SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For Quarter Ended March 31, 1996 OR Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934 For the transition period from to Commission File No. 1-12714 OSMONICS, INC (Exact name of registrant as specified in its charter) Minnesota 41-0955759 (State or other jurisdiction of (I.R.S. Employer Incorporation or organization) Identification Number) 5951 Clearwater Drive, Minnetonka, MN 55343 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (612) 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 X No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. At April 29, 1996, 12,807,547 shares of the issuer's Common Stock, $0.01 par value, were outstanding. OSMONICS, INC. INDEX PART I. FINANCIAL INFORMATION PAGE ITEM I. FINANCIAL STATEMENTS Consolidated Statements of Income - . . . . . . . . 2 For the Three Months Ended March 31, 1996 and 1995 Consolidated Balance Sheets - . . . . . . . . . . . 3 March 31, 1996 and December 31, 1995 Consolidated Statements of Cash Flows . . . . . . . 4 For the Three Months Ended March 31, 1996 and 1995 Notes to Consolidated Financial Statements . . . . . 5 ITEM II. MANAGEMENT'S DISCUSSION AND ANALYSIS OF . . . . . . 6-7 FINANCIAL CONDITION AND RESULTS OF OPERATIONS PART II. OTHER INFORMATION ITEM 5. OTHER INFORMATION . . . . . . . . . . . . . . . . . . 8 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K . . . . . . . . . . 8 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 ITEM I - FINANCIAL STATEMENTS OSMONICS, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands Except Per Share Data) Three Months Ended March 31, 1996 1995 Sales $33,229 $26,870 Cost of sales 19,667 14,958 Gross profit 13,562 11,912 Less: Selling, general and administrative 7,125 6,466 Research, development and engineering 2,081 1,869 Income from operations 4,356 3,577 Other income (expense) 226 507 Income before income taxes 4,582 4,084 Income taxes 1,420 1,284 Net income $ 3,162 $ 2,800 Net income per common share $ 0.25 $ 0.22 Average common shares outstanding 12,792 12,722 OSMONICS, INC. CONSOLIDATED BALANCE SHEETS (In thousands except share data) March 31, December 31, 1996 1995 ASSETS Current assets Cash and cash equivalents $ 2,346 $ 4,361 Marketable securities 23,119 26,307 Trade accounts receivable, net of allowance for doubtful accounts of $878 in 1996, and $1,127 in 1995 20,794 20,501 Inventories 26,226 26,227 Deferred tax assets 3,549 3,719 Other current assets 1,456 1,851 Total current assets 77,490 82,966 Property and equipment, at cost Land and land improvements 2,306 2,310 Building 16,519 15,557 Machinery and equipment 38,442 36,645 Construction in progress 3,195 5,970 66,138 60,482 Less accumulated depreciation and amortization (28,596) (27,923) 37,542 32,559 Other assets 9,995 9,533 $125,027 $125,058 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable $ 11,078 $ 12,247 Notes payable and current portion of long-term debt 1,606 1,695 Reserve for discontinued operations 1,957 1,957 Other accrued liabilities 11,320 12,843 Total current liabilities 25,961 28,742 Long-term debt 12,473 12,441 Deferred compensation and other liabilities 228 450 Deferred income taxes 4,825 4,954 Shareholders' equity Common stock, $0.01 par value Authorized -- 20,000,000 Issued -- 1996: 12,807,547 and 1995: 12,773,184 shares 129 129 Capital in excess of par value 22,044 21,709 Retained earnings 55,782 52,620 Unrealized gain on marketable securities 3,406 3,694 Foreign currency translation adjustments 179 319 Total shareholders' equity 81,540 78,471 $125,027 $125,058 OSMONICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) Three Months Ended March 31, Cash flows from: 1996 1995 Operations: Net income $3,162 $ 2,800 Non-cash items included in net income: Depreciation and amortization 1,047 814 Deferred income taxes (87) (41) Gain on sale of investments (164) (191) Accounts receivable (293) 558 Inventories and other current assets 396 (1,335) Accounts payable and accrued liabilities (2,692) 478 Net cash provided by operations 1,369 3,083 Investing activities: Purchase of investments (283) (3,094) Sale of investments 3,029 321 Purchase of property and equipment (6,068) (845) Other (320) 142 Cash provided by (used in) investing activities (3,642) (3,476) Financing activities: Reduction of debt (57) (426) Issuance of Common Stock 335 214 Net cash provided by (used in) financing activities 278 (212) Effect of exchange rate changes on cash (20) (164) Decrease in cash and cash equivalents (2,015) (769) Cash and cash equivalents - beginning of year 4,361 9,453 Cash and cash equivalents - end of quarter $ 2,346 $ 8,684 OSMONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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. Operating results for the three months ended March 31, 1996, are not necessarily indicative of the results that may be expected for the year 1996. 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, 1995. ITEM II. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in thousands except per share amounts) 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 ended March 31, 1996 and 1995. Percent of Sales Three Months Ended March 31, 1996 1995 Sales 100.0% 100.0% Cost of sales 59.2 55.7 Gross profit 40.8 44.3 Selling, general and administrative 21.4 24.0 Research, development and engineering 6.3 7.0 Operating expenses 27.7 31.0 Income from operations 13.1 13.3 Other income (expense) 0.7 1.9 Income before income taxes 13.8 15.2 Income taxes 4.3 4.8 Net income 9.5% 10.4% Sales Sales of $33,229 for the quarter ended March 31, 1996 increased 23.7% from the first quarter of 1995. The increase occurred primarily in capital equipment, which represented 61% of total sales for the first quarter of 1996. Sales of membrane products and cartridge filters also showed good growth over the prior year. Quarterly sales include sales of Western Filter, acquired in October 1995, but do not include any sales from Desalination Systems, Inc. (DESAL). It is anticipated that the previously announced merger with DESAL will be completed in the second quarter of 1996. Gross Margin Gross margin decreased from 44.3% of sales in the first quarter of 1995 to 40.8% of sales in the first quarter of 1996. Average gross profit margins are below the prior year first quarter due in large part to a change in product sales mix. This is a result of recent acquisitions and sales strategy changes. Gross margins also continue to be affected by increased costs that have not been fully passed on to our customers. Certain raw materials such as stainless steel and plastic continue to be above anticipated costs. Also, some non-recurring costs were incurred in the move to newly completed expansions of the Minnetonka and Phoenix facilities. Operating Expenses Operating expenses decreased from 31.0% of sales in the first quarter of 1995 to 27.7% in the first quarter of 1996. Selling, general and administrative expenses, and research, development and engineering expense were lower as a percentage of sales in the first quarter of 1996 than in the corresponding period of 1995. The rate of growth in operating expense slowed to 10.4%, compared to the sales growth rate of 23.7%. It is believed that the investment in sales and marketing during the prior years is producing results, and recent investments in office automation are showing returns in higher productivity. Other Income Other income decreased by $281 from the first quarter of 1995 to the first quarter of 1996. The decrease results from lower interest income on a lower investment portfolio, and the inclusion in 1995 of a non- recurring $200 recovery from an insurance policy. Income Taxes The effective tax rate for the first quarter 1996 is 31.0% based on the forecast for the full year. This compares to 31.4% in the corresponding period of 1995. Net Income Net income for the quarter was $3,162, as compared to $2,800 for the first quarter of 1995. Net income per share was $0.25 per share, an increase of 14% over the $0.22 per share reported for the same quarter last year. Liquidity and Capital Resources As of March 31, 1996, the Company had cash, cash equivalents and marketable securities of $25,465 versus $30,668 at December 31, 1995. The current ratio was 3.0 at March 31, 1996, as compared to 2.9 at year-end 1995. Inventory remained relatively constant during the first quarter of 1996, compared to year-end 1995. In the first quarter of 1996, the Company expended $6.1 million on capital improvements, primarily for the expansion of the Minnetonka and Phoenix facilities, for office automation and for new product tooling. 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. OSMONICS, INC. PART II OTHER INFORMATION Item 5. Other Information The Company announced in December 1995 the execution of an agreement in principle to merge with Desalination Systems Inc. (DESAL) in a stock transaction. The outstanding shares of DESAL will be exchanged on a share-for-share basis for the Company's common stock. The transaction is structured to qualify as a tax-free exchange and a "pooling-of-interests" for accounting and financial purposes. At current market prices, the value of the transaction is approximately $30 million. The transaction is expected to add over $20 million to Osmonics' 1996 sales. The transaction will require the approval of a definitive merger agreement by both companies, regulatory approvals, and the satisfaction of customary closing conditions. Preparation of the required documents is continuing, and the transaction is expected to be completed in the second quarter of 1996. Item 6. Exhibits and Reports on Form 8-K (a) None (b) During the quarter ended March 31, 1996, 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: ________________ OSMONICS, INC. (Registrant) /s/ L. Lee Runzheimer L. Lee Runzheimer Chief Financial Officer /s/ Howard W. Dicke Howard W. Dicke Treasurer and Vice President Corporate Development /s/ D. Dean Spatz D. Dean Spatz Chief Executive Officer