Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring.)" SFAS No. 146 is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. This standard has had no material impact through June 30, 2003 as the
Company has not enacted any exit or disposal activity to date.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure" which amended SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. It also amends the disclosure
provisions to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. The provisions of SFAS No. 148 are to be applied to
financial statements for fiscal years ending after December 15, 2002. The
adoption of SFAS No. 148 did not have an impact on the Company's financial
position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51" (FIN 46). This
interpretation addresses the consolidation of certain variable interest entities
(VIEs) for which a controlling financial interest exists. FIN 46 applies
immediately to financial interests obtained in VIEs after January 31, 2003. It
applies in the first fiscal year or interim period beginning after June 15,
2003, to VIEs in which a financial interest was obtained before February 1,
2003. FIN 46 may be applied prospectively with a cumulative-effect adjustment or
by restating previously issued financial statements with a cumulative-effect
adjustment as of the beginning of the first year restated. The Company has a
financial interest in certain entities that may be considered VIEs under FIN 46.
The Company is currently evaluating the impact of FIN 46 on its Investments in
Affiliated Companies, and if the Company determines that it has a controlling
financial interest in any of these entities, consolidation may be required. The
ultimate effect of adopting FIN 46 on the Company's financial position or
results of operations has not yet been determined.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies the accounting guidance on (1) derivative instruments, including
certain derivative instruments embedded in other contracts, and (2) hedging
activities that fall within the scope of SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No. 133
and certain other existing pronouncements to provide for more consistent
reporting of contracts that are derivatives in their entirety or that contain
embedded derivatives that warrant separate accounting. SFAS No. 149 is effective
(1) for contracts entered into or modified after June 30, 2003, with certain
exceptions, and (2) for hedging relationships designated after June 30, 2003.
The guidance is to be applied prospectively. The ultimate effect of adopting
SFAS No. 149 on the Company's financial position or results of operations has
not yet been determined.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity ("SFAS No.150").
This accounting standard establishes standards for classifying and measuring
certain financial instruments with characteristics of both liabilities and
equity. It requires that certain financial instruments that were previously
classified as equity now be classified as a liability. This accounting standard
is effective for financial instruments entered into or modified after May 31,
2003, and otherwise at the beginning of the first interim period beginning after
June 15, 2003. The Company does not believe that there will be any impact to its
financial statement presentation as a result of SFAS No. 150.
Page -14-
In May 2003, the FASB Emerging Issues Task Force finalized Issue No. 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21").
EITF 00-21 addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue-generating activities.
EITF 00-21 establishes three principles: (a) revenue arrangements with multiple
deliverables should be divided into separate units of accounting; (b)
arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values; and (c) revenue recognition
criteria should be considered separately for separate units of accounting. EITF
00-21 is effective for all arrangements entered into in fiscal periods beginning
after June 15, 2003, with early adoption permitted. The Company does not believe
that EITF 00-21 will have a material impact on the Company's financial position
or results of operations.
11. Impairment of Long-Lived Assets
During the second quarter of 2003, the Company recognized asset impairment
charges of approximately $4.0 million attributable to certain sodium
hypochlorite manufacturing equipment within the CWG business segment. As such,
the carrying value of these assets has been reduced to its estimated fair market
value of zero. Following an equipment failure during the second quarter of 2003,
the Company decided not to invest additional capital to repair the equipment and
decided to abandon the manufacturing equipment. The Company began to purchase
sodium hypochlorite from third party vendors during the second quarter of 2003
and will continue to do so in the future as it evaluates strategic alternatives
for the business.
12. Goodwill and Intangible Assets
The Company's intangible assets are included in other assets in the Consolidated
Balance Sheets and consist principally of patents and trademarks. At June 30,
2003 and 2002, the gross carrying value of these intangible assets was
approximately $3.1 million and $2.8 million, respectively, and the accumulated
amortization was $0.9 million and $0.6 million, respectively. The Company's
intangible assets are amortized on a straight-line basis over a period ranging
up to 20 years. Amortization expense for intangible assets is estimated to be
approximately $0.3 million in 2003 through 2005, $0.2 million in 2006 and $0.1
million in 2007. The change in the goodwill balance from December 31, 2002 to
June 30, 2003 was principally due to foreign currency translation adjustments.
13. Derivative Financial Instruments and Hedging Activity
On December 31, 2002, the Company entered into a series of U.S. dollar/euro
forward foreign exchange contracts with the intent of offsetting the foreign
exchange risk associated with the forecasted revenues related to an ongoing
project. At June 30, 2003, the notional amount of outstanding forward foreign
exchange contracts to exchange U.S. dollars for euros, which were designated as
forecasted cash flow hedging instruments, was $11.9 million. The fair values of
the forward contracts, based upon dealer quotations, are recorded as components
of other current assets or other current liabilities, depending upon the amount
of the valuation. At June 30, 2003, the fair value of these forward contracts of
$0.7 million was recorded as a component of other current assets. The net
unrealized gain of $0.6 million on the forward contracts that qualified as
cash-flow hedging instruments was included in accumulated other comprehensive
income. The Company expects these instruments to affect earnings over the next
twenty-one months. To the extent that any portion of the hedge is determined to
be ineffective, the related gain or loss is required to be included in income
currently. For the three months ended June 30, 2003, the Company recognized a
gain of approximately $0.1 million related to the ineffective portion of its
forecasted cash flow hedge.
At June 30, 2003, the Company has also entered into U.S. dollar/Taiwan dollar
foreign forward exchange contracts to hedge the balance sheet exposure related
to an intercompany loan. At June 30, 2003, the notional amount of outstanding
forward contracts to exchange Taiwan dollars for U.S. dollars, which were
designated as fair value hedging instruments, was $1.5 million. The fair values
of these forward contracts, based upon dealer quotations, are recorded as
components of other current assets or current liabilities, depending on the
amount of the valuation. At June 30, 2003, the fair value of these hedging
instruments, which was immaterial, was recorded as a component of other current
assets. The net unrealized gain on the instruments, which was immaterial, was
recorded in income.
Page -15-
At March 31, 2002, the Company's Italian subsidiary had outstanding
U.S.dollar/euro options contracts with a notional amount of $10.5 million. The
contracts were not entered into for trading purposes. In accordance with the
restrictions set forth in SFAS No. 133, the contracts did not qualify for hedge
accounting treatment. The fair value of the contracts of $1.4 million was
recorded as a component of other current liabilities at March 31, 2002. These
options contracts were closed in the second quarter of 2002.
14. Subsequent Event
On July 29, 2003, the Company completed the acquisition of substantially all of
the assets of CoolerSmart LLC ("CoolerSmart"), a limited liability company in
the business of leasing point-of-use "bottleless" water coolers to commercial
customers, primarily in the mid-Atlantic region. The assets acquired included
CoolerSmart's coolers, customer contracts, motor vehicles, accounts receivable,
and other tangible and intangible assets. The Company also assumed certain
CoolerSmart's liabilities incurred in the ordinary course of business. The
Company paid a purchase price of $7.0 million for the assets, subject to
adjustment based on changes from the represented net asset value and number of
active customer accounts.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of the financial condition and results of operations of
the Company should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this Form 10-Q
and the audited consolidated financial statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations included in our Annual Report on Form 10-K for the year ended
December 31, 2002, which has been filed with the Securities and Exchange
Commission.
The Company's critical accounting policies and estimates remain as described in
the Annual Report on Form 10-K for the year ended December 31, 2002. These
policies and estimates include the following clarification of the Company's
accounting for its equity method income and loss on its equity investment in
Desalination Company of Trinidad and Tobago Ltd. ("Desalcott"). With respect to
the Company's investment in Desalcott, in recognition of the fact that the
Company has provided all of the cash equity funding for Desalcott, the Company
has concluded that it would not be appropriate to recognize equity method losses
based solely on its ownership interest in Desalcott. The Company holds 200
ordinary shares of Desalcott, representing a 40% ownership interest. The Company
also loaned $10 million to Hafeez Karamath Engineering Services, Ltd. ("HKES"),
the founder of Desalcott and promoter of the Trinidad desalination project, to
enable HKES to acquire 200 ordinary shares of Desalcott and thereby raise its
existing equity interest in Desalcott from 100 to 300 ordinary shares. As a
result, the Company currently owns a 40% equity interest in Desalcott, and HKES
currently owns a 60% equity interest in Desalcott. In addition, the Company
expects to finalize a $10 million loan to Desalcott in the third quarter of
2003 as an additional source of long-term financing. Accordingly, based on its
aggregate economic interests in Desalcott, the Company records 100% of any net
loss reported by Desalcott and 40% of any net income reported by Desalcott. In
periods in which Desalcott has an accumulated loss (as opposed to retained
earnings), the Company records 100% of any net income of Desalcott up to the
amount of Desalcott's accumulated loss, and 40% of any net income reported
thereafter by Desalcott.
The following discussion and analysis describes material changes in the
Company's financial condition since December 31, 2002. The analysis of results
of operations compares the three- and six-month periods ended June 30, 2003 with
the comparable periods of the prior fiscal year.
Overview
The Company is a leading water purification company engaged worldwide in the
supply of water and related activities and the supply of water treatment
equipment through the use of proprietary separations technologies and systems.
The Company's products and services are used by the Company or its customers to
desalt brackish water and seawater, recycle and reclaim process water and
wastewater, to treat water in the home, to manufacture and supply water
treatment chemicals and ultrapure water, to process food products, and to
measure levels of waterborne contaminants and pollutants. The Company's
customers include industrial companies, consumers, municipalities and other
Page -16-
governmental entities and utilities. The following discussion and analysis of
financial condition and results of operations refers to the activities of the
Company's four business groups, which comprise the Company's reportable
operating segments. These groups are the Equipment Business Group (EBG),
Ultrapure Water Group (UWG), Consumer Water Group (CWG) and Instrument Business
Group (IBG). Within the existing business group structure, the Company has
instituted a matrix-type organization which became effective at the beginning of
2002. Within each business group, the Company has begun to focus on "centers of
excellence," which represent the application of treatment or separation
technologies contained in The Ionics Toolbox(R) to solve certain application
problems. These centers of excellence include desalination, reuse, surface
water, microelectronics, pharmaceuticals and instruments, among others, and each
represents a range of technology solutions to solve a related applications
problem. The Company utilizes its water treatment and liquids separation
expertise by employing its own proprietary products and other commodity products
in the best integrated combination to solve customers' application problems.
The EBG segment provides products and services for seawater and brackish water
desalination, water reuse and recycle, surface water treatment, and zero liquid
discharge. Significant factors influencing the desalination market include
worldwide water shortages, the need for better quality water in many parts of
the world, and the reduced cost of operating modern desalination facilities.
These factors have driven a trend toward larger plants, and toward the purchase
of water supply and operating and maintenance contracts. Trends impacting the
water reuse and recycle market are similar, with membrane technology becoming
proven in reuse and recycling applications. The surface water market has been
influenced primarily by regulatory pressures to reduce contaminants in water
supplies. The use of membrane technology is also becoming more accepted in
surface water applications. The zero liquid discharge market, which consists of
equipment and services for the minimization of liquid waste through such
techniques as evaporation, concentration and crystallization, has been
influenced by regulatory pressures on utilities to eliminate discharge of
process water. The Company believes that it is positioned to be able to compete
successfully in these applications, although it frequently faces substantially
larger competitors.
The UWG segment provides equipment and services for the microelectronics, power,
pharmaceutical, and other industries, where high quality ultrapure (i.e. very
highly purified) water is required for use in production processes, and is
critical to ultimate product quality and yield. The UWG segment has historically
been heavily reliant upon the microelectronics industry, and the continued
softness in that industry has adversely impacted both revenue and profitability.
The UWG segment has been pursuing applications in other markets, such as power,
pharmaceuticals and flat panel display, to lessen its reliance upon the
microelectronics market. The UWG segment has recently begun to engage in water
reuse projects for industrial applications.
The CWG segment provides home water units for the treatment of residential
water. In July 2003, the CWG segment significantly expanded its pilot activities
in the point-of-use "bottleless" water cooler market through an acquisition (see
Note 14 to Notes to Consolidated Financial Statements). Prior to the divestiture
of the Aqua Cool Pure Bottled Water business in the U.S., U.K. and France on
December 31, 2001, it was also engaged in the home and office delivery market
for bottled water. The CWG segment also produces bleach-based cleaning products
and automobile windshield wash solution. Trends in the consumer water market
include increased consumer awareness of and the need for improved water quality,
and reduced confidence in the quality of existing water supplies.
The IBG segment manufactures and sells instruments and related products for the
measurement of impurities in water. The segment serves the pharmaceutical,
microelectronics and power markets where the measurement of water quality,
including levels and types of contaminants in process water, is critical to
production processes. The IBG segment has established a strong position in the
pharmaceutical industry, providing products and services that facilitate
compliance with both domestic and foreign regulatory requirements. Like the UWG
segment, the performance of the IBG segment has been impacted by the downturn in
the microelectronics industry, although to a lesser extent than the UWG segment.
The EBG and UWG segments have historically supplied equipment and related
membranes. Starting in the mid-1980's, these groups also began to own and
operate facilities that sell desalted or otherwise treated water directly to
customers under water supply agreements. The revenues and cost of sales
associated with equipment sales are recorded in the revenue and cost of sales
lines on the Company's Consolidated Statement of Operations in the periods in
which the revenues are realized. Equipment contracts are generally accounted for
under the percentage completion accounting method, and the period of time over
which costs are incurred and revenues are realized may vary between six months
and two years, depending on the nature and amount of equipment being supplied.
For water supply agreements, with respect to smaller projects, of which the
Company is the sole owner, the initial cost of the equipment becomes part of the
Company's depreciable fixed asset base, and the revenues and cost of sales
recorded by the Company are those that are associated with the supply of water
under the water supply agreement. These contracts typically vary in length
between 5 and 15 years.
Page -17-
The EBG segment pursues large-scale, long-term water treatment projects,
typically through joint venture project companies in which the Company will hold
a minority ownership interest. Such project companies are formed to own and
operate larger scale desalination, reuse, or other projects in which the Company
may participate in several ways, including: having an ownership interest
(typically a minority interest) in the project company; selling the
desalination, reuse, or other treatment system to the project company; and
providing operating and maintenance services to the project company once the
project facility commences operations. These projects often exceed $100 million
in total cost and may involve multiple equity participants in the project
company. The Company's participation in major projects through a minority
interest in a project company structure generally mitigates the risks of
engaging in such activities, and also provides the Company with potential
long-term equity income from such investments, because these project companies
typically enter into long-term concession agreements with their customers.
The Company is currently evaluating opportunities for reducing costs, which
could include restructuring operations, consolidating facilities, and
discontinuing or divesting certain operations. As a result, the Company may
incur restructuring and/or impairment charges in the second half of the year,
pending finalization of a plan for such actions and approval of the plan by the
Board of Directors.
Restatement of Quarterly Financial Statements and Reclassifications
The Company's consolidated financial statements for the three and six months
ended June 30, 2002 have been restated primarily as a result of intercompany
transactions, including transactions between the Company and its French
subsidiary that were erroneously recorded at the subsidiary level. See Note 2 to
Notes to Consolidated Financial Statements.
Results of Operations
Comparison of the Three Months Ended June 30, 2003 with the Three Months Ended
- ------------------------------------------------------------------------------
June 30, 2002
- -------------
The Company reported consolidated revenues of $90.9 million and a net loss of
$4.9 million for the second quarter of 2003, compared to consolidated revenues
of $79.5 million and net income of $1.2 million for the second quarter of 2002.
Results for the second quarter of 2002 included the operating results of the
Company's majority-owned subsidiary, Ionics Enersave Engineering Sdn Bhd.
("Enersave"), which was divested in May 2002.
Revenues
- --------
Total Company revenues of $90.9 million for the second quarter of 2003 increased
$11.4 million, or 14.4%, from revenues of $79.5 million for the second quarter
of 2002. Revenues during the second quarter of 2002 included $1.6 million of
revenues from Enersave, which was divested in May 2002.
EBG revenues of $37.4 million in the second quarter of 2003 increased $1.5
million, or 4.1%, compared to revenues of $35.9 million in the second quarter of
2002. The increase in revenues was primarily attributable to EBG's Watertown,
Massachusetts operations relating to sales of capital equipment to several
domestic municipalities for surface water applications as well as the sale of
disinfection products equipment in the Middle East. This increase was partially
offset by lower revenues from the Zero Liquid Discharge ("ZLD") business.
UWG revenues of $23.6 million for the second quarter of 2003 decreased $1.8
million, or 7.2%, compared to revenues of $25.4 million for the second quarter
of 2002. The decrease was primarily attributable to the absence in 2003 of
revenues generated by the Company's Enersave subsidiary, which was divested in
May 2002.
CWG revenues of $10.0 million for the second quarter of 2003 increased $1.3
million, or 14.7%, compared to revenues of $8.7 million for the second quarter
of 2003. Revenue associated with CWG's automobile windshield wash solution and
consumer bleach products increased due to increased volume, primarily as a
result of the addition of several new customers. The increase in sales of
consumer chemical products was offset by lower demand for home water treatment
equipment as a result of economic conditions in the U.S.
IBG revenues of $6.9 million in the second quarter of 2003 increased $0.1
million, or 1.0%, compared to revenues of $6.8 million in the second quarter of
2002.
Revenues from sales to affiliated companies of $13.0 million in the second
quarter of 2003 increased $10.4 million compared to revenues from affiliated
companies of $2.6 million in the second quarter of 2002. The increase in
revenues from affiliated companies primarily results from the sale of capital
equipment to the Company's Kuwait joint venture company, Utilities Development
Company W.L.L. ("UDC"), for the Kuwait wastewater treatment project.
Page -18-
The Company has entered into a number of large contracts, which are generally
categorized as either "equipment sale" contracts or "build, own and operate"
(BOO) contracts. The Company believes that the remaining duration on its
existing sale of equipment contracts ranges from less than one year to three
years and the remaining duration on its existing BOO contracts ranges from one
year to 25 years. The time to completion of any of these contracts, however, is
subject to a number of variables, including the nature and provisions of the
contract and the industry being served. Historically, as contracts are
completed, the Company has entered into new contracts with the same or other
customers. In the past, the completion of any one particular contract has not
had a material effect on the Company's business, results of operations or cash
flows.
Cost of Sales
- -------------
The Company's total cost of sales as a percentage of total revenue was 74.3% in
the second quarter of 2003 compared to cost of sales as a percentage of total
revenue of 69.1% for the second quarter of 2002. Accordingly, the resulting
gross margin decreased to 25.7% in the second quarter of 2003 compared to 30.9%
in the second quarter of 2002. Cost of sales as a percentage of total revenue
increased in the second quarter of 2003 compared to the second quarter of 2002
for all four of the Company's business segments.
EBG's cost of sales as a percentage of revenue increased to 76.3% in the second
quarter of 2003 from 73.9% in the second quarter of 2002. The increase in cost
of sales as a percentage of revenue related primarily to cost overruns
associated with several projects as well as costs associated with contract
disputes concerning two completed ZLD projects.
UWG's cost of sales as a percentage of revenue increased to 76.6% in the second
quarter of 2003 from 73.2% in the second quarter of 2002. The increase in cost
of sales as a percentage of revenue primarily reflects cost overruns on several
domestic projects.
CWG's cost of sales as a percentage of revenue increased to 67.5% in the second
quarter of 2003 from 55.9% in the second quarter of 2002. The increase in the
2003 cost of sales as a percentage of revenue compared to the 2002 figure was
primarily attributable to higher costs in the consumer bleach product line as a
result of a production equipment failure, which required the Company to purchase
sodium hypochlorite from third-party vendors. In addition, the Company recorded
a $4.0 million impairment of long lived assets as a result of its decision to
abandon the equipment during the second quarter of 2003. The Company will
continue to purchase sodium hypochlorite from third-party vendors as it
evaluates strategic alternatives for this business.
IBG's cost of sales as a percentage of revenue increased to 43.8% in the second
quarter of 2003 from 37.9% in the second quarter of 2002, primarily as a result
of a shift in instrument product mix towards lower margin instrument lines.
Cost of sales to affiliated companies as a percentage of revenue decreased to
85.9% in the second quarter of 2003 from 88.4% in the second quarter of 2002.
The decrease in the second quarter of 2003 was primarily due to lower revenues
from sales to the Company's affiliate, Desalination Company of Trinidad and
Tobago Ltd. ("Desalcott"). All intercompany profit on sales to Desalcott has
been deferred. The decrease in costs of sales as a percentage of revenues was
also due to the increase in equipment sales to UDC, for which the Company defers
intercompany profit equal to its 25% equity ownership in UDC.
Operating Expenses
- ------------------
Research and development expenses as a percentage of revenue increased slightly
during the second quarter of 2003 compared to the second quarter of 2002. The
Company currently expects to continue to invest in new products and technologies
at approximately the same level as in prior quarters.
Selling, general and administrative expenses increased $1.3 million to $22.8
million in the second quarter of 2003 from $21.5 million in the second quarter
of 2002. The increase in selling, general and administrative costs in the second
quarter of 2003 compared to the second quarter of 2002 was primarily
attributable to increased pension costs due to plan amendments and changes in
plan assumptions, increased professional services fees, and increased insurance
costs.
Page -19-
Impairment of Long-Lived Assets
- -------------------------------
During the second quarter of 2003, the Company made a decision to abandon
production equipment within the CWG segment that it had previously utilized to
manufacture sodium hypochlorite. Accordingly, during the second quarter of 2003,
the Company recorded a pre-tax asset impairment charge of approximately $4.0
million and began purchasing sodium hypochlorite from third-party vendors.
Interest Income and Interest Expense
- ------------------------------------
Interest income totaled $0.8 million in the second quarter of 2003 compared to
$0.9 million in the second quarter 2002. Interest expense was $0.3 million in
the second quarter of 2003 compared to $0.4 million in the second quarter of
2002.
Equity (Loss) Income
- --------------------
Equity losses in affiliated companies amounted to $2.7 million in the second
quarter of 2003 compared to equity income in the second quarter of 2002 of $0.8
million. The Company's equity income is derived primarily from its 20% equity
interest in a Mexican joint venture company, its 40% equity interest in
Desalcott, its equity interests in several joint ventures in the Middle East,
and to a lesser extent from its other equity investments in affiliated
companies. The decrease in equity income of $3.5 million in the second quarter
of 2003 compared to the second quarter of 2002 was primarily related to
increased losses reported by Desalcott. Desalcott's loss reported during the
quarter included management fees and costs associated with the closing of
long-term financing and the settlement of the construction contract dispute,
income tax expense, as well as development costs associated with investigating
potential new projects in Trinidad.
Income Tax (Benefit) Expense
- ----------------------------
For the three months ended June 30, 2003, the Company recorded income tax
benefit of $2.9 million on a consolidated pre-tax loss before minority interest
expense of $7.6 million, yielding an effective tax rate of 38%. For the three
months ended June 30, 2002, the Company recorded income tax expense of $1.3
million on consolidated pre-tax income before minority interest of $2.7 million,
yielding an effective tax rate of 48%. The change in the effective tax rate for
the quarter ended June 30, 2003 compared to the quarter ended June 30, 2002
resulted from changes in the overall level of consolidated pre-tax profit and
the geographic mix of expected losses in several foreign subsidiaries, primarily
France, for which the Company may not be able to realize future tax benefits.
Net (Loss) Income
- -----------------
The Company's net loss amounted to $4.9 million in the second quarter of 2003
compared to net income of $1.2 million for the second quarter of 2002.
Comparison of the Six Months Ended June 30, 2003 with the Six Months Ended
- --------------------------------------------------------------------------
June 30, 2002
- -------------
The Company reported consolidated revenues of $179.1 million and a net loss of
$4.3 million for the first six months of 2003 compared to consolidated revenues
of $159.5 million and net income of $2.7 million for the first six months of
2002. Results for the Company's majority-owned Malaysian subsidiary, Enersave,
are included in the results for 2002 through the date the subsidiary was
divested of in May 2002.
Revenues
- --------
Total Company revenues of $179.1 million for the first six months of 2003
increased $19.6 million, or 12.3%, from revenues of $159.5 million for the first
six months of 2002. Revenues during the first six months of 2002 included $4.2
million of revenues from the Company's majority owned subsidiary, Enersave,
which was divested in May 2002.
EBG revenues of $70.1 million for the first six months of 2003 decreased $0.9
million, or 1.2%, compared to revenues of $71.0 million for the first six months
of 2002. The decrease in revenues was primarily attributable to reduced revenues
from the ZLD business. This decrease was partially offset by new sales of
capital equipment to several municipalities for surface water applications.
UWG revenues of $48.9 million for the first six months of 2003 decreased $1.3
million, or 2.6%, compared to revenues of $50.2 million for the first six months
of 2002. The decrease in revenues was primarily attributable to the absence of
revenues from the Company's Enersave subsidiary, which was divested in May 2002,
partially offset by the growth in UWG's operations in Asia and Australia.
Page -20-
CWG revenues of $20.8 million for the first six months of 2003 increased $1.5
million, or 8.0%, compared to revenues of $19.3 million for the first six months
of 2002. Revenues associated with CWG's automobile windshield wash solution
increased as a result of a severe winter in the Northeast, and consumer chemical
product revenues also increased due to increased volume, primarily as a result
of the addition of several new customers. The increase in sales of consumer
chemical products was offset by lower demand for the home water treatment
equipment as a result of economic conditions in the U.S.
IBG revenues of $14.6 million for the first six months of 2003 increased $1.2
million, or 9.0%, compared to revenues of $13.4 million for the first six months
of 2002. The increase in revenues primarily results from increased sales to the
pharmaceutical industry as well as continued growth in sales of consumable
products and instrument services.
Revenues from sales to affiliated companies of $24.8 million for the first six
months of 2003 increased $19.1 million compared to revenues from affiliated
companies of $5.7 million for the first six months of 2002. The increase in
revenues from affiliated companies primarily results from the sale of capital
equipment to the Company's Kuwait joint venture company, UDC, for the Kuwait
wastewater treatment project.
The Company has entered into a number of large contracts, which are generally
categorized as either "equipment sale" contracts or "build, own and operate"
(BOO) contracts. The Company believes that the remaining duration on its
existing sale of equipment contracts ranges from less than one year to three
years and the remaining duration on its existing BOO contracts ranges from one
year to 25 years. The time to completion of any of these contracts, however, is
subject to a number of variables, including the nature and provisions of the
contract and the industry being served. Historically, as contracts are
completed, the Company has entered into new contracts with the same or other
customers. In the past, the completion of any one particular contract has not
had a material effect on the Company's business, results of operations or cash
flows.
Cost of Sales
- -------------
The Company's total cost of sales as a percentage of total revenue was 72.9% for
the first six months of 2003 compared to cost of sales as a percentage of total
revenue of 70.3% for the first six months of 2002. Accordingly, total gross
margin decreased to 27.1% for the first six months of 2003 compared to 29.7% for
the first six months of 2002. Cost of sales as a percentage of total revenue
increased for the first six months of 2003 compared to the first six months of
2002 for all four of the Company's business segments.
EBG's cost of sales as a percentage of revenue increased to 74.2% for the first
six months of 2003 from 73.5% for the first six months of 2002. The increase in
cost of sales as a percentage of revenue relates primarily to cost overruns
associated with several projects as well as legal costs associated with contract
disputes concerning two completed ZLD projects, offset by the reduction of
losses incurred by the Company's French subsidiary.
UWG's cost of sales as a percentage of revenue increased to 75.4% for the first
six months of 2003 from 74.9% for the first six months of 2002. The increase in
cost of sales as a percentage of revenue primarily reflected cost overruns on
several domestic projects.
CWG's cost of sales as a percentage of revenue increased to 68.5% for the first
six months of 2003 from 60.7% for the first six months of 2002. The increase in
the 2003 cost of sales as a percentage of revenue compared to the 2002 figure
was primarily attributable to higher costs in the consumer bleach product line
as a result of a production equipment failure, which required the Company to
purchase sodium hypochlorite from third-party vendors. In addition, the Company
recorded a $4.0 million impairment of long-lived assets as a result of its
decision to abandon the equipment during the second quarter of 2003. The Company
will continue to purchase sodium hypochlorite from third-party vendors as it
evaluates strategic alternatives for this business.
IBG's cost of sales as a percentage of revenue increased to 42.1% for the first
six months of 2003 from 40.0% for the first six months of 2002. The increase in
cost of sales as a percentage of revenue was primarily associated with the
expansion of the field service force and expanded production capacity for
consumable products.
Cost of sales to affiliated companies as a percentage of revenue decreased to
86.3% for the first six months of 2003 from 93.4% for the first six months of
2002. The decrease in the cost of sales for the first six months of 2003 was
primarily due to lower revenues from sales to Desalcott. All intercompany profit
on sales to Desalcott has been deferred. The decrease in costs of sales as a
percentage of revenues was also due to the increase in equipment sales to UDC,
for which the Company defers intercompany profit equal to its 25% equity
ownership in UDC.
Page -21-
Operating Expenses
- ------------------
Research and development expenses as a percentage of revenue increased slightly
during the first six months of 2003 compared to the first six months of 2002.
The Company currently expects to continue to invest in new products and
technologies at approximately the same level as in prior quarters.
Selling, general and administrative expenses increased $4.0 million to $45.4
million for the first six months of 2003 from $41.4 million for the first six
months of 2002. The increase in selling, general and administrative costs for
the first six months of 2003 was primarily attributable to post-retirement
obligations incurred in connection with the announced retirement of the
Company's former Chief Executive Officer, increased pension costs due to plan
amendments and changes in plan assumptions, increased professional services
fees, and increased insurance costs.
Impairment of Long-Lived Assets
- -------------------------------
During the second quarter of 2003, the Company made a decision to abandon
production equipment within the CWG segment that it had previously utilized to
manufacture sodium hypochlorite. Accordingly, during the second quarter of 2003,
the Company recorded a pre-tax asset impairment charge of approximately $4.0
million and began purchasing sodium hypochlorite from third-party vendors.
Interest Income and Interest Expense
- ------------------------------------
Interest income totaled $1.5 million for the first six months of 2003 compared
to $1.9 million for the first six months of 2002. Interest expense was $0.5
million for the first six months of 2003 compared to $0.9 million for the first
six months of 2002.
Equity (Loss) Income
- --------------------
Equity losses in affiliated companies amounted to $2.8 million for the first six
months of 2003 compared to equity income of $1.7 million for the first six
months of 2002. The Company's equity income is derived primarily from its 20%
equity interest in a Mexican joint venture company, its 40% equity interest in
Desalcott, its equity interests in several joint ventures in the Middle East,
and to a lesser extent from its other equity investments in affiliated
companies. The decrease in equity income of $4.5 million for the first six
months of 2003 compared to the first six months of 2002 was primarily related to
increased losses reported by Desalcott. Desalcott's losses were primarily a
result of management fees and costs associated with the close of long-term
financing and the settlement of the construction contract dispute, as well as
development costs associated with investigating potential new projects in
Trinidad.
Income Tax (Benefit) Expense
- ----------------------------
For the six months ended June 30, 2003, the Company recorded income tax benefit
of $2.4 million on a consolidated pre-tax loss before minority interest expense
of $6.4 million, yielding an annual effective tax rate of 38%. For the six
months ended June 30, 2002, the Company recorded income tax expense of $2.2
million on consolidated pre-tax income before minority interest of $5.3 million,
yielding an annual effective tax rate of 40.7%. The change in the effective tax
rate for the six months ended June 30, 2003 compared to the six months ended
June 30, 2002 resulted from changes in the overall level of consolidated pre-tax
profit and the geographic mix of expected losses in several foreign subsidiaries
for which the Company may not be able to realize future tax benefits.
Net (Loss) Income
- -----------------
The Company's net loss amounted to $4.3 million for the first six months of
2003, compared to net income of $2.7 million for the first six months of 2002.
Financial Condition
Net working capital increased $3.4 million during the first six months of 2003,
while the Company's current ratio of 3.0 at June 30, 2003 increased from 2.9 at
December 31, 2002.
At June 30, 2003, the Company had total assets of $608.9 million, compared to
total assets of $608.0 million at December 31, 2002. Cash, cash equivalents and
restricted cash decreased $13.3 million during the first six months of 2003,
primarily reflecting payments of current accounts payable and funding
requirements of the Kuwait wastewater project. At December 31, 2002, the Company
had $4.3 million in restricted cash, reflecting advance payments for work to be
performed on the Kuwait wastewater treatment facility, the restrictions on which
expired during the first quarter of 2003.
Page -22-
Net cash used by operating activities amounted to $6.8 million during the first
six months of 2003. The primary uses of operating cash flow during the first six
months of 2003 reflect a net increase in affiliate accounts receivable,
primarily from continuing work on the Kuwait wastewater project, as well as
equity loans made to UDC. Additionally, operating cash was used for reduction of
accounts payable and accrued expenses, offset by non-cash charges for
depreciation and impairment of long-lived assets, and a reduction of accounts
receivable. In July 2003, the Company utilized $7.0 million in cash to purchase
substantially all the assets of CoolerSmart LLC., a limited liability company in
the business of leasing point-of-use "bottleless" water coolers.
Net cash used in investing activities amounted to $12.0 million during the first
six months of 2003, reflected additions to property, plant and equipment,
primarily related to investments made in the UWG segment for a build, own, and
operate facility in the power industry. The Company currently expects to invest
a similar amount in property, plant and equipment during the last six months of
2003.
Net cash provided by financing activities totaled $5.3 million during the first
six months of 2003, primarily reflecting the expiration of the restriction on
the use of cash which existed at December 31, 2002.
Other Commitments and Contingencies
- -----------------------------------
From time to time, the Company enters into joint ventures with respect to
specific projects, including the projects in Trinidad, Kuwait and Israel
described below. Each joint venture arrangement is independently negotiated
based on the specific facts and circumstances of the project, the purpose of the
joint venture company related to the project, as well as the rights and
obligations of the other joint venture partners. Generally, the Company has
structured its project joint ventures so that the Company's obligation to
provide funding to the underlying project or to the joint venture entity is
limited to its proportional capital contribution, which can take the form of
equity or subordinated debt. Except in situations that are negotiated with a
specific joint venture entity as discussed below, the Company has no other
commitment to provide for the joint venture's working capital or other cash
needs. In addition, the joint venture entity typically obtains third-party debt
financing for a substantial portion of the project's total capital requirements.
In these situations, the Company is typically not responsible for the repayment
of the indebtedness incurred by the joint venture entity. In connection with
certain joint venture projects, the Company may also enter into contracts for
the supply and installation of the Company's equipment during the construction
of the project, for the operation and maintenance of the facility once it begins
operation, or both. These commercial arrangements do not require the Company to
commit to any funding for working capital or any other requirements of the joint
venture company. As a result, the Company's exposure with respect to its joint
ventures is typically limited to its debt and equity investments in the joint
venture entity, the fulfillment of any contractual obligations it has to the
joint venture entity and the accounts receivable owing to the Company from the
joint venture entity.
Trinidad
- --------
In 2000, the Company acquired 200 ordinary shares of Desalination Company of
Trinidad and Tobago Ltd. ("Desalcott") for $10 million and loaned $10 million to
Hafeez Karamath Engineering Services Ltd. ("HKES"), the founder of Desalcott and
promoter of the Trinidad desalination project, to enable HKES to acquire an
additional 200 ordinary shares of Desalcott. Prior to those investments, HKES
owned 100 ordinary shares of Desalcott. As a result, the Company currently owns
a 40% equity interest in Desalcott, and HKES currently owns a 60% equity
interest in Desalcott. In the second quarter of 2002, construction was completed
on the first four (out of five) phases of the Trinidad desalination facility
owned by Desalcott, and the facility commenced water deliveries to its customer,
the Water and Sewerage Authority of Trinidad and Tobago.
The Company's $10 million loan to HKES is included in notes receivable,
long-term in the Company's Consolidated Balance Sheets. The loan bears interest
at a rate equal to 2% above the London Interbank Offered Rate (LIBOR), with
interest payable (subject to availability of funds) starting October 25, 2002
and every six months thereafter and at maturity. Prior to maturity, accrued
interest (as well as principal payments) is payable only to the extent dividends
or other distributions are paid by Desalcott on the ordinary shares of Desalcott
owned by HKES and pledged to the Company. Principal repayment is due in 14 equal
installments commencing on April 25, 2004 and continuing semiannually
thereafter. The loan matures and is payable in full on April 25, 2011. The loan
is secured by a security interest in the shares of Desalcott owned by HKES and
purchased with the borrowed funds, which is subordinate to the security interest
in those shares in favor of the Trinidad bank that provided the financing for
Desalcott. In addition, any dividends or other distributions paid by Desalcott
to HKES on the pledged shares must be applied to loan payments to the Company.
Page -23-
In 2000, Desalcott entered into a "bridge loan" agreement with a Trinidad bank
providing $60 million in construction financing. Effective November 8, 2001, the
loan agreement was amended to increase maximum borrowings to $79.9 million. The
bridge loan of $79.9 million and the $20 million equity provided to Desalcott
did not provide sufficient funds to pay all of Desalcott's obligations in
completing construction and commissioning of the project prior to receipt of
long-term financing in the second quarter of 2003. Consequently, included in
Desalcott's obligations at March 31, 2003 was approximately $30.1 million
payable to the Company's Trinidad subsidiary for equipment and services
purchased in connection with the construction of the facility. However,
Desalcott had disputed certain amounts payable under the construction contract,
and the parties made their dispute subject to the dispute resolution procedures
of the contract.
In June 2003, Desalcott and the Company's Trinidad subsidiary resolved certain
disputes under the construction contract, and reached agreement as to the final
amount owing to the Company for completion of the first four phases of the
project. As a result of this agreement, the Company will not realize
approximately $2.7 million of the deferred profit on the construction project,
and therefore reduced the related accounts receivable and deferred revenue
balances by $2.7 million each. In June 2003, Desalcott entered into a long-term
loan agreement with the Trinidad bank that had provided the bridge loan. In
connection with the funding of the loan, Desalcott paid the Company's Trinidad
subsidiary approximately $12 million of outstanding accounts receivable under
the construction contract in July 2003. In addition, pursuant to a previous
commitment made by the Company, the Company expects in the third quarter of 2003
to convert an additional $10 million of amounts owing under the construction
contract into a loan to Desalcott as an additional source of long-term project
financing. That loan will have a seven-year term and will be payable in 28
quarterly payments of principal and interest. The interest rate will be fixed at
two percent (2%) above the interest rate payable by Desalcott on the U.S. dollar
portion of its borrowings under its long-term loan agreement with the
Trinidadian bank (the initial annual rate on the U.S. dollar portion was 8
1/2%). In the event of a default by Desalcott, Desalcott's obligations to the
Company will be subordinated to Desalcott's obligations to the Trinidad bank.
As a result of the settlement of the construction contract dispute described
above and Desalcott's $12 million payment to the Company's Trinidad subsidiary,
together with the conversion of an additional $10 million of accounts receivable
into a long-term note receivable as described above, the remaining amount due to
the Company's Trinidad subsidiary from Desalcott for construction work on the
first four phases of the project is approximately $6 million. This amount will
be partially paid out of Desalcott's future cash flow from operations, and the
balance from loan proceeds upon completion by the Company of certain "punch
list" items, over a period of time estimated to be two years. In addition,
Desalcott and the Company agreed that the Company's Trinidad subsidiary would
complete the last phase (phase 5) of the project (which will increase water
production capacity by approximately 9%) for a fixed price of $7.7 million. Work
on phase 5 has commenced and is expected to be completed in the second quarter
of 2004.
Kuwait
- ------
During 2001, the Company acquired a 25% equity interest in a Kuwaiti project
company, Utilities Development Company W.L.L. ("UDC"), which was awarded a
concession agreement by an agency of the Kuwaiti government for the
construction, ownership and operation of a wastewater reuse facility in Kuwait.
During the second quarter of 2002, UDC entered into agreements for the long-term
financing of the project, and construction of the project commenced. At June 30,
2003, the Company had invested a total of $6.7 million as equity and
subordinated debt in UDC. The Company has commitments to make additional equity
investments or issue additional subordinated debt to UDC of approximately $12.0
million over the next two years.
Israel
- ------
In 2001, the Company entered into agreements with an Israeli cooperative society
and an Israeli corporation for the establishment of Magan Desalination Ltd.
("MDL") as an Israeli project company in which the Company has a 49% equity
interest. During the second quarter of 2003, the Israeli cooperative society
obtained the ownership interest in the Israeli corporation. On June 17, 2003,
MDL finalized a concession contract originally entered into in August 2002 with
a state-sponsored water company for the construction, ownership and operation of
a brackish water desalination facility in Israel. In June 2003, MDL secured $8
million of debt financing for the project from an Israeli bank, and the Company
has guaranteed repayment of 49% of the loan amount. In July 2003, the Company
through its Israeli subsidiary currently anticipates making an equity investment
of $1.3 million in MDL, for a 49% equity interest. This project is scheduled to
be completed in the first half of 2004.
Page -24-
In January 2002, the Company entered into agreements with two Israeli
corporations giving the Company the right to a one-third ownership interest in
an Israeli project company, Carmel Desalination Ltd. ("CDL"). On October 28,
2002, CDL was awarded a concession agreement by the Israeli Water Desalination
Agency (established by the Ministry of Finance and the Ministry of
Infrastructure) for the construction, ownership and operation of a major
seawater desalination facility in Israel. At December 31, 2002, the Company made
an equity investment of $0.2 million in CDL. Additionally, at June 30, 2003 the
Company had deferred costs of approximately $0.6 million relating to the
engineering design and development work on the project. If CDL obtains long-term
project financing, the Company has committed to make additional equity
investments to CDL of approximately $9.7 million. The timing and amount of such
investments will depend upon the terms of the long-term financing agreement. The
terms of the concession agreement originally required that long-term financing
be obtained by April 2003. CDL has been granted an extension to August 20, 2003
and has requested a further extension to obtain such financing. Although the
Company currently anticipates that CDL will obtain long-term financing for the
project, if CDL is unable to obtain such financing, the Company would expense
its deferred costs relating to the construction project and its investment in
CDL (estimated to be approximately $0.8 million by the time of the closing of
the long-term financing). Additionally, the Company could incur its one-third
proportionate share ($2.5 million) of liability under a $7.5 million performance
bond issued on behalf of CDL. In August 2003, the Company entered into an
agreement with the two other equity participants in CDL which would permit one
of them to withdraw from the project subject to the approval of the WDA. Should
the withdrawal of the partner be approved by theWDA, the Company's equity
interest in CDL would increase from one-third to 50%, proportionately increasing
its obligation under the performance bond, as well as increasing its required
equity investment in the project.
Guarantees and Indemnifications
- -------------------------------
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45 "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others an
interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB
Interpretation No. 34" ("FIN 45"). FIN 45 requires that a guarantor recognize,
at the inception of a guarantee, a liability for the fair value of the
obligation undertaken by issuing the guarantee and additional disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees it has issued. The accounting requirements
for the initial recognition of guarantees became applicable on a prospective
basis for guarantees issued or modified after December 31, 2002. The disclosure
requirements are effective for all guarantees outstanding, regardless of when
they were issued or modified as of December 15, 2002. The adoption of FIN 45 did
not have a material effect on the Company's consolidated financial statements.
The following is a summary of the Company's agreements that have determined to
be within the scope of FIN 45.
Under its By-laws, the Company has an obligation to indemnify its directors and
officers to the extent legally permissible against liabilities reasonably
incurred in connection with any action in which such individual may be involved
by reason of such individual being or having been a director or officer of the
Company. The Company has obtained director and officer liability insurance
policies that may limit its exposure and enable it to recover a portion of any
future amounts paid. As a result of this insurance policy coverage, the
estimated fair value of this indemnification is not material. This obligation to
indemnify its directors and officers is grandfathered under the provisions of
FIN 45 as it existed prior to December 31, 2002. Accordingly, the Company has
not recorded any liabilities for these obligations as of June 30, 2003.
As part of past acquisitions and divestitures of businesses or assets, the
Company made a variety of warranties and indemnifications to the sellers and
purchasers that are typical for such transactions. The Company only provides
such warranties or indemnifications after considering the economics of the
transaction and the liquidity and credit risk of the other party in the
transaction. Typically, certain of the warranties and the indemnifications
expire after a defined period of time following the transaction, but others may
survive indefinitely. The warranty and indemnification obligations noted above
were grandfathered under the provisions of FIN 45 as they were in effect prior
to December 31, 2002. In addition, the Company has not made any similar warranty
or indemnification obligations during the second quarter of 2003. Accordingly,
the Company has not recorded any liabilities for these obligations as of June
30, 2003.
In April 2003, the Company reinstated and amended its domestic unsecured working
capital credit facility with Fleet Bank. The terms of the facility, which
expires on April 30, 2004, are substantially the same as that of the expired
facility, except that at the request of the Company the maximum borrowings under
the facility were reduced from $30.0 million to $15.0 million. Loans against the
facility bear interest at the Prime Rate or LIBOR plus 1.25%, at the discretion
of the Company. The facility includes certain financial convenants relating to
liquidity levels, capital expenditures and consolidated tangible net worth. The
Company also maintains several foreign lines of credit. The Company may borrow a
total of $23.0 million under its domestic and international unsecured credit
facilities. At June 30, 2003, the Company's total borrowings under all its
existing credit facilities was $3.8 million.
Page -25-
In addition, the Company maintains a $25.0 million credit line with another bank
under which letters of credit are issued from time to time under commercial
transactions for the benefit of customers and other parties with whom the
Company does business. In the normal course of business, the Company issues
letters of credit to customers, vendors and lending institutions as guarantees
for payment, performance or both under various commercial contracts into which
it enters. Bid bonds are also sometimes obtained by the Company as security for
the Company's commitment to proceed with a project if it is the successful
bidder. Performance bonds are typically issued for the benefit of the Company's
customers as financial security for the completion or performance by the Company
of its contractual obligations under certain commercial contracts. In the past,
the Company has not incurred significant liabilities or expenses as a result of
the use of these instruments. Approximately $128.5 million of these instruments
were outstanding at June 30, 2003. Based on the Company's experience with
respect to letters of credit, bid bonds and performance bonds, the Company
believes the estimated fair value of the instruments entered into during the
first six months of 2003 is not material. Accordingly, the Company has not
recorded any liabilities for these instruments as of June 30, 2003.
The Company believes that its future capital requirements will depend on a
number of factors, including the amount of cash generated from operations and
its capital commitments to new "own and operate" projects, either directly or
through joint ventures, that the Company may be successful in obtaining. The
Company believes that its existing cash and cash equivalents, cash generated
from operations, lines of credit and foreign exchange facilities will be
sufficient to fund its capital expenditures, working capital requirements and
contractual obligations and commitments beyond the next twelve months, based on
its current business plans and projections.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No.
143, "Accounting for Obligations Associated with the Retirement of Long-Lived
Assets." SFAS No. 143 provides the accounting requirements for retirement
obligations associated with tangible long-lived assets. SFAS No. 143 is
effective for financial statements for fiscal years beginning after June 15,
2002. The adoption of SFAS No. 143 did not have a material impact on the
Company's financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." SFAS No. 146 requires companies to recognize
costs associated with exit or disposal activities when they are incurred rather
than at the date of a commitment to an exit or disposal plan and nullifies
Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring.)" SFAS No. 146 is to be
applied prospectively to exit or disposal activities initiated after December
31, 2002. This standard has had no material impact through June 30, 2003 as the
Company has not enacted any exit or disposal activity to date.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure" which amended SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. It also amends the disclosure
provisions to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. The provisions of SFAS No. 148 are to be applied to
financial statements for fiscal years ending after December 15, 2002. The
adoption of SFAS No. 148 did not have an impact on the Company's financial
position or results of operations.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51" (FIN 46). This
interpretation addresses the consolidation of certain variable interest entities
(VIEs) for which a controlling financial interest exists. FIN 46 applies
immediately to financial interests obtained in VIEs after January 31, 2003. It
applies in the first fiscal year or interim period beginning after June 15,
2003, to VIEs in which a financial interest was obtained before February 1,
2003. FIN 46 may be applied prospectively with a cumulative-effect adjustment or
by restating previously issued financial statements with a cumulative-effect
adjustment as of the beginning of the first year restated. The Company has a
financial interest in certain entities that may be considered VIEs under FIN 46.
The Company is currently evaluating the impact of FIN 46 on its Investments in
Affiliated Companies, and if the Company determines that it has a controlling
financial interest in any of these entities, consolidation may be required. The
ultimate effect of adopting FIN 46 on the Company's financial position or
results of operations has not yet been determined.
Page -26-
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies the accounting guidance on (1) derivative instruments, including
certain derivative instruments embedded in other contracts, and (2) hedging
activities that fall within the scope of SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No. 133
and certain other existing pronouncements to provide for more consistent
reporting of contracts that are derivatives in their entirety or that contain
embedded derivatives that warrant separate accounting. SFAS No. 149 is effective
(1) for contracts entered into or modified after June 30, 2003, with certain
exceptions, and (2) for hedging relationships designated after June 30, 2003.
The guidance is to be applied prospectively. The ultimate effect of adopting
SFAS No. 149 on the Company's financial position or results of operations has
not yet been determined.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity ("SFAS No.150").
This accounting standard establishes standards for classifying and measuring
certain financial instruments with characteristics of both liabilities and
equity. It requires that certain financial instruments that were previously
classified as equity now be classified as a liability. This accounting standard
is effective for financial instruments entered into or modified after May 31,
2003, and otherwise at the beginning of the first interim period beginning after
June 15, 2003. The Company does not believe that there will be any impact to its
financial statement presentation as a result of SFAS No. 150.
In May 2003, the FASB Emerging Issues Task Force finalized Issue No. 00-21,
"Accounting for Revenue Arrangements with Multiple Deliverables" ("EITF 00-21").
EITF 00-21 addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue-generating activities.
EITF 00-21 establishes three principles: (a) revenue arrangements with multiple
deliverables should be divided into separate units of accounting; (b)
arrangement consideration should be allocated among the separate units of
accounting based on their relative fair values; and (c) revenue recognition
criteria should be considered separately for separate units of accounting. EITF
00-21 is effective for all arrangements entered into in fiscal periods beginning
after June 15, 2003, with early adoption permitted. The Company does not believe
that EITF 00-21 will have a material impact on the Company's financial position
or results of operations.
Forward-Looking Information
Safe Harbor Statement under Private Securities Litigation Reform Act of 1995
- ----------------------------------------------------------------------------
Certain statements contained in this report, including, without limitation,
statements regarding expectations as to the Company's future results of
operations, statements in the "Notes to the Consolidated Financial Statements"
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations" constitute forward-looking statements. Such statements are based on
management's current views and assumptions and are neither promises or
guarantees but involve risks, uncertainties and other factors that could cause
actual results to differ materially from management's current expectations as
described in such forward-looking statements. Among these factors are the
matters described under "Risks and Uncertainties" contained in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
section of the Company's Annual Report on Form 10-K for the year ended December
31, 2002, as well as overall economic and business conditions; competitive
factors, such as acceptance of new products and pricing pressures and
competition from companies larger than the Company; risk of nonpayment of
accounts receivable, including those from affiliated companies; risks associated
with foreign operations; risks associated with joint venture entities, including
their respective abilities to arrange for necessary long-term project financing;
risks involved in litigation; regulations and laws affecting business in each of
the Company's markets; market risk factors, as described below under
"Quantitative And Qualitative Disclosures About Market Risk"; fluctuations in
the Company's quarterly results; and other risks and uncertainties described
from time to time in the Company's filings with the Securities and Exchange
Commission. Readers should not place undue reliance on any such forward looking
statements, which speak only as of the date they are made, and the Company
disclaims any obligation to update, supplement or modify such statements in the
event the facts, circumstances or assumptions underlying the statements change,
or otherwise.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Derivative Instruments
- ----------------------
The Company enters into foreign exchange contracts including forwards, options
and swaps. The Company's policy is to enter into such contracts only for the
purpose of managing exposures and not for speculative purposes. The Company
holds a series of U.S. dollar/euro forward contracts that were executed to
Page -27-
offset the foreign exchange risk associated with forecasted revenues related to
an ongoing project. As of June 30, 2003, the notional amount of the contracts
was $11.9 million. The fair value of the forward contracts, which was $0.7
million at June 30, 2003, is recorded in the "Other current assets" section of
the Consolidated Balance Sheets. End of period changes in the market value of
the forward contracts that qualify as cash flow hedging contracts are recorded
as a component of "Accumulated other comprehensive loss" in the "Stockholders'
equity" section of the Consolidated Balance Sheets.
The Company also maintains foreign exchange forward contracts to hedge the
balance sheet exposure related to an intercompany loan. At June 30, 2003, the
fair value of the forward contracts, which was immaterial, was recorded in the
"Other current assets" section of the Consolidated Balance Sheets. The end of
period change in the fair market value of the contracts, which was immaterial,
was recorded in "Selling, general and administrative" expenses. At June 30,
2003, a hypothetical change of 10% in exchange rates would change the fair value
of the Company's portfolio of foreign exchange contracts by approximately $0.8
million.
Market Risk
- -----------
The Company's primary market risk exposures are in the areas of interest rate
risk and foreign currency exchange rate risk. The Company's investment portfolio
of cash equivalents is subject to interest rate risk fluctuations, but the
Company believes the risk is not material due to the short-term nature of these
investments. At June 30, 2003, the Company had $5.1 million of short-term debt
and $9.4 million of long-term debt outstanding. The major portion of this debt
has fixed interest rates and is not subject to risk arising from interest rate
variability. A hypothetical increase of 10% in interest rates for a one-year
period would result in additional interest expense that would not be material in
the aggregate. The Company's net foreign exchange currency gain was $1.0 million
and $1.5 million for the three months ended June 30, 2003 and 2002,
respectively. The Company's exposure to foreign currency exchange rate
fluctuations is mitigated by the fact that the operations of its international
subsidiaries are primarily conducted in their respective local currencies. Also,
in certain situations, the Company enters into foreign exchange contracts to
mitigate the impact of foreign exchange fluctuations.
Item 4. Controls and Procedures
The Company carried out an evaluation, under the supervision and with the
participation of the Company's management, including the Company's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
Company's "disclosure controls and procedures" as of June 30, 2003. The
Securities and Exchange Commission ("SEC") defines "disclosure controls and
procedures" as a Company's controls and procedures that are designed to ensure
that information required to be disclosed by the Company in the reports it files
or submits under the Securities Exchange Act of 1934 (the "Exchange Act") is
recorded, processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Based on their evaluation of the Company's
disclosure controls and procedures, the Company's Chief Executive Officer
(principal executive officer) and Chief Financial Officer (principal financial
officer) concluded that the Company's disclosure controls and procedures as of
June 30, 2003 were effective to provide reasonable assurances that information
required to be disclosed by the Company in the reports it files or submits under
the Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC's rules and forms.
Between the evaluation date in May 2003 and the filing of this quarterly report,
the Company implemented the following measures designed to address the
deficiencies and material control weaknesses previously identified by the
Company's independent auditors in connection with the audit of the 2002
financial statements:
o To evaluate and strengthen its financial and accounting staff and their
knowledge and understanding of key policies under U.S. generally accepted
accounting principles and of their responsibilities;
- conducted a Web-Based Controllers Conference which addressed key
accounting policies, as well as responsibilities in the financial
reporting process;
- began a training program for corporate, segment and subsidiary
management that is focused on U.S. generally accepted accounting
principals (GAAP), including periodic testing and assessment;
- hired an additional senior financial controller to oversee a
significant foreign subsidiary.
o To improve monitoring controls to assure the prevention or detection of
material accounting errors on a timely basis;
- increased the scope and depth of reviews of quarterly consolidated and
subsidiary financial statements performed by corporate financial
management with segment and subsidiary controllers for the second
quarter of 2003.
o To reduce the time necessary to collect and report financial and operating
data by improving the timing and accuracy of forecasting and emphasizing
more frequent reviews of the Company's balance sheets and reconciliation of
intercompany balances;
- improved and enhanced the subsidiary financial information data
collection process, in addition to enhancing the financial statement
review process as described above.
Page -28-
o To continue to update its accounting policies and procedures;
- issued the first of two phases of the revised Financial Reporting
Manual, which includes approximately 30 new and/or updated
corporate accounting and financial reporting policies.
Other than these measures, there were no significant changes in the Company's
internal controls or in other factors that could significantly affect the
Company's internal controls between March 31, 2003 and the date of the filing of
this quarterly report.
Page -29-
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The Company, its Chief Financial Officer, and its former Chief Executive Officer
have been named as defendants in a class action lawsuit captioned Jerome Deckler
v. Ionics, Inc., et al., filed in the U.S. District Court, District of
Massachusetts, in March 2003. Plaintiffs allege violations of the federal
securities laws relating to the restatement of the Company's financial
statements for the first and second quarters of 2002, announced in November
2002, and are seeking an unspecified amount of compensatory damages and their
costs and expenses, including legal fees. The Company believes that the
allegations in the lawsuit are without merit and intends vigorously to defend
the litigation. While the Company believes that the litigation will have no
material adverse impact on its financial condition, results of operations or
cash flows, the litigation process is inherently uncertain and the Company can
make no assurances as to the ultimate outcome of this matter.
The Company and its wholly owned subsidiary, Sievers Instruments, Inc.
("Sievers"), have been named as defendants in a lawsuit captioned Aerocrine AB
v. Ionics, Inc. and Sievers Instruments, Inc., filed in the U.S. District Court,
District of Maine, in July 2003. Plaintiff alleges that the Company and Sievers
have infringed four patents owned by plaintiff relating to the measurement of
nitric oxide in exhaled breath for medical diagnostic purposes, as a result of
Sievers' manufacture and sale of an instrument for the detection of nitric
oxide. Plaintiff is seeking an injunction, an unspecified amount of damages, and
attorneys' fees and expenses. Plaintiff is also seeking to have two patents
owned by Sievers relating to nitric oxide detection declared invalid. The
Company believes that the activities carried out by Sievers do not infringe
plaintiff's patents and that its own patents are valid. The Company and the
plaintiff are currently engaged in discussions concerning a commercial
resolution of the matter. If these discussions are not effective, the Company
intends to defend this litigation. While the Company believes that the
litigation will have no material adverse impact on its financial condition,
results of operations or cash flows, the litigation process is inherently
uncertain and the Company can make no assurances as to the ultimate outcome of
this matter.
Item 4. Submission of Matters to a Vote of Security Holders
a) The Annual Meeting of the Stockholders was held on May 7, 2003.
Daniel I. C. Wang and Mark. S. Wrighton were reelected as Class II
Directors for a three-year term. The number of votes cast for the
election of the Class II Directors were as follows:
For Withheld
--- --------
Daniel I. C. Wang 12,973,000 1,093,927
Mark S. Wrighton 12,971,618 1,095,309
At the meeting of the Board of Directors held immediately
preceding the Annual Meeting of Stockholders on May 7, 2003, the
Board voted, effective immediately following the conclusion of the
Annual Meeting, to fix the number of Class I Directors at three,
and to reassign and appoint John J. Shields as a Class II
Director. As a result of these actions and the subsequent action
of the stockholders, the Board of Directors has the following
structure and composition:
Class I Directors (terms expire at the 2005 Annual Meeting)
-----------------
Douglas R. Brown
Arthur L. Goldstein
Kathleen F. Feldstein
Class II Directors (terms expire at the 2006 Annual Meeting)
------------------
John J. Shields
Daniel I. C. Wang
Mark S. Wrighton
Page -30-
Class III Directors (terms expire at the 2004 Annual Meeting)
-------------------
Stephen L. Brown
William K. Reilly
Allen S. Wyett
b) The other matters submitted for stockholder approval were (i)
adoption of the 2003 Non-Employee Directors Stock Option Plan, and
(ii) the ratification of the selection of PricewaterhouseCoopers
LLP as the Company's auditors for 2003. The following were cast in
connection with these matters:
i) Approval of 2003 Non-Employee Directors Stock Option Plan
Votes for: 11,083,532
Votes against: 2,900,209
Abstentions: 83,186
ii) Ratification of the selection of PricewaterhouseCoopers LLP as independent
auditors for 2003.
Votes for: 13,933,120
Votes against: 108,689
Abstentions: 25,118
Item 6. Exhibits and Reports on Form 8-K
a) Exhibits
Exhibit
No. Description
- ------- -----------
10.1 Employment Agreement dated as of April 1, 2003 between the Company
and Douglas R. Brown.
10.2 Inducement Non-Qualified Stock Option Agreement dated as of April 1,
2003 between the Company and Douglas R. Brown (filed as Exhibit 4.3 to
Registration Statement No. 333-107473 on Form S-8 effective July 30,
2003).*
31.1 Rule 13a-14(a) Certification of Chief Executive Officer.
31.2 Rule 13a-14(a) Certification of Chief Financial Officer.
32.1 Section 1350 Certification of Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer.
- ---------------------
* Incorporated herein by reference.
b) Reports on Form 8-K
One report on Form 8-K was filed by the Company with the Securities and
Exchange Commission during the three-month period ended June 30, 2003.
This report, filed on May 6, 2003, reported under Item 9 the issuance by
the Company of a press release reporting financial results for the first
quarter of 2003, ended March 31, 2003. This item was reported under Item
7 of Form 8-K and, in lieu of availability to furnish information via
EDGAR under Item 12, Item 9. A copy of the financial results press
release was filed as Exhibit 99 to the Form 8-K.
Page -31-
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
IONICS, INCORPORATED
Date: August 13, 2003 By: /s/Douglas R. Brown
--------------------------------------
Douglas R. Brown
President and Chief Executive Officer
(duly authorized officer)
Date: August 13, 2003 By: /s/Daniel M. Kuzmak
---------------------------------------
Daniel M. Kuzmak
Vice President and Chief Financial Officer
(principal financial officer)
Page -32-
EXHIBIT INDEX
Exhibit
No. Description
- ------- -----------
10.1 Employment Agreement dated as of April 1, 2003 between the Company and
Douglas R. Brown.
10.2 Inducement Non-Qualified Stock Option Agreement dated as of April 1,
2003 between the Company and Douglas R. Brown (filed as Exhibit 4.3 to
Registration Statement No. 333-107473 on Form S-8 effective July 30,
2003).
31.1 Rule 13a-14(a) Certification of Chief Executive Officer.
31.2 Rule 13a-14(a) Certification of Chief Financial Officer.
32.1 Section 1350 Certification of Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer.