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 September 30, 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 October 22, 1996, 14,184,091 shares of the issuer's Common Stock, $0.01 par value, were outstanding. <P1> OSMONICS, INC. INDEX PART I. FINANCIAL INFORMATION PAGE ITEM I. FINANCIAL STATEMENTS Consolidated Statements of Income - . . . . . . . . 2 For the Three and Nine Month Periods Ended September 30, 1996 and 1995 Consolidated Balance Sheets - . . . . . . . . . . . 3 September 30, 1996 and December 31, 1995 Consolidated Statements of Cash Flows . . . . . . . 4 For the Nine Months Ended September 30, 1996 and 1995 Notes to Consolidated Financial Statements . . . . . 5 ITEM II. MANAGEMENT'S DISCUSSION AND ANALYSIS OF . . . . . . 6-9 FINANCIAL CONDITION AND RESULTS OF OPERATIONS PART II. OTHER INFORMATION ITEM 5. OTHER INFORMATION . . . . . . . . . . . . . . . . 10-32 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K . . . . . . . . . 33 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . 34 <P2> ITEM I - FINANCIAL STATEMENTS OSMONICS, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands Except Per Share Data) Three Months Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 Sales $39,493 $31,995 $115,271 $94,829 Cost of sales 23,247 18,533 67,776 53,864 Gross profit 16,246 13,462 47,495 40,965 Less: Selling, general and administrative 8,771 7,504 25,664 22,824 Research, development and engineering 2,750 2,446 7,930 7,101 Income from operations 4,725 3,512 13,901 11,040 Other income 297 502 912 1,228 Income before income taxes 5,022 4,014 14,813 12,268 Income taxes 1,708 1,301 4,803 3,808 Net income $ 3,314 $ 2,713 $ 10,010 $ 8,460 Net income per common share $ 0.23 $ 0.19 $ 0.69 $ 0.59 Average common shares outstanding 14,470 14,371 14,442 14,274 <P3> OSMONICS, INC. CONSOLIDATED BALANCE SHEETS (In Thousands Except Share Data) September 30, December 31, 1996 1995 ASSETS Current assets Cash and cash equivalents $ 2,344 $ 4,729 Marketable securities 21,237 26,307 Trade accounts receivable, net of allowance for doubtful accounts of $967 in 1996, and $1,177 in 1995 24,789 23,552 Inventories 32,639 28,973 Deferred tax assets 3,907 4,271 Other current assets 3,638 2,181 Total current assets 88,554 90,013 Property and equipment, at cost Land and land improvements 4,457 4,558 Building 26,793 18,928 Machinery and equipment 43,913 41,592 Construction in progress 7,724 8,009 82,887 73,087 Less accumulated depreciation and amortization (33,506) (30,598) 49,381 42,489 Other assets 10,814 12,181 $148,749 $144,683 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable $ 10,815 $ 13,957 Notes payable and current portion of long-term debt 6,454 3,811 Reserve for discontinued operations 1,957 1,957 Other accrued liabilities 13,358 14,330 Total current liabilities 32,584 34,055 Long-term debt 16,205 20,919 Deferred compensation and other liabilities 224 450 Deferred income taxes 4,840 4,986 Shareholders' equity Common stock, $0.01 par value Authorized -- 50,000,000 Issued -- 1996: 14,184,091 and 1995: 14,086,007 shares 142 141 Capital in excess of par value 22,966 21,805 Retained earnings 68,324 58,314 Unrealized gain on marketable securities 3,387 3,694 Foreign currency translation adjustments 77 319 Total shareholders' equity 94,896 84,273 $148,749 $144,683 <P4> OSMONICS,INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands) Nine Months Ended September 30, 1996 1995 Cash flows from: Operations: Net income $ 10,010 $ 8,460 Non-cash items included in net income: Depreciation and amortization 3,672 2,992 Gain on sale of investments (1,328) (702) Gain on sale of land (640) - Deferred income taxes 366 117 Accounts receivable (1,237) (2,758) Inventories and other current assets (5,123) (3,376) Accounts payable and accrued liabilities (4,340) 1,478 Net cash provided by operations 1,380 6,211 Investing activities: Purchase of investments (608) (4,012) Sale of investments 6,311 6,374 Purchase of property and equipment (12,167) (15,327) Sale of property and equipment 2,398 - Other (841) (5) Cash provided (used) in investing activities (4,907) (12,970) Financing activities: Notes payable and current debt - 14,956 Reduction of debt (2,071) (7,170) Issuance of common stock 1,162 548 Application of restricted cash to property and equipment 2,034 - Net cash provided (used) in financing activities 1,125 8,334 Effect of exchange rates on cash 17 (89) (Decrease)/increase in cash and cash equivalents (2,385) 1,486 Cash and cash equivalents - beginning of year 4,729 9,705 Cash and cash equivalents - end of quarter $ 2,344 $11,191 <P5> 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 nine months ended September 30, 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. <P6> ITEM II. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Company's Consolidated Financial Statements and Notes incorporated by reference in this Prospectus and the other financial information. Results of Operations: In July 1996, the Company acquired Desalination Systems, Inc. ("Desal") in a transaction accounted for as a pooling of interests. Accordingly, the historical consolidated financial data for all periods presented here have been restated to include the operations of Desal. The following table sets forth certain statement of operations data as a percentage of net sales for the periods indicated. Three Months Ended Nine Months Ended September 30 September 30 1995 1996 1995 1996 Net Sales 100.0% 100.0% 100.0% 100.0% Cost of Goods Sold 57.9 58.9 56.8 58.8 Gross Profit 42.1 41.1 43.2 41.2 SG&A 23.5 22.2 24.1 22.3 RD&E 7.6 7.0 7.5 6.9 Operating Profit 11.0 11.9 11.6 12.0 Other Income 1.6 0.8 1.3 0.8 Income Taxes 4.1 4.3 4.0 4.2 Net Income 8.5 8.4 8.9 8.6 Comparison of Three Months Ended September 30, 1996, and Three Months Ended September 30, 1995. Sales for the quarter ended September 30, 1996, of $39,493 increased 23% over sales for the third quarter of 1995. The increase was in both capital and replaceable products. The sales growth reflects the Company's recent and continued investment in expanded sales efforts, and the general strength of the economy. Gross Margin for the third quarter of 1996 was 41.1% versus 42.1% in the corresponding period of 1995. The lower gross margin was primarily due to a less favorable product mix, as well as some raw material cost increases and more aggressive pricing. <P7> Operating Expenses decreased from 31.1% of sales in the third quarter of 1995 to 29.2% in the third quarter of 1996. The decrease in operating expense is primarily attributable to improved operating efficiency realized in the integration of the Company's recent acquisitions. Other Income decreased by $0.2 million from the third quarter of 1995 to the third quarter of 1996. The decrease is due to lower interest income and higher acquisition-related expense. Net Income for the quarter ended September 30, 1996, was $3,314, up 22.2% from $2,713 in the corresponding quarter last year. Net income per common share for the quarter increased to $0.23 from $0.19 in the prior year. Comparison of Nine Months Ended September 30, 1996, and Nine Months Ended September 30, 1995 Net Sales for the nine months ended September 30, 1996, increased $20.4 million or 21.6% to $115.3 million as compared to net sales of $94.8 million for the nine months ended September 30, 1995. The sales increase was realized across nearly all product lines, and for both domestic and international markets. Gross Profit increased $6.5 million or 15.9% to $47.5 million in the nine months ended September 30, 1996, compared to $41.0 million in the nine months ended September 30, 1995. As a percentage of net sales, gross profit decreased to 41.2% from 43.2%. The reduction in gross profit was due to a less favorable sales mix, more aggressive pricing in certain product lines, and some effect of higher material costs. Sales in 1996 included some order backlog acquired from Western Filter in October 1995, which was at lower gross margins than other of the Company's products. Selling, General and Administrative Expenses increased $2.8 million or 12.4% to $25.7 million in the nine months ended September 30, 1996, compared to $22.8 million in the nine months ended September 30, 1995. As a percentage of sales, SG&A expense decreased to 22.3% from 24.1%, primarily reflecting improved productivity of both sales and administrative personnel. Research, Development and Engineering Expenses increased $0.8 million to $7.9 million in the nine months ended September 30, 1996, from $7.1 million in the nine months ended September 30, 1995. As a percentage of sales, these expenses were 6.9% of sales in the nine months ended September 30, 1996, compared to 7.5% in the nine months ended September 30, 1995. The Company believes the current level of funding is adequate to support its product development program. The effective tax rate for each of the nine months ended September 30, 1996 and 1995 were 32.4% and 31.0%, respectively. The increase in the tax rate is primarily due to the reduced availability of tax loss carryforwards and credits from Autotrol and its subsidiaries. <P8> Net Earnings increased $1.6 million or 18.3% to $10.0 million or $0.69 per share for the nine months ended September 30, 1996, compared to $8.5 million or $0.59 per share for the nine months ended September 30, 1995. As a percentage of net sales, net earnings were 8.6% in the nine months ended September 30, 1996, compared to 8.9% in the nine months ended September 30, 1995. Liquidity and Capital Resources At September 30, 1996, the Company had cash and marketable securities of $23.6 million as compared to $31.0 million at December 31, 1995. The reduction in cash and marketable securities was primarily the result of investments of $12.2 million in facilities and equipment during the first nine months of 1996. Cash provided by operating activities was $1.4 million, $8.4 million, and $10.1 million for the nine month period ended September 30, 1996, and the years ending December 31, 1995 and 1994 respectively. The decrease in cash provided by operating activities in 1996 and 1995 was principally due to increased working capital requirements to support the Company's sales growth. The current ratio was 2.7 at September 30, 1996, compared to 2.6 at year-end 1995. Capital expenditures for the nine months ended September 30, 1996, and the years ending December 31, 1995, and 1994 were $12.2 million, $20.8 million, $4.2 million, respectively. During 1995, the Company purchased its previously leased Milwaukee facility for $3.1 million and invested $4.6 million in the expansion of its Minnetonka facility. For the year ending December 31, 1996, capital expenditures are expected to be $15.0 million. The level of capital expenditures in 1997 is expected to be less than the levels of 1996 and 1995. The Company has negotiated a new $7 million unsecured revolving line of credit for working capital needs. The revolving line of credit is for two years with an annual interest rate of LIBOR plus 50 basis points. This revolving line of credit replaces a $1 million line of credit. At September 30, 1996, the Company had $6.7 million available under the revolving line of credit. The Company's operating cash requirements consist principally of working capital requirements, capital expenditures and scheduled payments of principal on outstanding indebtedness. The Company believes that its cash and marketable securities, cash flow from operating activities and borrowings under its bank facility will be adequate to meet the Company's liquidity and capital investment requirements in the foreseeable future. <P9> Private Securities Litigation Reform Act The Private Securities Litigation Reform Act of 1995 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 oral or other written statements made or to be made by the Company) contains statements that are forward-looking. Such statements may relate to plans for future expansion, business development activities, other capital spending, financing, or the effects of regulation and competition. Such information involves important risks and uncertainties that could significantly affect anticipated results in the future and, accordingly, such results may differ from those expressed in any forward-looking statements made by or on behalf of the Company. These risks and uncertainties include, but are not limited to, those relating to product development activities, dependence on existing management, global economic and market conditions, and changes in federal or state laws. <P10> OSMONICS, INC. PART II OTHER INFORMATION Item 5. Other Information On July 24, 1996, the Registrant acquired Desalination Systems, Inc. ("Desal") in a transaction accounted for as a pooling-of- interests. The following information has been restated for all periods presented to give effect to the acquisition as though the companies had operated together from the beginning of the earliest period presented. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Osmonics, Inc. Minnetonka, Minnesota We have audited the accompanying consolidated balance sheets of Osmonics, Inc. and subsidiaries (the Company) as of December 31, 1995 and 1994 and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1995. Our audits also included the financial statement schedule Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 signifigant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Osmonics, Inc. and subsidiaries at December 31, 1995 and 1994 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1995 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therin. As discussed in Note 4 to the financial statements, in 1994 the Company adopted Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. /s/ Deloitte & Touche LLP Deloitte & Touche LLP Minneapolis, Minnesota October 22, 1996 <P11> OSMONICS, INC. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except share data) Year ended December 31, 1995 1994 1993 Sales $130,783 $112,908 $108,212 Cost of sales 74,670 62,503 59,885 Gross profit 56,113 50,405 48,327 Operating expenses: Selling, general and administrative 31,377 27,967 26,831 Research, development and engineering 9,399 8,989 8,322 Embezzlement recovery (Note 3) - - (562) Merger and transition expense - - 1,644 40,776 36,956 36,235 Income from operations 15,337 13,449 12,092 Other income (expense), net (Note 4): Interest income 1,649 1,543 1,279 Interest expense (1,565) (878) (1,017) Other 1,412 148 476 1,496 813 738 Income before income taxes 16,833 14,262 12,830 Income taxes (Note 11) 4,954 3,808 3,536 Net income $ 11,879 $10,454 $ 9,294 Net income per common and $ 0.83 $ 0.74 $ 0.66 common equivalent share Weighted average number of common and 14,365,000 14,206,000 14,075,000 common equivalent shares outstanding <P12> OSMONICS, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except share data) December 31, 1995 1994 ASSETS Current assets Cash and cash equivalents 4,729 $ 9,705 Marketable securities (Note 4) 26,307 27,623 Trade accounts receivable, net of allowance for doubtful accounts of $1,177 in 1995 and $1,329 in 1994 23,552 18,324 Inventories (Note 5) 28,973 21,743 Deferred tax assets (Note 12) 4,271 3,685 Other current assets 2,181 1,483 Total current assets 90,013 82,563 Property and equipment, at cost Land and land improvements 4,558 1,951 Buildings 18,928 13,093 Machinery and equipment 41,592 36,886 Construction in progress 8,009 818 73,087 52,748 Less accumulated depreciation and amortization (30,598) (27,933) 42,489 24,815 Cash restricted for purchase and construction of equipment (Note 6) 2,034 - Goodwill, net of accumulated amortization of $289 in 1995 and $170 in 1994 7,655 1,695 Other assets, net of accumulated amortization of intangible assets of $230 in 1995 and $145 in 1994 2,492 1,642 Total assets $144,683 $110,715 LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable $ 13,957 $ 7,319 Line of credit advances (Note 8) 1,619 1,312 Notes payable and current portion of long-term debt (Note 9) 2,192 961 Accrued compensation and employee benefits 4,231 4,860 Reserve for discontinued operations 1,957 2,088 Other accrued liabilities (Note 7) 10,099 7,311 Total current liabilities 34,055 23,851 Long-term debt (Note 9) 20,919 14,475 Deferred income taxes (Note 12) 4,986 2,774 Other liabilities 450 689 Commitments and contingencies (Note 14) - - Shareholders' equity Common stock, $0.01 par value Authorized -- 50,000,000 Issued -- 1995: 14,086,007 and 1994: 13,999,457 141 140 Capital in excess of par value 21,805 21,045 Retained earnings 58,314 46,525 Unrealized gain on marketable securities (Note 4) 3,694 1,038 Cumulative effect of foreign currency translation adjustments 319 178 Total shareholders' equity 84,273 68,926 Total liabilities and shareholders' equity $144,683 $110,715 <P13> OSMONICS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year ended December 31, 1995 1994 1993 Cash flows from operations: Net income $11,879 $10,454 $ 9,294 Non-cash items included in net income: Depreciation and amortization 3,795 3,523 3,449 Deferred income taxes (71) (231) 112 Gain on sale of land and investments (810) - (484) Changes in assets and liabilities (net of business acquisitions) Reserve for VAT tax - (1,605) (1,030) Accounts receivable (4,494) (1,902) (518) Inventories (6,517) (2,617) 2,778 Other current assets (727) 1,479 (287) Accounts payable and accrued liabilities 5,798 1,074 289 Reserve for deferred compensation (432) 78 72 Reserves for losses of discontinued operations - - (471) Net cash provided (used) by operations 8,421 10,097 13,204 Cash flows from investing activities: Business acquisitions (net of cash acquired) (5,380) (673) - Purchase of investments (6,633) (17,467) (15,253) Maturities and sales of investments 13,228 11,225 8,680 Purchase of property and equipment (20,818) (4,212) (4,074) Proceeds from sale of subsidiary - - 798 Other (367) 367 (111) Net cash provided (used) for investing activities (19,970) (10,760) (9,960) Cash flows from financing activities: Notes payable and current debt 13,928 1,674 784 Reduction of long-term debt (5,898) (1,365) (833) Cash restricted for purchase and construction of equipment (2,034) - - Issuance of common stock 761 680 295 Re-acquisition and retirement of common stock - - (893) Dividends paid by a pooled company (90) (180) (240) Net cash provided (used) in financing activities 6,667 809 (887) Effect of exchange rate changes on cash (94) (444) 143 Increase (decrease) in cash and cash equivalents (4,976) (298) 2,500 Cash and cash equivalents - beginning of year 9,705 10,003 7,503 Cash and cash equivalents - end of year $ 4,729 $ 9,705 $10,003 <P14> OSMONICS, INC. RESTATED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands, except share data) Unrealized Capital in Gain on Cumulative Common Stock Excess of Retained Marketable Translation Shares Amount Par Value Earnings Securities Adjustment Balance, January 1, 1993 as previously reported 12,607,707 $126 $20,026 $23,558 $ - $133 Restatement for pooling of interests 1,368,665 14 50 4,526 Balance, January 1, 1993 as restated 13,976,372 140 20,076 28,084 0 133 Net income 9,294 Translation adjustment 37 Dividend of pooled company (240) Employee stock purchase plan 29,766 295 Re-acquisition and retirement of common shares of pooled company (70,249) (1) (5) (887) Balance - December 31, 1993 as restated 13,935,889 139 20,366 36,251 0 170 Net income 10,454 Translation adjustment 8 Unrealized gain on marketable securities 1,038 Dividend of pooled company (180) Business combinations 7,000 102 Employee stock purchase plans 56,568 1 577 Balance - December 31, 1994 as restated 13,999,457 140 21,045 46,525 1,038 178 Net income 11,879 Translation adjustment 141 Unrealized gain on marketable securities 2,656 Dividend of pooled company (90) Employee stock purchase plans 86,550 1 760 Balance - December 31, 1995 14,086,007 $141 $21,805 $58,314 $3,694 $319 as restated <P15> SELECTED FINANCIAL DATA (In thousands, except per share amounts) INCOME DATA: Year ended December 31, 1995 1994 1993 1992 1991 Sales $130,783 $112,908 $108,212 $99,992 $90,242 Income from continuing operations 11,879 10,454 9,294 4,482 6,174 Income from continuing operations per share $0.83 $0.74 $0.66 $0.32 $0.44 Average shares outstanding 14,365 14,206 14,075 14,036 13,926 BALANCE SHEET DATA: Total assets $144,683 $110,715 $96,812 $89,730 $87,708 Long-term debt 20,919 14,475 14,532 14,705 15,940 <P16> QUARTERLY INCOME DATA (In thousands, except per share amounts) Quarterly Income Data - 1995 Quarter Ended March 31 June 30 September 30 December 31 Sales $31,412 $31,422 $31,995 $35,954 Gross profit 13,700 13,803 13,462 15,148 Net income 2,926 2,821 2,713 3,419 Net income per share $0.20 $0.20 $0.19 $0.24 Quarterly Income Data - 1994 Quarter Ended March 31 June 30 September 30 December 31 Sales $27,252 $29,293 $27,581 $28,782 Gross profit 12,077 12,853 12,181 13,294 Net income 2,435 2,647 2,468 2,904 Net income per share $0.17 $0.19 $0.17 $0.21 <P17> NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share amounts) 1. Summary of Significant Accounting Policies The Company is a manufacturer and marketer of high technology water purification, fluid filtration, fluid separation, and fluid transfer equipment, as well as the replaceable components used in purification, filtration, and separation equipment. These products are used by a broad range of industrial, commercial and institutional customers. The consolidated financial statements include the accounts of Osmonics, Inc. and its wholly and majority owned subsidiaries (the Company). Significant intercompany accounts and transactions have been eliminated. Sales are recorded when the product is shipped. The estimated fair value for cash and cash equivalents, trade accounts receivable, accounts payable, notes payable, and long-term debt approximates carrying value due to the relatively short-term nature of the instruments and/or due to the short-term floating interest rates on the borrowing. The estimated fair value of notes receivable approximates the net carrying value, as management believes the respective interest rates are commensurate with the credit, interest rate, and prepayment risks involved. The Company considers highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Inventories are stated at lower of cost (FIFO method) or market for all operations except the Autotrol subsidiary domestic operations which have historically valued inventory on the LIFO method. Depreciation and amortization of property and equipment are provided on the straight-line method over estimated lives of 3 to 40 years. Deferred income taxes have been provided for income and expenses which are recognized in different accounting periods for financial reporting purposes than for income tax purposes. The Company accrues for the estimated cost of warranty and start-up obligations at the time revenue is recognized. The excess of cost over the fair market value of assets acquired in acquisitions is amortized over not more than 40 years, with the majority at 30 years. The carrying values of these intangibles are reviewed quarterly based on the sales and profitability of the acquired assets. Other intangibles are carried at cost and amortized using the straight-line method over their estimated lives of 5 to 17 years. <P18> Net income per common and common equivalent share is based on the weighted average number of shares outstanding during each year and, when applicable, those outstanding options that are dilutive. Fully diluted earnings per share did not differ significantly from primary earnings per share in any period presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation." The Company will evaluate adoption of SFAS 123 in 1996. Certain reclassifications have been made to prior year amounts to conform with current year presentation. 2. Business Acquisitions On July 24, 1996, Desalination Systems, Inc. (DSI) merged with the Company through an exchange of 144.070 shares of the Company's common stock for each share of Class A common stock of DSI and 157.107 shares of the Company's common stock for each share of pooling-of-interests. DSI's principal business is the manufacture of membrane used for reverse osmosis, nanofiltration, ultrafiltration, and microfiltration. The historical financial statements of the Company have been restated to give effect to the acquisition as though the companies had operated together from the beginning of the earliest period presented. Separate results of operations of the combined entities for the years ended December 31, 1995, 1994, and 1993 were as follows: 1995 1994 1993 Sales: Osmonics (as previously reported) $111,610 $96,180 $89,043 DSI 20,348 17,610 19,721 Eliminations (1,175) (882) (552) Combined $130,783 $112,908 $108,212 Net income: Osmonics (as previously reported) $11,212 $ 9,955 $ 7,895 DSI 667 499 1,399 Combined $11,879 $10,454 $ 9,294 <P19> The eliminations represent sales between the combined entities prior to the combination. The sales elimination had no significant effect on net income in the years presented. On October 4, 1995, the Company acquired the assets and operations of Western Filter Co., Denver, Colorado. The purchase price was approximately $7,000 and included $5,780 of intangible assets. Western Filter products will be sold through the existing Osmonics distribution channels, offering a more complete line of water and waste water treatment options. Revenues of Western Filter were less than $10,000 in 1994 and 1995. The purchase method of accounting was used. On November 18, 1994, the Company acquired the assets of Lakewood Instruments, Inc. The Company also obtained noncompetition agreements from two previous Lakewood directors. The purchase method of accounting was used. On January 1, 1994, the Company acquired the 18% minority shareholder interest of its majority-owned subsidiary, Poretics. The Company owns 100% of Poretics' shares after the transaction. The purchase method of accounting was used. These acquisitions had no significant pro forma effect on the Company's sales, net income, or net income per share in 1995 or 1994. On October 15, 1993, Autotrol Corporation (Autotrol) merged with Osmonics through an exchange of 0.77 of a share of Osmonics common stock for each share of Autotrol common stock. The exchange ratio and share amounts, when revised to reflect Osmonics' 3-for-2 stock split on March 21, 1994, equate to an exchange of 1.155 shares of Osmonics common stock for each of the 3.0 million shares of Autotrol common stock. The transaction was accounted for as a pooling-of- interests. Autotrol's principal business is the manufacture and marketing of controls, valves and measuring devices related to water conditioning. The historical financial statements of the Company have been restated to give effect to the Autotrol acquisition as though the companies had operated together from the beginning of the earliest period presented. Before pooling, results for the first nine months of 1993 for Osmonics were net sales of $41,213 and net income of $3,678, and for Autotrol were sales of $25,272 and net income of $2,076. 3. Embezzlement In February 1993, Autotrol, prior to acquisition by Osmonics, discovered that a former employee of its French subsidiary had been embezzling funds for several years. The funds were embezzled through the issuing of fraudulent checks by the former employee and the falsifying of value added tax (VAT) returns and diverting the funds received from the French government. <P20> Autotrol's investigation of the embezzlement revealed that approximately $4,750 was embezzled from 1988 to 1992. The prior years' financial statements reflect embezzlement losses in the year the embezzlement initially occurred. The Company had net recoveries of $562 in 1993 from insurance and reductions in VAT payable. 4. Marketable Securities Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standard No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities," which requires the Company to report certain marketable securities at fair market value. The Company considers all of its marketable securities available-for-sale. Marketable securities at December 31, 1995 consisted of the following: Fair Amortized Unrealized Unrealized Market Cost Gain (Loss) Value U.S. government securities 0-5 year maturity $ 4,784 $ 60 $ (23) $ 4,821 6 year or greater maturity 648 24 - 672 Municipal bonds 0-5 year maturity 2,320 112 - 2,432 6 year or greater maturity 4,777 211 - 4,988 Corporate debt securities and other 0-5 year maturity 1,505 24 (43) 1,486 6 year or greater maturity 699 16 - 715 Equity securities 5,616 5,681 (104) 11,193 Total before tax effect $20,349 6,128 (170) $26,307 Deferred tax effect of unrealized (gain) loss (2,329) 65 Unrealized gain (loss) on marketable securities $3,799 $(105) <P21> Marketable securities at December 31, 1994 consisted of the following: Fair Amortized Unrealized Unrealized Market Cost Gain (Loss) Value U.S. government securities 0-5 year maturity $ 6,479 $ - $ (318) $ 6,161 6 year or greater maturity 1,748 - (101) 1,647 Municipal bonds 0-5 year maturity 1,977 100 - 2,077 6 year or greater maturity 6,348 28 (374) 6,002 Corporate debt securities and other 0-5 year maturity 3,764 15 - 3,779 6 year or greater maturity 599 - (44) 555 Equity securities 5,104 2,319 (21) 7,402 Total before tax effect $26,019 2,462 (858) $27,623 Deferred tax effect of unrealized (gain) loss (869) 303 Unrealized gain (loss) on marketable securities $1,593 $ (555) Market values are based on quoted market prices. In 1995, proceeds from sales of available-for-sale securities were $7,037. The net gain on these sales was $919, determined on the specific identification method. In 1994, proceeds from sales of available-for-sale securities were $2,846. There were no material gross realized gains or losses on these sales, as determined on the specific identification method. 5. Inventories Inventories consist of the following: December 31, 1995 1994 Finished goods $ 4,979 $ 3,409 Work in process 7,759 5,946 Raw materials 16,884 13,037 29,622 22,392 Less adjustment to reduce inventories of $4,728 and $3,475 to last-in, first-out method (See Note 1) (649) (649) $28,973 $21,743 <P22> 6. Cash Restricted for Purchase and Construction of Equipment Cash restricted for purchase and construction of equipment at December 31, 1995 represents proceeds received from the issuer of Industrial Development Revenue Bonds (see Note 8) restricted to use in the purchase and construction of property and equipment used in the Company's operations. 7. Other Accrued Liabilities Other accrued liabilities consist of the following: December 31, 1995 1994 Warranty and start-up $1,868 $1,981 Professional fees and other accruals 4,252 2,395 Customer deposits 2,258 1,074 Accrued property taxes, income taxes and other taxes 1,721 1,861 $10,099 $7,311 8. Line of Credit Prior to the merger with the Company, DSI had an available bank line of credit which provided for borrowings up to $4,000. Advances under the line were repaid after the merger and the line has been terminated. Advances under the line bore interest at 25 b.p. over the bank's prime rate (the bank's prime rate was 8.5% at December 31, 1995). Advances under the line were collateralized by trade receivables, inventories and equipment of DSI. Under the terms of the agreement, DSI was required to maintain certain minimum financial ratios and a minimum amount of working capital and tangible net worth. At December 31, 1995 and 1994 DSI had outstanding borrowings under the line of $1,619 and $1,312, respectively. 9. Debt Long-term debt is as follows: December 31, 1995 1994 Promissory Notes; interest payable quarterly at the three month LIBOR rate plus 80 b.p.; due 1996 through 2001. The interest rate on December 31, 1995 was 6.64%. $10,000 $10,000 <P23> December 31, 1995 1994 Industrial development revenue bonds, (IDB's) secured by a bank letter of credit under which all assets of the Company have been pledged as collateral, principal due in varying annual payments over 30 years, interest payable monthly at a variable rate determined periodically by the bond remarketing agent (5.45% at December 31, 1995). 8,550 - Industrial revenue bonds (IRB's); interest payable at LIBOR plus 45 to 95 b.p. depending on collateral deposited with the lender; due in 1997. The interest rate on December 31, 1995 was 6.29%. 2,800 2,800 Mortgage notes payable to two French banks; interest payable monthly at PIBOR plus 40 b.p. The interest rate on December 31, 1995 was 5.43%. 928 993 Note payable to a bank, collateralized by the Company's accounts receivable, inventory and equipment, due in monthly installments of $18 with interest at the bank's prime rate plus 75 b.p. (9.5% at December 31, 1995). 425 642 Other notes 408 1,001 23,111 15,436 Less current portion (2,192) (961) $20,919 $14,475 The IRB debt and mortgage notes payable to French banks are collateralized by real and personal property of the Company. The aggregate maturities of outstanding long-term debt are: 1996 - $2,192; 1997 - $4,987; 1998 - $2,159; 1999 - $2,159; 2000 - $2,250; beyond 2000 - $9,364. The interest rate on the IRB's is determined in part by the amount of collateral held by the lender. At December 31, 1995, $2,000 of collateral was held by the lender, resulting in an interest rate of LIBOR plus 45 b.p. The $2,000 of collateral is included in marketable securities. The Company has a $1,000 line of credit with a bank, with interest at the bank reference rate (8.5% at December 31, 1995) and which <P24> requires a 5% compensating cash balance. The line of credit was unused at year end and the $50 compensating balance is included in the balance of cash and cash equivalents. Subsequent to December 31, 1995, the Company negotiated a new $7 million unsecured revolving line of credit for working capital needs. The revolving line of credit is for two years with an annual interest rate of LIBOR plus 50 basis points. This revolving line of credit replaces a $1 million line of credit. The promissory notes contain a covenant which limits the payment of dividends to shareholders. At December 31, 1995, approximately $24,742 of retained earnings was restricted under this covenant. In addition, the promissory notes and IRB debt contain certain restrictions related to financial ratios, indebtedness, tangible net worth and capital expenditures. Cash payments for interest related to all debts of the Company were $1,409, $865, and $1,029, for 1995, 1994, and 1993, respectively. 10. Stock Options At December 31, 1995, the Company had reserved 86,206 common shares for issuance to key employees under a 1983 stock option plan. Options are issued at a price not less than market value on date of grant and become exercisable over a five-year period, after which they expire. The following is a summary of activity under the 1983 stock option plan. No additional options can be granted under the 1983 plan. Year ended December 31, 1995 1994 1993 Options held by employees at December 31 86,206 121,126 143,850 Exercise price range on $ 6.45 to $ 3.63 to $3.63 to options held at December 31 $13.50 $13.50 $13.50 Number of options exercised during the year 34,920 22,724 1,875 Price range of options $ 3.63 to $ 3.63 to $10.16 to exercised during the year $10.16 $10.16 $10.16 Exercisable options held at December 31 84,330 97,500 83,289 Exercise price range of $ 6.45 to $ 3.63 to $ 3.63 to exercisable options $13.50 $13.50 $13.50 The Company also has reserved 299,313 common shares at December 31, 1995 for issuance to key employees under a 1993 Stock Option Plan. Options are granted at a price not less than market value on the date of the grant and become exercisable over a period of up to ten years, after which they expire. The following is a summary of activity under the 1993 Stock Option Plan. <P25> Year ended December 31, 1995 1994 1993 Options held by employees at December 31 34,163 12,633 2,250 Exercise price range on $13.67 to $13.67 to $13.67 options held at December 31 $18.25 $14.50 Number of options exercised during the year 500 187 0 Price range of options $14.38 to $13.67 to N/A exercised during the year $14.38 $13.67 Exercisable options held at December 31 2,463 375 0 Exercise price range of $13.67 to $13.67 to N/A exercisable options $14.50 $13.67 The Company also had a 1985 Employee Stock Purchase Plan. No additional shares may be issued under the 1985 Plan. The following is a summary of shares issued under this plan: 1985 Plan 1995 1994 1993 Number of shares 14,548 34,048 23,380 Average price per share $13.58 $12.80 $10.62 The 1985 Plan was superseded by the 1995 Employee Stock Purchase Plan, approved by the shareholders at the 1995 Annual Meeting and effective June 1, 1995. Employees may purchase common shares of the Company at 85% of market price. In 1995, 22,175 shares were issued under the 1995 Plan at an average price per share of $14.79. At December 31, 1995, 377,825 shares remain unissued in the 1995 Plan. Desalination Systems, Inc. (DSI), a pooled company (Note 2), has a stock option plan for which 386,298 equivalent shares of the Company's common stock are reserved. Options issued under the plan vest in varying periods of up to 5 years and expire on various dates through March 2003. The following is a summary of activity under the plan. No additional options can be granted under the DSI plan. <P26> Year ended December 31, 1995 1994 1993 Options held by employees at December 31 371,841 386,248 229,142 Exercise price range on $3.18 to $3.18 to $3.18 to options held at December 31 $6.94 $6.94 $6.94 Number of options exercised during the year 14,407 - - Price range of options exercised during the year $3.47 - - Exercisable options held at December 31 351,672 354,553 185,921 Exercise price range of $3.18 to $3.18 to $3.18 to exercisable options $6.94 $6.94 $6.94 The Company had 500,000 authorized and unissued shares of preferred stock at December 31, 1995 and 1994. In 1993, the Company granted a director an option to purchase 45,000 shares of common stock at an exercise price of $12.33 per share. This option vests over a five-year period. In 1995, the Board of Directors adopted a 1995 Director Stock Option Plan. The plan provides that each director of the Company shall automatically receive, as of the date of each Annual Meeting of Shareholders, a non-qualified option to purchase 3,000 shares of the Company's common stock. The options have a ten year term and are exercisable one year after the grant date at an exercise price equal to the fair market value of the shares on the grant date. In 1995, options to purchase 18,000 shares at a price of $17.13 were issued under this plan. No options were exercisable at December 31, 1995. <P27> 11. Income taxes Income tax expense consists of: Year ended December 31, 1995 1994 1993 Current: Federal $4,219 $3,520 $3,292 State 429 370 282 Foreign 372 156 (250) Deferred: Depreciation 144 (204) (129) Valuation allowance adjustment (197) 0 0 Allowance for doubtful accounts, start-up, warranty, inventory and other accruals 314 (223) 10 Discontinued operations 228 350 524 Other (555) (161) (193) $4,954 $3,808 $3,536 Cash payments for income taxes were $5,382, $3,195, and $3,700 for 1995, 1994, and 1993, respectively. <P28> A reconciliation of the income taxes computed at the Federal statutory rate to the Company's income tax expense is as follows: Year ended December 31, 1995 1994 1993 Taxes at federal rate (35% in $5,892 $4,992 $4,362 1995 and 1994, and 34% in 1993) Increase (decrease) resulting from: Valuation allowance adjustment (471) (608) (350) State taxes, net of Federal tax benefit 201 231 81 Foreign Sales Corp. benefit (248) (223) (243) Tax credits (273) (312) (265) Tax exempt interest/dividend deduction (200) (193) (176) Effect of foreign affiliates with different tax rates or net losses 245 (324) (446) Nondeductibility of merger costs - - 363 Other (192) 245 210 $4,954 $3,808 $3,536 During 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes," which requires the Company to adjust its deferred tax assets and liabilities to reflect current tax rates. Autotrol Corporation and its subsidiaries adopted SFAS 109 in 1993, prior to the merger of Osmonics, Inc. and Autotrol Corporation. As a result of the adoption of SFAS 109, Autotrol Corp. increased its current deferred tax assets from zero to $4,328 and its long-term deferred tax assets from zero to $14. These increases in deferred tax assets were accompanied by increases in offsetting valuation reserves for the same amounts, thus creating no increase or decrease in income for the year ending December 31, 1993. As a result of the merger between Osmonics, Inc., and Autotrol Corp. in 1993, value was created for the deferred tax assets of Autotrol Corp., due to the deductibility of Autotrol expenses on future consolidated tax returns. This increased Autotrol Corp.'s equity value by $2,081 above its previously stated book value prior to the merger. The combination of adopting SFAS 109, and the merger in 1993, resulted in increased tax expense from continuing operations for Autotrol Corporation of $384 for the year ended December 31, 1993. <P29> 12. Deferred Tax Assets and Liabilities Temporary differences which give rise to Deferred Tax Assets and Liabilities are as follows as of December 31: 1995 1994 Current assets: Allowance for doubtful accounts, start-up, warranty, inventory and other accruals $3,863 $3,699 Inventory costs capitalized for tax 363 179 Net operating loss and credit carryforwards 61 335 Other (16) (3) Less valuation allowance - (525) Total current deferred assets $4,271 $3,685 Noncurrent liabilities: Depreciation $2,641 $2,562 Unrealized gain on marketable securities 2,264 566 Investment in business transferred under contractual arrangement (334) (306) Other 415 (48) Total non-current deferred tax liabilities $4,986 $2,774 The Company had outstanding net operating loss carryforwards and tax credit carryforwards of $61 and $633 at December 31, 1995 and 1994, respectively. The carryforwards will expire in the years of 2008 to 2009. The valuation reserve decreased by $527 to $0 during the year ended December 31, 1995. This decrease was due to the use of net operating loss carryforwards and credits during the year, as offsets against taxable income, and to the determination that the remaining deferred tax assets are more likely than not to confer future tax benefits to the Company. The carryforwards outstanding at December 31, 1994 have been fully offset by valuation reserves. <P30> 13. Sales and Segment Information All continuing operations for which geographic data is presented below are in one principal industry (design, manufacture and marketing of machines, systems, and components used in the processing of fluids). 1995 1994 1993 Sales to unaffiliated customers from: United States $116,964 $100,632 $ 96,381 Foreign operations 13,819 12,276 11,831 Transfers from (to) geographic areas: United States 7,936 6,696 7,139 Foreign operations (7,936) (6,699) (7,139) $130,783 $112,908 $108,212 Pretax income from continuing operations: United States $ 16,190 $ 12,950 $ 12,311 Foreign operations 643 1,312 519 $ 16,833 $ 14,262 $ 12,830 Identifiable assets: United States $136,672 $103,184 $ 87,443 Foreign operations 8,011 7,531 9,369 $144,683 $110,715 $ 96,812 NOTE: Transfers are made at market value. Sales by United States operations to unaffiliated customers in foreign geographic areas are as follows: Year ended December 31, 1995 1994 1993 Asia/Pacific $10,915 $ 8,187 $ 7,403 Europe 7,798 7,853 6,044 Rest of the World 9,641 7,841 9,478 $28,354 $23,881 $22,925 Total international sales for the Company were as follows: 1995 - $42,173; 1994 - $36,157; and 1993 - $34,756. <P31> 14. Commitments and Contingencies The Company leases facilities for sales, service or manufacturing purposes in Minnesota, Wisconsin, Massachusetts, California, Iowa, Arizona, Switzerland, Hong Kong, Japan, Singapore, Indonesia, and Thailand. Future minimum lease payments on all operating leases of $3,715 are as follows: 1996 - $1,254; 1997 - $733; 1998 - $500; 1999 - $281; 2000 - $256; and beyond 2000 - $727. Rent expense for the past three years was: 1995 - $1,718; 1994 - $1,851; and 1993 - $1,995. The Company is involved in certain legal actions arising in the ordinary course of business. In the opinion of management, based on the advice of legal counsel, such litigation and claims will be resolved without a material effect on the Company's financial position or results of operations. The Company may be required to make additional payments of up to $2,000 over the period ending December 1998, contingent upon the sales and gross margins of Western Filter Co. 15. Stock Split On February 18, 1994, the Company approved a three-for-two stock split in the form of a 50% stock dividend for shareholders of record March 4, 1994. All share and per share amounts have been restated to reflect the stock split. 16. Employee Benefit Plans The Company has a noncontributory discretionary profit sharing plan covering certain employees meeting age and length of service requirements. The Company contributes annually to the plan an amount established at the discretion of the Board of Directors. Total expense recognized by the Company under these plans amounted to $996, $1,077, and $1,115 in 1995, 1994, and 1993, respectively. <P32> OSMONICS, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands) Years Ended December 31, 1995, 1994 and 1993 Column A Column B Column C Column D Column E Additions Balance Charged Charged Balance at to to at Beginning Cost and Other End of Description of Period Expensed Accounts Deductions Period Year Ended December 31, 1995: Current Operations: Allowance for Doubtful Accounts $1,329 $ 80 $109(F3) $ 341(F1) $1,177 Warranty and Start-up Reserve $1,981 $1,406 $1,519(F2) $1,868 Discontinued Operations: Allowance for Doubtful Accounts $ 46 $ 46(F1) $ 0 Warranty Reserve $1,961 $ 4(F2) $1,957 Reserve for Discontinued Operations $ 127 $ 127 $ 0 Year Ended December 31, 1994: Current Operations: Allowance for Doubtful Accounts $1,276 $ 134 $ 81(F1) $1,329 Warranty and Start-up Reserve $1,996 $1,350 $1,365(F2) $1,981 Discontinued Operations: Allowance for Doubtful Accounts $ 87 $ 41(F1) $ 46 Warranty Reserve $1,972 $ 10(F2) $1,961 Reserve for Discontinued Operations $ 240 $ 113 $ 127 Year Ended December 31, 1993: Current Operations: Allowance for Doubtful Accounts $ 803 $ 556 $ 83(F1) $1,276 Warranty and Start-up Reserve $1,901 $1,257 $1,162(F2) $1,996 Discontinued Operations: Allowance for Doubtful Accounts $ 149 $ 62(F1) $ 87 Warranty Reserve $2,134 $ 162(F2) $1,972 Reserve for Discontinued Operations $ 549 $ 309 $ 240 <FN> <F1> Uncollectible accounts charged against allowance. <F2> Actual warranty claims and start-up costs charged against reserve. <F3> Addition due to acquisition. </FN> <P33> Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 23 - Consent of Deloitte & Touche, LLP Exhibit 27 - Financial Data Schedule (b) Form 8-K was filed on July 25, 1996, reporting on Items 2 and 7. The 8-K reported on Financial Statements previously reported on the S-3 Registration Statement, File Number 33-05029. <P34> 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: October 25, 1996 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