ITEM 1. BUSINESS
Unless otherwise indicated by the context, as used in this Annual Report on Form 10-K, “we,” “us” and “our” refer to International Absorbents Inc. (“International Absorbents”) and our wholly-owned U.S. subsidiary, Absorption Corp. (“Absorption”).
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 based on current expectations, estimates and projections about our industry and our management’s beliefs and assumptions. They can be identified by the use of forward-looking words such as “believes,” “expects,” “plans,” “may,” “will,” “would,” “could,” “should” or “anticipates” or other comparable words, or by discussions of strategy, plans or goals that involve risks and uncertainties that could cause actual results to differ materially from those currently anticipated. You are cautioned that any forward-looking statements are not guarantees of future performance and involve risks and uncertainties, including those set forth below under “Item 1A
ITEM 1A. RISK FACTORS
The following risk factors and other information included in this Annual Report should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks occur, our business, financial condition, operating results and cash flows could be materially adversely affected.
We are still building our market presence and are subject to substantial competition that could inhibit our ability to succeed as planned.
We are one of many companies that compete in the animal care market. We continue to build and maintain our market presence as we compete with both domestic and foreign companies. Any reputation that we may successfully gain with retailers for quality product does not necessarily translate into name recognition or increased market share with the end consumer. Our products may not be well received by pet owners, or other companies may surpass us in product innovations. Any failure to continue to gain consumer awareness and market share could decrease our revenues and have an adverse effect on our financial results.
We may be adversely affected by trends in the retail industry.
With the growing trend towards retail trade consolidation, we are increasingly dependent upon key retailers whose bargaining strength is growing. As a result, our business may be negatively affected by changes in the policies of our retailer customers, such as inventory delisting, limitations on access to shelf space, price demands and other conditions. In addition, as a result of the desire of retailers to more closely manage inventory levels, there is a growing trend among retailers to make purchases on a “just-in-time” basis. This requires us to shorten our lead time for production in certain cases and more closely anticipate demand, which could in the future require the carrying of additional inventories and increase our working capital and related financing requirements.
Moreover, a significant deterioration in the financial condition of one of our major customers could have a material adverse effect on our sales, profitability and cash flow. We continually monitor and evaluate the credit status of our customers and attempt to adjust sales terms as appropriate. Despite these efforts, a bankruptcy filing by a key customer could have a material adverse effect on our business, results of operations and financial condition.
We depend on a few customers for a significant portion of our business.
Our two largest customers accounted for approximately 23% (Petco) and 24% (Petsmart) of our net sales in fiscal year 2007, while the same customers accounted for approximately 23% and 22%, respectively, of our net sales in fiscal year 2006.
The loss of, or significant adverse change in, our relationship with any of these key retailers could cause our net sales, income from operations and cash flow to decrease substantially. The loss of, or reduction in, orders from any significant customer, losses arising from customer disputes regarding shipments, fees, merchandise condition or related matters, or our inability to collect accounts receivable from any major customer could reduce our income from operations and cash flow.
We cannot be certain that our product innovations and marketing successes will continue.
We believe that our future success will partially depend upon our ability to continue to improve our existing products through product innovation and to develop, market and produce new products. We cannot assure you that we will be successful in the introduction, marketing and production of any new products or product innovations, or develop and introduce in a timely manner innovations to our existing products which satisfy customer needs or achieve market acceptance. Our failure to develop new products and introduce them successfully and in a timely manner could harm our ability to grow our business and could have a material adverse effect on our business, results of operations and financial condition.
Competition in our industries may hinder our ability to execute our business strategy, maintain profitability, or maintain relationships with existing customers.
We operate in highly competitive industries, which have experienced increased consolidation in recent years. We compete against numerous other companies, some of which are more established in their industries and have substantially greater revenue or resources than we do. Our products compete against national and regional products and private label products produced by various suppliers. To compete effectively, among other things, we must:
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maintain our relationships with key retailers and distributors;
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develop and grow brands that are attractive to consumers and gain market share;
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continually develop innovative new products that appeal to consumers;
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maintain strict quality standards; and
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deliver products on a reliable basis at competitive prices.
Competition could cause lower sales volumes, price reductions, reduced profits, losses, or loss of market share. Moreover, as we add new items to our line of products, they will need to compete for limited shelf space at the mass merchandiser and grocery stores with our competitors’ products. Our inability to compete effectively could have a material adverse effect on our business, results of operations and financial condition.
Additional increases in our costs of goods sold, including the costs of raw materials, transportation costs or labor expenses, could have an adverse effect on our financial condition.
Our business places heavy reliance on raw materials being readily available. Although we believe that there are a number of pulp and paper mills in British Columbia, Canada, the State of Washington, the State of Georgia, and the State of Florida that can provide us with the raw materials necessary to conduct our business, any significant decreases in supplies, or any increase in costs or a greater increase in delivery costs for these materials, could result in a decrease in our margins, which would harm our financial condition. For example, in the second quarter of fiscal year 2005, we experienced a decreased availability of our main raw material, waste wood fiber, which resulted in downward pressure on our gross profits for the period. We currently do not have ideal raw material sources for our needed primary raw material, waste wood pulp, to be supplied to our Georgia facility. Although we believe we will be able to obtain the required material in the region, any significant shortfall of material would result in a significant increase in the cost of producing our primary products.
In addition, we have recently experienced exceedingly high energy and transportation expenses. Any further increases in these costs will continue to have an adverse effect on our financial results. Moreover, we face a risk of increased labor costs, including significant increases in worker’s compensation insurance premiums and health care benefits, which could further negatively impact our results of operations.
Rising energy prices could adversely affect our operating results.
In the last few years, energy prices have risen dramatically, which has resulted in increased fuel costs for our businesses and raw materials costs for our branded products. Rising energy prices could adversely affect consumer spending and demand for our products and increase our operating costs, both of which would reduce our sales and operating income.
Our business is subject to many regulations and noncompliance could be costly.
The manufacture, marketing and sale of our products are subject to the rules and regulations of various federal, provincial, and state agencies, including, without limitation, regulations governing emissions into the air, discharges into the water, generation, handling, storage, transportation, treatment, and disposal of waste materials. Environmental regulations may affect us by restricting the manufacturing or use of our products ore regulating their disposal. We are also subject to other federal and state laws and regulations regarding health and safety matters.
If we do not obtain all material licenses and permits required by government, we may be subject to regulatory action by government authorities. Moreover, if our policies and procedures do not comply in all respects with existing laws and regulations, our activities may violate such laws and regulations. Even if our policies and procedures do comply, but our employees fail or neglect to follow them in all respects, we might incur similar liability. For example, if a regulatory authority finds that a current or future product or production run is not in compliance with any of these regulations, we may be fined, production may be stopped or a product may be pulled from the shelves, any of which could adversely affect our financial conditions and operations.
In addition, any adverse publicity associated with any noncompliance may damage our reputation and our ability to successfully market our products. Furthermore, the rules and regulations are subject to change from time to time and while we closely monitor developments in this area, we have no way of anticipating whether changes in these rules and regulations will be made that would impact our business adversely. Additional or revised regulatory requirements, whether labeling, environmental, health and safety, tax or otherwise, could have a material adverse effect on our financial condition and results of operations.
We have significant indebtedness, the nonpayment of which could harm our business.
As of January 31, 2007, we had total long-term and current indebtedness under three different bonds of $8,326,000. We make interest payments (and principal payments on the taxable bond) on the indebtedness under three bonds, which are due in 2007, 2014, and 2019, respectively. We may incur substantial additional debt in the future. Our indebtedness could limit our ability to obtain necessary additional financing for working capital, capital expenditures, debt service requirements or other purposes in the future; to plan for, or react to, changes in technology and in our business and competition; and to react in the event of an economic downturn. There is no guarantee that we will be able to meet our debt service obligations. If we are unable to generate sufficient cash flow or obtain funds for required payments, or if we fail to comply with covenants in our indebtedness, we will be in default. The indebtedness underlying our bonds is secured by a mortgage on our real property and a security interest in our assets. If we are in default under the agreements governing our indebtedness, the creditors may be able to foreclose on our property and assets, which would substantially harm our business and financial condition.
If we fail to maintain an effective system of internal and disclosure controls, we may not be able to accurately report our financial results or prevent fraud.
Effective internal and disclosure controls help us to provide reliable financial reports and effectively prevent fraud and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. As a result, current and potential shareholders could lose confidence in our financial reporting, which would harm our business and the trading price of our securities. We have in the past discovered deficiencies in our internal controls as defined under interim standards adopted by the Public Company Accounting Oversight Board (“PCAOB”) that require remediation. Furthermore, our independent auditor has, in the past, advised us that it had noted certain reportable conditions in our internal financial reporting and accounting controls. Additionally, it is possible that as we continue our ongoing review and analysis of internal control over financial reporting for compliance with the Sarbanes-Oxley Act of 2002, additional weaknesses in internal controls may be discovered.
If we need to raise additional capital for our operating plan, our business would be harmed if we were unable to do so on acceptable terms.
We currently anticipate that our existing capital resources and cash flows from operations will enable us to maintain our currently planned operations for the foreseeable future. However, our current operating plan may change as a result of many factors, including general economic conditions affecting the U.S. economy, which are beyond our control. If we are unable to generate and maintain positive operating cash flows and operating income in the future, we may need additional funding. We may also choose to raise additional capital due to market conditions or strategic considerations even if we believe that we have sufficient funds for our current or future operating plans. If additional capital were needed, our inability to raise capital on favorable terms would harm our business and financial condition. To the extent that we raise additional capital through the sale of equity or debt securities convertible into equity, the issuance of these securities could result in dilution to our shareholders.
The indentures governing our bonds and bank debt financing includes financial covenants that restrict certain of our activities and impose certain financial tests that we must meet in order to be in compliance with their terms.
The terms of the indentures governing our bonds and bank debt financing restrict our ability to, among other things, incur additional indebtedness, pay dividends or make other restricted payments on investments, consummate asset sales or similar transactions, create liens, or merge or consolidate with any other person or sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of our assets. The terms also contain covenants that require us to meet financial tests. We currently are in compliance with these restrictions and covenants and expect that we will continue to comply. If we were not able to do so, we could be materially and adversely affected.
The loss of key senior management personnel could negatively affect our business.
We depend on the continued services and performance of our senior management and other key personnel. We do not have “key person” life insurance policies. The loss of any of our executive officers or other key employees could harm our business.
Our future growth may depend on our ability to penetrate new domestic and international markets, which could reduce our profitability.
Our current sales projections indicate that growth in sales may need to come from new products and new markets, including international markets. International small animal care customs, standards, techniques, and methods differ from those in the United States. Laws and regulations applicable in new markets may be unfamiliar to us. Compliance may be substantially more costly than we anticipate. As a result we may need to redesign products, or invent or design new products, to compete effectively and profitably in new markets. We expect that we will need significant time, which may be years, to generate substantial sales or profits in new markets.
Other significant challenges to conducting business in foreign countries include, among other factors, local acceptance of our products, political instability, currency controls, changes in import and export regulations, changes in tariff and freight rates, and fluctuations in foreign exchange rates. We might not be able to penetrate these markets and any market
penetration that occurs might not be timely or profitable. If we do not penetrate these markets within a reasonable time, we will be unable to recoup part or all of the significant investments we may have made in attempting to do so.
The inability to successfully obtain or protect our patents could harm our competitive advantage.
Our success will depend, in part, on our ability to maintain protection for our products under U.S. patent laws, to preserve our trade secrets and to operate without infringing the proprietary rights of third parties. We have been issued two U.S. patents and have one pending and one provisional patent on various degradable particulate absorbent materials and our manufacturing process. Patent applications may not successfully result in an issued patent. Issued patents may be subject to challenges and infringements. Moreover, upon expiration of any of our issued patents, other parties may be able to develop competing products, which could decrease our sales and reduce our market share. Furthermore, others may independently develop similar products or otherwise circumvent our patent protection. Should we fail to obtain and protect our patents, our competitive advantage will be harmed.
The products that we manufacture could expose us to product liability claims, and our manufacturing process may pose additional risks.
Our business exposes us to potential product liability risks that are inherent in the manufacture and distribution of certain of our products. Although we generally seek to insure against such risks, there can be no assurance that such coverage is adequate or that we will be able to maintain such insurance on acceptable terms. A successful product liability claim in excess of our insurance coverage could have a material adverse effect on us and any successful material product liability claim could prevent us from obtaining adequate product liability insurance in the future on commercially reasonable terms. Moreover, as part of our manufacturing process, we use complex and heavy machinery and equipment that can pose severe safety hazards, especially if not properly and carefully used.
We will incur substantial costs to comply with the requirements of the Sarbanes-Oxley Act of 2002, and our internal controls may not be in compliance with all of the requirements prior to the currently proposed compliance date.
The Sarbanes-Oxley Act of 2002 (the “Act”) introduced new requirements regarding corporate governance and financial reporting. Among the many requirements is the requirement under Section 404 of the Act for management to annually assess and report on the effectiveness of our internal control over financial reporting and for our registered public accountant to attest to this report. The SEC has modified the effective date and adoption requirements of Section 404 implementation for non-accelerated filers, such as us, such that we are first required to issue our management report on internal control over financial reporting in our annual report on Form 10-K for the fiscal year ending January 31, 2008. We will be required to dedicate significant time and resources during fiscal year 2008 to ensure compliance. The costs to comply with these requirements will likely be significant and adversely affect our operating results. In addition, there can be no assurance that we will be successful in our efforts to comply with Section 404 and, in fact, we may not be in compliance with all of the requirements prior to the currently proposed compliance date. Failure to do so could result in penalties and additional expenditures to meet the requirements, which could affect the ability of our auditors to issue an unqualified report which, in turn, may further adversely affect our business and operating results.
Natural disasters could decrease our manufacturing capacity.
Most of our current and planned manufacturing facilities are located in geographic regions that have experienced major natural disasters, such as earthquakes, floods, and hurricanes. Our disaster recovery plan may not be adequate or effective. We do not carry earthquake or flood insurance. Other insurance that we carry is limited in the risks covered and the amount of coverage. Our insurance would not be adequate to cover all of our resulting costs, business interruption and lost profits when a major natural disaster occurs. A natural disaster rendering one or more of our manufacturing facilities totally or partially unusable, whether or not covered by insurance, would materially and adversely affect our business and financial condition.
The price for our common shares may continue to be volatile.
The market price of our common shares, like that of many other small-cap companies, has been highly volatile, experiencing wide fluctuations not necessarily related to the operating performance of such companies. Factors such as our operating results, announcements by us or our competitors concerning innovations and new products or systems may have a significant impact on the market price of our securities. In addition, we have experienced limited trading volume in our common shares.
It might be difficult for a third-party to acquire us even if doing so would be beneficial to our shareholders.
In fiscal year 2007, we adopted a shareholder rights plan. The shareholder rights plan is designed to protect shareholders from unfair, abusive or coercive take-over strategies, including the acquisition of control of our company by a bidder in a transaction or series of transactions that does not treat all shareholders equally or fairly or provide all shareholders an equal opportunity to share in the premium paid on an acquisition of control. However, the shareholder rights plan may discourage certain types of take-over bids that might be made for us and may render more difficult a merger, tender offer, assumption of control by the holders of a large block of our securities or the removal of incumbent management, even though certain of such transactions or effects might be beneficial in the judgement of certain shareholders or shareholders generally. For example, the shareholder rights plan could have the effect of preventing a particular take-over bid from being made or being successful, even though a majority of our shareholders might wish to participate in that take-over bid. The shareholder rights plan will cause substantial dilution to a person or group that attempts to acquire us other than through a “permitted bid” (as defined in the plan) or on terms approved by the Board. If triggered, the shareholder rights plan will also likely cause substantial dilution to any shareholder who fails to or elects not to exercise its rights. The existence of these anti-takeover provisions could limit the price that investors might be willing to pay in the future for our common shares.
Our results of operations could vary as a result of the methods, estimates, and judgments we use in applying our accounting policies or as the result of the adoption of new accounting pronouncements.
The methods, estimates, and judgments we use in applying our accounting policies have a significant impact on our results of operations. Such methods, estimates, and judgments are, by their nature, subject to substantial risks, uncertainties, and assumptions, and factors may arise over time that lead us to change our methods, estimates, and judgments. Changes in those methods, estimates, and judgments could significantly affect our results of operations. In particular, the calculation of share-based compensation expense (as described below), requires us to use valuation methodologies and a number of assumptions, estimates, and conclusions regarding matters such as expected forfeitures, expected volatility of our share price, the expected dividend rate with respect to our common stock, and the exercise behavior of our employees. Furthermore, there are no means, under applicable accounting principles, to compare and adjust our expense if and when we learn about additional information that may affect the estimates that we previously made, with the exception of changes in expected forfeitures of share-based awards. Factors may arise over time that lead us to change our estimates and assumptions with respect to future share-based compensation arrangements, resulting in variability in our share-based compensation expense over time. Changes in forecasted share-based compensation expense could impact our gross margin percentage; research and development expenses; marketing, general and administrative expenses; and our tax rate. Moreover, the issuance and adoption of new accounting pronouncements may require us to change our accounting policies, which could have an adverse effect on our operating results.
The liquidity of our stock depends in part on our continued listing with the American Stock Exchange.
In March 2003, we received official notice from the American Stock Exchange (“AMEX”) that our common stock had been approved for listing. In order to continue to have our common shares listed, we must remain in compliance with the AMEX listing standards, including standards related to stock price, market capitalization and corporate governance. If we are unable to do so, AMEX could de-list our stock, in which event the liquidity and the value of our shares could be adversely impacted.
As a result of our principal executive offices being located in Canada, and a majority of our directors and certain of our officers residing in Canada, investors may find it difficult to enforce, within the United States, any judgments obtained against our company or our directors or officers.
Our principal executive offices, a majority of our directors and certain of our officers are located in and/or residents of Canada, and all or a substantial portion of such persons’ assets are located outside the United States. As a result, it may be difficult for investors to obtain jurisdiction over us or our directors or officers in courts in the United States in actions predicated on the civil liability provisions of the U.S. federal securities laws; enforce against us or our directors or officers judgments obtained in such actions; obtain judgments against us or our directors or officers in actions in non-U.S. courts predicated solely upon the U.S. federal securities laws; or enforce against us or our directors or officers in non-U.S. courts judgments of courts in the United States predicated upon the civil liability provisions of the U.S. federal securities laws.
ITEM 2.
ITEM 2. PROPERTIES
Bellingham, Washington
Absorption leases approximately 0.7 acres of land from the Port of Bellingham in the State of Washington, where our absorbent manufacturing facility is situated. In calendar year 2005 we negotiated a two-year extension of the existing lease which will now expire on August 31, 2007. Under the terms of the lease extension, monthly lease payments have been waived in lieu of our agreement to remove all buildings and equipment from the property prior to the expiration of the lease. We believe that the cost of removal will approximately equal the waived lease payments. Under the lease, Absorption must maintain a performance bond and pay for all maintenance, taxes and insurance on the property. We intend to begin the removal of the property and equipment by the middle of fiscal year 2008 and to transfer it to our Ferndale, Washington location, and expect that all property and equipment will be removed prior to the expiration of the lease.
Ferndale, Washington
On October 18, 2002, we purchased for cash approximately 15.6 acres of bare land, described as Lots 4, 5, and 6 of the Grandview Light Industrial Park, Ferndale, Washington. The total purchase price of the land was $1,500,000, plus closing costs, which was determined through arms-length negotiations.
During the fiscal year 2004, we completed the construction of a 105,000 square foot production, warehousing, and office space facility on this property. The construction of this facility was financed through the issuance of industrial revenue bonds in the amount of $2,910,000 and from cash on hand. Manufacturing of our animal care products, hydro mulch products, and some ancillary products along with the majority of our warehousing takes place at this facility.
During the third quarter of fiscal year 2007 we commenced the move of our Bellingham, Washington manufacturing facility to our Ferndale, Washington location (engineering was started during the second quarter of fiscal year 2007). This move is nearing completion and the additional facility should be ready for commissioning by the middle of fiscal year 2008.
We believe the Ferndale facility, in combination with our Georgia facility described below, will be adequate for our manufacturing needs for products in both of our segments for the near future.
Jesup, Georgia
On August 20, 2003, we purchased 14 acres of land zoned light industrial in Jesup, Georgia for $140,000, which included a 41,000 square foot steel warehouse building. During fiscal year 2005, we constructed approximately 45,000 square feet of additional warehousing and manufacturing space on the property at a cost of $6,650,000 (including equipment we installed). The construction was financed with cash on hand and a debt facility from Branch Banking &Trust Co. (“BB&T”). Pursuant to our letter of credit with BB&T and in connection with the issuance of certain tax exempt bonds by Wayne County Industrial Development Authority (“Wayne County IDA”), we sold our real property in Jesup, Georgia to Wayne County IDA and are currently leasing the real property back from Wayne County IDA. Upon repayment of the bonds in full, Wayne County IDA will transfer all right, title and interest in the real property and related production facility to Absorption for no additional consideration. While the bonds remain outstanding, as security for the indebtedness underlying the letter of credit, BB&T will hold a mortgage on the real property and a security interest in the equipment assets located on that property. Please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” for additional information regarding this financing transaction. We manufacture and warehouse multiple product lines in both segments at this facility.
Vancouver, British Columbia, Canada
We also share 1,640 square feet of office space with a related party in North Vancouver, British Columbia, Canada. The terms of our rental agreement call for monthly payments of $500 towards the office space and include the use of office furniture and equipment.
We believe that our existing properties are in good condition, are adequately insured in a manner consistent with other similarly situated companies and will meet our manufacturing and warehousing needs for the foreseeable future.
Our owned properties are subject to mortgages to secure the indebtedness under our bonds and long-term debt, which together amounted to $8,326,000 as of January 31, 2007.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On October 10, 2006, we were notified that the American Arbitration Association (the “Arbitrator”) had issued a decision in the arbitration between R. Wilder Sales, R&D Midwest Pet Supply (the “Claimants”) and Absorption (the “Wilder Arbitration”). As previously disclosed in our filings with the SEC, the Wilder Arbitration demand was filed against Absorption on February 23, 2004. At that time, the Claimants were seeking damages in the amount of approximately $1,000,000. The Wilder Arbitration demand related to a lawsuit that was filed on June 22, 1995 in the Boone Circuit Court of the Commonwealth of Kentucky against Absorption. The lawsuit was captioned Wilder et.al. v. Absorption Corp., Civil Action No. 95-CI-547, and alleged breach of contract, fraud, violation of the Kentucky Unfair Trade Practices Act and other related claims. The Arbitrator ruled in favor of the Claimants and ordered us to pay to the Claimants an aggregate amount totaling $1,186,435 for damages and recovery of attorney fees and expenses as well as the administrative fees, compensation and expenses of the Arbitrator. This amount was expensed as selling, general and administrative expenses as of October 10, 2006. We paid the full amount of the award on November 10, 2006.
Except for ordinary routine litigation incidental to our business, there are no material legal proceedings pending to which we are a party, or of which any of our properties is the subject.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of fiscal year 2007 there were no matters submitted to a vote of our security holders.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS,AND ISSUER PURCHASES OFEQUITY SECURITIES
Market information
Our Common Shares are currently listed on AMEX (since March 21, 2003), under the trading symbol IAX. Shown below are the high and low sale prices for the Common Shares for the periods indicated below as listed on AMEX and the OTC Bulletin Board. The following quotations, as provided by the AMEX and the OTC Bulletin Board (Nasdaq Trading & Market Services), represent prices between dealers and do not include retail markup, markdown or commission. In addition, these quotations may not represent actual transactions.
Shareholders
We had 457 holders of record of our Common Shares at January 31, 2007.
Dividends
We have never paid dividends to the holders of our Common Shares. The decision whether to pay dividends and the amount thereof is at the discretion of our board of directors, and will be governed by such factors as earnings, capital requirements and our operating and financial condition. In addition, our credit facility prohibits us from paying dividends
without our lender’s consent. Furthermore, the indentures pursuant to which our bonds were issued each prohibit us from declaring a cash dividend unless, after giving effect to such dividend, we would not be in default under such indentures, we remained in compliance with certain financial ratios and the amount of the dividend did not exceed the limits set forth in the indentures. We intend to retain our earnings to finance the continuing growth of our business and, thus do not intend to pay dividends in the foreseeable future.
Exchange controls and other limitations affecting security holders
Canada has no system of exchange controls. There are no restrictions on the remittance of dividends, interest, or other similar payments to nonresidents of Canada holding our securities. There are generally no restrictions on the right of nonresidents of Canada to hold or vote securities in a Canadian company. However, the Investment Canada Act (the “Investment Act”) requires prior notification to the Government of Canada on the acquisition of control of Canadian businesses by non-Canadians. The term “acquisition of control” is defined as any one or more non-Canadian persons acquiring all or substantially all of the assets used in the Canadian business, the acquisition of the voting shares of a Canadian corporation carrying on the Canadian business or the acquisition of an entity controlling or carrying on the Canadian business. The acquisition of the majority of the outstanding shares is deemed to be an “acquisition of control” of a corporation unless it can be established that the purchaser will not control the corporation.
Subject to the exceptions noted below for World Trade Organization (“WTO”) investors, investments which require prior notification under the Investment Act are all direct acquisitions of Canadian businesses with assets of (Cdn) $5,000,000 or more and all indirect acquisitions of Canadian businesses with assets of more than (Cdn) $50,000,000 or with assets between (Cdn) $5,000,000 and (Cdn) $50,000,000 which represent more than 50% of the value of the total international operations. In addition, specific acquisitions or businesses in designated types of activities related to Canada’s cultural heritage or national identity could be reviewed if the government considers it to be in the public interest to do so.
The WTO investor exception to the Investment Act provides special review thresholds in the case of acquisitions by such investors. WTO investors include individuals who are a national of a WTO member or who has the right of permanent residence in relation to a WTO member, governments of WTO members and entities that are not Canadian controlled but which are WTO investor controlled. The United States is a member of the WTO. The WTO review thresholds are calculated using a formula and for 1996 and 1997 are (Cdn) $168,000,000 and (Cdn) $172,000,000.
Based on the current amount of our assets, the review provisions of the Investment Act will not be applicable to us. However, there can be no assurance that it will not become applicable to us in the future.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth our selected consolidated financial information for each of the five years ended January 31, 2007, 2006, 2005, 2004, and 2003 (presented in thousands of U.S. dollars, except per share amounts), derived from our audited consolidated financial statements, the most recent three years of which appear elsewhere herein.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion is intended to further the reader’s understanding of the consolidated financial statements, financial condition, and results of operations of International Absorbents and Absorption. It should be read in conjunction with the consolidated financial statements, notes and tables which are included elsewhere in this quarterly report.
Some statements and information contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are not historical facts but are forward-looking statements. For a discussion of these forward-looking statements and important factors that could cause results to differ materially from the forward-looking statements, see Item 1 of Part I, “Business - Forward-Looking Statements” and Item 1A of Part I, “Risk Factors.”
Overview
International Absorbents is the parent company of its wholly owned U.S. subsidiary, Absorption. International Absorbents is a holding company and Absorption is its operating entity. Management divides the activities of the operating company into two segments: the animal care industry and the industrial/commercial industry. We manufacture, distribute and sell products for these segments to both distributors and direct buying retailers.
Absorption is a leading manufacturer and seller of premium small animal bedding in North America. The primary product that we sell in this market is small animal bedding sold under the brand name CareFRESH®. We consider the activities that surround the manufacture and distribution of CareFRESH® to be our core business. Our business strategy is to promote and grow our core business and to create diversification in our market channels, our production methods, and our product lines in an effort to add strength and breadth to our business structure. As a result, we are dedicating significant resources to both building infrastructure for the support of our core business, and creating more product and customer diversification. We believe that this strategy has started to provide results. Specifically, we continue to grow sales in our core business and improve the production process of our core CareFRESH® product while expanding sales of new products and existing products into new market channels.
The financial results from fiscal year 2007 met the expectations of management, excluding the effect of the arbitration ruling issued on October 10, 2006 in the Wilder Arbitration as described above. We met our projections for both top line sales (see “Net Sales” below) and bottom line profits (see “Net Income” below), excluding the arbitration ruling. As described in the “Gross Profits” discussion below, part of our success was our ability to maintain and improve on the production efficiencies we achieved during the fourth quarter of fiscal year 2006. We were also able to maintain our sales, general and administrative expenses, net of stock based compensation, which we were required to account for the first time during the first quarter of fiscal year 2007.
During fiscal year 2007, we continued to focus our sales and marketing efforts on our market leading CareFRESH®, CareFRESH® Ultra, and CareFRESH® Colors brands of small animal bedding products. We also continue to aggressively sell our Healthy Pet ™ Cat Litter line. Healthy Pet ™ Cat Litter is a line of cat litters in which our distributors are offered a selection of five cat litters designed to be displayed together in one section of shelf space. They are all made of natural products in keeping with our corporate philosophy of being environmentally friendly. Because these are relatively new product lines, management believes it is too early to be able to predict if these growth trends will continue.
Even though we are currently experiencing significant infrastructure-related costs, we believe our progress with the sales of new product lines will continue to move us toward developing more diversified sources of income, which we anticipate will help reduce the risks associated with a substantial reliance on sales from a single product.
Results of Operations
The following table illustrates our financial results for the fiscal year 2007 as compared to the two prior fiscal years. (U.S. dollars, in thousands):
Comparison for the years ended January 31, 2007 and 2006
The following table compares the percentage change of our financial results between fiscal year 2007 and fiscal year 2006. (U.S. dollars in thousands):
Net Sales
In fiscal year 2007, our net sales increased by 16% over fiscal year 2006. The majority of this growth in net sales was a result of the growth in sales of our animal care products. During fiscal year 2007, net sales for animal care products grew from $23,913,000 to $28,288,000, as compared to the same period of fiscal year 2006. Net sales of our industrial products decreased from $1,523,000 to $1,207,000 for fiscal years 2007 and 2006, respectively. There were four key sources of growth in our animal care product lines. First, the price increase which was implemented in the second quarter of fiscal year 2007 had a half year of positive effect on financial results. Second, we had strong seasonal promotional activity in preparation for the holiday season. Third, we had strong sales growth for both our CareFRESH® Ultra™ and CareFRESH® Colors products. Fourth, we reduced certain amounts we had been accruing as a result of less-than-anticipated off-invoice promotional activity, which increased our net sales. Our strategy in regard to our industrial line of products has remained the same, which is to effectively service existing customers while focusing growth on animal care products.
We currently believe that our fiscal year 2008 overall annual net sales will grow approximately 10% to 16% over our fiscal year 2007 net sales levels. Specifically, during fiscal year 2008, we expect sales of natural, non-colored CareFRESH® in pet specialty channels to be approximately the same as they were in fiscal year 2007 as we have now reached significant levels of distribution throughout the United States. We have also introduced line extensions such as CareFRESH Ultra™ and CareFRESH® Colors. Therefore, although we anticipate that natural CareFRESH® will continue to represent the majority of our sales through the 2008 fiscal year, we also see growth opportunities for our full line of bedding products as they continue to gain market share and growing customer acceptance, subject to the following challenges. First, as we add new items to our line of products, they will need to compete for limited shelf space at the pet specialty stores with our other existing products and those of our competitors, which could limit the number of products we are able to sell at a particular store. Second, although we believe that the high quality of our CareFRESH® line of products gives us a significant competitive advantage, many of our competitors have a larger breadth of products and more established relationships with the mass merchandiser and grocery stores, which makes competition in these channels more challenging for us. With respect to our lines of cat litter products, we continue to expect revenue growth from these products. Finally, at this time we do not have plans to invest additional sales resources in our industrial line of products.
Gross Profit
Our Georgia production facility continued to make progress at increasing its production rate and efficiencies during the fourth quarter of fiscal year 2007 by achieving record production levels. Our facilities continue to work towards overcoming the additional burdens of increases in utility rates, increased depreciation, and increased fuel surcharges on freight. Mostly as a result of improvements in production efficiencies at our Georgia facility as compared to the prior year, our gross margin (gross profit divided by sales) improved from 30% in fiscal year 2006 to 33% in fiscal year 2007. The high cost of energy, transportation, and raw materials were leading factors placing downward pressure on our gross margin, which were off-set by increased production efficiencies.
As discussed in Note 14 (“Segmented Information”) to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K, operating income including selling, general and administrative expenses, but before depreciation for our animal care product segment, increased by 13% in fiscal year 2007 as compared to fiscal year 2006. Operating loss before depreciation for our industrial product segment decreased by 32% comparing fiscal year 2006 to fiscal year 2007.
For fiscal year 2008 we continue to expect that our gross margin will remain in the range of 30% to 34%. The reasons for this expectation are as follows. First, the cost savings we had projected from reduced transportation costs resulting from shipping to east coast customers from the Georgia production facility have been offset by increases in fuel charges. However, without this facility being located where it is, margin expectations would be even lower. Second, we are not achieving the overall reduced costs of raw materials that we had initially expected due to: our product mix (with increased sales of our higher-cost products); slow reactions from raw material suppliers in response to our request for additional supplies; increases in the prices of petroleum-based product prices, such as the cost of plastic bags; and the shortage of key low-cost raw material sources for certain of our facilities. Third, in the third quarter of fiscal year 2007 we began moving our Bellingham, Washington plant to our new Ferndale, Washington facility. During the fourth quarter of fiscal year 2007 and the first quarter of fiscal year 2008, we continued to incur relocation and commissioning costs, which could further reduce our gross margin. Fourth, additional depreciation charges resulting from our new production facilities will also have a negative effect on our gross margin.
To offset the significant increases in the cost of natural gas, we have installed new burners to heat our dryers at our Georgia facility that operate at less than one-third the cost of our current natural gas burners. The new burners became operational during the fourth quarter of fiscal year 2007. As we continue to use this technology, we expect it to become more efficient and, as a result, we should move closer to achieving the projected cost savings at our Georgia facility. We plan to continue to make capital investments in technology at all of our facilities to help decrease the costs of production.
Selling, Administrative and General Expenses
During fiscal year 2007, our selling, general and administrative expenses increased by 26% as compared to fiscal year 2006. The table below illustrates the comparison of selling, administrative, and general expenses both with and without the effect of the Wilder Arbitration award and stock-based compensation. (U.S. dollars in thousands):
As discussed in Item 3, Part I, “Legal Proceedings,” on October 10, 2006, we were notified that the Arbitrator had issued a decision in the Wilder Arbitration. As previously disclosed in our filings with the SEC, the Wilder Arbitration demand was filed against Absorption on February 23, 2004. At that time, the Claimants were seeking damages in the amount of approximately $1,000,000. The Wilder Arbitration demand related to a lawsuit that was filed on June 22, 1995 in the Boone Circuit Court of the Commonwealth of Kentucky against Absorption. The lawsuit was captioned Wilder et.al. v. Absorption Corp., Civil Action No. 95-CI-547, and alleged breach of contract, fraud, violation of the Kentucky Unfair Trade Practices Act and other related claims. The Arbitrator ruled in favor of the Claimants and ordered us to pay to the Claimants an aggregate amount totaling $1,186,435 for damages and recovery of attorney fees and expenses as well as the administrative fees, compensation and expenses of the Arbitrator. This amount was expensed as selling, general and administrative expenses as of October 10, 2006. We paid the full amount of the award on November 10, 2006.
The first quarter of fiscal year 2007 was the first period under which we were required to account for stock-based compensation under SFAS No. 123(R). As a result, we incurred $347,000 in stock-based compensation for fiscal year 2007 as compared to $8,000 during the same periods of the prior year. Of this amount, $347,000 was included in selling, general and administrative expenses. Costs resulting from our compliance with requirements of the SEC and the American Stock Exchange (“AMEX”) continue to have an impact on our general and administrative expenses. Moreover, we now have overhead expenses related to operating our Georgia facility, increased property taxes on both of our new facilities, and increased depreciation expense. We anticipate that these factors, along with our new stock-based compensation expenses, will continue to increase general and administrative expenses during fiscal year 2008.
During fiscal year 2008, we intend to continue our marketing initiatives at the rate at which we completed fiscal year 2007. Our seasoned sales staff is respected in the animal care industry and has proven to be efficient and effective in selling to the wholesale distribution segment of the pet specialty channel. We expect to enhance our sales staff to include expertise in specific markets where we see growth opportunities. In addition, if our product mix were to change with more emphasis on food, treats or accessories, we would need to add sales people at the retail level. We feel that this plan should enable us to achieve our strategic objectives without significantly increasing our selling expenses, provided that this projection may change depending on the reaction of our competitors. On the administrative side, costs resulting from compliance with SEC and AMEX requirements are projected to continue to grow and we may also need to hire additional administrative personnel growth as sales levels increase.
Interest Expense
Interest expense in fiscal year 2007 totaled $361,000 as compared to $326,000 during fiscal year 2006. These increases were due to interest rate increases for our variable interest rate bonds that constitute the debt facility for the Georgia plant. The move of our Bellingham, Washington facility during fiscal year 2007 has resulted in additional interest charges, which
will be capitalized, until the new facility is in operation.
Income Tax
Absorption incurred federal income taxes during the 2007 at an effective rate of 45%. The effective rate is higher due to the recognition of stock-based compensation expenses from stock options that are not deductible for federal income taxes. We anticipate that we will have a higher effective rate going forward, although the rate itself will be higher or lower depending on the ratio of net income before taxes to stock-based compensation recognized in a particular period. Losses incurred in Canada by International Absorbents have been fully reserved through the recording of a valuation allowance as Canadian net operating losses and deferred tax assets are not expected to be utilized in future periods.
Net Income
Our net income for the year ended January 31, 2007 increased by 7% as compared to the same period in the prior fiscal year. This increase in net income over the prior fiscal year was primarily caused by increased sales, and improvement in gross margins, and our ability to control selling, administrative and general expenses. We feel that continued concentration on the implementation of the key components of our business plan that focus on production efficiencies and controlled costs should provide us with continued increases in production rates, which should help us to service the increase in demand for our products and generate additional revenues.
We expect that the production efficiencies that we saw at our Georgia facility in our most recent fiscal quarters will continue, as has been demonstrated by the results of fiscal year 2007. With these efficiencies now stabilized and moving in the right direction, we expect to be able to produce product at the higher end of our gross margin projections, unless there are additional downward pressures from the costs of raw materials or energy and subject to the commissioning rate of our new Bellingham, Washington production facility. We project that selling and administrative costs will continue to grow, but only marginally during the coming fiscal year. We will continue to invest in future marketing programs to offset competitive pressures as necessary and anticipate additional administrative costs resulting from regulatory requirements, all of which may continue to lead to increased expenses and lower net income. During fiscal year 2008 we will incur additional interest expense as a result of financing the move of our Bellingham, Washington production facility. In addition, we anticipate that increased depreciation resulting from our investment in plant and equipment will negatively affect our fiscal year 2008 net income.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
We believe that one of our key financial and operating performance metrics is Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). Our EBITDA increased by 18% during fiscal year 2007 as compared to fiscal year 2006. The increase for fiscal year 2007 was substantially the result of increased sales, improved gross profit margins, and controlled selling, administrative, and general expenses.
EBITDA is not a measure of financial performance under generally accepted accounting principles (GAAP) in the United States. Accordingly, it should not be considered a substitute for net income (loss), cash flow provided by operating activities, or other income or cash flow data prepared in accordance with GAAP. However, we believe that EBITDA may provide additional information with respect to our financial performance and our ability to meet our future debt service, capital expenditures and working capital requirements. This measure is widely used by investors and rating agencies in the valuation, comparison, rating, and investment recommendations of companies. In addition, we use EBITDA as one of several factors when determining the compensation for our executive officers. Because EBITDA excludes some, but not all items that affect net income (loss) and may vary among companies, the EBITDA presented by us may not be comparable to similarly titled measures of other companies. The following schedule reconciles EBITDA to net income (loss) reported on our Condensed Consolidated Statement of Operations, which we believe is the most directly comparable GAAP measure:
For the year ended
During the fiscal year 2008 management will continue to focus on EBITDA as a key performance indicator.
Comparison of the years ended January 31, 2006 and 2005
The following table compares the percentage change of our financial results between fiscal year 2006 and fiscal year 2005. (U.S. dollars in thousands):
Net Sales
In fiscal year 2006, our net sales increased by 15% over fiscal year 2005. Net sales of our animal care products grew from $20,943,000 to $23,913,000 between January 31, 2005 and January 31, 2006. Net sales of our industrial products grew from $1,220,000 to $1,523,000 between January 31, 2005 and January 31, 2006. Our core product line, CareFRESH®, continued to gain market share during fiscal year 2006 in the pet specialty market channel. Our strategy of diversification also showed some success with the continued growth of pet products such as CareFRESH® Ultra™ and Critter Care™, due to increased shelf facings and a reduction in the price of CareFRESH® Ultra™. Our strategy in regard to our industrial line of products has remained the same, which is to effectively service existing customers while focusing growth on consumer products.
Gross Profit
Our Georgia production facility continued to make progress during the fourth quarter of fiscal year 2006 at increasing its production rate and efficiencies. During the fourth fiscal quarter of 2006, the Georgia facility reached break-even as a stand alone gross profit center. All of our facilities continued to work to overcome the additional burden of major increases in utility rates, increased depreciation, and increased fuel surcharges on freight, all of which contributed to the reduction of our gross profit margin during fiscal year 2006 as compared to the prior year. These increased production costs, combined with increased promotional expenses, which reduced our net revenue, resulted in a decreased gross margin (gross profit divided by sales) for fiscal year 2006, as compared to fiscal year 2005. Specifically, our gross margin decreased from 38% in fiscal year 2005 to 30% in fiscal year 2006. One significant factor in the reduction of our gross profit was the increase in our depreciation as a result of our plant expansion that has taken place over the past three years. Depreciation, which we attributed to plant and equipment, grew from $712,000 in fiscal year 2005, to $1,048,000 in fiscal year 2006. Operating income before depreciation for our animal care product segment decreased from $3,619,000 in fiscal year 2005 to $2,580,000 in fiscal year 2006. Operating loss before depreciation for our industrial product segment increased from $71,000 in fiscal year 2005 to $77,000 in fiscal year 2006.
Selling, General and Administrative Expenses
During fiscal year 2006, our selling, general and administrative expenses increased by 13% as compared to fiscal year 2005. Costs resulting from our compliance with SEC and AMEX requirements started to have an impact on our general and administrative expenses. Moreover, we began to incur overhead expenses related to operating our Georgia facility, increased property taxes on both of our new facilities, and increased depreciation expense.
Interest Expense
Interest expense in fiscal year 2006 totaled $326,000 as compared to $173,000 in fiscal year 2005. This increase was due to interest charges for the debt facility for the Georgia plant.
Income Tax
Absorption incurred federal income taxes during fiscal year 2006 at an effective rate of 30.1%. Losses incurred in Canada by International Absorbents were fully reserved through the recording of a valuation allowance as Canadian net operating losses and deferred tax assets.
Net Income
Our net income for the year ended January 31, 2006 decreased by 63% as compared to the same period in the prior fiscal year. This decrease was the result of increased cost of goods sold (costs related to the commissioning of the Georgia production facility, increased depreciation, increased energy and higher freight charges), increased promotional expenses, increased marketing expenses, and increased general and administrative expenses related to our compliance with regulatory requirements. Selling, general and administrative expenses increased by $764,000, however, as a percentage of sales these expenses remained virtually flat and such increase was not as significant as the increase in cost of goods sold. As such we feel that the significant factors related to our reduced net income were those related to our cost of goods sold.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
Our EBITDA decreased by 29% during fiscal year 2006 as compared to fiscal year 2005. The decrease for fiscal year 2006 was substantially the result of reduced gross profit margins, and increased selling, administrative, and general expenses. The following schedule reconciles EBITDA to net income (loss) reported on our Condensed Consolidated Statement of Operations, which we believe is the most directly comparable GAAP measure:
For the year ended
Liquidity and Capital Resources
During fiscal year 2007 we began the third phase of our three-phase capital expansion plan. This three-phase plan includes: the building of the new manufacturing and warehousing facility in Ferndale, Washington, which is now complete; the building of a new production facility in Georgia, which has also been completed; and the move of the Bellingham, Washington manufacturing facility to the Ferndale, Washington location, which we commenced during the third quarter of fiscal year 2007 (engineering was started during the second quarter of fiscal year 2007) and is nearing completion and the additional facility should be ready for commissioning by the middle of fiscal year 2008. The intent of this capital expansion plan is first, to protect our core business by reducing our production costs and decreasing the cost of shipping product to our customers; second, to give us the ability to manufacture, warehouse and distribute a wider diversity of product; and third, to increase our production capacity.
The table below illustrates the effects this capital expansion plan has had on our financial statements (U.S. dollars, in thousands):
Financial Condition
During fiscal year 2007, the value of our total assets increased. This was primarily the result of restricted cash we acquired from the debt facility obtained for the move of our Bellingham, Washington plant and from cash generated from operating activities. We also had an increase in total liabilities resulting from the debt facility for the Bellingham, Washington plant move and payables directly relating to phase three of our capital expansion plan.
As discussed under Note 7 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K,
we currently have three long-term debt facilities, including our September 2006 bond financing arrangement with GE Capital Public Finance, Inc (“GECPF”), our March 2003 bond financing with GECPF and our September 2004 tax-exempt bond financing with BB & T.
We believe that our main credit risk exposure in fiscal year 2008 will come from meeting the covenants attached to our debt facilities by our lenders. As of the end of fiscal year 2007 we were over minimum financial requirements and under maximum requirements. The covenant-related ratios that could pose a potential risk in the future are those based on cash flow. If the additional production facility in Ferndale, Washington takes longer to commission than anticipated, we could be at risk of violating our cash flow related loan covenants. As such, any significant decrease in our current cash flow could result in the breach of one or more of these loan covenants. If we fail to satisfy the financial covenants and other requirements contained in our debt facilities, our debts could become immediately payable at a time when we are unable to pay them, which could adversely affect our liquidity and financial condition. In addition, if we are to make cash flow decisions to remain within our loan covenants, these decisions could affect our ability to effectively execute on our long term business strategy.
Debt retirement is an alternative that we consider on an ongoing basis. Relevant factors in our analysis include the cost of equity and the rate of interest on our debt. Our long-term debt has been at very favorable rates such that it was and continues to be considered advantageous to use our capital for other applications.
Working Capital
During fiscal year 2007, our working capital position continued to improve as current assets grew faster than current liabilities. The majority of the increase in current assets occurred due to an increase in restricted cash as a result of the issuance of industrial revenue bonds in September 2006 and the growth of inventory levels in anticipation of the period of time that our west coast manufacturing facility will be shut down for the move from Bellingham, Washington to our Ferndale, Washington facility. These increases in current assets were off-set by the use of cash from short term investments to pay for a portion of the capital costs associated with the production facility move. Current liabilities increased primarily due to increases in accounts payable resulting from credit purchases made relating to the plant move and an increase in the current portion of long term debt as a result of the issuance of industrial revenue bonds during the current fiscal year. These changes resulted in our current ratio (current assets divided by current liabilities) decreasing from 2.75 at the end of fiscal year 2006 to 2.36 at the end of fiscal year 2007.
In fiscal year 2008 we expect that our current assets will continue to increase once the commissioning of the additional Ferndale, Washington plant is complete, as a result of positive cash flow and an increase in accounts receivable as sales levels grow. We also expect that current liabilities will increase as a result of growing accounts payable related to the general growth of the company. Even though we expect both current assets and current liabilities to grow, we believe that our net working capital position will improve over the coming fiscal year.
Cash Position
We believe that our existing cash on hand, long-term debt and available line of credit currently provide us with enough cash to meet our existing needs for the foreseeable future. Cash and investments increased during fiscal year 2007, primarily as a result of a positive cash flow from operations and the closing of the debt facility for the Bellingham, Washington plant move. We expect cash to increase during fiscal year 2008 even though we are investing approximately $2,000,000 in cash for our move of the Bellingham, Washington production facility, a portion of which was invested in fiscal year 2007. We believe cash balances will increase during the coming fiscal year mostly as a result of cash generated from operations. We believe that our existing $2,000,000 line of credit with BB&T will suffice in covering any potential cash shortfall during this construction and commissioning of our additional Ferndale, Washington production facility. This line of credit is secured by inventory and accounts receivable, which will provide enough collateral to support the related debt. Interest is payable on funds advanced at the LIBOR rate plus 2.5%. The line of credit matures on May 23, 2007. As of January 31, 2007, no borrowings were outstanding under the line of credit. If we do borrow against this line of credit, we intend to pay it off before the end of fiscal year 2008, assuming that we are able to extend the line beyond the current May 23, 2007 maturity date. We will continue to closely monitor both current liabilities and current assets as they relate to the generation of cash, with an emphasis on maximizing potential sources of cash.
Cash Generated from Operations
During fiscal year 2007 we generated $2,324,000 in cash from operating activities. This amount decreased during the final quarter of the year by $404,000 from $2,728,000 primarily as the result of increasing inventories to allow us to be able to service customers while our Bellingham, Washington production facility is moved and as a result of paying the $1,186,435 damage award as a result of the Wilder Arbitration. The cash generated during the fiscal year 2007 was a 248% increase over the $667,000 in cash generated during fiscal year 2006. If our sales continue to increase and we are able to continue to profitably produce our products, we should be able to continue to generate cash from operating activities during fiscal year 2008, although it cannot be assured that this will be the case.
Financing and Investing Activities
Cash generated from financing activities during fiscal year 2007 was $1,251,000. This was the result of receiving $188,000 from the issuance of common shares as a result of the exercise of stock options and $1,600,000 received from the bond financing for the Bellingham, Washington plant move, off-set by principal payments on long-term debt of $537,000. Cash was used during fiscal year 2007 for investing activities mainly related to the installation of our new burners at our Georgia facility, the installation of a new burner and rotary dryer system at our Ferndale, Washington facility, and the start of construction related to the move of the Bellingham, Washington production facility. Also, the cash related to the debt facility for the plant move was placed in a restricted account to be released as construction progresses. Cash used in investing activities during fiscal year 2007 was approximately $3,496,000.
The first phase of our production expansion plan was substantially completed during the third quarter of fiscal year 2004. This was the construction of our new west coast facility located in Ferndale, Washington. We had previously been operating in five separate long-term leased facilities in Whatcom County, Washington. This new facility, which was financed approximately half through debt and half through cash, consolidated four of these leased facilities, resulting in annual savings of approximately $450,000 in lease payments. The consolidation of these facilities has also provided us with savings in other expenses caused by inefficient logistics. The annual interest expense of the debt used to finance this facility is approximately $144,000 per year.
Phase two of our production expansion plan was the commissioning of the facility located in Georgia. We purchased approximately fifteen acres of real property in Jesup, Georgia, with an existing 41,000 square foot facility, during August 2003 for $140,000, which we subsequently sold to, and leased back from, Wayne County IDA, as described in more detail in our Annual Report on Form 10-K for the fiscal year ended January 31, 2006. We began construction during the fourth quarter of fiscal year 2004 on this property. The total project was completed at a cost of $6,650,000. Of the total cost, approximately $4,900,000 was financed through a long-term bank debt instrument and the balance was financed with cash on hand. The annual interest expense of the debt used to finance this facility is approximately $149,000 a year. This plant is now fully functional.
The third phase of our production expansion plan is the relocation of our Bellingham, Washington production facility to our new Ferndale, Washington facility. This phase began during the second quarter of fiscal year 2007 and is estimated to cost approximately $3,600,000. Of this amount, $2,000,000 will come from cash and the remaining $1,600,000 was generated through our September 2006 bond financing with GECPF, as described above. We expect to begin commissioning this facility during the first quarter of fiscal year 2008 and hope to achieve minimal levels of efficiency by the middle of fiscal year 2008.
We believe that this three-phase plan will give us the ability to continue to grow our business, achieve significant cost savings, better serve our customers, expand our production lines, diversify and expand our production capacity and physically move manufacturing in a manner which is transparent to the users of our products.
Our contractual obligations for future payments are as follows:
Environmental Matters
We are committed to being an environmentally friendly company and to manufacturing products which benefit the quality of the environment. Hazardous wastes are not produced, treated, or stored at any company-owned or operated facilities. State, federal, and local laws all have jurisdiction over production activities. We believe we are currently in compliance with these laws and expect to remain so in the foreseeable future.
Off-Balance Sheet Arrangements
The SEC requires companies to disclose off-balance sheet arrangements. As defined by the SEC, an off-balance sheet arrangement includes any contractual obligation, agreement or transaction arrangement involving an unconsolidated entity under which a company 1) has made guarantees, 2) has a retained or a contingent interest in transferred assets, 3) has an obligation under derivative instruments classified as equity, or 4) has any obligation arising out of a material variable interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the company, or that engages in leasing, hedging or research and development services with the company.
We have examined our contractual obligation structures that may potentially be impacted by this disclosure requirement and have concluded that no arrangements of the types described above exist with respect to our company.
Critical Accounting Policies
Introduction
In preparing our consolidated financial statements in conformity with accounting principles generally accepted in the United States, judgments and estimates are made that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. We believe that the material estimates that are particularly susceptible to significant change relate to the determination of the allowance for doubtful accounts, income taxes, including deferred income taxes and the related valuation allowance, accrual for self-insured medical insurance plans and sales incentives. As part of the financial reporting process, our management collaborates to determine the necessary information on which to base judgments and develop estimates used to prepare the consolidated financial statements. Historical experience and available information is used to make these judgments and estimates. However, different amounts could be reported using different assumptions and in light of different facts and circumstances. Therefore, actual amounts could differ from the estimates reflected in the consolidated financial statements.
In addition to the significant accounting policies described in Note 1 of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, we believe that the following discussion addresses our critical accounting policies.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for doubtful accounts, income taxes, deferred income taxes and the related valuation allowance, accrual for self-insured medical insurance plan, and sales incentives.
Inventory
Unexpected change in market demand or buyer preferences could reduce the rate of inventory turnover and require us to record a reserve for obsolescence. Finished goods inventory are valued at the lower of cost (determined on the first-in, first-out basis) or net realizable value. Cost includes direct materials, labor and overhead allocation. Raw materials and supplies are valued at the lower of cost (determined on the first-in, first-out basis) or net realizable value. We have not historically experienced a period where a material amount of finished goods inventory or raw materials inventory has been required to be reduced in value as a result of changes in market demand or buyer preference. Because of this lack of historical change we have not yet had to record a reserve for obsolete inventory. Our assumptions and valuation methodology for inventory have historically not changed. Even though we have not historically had to record a reserve for obsolete inventory as a result of changes in market demand or buyer preference, there is no guarantee that one or both of these events will not happen. As a result even though we believe that it is unlikely that a change will occur, we do recognize that change is possible and will record a reserve for obsolete inventory if the circumstance dictate as previously described.
Property, Plant and Equipment
There is a risk that our estimate of the useful life of a component of our property plant or equipment was over estimated. If that was the case the depreciated value of the equipment or building would be greater than its actual value, which would result in our recording a reserve to lower the net carrying value of the asset. Property, plant and equipment assets are recorded at cost. Our building and equipment are located on owned and leased land. Buildings are depreciated on a straight line basis over a period of 40 years. Leasehold improvements are depreciated on a straight line basis over the life of the lease agreement for property located on leased land. Most of our equipment is depreciated over its estimated useful life using a 15% declining balance method; the remainder is depreciated using a straight line method over five years. We have chosen to use the 15% declining value method over a fixed period straight line method to better reflect the fair market value and useful life of equipment which is typically used in our facilities. We also review the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The determination of any impairment would include a comparison of estimated future cash flows anticipated to be generated during the remaining life of the asset. Due to the nature of the buildings and equipment we purchase, the depreciation method that we use, and the cash flows generated during the life of the assets, we have not had to historically record a reserve to reflect a decrease in the net carrying value of assets. We have historically neither changed our depreciation methods, our assumptions behind the depreciation methods, or our methodology for determining impairment. Based on the length of time we have been manufacturing in the industry in which we operate, we believe that it is unlikely that an impairment of existing buildings or equipment will have to be recorded. If we were to expand into a manufacturing industry in which we do not have as much history, the likelihood of being required to record an impairment increases. If at some future date we enter an industry in which we have no historic knowledge, then the risk of recording an impairment would also increase.
Revenue Recognition
If the actual costs of sales returns and incentives were to significantly exceed the recorded estimated allowance, our sales would be adversely affected in that we would record additional reserves which would reduce our net sales revenue. Revenues from the sale of products are recognized at the time title passes to the purchaser, which is generally when the goods are conveyed to a carrier. When we sell F.O. B. destination point, title is transferred and we recognize revenue on delivery or customer acceptance, depending on terms of the sales of the agreement. Sales incentives are accounted for in accordance with the provisions of EITF 01-9 “Accounting for Consideration Given by a Vendor to a Customer.” Historically we have not had sales returns or incentive requests applied to a fiscal year in greater amounts than what was reserved for. By following our revenue recognition policies we have been able to accurately assess the value of both sales returns and sales incentives. We have annually updated the sales incentive amounts that are annually accrued to match the sales incentive agreements that we have with our customers. By doing so, we have maintained a consistent methodology while adjusting our estimates to more closely reflect our activities within the market place. We believe that it is unlikely that our assumptions or methodology for accounting for revenue recognition, sales returns, and sales incentives will change in the future. However, we do believe that it is likely that the actual estimates that we use for our sales incentive programs and sales returns may change in the future from time to time as a result of a dynamic marketplace.
Income Tax
We account for income taxes using the asset and liability method. The liability method recognizes the amount of tax payable at the date of the financial statements as a result of all events that have been recognized in the consolidated financial statements, as measured by the provisions of currently enacted tax laws and rates. The accumulated tax effect of all
temporary differences is presented as deferred federal income tax assets and liabilities within the balance sheet. A valuation allowance is established when necessary to reduce deferred tax assets to the amounts expected to be realized. We have preliminarily reviewed the implications of FASB issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions (“tax positions”). FIN 48 requires us to recognize in our financial statements the impact of a tax position if that tax position is more likely than not of being sustained on audit, based on the technical merits of the tax position. The provisions for FIN 48 are effective as of the beginning of our 2008 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We do not anticipate this statement will have a material effect on our financial condition or results of operations. We believe that once the final FIN 48 review is completed, there will be an on-going tax impact on our financial statements, though we are not yet certain of the amount involved.
Stock-Based Compensation
Prior to February 1, 2006, we accounted for our stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”) and related interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). Accordingly, no stock-based compensation expense was recognized in the income statement for the years ended January 31, 2006 and 2005 related to options issued to employees and non-employee directors, as all options granted under our stock-based employee compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant. As permitted by SFAS No. 123, stock-based compensation was included as a pro forma disclosure in the notes to our consolidated financial statements for the years ended January 31, 2006 and 2005.
Effective February 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R) using the modified prospective transition method. Under that transition method, compensation cost recognized in the year ended January 31, 2007 includes: (a) compensation cost for all stock-based payments granted prior to, but not yet vested, as of January 31, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all stock-based payments granted subsequent to February 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated, as provided for under the modified-prospective method. For details regarding the effect on our financial statements of using this methodology, please see Note 2 of our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
In our calculation of stock-based compensation we use the Black-Scholes model. This model is an estimate of potential actual results. As such, actual results may vary significantly from our estimated stock-based compensation expense. Specifically, in the event that options were to expire at an exercise price which is below the option’s strike price and the options are not exercised, then we would have taken stock-based compensation expense for options which did not ultimately have a dilutive effect on the outstanding common shares. We believe that it is not likely that we will change our methodology for calculating stock based compensation in the future.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are subject to market risk arising from changes in interest rates. We have outstanding variable rate demand bonds from which our primary market rate risk arises. The interest variability results from changes in BB&T’s Capital Markets Low Floater Rate, upon which our variable bond interest rate is based. Our potential loss over one year that would result from a hypothetical, instantaneous and unfavorable change of 10% (e.g., a change in interest rate from 5% to 5.5%) in the interest rate of our variable rate bond obligations would be approximately $20,000.
As of January 31, 2006, the outstanding principle of these bonds was $4,700,000. As of that date, the variable interest rate was 3.15%. The balance of our other outstanding bonds is subject to a fixed interest rate.
We currently are not subject to market risk arising from interest rate changes relating to our line of credit. We have a line of credit extended from BB&T, which has a variable interest rate based on the 30-day LIBOR rate. We have never drawn on this line of credit and currently have no intention to draw on it in the foreseeable future.
We do not use any derivative financial instruments in the management of our financial rate exposures. Interest rate exposure is monitored through regular communications with senior management. We would be exposed to higher interest rates through poor financial performance of BB&T as a result of BB&T supplying the irrevocable letter of credit attached to the bonds. This credit risk is minimized by maintaining relationships with alternative financial institutions who could replace the irrevocable letter of credit. We do not anticipate poor financial performance by our banking partner.
The Company does not use financial instruments for trading or other speculative purposes.
We believe that we do not have a material exposure to fluctuations in foreign currencies.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at January 31, 2007 and 2006
Consolidated Statements of Earnings for the Fiscal Years ended January 31, 2007, 2006 and 2005
Consolidated Statements of Changes In Stockholders’ Equity for the Fiscal Years ended January 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the Fiscal Years ending January 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements, January 31, 2007 and 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders International Absorbents, Inc.
We have audited the accompanying consolidated balance sheets of International Absorbents, Inc. and subsidiary (“the Company”) as of January 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of International Absorbents, Inc. and subsidiary as of January 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended January 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, effective February 1, 2006, the Company changed its method of accounting for share-based payment arrangements to conform to Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
Seattle, Washington
April 9, 2007
International Absorbents Inc. and Subsidiary
Consolidated Balance Sheets
As at January 31, 2007 and 2006
(in thousands of U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements.
International Absorbents, Inc. and Subsidiary
Consolidated Statements of Earnings
For the years ended January 31, 2007, 2006 and 2005
(in thousands of U.S. dollars, except earnings per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
International Absorbents Inc. and Subsidiary
Consolidated Statement of changes in Stockholders’ Equity
For the years ended January 31, 2007, 2006 and 2005
(in thousands of U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements.
International Absorbents Inc. and Subsidiary
Consolidated Statement of Cash Flows
For the years ended January 31, 2007, 2006 and 2005
(in thousands of U.S. dollars)
The accompanying notes are an integral part of these consolidated financial statements.
Notes to Consolidated Financial Statements
International Absorbents Inc. and Subsidiary
Operations
International Absorbents Inc. (“IAX”) is a Canadian company operating in the States of Washington and Georgia, U.S.A. through its wholly-owned subsidiary, Absorption Corp (“Absorption,” and collectively with IAX, the “Company”).
The Company operates in two segments and is engaged in the development and sale of value added products made from waste short fiber pulp (“SFP”) utilizing proprietary technology. The Company markets and sells animal and pet bedding products that are sold in consumer retail and commercial bedding markets. In addition, the Company markets and sells SFP-based products used for general industrial spill cleanup, marine oil-cleanup, and oil/water filtration, and has recently began manufacturing hydro mulch products. The Company has established distribution primarily in North America.
Significant accounting policies
Generally accepted accounting principles
These consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America.
Basis of presentation
The consolidated financial statements include the accounts of IAX and its wholly-owned subsidiary, Absorption, a Nevada corporation doing business in the states of Washington and Georgia. All significant intercompany transactions are eliminated in consolidation.
Cash and cash equivalents
Cash and cash equivalents includes cash and highly liquid investments with original maturities of 90 days or less.
Restricted Cash
During the fiscal year 2007, the Company entered into a bond financing agreement in the amount of $1,600,000 with GE Capital Public Finance, Inc. (“GECPF”) to fund the purchase and installation of manufacturing equipment to be used in connection with the relocation of the Bellingham, Washington production facility to the new Ferndale, Washington manufacturing and warehouse facility. These funds have been placed in an escrow account during the purchase and installation of the equipment. Funds are drawn on the account as the equipment is purchased. The escrow account balance (restricted cash) at January 31, 2007 was $1,146,000.
Investments
Investments consist of interest-bearing Certificates of Deposit with maturities at the date of purchase of more than 90 days which are accounted for as held-to-maturity securities and municipal bonds with maturities at the date of purchase of more than 90 days which are accounted for as available for sale securities. There were no investments as of January 31, 2007. The carrying amount of the certificates of deposits and municipal bonds is equivalent to the fair value at January 31, 2006 due to the short-term nature and interest rates approximating market rates.
Accounts Receivable and Allowance for Doubtful Accounts
The Company typically offers credit terms to its customers without collateral. The Company records accounts receivable at the face amount less an allowance for doubtful accounts. On a regular basis, the Company evaluates its accounts receivable and establishes these allowances based on a combination of specific customer circumstances, as well as credit conditions and the history of write-offs and collections. Where appropriate, the Company obtains credit rating reports and financial statements of the customer to initiate and modify their credit limits. The Company obtains
credit insurance for certain accounts that qualify for coverage in order to minimize credit risk exposure. If circumstances related to specific customers change, our estimates of the recoverability of receivables could materially change. At January 31, 2007 and 2006, management considered all accounts receivable in excess of the allowances for doubtful accounts to be fully collectible.
Inventories
Finished good inventories are valued at the lower of cost (determined on the first-in, first-out basis) or net realizable value. Cost includes direct materials, labor and overhead allocation. Raw materials and supplies are valued at the lower of cost (determined on the first-in, first-out basis) or net realizable value.
Property, plant and equipment
Property, plant and equipment assets are recorded at cost. The Company’s buildings and equipment are located on owned and leased land. Buildings located on land owned by the Company are depreciated on a straight line basis over a period of 40 years. Leasehold improvements are depreciated on a straight line basis over the shorter of the estimated useful life or the life of the lease agreement for property located on leased land. The Company’s manufacturing equipment is depreciated over the estimated useful life using a 15% declining balance method. The Company’s computer equipment, computer software and office equipment are depreciated on a straight-line basis over the estimated useful life of five, seven and ten years respectively. Maintenance and repairs are expensed as incurred.
Intangible assets
The Company accounts for intangible assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under the provisions of SFAS 142, if an intangible asset is determined to have indefinite useful life, it will not be amortized until its useful life is determined no longer to be indefinite. An intangible asset that is not subject to amortization shall be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.
Impairment of long lived assets
The Company reviews the carrying amount of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The determination of any impairment would include a comparison of estimated future operating cash flows anticipated to be generated during the remaining life with the net carrying value of the asset.
Other Assets
Other assets include deferred financing fees, which represent costs incurred in connection with long-term debt (see Note 9). As of January 31, 2007 and 2006, the deferred financing fees were $266,000 and $261,000, respectively, which are net of accumulated amortization of $78,000 and $52,000, respectively. Amortization expense was $26,000, $27,000 and $19,000 for the years ended January 31, 2007, 2006 and 2005, respectively. The Company is amortizing into interest expense the deferred financing fees on a straight line basis which approximates the interest method over the term of the related debt.
Revenue recognition
Revenues from the sale of products are recognized at the time title passes to the purchaser, which is generally when the goods are conveyed to a carrier. When the Company sells F.O. B. destination point, title is transferred and the Company recognizes revenue on delivery or customer acceptance, depending on terms of the sales agreement. Sales incentives are recorded as a reduction of sales, the recognition of which is determined in accordance with the provisions of Emerging Issues Task Force (“EITF”) 01-09 “Accounting for Consideration Given by a Vendor to a Customer.”
Shipping and Handling Costs
Shipping and handling costs are accounted for under EITF No. 00-10: “Accounting for Shipping and Handling Fees and Costs.” Revenues generated from shipping and handling costs charged to customers are included in sales and were $662,000, $527,000 and $462,000 in fiscal years 2007, 2006 and 2005, respectively. Shipping and handling costs for outbound and inbound shipping charges are included in cost of goods sold and were $4,643,000, $3,019,000 and $2,395,000 in fiscal years 2007, 2006 and 2005, respectively.
Foreign exchange
The Company’s reporting currency is the U.S. dollar. The Company considers the U.S. dollar to be the functional currency in foreign jurisdictions. Accordingly, amounts denominated in foreign currencies are re-measured to U.S.
dollars at historical and current exchange rates as required under SFAS No. 52. Gains and losses resulting from foreign currency transactions are included in the consolidated statement of earnings.
Advertising
The Company accounts for advertising expenses under Statement of Position (“SOP”) No. 93-7. Advertising costs are expensed when incurred and were $394,000, $403,000 and $468,000 during fiscal years 2007, 2006 and 2005, respectively.
Research and development
The Company’s research and development costs are expensed in the period in which they are incurred. Research and development expenses were $10,000, $35,000 and $85,000 during fiscal years 2007, 2006 and 2005, respectively.
Net earnings per share
Net earnings per share computations are in accordance with SFAS No. 128, “Earnings Per Share.” Basic net earnings per share is computed using the weighted average number of common shares outstanding. Diluted net earnings per share is computed using the weighted average number of common shares and potentially dilutive common share equivalents outstanding. Stock options and warrants that are anti-dilutive are not included in diluted net earnings per share.
Income taxes
The Company accounts for income taxes using the asset and liability method. The liability method recognizes the amount of tax payable at the date of the financial statements as a result of all events that have been recognized in the financial statements, as measured by the provisions of currently enacted tax laws and rates. The accumulated tax effect of all temporary differences is presented as deferred federal income tax assets and liabilities within the balance sheet. A valuation allowance is established when necessary to reduce deferred tax assets to the amounts expected to be realized.
Stock-based employee compensation
Prior to February 1, 2006, the Company accounted for its stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”) and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation.” No stock-based compensation expense was recognized in the income statement for the years ended January 31, 2006 and 2005, related to options issued to employees and non-employee directors, as all options granted under the Company’s stock-based employee compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant. As permitted by SFAS No. 123, stock-based compensation was included as a pro forma disclosure in the notes to the Company’s financial statements for the years ended January 31, 2006 and 2005.
Effective February 1, 2006, the Company adopted the fair value recognition provisions of SFAS No. 123(R), “Share Based Payment” using the modified prospective transition method. Under this transition method, compensation cost recognized in the year ended January 31, 2007 includes: (a) compensation cost for all stock-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value calculated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all stock-based payments granted subsequent to January 1, 2006, based on the grant date fair value calculated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated, as provided for under the modified-prospective method.
Total stock-based compensation expense recognized in the income statement for the year ended January 31, 2007 was $340,000, of which $33,000 was recognized in cost of goods sold and $307,000 was recognized in selling, general and administrative expenses. All of the stock-base compensation was related to Incentive Stock Options (“ISO”s) held by employees and non-employee directors for which no tax benefit is recognized.
Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits of deductions resulting from the
exercise of stock options as operating cash flows in the consolidated statements of cash flows. SFAS No. 123(R) requires the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (“excess tax benefits”) to be classified and reported as both an operating cash outflow and a financing cash inflow on a prospective basis upon adoption.
The following table shows the effect on net income and basic and diluted earnings per share for the years ended January 31, 2006 and 2005 had compensation cost been recognized based upon the estimated fair value on the grant date of stock options in accordance with SFAS No. 123, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure.”
Disclosure for the year ended January 31, 2007 is not presented because all stock based compensation expense is recognized in the financial statements in connection with the adoption of SFAS No.123(R).
SFAS No. 123(R) requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes-Merton (“BSM”) option valuation model, which incorporates various assumptions including volatility, expected life forfeiture rate and risk-free interest rates. The assumptions used for the years ended January 31, 2007, 2006 and 2005 and the resulting estimates of weighted-average fair value per share of options granted during those periods are as follows:
The expected life of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. Expected stock price volatility is based on historical volatility of the Company’s stock. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term. The Company has not paid dividends in the past and does not plan to pay any dividends in the near future. As stock-based compensation expense recognized is based on awards ultimately expected to vest, it should be reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company forfeiture
rate for 2006 was calculated based on its historical experience of awards which ultimately vested.
In November 2005, the Financial Accounting Staff Board (“FASB”) issued FASB Staff Position No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). The Company has elected to adopt the “long form” method for calculating the tax effects of share-based compensation pursuant to SFAS No. 123(R). The “long form” method establishes the beginning balance of the additional paid-in capital pool related to the effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R).
The remaining unvested compensation for the fair value of stock options to be recognized was $657,000, $769,000 and $432,000 at January 31, 2007, 2006 and 2005 respectively.
Other stock-based compensation
The Company accounts for equity instruments issued in exchange for the receipt of goods or services from other than employees and non-employee directors in accordance with SFAS No. 123 and the conclusions reached by the EITF in Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). Costs are measured at the estimated fair market value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable. The value of equity instruments issued for consideration other than employee services is determined on the earlier of a performance commitment or completion of performance by the provider of goods or services as defined by EITF 96-18. Stock-based compensation recognized under SFAS No. 123 and EITF 96-18 was $7,000, $8,000 and 38,000 during 2007, 2006 and 2005, respectively.
Comprehensive income
The Company has adopted SFAS No. 130, “Reporting Comprehensive Income.” SFAS No. 130 establishes standards for reporting and presentation of comprehensive income and its components in consolidated financial statements. The statement requires only additional disclosures in the financial statements and it does not affect the Company’s financial position or results of operations. The Company has no material components of other comprehensive income or accumulated other comprehensive income.
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for doubtful accounts, deferred income taxes valuation allowance, accrual for self-insured medical insurance plan, and sales incentives.
New accounting pronouncements
In June 2006, FASB issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions (“tax positions”). FIN 48 requires the Company to recognize in its financial statements the impact of a tax position if that tax position is more likely than not of being sustained on audit, based on the technical merits of the tax position. The provisions of FIN 48 are effective as of the beginning of the Company’s 2008 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company does not anticipate this statement will have a material effect on our financial condition or results of operations.
In September 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”) 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatement in Current Year Financial Statements (“SAB 108”). SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused
4.
Property, Plant and Equipment
7.
Concentration of credit risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and cash equivalents, restricted cash, short-term investments and trade accounts receivable. Receivables arising from sales to customers are generally not significant individually and are not collateralized; as a result, management continually monitors the financial condition of its customers to reduce the risk of loss. The Company had two customers who individually exceeded 10% of sales, who collectively accounted for 39% and 43% of total trade accounts receivable at January 31, 2007 and 2006, respectively, and who collectively accounted for 47%, 45% and 43% of total sales during the fiscal year ending January 31, 2007, 2006 and 2005, respectively.
The Company invests its cash and cash equivalents in high quality issuers. These cash balances may be insured by the Federal Deposit Insurance Corporation, the Canada Deposit Insurance Corporation, the Securities Investor Protection Corporation or through other private insurance purchased by the issuer. The Company maintains its cash in demand deposits and money market accounts held primarily by four banks and in the normal course of business, maintains cash balances in excess of these insurance limits.
8.
Operating line of credit
On May 23, 2005, Absorption renewed a bank line of credit with Branch Banking & Trust Co. that provides for up to $2,000,000 of cash borrowings for general corporate purposes which is secured by accounts receivable and inventory of Absorption. Interest is payable on funds advanced at the one-month London Interbank Offered Rate (“LIBOR”) plus 2.5%. The line of credit matures on May 23, 2007. At January 31, 2007, the Company had no borrowings outstanding.
9.
Long-term debt (in thousands of U.S. dollars)
securities laws. The exercise price of options granted under the 2003 Omnibus Plan must be paid in cash, property, qualifying services or under a qualifying deferred payment arrangement. In addition, subject to applicable law, the Company may make loans to individual grantees on such terms as may be approved by the Board of Directors for the purpose of financing the exercise of options granted under the 2003 Omnibus Plan and the payment of any taxes that may be due in respect of such exercise. The Compensation Committee will fix the term of each option, but no option under the 2003 Omnibus Plan will be exercisable more than ten years after the option is granted. Each option will be exercisable at such time or times as determined by the Compensation Committee, provided, however, that no stock option granted under the 2003 Omnibus Plan, or any portion thereof, to any grantee who is subject to Section 16 of the Exchange Act shall be exercisable prior to seven (7) months after the grant date of the option; and stock options, or any portion thereof, granted to grantees who are not subject to Section 16 of the Exchange Act shall not be exercisable prior to ninety (90) days after the grant date of the option. Upon a grantee’s termination of employment with the Company or its subsidiary (other than as a result of death), the 2003 Omnibus Plan provides for an expiration of any outstanding options expire immediately or within a period of 12 months or less, depending upon the cause of termination. No option shall be transferable by the option holder otherwise than by will or the laws of descent.
The following table summarizes the Company’s stock option activity for the years ended January 31, 2007, 2006 and 2005:
13.
Income taxes
The components of income before income taxes are as follows (in thousands of U.S. dollars):
The components of the provision for current income taxes consist of the following (in thousands of U.S. dollars):
The components of the provision for deferred income taxes consist of the following (in thousands of U.S. dollars):
The provision for income taxes differs from the amount computed by applying the statutory income tax rate to net income before taxes as follows (in thousands of U.S. dollars):
Deferred income taxes are provided for temporary differences. Deferred income tax assets and liabilities are comprised of the following (in thousands of U.S. dollars):
The Company has Canadian tax losses from prior years which are available to offset taxable income of future years. These tax losses expire as follows (in thousands of U.S. dollars):
The Company has recorded a valuation allowance against deferred tax assets which relates to uncertainties related to utilization of Canadian Net Operating Loss Carry Forwards and other Canadian deferred tax assets. The valuation allowance increased by $42,000 during the year ended January 31, 2006 and decreased by $160,000 and $142,000 during the years ended January 31, 2007 and 2005, respectively.
The Company has not provided for Canadian deferred income taxes on undistributed earnings of International’s U.S. subsidiary because of its intention to indefinitely reinvest these earnings in the U.S. The determination of the amount of the unrecognized deferred U.S. income tax liability related to the undistributed earnings is not practicable.
14.
Commitments and Contingencies
Operating Leases
The Company’s Bellingham, Washington plant is leased from the Port of Bellingham under a lease that expires in August 2007. The terms and conditions of the lease require monthly payments of the excise tax only. The normal monthly lease payments were waived in lieu of Absorption agreeing to remove the building and associated utilities at the expiration of the lease. The estimated cost for this work is $120,000 and has been accounted for in accordance with
Management of the Company evaluates these segments based upon the operating income before depreciation and amortization generated by each segment. Depreciation, amortization, and interest expense are managed on a consolidated basis and as such are not allocated to individual segments. Certain segment information, including segment assets, asset expenditures and related depreciation expense, is not presented as all of the Company’s assets are commingled and are not available by segment. There are no inter-segment transactions or significant differences between segment accounting and corporate accounting basis.
Business segment data (in thousands of U.S. dollars)
Sales revenues by geographic areas are as follows:
Two customers from the Animal Care segment represent 10% or more of the Company’s sales.
16.
Earnings per share (in thousands of U.S. dollars, except per share amounts)
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, we performed an evaluation under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based upon that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
There was no change in our internal control over financial reporting during the fourth quarter of fiscal year 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
For information with respect to our officers and directors see “Election of Directors” in our definitive Proxy Statement (“Proxy Statement”) for our Annual General Meeting of Shareholders to be held on June 7, 2007 (“Annual Meeting”), which information is incorporated herein by this reference.
For information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 by our directors and executive officers and holders of ten percent of a registered class of our equity securities, see the section titled “Section 16(a) Beneficial Ownership Reporting Compliance” in our Proxy Statement, which information is incorporated herein by this reference.
For information regarding our audit committee and audit committee financial expert and any material changes to the procedures by which shareholders may recommend nominees to our board of directors, see the section titled “Election of Directors” in our Proxy Statement, which information is incorporated herein by this reference.
We have adopted a Code of Business Conduct and Ethics in compliance with the applicable rules of the SEC that applies to our principal executive officer, our principal financial officer and our principal accounting officer or controller, or persons performing similar functions. A copy of this policy is available free of charge on our website at www.internationalabsorbents.com under the “Governance” tab. We intend to disclose any amendment to, or a waiver from, a provision of our code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions and that relates to any element of the code of ethics enumerated in applicable rules of the SEC on our website at www.internationalabsorbents.com under the “Governance” tab.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
For information required by this item regarding compensation of our executive officers and directors, see the section titled “Information Regarding Compensation of our Executive Officers and Directors” in our Proxy Statement, which information is incorporated herein by this reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
For information with respect to the security ownership of certain beneficial owners and management, see the section titled “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement, which information is incorporated herein by this reference.
For information required by this item regarding equity compensation plan information, see the section titled “Equity Compensation Plan Information” in our Proxy Statement, which information is incorporated herein by this reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
For information with respect to certain relationships and related transactions, see the section titled “Transactions with Related Persons” in our Proxy Statement, which information is incorporated herein by this reference.
For information with respect to the independence of our directors, see the section titled “Election of Directors” in our Proxy Statement, which information is incorporated herein by this reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
For information with respect to our principal accountant fees and services, see the section titled “Ratification of Independent Auditors” in our Proxy Statement, which information is incorporated herein by this reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
1. Financial Statements.
The following Financial Statements are included in Part II, Item 8:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at January 31, 2007 and 2006
Consolidated Statements of Earnings for the Fiscal Years ended January 31, 2007, 2006 and 2005
Consolidated Statements of Stockholders’ Equity for the Fiscal Years ended January 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows for the Fiscal Years ending January 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements, January 31, 2007 and 2006
2. Financial Statement Schedules.
Financial Statement Schedules not included herein have been omitted because they are either not required, not applicable, or the information is otherwise included herein.
3. Exhibits.
The exhibits listed in the accompanying Index to Exhibits on page 55 are filed or incorporated by reference as part of this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
INTERNATIONAL ABSORBENTS INC., a
British Columbia, Canada corporation
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Gordon L. Ellis his attorney-in-fact, with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file same, with exhibits thereto and other documents in connection therewith, with the U.S. Securities and Exchange Commission, hereby ratifying and confirming all that said attorney-in-fact, or his substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX