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UNITED STATES
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, 2004
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 or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
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 preceding 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 31, 2004 the Company had 22,620,928 shares of Common Stock, par value
$1.00 per share, outstanding.
INDEX
Page
PART I - FINANCIAL INFORMATION 2
ITEM 1. Financial Statements 2
Consolidated Statements of Operations
Three and Six Months Ended June 30, 2004 and 2003 2
Consolidated Balance Sheets
June 30, 2004 and December 31, 2003 3
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2004 and 2003 4
Notes to Consolidated Financial Statements 5
ITEM 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 21
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk 42
ITEM 4. Controls and Procedures 42
PART II - OTHER INFORMATION 44
ITEM 1. Legal Proceedings 44
ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities 44
ITEM 4. Submission of Matters to a Vote of Security Holders 45
ITEM 6. Exhibits and Reports on Form 8-K 45
SIGNATURES 47
EXHIBIT INDEX 48
-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,
---------------------- ----------------------
2004 2003 2004 2003
---------- ---------- ---------- ----------
Revenues:
Equipment Sales $ 37,991 $ 33,286 $ 71,421 $ 62,838
Operations 62,270 26,589 114,676 54,271
Consumer Water 4,038 2,626 7,990 5,477
Instruments 9,700 8,049 18,451 16,428
Affiliated companies 11,801 13,006 18,916 24,783
---------- ---------- ---------- ----------
125,800 83,556 231,454 163,797
---------- ---------- ---------- ----------
Costs and expenses:
Cost of sales of Equipment Sales 30,433 26,673 58,306 49,315
Cost of sales of Operations 38,805 19,096 73,353 38,229
Cost of sales of Consumer Water 1,606 1,039 3,477 2,413
Cost of sales of Instruments 3,977 3,872 7,983 7,461
Cost of sales to affiliated companies 10,494 11,166 16,603 21,383
Research and development 1,572 1,954 3,103 3,731
Selling, general and administrative 30,874 20,449 58,729 40,752
Restructuring charges 624 - 1,188 -
---------- ---------- ---------- ----------
118,385 84,249 222,742 163,284
---------- ---------- ---------- ----------
Income (loss) from continuing operations 7,415 (693) 8,712 513
Interest income 334 755 848 1,533
Interest expense (5,248) (264) (9,084) (486)
Equity income (loss) 801 (2,742) 1,291 (2,843)
---------- ---------- ---------- ----------
Income (loss) from continuing operations before
income taxes and minority interest expense 3,302 (2,944) 1,767 (1,283)
Income tax (expense) benefit (4,724) 1,142 (4,228) 561
---------- ---------- ---------- ----------
Loss from continuing operations before
minority interest expense (1,422) (1,802) (2,461) (722)
Minority interest expense 231 188 484 386
---------- ---------- ---------- ----------
Loss from continuing operations (1,653) (1,990) (2,945) (1,108)
Loss from discontinued operations, net of income tax (2,934) (3,334) (3,240)
---------- ---------- ---------- ----------
Net loss $ (2,329) $ (4,924) $ (6,279) $ (4,348)
========== ========== ========== ==========
Basic loss per share from continuing operations $ (0.07) $ (0.11) $ (0.14) $ (0.06)
Basic loss per share from discontinued operations (0.17) (0.16) (0.18)
---------------------- ----------------------
Basic loss per share $ (0.10) $ (0.28) $ (0.29) $ (0.25)
====================== ======================
Diluted loss per share from continuing operations $ (0.07) $ (0.11) $ (0.14) $ (0.06)
Diluted loss per share from discontinued operations (0.17) (0.16) (0.18)
---------------------- ----------------------
Diluted loss per share $ (0.10) $ (0.28) $ (0.29) $ (0.25)
====================== ======================
Shares used in basic earnings (loss) per share 22,588 17,564 21,455 17,559
calculations ========== ========== ========== ==========
Shares used in diluted earnings (loss) per share 22,588 17,564 21,455 17,559
calculations ========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
-2-
IONICS, INCORPORATED
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Amounts in thousands, except share and par value amounts)
June 30, December 31,
2004 2003
------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 60,258 $ 133,815
Restricted cash 16,736 -
Short-term investments 1,476 -
Notes receivable, current 7,872 6,365
Accounts receivable, net 116,641 87,415
Receivables from affiliated companies 29,470 22,140
Inventories:
Raw materials 19,193 15,269
Work in process 5,609 5,621
Finished goods 4,032 3,705
------------- -------------
28,834 24,595
Deferred income taxes 15,726 13,585
Assets from discontinued operations 1,081 7,959
Other current assets 27,248 20,196
------------- -------------
Total current assets 305,342 316,070
Receivables from affiliated companies, long-term 10,720 20,915
Notes receivable, long-term 31,951 28,408
Investments in affiliated companies 10,615 14,362
Property, plant and equipment:
Land 11,626 6,297
Buildings 65,405 43,070
Machinery and equipment 493,326 279,997
Other, including furniture, fixtures and vehicles 39,234 34,338
------------- -------------
609,591 363,702
Less accumulated depreciation 213,117 192,169
------------- -------------
396,474 171,533
Goodwill 185,377 7,695
Intangible assets, net 77,199 6,378
Deferred income taxes, long-term 20,727 21,305
Other assets 8,540 5,311
------------- -------------
Total assets $ 1,046,945 $ 591,977
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable and current portion of long-term debt $ 11,877 $ 6,276
Accounts payable 42,369 28,279
Billings in advance from affiliated companies - 3,629
Income taxes payable 32,424 32,840
Liabilities from discontinued operations - 396
Other current liabilities 62,901 46,672
------------- -------------
Total current liabilities 149,571 118,092
Long-term debt and notes payable 281,499 8,889
Deferred income taxes 33,054 30,979
Minority interest 15,592 1,426
Accumulated losses in investments in affiliated companies 4,117 5,068
Other liabilities 10,803 11,358
Commitments and contingencies
Stockholders' equity:
Common stock, par value $1, authorized
shares: 100,000,000 at June 30,2004 and 55,000,000
at December 31, 2003
issued: 22,620,529 at June 30, 2004 and 17,898,486
at December 31, 2003 22,621 17,898
Additional paid-in capital 335,141 198,285
Retained earnings 196,060 202,339
Accumulated other comprehensive loss (1,513) (2,357)
------------- -------------
Total stockholders' equity 552,309 416,165
------------- -------------
Total liabilities and stockholders' equity $ 1,046,945 $ 591,977
============= =============
The accompanying notes are an integral part of these consolidated financial statements.
-3-
IONICS, INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Amounts in thousands)
Six months ended
June 30,
-------------------------
2004 2003
----------- -----------
Operating activities:
Net loss $ (6,279) $ (4,348)
Less: loss from discontinued operations - (714)
Less: loss on disposal of discontinued operations (3,334) (2,526)
----------- -----------
Loss from continuing operations (2,945) (1,108)
Adjustments to reconcile net loss from
continuing operations to net cash used in
operating activities:
Depreciation 19,693 11,960
Amortization of intangibles 3,819 220
Deferred tax valuation allowance 3,278 -
Provision for losses on accounts and notes receivable 1,411 981
Equity in earnings (losses) of affiliates (1,291) 2,843
Changes in assets and liabilities,
net of effects of businesses acquired:
Notes receivable (6,585) 704
Accounts receivable (11,840) 12,655
Receivables from affiliated companies (15,603) (30,822)
Inventories (1,088) 696
Other current assets 1,174 2,459
Investments in affiliated companies 1,366 609
Deferred income taxes 7,971 (270)
Accounts payable and accrued expenses (1,158) (12,992)
Deferred revenue from affiliates (335) 7,508
Accrued expenses for affiliated companies (3,530) -
Customer deposits 8,262 (2,122)
Income taxes payable (2,126) (2,313)
Accumulated losses in investments in affiliated companies 270 -
Other 450 (337)
-------------------------
Net cash provided by (used in) operating activities 1,193 (9,329)
Investing activities:
Additions to property, plant and equipment (18,042) (11,936)
Disposals of property, plant and equipment 714 112
Additional investments in affiliated companies - (36)
Acquisitions, net of cash acquired (223,798) -
(Purchases) sales of short-term investments (1,518) 1
-------------------------
Net cash used in investing activities (242,644) (11,859)
Financing activities:
Restricted cash (648) 4,250
Principal payments on current debt (3,384) (456)
Proceeds from borrowings of current debt 244 1,051
Principal payments on long-term debt (8,628) (684)
Proceeds from borrowings of long-term debt 175,419 -
Deferred financing costs (6,233) -
Hedge 4,620 -
Proceeds from issuance of stock under stock option plans 1,927 1,181
-------------------------
Net cash provided by financing activities 163,317 5,342
Effect of exchange rate changes on cash (1,036) 4,334
Net cash used in continuing operations (79,170) (11,512)
Net cash provided by discontinued operations 5,613 2,447
Cash and cash equivalents at beginning of period 133,815 136,044
-------------------------
Cash and cash equivalents at end of period $ 60,258 $ 126,979
=========================
The accompanying notes are an integral part of these consolidated financial statements.
-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 of a normal recurring nature have
been made that are necessary for a fair statement 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, 2003.
Accordingly, footnote disclosures that would substantially duplicate the
disclosures contained in the Company's audited financial statements as of and
for the year ended December 31, 2003 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 2003 Annual Report on Form 10-K as filed with
the Securities and Exchange Commission.
During the first quarter of 2004, the Company realigned its business structure
and began reporting new business segments. This segment realignment combined
most of its existing Equipment Business Group and Ultrapure Water Group, as well
as the operations of Ecolochem, Inc. and its affiliated companies (the
"Ecolochem Group") acquired by the Company on February 13, 2004 (see Note 3) and
the Desalination Company of Trinidad and Tobago Ltd. ("Desalcott") which has
been consolidated effective January 1, 2004 upon the adoption of Interpretation
No. 46, "Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51" ("FIN 46"), into a new business group
called Water Systems. The newly formed Water Systems Group is comprised of two
reporting segments, Equipment Sales and Operations. The Consumer Water Group
remains a reporting group as previously constituted. The Instruments Group
continues with its existing activities and includes all worldwide instrument
sales. The Corporate Group captures all corporate overhead.
Certain prior year amounts have been reclassified to conform to the current year
presentations with no impact on net income.
2. Variable Interest Entities
In January 2003, the Financial Accounting Standards Board ("FASB") issued FIN
46. In December 2003, the FASB issued a revised version of FIN 46, which
incorporated a number of changes to the prior version. Prior to the effective
date of FIN 46, an entity was generally included in the consolidated financial
statements if it was controlled through ownership of a majority voting interest.
In FIN 46, the FASB concluded that the voting interest approach is not always
effective in identifying controlling financial interests. In some arrangements,
equity investors may not bear the residual economic risks, and in others,
control is not exercised through voting shares. Prior to the first quarter of
2004, the Company was required to apply the provisions of FIN 46 to variable
interests in variable interest entities ("VIEs") created after January 31, 2003.
There were no VIEs meeting this criteria. During the first quarter of 2004, the
Company was required to apply the provisions of FIN 46 to variable interests in
VIEs created before February 1, 2003.
FIN 46 provides guidance for determining whether an entity lacks sufficient
equity or its equity holders lack adequate decision-making ability. These VIEs
are evaluated for consolidation. Variable interests are ownership, contractual
or other interests in a VIE that change with changes in the VIE's net assets.
The Company has evaluated its equity investments and non-wholly-owned
subsidiaries to determine whether the Company is the primary beneficiary,
defined as the entity that is required to absorb the majority of the expected
gains or losses of the VIE. For any VIE in which the Company has been determined
to be the primary beneficiary, the VIE has been consolidated.
-5-
As a result, effective January 1, 2004, the Company consolidated the operations,
assets, liabilities and minority interests of Desalcott in which the Company
holds a 40% equity interest, because the Company believes it holds a majority of
the related financial risks. As of June 30, 2004, Desalcott had total assets and
total liabilities of approximately $157.4 million and $132.9 million,
respectively. Included in assets is $16.7 million of restricted cash and
property, plant and equipment totaling $128.1 million and included in
liabilities is debt of $111.3 million, which is collateralized by substantially
all of the assets and the outstanding common stock of Desalcott, and is
non-recourse to the Company.
3. Ecolochem Acquisition
On February 13, 2004, the Company acquired all of the outstanding shares of
capital stock and ownership interests of Ecolochem, Inc. and its affiliated
companies ("Ecolochem Group"). The Ecolochem Group, privately held companies
headquartered in Norfolk, Virginia, is a leading provider of emergency, short
and long-term mobile water treatment services to the power, petrochemical and
other industries. The acquisition expands the Company's outsourced or customer
facility-based water treatment capabilities in North America and Europe and
provides the Company with better access into the energy and utilities markets.
The Company's financial statements include the results of operations of the
Ecolochem Group subsequent to the acquisition date.
The total purchase price was $366.9 million, consisting of $219.0 million in
cash (which includes $9.8 million in escrow to be paid in the event the Company
makes an election pursuant to Section 338 (h)(10) election of the Internal
Revenue Code with respect to selected acquired intangible assets) and 4,652,648
shares of the Company's common stock. The issuance of 4,652,648 shares of the
Company's common stock was valued at $139.9 million based on the closing price
of the common stock for the two days before, the day of and the two days after
the announcement by the Company of its agreement to acquire the Ecolochem Group.
The purchase price includes capitalizable acquisition costs of $8.0 million,
consisting of investment banking, legal, consulting and accounting services. The
cash portion of the consideration was financed with the Company's available cash
resources and proceeds from $255 million senior credit facilities with a
syndication of lenders led by UBS, Fleet Bank and Bank of America. Proceeds from
these credit facilities were used to fund the acquisition, pay certain
transaction-related fees and expenses, provide for ongoing working capital and
support the issuance of letters of credit. The credit facilities consist of a
$175 million 7-year term loan, of which $167.9 million was outstanding at June
30, 2004, and an $80 million 5-year revolving credit facility, of which $2.5
million was outstanding at June 30, 2004. Borrowings under the credit facilities
bear interest equal to a base rate (generally the Prime Rate) plus a specified
margin or the London Interbank Offered Rate ("LIBOR") plus a specified margin,
at the Company's option; the specified margins are a function of the Company's
leverage ratio. Interest on outstanding borrowings is payable quarterly. The
credit facilities are collateralized by the assets of the Company and of its
domestic subsidiaries and by 65% of certain of the equity of the Company's
international subsidiaries. The terms of the credit facilities include financial
covenants relating to fixed charge coverage, interest coverage, leverage ratio
and capital expenditures, the most restrictive of which are anticipated to be
the leverage ratio and limitations on capital spending. The terms of the credit
facilities contain provisions that limit the Company's ability to incur
additional indebtedness in the future and place other restrictions on the
Company's business. At June 30, 2004, the Company was in compliance with the
facilities' covenants. In connection with the execution of the credit
facilities, the Company entered into interest rate swap agreements that fix the
Company's LIBOR rate on $100 million of the term loan at 3.1175% per annum. The
swap agreements expire in 2010.
-6-
The preliminary allocation of the $366.9 million purchase price to the estimated
fair values of the assets acquired and liabilities assumed at the date of
acquisition was as follows:
(Dollars in millions)
Assets
Current assets $ 27.4
Property, plant and equipment 101.6
Intangible assets 72.8
Goodwill 179.1
Other assets 1.8
-------------
Total assets acquired $ 382.7
-------------
Liabilities
Current liabilities $ 13.7
Other liabilities 2.1
-------------
Total liabilities assumed 15.8
-------------
-------------
Total purchase price including acquisition costs $ 366.9
=============
The purchase price is subject to a final determination of certain cash-related
and working capital amounts, to be agreed to by the sellers and the Company.
Goodwill was recognized for the excess purchase price over the fair value of the
assets and liabilities acquired. Goodwill is primarily attributable to
anticipated growth from new customers and synergies related to the integration
of Ecolochem. Goodwill apportioned to domestic operations for tax purposes is
deductible over a 15-year period. During the second quarter of 2004, goodwill
increased by approximately $2.5 million, primarily as a result of payments made
in contemplation of the Company's Section 338 (h)(10) election of the Internal
Revenue Code
The following table reflects the estimated fair values of the acquired
intangible assets and related estimates of useful lives:
(Dollars in millions)
Contractual relationships $ 57.8 10-year economic consumption life
Technology and know-how 10.8 10-year useful life
Trade names and trademarks 2.4 9-year useful life
Non-compete agreements 0.1 5-year useful life
Discharge permits 1.7 Indefinite life
-------------
$ 72.8
=============
The following pro forma information presents a summary of the historical
consolidated statements of operations of the Company and Ecolochem for the three
and six months ended June 30, 2004 and 2003, giving effect to the merger as if
it occurred on January 1, 2004 and 2003, respectively.
(Amounts in thousands, except per share amounts)
Three months ended June 30, Six months ended June 30,
-------------------------------------------- --------------------------------------------
2004 2003 2004 2003
-------------------- -------------------- -------------------- --------------------
Pro forma revenues $ 125,800 $ 108,066 $ 243,235 $ 216,492
Pro forma net (loss) income (2,329) (3,338) (6,224) 1,534
Pro forma (loss) earnings per share:
Basic $ (0.10) $ (0.15) $ (0.29) $ 0.07
Diluted (0.10) (0.15) (0.29) 0.07
The pro forma net (loss) income and (loss) earnings per share for each period
presented primarily includes adjustments for depreciation of fixed assets,
amortization of intangibles and debt financing costs, interest expense, tax rate
changes and the issuance of common stock. Amortization of the acquired
intangibles is included on an economic consumption basis for contractual
relationships and a straight-line basis for all other intangibles. This pro
-7-
forma information does not purport to indicate the results that would have
actually been obtained had the acquisition been completed on the assumed date or
for the periods presented, or which may be realized in the future.
4. Accounting for Stock-Based Compensation
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, 2004 and
2003, no stock-based compensation expense is reflected in net (loss) income, as
all options granted under those plans had an exercise price equal to or greater
than the market value of the underlying common stock on the date of grant.
The following table illustrates the pro forma effect on net (loss) income and
(loss) earnings per share if the Company had applied the fair value method of
accounting for stock options and other equity instruments defined by SFAS 123,
"Accounting for Stock-Based Compensation," as amended by SFAS 148 "Accounting
for Stock-Based Compensation-Transition and Disclosure." The effect of applying
SFAS 123 in the pro forma disclosure is not indicative of future awards, which
are anticipated.
Three months ended Six months ended
June 30, June 30,
--------------------------- ---------------------------
(Amounts in thousands, except per share amounts) 2004 2003 2004 2003
------------ ------------- ------------ -------------
Net loss, as reported $ (2,329) $ (4,924) $ (6,279) $ (4,348)
Less: Stock-based employee compensation expense determined
under fair value method for all awards, net of related (1,264) (1,611) (2,019) (2,403)
effects ------------ ------------- ------------ -------------
Pro forma net loss $ (3,593) $ (6,535) $ (8,298) $ (6,751)
============ ============= ============ =============
------------ ------------- ------------ -------------
Loss per basic share, as reported $ (0.10) $ (0.28) $ (0.29) $ (0.25)
============ ============= ============ =============
Loss per basic share, pro forma $ (0.16) $ (0.37) $ (0.39) $ (0.38)
============ ============= ============ =============
------------ ------------- ------------ -------------
Loss earnings per diluted share, as reported $ (0.10) $ (0.28) $ (0.29) $ (0.25)
============ ============= ============ =============
Loss per diluted share, pro forma $ (0.16) $ (0.37) $ (0.39) $ (0.38)
============ ============= ============ =============
The fair value of each option granted during the first six months of 2003 was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following assumptions:
Three months ended Six months ended
June 30, June 30,
--------------------------- ---------------------------
2004 2003 2004 2003
------------ ------------- ------------ -------------
Expected term (years) 6 6 6 6
Volatility 43.07% 40.8% 43.07% 40.8%
Risk-free interest rate (zero coupon U.S. treasury note) 4.19% 3.28% 4.19% 3.28%
Dividend yield None None None None
The Company granted 1,306,950 options with a weighted average fair value of
$11.41 during the quarter ended June 30, 2004.
5. Discontinued Operations
During the second quarter of 2004, the Company's management decided to sell a
portion of its General Ionics home water operation, which is part of the
Consumer Water Group. In the third quarter of 2003, the Company's management and
Board of Directors approved a plan to sell its consumer chemical business, the
Elite Consumer Products division in Ludlow, Massachusetts, which was part of the
Consumer Water Group. In the fourth quarter of 2003, the Company's management
and Board of Directors approved a plan to sell its European point-of-use (POU)
cooler businesses in the United Kingdom (UK) and Ireland, which was also part of
the Consumer Water Group. Accordingly, the Company's financial statements and
notes reflect these businesses as discontinued operations in accordance with the
Financial Accounting Standards Board Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets."
-8-
The net loss from discontinued operations for the General Ionics operation for
the three months ended June 30, 2004 was $16,000 ($26,000 on a pretax basis).
The General Ionics operation recognized net income of $25,000 ($40,000 on a
pretax basis) for the six months ended June 30, 2004. The net loss from
discontinued operations for the Elite Consumer Products division for the three
months ended March 31, 2004 was $0.1 million, or $0.2 million on a pre-tax
basis. In the first quarter of 2004, the Company completed the sale of the Elite
Consumer Products division for approximately $5.2 million.
The net loss from discontinued operations for the European POU cooler business
in the UK for the three months ended June 30, 2004 was $60,000, or $94,000 on a
pre-tax basis. The net loss for the six months ended June 30, 2004 was $1.0
million, or $1.7 million on a pre-tax basis. The net loss from discontinued
operations for the European POU cooler business in Ireland for the three months
and six months ended June 30, 2004 was $0.6 million and $2.2 million,
respectively. The Company completed the sale of the European POU cooler business
in the UK and Ireland during the second quarter of 2004 for approximately $3.0
million.
The Company's financial statements have been reclassified to reflect these
businesses as discontinued operations for all periods presented. The operating
results of the discontinued operations are summarized below, which exclude
general corporate overhead previously allocated to each entity.
(Dollars in thousands)
Three months ended Six months ended
June 30, June 30,
------------------------------------- -------------------------------------
2004 2003 2004 2003
----------------- ----------------- ----------------- -----------------
Revenues $ 1,982 $ 7,380 $ 5,475 $ 15,334
Gross margin 1,777 1,665 2,844 3,488
================= ================= ================= =================
Loss from discontinued operations,
before income tax (720) (714) (3,957) (1,126)
Income tax benefit 44 268 623 412
----------------- ----------------- ----------------- -----------------
Loss from discontinued operations,
net of income tax (676) (446) (3,334) (714)
Loss on disposal of discontinued operations,
net of income tax - (2,488) - (2,526)
----------------- ----------------- ----------------- -----------------
Loss from discontinued operations,
net of income tax $ (676) $ (2,934) $ (3,334) $ (3,240)
================= ================= ================= =================
Assets and liabilities from discontinued operations at June 30, 2004 and
December 31, 2003 consist of the following:
(Dollars in thousands)
June 30, December 31,
2004 2003
-------------- --------------
Current assets $ 722 $ 2,950
Non-current assets 359 5,009
-------------- --------------
Assets from discontinued operations $ 1,081 $ 7,959
============== ==============
Liabilities from discontinued operations $ - $ 396
============== ==============
At June 30, 2004, current assets primarily include accounts and notes
receivable, inventory and other current assets. Non-current assets primarily
include property, plant and equipment. At December 31, 2003, current assets
primarily include cash and cash equivalents, accounts and notes receivable,
inventory and other current assets. Non-current assets primarily include
property, plant and equipment, intangible assets and other assets. Liabilities
consist of accounts payable and accrued expenses.
-9-
6. Restructuring Charges
During the third quarter of 2003, the Company announced a restructuring plan
intended to improve financial performance through a realignment of the Company's
management structure, a reduction in personnel, and the consolidation of certain
operations. The program is consolidating the Company's sales, engineering,
manufacturing and accounting functions, which existed in many reporting
entities, into several regional centers in the United States, Europe and Asia.
During the first six months of 2004, the Company recorded restructuring charges
of approximately $1.2 million relating primarily to vacating leased facilities.
At June 30, 2004, the Company had approximately $0.7 million and $0.3 million
accrued for restructuring costs associated with vacated leased facilities
included in "Other current liabilities" and "Other long-term liabilities,"
respectively. The Company expects lease payments, less estimates of sub-lease
rental income, to be made for these leased facilities through 2007.
Reconciliation of the restructuring liability as of June 30, 2004 is as follows:
Equipment Consumer
(Dollars in thousands) Sales Operations Water Instruments Corporate Total
-------------- --------------- --------------- -------------- ------------- -------------
Balance December 31, 2003 $ 393 $ 382 $ 28 $ - $ 69 $ 872
Accrual for severance 21 21 - - 129 171
Accruals for facilities 749 208 - - 51 1,008
Payments (269) (587) (28) - (196) (1,080)
-------------- --------------- --------------- -------------- ------------- -------------
Balance June 30, 2004 $ 894 $ 24 $ - $ - $ 53 $ 971
============== =============== =============== ============== ============= =============
No accrual for restructuring costs existed at December 31, 2002 or June 30,
2003.
7. Goodwill and Intangible Assets
The carrying amounts of goodwill for the quarters ended June 30, 2004 and 2003
are as follows:
Equipment Consumer
(Dollars in thousands) Sales Operations Water Instruments Corporate Total
------------- ------------ ------------ -------------------------- -----------
Balance December 31, 2002 $ 9,880 $ 9,376 $ 862 $ - $ - $ 20,118
Cumulative translation adjustment/other - 282 - - - 282
------------- ------------ ------------ ------------ ----------- -----------
Balance June 30, 2003 $ 9,880 $ 9,658 $ 862 $ - $ - $ 20,400
============= ============ ============ ============ =========== ===========
Balance December 31, 2003 $ 899 $ 5,934 $ 862 $ - $ - $ 7,695
Goodwill acquired during the period - 179,138 - - - 179,138
Cumulative translation adjustment/other - (1,456) - - - (1,456)
------------- ------------ ------------ ------------ ----------- -----------
Balance June 30, 2004 $ 899 $ 183,616 $ 862 $ - $ - $ 185,377
============= ============ ============ ============ =========== ===========
The gross carrying value and accumulated amortization of intangible assets as of
June 30, 2004 and 2003 are as follows:
(Dollars in thousands)
Intangible Assets at June 30, 2003
Contractual Non-Compete Technology and
Relationships Agreements Know-How Patents Trademarks Other Total
---------------------------------------------------------------------------------------------
Gross Carrying Amount $ - $ 281 $ - $ 671 $ - $ 2,407 $ 3,359
Accumulated Amortization - (72) - (267) - (775) (1,114)
---------------------------------------------------------------------------------------------
Net Intangible Assets - 209 - 404 - 1,632 2,245
--------------------------------------------------------------------------------------------
Unamortized Intangible Assets: - - - - - - -
---------------------------------------------------------------------------------------------
Total Intangible Assets $ - $ 209 $ - $ 404 $ - $ 1,632 $ 2,245
=============================================================================================
Intangible Assets at June 30, 2004
Contractual Non-Compete Technology and
Relationships Agreements Know-How Patents Trademarks Other Total
----------------------------------------------------------------------------------------------
Amortized Intangible Assets:
Gross Carrying Amount $ 62,562 $ 399 $ 10,812 $ 708 $ 2,340 $ 3,877 $ 80,698
Accumulated Amortization (3,277) (142) (413) (378) (99) (1,163) (5,472)
----------------------------------------------------------------------------------------------
Net Intangible Assets 59,285 257 10,399 330 2,241 2,714 75,226
----------------------------------------------------------------------------------------------
Unamortized Intangible Assets: - - - - 262 1,711 1,973
----------------------------------------------------------------------------------------------
Total Intangible Assets $ 59,285 $ 257 $ 10,399 $ 330 $ 2,503 $ 4,425 $ 77,199
==============================================================================================
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The increase in intangible assets primarily reflects the acquisition of the
Ecolochem Group (see Note 3) during the first quarter of 2004. Amortization
expense for intangible assets is estimated to be approximately $8.6 million in
2004, $9.4 million in 2005, $9.2 million in 2006, $8.7 million in 2007 and $8.4
million in 2008.
8. Long-Term Debt and Notes Payables
June 30, December 31,
(Dollars in thousands) 2004 2003
------------ ---------------
Borrowings outstanding $ 293,376 $ 15,165
Less: Installments due within one year 11,877 6,276
------------ ---------------
Long-term debt and notes payable $ 281,499 $ 8,889
============ ===============
Acquisition of the Ecolochem Group
On February 13, 2004, the Company acquired the stock and membership interests of
the Ecolochem Group from the shareholders and owners of the Ecolochem Group. The
total purchase price was $366.9 million, consisting of $219.0 million in cash
(which includes $9.8 million in escrow to be paid in the event the Company makes
a Section 338 (h)(10) election of the Internal Revenue Code with respect to
selected acquired intangible assets) and 4,652,648 shares of the Company's
common stock. The issuance of 4,652,648 shares of the Company's common stock was
valued at $139.9 million based on the closing price of the common stock for the
two days before, the day of and the two days after the announcement by the
Company of its agreement to acquire the Ecolochem Group. The purchase price
includes capitalizable acquisition costs of $8.0 million, consisting of
investment banking, legal, consulting and accounting services. The cash portion
of the consideration was financed with the Company's available cash resources
and proceeds from $255 million senior credit facilities with a syndication of
lenders led by UBS, Fleet Bank and Bank of America. Proceeds from these credit
facilities were used to fund the acquisition, pay certain transaction-related
fees and expenses, provide for ongoing working capital and support the issuance
of letters of credit. The credit facilities consist of a $175 million 7-year
term loan, of which $167.9 million was outstanding at June 30, 2004 at an
average interest rate of 5.75%, and an $80 million 5-year revolving credit
facility, of which $2.5 million was outstanding at June 30, 2004 at an average
interest rate of 5.5%. Borrowings under the credit facilities bear interest
equal to a base rate (generally the Prime Rate) plus a specified margin or LIBOR
plus a specified margin, at the Company's option; the specified margins are a
function of the Company's leverage ratio. Interest on outstanding borrowings is
payable quarterly. The credit facilities are collateralized by the assets of the
Company and of its domestic subsidiaries and by 65% of the equity of certain of
the Company's international subsidiaries. The terms of the credit facilities
include financial covenants relating to fixed charge coverage, interest
coverage, leverage ratio and capital expenditures, the most restrictive of which
are anticipated to be the leverage ratio and limitations on capital spending.
The terms of the credit facilities contain provisions that limit the Company's
ability to incur additional indebtedness in the future and place other
restrictions on the Company's business. At June 30, 2004, the Company was in
compliance with the facilities covenants. In connection with the execution of
the credit facilities, the Company entered into interest rate swap agreements
that fix the Company's LIBOR rate on $100 million of the term loan at 3.1175%
per annum. The swap agreements expire in 2010.
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Consolidation of Desalcott
Pursuant to FIN 46 (see note 2), effective January 1, 2004, the Company
consolidated the operations, assets, liabilities and majority interests of the
Desalination Company of Trinidad and Tobago Ltd. ("Desalcott"), in which the
Company holds a 40% equity interest, because the Company believes it holds a
majority of the related financial risks. Included in liabilities at June 30,
2004 is debt of $111.3 million. The debt outstanding consists of 20-year loans
for $78.2 million and $33.1 million. Each loan bears interest at 8.5%, which is
payable quarterly. As a result of an agreed upon "Moratorium Period" on the
$33.1 million loan, interest payments do not commence until October 2005.
Interest rates are fixed on each loan for the first five years and ten years,
respectively. Interest rates may change at the end of each subsequent five-year
period. The total debt is collateralized by substantially all of the assets and
the outstanding common stock of Desalcott, and is non-recourse to the Company.
Notes Payable
The Company has three project finance loans for its controlled affiliate in
Barbados. These loans are payable in equal quarterly installments over a
ten-year period that began in 2000, and bear interest at rates ranging from
LIBOR + 2.0% to 8.75%. The controlled affiliate had outstanding borrowings of
$6.1 million and $6.4 million against these loans at June 30, 2004 and December
31, 2003, respectively. The Company also has project financing loans for its
controlled affiliate in Italy. The loans have a ten-year maturity and bear
interest at EURIBOR plus a specified margin. The controlled affiliate had
outstanding borrowings of $5.5 million and $3.8 million against these loans at
June 30, 2004 and December 31, 2003, respectively.
Maturities of all cash borrowings outstanding for the five years ending December
31, 2004 through December 31, 2008 are approximately $11.9 million, $8.6
million, $9.0 million, $9.1 million, and $9.0 million, respectively, and $245.8
million thereafter. The weighted average interest rate on all borrowings was
6.4% and 6.0% at June 30, 2004 and December 31, 2003, respectively.
9. Commitments and Contingencies
Litigation
In August 2004, the Company agreed in principle to settle the securities
class action lawsuit brought in March 2003 against the Company and its former
Chief Executive Officer and current Chief Financial Officer in the U.S. District
Court, District of Massachusetts (Jerome Deckler v. Ionics, Inc. et al., Civil
Action No. 03-CV10393(WGY)). Under the terms of the settlement-in-principle, a
settlement fund will be created in the total amount of $3 million, to be paid
entirely by the Company's insurer. The Company will not be required to make any
contribution to this settlement fund. The settlement-in-principle is subject to
the execution and filing with the U.S. District Court of a definitive
stipulation of settlement and also final approval of the settlement by the
Court.
On April 28, 2004, the Company was served with a summons and complaint captioned
Caldon, Inc. v. Ionics, Incorporated and Key Technologies, Inc., filed in the
U.S. District Court for the Western District of Pennsylvania, Pittsburgh.
Caldon, Inc. ("Caldon") alleges that certain flow measurement systems, which
Caldon provides to the nuclear power industry to measure feedwater flow, and
which were designed by defendant Key Technologies, Inc., failed after
installation. Caldon engaged the Company to fabricate these systems using Key
Technologies, Inc.'s designs. Caldon further alleges that defendant Key
Technologies, Inc. failed to design the systems adequately and that the Company
failed to weld the systems properly. Caldon claims that it has incurred damages
in excess of $2.7 million and has made commitments to customers that will cause
it to incur an additional $4.0 million, as well as other damages in an
unspecified amount. The Company believes that Caldon's allegations as to the
Company are without merit, and intends to defend itself vigorously in this
matter. The lawsuit is currently in the early discovery stages. While the
Company believes that this litigation should 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.
On December 16, 2003, Ionics Iberica, S.A., the Company's wholly-owned Spanish
subsidiary ("Iberica"), brought suit in Palencia, Spain against Intersuero, S.A.
("Intersuero"). Iberica is seeking the return of certain membrane-based
production equipment, which it had supplied under a lease agreement to
Intersuero (which had previously initiated insolvency proceedings) or payment of
2.8 million Euros, or $3.5 million, plus interest for the equipment. On February
17, 2004, Intersuero filed an answer and counterclaim, alleging that the
equipment did not perform to specifications and seeking 15.8 million Euros, or
$19.9 million, in damages, lost profits, interests and costs. The Company
believes Intersuero's allegations to be without merit and intends to defend
itself vigorously in this matter. While the Company believes that this
litigation should have no material adverse impact on its financial condition,
-12-
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.
On September 15, 2003, the Company was served with a summons and complaint
captioned Brazos River Authority v. Ionics, Incorporated, Cajun Constructors,
Inc. f/k/a Cajun Contractors, Inc., and HDR Engineering, Inc., in Texas state
court. The suit was subsequently removed to the U.S. District Court, Western
Division of Texas, Waco Division (Civil Action WA: 03-CV-324). On July 1, 2004,
plaintiff filed a first amended complaint. Plaintiff alleges that an
electrodialysis reversal ("EDR") desalination system originally sold by the
Company to the plaintiff in 1989 and expanded by the Company in 1998 is
defective and accuses the Company and the other defendants of, among other
things, negligence, breach of contract, and misrepresentation. The complaint
seeks both compensatory and punitive damages in an unspecified amount, among
other relief. The plaintiff subsequently made a settlement demand of $25
million. The Company has filed an answer to the complaint which states the
Company's belief that any problems encountered by the plaintiff resulted from
its failure to operate and maintain the equipment properly. The Company intends
to defend itself vigorously in this matter. Trial on this matter is currently
scheduled to commence in the third quarter of 2004. While the Company believes
that this litigation should have no material adverse impact on its financial
condition, results of operations or cash flow, the litigation process is
inherently uncertain, and the Company can make no assurances as to the ultimate
outcome of this matter.
The Company is involved in the normal course of its business in various other
litigation matters. 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, Israel and
Algeria 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 entity 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. The Company generally has no commitment to
fund the joint venture's working capital or other cash needs. The joint venture
entities typically obtain third-party debt financing for a substantial portion
of the project's total capital requirements. In these situations, the Company is
not responsible for the repayment of the indebtedness incurred by the joint
venture entity. In connection with a joint venture's project, the Company may
also enter into contracts for the supply and installation of the Company's
equipment during the construction of the project or 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.
The operations, assets and liabilities of Desalcott are consolidated with the
Company effective January 1, 2004, as a result of the adoption of FIN 46. The
operations, assets and liabilities of the Algerian joint venture company are
consolidated with the Company as a majority-owned subsidiary. The Kuwait and
Israel projects discussed below constitute off-balance sheet arrangements.
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 ("WASA").
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 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
-13-
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 collateralized 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. No payments have
been made by HKES to the Company on this loan.
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 disputed certain amounts payable under the construction contract. In
June 2003, Desalcott and the Company's Trinidad subsidiary resolved their
dispute 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. This settlement had no impact on the Company's Statements of
Operations.
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, effective July 31, 2003, converted 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, subordinated to the long-term
loan with the Trinidad bank. That loan has a seven-year term, and is payable in
28 quarterly payments of principal and interest. No payments can be made by
Desalcott to the Company until Desalcott has established a level of cash
reserves required by the Trinidad bank. The interest rate is fixed at two
percent above the interest rate payable by Desalcott on the U.S. dollar portion
of its borrowings under its long-term loan agreement with the Trinidad 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 obligation to the Company is 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 $3.2 million. This amount will
be partially paid out of Desalcott's future cash flow from operations over a
period of time estimated to be two years, and the balance from funds available
from long-term financing proceeds upon completion by the Company of certain
"punch list" items relating to phases 1 through 4. 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 $7.4 million. Work on phase 5
was completed during the second quarter of 2004. As of June 30, 2004, the
Company had been paid a total of $3.9 million for its work on phase 5.
In April 2004, following an unsuccessful mediation attempt, Desalcott notified
WASA that it had commenced an arbitration proceeding under the dispute
resolution procedures of the water supply agreement between Desalcott and WASA
dated August 29, 1999 and amended in May 2000 (the "Water Supply Agreement").
Desalcott is seeking, among other things, payments from WASA for certain water
price increases as provided for in the Water Supply Agreement, as well as
damages for delays in plant completion which Desalcott claims resulted from
delays in obtaining a government guaranty of payments by WASA and certain tax
incentives. At June 30, 2004, Desalcott claimed that WASA owed it $3.2 million,
representing revenues under the Water Supply Agreement corresponding to
contractual price increases. WASA has contested the amounts of the water price
increases claimed by Desalcott, asserting that Desalcott did not pass along to
WASA certain cost savings realized by Desalcott. In addition, WASA asserts that
Desalcott's ability to make up production shortfalls by selling excess
production is more limited contractually than claimed by Desalcott. In addition,
WASA has also asserted that Desalcott is liable for liquidated damages because
of delays in the completion of the plant, irrespective of the delay in obtaining
the government guaranty, and that such liquidated damages currently total
approximately $4.0 million and are still accumulating. WASA has asserted
additional liquidated damages will be owed by Desalcott for the delay in the
-14-
completion of Phase 5 of the project, or that in the alternative it may seek to
reject Phase 5. Under the currently projected timetable, this matter should be
heard in arbitration by the International Chamber of Commerce in London in 2005.
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,
2004, the Company had invested a total of $11.5 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 $5.7
million over the next year. In addition, a total of $18.6 million in performance
bonds have been issued on behalf of the Company's Italian subsidiary in
connection with the project. UDC's wastewater treatment facility is expected to
become operational in early 2005.
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 and
the Company acquired the ownership interest of the Israeli corporation in MDL.
In the second quarter of 2003, MDL finalized a concession contract with a
state-sponsored water company for the construction, ownership and operation of a
brackish water desalination facility in Israel. In the second quarter of 2003,
MDL obtained $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 the form
of a bank letter of guarantee. In the third quarter of 2003, the Company through
its Israeli subsidiary made an equity investment of $1.5 million in MDL for its
49% equity interest. Substantial completion of this project was achieved in the
second quarter of 2004.
In 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"). 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. As
of March 31, 2004, the Company had made an equity investment of $0.2 million in
CDL and had deferred costs of $0.6 million relating to the engineering design
and development work on the project. The terms of the concession agreement
originally required that long-term financing be obtained by April 2003. CDL was
initially granted an extension to August 20, 2003 and a further extension to
April 1, 2004 was granted by the WDA. CDL was unable to obtain long-term
financing by the required date. CDL asserts that its inability to obtain
financing resulting from certain errors and omissions in WDA's tendering process
which would have prevented CDL from constructing the facility as proposed. On
April 1, 2004 the WDA notified CDL of its intent to terminate the concession
agreement and to take action to collect on a bid bond (of which it is the
beneficiary) issued on behalf of CDL. On May 5, 2004, the WDA issued a notice of
termination to CDL and made a demand upon the issuing bank of the bid bond. The
Company's liability under the bid bond was approximately $2.5 million (a
one-third proportionate share of the approximate $7.5 million bid bond). During
the first quarter of 2004, as a result of the notification by the WDA of their
intent to collect on the bid bond, the Company recorded a liability of $2.5
million related to its proportionate share. WDA collected on the bid bond in the
second quarter of 2004. In addition, the Company expensed its deferred costs
relating to the construction project and its investment in CDL of $0.8 million.
The dispute between CDL and the WDA concerning the errors and omissions in the
tendering process, the termination of the concession agreement and the demand
made upon the bid bond has been submitted to binding arbitration in Israel (with
CDL and WDA both as claimants and respondents), and it is expected that the
matter will be heard and a decision rendered by the arbitrator in the latter
part of 2004. The Company believes that CDL has legitimate claims and
meritorious defenses in this matter and, in cooperation with the Company's
partners in CDL and CDL's outside counsel, intends to aggressively pursue
recovery of bid bond payments made to WDA as well as other damages.
In the third quarter of 2003, a 50/50 joint venture between the Company and an
Israeli engineering corporation was selected by Mekorot, the Israeli
state-sponsored water company, to design, supply and construct a 123,000 cubic
meter per day (32.5 million gallons per day) seawater desalination facility in
Ashdod, Israel. The estimated value of the equipment supply and construction
contract to be negotiated and entered into with respect to the project is
approximately $95 million, and it is estimated that the plant will require
approximately two years to construct. The joint venture submitted a $5 million
bid bond with its proposal, and the Company would be responsible for 50% of this
amount if a demand were made on the bid bond. It is currently anticipated that
-15-
the parties will sign a final form of contract in 2004, at which time the joint
venture will replace the bid bond with a performance bond in the principal
amount of 10% of the contract value.
Algeria
In the fourth quarter of 2003, the Company and Algerian Energy Company ("AEC")
were selected for a 25-year seawater desalination build-own-operate project.
Sonatrach, the Algerian national energy company, will guarantee the water supply
contract. The Company and AEC have formed a joint project company, Hamma Water
Desalination S.p.A. ("HWD"), in which the Company has a 70% ownership interest.
The projected $220 million capital investment will be financed by a combination
of equity and non-recourse debt. Through June 30, 2004, the Company made an
equity investment of $0.2 million in HWD and deferred costs of approximately
$0.9 million relating to the engineering design and development work on the
project. If HWD obtains long-term project financing, the Company has committed
to make additional equity investments to HWD of approximately $45.6 million. The
Company expects HWD will obtain long-term project financing by December 31,
2004. If HWD is unable to obtain such financing, the Company would expense its
deferred costs relating to the construction project and its investment in HWD.
Additionally, the Company has provided a $1.0 million bid bond to the customer.
Guarantees and Indemnifications
In the fourth quarter of 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 5, 57, and 107 and rescission of FASB
Interpretation 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 and other undertakings
that were determined to be within the scope of FIN 45.
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 in the form of bank guarantees are sometimes 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 with the exception of the bid bond
associated with CDL, as described above. Approximately $111.9 million of these
instruments were outstanding at June 30, 2004. Based on the Company's experience
with respect to letters of credit and credit, bid bonds and performance bonds,
the Company believes the estimated fair value of the instruments entered into
during the first six months of 2004 is not material. Accordingly, the Company
has not recorded any liabilities for these instruments as of June 30, 2004.
As part of 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 entered into
prior to December 31, 2002, were grandfathered under the provisions of FIN 45.
For warranties and indemnifications made to sellers and purchasers subsequent to
December 31, 2002, the Company has not recorded any liabilities for these
obligations as of June 30, 2004, as it believes that it will incur no
liabilities under such provisions.
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
-16-
warranty obligations may be required in the period in which determined. The
changes in accrued warranty obligations for the six months ended June 30, 2004
and 2003 are as follows:
Six months ended
June 30,
-------------------------------
(Dollars in Thousands) 2004 2003
-------------- ---------------
Balance at end of prior year $ 1,173 $ 1,067
Accruals for warranties issued during the period 589 461
Accruals related to pre-existing warranties - 78
Settlements made (in cash or in kind) during the period (555) (511)
-------------- ---------------
Balance at end of current period $ 1,207 $ 1,095
============== ===============
In addition to warranty obligations, the Company recorded a $4.8 million charge
in the third quarter of 2003 to retrofit certain components of the Company's
demineralization systems.
10. Income Taxes
For the three months ended June 30, 2004, the Company recorded income tax
expense of $4.7 million on consolidated pre-tax income from continuing
operations before minority interest expense of $3.3 million, yielding a tax rate
of 143.1% or an annual effective tax rate of 53.7% excluding a $3.3 million
valuation allowance recorded against certain deferred tax assets in the U.S. and
a foreign subsidiary. For the three months ended June 30, 2003, the Company
recorded income tax benefit of $1.1 million on consolidated pre-tax loss from
continuing operations before minority interest of $2.9 million, yielding an
annual effective tax rate of 38.8%. The change in the effective tax rate for the
three months ended June 30, 2004 compared to the three months ended June 30,
2003 resulted primarily from recording valuation allowances against certain U.S.
deferred tax assets originating during the year, for which the Company may not
be able to realize future tax benefits. During the three months ended June 30,
2004, the Company determined that for financial reporting purposes there is
sufficient uncertainty that certain deferred tax assets, principally related to
foreign tax credits in the U.S. and a deferred tax asset of a foreign subsidiary
will be realized, primarily in light of the softness in the power industry,
which impacts domestic mobile water treatment revenues.
The Company continually assesses the realizability of its deferred tax assets.
Deferred tax assets may be reduced by a valuation allowance, if based on the
weight of available evidence, it is more likely than not that some portion or
all of the recorded deferred tax assets will not be realized in future periods.
All available evidence, both positive and negative, is considered in the
determination of recording a valuation allowance. The Company considers future
taxable income and ongoing tax planning strategies when assessing the need for a
valuation allowance. Negative evidence that would suggest the need for a
valuation allowance consists of the Company's recent cumulative operating losses
that were attributable to unprofitable businesses.
11. Earnings Per Share (EPS)
All options outstanding for the three and six months ended June 30, 2004 and
2003 were antidilutive, based on the Company's net loss. 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, 2004 were 1,216,617 and
1,204,617, respectively. The number of options that were antidilutive for the
three and six months ended June 30, 2003 were 3,227,367. All options outstanding
are antidilutive for the three and six months ended June 30, 2004 and 2003 based
on the Company's net loss.
12. Profit Sharing and Pension Plans
The Company has contributory profit-sharing plans (defined contribution plans)
which cover employees of the Company who are members of the Fabricated Products
group of the Bridgeville division ("FPG Plan") and Ecolochem (the "Ecolochem
Plan"). The Company contributions to the FPG Plan are made from the group's
pre-tax profits, may vary from 8% to 15% of participants' compensation, and are
allocated to participants' accounts in proportion to each participant's
respective compensation. The Company made no contributions to the FPG Plan
during either of the six month periods ended June 30, 2004 and 2003. The Company
will contribute $0.5 million to the FPG Plan in 2004 in respect of the 2003 plan
year. The Ecolochem Plan covers all eligible U.S. employees of the Ecolochem
Group and all contributions are made at the discretion of the Board of Directors
of Ecolochem, Inc.
-17-
The Company also had a contributory defined benefit pension plan ("Retirement
Plan") for all other domestic employees. On December 30, 2003, the Board of
Directors authorized the closing of the Retirement Plan and the associated SERP
(described in the next paragraph) to new participants, effective January 1,
2004. On February 13, 2004, the Company notified the participants in these plans
that no further benefits would occur after March 31, 2004. Accrued benefits
under the Retirement Plan are based on years of service and the employee's
average compensation. The Company's funding policy for the Retirement Plan had
been to contribute annually an amount that could be deducted for federal income
tax purposes. In 2002, the Board of Directors approved a "prior period update"
to January 1, 1996, so that the base monthly salary for participants in the
Retirement Plan at each January 1 prior to January 1, 1996 is deemed to be the
same as it was on January 1, 1996. Company contributions to the pension plan
were $1.4 million and $0.9 million for the six months ended June 30, 2004 and
2003, respectively. The Company expects to contribute $3.0 million to this plan
in 2004.
In 1996, the Company's Board of Directors adopted a Supplemental Executive
Retirement Plan for officers and key employees of the Company ("SERP"). As
described above, no further benefits accrue under the SERP after March 31, 2004.
The purpose of the SERP was to permit officers and other key employees whose
base salary exceeds the maximum pay upon which retirement benefits could be
accrued in any year under the Retirement Plan to accrue retirement benefits on
base salary in excess of that amount, equivalent to the benefits that would have
been accrued under the Retirement Plan if base salary levels over that amount
could be taken into account in calculating benefits under the Retirement Plan.
The SERP is administered by the Compensation Committee of the Board of
Directors.
Closing the Retirement Plan and the SERP to new participants and ceasing future
benefit accruals after March 31, 2004 required the recognition of curtailment
losses for both the Retirement Plan and SERP, which were recorded during the
period ended December 31, 2003.
The Company's Section 401(k) Savings Plan ("Savings Plan"), which covers all
domestic employees except those of Ecolochem, Inc., was amended effective July
1, 2004, to add a profit-sharing feature. Under the Savings Plan, the Company
will make profit-sharing contributions to all participants in the Savings Plan
in the event that the Company achieves or exceeds a stated earnings-per-share
target for the fiscal year. The Company's profit-sharing contribution will range
from 2% to 4% of participants' compensation, depending upon the extent to which
the Company exceeds the year's target (there will be no profit-sharing
contribution in the event earnings per share fall short of the target). The
profit-sharing structure is in addition to the Company's matching contribution
to the Savings Plan of up to 2% of a participant's total compensation.
The Savings Plan was also amended, effective April 1, 2004, to provide, at the
Company's discretion, a prospective "make-up" contribution based on continued
service to all participants in the Retirement Plan who were age 40 or older and
who had at least 10 years of service with the Company at March 31, 2004, when
benefits under the Retirement Plan ceased to accrue. Depending upon the
combination of age and years of service of a participant, the make-up
contribution ranges from 1.5% to 2.5% of a participant's compensation.
Net periodic benefit cost for all defined benefit plans consisted of the
following:
Three Months Six Months
ended June 30, ended June 30,
--------------------------------- --------------------------------
Dollars in Thousands) 2004 2003 2004 2003
--------------- -------------- -------------- --------------
Components of Net Periodic Benefit Cost:
Service cost - $ 443 513 $ 884
Interest cost 458 492 917 984
Expected return on plan assets (412) (298) (824) (597)
Amortization of transition asset - (11) - (22)
Amortization of prior service cost - 137 - 273
Recognized net actuarial loss 73 147 146 294
--------------- -------------- -------------- --------------
Net periodic benefit cost $ 119 $ 910 $ 752 $ 1,816
=============== ============== ============== ==============
-18-
13. Comprehensive (Loss) Income
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 (loss) income as
defined by SFAS No. 130 for the three and six months ended June 30, 2004 and
2003.
Three months ended Six months ended
June 30, June 30,
------------------------------- -------------------------------
(Dollars in thousands) 2004 2003 2004 2003
------------- -------------- -------------- --------------
Net loss $ (2,329) $ (4,924) $ (6,279) $ (4,348)
Other comprehensive income (loss), net of tax:
Changes in value of foreign exchange
contracts designated as cash flow hedges 4,104 187 3,572 571
Translation adjustments (1,325) 5,998 (2,728) 7,008
------------- -------------- -------------- --------------
Comprehensive (loss) income $ 450 $ 1,261 $ (5,435) $ 3,231
============= ============== ============== ==============
14. Segment Information
During the first quarter of 2004, the Company realigned its business structure
and began reporting new business segments. This realignment combined most of the
Equipment Business Group and Ultrapure Water Group with the operations of the
Ecolochem Group (see Note 3), into the new business group called Water Systems.
The newly formed Water Systems Group is comprised of two operating segments,
Equipment Sales and Operations. The Consumer Water Group remains a reporting
group as previously constituted. The Instruments segment continues with its
existing activities and combines global instrument sales by all business units.
The Corporate Group captures all corporate overhead not specifically assignable
to the other business groups including; certain corporate administrative and
insurance costs, foreign exchange gains and losses on corporate assets, as well
as the elimination of inter-segment transfers. Prior year amounts have been
reclassified to conform to the current year presentations with no impact on net
income.
The following table summarizes the Company's operations by the four major
operating segments. Corporate includes legal and research and development
expenses not allocated to the business groups, certain corporate administrative
and insurance costs, certain foreign exchange gains and losses, as well as the
elimination of inter-segment transfers. The Company measures segment
profitability on earnings before interest, taxes and minority interest.
-19-
For the three months ended June 30, 2004
--------------------------------------------------------------------
Equipment Consumer
Sales Operations Water Instruments Corporate Total
---------- ---------------------- ---------------------------------
(Amounts in thousands)
Revenue - unaffiliated $ 37,991 $ 62,270 $ 4,038 $ 9,700 $ - $ 113,999
Revenue - affiliated 11,438 338 - 25 - 11,801
Inter-segment transfers 1,712 743 384 91 (2,930) -
Gross profit - unaffiliated 7,558 23,465 2,432 5,723 - 39,178
Gross profit - affiliated 1,259 42 - 6 - 1,307
Equity (loss) income (16) 564 82 0 171 801
Earnings (loss) before interest,
tax and minority interest 875 9,438 347 2,122 (4,566) 8,216
Interest income 334
Interest expense (5,248)
Earnings before income taxes and
minority interest 3,302
For the three months ended June 30, 2003
--------------------------------------------------------------------
Equipment Consumer
Sales Operations Water Instruments Corporate Total
---------- ---------------------- ---------------------------------
(Amounts in thousands)
Revenue - unaffiliated $ 33,286 $ 26,589 $ 2,626 $ 8,049 $ - $ 70,550
Revenue - affiliated 12,791 94 75 46 - 13,006
Inter-segment transfers 5,127 82 27 678 (5,914) -
Gross profit - unaffiliated 6,613 7,493 1,587 4,177 - 19,870
Gross profit - affiliated 1,717 55 45 23 - 1,840
Equity (loss) income - (2,859) 217 - (100) (2,742)
Income (loss) before interest,
tax and minority interest 1,348 347 286 619 (6,035) (3,435)
Interest income 755
Interest expense (264)
Loss before income taxes and
minority interest (2,944)
For the six months ended June 30, 2004
--------------------------------------------------------------------
Equipment Consumer
Sales Operations Water Instruments Corporate Total
---------- ---------------------- ---------------------------------
(Amounts in thousands)
Revenue - unaffiliated $ 71,421 $ 114,676 $ 7,990 $ 18,451 $ - $ 212,538
Revenue - affiliated 18,443 422 - 51 - 18,916
Inter-segment transfers 3,043 1,149 386 129 (4,707) -
Gross profit - unaffiliated 13,115 41,323 4,513 10,468 - 69,419
Gross profit - affiliated 2,261 34 - 18 - 2,313
Equity (loss) income (16) 1,147 162 - (2) 1,291
Income (loss) before interest,
tax and minority interest 753 17,834 374 3,552 (12,510) 10,003
Interest income 848
Interest expense (9,084)
Income before income taxes and
minority interest 1,767
Identifiable assets 412,426 738,531 119,565 39,390 (273,582) 1,036,330
Goodwill 899 183,616 862 - - 185,377
Other intangible assets 368 72,115 4,468 248 77,199
-20-
For the six months ended June 30, 2003
--------------------------------------------------------------------
Equipment Consumer
Sales Operations Water Instruments Corporate Total
---------- ---------------------- ---------------------------------
(Amounts in thousands)
Revenue - unaffiliated $ 62,838 $ 54,271 $ 5,477 $ 16,428 $ - $ 139,014
Revenue - affiliated 24,443 169 92 79 - 24,783
Inter-segment transfers 6,361 1,221 31 1,113 (8,726) -
Gross profit - unaffiliated 13,523 16,042 3,064 8,967 - 41,596
Gross profit - affiliated 3,217 90 53 40 - 3,400
Equity (loss) income - (2,937) 398 - (304) (2,843)
Income (loss) before interest,
tax and minority interest 2,548 4,655 699 2,153 (12,385) (2,330)
Interest income 1,533
Interest expense (486)
Loss before income taxes and
minority interest (1,283)
Identifiable assets 294,567 198,290 109,971 32,760 (45,753) 589,835
Goodwill 9,880 9,658 862 - 20,400
Other intangible assets 1,000 742 - 309 2,051
15. Derivative Financial Instruments and Hedging Activity
In the fourth quarter of 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, 2004, 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 $3.4 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, 2004, the fair value of
these forward contracts of $0.3 million was recorded as a component of "Other
current assets." The net unrealized gain of $0.3 million on the forward
contracts that qualified as cash-flow hedging instruments was included in
"Accumulated other comprehensive loss," in the "Stockholders equity" section of
the Consolidated Balance Sheets. The Company expects these instruments to affect
earnings over the next nine 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 and six months ended June 30, 2004,
the Company had no gains or losses related to ineffective cash flow hedges.
In February 2004, the Company entered into a British pound ("GBP")/U.S. dollar
foreign forward exchange contract to hedge the balance sheet exposure related to
an inter-company loan. At June 30, 2004, the notional amount of the outstanding
forward contract to exchange U.S. dollars for GPBs, which was designated as fair
value hedging instrument, was GBP 1.3 million. The fair value of this forward
contract, based upon dealer quotations, is recorded as a component of "Other
current assets" or "Current liabilities," depending on the amount of the
valuation. At June 30, 2004, the fair value of this hedging instrument, which
was immaterial, was recorded as a component of "Other current liabilities." The
net unrealized loss on the instrument, which was immaterial, was recorded in
"Selling, general and administrative expenses."
In connection with the acquisition of the Ecolochem Group and the execution of
the credit facility, the Company entered into interest rate swap agreements that
fix the Company's LIBOR rate on $100 million of the term loan at 3.1175% per
annum. The swap agreements, which qualify for hedge accounting, expire in 2010.
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, 2003, which has been filed with the Securities and Exchange
Commission.
-21-
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
governmental entities and utilities.
During the first quarter of 2004, the Company realigned its business structure
and began reporting new business segments. The segment realignment combined two
previously reported segments, the Equipment Business Group and Ultrapure Water
Group, with the operations of the Ecolochem Group, which was acquired on
February 13, 2004, to form the Water Systems Group ("WSG").
The following discussion and analysis of financial condition and results of
operations refers to the activities of the Company's four operating units, which
comprise the Company's reportable operating segments. These groups are Equipment
Sales, Operations, Consumer Water (Consumer Water Group) and Instruments
(Instruments Business Group). The Water Systems Group ("WSG") consists of
equipment sales and operations, and includes the operations of the Ecolochem
Group, which was acquired in February 2004, and of Desalcott, which was
consolidated as of January 1, 2004 under FIN 46. The Equipment Sales segment
reflects all sales of capital equipment and related spare parts, and the
Operations segment includes recurring revenue from regeneration, operating
plants, disinfection chemicals and other related products. The Consumer Water
Group ("CWG") remains unchanged, except to the extent that operations have been
sold, discontinued or shutdown. The Instruments Business Group ("IBG")
operations includes all sales of instruments.
WSG provides products and related activities for seawater and brackish water
desalination, water reuse and recycling, 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 recycling 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 ("ZLD")
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 discharges
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.
WSG also provides equipment and services for the microelectronics, power, and
pharmaceutical 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. WSG has historically been heavily reliant
upon the microelectronics industry and the continued softness in that industry
has adversely impacted both revenue and profitability. WSG has been pursuing
applications in other markets, such as power, pharmaceuticals and flat panel
display, to lessen its reliance upon the microelectronics market.
WSG has historically supplied equipment and related membranes. Starting in the
mid-1980s, 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 "Revenues" and "Cost of sales" lines on the Company's
Consolidated Statements of Operations in the periods in which the revenues are
realized. Equipment contracts are generally accounted for under the percentage
of 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.
-22-
WSG pursues large-scale, long-term water treatment projects and participates in
such projects through joint venture project companies in which the Company holds
an 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 an interest in a project company
structure 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 the customer entity.
CWG provides home water units for the treatment of residential water and
point-of-use "bottleless" water coolers. The CWG segment also produced
bleach-based cleaning products and automobile windshield wash solution in its
Elite Consumer Products division, which was reclassified as a discontinued
operation in 2003 and sold in January 2004. 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.
IBG manufactures and sells instruments and related products for the measurement
of impurities in water in 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. IBG has
established a strong position in the pharmaceutical industry, providing products
and services that facilitate compliance with both domestic and foreign
regulatory requirements.
On September 3, 2003, the Company announced a restructuring plan intended to
improve financial performance through a realignment of the Company's management
structure, a reduction in personnel, and the consolidation of certain
operations. The program is consolidating the Company's sales, engineering,
manufacturing and accounting functions, which were spread among numerous
reporting entities, into several regional centers in the United States, Europe
and Asia. The Company also announced plans to divest the Elite Consumer Products
division in Ludlow, Massachusetts (which was sold in January 2004), and shut
down operations at the Company's Ionics Watertec facility in Australia.
Additionally, during the fourth quarter of 2003, the Company decided to divest
its European POU cooler business, which was completed in the second quarter of
2004.
As a result of these decisions, the Company recorded restructuring charges of
approximately $2.8 million during 2003 relating primarily to employee severance
costs for the elimination of approximately 160 positions, and an additional $1.2
million during the first six months of 2004 relating primarily to facility
closings. The Company expects to realize a reduction of approximately $15.4
million in expenses in 2004 as a result of these restructuring initiatives.
During 2003, the Company's management and Board of Directors approved a plan of
disposition to sell its consumer chemical business, the Elite Consumer Products
division in Ludlow, Massachusetts, which was part of CWG, and its European POU
cooler business, which sells point-of-use "bottleless" water coolers in Ireland
and the U.K. Additionally, during the second quarter of 2004, a decision was
made to dispose of the General Ionics operation, which was part of CWG.
Accordingly, the Company's Consolidated Financial Statements and Notes have been
reclassified to reflect these businesses as discontinued operations in
accordance with Financial Accounting Standards Board Statement No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets," for all
periods presented. Losses from discontinued operations were $0.7 million and
$3.3 million for the three months and six months ended June 30, 2004,
respectively. For the three months and six months ended June 30, 2003, the
losses from discontinued operations were $2.9 million and $3.2 million,
respectively.
In the first quarter of 2004, the Company completed the acquisition of the
Ecolochem Group. The Ecolochem Group, privately held companies headquartered in
Norfolk, Virginia, is a leading provider of emergency, short and long-term
mobile water treatment services to the power, petrochemical and other
industries. The acquisition significantly increases the Company's ability to
offer extensive outsourced water services to its customer base and adds
significantly to the Company's recurring revenue base. The Ecolochem Group,
which will be included in the Operations unit of the Company's Water Systems
segment, offers three broad categories of water treatment offerings: emergency,
supplemental and extended term outsourcing.
Emergency. Mobile emergency water treatment responds to unplanned requests by
customers to fulfill their short-term treated water needs. Periodically, a
customer may require a temporary supply of demineralized water as a result of
-23-
unpredictable events, such as breakdowns at its water treatment facilities,
extreme temperature and weather conditions, periods of high production demand or
deterioration in the quality of the raw water supply. In those situations, the
customer is often faced with the decision whether to shut down its facility,
reduce production levels or find an alternative water treatment service. To
address these needs, the Ecolochem Group offers mobile emergency water treatment
services provided by mobile units or trailers with the equipment needed to
produce water treated to the customer's specifications. Once a customer contacts
its centralized dispatch center, the Ecolochem Group's standard procedure
requires the prompt dispatch of a mobile unit to the customer's site. For these
services, customers pay fees for the delivery and use of the mobile units.
Supplemental. Supplemental product offerings address customers' interim, but
planned, water treatment needs, provided with advance notice, to customers for a
variety of reasons, including planned outages (such as scheduled overhauls or
inspections) of their own water treatment facilities, start-up procedures for
the construction of new plants, temporary production requirements (such as
specialty batch processing) and other anticipated increases in demand for
treated water. The typical term of a supplemental services contract is less than
12 months. The Ecolochem Group also uses its mobile water treatment fleet to
provide these services. For these services, customers pay fees for the
transportation and use of the mobile units.
Extended Term Outsourcing. Extended term outsourcing, or customer facility-based
services, supply customers with long-term on-site water treatment solutions. The
term of a typical extended term contract is five to ten years, but may range
from as short as 12 months to 15 years or more. The Ecolochem Group retains
ownership of the equipment and often operates and maintains the water treatment
system. The technology used in outsourcing is identical to that used in the
mobile services, and although installed at the customer's site, the equipment is
substantially similar to that used in mobile services. This equipment similarity
allows the Ecolochem Group to back-up, with its mobile fleet, any outsourced
installations that are shut down for upgrading or repair or that requires
additional capacity. For these services, customers pay both a fixed fee based on
the cost of the equipment provided and a variable fee based on the volume of
water treated.
Other Activities. The Ecolochem Group also resells both ion-exchange resins and
reverse osmosis membranes. Often, it will provide temporary mobile services
during the replacement and installation of resins or membranes at the customer's
plant. The Ecolochem Group also provides off-site ion exchange resin
regeneration and reclamation services for customer-owned resins. It also
supplies water softening and filtration treatment equipment to residential and
light industrial customers in Southeast Virginia.
The following discussion and analysis describes material changes in the
Company's financial condition since December 31, 2003. The analysis of results
of operations compares the three months and six months ended June 30, 2004 with
the comparable periods of the prior fiscal year.
RESULTS OF OPERATIONS
Comparison of the Three Months Ended June 30, 2004 and June 30, 2003
The Company reported consolidated revenues of $125.8 million and a net loss of
$2.3 million for the three months ended June 30, 2004, compared to consolidated
revenues of $83.6 million and net loss of $4.9 million for the three months
ended June 30, 2003. During 2003, as part of the Company's restructuring plan,
the Company approved plans to divest its Elite Consumer Products division and
its European Point of Use ("POU") cooler business. Additionally, during the
second quarter of 2004, the Company approved plans to dispose of its General
Ionics home water operation. Accordingly, results for the Company's Elite
Consumer Products division, European POU cooler business and a portion of
General Ionics home water operations, which are all part of the Consumer Water
Group, have been reclassified to discontinued operations in the Consolidated
Statements of Operations for all periods presented. In the third quarter of
2003, the Company completed the acquisition of substantially all of the assets
of CoolerSmart LLC, a limited liability company in the business of leasing POU
"bottleless" water coolers. In the first quarter of 2004, the Company acquired
the Ecolochem Group, a group of privately held companies, which is a leading
provider of emergency, short and long-term mobile water treatment services to
the power, petrochemical and other industries. Also, the Company has
consolidated Desalination Company of Trinidad and Tobago Ltd. ("Desalcott"), a
Trinidad project company, upon adoption of FIN 46, which the Company adopted
effective January 1, 2004.
-24-
Revenues
Total Company revenues of $125.8 million for the three months ended June 30,
2004 increased $42.2 million, or 50.6%, from revenues of $83.6 million for the
three months ended June 30, 2003. This increase is primarily attributable to the
Operations segment in which revenues increased $35.7 million as a result of the
acquisition of Ecolochem as of February 13, 2004 ($24.4 million) and the
inclusion of Desalcott ($7.5 million) for the three months ended June 30, 2004.
The following table reflects the revenues of the Company's four business
segments and sales to affiliated companies for the three months ended June 30,
2004 and 2003:
(Dollars in thousands) Three months ended June 30,
-------------------------------------
2004 2003 Dollar Change Percentage Change
----------------- ------------------ --------------- -----------------
Revenues
Equipment Sales $ 37,991 $ 33,286 $ 4,705 14.1 %
Operations 62,270 26,589 35,681 134.2 %
Consumer Water 4,038 2,626 1,412 53.8 %
Instruments 9,700 8,049 1,651 20.5 %
Affiliated companies 11,801 13,006 (1,205) (9.3)%
----------------- ------------------ --------------- -------------
$ 125,800 $ 83,556 $ 42,244 50.6 %
================= ================== =============== =============
Equipment Sales revenues of $38.0 million in the second quarter of 2004
increased $4.7 million, or 14.1%, compared to revenues of $33.3 million in the
second quarter of 2003. The increase in revenues was primarily attributable to
the sale of capital equipment to the microelectronics industry in Singapore.
Operations revenue of $62.3 million in the second quarter of 2004 increased
$35.7 million, or 134.2%, compared to revenues of $26.6 million in the second
quarter of 2003. The increase in revenue was attributable to several sources,
including revenues from the Ecolochem Group of $24.4 million, which was acquired
on February 13, 2004, and from Desalcott of $7.5 million, which was consolidated
upon adoption of FIN 46 effective January 1, 2004. Operations revenue also
increased as a result of increased domestic ion-exchange regeneration revenue.
CWG revenues totaled $4.0 million in the second quarter of 2004 compared to
revenues of $2.6 million in the second quarter of 2003, representing an increase
of $1.4 million, or 53.8%. The increase in revenues was primarily attributable
to the CoolerSmart POU division, which was acquired during the third quarter of
2003. All sales relating to the Elite Consumer Products division in Ludlow,
Massachusetts, European POU cooler businesses and the General Ionics home water
operation have been reclassified to discontinued operations for all periods
presented.
IBG revenues of $9.7 million in the second quarter of 2004 increased $1.7
million, or 20.5%, compared to revenues of $8.0 million in the second quarter of
2003. The increase in revenues primarily resulted from increased sales of
instruments to customers in Europe and Asia.
Revenues from sales to affiliated companies of $11.8 million in the second
quarter of 2004 decreased $1.2 million, or 9.3%, compared to revenues from
affiliated companies of $13.0 million in the second quarter of 2003. Revenues
from affiliated companies for 2004 and 2003 consisted primarily of sales of
capital equipment to the Company's Kuwait joint venture company, Utilities
Development Company, W.L.L. ("UDC"), in connection with the Kuwait wastewater
treatment project, which is currently expected to be operational in early 2005.
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.
-25-
Cost of Sales
The following table reflects cost of sales and cost of sales as a percentage of
revenue of the Company's four business segments and to affiliated companies for
the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
-------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
----------------- ----------------------------------- ---------------
Cost of Sales
Equipment Sales $ 30,433 80.1% $ 26,673 80.1%
Operations 38,805 62.3% 19,096 71.8%
Consumer Water 1,606 39.8% 1,039 39.6%
Instruments 3,977 41.0% 3,872 48.1%
Affiliated companies 10,494 88.9% 11,166 85.9%
----------------- --------------- ----------------- ---------------
$ 85,315 67.8% $ 61,846 74.0%
================= =============== ================= ===============
The Company's total cost of sales as a percentage of revenue was 67.8% in the
second quarter of 2004 and 74.0% in the second quarter of 2003. The resulting
gross margin increased to 32.2% in the second quarter of 2004 from 26.0% in the
second quarter of 2003.
Equipment Sales cost of sales as a percentage of revenue was 80.1% in the second
quarter of 2004 and in the second quarter of 2003. Cost of sales from domestic
operations as a percentage of revenue decreased to 73.8% in the second quarter
of 2004 compared to 79.8% in the second quarter of 2003. Cost of sales from
international operations as a percentage of revenue increased to 87.0% in the
second quarter of 2004 compared to 80.7% in the second quarter of 2003.
Operations cost of sales as a percentage of revenue decreased to 62.3% in the
second quarter of 2004 from 71.8% in the second quarter of 2003. The decrease in
cost of sales as a percentage of revenue is attributable to the consolidation of
Desalcott effective January 1, 2004 and the acquisition of the Ecolochem Group
on February 13, 2004, both of which have lower prevailing cost of sales
percentages than do the Company's other operations. The approximate impact of
the Desalcott consolidation was 3.4 percentage points and the impact of
Ecolochem was approximately 7.0 percentage points.
CWG's cost of sales as a percentage of revenue slightly increased to 39.8 % in
the second quarter of 2004 from 39.6% in the second quarter of 2003. Results for
the Company's Elite Consumer Products division in Ludlow, MA, the General Ionics
home water operation, as well as the Company's European POU cooler business,
have been reclassified to discontinued operations for all periods presented.
IBG's cost of sales as a percentage of revenue decreased to 41.0% in the second
quarter of 2004 from 48.1% in the second quarter of 2003, primarily due to
manufacturing productivity gains as a result of increased sales volume.
Cost of sales to affiliated companies as a percentage of revenue increased to
88.9% in the second quarter of 2004 from 85.9% in the second quarter of 2003 and
primarily represents cost of sales to UDC, for which the Company eliminates
inter-company profit equal to its 25% equity ownership in UDC.
-26-
Operating Expenses
The following table compares the Company's operating expenses for the three
months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
--------------------------------------------------------
2004 Percentage of Reven2003 Percentage of Revenue
----------- ---------------------------- ------------
Operating expenses
---------- ------------- ------------- ------------
Research and development expenses $ 1,572 1.2% $ 1,954 2.3%
---------- ------------- ------------- ------------
---------- ------------- ------------- ------------
Selling, general and administrative expenses $ 30,874 24.5% $ 20,449 24.5%
----------- ------------- ------------- ------------
Research and development expenses consist primarily of personnel and other costs
associated with the development of new products and the enhancement of existing
products for the Equipment Sales, Operations and IBG segments. Research and
development expenses decreased $0.4 million during the quarter ended June 30,
2004 compared to the same period in 2003. The Company currently expects to
continue to invest in new products, processes and technologies at the current
spending level.
Selling, general and administrative expenses increased $10.4 million, or 51.0%,
during the second quarter of 2004 to $30.9 million from $20.4 million during the
second quarter of 2003. Selling, general and administrative expenses as a
percentage of sales were 24.5% in the second quarter of 2004. The increase in
selling, general, and administrative costs was primarily attributable to the
operating expenses of Desalcott, ($1.3 million), upon the adoption of FIN 46
effective January 1, 2004, and of Ecolochem ($8.0 million, including $2.5
million of intangible asset amortization including selling, general and
administrative expenses) on February 13, 2004, as well as costs associated with
Sarbanes-Oxley compliance and the implementation of a Company-wide enterprise
resource planning system.
Restructuring Charges
The following table compares the Company's expenses relating to restructuring
expenses for the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
----------------- ----------------------------------- ---------------
---------------- ---------------- ----------------- ---------------
Restructuring charges $ 624 0.5% $ - 0.0%
----------------- ---------------- ----------------- ---------------
During the third quarter of 2003, the Company announced a restructuring plan
intended to improve financial performance through a realignment of the Company's
management structure, a reduction in personnel, and the consolidation of certain
operations. The program is consolidating the Company's sales, engineering,
manufacturing and accounting functions, which were located in many reporting
entities, into several regional centers in the United States, Europe and Asia.
The Company also announced plans to consolidate the Equipment Business Group and
Ultrapure Water Group into a single business group, divest the Elite Consumer
Products division in Ludlow, Massachusetts, shut down the Ionics Watertec
facility in Australia as well as the Company's European Home Water activities
(the sale of home water conditioners in Ireland and the U.K.). During the fourth
quarter of 2003, the Company decided to divest its European POU cooler business,
which engaged in the sale of POU "bottleless" coolers in Ireland and the U.K.
Additionally, during the second quarter of 2004, the Company decided to dispose
of its General Ionics home water operation which is reported in the CWG segment.
As a result of these decisions, the Company recorded restructuring charges of
approximately $2.8 million during 2003 relating to employee severance costs for
the elimination of approximately 160 positions, primarily in the WSG, and an
additional $0.6 million in the second quarter of 2004, relating primarily to the
termination of facility leases. At June 30, 2004, substantially all of the
employees whose employment was terminated as a result of these restructuring
activities had left the Company. Additionally, at June 30, 2004, the Company had
accrued approximately $1.0 million for restructuring costs associated with
vacated leased facilities and employee severance arrangements. The Company
expects the remaining lease payments, less estimates of sub-lease rental income,
-27-
to be paid for the leased facilities through 2007. The Company expects to
realize a reduction of approximately $15.4 million in expenses in 2004 as a
result of these actions.
Interest Income and Interest Expense
The following table compares the Company's interest income and interest expense
for the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
--------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
------------------ ----------------------------------- ---------------
----------------- --------------- ------------------ ---------------
Interest Income $ 334 0.3% $ 755 0.9%
------------------ --------------- ------------------ ---------------
----------------- --------------- ------------------ ---------------
Interest Expense $ (5,248) (4.2)% $ (264) (0.3)%
------------------ --------------- ------------------ ---------------
Interest income totaled $0.3 million in the second quarter of 2004 and $0.8
million in the second quarter of 2003. Interest expense was $5.2 million in the
second quarter of 2004 compared to $0.3 million in the second quarter of 2003.
The increase in interest expense is attributable to increased borrowings as a
result of the Ecolochem Group acquisition as well as interest expense from the
consolidation Desalcott upon adoption of FIN 46, effective January 1, 2004.
Equity Income (Loss)
The Company's proportionate share of the earnings and losses of affiliated
companies in which it holds a minority equity interest is included in equity
income. The following table compares the Company's equity income (loss) relating
to the results of its minority equity investments for the three months ended
June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
--------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
------------------ ----------------------------------- ---------------
----------------- --------------- ------------------ ---------------
Equity income (loss) $ 801 0.6 % $ (2,742) (3.3)%
------------------ --------------- ------------------ ---------------
Equity income amounted to $0.8 million in the second quarter of 2004 and an
equity loss of $2.7 million was incurred in the second quarter of 2003. The
Company's equity income (loss) is derived primarily from its 20% equity interest
in a Mexican joint venture company, which owns two water treatment plants in
Mexico, its 43% ownership in Toray Membrane America, Inc. (TMA), a membrane
manufacturer, its equity interests in several joint ventures in the Middle East,
which engage in bottled water distribution, and to a lesser extent from its
other equity investments in affiliated companies. The $3.5 million increase in
equity income in the second quarter of 2004 compared to the second quarter of
2003 was primarily due to the equity loss reported by Desalcott in 2003, as a
result of the Company's 40% equity interest in Desalcott, whereas upon adoption
of FIN 46, effective January 1, 2004, the Company consolidated the operating
results of Desalcott.
Income Tax Benefit (Expense)
The following table compares the Company's income tax benefit (expense) and
effective tax rates for the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
--------------------------------------------------------------------------
2004 Effective Tax Rate 2003 Effective Tax Rate
------------------ ----------------------------------- ---------------
----------------- --------------- ------------------ ---------------
Income tax (expense) benefit $ (4,724) (143.1)% $ 1,142 (38.8)%
------------------ --------------- ------------------ ---------------
-28-
For the three months ended June 30, 2004, the Company recorded income tax
expense of $4.7 million on consolidated pre-tax income from continuing
operations before minority interest expense of $3.3 million, yielding a tax rate
of 143.1% or an annual effective tax rate of 53.7%, excluding a $3.3 million
valuation allowance recorded against certain deferred tax assets in the U.S. and
a foreign subsidiary. For the three months ended June 30, 2003, the Company
recorded income tax benefit of $1.1 million on consolidated pre-tax loss from
continuing operations before minority interest of $2.9 million, yielding an
annual effective tax rate of 38.8%. The change in the effective tax rate for the
three months ended June 30, 2004 compared to the three months ended June 30,
2003 resulted primarily from recording valuation allowances against certain U.S.
deferred tax assets originating during the year, for which the Company may not
be able to realize future tax benefits. During the three months ended June 30,
2004, the Company determined that for financial reporting purposes there is
sufficient uncertainty that certain deferred tax assets, principally related to
foreign tax credits in the U.S. and a deferred tax asset of a foreign subsidiary
will be realized, primarily in light of the softness in the power industry,
which impacts domestic mobile water treatment revenues. In the event that the
Company does generate sufficient future taxable income, this allowance would be
recovered.
The Company continually assesses the realizability of its deferred tax assets.
Deferred tax assets may be reduced by a valuation allowance, if based on the
weight of available evidence, it is more likely than not that some portion or
all of the recorded deferred tax assets will not be realized in future periods.
All available evidence, both positive and negative, is considered in the
determination of recording a valuation allowance. The Company considers future
taxable income and ongoing tax planning strategies when assessing the need for a
valuation allowance. Negative evidence that would suggest the need for a
valuation allowance consists of the Company's recent cumulative operating losses
that were attributable to unprofitable businesses.
Discontinued Operations
During the second quarter of 2004, the Company's management approved a plan to
sell a portion of its General Ionics home water operation, which is part of CWG.
In the third quarter of 2003, the Company approved a plan of disposition to sell
its consumer chemical business, the Elite Consumer Products division in Ludlow,
Massachusetts, which was part of CWG. In the first quarter of 2004, the Company
completed the sale of the Elite Consumer Products division for approximately
$5.2 million. Additionally, during the fourth quarter of 2003, the Company
approved a plan to sell its European POU cooler business, which sells
point-of-use "bottleless" water coolers in Ireland and the U.K. Accordingly, the
Company's Consolidated Financial Statements and Notes have been reclassified to
reflect these businesses as discontinued operations in accordance with Financial
Accounting Standards Board Statement No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets."
The following table compares the Company's results of discontinued operations
for the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
------------------------------------
---------------- -----------------
2004 2003
----------------- -----------------
Discontinued Operations
Loss from operations $ (720) $ (714)
Income tax benefit 44 268
Loss from disposal - (2,488)
---------------- -----------------
Loss from discontinued operations, net of tax $ (676) $ (2,934)
================= =================
The loss from discontinued operations of $0.7 million in the second quarter of
2004 included losses to adjust the net book value to the purchase price of the
European POU business. During the second quarter of 2004, the Company completed
the sale of the European POU business for approximately $3.0 million. The
Company expects to complete the sale of its General Ionics home water operations
during the second half of 2004.
-29-
Net (Loss) Income
The following table compares the Company's net (loss) income and percentage of
revenues for the three months ended June 30, 2004 and 2003:
(Dollars in thousands) Three months ended June 30,
--------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
------------------ ----------------------------------- ---------------
----------------- --------------- ------------------ ---------------
Net loss $ (2,329) (1.9)% $ (4,924) (5.9)%
------------------ --------------- ------------------ ---------------
Net loss amounted to $2.3 million in the second quarter of 2004 compared to a
net loss of $4.9 million for the second quarter of 2003.
Comparison of the Six Months Ended June 30, 2004 and June 30, 2003
The Company reported consolidated revenues of $231.5 million and a net loss of
$6.3 million for the six months ended June 30, 2004, compared to consolidated
revenues of $163.8 million and a net loss of $4.3 million for the six months
ended June 30, 2003. During 2003, as part of the Company's restructuring plan,
the Company approved plans to divest its Elite Consumer Products division and
its European Point of Use ("POU") a portion of cooler business. Additionally,
during the second quarter of 2004, the Company approved plans to dispose of its
General Ionics home water operation. Accordingly, results for the Company's
Elite Consumer Products division, European POU cooler business and General
Ionics, which were all part of the Consumer Water Group, have been reclassified
to discontinued operations in the Consolidated Statements of Operations for all
periods presented. In the third quarter of 2003, the Company completed the
acquisition of substantially all of the assets of CoolerSmart LLC, a limited
liability company in the business of leasing POU "bottleless" water coolers. In
the first quarter of 2004, the Company acquired the Ecolochem Group, a leading
provider of emergency, short and long-term mobile water treatment services to
the power, petrochemical and other industries. Also, the Company has
consolidated Desalination Company of Trinidad and Tobago Ltd. ("Desalcott"), a
Trinidad project company, upon adoption of FIN 46, which the Company adopted
effective January 1, 2004.
Revenues
Total Company revenues of $231.5 million for the six months ended June 30, 2004
increased $67.7 million, or 41.3% from revenues of $163.8 million for the six
months ended June 30, 2003. The increase is primarily attributable to the
Operations segment in which revenues increased $60.4 million as a result of the
acquisition of the Ecolochem Group on February 13, 2004 ($36.3 million), as well
as the inclusion of revenues from Desalcott ($14.4 million) for the six months
ended June 30, 2004.
The following table reflects the revenues of the Company's four business
segments and sales to affiliated companies for the six months ended June 30,
2004 and 2003:
(Dollars in thousands) Six months ended June 30,
-------------------------------------------
2004 2003 Dollar Change Percentage Change
----------------- ------------------ --------------- -------------
Revenues
Equipment Sales $ 71,421 $ 62,838 $ 8,583 13.7 %
Operations 114,676 54,271 60,405 111.3 %
Consumer Water 7,990 5,477 2,513 45.9 %
Instruments 18,451 16,428 2,023 12.3 %
Affiliated companies 18,916 24,783 (5,867) (23.7)%
----------------- ------------------ --------------- -------------
$ 231,454 $ 163,797 $ 67,657 41.3 %
================= ================== =============== =============
Equipment Sales revenues of $71.4 million in the six months ended June 30, 2004
increased $8.6 million, or 13.7%, compared to revenues of $62.8 million in the
six months ended June 30, 2003. The increase in revenues was primarily
attributable to the sale of capital equipment to the microelectronics industry
in Singapore.
Operations revenue of $114.7 million in the six months ended June 30, 2004
increased $60.4 million, or 111.3%, compared to revenues of $54.3 million in the
six months ended June 30, 2003. The increase in revenues was attributable to
several sources, including revenues from the Ecolochem Group of $36.3 million,
-30-
which was acquired on February 13, 2004, and from Desalcott of $14.4 million,
which was consolidated upon adoption of FIN 46 effective January 1, 2004.
Operations revenue also increased in the first six months of 2004 compared to
the same period in 2003 as a result of increased sales of $3.3 million of sodium
hypochlorite in Australia and increased domestic ion-exchange regeneration
revenue of $3.2 million.
CWG revenues totaled $8.0 million in the six months ended June 30, 2004 compared
to revenues of $5.5 million in the six months ended June 30, 2003, representing
an increase of $2.5 million, or 45.9%. The increase in revenues was primarily
attributable to the CoolerSmart POU division, which was acquired during the
third quarter of 2003. All sales relating to the Elite Consumer Products
division in Ludlow, Massachusetts, the European POU cooler businesses and a
portion of the General Ionics home water operation have been reclassified to
discontinued operations for all periods presented.
IBG revenues of $18.5 million in the six months ended June 30, 2004 increased
$2.0 million, or 12.3%, compared to revenues of $16.4 million in the six months
ended June 30, 2003. The increase in revenues primarily resulted from increased
sales of instruments to customers in Europe and Asia.
Revenues from sales to affiliated companies of $18.9 million in the six months
ended June 30, 2004 decreased $5.9 million, or 23.7%, compared to revenues from
affiliated companies of $24.8 million in the same period of 2003. The decrease
in revenues from sales to affiliated companies primarily resulted from lower
capital equipment revenue associated with sales of equipment by the Company to
its Kuwait joint venture company, Utilities Development Company, W.L.L. ("UDC"),
in connection with the Kuwait wastewater treatment project, which is expected to
be operational in early 2005.
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 following table reflects cost of sales and cost of sales as a percentage of
revenue of the Company's four business segments and to affiliated companies for
the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
-------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
----------------- ----------------------------------- ---------------
Cost of Sales
Equipment Sales $ 58,306 81.6% $ 49,315 78.5%
Operations 73,353 64.0% 38,229 70.4%
Consumer Water 3,477 43.5% 2,413 44.1%
Instruments 7,983 43.3% 7,461 45.4%
Affiliated companies 16,603 87.8% 21,383 86.3%
---------------- --------------- ----------------- ---------------
$ 159,722 69.0% $ 118,801 72.5%
================= =============== ================= ===============
The Company's total cost of sales as a percentage of revenue was 69.0% in the
six months ended June 30, 2004 and 72.5% in the six months ended June 30, 2003.
The resulting gross margin increased to 31.0% in the first six months of 2004
from 27.5% in the first six months of 2003. Cost of sales as a percentage of
revenue increased in Equipment Sales and Affiliated companies and decreased for
Operations and Consumer Water.
Equipment Sales cost of sales as a percentage of revenue increased to 81.6% in
the six months ended June 30, 2004 from 78.5% in the six months ended June 30,
2003. The increase in cost of sales as a percentage of revenue for Equipment
Sales was primarily attributable to charges relating to the write-off of
deferred project costs of $0.6 million associated with the CDL joint venture
desalination project in Israel, and $0.4 million for charges for domestic
project overruns. Additionally, several other long-term contracts generated less
gross profit during the six months ended June 30, 2004 compared to the six
months ended June 30, 2003.
-31-
Operations cost of sales as a percentage of revenue decreased to 64.0% in the
six months ended June 30, 2004 from 70.4% in the same period of 2003. The
decrease in cost of sales as a percentage of revenue was attributable to the
consolidation of Desalcott on January 1, 2004 and the acquisition of the
Ecolochem Group on February 13, 2004, both of which have lower prevailing cost
of sales percentages. The approximate impact of the Desalcott consolidation was
3.6 percentage points and the impact of Ecolochem was approximately 4.9
percentage points.
CWG cost of sales as a percentage of revenue decreased to 43.5% in the six
months ended June 30, 2004 from 44.1% in the same period of 2003. Results for
the Company's Elite Consumer Products division in Ludlow, Massachusetts, the
General Ionics home water operation, as well as the Company's European POU
cooler business, have been reclassified to discontinued operations for all
periods presented.
IBG's cost of sales as a percentage of revenue decreased to 43.3% in the six
months ended June 30, 2004 from 45.4% in the six months ended June 30, 2003
primarily due to manufacturing productivity gains as a result of increased sales
volume.
Cost of sales to affiliated companies as a percentage of revenue increased to
87.8% in the first six months of 2004 from 86.3% in the first six months of 2003
and primarily represents cost of sales to UDC, for which the Company eliminates
inter-company profit equal to its 25% equity ownership in UDC.
Operating Expenses
The following table compares the Company's operating expenses for the six months
ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
--------------------------------------------------------
2004 Percentage of Reven2003 Percentage of Revenue
----------- ---------------------------- ------------
Operating expenses
---------- ------------- ------------- ------------
Research and development expenses $ 3,103 1.3% $ 3,731 2.3%
----------- ------------- ------------- ------------
---------- ------------- ------------- ------------
Selling, general and administrative expenses $ 58,729 25.4% $ 40,752 24.9%
----------- ------------- ------------- ------------
Research and development expenses consist primarily of personnel and other costs
associated with the development of new products and the enhancement of existing
products for the Equipment Sales, Operations and Instruments segments. Research
and development expenses decreased $0.6 million during the six months ended June
30, 2004 compared to the same period in 2003. The Company currently expects to
continue to invest in new products, processes and technologies at the current
spending levels.
Selling, general and administrative expenses increased $18.0 million during the
six months ended June 30, 2004 to $58.7 million from $40.8 million during the
six months ended June 30, 2003. Selling, general and administrative expenses as
a percentage of revenue increased to 25.4% in the six months ended June 30, 2004
from 24.9% in the six months ended June 30, 2003. The increase in selling,
general, and administrative costs was primarily attributable to the additional
operating expenses of Desalcott ($3.5 million), which was consolidated upon the
adoption of FIN 46 on January 1, 2004, and of Ecolochem ($11.7 million including
$3.2 million of intangible asset amortization including selling, general and
administrative expenses) after February 13, 2004. The Company recorded a $2.5
million charge associated with a bid bond that has been drawn upon in connection
with the CDL joint venture's desalination project in Israel. The Company also
incurred $1.4 million in costs associated with the implementation of a
Company-wide enterprise resource planning system.
-32-
Restructuring Charges
The following table compares the Company's expenses relating to restructuring
expenses for the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
----------------- ----------------------------------- ---------------
----------------- ---------------- ----------------- ---------------
Restructuring charges $ 1,188 0.5% $ - 0.0%
----------------- ---------------- ----------------- ---------------
During the third quarter of 2003, the Company announced a restructuring plan
intended to improve financial performance through a realignment of the Company's
management structure, a reduction in personnel, and the consolidation of certain
operations. The program is consolidating the Company's sales, engineering,
manufacturing and accounting functions, which were located in many reporting
entities, into several regional centers in the United States, Europe and Asia.
The Company also announced plans to consolidate the Equipment Business Group and
Ultrapure Water Group into a single business group, divest the Elite Consumer
Products division in Ludlow, Massachusetts, shut down the Ionics Watertec
facility in Australia as well as the Company's European Home Water activities
(the sale of home water conditioners in Ireland and the U.K.). During the fourth
quarter of 2003, the Company decided to divest its European POU cooler business,
which engaged in the sale of POU "bottleless" coolers in Ireland and the U.K.
Additionally, during the second quarter of 2004, the Company decided to dispose
of its General Ionics home water operation, which was reported in the CWG
segment.
As a result of these decisions, the Company recorded restructuring charges of
approximately $2.8 million during 2003 relating to employee severance costs for
the elimination of approximately 160 positions, primarily in the WSG segment,
and an additional $1.2 million in the first six months of 2004, relating
primarily to the termination of facility leases. At June 30, 2004, substantially
all of the employees whose employment was terminated as a result of these
restructuring activities had left the Company. Additionally, at June 30, 2004,
the Company had accrued approximately $1.0 million for restructuring costs
associated with vacated leased facilities. The Company expects the remaining
facility lease payments, less estimates of sub-lease rental income, to be paid
through 2007. The Company expects to realize a reduction of approximately $15.4
million in expenses in 2004 as a result of these actions.
Interest Income and Interest Expense
The following table compares the Company's interest income and interest expense
for the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
--------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
------------------ ----------------------------------- ---------------
----------------- --------------- ------------------ ---------------
Interest Income $ 848 0.4% $ 1,533 0.9%
------------------ --------------- ------------------ ---------------
----------------- --------------- ------------------ ---------------
Interest Expense $ (9,084) (3.9)% $ (486) (0.3)%
------------------ --------------- ------------------ ---------------
Interest income totaled $0.8 million in the six months ended June 30, 2004 and
$1.5 million in the six months ended June 30, 2003. Interest expense was $9.1
million in the six months ended June 30, 2004 compared to $0.5 million in the
same period of 2003. The increase in interest expense was attributable to
increased borrowings as a result of the Ecolochem acquisition as well as
interest expense from the consolidation of Desalcott upon adoption of FIN 46,
effective January 1, 2004.
-33-
Equity Income (Loss)
The Company's proportionate share of the earnings and losses of affiliated
companies in which it holds a minority equity interest is included in equity
income. The following table compares the Company's equity income (loss) relating
to the results of its minority equity investments for the six months ended June
30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
--------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
------------------ ----------------------------------- ---------------
------------------ --------------- ------------------ ---------------
Equity income (loss) $ 1,291 0.6 % $ (2,843) (1.7)%
------------------ --------------- ------------------ ---------------
Equity income amounted to $1.3 million in the six months ended June 30, 2004 and
an equity loss of $2.8 million was incurred in the six months ended June 30,
2003. The Company's equity income (loss) is derived primarily from its 20%
equity interest in a Mexican joint venture company, which owns two water
treatment plants in Mexico, its 43% ownership in Toray Membrane America, Inc.
("TMA"), a membrane manufacturer, its equity interests in several joint ventures
in the Middle East which engage in bottled water distribution, and to a lesser
extent from its other equity investments in affiliated companies. The $4.1
million increase in equity income in the first six months of 2004 compared to
the first six months of 2003 is primarily due to equity loss reported by
Desalcott, which were included in equity income in 2003, as a result of the
Company's 40% equity interest in Desalcott, whereas upon the adoption of FIN 46,
effective January 1, 2004, the Company consolidated the operating results of
Desalcott.
Income Tax Benefit (Expense)
The following table compares the Company's income tax benefit (expense) and
effective tax rates for the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
--------------------------------------------------------------------------
2004 Effective Tax Rate 2003 Effective Tax Rate
------------------ ----------------------------------- ---------------
------------------ --------------- ------------------ ---------------
Income tax expense (benefit) $ (4,228) (239.3)% $ 561 (43.7)%
------------------ --------------- ------------------ ---------------
For the six months ended June 30, 2004, the Company recorded income tax expense
of $4.2 million on consolidated pre-tax income from continuing operations before
minority interest expense of $1.8 million, yielding a tax rate of 239.3% or an
annual effective tax rate of 53.7% excluding a $3.3 million valuation allowance
recorded against certain deferred tax assets in the U.S. and a foreign
subsidiary. For the six months ended June 30, 2003, the Company recorded income
tax benefit of $0.6 million on consolidated pre-tax loss from continuing
operations before minority interest of $1.3 million, yielding an annual
effective tax rate of 43.7%. The change in the effective tax rate for the six
months ended June 30, 2004 compared to the six months ended June 30, 2003
resulted primarily from recording valuation allowances against certain U.S. tax
assets originating during the year, for which the Company may not be able to
realize future tax benefits. During the second quarter, the Company determined
that for financial reporting purposes there is sufficient uncertainty that
certain deferred tax assets, principally related to foreign tax credits in the
U.S. and a deferred tax asset of a foreign subsidiary will be realized,
primarily in light of the softness in the power industry, which impacts domestic
mobile water treatment revenues. In the event that the Company does generate
sufficient future taxable income, this allowance would be recovered.
The Company continually assesses the realizability of its deferred tax assets.
Deferred tax assets may be reduced by a valuation allowance, if based on the
weight of available evidence, it is more likely than not that some portion or
all of the recorded deferred tax assets will not be realized in future periods.
All available evidence, both positive and negative, is considered in the
determination of recording a valuation allowance. The Company considers future
taxable income and ongoing tax planning strategies when assessing the need for a
valuation allowance. Negative evidence that would suggest the need for a
valuation allowance consists of the Company's recent cumulative operating losses
that were attributable to unprofitable businesses.
-34-
Discontinued Operations
During the second quarter of 2004, the Company approved a plan to sell a portion
of its General Ionics home water operation, which is part of CWG. In the third
quarter of 2003, the Company approved a plan of disposition to sell its consumer
chemical business, the Elite Consumer Products division in Ludlow,
Massachusetts, which was part of CWG. In the first quarter of 2004, the Company
completed the sale of the Elite Consumer Products division for approximately
$5.2 million. Additionally, during the fourth quarter of 2003, the Company
approved a plan to sell its European POU cooler business, which sells
point-of-use "bottleless" water coolers in Ireland and the U.K. Accordingly, the
Company's Consolidated Financial Statements and Notes have been reclassified to
reflect these businesses as discontinued operations in accordance with Financial
Accounting Standards Board Statement No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets."
The following table compares the Company's results of discontinued operations
for the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
------------------------------------
2004 2003
----------------- -----------------
Discontinued operations
Loss from operations $ (3,957) $ (1,126)
Income tax benefit 623 412
Loss on disposal - $ (2,526)
---------------- -----------------
Loss from discontinued operations, net of tax $ (3,334) $ (3,240)
================= =================
The loss from discontinued operations of $3.3 million, or $4.0 million on a
pre-tax basis, in the first six months of 2004 included losses to adjust the net
book value to the expected purchase price of the European POU business. During
the second quarter of 2004, the Company completed the sale of the European POU
business for approximately $3.0 million. The Company expects to complete the
sale of its General Ionics home water operations during the second half of 2004.
Net (Loss) Income
The following table compares the Company's net (loss) income and percentage of
revenues for the six months ended June 30, 2004 and 2003:
(Dollars in thousands) Six months ended June 30,
-------------------------------------------------------------------------
2004 Percentage of Revenue 2003 Percentage of Revenue
----------------- ----------------------------------- ---------------
---------------- --------------- ----------------- ---------------
Net loss $ (6,279) (2.7)% $ (4,348) (2.7)%
----------------- --------------- ----------------- ---------------
Net loss amounted to $6.3 million in the first six months of 2004 compared to a
net loss of $4.4 million for the first six months of 2003.
-35-
FINANCIAL CONDITION
The following table compares the Company's net working capital and current ratio
at June 30, 2004 and at December 31, 2003:
(Dollars in thousands)
June 30, 2004 December 31, 2003 Change
------------------ -------------------- ----------------
Total current assets $ 305,342 $ 316,070 $ (10,728)
Total current liabilities 149,571 118,092 31,479
----------------- -------------------- ----------------
Net working capital $ 155,771 $ 197,978 $ (42,207)
------------------ -------------------- ----------------
----------------- -------------------- ----------------
Current ratio 2.0 2.7 (0.7)
------------------ -------------------- ----------------
Net working capital decreased $42.0 million during the first six months of 2004,
while the Company's current ratio, defined as current assets divided by current
liabilities, of 2.0 at June 30, 2004 decreased from 2.7 at December 31, 2003.
The decrease in net working capital and the current ratio primarily reflects the
use of a portion of the Company's cash for the acquisition of the Ecolochem
Group.
At June 30, 2004, the Company had total assets of $1,046.9 million, compared to
total assets of $592.0 million at December 31, 2003. The increase in total
assets primarily relates to the acquisition of the Ecolochem Group ($382.7)
million and the consolidation of Desalcott ( $157.4) million, upon adoption of
FIN 46, effective January 1, 2004. Cash and cash equivalents decreased $73.6
million, primarily reflecting funds used for the acquisition of the Ecolochem
Group on February 13, 2004.
Net cash provided by operating activities amounted to $1.2 million during the
six months ended June 30, 2004 including the loss from continuing operations,
adjusted to exclude the effects of non-cash items for depreciation and
amortization of $23.5 million and deferred tax valuation allowance of $3.3
million. These sources of operating cash were offset by uses for increased
affiliate accounts receivable of $15.6 million, primarily from continuing work
on the Kuwait wastewater project and the reduction of customer deposits of $8.3
million.
Net cash used in investing activities during the first six months of 2004
amounted to $242.6 million, primarily reflecting the use of $223.8 million for
the acquisition of the Ecolochem Group, net of cash acquired, and investments of
$18.0 million for property, plant, and equipment.
Net cash provided by financing activities during the six months ended June 30,
2004 amounted to $163.3 million, reflecting the borrowings under the Company's
new credit facilities established for the acquisition of the Ecolochem Group of
$175.4 million, deferred financing costs of $6.2 million and restricted cash
from Desalcott upon adoption of FIN 46 effective January 1, 2004.
Borrowings and Lines of Credit
On February 13, 2004, the Company acquired the stock and membership interests of
the Ecolochem Group from the shareholders and owners of the Ecolochem Group. The
total purchase price was $366.9 million, consisting of $219.0 million in cash
(which includes $9.8 million in escrow to be paid in the event the Company makes
a Section 338 (h)(10) election of the Internal Revenue Code with respect to
selected acquired intangible assets) and 4,652,648 shares of the Company's
common stock. The issuance of 4,652,648 shares of the Company's common stock was
valued at $139.9 million based on the closing price of the common stock for the
two days before, the day of and the two days after the announcement by the
Company of its agreement to acquire the Ecolochem Group. The purchase price
includes capitalizable acquisition costs of $8.0 million, consisting of
investment banking, legal, consulting and accounting services. The cash portion
of the consideration was financed with the Company's available cash resources
and proceeds from $255 million senior credit facilities with a syndication of
lenders led by UBS, Fleet Bank and Bank of America. Proceeds from these credit
facilities were used to fund the acquisition, pay certain transaction-related
fees and expenses, provide for ongoing working capital and support the issuance
of letters of credit. The credit facilities consist of a $175 million 7-year
term loan, of which $167.9 million was outstanding at June 30, 2004 at an
average interest rate of 5.75%, and an $80 million 5-year revolving credit
facility, of which $2.5 million was outstanding at June 30, 2004 at an average
interest rate of 5.5%. Borrowings under the credit facilities bear interest
equal to a base rate (generally the Prime Rate) plus a specified margin or LIBOR
-36-
plus a specified margin, at the Company's option; the specified margins are a
function of the Company's leverage ratio. Interest on outstanding borrowings is
payable quarterly. The credit facilities are collateralized by the assets of the
Company and of its domestic subsidiaries and by 65% of the equity of certain of
the Company's international subsidiaries. The terms of the credit facilities
include financial covenants relating to fixed charge coverage, interest
coverage, leverage ratio and capital expenditures, the most restrictive of which
are anticipated to be the leverage ratio and limitations on capital spending.
The terms of the credit facilities contain provisions that limit the Company's
ability to incur additional indebtedness in the future and place other
restrictions on the Company's business. At June 30, 2004, the Company was in
compliance with the facilities' covenants. In connection with the execution of
the credit facilities, the Company entered into interest rate swap agreements
that fix the Company's LIBOR rate on $100 million of the term loan at 3.1175%
per annum. The swap agreements expire in 2010.
During the first quarter of 2004, the Company was required to apply the
provisions of FIN 46 to variable interests entities created before February 1,
2003. As a result, effective January 1, 2004, the Company consolidated the
operations, assets, liabilities and minority interests of the Desalination
Company of Trinidad and Tobago Ltd. ("Desalcott"), in which the Company holds a
40% equity interest, because the Company believes it holds a majority of the
related financial risks. As of June 30, 2004, Desalcott had total assets and
total liabilities of approximately $157.4 million and $132.9 million,
respectively. Included in liabilities is debt of $111.3 million, which is
collateralized by substantially all of the assets of Desalcott, and is
non-recourse to the Company.
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, Israel and
Algeria 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 entity 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. The Company generally has no commitment to
fund the joint venture's working capital or other cash needs. The joint venture
entities typically obtain third-party debt financing for a substantial portion
of the project's total capital requirements. In these situations, the Company is
not responsible for the repayment of the indebtedness incurred by the joint
venture entity. In connection with a joint venture's project, the Company may
also enter into contracts for the supply and installation of the Company's
equipment during the construction of the project or 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.
The operations, assets and liabilities of Desalcott are consolidated with the
Company effective January 1, 2004, as a result of the adoption of FIN 46. The
operations, assets and liabilities of the Algerian joint venture company are
consolidated with the Company as a majority-owned subsidiary. The Kuwait and
Israel projects discussed below constitute off-balance sheet arrangements.
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 ("WASA").
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 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 collateralized by a security
-37-
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. No payments have
been made by HKES to the Company on this loan.
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 disputed certain amounts payable under the construction contract. In
June 2003, Desalcott and the Company's Trinidad subsidiary resolved their
dispute 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. This settlement had no impact on the Company's Statements of
Operations.
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, effective July 31, 2003, converted 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, subordinated to the long-term
loan with the Trinidad bank. That loan has a seven-year term, and is payable in
28 quarterly payments of principal and interest. No payments can be made by
Desalcott to the Company until Desalcott has established a level of cash
reserves required by the Trinidad bank. The interest rate is fixed at two
percent above the interest rate payable by Desalcott on the U.S. dollar portion
of its borrowings under its long-term loan agreement with the Trinidad 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 obligation to the Company is 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 $3.2 million. This amount will
be partially paid out of Desalcott's future cash flow from operations over a
period of time estimated to be two years, and the balance from funds available
from long-term financing proceeds upon completion by the Company of certain
"punch list" items relating to phases 1 through 4. 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 $7.4 million. Work on phase 5
was completed during the second quarter of 2004. As of June 30, 2004, the
Company had been paid a total of $3.9 million for its work on phase 5.
In April 2004, following an unsuccessful mediation attempt, Desalcott notified
WASA that it had commenced an arbitration proceeding under the dispute
resolution procedures of the water supply agreement between Desalcott and WASA
dated August 29, 1999 and amended in May 2000 (the "Water Supply Agreement").
Desalcott is seeking, among other things, payments from WASA for certain water
price increases as provided for in the Water Supply Agreement, as well as
damages for delays in plant completion which Desalcott claims resulted from
delays in obtaining a government guaranty of payments by WASA and certain tax
incentives. At June 30, 2004, Desalcott claimed that WASA owed it $3.2 million,
representing revenues under the Water Supply Agreement corresponding to
contractual price increases. WASA has contested the amounts of the water price
increases claimed by Desalcott, asserting that Desalcott did not pass along to
WASA certain cost savings realized by Desalcott. In addition, WASA asserts that
Desalcott's ability to make up production shortfalls by selling excess
production is more limited contractually than claimed by Desalcott. In addition,
WASA has also asserted that Desalcott is liable for liquidated damages because
of delays in the completion of the plant, irrespective of the delay in obtaining
the government guaranty, and that such liquidated damages currently total
approximately $4.0 million and are still accumulating. WASA has asserted
additional liquidated damages will be owed by Desalcott for the delay in the
completion of Phase 5 of the project, or that in the alternative it may seek to
reject Phase 5. Under the currently projected timetable, this matter should be
heard in arbitration by the International Chamber of Commerce in London in 2005.
-38-
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,
2004, the Company had invested a total of $11.5 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 $5.7
million over the next year. In addition, a total of $18.6 million in performance
bonds have been issued on behalf of the Company's Italian subsidiary in
connection with the project. UDC's wastewater treatment facility is expected to
become operational in early 2005.
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 and
the Company acquired the ownership interest of the Israeli corporation in MDL.
In the second quarter of 2003, MDL finalized a concession contract with a
state-sponsored water company for the construction, ownership and operation of a
brackish water desalination facility in Israel. In the second quarter of 2003,
MDL obtained $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 the form
of a bank letter of guarantee. In the third quarter of 2003, the Company through
its Israeli subsidiary made an equity investment of $1.5 million in MDL for its
49% equity interest. Substantial completion of this project was achieved in the
second quarter of 2004.
In 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"). 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. As
of March 31, 2004, the Company had made an equity investment of $0.2 million in
CDL and had deferred costs of $0.6 million relating to the engineering design
and development work on the project. The terms of the concession agreement
originally required that long-term financing be obtained by April 2003. CDL was
initially granted an extension to August 20, 2003 and a further extension to
April 1, 2004 was granted by the WDA. CDL was unable to obtain long-term
financing by the required date. CDL asserts that its inability to obtain
financing resulting from certain errors and omissions in WDA's tendering process
which would have prevented CDL from constructing the facility as proposed. On
April 1, 2004 the WDA notified CDL of its intent to terminate the concession
agreement and to take action to collect on a bid bond (of which it is the
beneficiary) issued on behalf of CDL. On May 5, 2004, the WDA issued a notice of
termination to CDL and made a demand upon the issuing bank of the bid bond. The
Company's liability under the bid bond was approximately $2.5 million (a
one-third proportionate share of the approximate $7.5 million bid bond). During
the first quarter of 2004, as a result of the notification by the WDA of their
intent to collect on the bid bond, the Company recorded a liability of $2.5
million related to its proportionate share. WDA collected on the bid bond in the
second quarter of 2004. In addition, the Company expensed its deferred costs
relating to the construction project and its investment in CDL of $0.8 million.
The dispute between CDL and the WDA concerning the errors and omissions in the
tendering process, the termination of the concession agreement and the demand
made upon the bid bond has been submitted to binding arbitration in Israel (with
CDL and WDA both as claimants and respondents), and it is expected that the
matter will be heard and a decision rendered by the arbitrator in the latter
part of 2004. The Company believes that CDL has legitimate claims and
meritorious defenses in this matter and, in cooperation with the Company's
partners in CDL and CDL's outside counsel, intends to aggressively pursue
recovery of bid bond payments made to WDA as well as other damages.
-39-
In the third quarter of 2003, a 50/50 joint venture between the Company and an
Israeli engineering corporation was selected by Mekorot, the Israeli
state-sponsored water company, to design, supply and construct a 123,000 cubic
meter per day (32.5 million gallons per day) seawater desalination facility in
Ashdod, Israel. The estimated value of the equipment supply and construction
contract to be negotiated and entered into with respect to the project is
approximately $95 million, and it is estimated that the plant will require
approximately two years to construct. The joint venture submitted a $5 million
bid bond with its proposal, and the Company would be responsible for 50% of this
amount if a demand were made on the bid bond. It is currently anticipated that
the parties will sign a final form of contract in 2004, at which time the joint
venture will replace the bid bond with a performance bond in the principal
amount of 10% of the contract value.
Algeria
In the fourth quarter of 2003, the Company and Algerian Energy Company ("AEC")
were selected for a 25-year seawater desalination build-own-operate project.
Sonatrach, the Algerian national energy company, will guarantee the water supply
contract. The Company and AEC have formed a joint project company, Hamma Water
Desalination S.p.A. ("HWD"), in which the Company has a 70% ownership interest.
The projected $220 million capital investment will be financed by a combination
of equity and non-recourse debt. Through June 30, 2004, the Company made an
equity investment of $0.2 million in HWD and deferred costs of approximately
$0.9 million relating to the engineering design and development work on the
project. If HWD obtains long-term project financing, the Company has committed
to make additional equity investments to HWD of approximately $45.6 million. The
Company expects HWD will obtain long-term project financing by December 31,
2004. If HWD is unable to obtain such financing, the Company would expense its
deferred costs relating to the construction project and its investment in HWD.
Additionally, the Company has provided a $1.0 million bid bond to the customer.
Guarantees and Indemnifications
In the fourth quarter of 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 5, 57, and 107 and rescission of FASB
Interpretation 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 and other undertakings
that were determined to be within the scope of FIN 45.
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 in the form of bank guarantees are sometimes 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 with the exception of the bid bond
associated with CDL, as described above. Approximately $111.9 million of these
instruments were outstanding at June 30, 2004. Based on the Company's experience
with respect to letters of credit and credit, bid bonds and performance bonds,
the Company believes the estimated fair value of the instruments entered into
during the first six months of 2004 is not material. Accordingly, the Company
has not recorded any liabilities for these instruments as of June 30, 2004.
As part of 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 entered into
prior to December 31, 2002, were grandfathered under the provisions of FIN 45.
For warranties and indemnifications made to sellers and purchasers subsequent to
December 31, 2002, the Company has not recorded any liabilities for these
obligations as of June 30, 2004, as it believes that it will incur no
liabilities under such provisions.
-40-
The following table reflects significant changes to the Company's contractual
obligations from December 31, 2003. The cash portion of the Ecolochem Group
acquisition was primarily financed from the proceeds from the new $255 million
senior credit facilities with the syndication of lenders. The credit facilities
consist of a $175 million 7-year term loan, of which $167.9 million was
outstanding at June 30, 2004 and an $80 million 5-year revolving credit
facility, of which $2.5 million was outstanding at June 30, 2004. Also, pursuant
to FIN 46, effective January 1, 2004, the Company consolidated the assets,
liabilities and minority interests of Desalcott. The Desalcott debt consists of
20-year loans and is secured by substantially all the assets of Desalcott, and
is non-recourse to the Company.
Less 1-3 4-5 After 5
(Dollars in Thousands) than 1 Year Years Years Years Total
- -----------------------------------------------------------------------------------------------------------------
Notes Payable and
Current Portion of Long-Term Debt $ 6,137 $ 3,107 $ 3,094 $ 1,802 $ 14,140
Debt for Ecolochem acquisition 1,683 3,366 3,366 159,485 $ 167,900
Desalcott Notes Payable 4,057 11,156 11,618 84,505 $ 111,336
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Total Contractual Obligations $ 11,877 $ 17,629 $ 18,078 $ 245,792 $ 293,376
================================================================================
Maturities of all cash borrowings outstanding for the five years ended December
31, 2004 through December 2008 are approximately $11.9 million, $8.6 million,
$9.0 million, $9.1 million and $9.0 million, respectively, and $245.8 million
thereafter. The weighted average interest rate on all borrowings was 6.4% and
6.0% at June 30, 2004 and December 31, 2003, respectively.
The Company believes that its existing cash and cash equivalents, cash generated
from operations, and senior credit facilities will be sufficient to fund its
capital expenditures, working capital requirements and contractual obligations
and commitments at least through 2005.
RISKS AND UNCERTAINTIES
The Company's operations and financial results are subject to risks and
uncertainties, as described in Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations," of the Company's Annual Report
on Form 10-K for the year ended December 31, 2003, and to the following
additional risk factor:
Our internal controls over financial reporting may have weaknesses and
conditions that need to be addressed, the disclosure of which may have an
adverse impact on the price of our common stock. We are required to establish
and maintain appropriate internal controls over financial reporting. Failure to
establish those controls, or any failure of those controls once established,
could adversely impact our public disclosures regarding our business, financial
condition or operating results. During 2003 and 2004 we have been implementing
new operating software systems and continuing other efforts to improve our
internal controls. We expect to have completed the implementation of our new
software systems in our principal business units and locations by the middle of
2005, with initial implementation scheduled for the third quarter 2004. The
systems will not have been implemented in all our locations and business units
by the end of 2004. Further, the operation of that system will be relatively new
and unseasoned. In addition, management's assessment of our internal controls
over financial reporting as of the end of 2004 may identify weaknesses and
conditions that need to be addressed in our internal controls over financial
reporting or other matters that may raise concerns for investors. Any actual or
perceived weaknesses and conditions that need to be addressed in our internal
controls over financial reporting, disclosure of management's assessment of our
internal controls over financial reporting, or disclosure of our registered
public accounting firm's attestation to or report on management's assessment of
our internal controls over financial reporting may have an adverse impact on the
price of our common stock.
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
-41-
Operations" constitute forward-looking statements. Such statements are based on
management's current views and assumptions and are neither promises nor
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, 2003, and in this quarterly report on Form 10-Q, 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 the recently announced restructuring program;
risks associated with the integration of the activities of the Ecolochem Group
with those of the Company; 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
offset the foreign exchange risk associated with forecasted revenues related to
an ongoing project. As of June 30, 2004, the notional amount of the contracts
was $3.4 million. The fair value of the forward contracts, which was $0.3
million at June 30, 2004, 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 inter-company loan. At June 30, 2004, 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,
2004, a hypothetical change of 10% in exchange rates would change the fair value
of the Company's portfolio of foreign exchange contracts by approximately $1.0
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, 2004, the Company had $11.9 million of short-term debt
and $281.5 million of long-term debt outstanding, which amounts include $4.1
million and $107.2 million, respectively, of Desalcott debt, which is
non-recourse to the Company. A hypothetical increase of 10% in interest rates
for a one-year period would result in additional interest expense of $0.6
million. In connection with the acquisition of the Ecolochem Group and the
execution of the credit facility, the Company entered into interest rate swap
agreements that fix the Company's LIBOR rate on $100 million of the term loan at
3.1175%. The swap agreements expire in 2010. The Company's net foreign exchange
currency gain was $0.5 million and $1.0 million for the three months ended June
30, 2004 and 2003, 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, 2004. The
Securities and Exchange Commission ("SEC") defines "disclosure controls and
-42-
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, 2004 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.
There were no changes in the Company's internal control over financial reporting
during the quarter ended June 30, 2004 that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting. The Company has undertaken a review of its internal control
over financial reporting in light of the requirements of Section 404 of the
Sarbanes-Oxley Act of 2002. In connection with this review, the Company has made
and will continue to make changes that enhance the effectiveness of its internal
controls.
-43-
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In August 2004, the Company agreed in principle to settle the securities class
action lawsuit brought in March 2003 against the Company and its former Chief
Executive Officer and current Chief Financial Officer in the U.S. District
Court, District of Massachusetts (Jerome Deckler v. Ionics, Inc. et al., Civil
Action No. 03-CV10393(WGY)). Under the terms of the settlement-in-principle, a
settlement fund will be created in the total amount of $3 million, to be paid
entirely by the Company's insurer. The Company will not be required to make any
contribution to this settlement fund. The settlement-in-principle is subject to
the execution and filing with the U.S. District Court of a definitive
stipulation of settlement and also final approval of the settlement by the
Court.
On September 15, 2003, the Company was served with a summons and complaint
captioned Brazos River Authority v. Ionics, Incorporated, Cajun Constructors,
Inc. f/k/a Cajun Contractors, Inc., and HDR Engineering, Inc., in Texas state
court. The suit was subsequently removed to the U.S. District Court, Western
Division of Texas, Waco Division (Civil Action WA: 03-CV-324). On July 1, 2004,
plaintiff filed a first amended complaint. Plaintiff alleges that an
electrodialysis reversal ("EDR") desalination system originally sold by the
Company to the plaintiff in 1989 and expanded by the Company in 1998 is
defective and accuses the Company and the other defendants of, among other
things, negligence, breach of contract, and misrepresentation. The complaint
seeks both compensatory and punitive damages in an unspecified amount, among
other relief. The plaintiff subsequently made a settlement demand of $25
million. The Company has filed an answer to the complaint which states the
Company's belief that any problems encountered by the plaintiff resulted from
its failure to operate and maintain the equipment properly. The Company intends
to defend itself vigorously in this matter. Trial on this matter is currently
scheduled to commence in the third quarter of 2004. While the Company believes
that this litigation should have no material adverse impact on its financial
condition, results of operations or cash flow, the litigation process is
inherently uncertain, and the Company can make no assurances as to the ultimate
outcome of this matter.
On April 28, 2004, the Company was served with a summons and complaint captioned
Caldon, Inc. v. Ionics, Incorporated and Key Technologies, Inc., filed in the
U.S. District Court for the Western District of Pennsylvania, Pittsburgh.
Caldon, Inc. ("Caldon") alleges that certain flow measurement systems, which
Caldon provides to the nuclear power industry to measure feedwater flow, and
which were designed by defendant Key Technologies, Inc., failed after
installation. Caldon engaged the Company to fabricate these systems using Key
Technologies, Inc.'s designs. Caldon further alleges that defendant Key
Technologies, Inc. failed to design the systems adequately and that the Company
failed to weld the systems properly. Caldon claims that it has incurred damages
in excess of $2.7 million and has made commitments to customers that will cause
it to incur an additional $4.0 million, as well as other damages in an
unspecified amount. The Company believes that Caldon's allegations as to the
Company are without merit, and intends to defend itself vigorously in this
matter. The lawsuit is currently in the early discovery stages. While the
Company believes that this litigation should 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 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
A third-party trustee makes open-market purchases and sales of the Company's
common stock from time to time in connection with the Company's 401(k) Savings
Plan, under which participating employees may invest in the Company's common
stock.
-44-
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) The Annual Meeting of the Stockholders was held on May 6, 2004. Stephen
L. Brown, William K. Reilly, Robert H. Temkin and Allen S. Wyett were
elected as Class III Directors for a three-year term. The number of votes
cast for the election of the Class III Directors were as follows:
For Withheld
Stephen L. Brown 20,339,244 264,522
William K. Reilly 19,845,125 758,641
Robert H. Temkin 20,342,152 261,614
Allen S. Wyett 19,928,765 775,001
The following members of the Board of Directors continued in office:
Class I Directors (terms expire at the 2005 Annual Meeting)
-----------------
Douglas R. Brown
Kathleen F. Feldstein
Frederick T. Stant, III
Class II Directors (terms expire at the 2006 Annual Meeting)
------------------
Lyman B. Dickerson
John J. Shields
Daniel I. C. Wang
Mark S. Wrighton
Arthur L. Goldstein resigned as a Class I Director following the Annual
Meeting of Stockholders.
b) The other matter submitted for stockholder approval was the ratification
of the selection of PricewaterhouseCoopers LLP as the Company's auditors
for 2004. The following votes were cast in connection with this matter:
Votes for: 20,253,851
Votes against: 323,445
Abstentions: 26,470
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
Exhibit No. Description
----------- -----------
10.1 Second Amendment to Credit Agreement dated
as of July 9, 2004, by and among the Company
as borrower; certain of its domestic
subsidiaries as guarantors; UBS Securities
LLC as Lead Arranger, Sole Bookmanager and
Documentation Agent; and certain other
parties thereto. +
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. +
---------------------
+ Filed herewith.
-45-
b) Reports on Form 8-K
The Company filed two reports on Form 8-K with the Securities and
Exchange Commission during the three-month period ended June 30, 2004, as
follows:
(1) Filed on May 11, 2004, reporting under Item 7 and Item 12 the
issuance by the Company of a press release reporting financial results
for the first quarter of 2004, ended March 31, 2004. A copy of the
financial results press release was filed as Exhibit 99 to the Form 8-K,
(2) Filed April 28, 2004, amending a report on Form 8-K originally
filed on February 27, 2004, by reporting under Item 7 certain pro forma
financial information which was filed as Exhibit 99.1.
-46-
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 9, 2004 By: /s/Douglas R. Brown
-------------------------------------------
Douglas R. Brown
President and Chief Executive Officer
(duly authorized officer)
Date: August 9, 2004 By: /s/Daniel M. Kuzmak
-------------------------------------------
Daniel M. Kuzmak
Vice President and Chief Financial Officer
(principal financial officer)
-47-
EXHIBIT INDEX
Exhibit No. Description
10.1 Second Amendment to Credit Agreement dated as of July 9, 2004, by +
and among the Company as borrower, certain of its domestic
subsidiaries as guarantors; UBS Securities LLC as Lead Arranger,
Sole Bookmanager and Documentation Agent; and certain other parties
thereto.
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 +
- --------------------
+Filed herewith.
-48-