Osmonics (OSM) 10-Q 2001 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10–Q

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For Quarter Ended June 30, 2001

or

o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from              to              

Commission File No.  1-12714

OSMONICS, INC

(Exact name of registrant as specified in its charter)

Minnesota	41–0955759
(State or other jurisdiction of Incorporation or organization)	(I.R.S. Employer Identification Number)
5951 Clearwater Drive, Minnetonka, MN	55343
(Address of principal executive offices)	(Zip Code)

Registrant's telephone number, including area code    (952) 933–2277

N/A

Former name, former address and former fiscal year, if changed since last report

             Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for at least the past 90 days.

Yes  ý  No  o

             Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.  At July 31, 2001, 14,473,436 shares of the issuer's Common Stock, $0.01 par value, were outstanding.

OSMONICS, INC.

INDEX

PART I.	FINANCIAL INFORMATION
ITEM I.	FINANCIAL STATEMENTS
	Consolidated Statements of Operations – For the Three and Six Months Ended June 30, 2001 and 2000
	Consolidated Balance Sheets – June 30, 2001 and December 31, 2000
	Consolidated Statements of Cash Flows - For the Six Months Ended June 30, 2001 and 2000
	Notes to Consolidated Financial Statements
ITEM II.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PART II.	OTHER INFORMATION
ITEM 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 6	EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES

ITEM I FINANCIAL STATEMENTS

OSMONICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS(In Thousands Except Per Share Data)

(UNAUDITED)

		Three Months Ended June 30,					Six Months Ended June 30,
		2001			2000		2001			2000
Sales		$	51,721		$	50,110	$	105,023		$	101,205
Cost of sales		35,477			34,222		71,081			69,033
Gross profit		16,244			15,888		33,942			32,172
Less:
	Selling, general and administrative	11,516			11,273		22,925			22,846
	Research, development and engineering	2,174			1,977		4,003			4,073
	Special charges	-			-		-			250
Income from operations		2,554			2,638		7,014			5,003
Other income (expense)		(768		)	162		(1,027		)	209
Income from continuing operations before income taxes		1,786			2,800		5,987			5,212
Income taxes		625			952		2,095			1,772
Net income		$	1,161		$	1,848	$	3,892		$	3,440
Earnings per share
	Net income - basic	$	0.08		$	0.13	$	0.27		$	0.24
	Net income – assuming dilution	$	0.08		$	0.13	$	0.27		$	0.24
Average shares outstanding
	Basic	14,451			14,309		14,435			14,291
	Assuming dilution	14,617			14,391		14,534			14,361

OSMONICS, INC.

CONSOLIDATED BALANCE SHEETS(In Thousands Except Share Data)

				(UNAUDITED) June 30, 2001			December 31, 2000
ASSETS
Current assets
	Cash and cash equivalents			$	1,951		$	21
	Marketable securities			160			1,889
	Trade accounts receivable, net of allowance for doubtful accounts of $633 in 2001, and $1,008 in 2000			37,913			37,092
	Inventories			33,134			32,758
	Deferred tax assets			4,606			4,314
	Other current assets			4,042			2,487
		Total current assets		81,806			78,561
Property and equipment, at cost				5,056			5,056
	Land and land improvements			30,831			30,283
	Building			79,603			76,943
	Machinery and equipment			115,490			112,282
	Less accumulated depreciation			(58,428		)	(55,381		)
				57,062			56,901
Other assets				52,397			53,230
Total assets				$	191,265		$	188,692
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities				$	13,475		$	15,262
	Accounts payable
	Notes payable and current portion of long – term debt			21,288			19,759
	Other accrued liabilities			13,805			13,784
		Total current liabilities		48,568			48,805
Long – term debt				23,893			24,603
Other liabilities				-			4
Deferred income taxes				6,335			6,335
Shareholders’ equity
	Common stock, $0.01 par value
		Authorized –– 50,000,000 shares
		Issued ––	2001: 14,467,919 and 2000: 14,408,634 shares	145			144
	Capital in excess of par value			24,158			23,818
	Retained earnings			89,350			85,458
	Other comprehensive income			(1,184		)	(475		)
	Total shareholders’ equity			112,469			108,945
		Total liabilities and shareholders' equity		$	191,265		$	188,692

OSMONICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS(In Thousands)

(UNAUDITED)

			Six Months Ended June 30,
			2001			2000
Cash flows from operations:
	Net income		$	3,892		$	3,440
	Non – cash items included in net income:
		Depreciation and amortization	5,168			4,837
		Deferred income taxes	(77		)	50
		Gain on sale of investments	(972		)	(2,088		)
		Loss on sale of property and equipment	-			49
Changes in assets and liabilities (net of business acquisitions)
		Accounts receivable	(712		)	(3,940		)
		Inventories	(376		)	(4,900		)
		Other current assets	(2,080		)	(399		)
		Accounts payable and accrued liabilities	(1,770		)	(642		)
	Net cash provided by (used in) operations		3,073			(3,593		)
Cash flows from investing activities:
	Purchase of investments		-			(1,004		)
	Sale of investments		2,088			9,947
	Purchase of property and equipment		(4,338		)	(3,517		)
	Sales of property and equipment		24			311
	Other		(91		)	(1,116		)
	Cash provided by (used in) investing activities		(2,317		)	4,621
Cash flows from financing activities:
	Proceeds from notes payable and debt		1,529			1,006
	Reduction of debt		(710		)	(4,173		)
	Cash restricted for purchase and construction of equipment		325			325
	Issuance of common stock		341			651
	Net cash provided by (used in) financing activities		1,485			(2,191		)
Effect of exchange rate changes on cash			(311		)	(190		)
Increase (decrease) in cash and cash equivalents			1,930			(1,353		)
Cash and cash equivalents – beginning of year			21			1,807
Cash and cash equivalents – end of quarter			$	1,951		$	454

OSMONICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Dollars in Thousands)

The accompanying unaudited condensed financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

On June 29, 2001, the Financial Accounting Standards Board approved its proposed Statements of Financial Accounting Standards No. 141 (FAS 141), “Business Combinations,” and No. 142 (FAS 142), “Goodwill and Other Intangible Assets.”  FAS 141 requires that all business combinations subsequent to June 30, 2001 be accounted for under the purchase method of accounting.  FAS 142 requires cessation of goodwill amortization and periodic evaluation of the goodwill carrying value.  The provisions of FAS 142 will be effective for fiscal years beginning after December 15, 2001.  The Company is evaluating the impact of the adoption of these standards and has not yet determined the effect of adoption on its financial position and results of operations.

The Company has the following components of comprehensive income:

		Six Months Ended June 30,
		2001			2000
Net income		$	3,892		$	3,440
Other comprehensive income (loss), net of tax:
	Foreign currency translation adjustments	(311		)	(190		)
	Unrealized gains/(losses) on securities	(398		)	(423		)
	Other comprehensive income (loss), before tax	(709		)	(613		)
Comprehensive income		$	3,183		$	2,827

The Company has $13,900 of goodwill recorded as of June 30, 2001 associated with the 1998 acquisition of Membrex Corp. (Membrex).  Safety Kleen (SK), the principal customer for the Membrex products, filed for Chapter 11 bankruptcy in June of 2000.  As a result, six months sales ended June 30, 2001 to SK of $1,097 were substantially below same period 2000 sales of $2,781.  SK has continued to order product and parts at reduced levels to support its installed base.  Future sales levels are uncertain and could be minimal.

The Company has a contract with SK that provides some exclusivity to SK for certain Membrex products.  The Company anticipates that the exclusivity provisions of the contract will expire in the third quarter of 2001 due to anticipated failure of SK to buy the required minimum amount of products and continues discussions with SK to renegotiate the contract based on the current situation.

The Company has determined that two-thirds ($9,300) of the Membrex goodwill is associated with the SK products.  Business activity in the first six months of 2001 approximated the financial forecasts used to support the goodwill balance at December 31, 2000; therefore, the Company has concluded there was no impairment of goodwill at June 30, 2001.

Inventory related to the Membrex products for SK was $1,700 while net receivables from SK were current at June 30, 2001.  The Company is monitoring the Chapter 11 bankruptcy proceedings to determine any further financial impact to the Company.

Operating results for the three months or six months ended June 30, 2001, are not necessarily indicative of the results that may be expected for the full year 2001.

These statements should be read in conjunction with the financial statements and related notes included in the Company’s Annual Report to shareholders and Form 10-K for the year ended December 31, 2000.

ITEM II.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	(Dollars in thousands, except share data)

As an aid to understanding the Company’s operating results, the following table shows the percentage of sales that each income statement item represents for the three months and six months ended June 30, 2001 and 2000.

	Percent of Sales				Percent of Sales
	Three Months Ended June 30,				Six Months Ended June 30,
	2001		2000		2001		2000
Sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	68.6		68.3		67.7		68.2
Gross profit	31.4		31.7		32.3		31.8
Selling, general and administrative	22.3		22.5		21.8		22.7
Research, development and engineering	4.2		3.9		3.8		4.0
Special charges	-		-		-		0.2
Operating expenses	26.5		26.4		25.6		26.9
Income from operations	4.9		5.3		6.7		4.9
Other income (expense)	(1.5	)	0.3		(1.0	)	0.2
Income from continuing operations before income taxes	3.4		5.6		5.7		5.1
Income taxes	1.2		1.9		2.0		1.7
Net income	2.2	%	3.7	%	3.7	%	3.4	%

SALES

Sales for the second quarter ended June 30, 2001 of $51,721 increased 3.2% from sales for the second quarter of 2000.  Year-to-date 2001 sales through June increased 3.8% over the corresponding 2000 level.  The second quarter 2001 Filtration & Separations, Process Water and Household Water segment sales were 40%, 43% and 17% of total sales, respectively.  The second quarter and year-to-date 2001 sales increase is attributed to internal growth of existing product offerings.  Globally, international sales have remained relatively flat as a percentage of total Osmonics sales through the first six months of 2001 compared to full year 2000.  The Americas market grew as a percentage of total Osmonics sales in the first six months of 2001, while the Asia/Pacific market dropped slightly.

GROSS MARGIN

Gross margin for the second quarter of 2001 was 31.4% versus 31.7% for the corresponding period in 2000.  Gross margin for the six months ended June 30 was 32.3% in 2001 compared to 31.8% for the same period in 2000.  The second quarter 2001 decrease in gross margins is primarily due to an unfavorable sales mix within the Filtration and Separations segment and larger weighting of Process Water segment shipments that carry gross margins below the Company average.  Also, lower utilization of manufacturing capacity in the Household segment contributed to the decrease.

The increase in gross margins for the six months ended June 30, 2001 is primarily due to reduced overhead costs resulting from the Company-wide Year 2000 restructuring, plant closures and cost reduction efforts.

Energy costs in California during the first half of 2001 were approximately 33% above the levels experienced during the second half of 2000.  Management believes that due to product demand the Company has been able to pass the additional costs onto its customers in the first half of 2001; however, there is no assurance that this will continue.

Raw material costs in the first half of 2001 remained comparable to costs incurred during Year 2000.

OPERATING EXPENSES

Operating expenses increased to 26.5% of sales in the second quarter of 2001 compared to 26.4% in the second quarter of 2000.  Operating expenses decreased to 25.6% of sales for the six months ended June 30, 2001 compared to 26.9% for the same period in 2000.  The six months ended June 30, 2000 decrease is primarily attributed to the Year 2000 restructurings and continued consolidation of administrative services.  Year 2000 also contained special charges of 0.2% of sales (see Special Charges discussion).

SPECIAL CHARGES

In the first six months of 2001, the Company recorded no special charges.  In first quarter 2000, the Company recorded special charges and recoveries that netted to zero.

Special charges in the first quarter 2000 included a $250 recovery of inventory accruals primarily due to gains recognized on the sale of inventory at the Company’s Rockland, Massachusetts manufacturing facility.  The special charges also included $250 of workforce reduction severance costs related to the first quarter 2000 restructuring of several corporate functions.  These special charges (recovery) are summarized below:

Corporate restructuring		$	250
Special inventory recovery related to plant closings		(250		)
	Gross special charges (recovery)	$	-
	Less special inventory recovery – in COS	(250		)
	Special charge in operating expense	$	250

OTHER INCOME (EXPENSE)

Other expense increased by $930 in the second quarter of 2001 versus the same period for 2000.  The increase is primarily the result of a $1,142 pretax gain ($0.05 per diluted share after tax) recognized on the sale of marketable securities in the second quarter of 2000.  There were no sales of marketable securities in the second quarter of 2001.  Translation loss, primarily from converting net assets of a foreign subsidiary to US dollars, increased $138 to $176 in the second quarter 2001 from $38 in the second quarter 2000.  Net interest expense decreased $275 to $673 in the second quarter 2001 from $948 in the second quarter of 2000.

Year-to-date other expense increased $1,236 in 2001 compared to 2000.  This increase is primarily due to $2,088 pretax gains ($0.10 per diluted share after tax) recognized on the sale of securities during the first six months of 2000 compared to $972 pretax gains ($0.04 per diluted share after tax) in the first six months of 2001.  Translation loss, primarily from converting net assets of a foreign subsidiary to US dollars, increased $598 to $639 in the first six months of 2001 from $41 in the first six months of 2000.  Net interest expense decreased $434 to $1,434 in the first six months of 2001 from $1,868 in the first six months of 2000.

INCOME TAXES

The effective tax rate for the second quarter and year-to-date 2001 was 35.0% based on the forecast for the full year.  This rate is comparable to 34.0% in the same periods of 2000.

NET INCOME

Net income for the quarter ended June 30, 2001 was $1,161 compared to $1,848 for the quarter ended June 30, 2000.  Net income per diluted share for the quarter was $0.08 compared to $0.13 for the same period last year.

Year-to-date 2001 net income was $3,892 compared to $3,440 for the same period last year.  Net income per diluted share year-to-date was $0.27 in 2001 compared to $0.24 in 2000.

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2001, the Company had cash, cash equivalents and marketable securities of $2,111 versus $1,910 at December 31, 2000.  The current ratio at June 30, 2001 was 1.7 versus 1.6 at year end 2000.

The Company’s long-term and current debt increased $819 from $44,362 at December 31, 2000 to $45,181 at June 30, 2001.  The Company’s borrowing outstanding against its $24,000 revolving line of credit increased to $16,500 as of June 30, 2001 compared to $15,000 as of December 31, 2000.

The Company believes that its current cash and investments position, its cash flow from operations, and amounts available from bank credit will be adequate to meet its anticipated cash needs for working capital, capital expenditures, and potential acquisitions during the foreseeable future.

REVIEW OF INDUSTRY SEGMENTS

The Company designs, manufactures and markets equipment, systems and components used in the processing and handling of fluids.  In 2000, the Company changed the focus of its reporting structure from a two segment, product focused structure to a three segment, market focused structure.

The three-market-segment structure was established to provide strategic leadership within the three major market segments in which the Company conducts business.  The new structure was implemented on January 1, 2000.

The Filtration and Separations segment includes products such as filter cartridges, membrane elements, membranes, instruments and laboratory products. The Process Water segment includes products such as pumps, housings, valves, controls, reverse osmosis/ultrafiltration (RO/UF) machines, ozonators and water treatment systems used for industrial, commercial and municipal applications. The Household Water segment includes products such as valves, controls and home reverse osmosis membranes and filters used for the residential water purification and water softening market segments. Each segment is currently supported by several manufacturing facilities, a sales force and various corporate functions. The segments do not have separate accounting, administration or research and development functions.

The reportable segment information for the three months and six months ended June 30, 2001 and 2000 are as follows:

		Second Quarter Ended June 30,					Six Months Ended June 30,
		2001		2000			2001		2000
Sales:
Filtration and Separations		$	20,514	$	20,081		$	42,613	$	41,407
Process Water		22,251		19,865			44,257		39,444
Household Water		8,956		10,164			18,153		20,354
	Net Sales	51,721		50,110			105,023		101,205
Gross Profit:
Filtration and Separations		7,243		7,694			16,139		15,259
Process Water		6,516		5,104			12,460		10,258
Household Water		2,485		3,090			5,343		6,405
	Gross Profit	16,244		15,888			33,942		31,922
Operating Income:
Filtration and Separations		1,289		1,987			4,711		3,478
Process Water		1,217		(117		)	1,944		(185		)
Household Water		48		768			359		1,710
	Operating Income	$	2,554	$	2,638		$	7,014	$	5,003

Net sales in the Fitration and Separations and Process Water segments increased in both the second quarter ended and first six months ended June 30, 2001 compared to the same periods in 2000.  Filtration and Separations and Process Water segments sales growth was organic.  Net sales in the Household Water segment decreased in both the second quarter ended and first six months ended June 30, 2001 compared to the same periods in 2000.  Management believes this decrease was the result of the continued economic slowdown and customer inventory level adjustments.

Gross profit margins and operating income margins in the Filtration and Separations segment were lower in the second quarter and higher in the first six months ended June 30, 2001 compared to the same periods in 2000.  The second quarter 2001 decrease was primarily related to a reduction in sales of its higher margin filtration products and a unfavorable sales mix shift within its membrane element products.  The six months 2001 increase is primarily related to a favorable sales mix within the Segment’s membrane element product shipments.

Gross profit margins and operating income margins in the Process Water segment were higher in the second quarter and six months ended June 30, 2001 compared to the same periods in 2000.  This was primarily related to increased sales volume (six month 2001 organic growth rate over 12%), improved utilization of manufacturing capacity, and cost reductions resulting from the Year 2000 restructuring and plant closures.

Gross profit margins and operating income margins in the Household Water segment were lower in the second quarter and six months ended June 30, 2001 compared to the same periods in 2000.  This was primarily related to reduced sales volume (three and six month 2001 sales declined approximately 11%) that resulted in lower utilization of manufacturing capacity.  The Segment incurred one-time separation charges of $250K in the second quarter of 2001 resulting from efforts to reduce staff and management levels to match the current and anticipated business needs.

Management does not report the balance sheet or any cash-generating measurements by such segments.

PRIVATE SECURITIES LITIGATION REFORM ACT

The Private Securities Litigation Reform Act provides a “safe harbor” for forward-looking statements. Certain information included in this Form 10-Q and other materials filed or to be filed with the Securities and Exchange Commission (as well as information included in statements made or to be made by the Company) contains statements that are forward looking.  Such statements may relate to plans for future expansion and acquisitions, financial status of major customers, the relocation of certain manufacturing processes, business development activities, capital spending, financing, or the effects of regulation and competition.  Such information involves important risks and uncertainties that could significantly affect results in the future.  Such results may differ from those expressed in any forward-looking statements made by the Company.  These risks and uncertainties include, but are not limited to, those relating to product development activities, the inability to accurately estimate the costs of relocation of certain manufacturing processes, dependence on existing management, financial viability of major customers, global economic and market conditions, and changes in federal or state laws.  Investors are referred to the discussion of certain risks and uncertainties associated with forward looking statements contained in the Company’s report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2000.

OSMONICS, INC.

PART II

OTHER INFORMATION

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company’s Annual Meeting of Stockholders was held on May 9, 2001.  The following members were elected to the Company’s Board of Directors to hold office for the ensuing three years:

Nominee	In Favor	Withheld
William Eykamp	12,270,296	110,052
Michael L. Snow	12,176,866	230,482
Ruth Carol Spatz	11,577,640	802,708

An amendment of the Company’s 1993 Employee Stock Option and Compensation Plan to increase by 150,000 the number of shares reserved under such Plan was approved with the vote of 9,785,628 in favor, 2,108,011 against, and 486,709 abstained.

An amendment of the Company’s 1995 Employee Stock Purchase Plan to increase by 400,000 the number of shares reserved under such Plan was approved with the vote of 11,065,992 in favor, 815,534 against, and 498,822 abstained.

An amendment to Osmonics’ By-Laws to provide that no person over the age of 72 may be elected or appointed to the Board was approved with the vote of 11,377,200 in favor, 875,913 against, and 103,245 abstained.

Item 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)             During the quarter ended June 30, 2001 the Registrant did not file a Form 8-K report.

SIGNATURES

             Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated:	August 10, 2001
		OSMONICS, INC.
		(Registrant)
		/s/	Keith B. Robinson
			Keith B. Robinson
			Chief Financial Officer
		/s/	D. Dean Spatz
			D. Dean Spatz
			Chief Executive Officer