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KMG > SEC Filings for KMG > Form 10-Q on 9-Jun-2014All Recent SEC Filings

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Form 10-Q for KMG CHEMICALS INC


9-Jun-2014

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We manufacture, formulate and distribute specialty chemicals globally. We operate businesses engaged in electronic chemicals and industrial wood treating chemicals. Our electronic chemicals are sold to the semiconductor industry, where they are used primarily to clean and etch silicon wafers in the production of semiconductors. Our wood treating chemicals, pentachlorophenol ("penta") and creosote are used by our industrial customers primarily to extend the useful life of utility poles and railroad crossties.

Acquisition

We completed our acquisition of the ultra pure chemicals ("UPC") business subsidiaries of OM Group, Inc., in the fourth quarter of fiscal year 2013. The purchase price was $62.6 million. The UPC subsidiaries sell high purity, wet process chemicals to the semiconductor industry.

Restructuring

In October 2013, we announced that, as part of global restructuring of our electronic chemicals operations, we would close our Fremont, California manufacturing site acquired in the UPC acquisition, and shift production primarily to our Hollister, California and Pueblo, Colorado facilities. As planned, we ceased production at the Fremont facility, and expect to complete site decommissioning by the end of the fiscal year. In November 2013, we announced that we would close a facility in Milan, Italy, and shift production to our facilities in France and the United Kingdom. We will continue to operate our warehouse facility in Milan. We have begun decommissioning certain manufacturing equipment in Milan, and have started to transition products from there to other sites in Europe. Overall, the consolidation of our global operations remains on schedule. Total costs related to restructuring accrued for the three and nine months ended April 30, 2014 was approximately $1.1 million and $5.1 million, respectively. See Note 13 to the financial statements included in this report. We estimate that restructuring charges, exclusive of accelerated depreciation, will range between $7.0 million and $9.0 million cumulatively over fiscal years 2014 and 2015, and that accelerated depreciation with respect to the closed facilities will be approximately $4.0 million over those two fiscal years.


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Results of Operations

Three and Nine Month Periods Ended April 30, 2014 compared with the Three and Nine Month Periods Ended April 30, 2013

Segment Net Sales

Segment data is presented for our two reportable segments for the three and nine
month periods ended April 30, 2014 and 2013. The segment data should be read in
conjunction with our condensed consolidated financial statements and related
notes thereto included elsewhere in this report.



                                          Three Months Ended           Nine Months Ended
                                               April 30,                   April 31,
                                           2014          2013         2014          2013
                                                      (Amounts in thousands)
  Sales
  Electronic chemicals                  $   61,542     $ 36,333     $ 187,422     $ 111,487
  Wood treating chemicals                   22,851       23,525        74,710        70,408

  Total sales for reportable segments   $   84,393     $ 59,858     $ 262,132     $ 181,895

Net Sales

Net sales for reportable segments increased $24.5 million, or 41.0%, to $84.4 million in the third quarter of fiscal year 2014 from $59.9 million for the same period of the prior year. For the nine months ended April 30, 2014, net sales for reportable segments increased $80.2 million, or 44.1%, to $262.1 million from $181.9 million in the prior year period. The increase in net sales was because of the UPC acquisition in our electronic chemicals segment.

In the third quarter of fiscal year 2014, the electronic chemicals segment had net sales of $61.5 million, an increase of $25.2 million, or 69.4%, as compared to $36.3 million for the prior year period. For the nine month periods, net sales in the electronic chemicals segment increased $75.9 million, or 68.1%, to $187.4 million from $111.5 million. Net sales in both the third quarter and the first nine months of fiscal year 2014 increased over the prior year periods, because of the UPC acquisition. That acquisition has allowed us to expand our global presence, and expand our ability to serve a broader spectrum of our semiconductor customers' requirements.

Net sales of wood treating chemicals decreased $674,000, or 2.9%, to $22.9 million in the third quarter of fiscal year 2014 as compared to $23.5 million for the prior year period. For the nine month comparison, net sales in the wood treating segment increased $4.3 million, or 6.1%, to $74.7 million from $70.4 million, because of a greater volume of creosote shipments to customers that service the crosstie market. Although our creosote volume increased, demand for creosote is impacted by customers continuing to pre-treat railroad ties with borate to increase the service life of the crosstie. This practice has the effect of reducing the amount of creosote used to treat the tie, and Class I railroads intend to continue purchasing a portion of their ties with the borate treatment. Penta product sales declined approximately $1.1 million in the third quarter of fiscal year 2014, and declined $2.1 million for the first nine months of fiscal year 2014. Penta sales were down primarily on lower pricing for hydrochloric acid that is a byproduct of penta production. Penta sales in the Southeast remained weak due to limited timber availability and the absence of severe weather conditions.

Gross Profit

Gross profit increased by $8.4 million, or 51.6%, to $24.8 million in the third quarter of fiscal year 2014 from $16.3 million in the same quarter of the prior year. For the nine month period, gross profit increased $23.4 million or 44.8%, to $75.5 million from $52.1 million in the prior year period. The increase in aggregate gross profit for the quarter and the nine months period was due to sales attributable to the UPC acquisition. Gross profit as a percentage of sales improved to 29.3% in the third quarter of fiscal year 2014 from 27.3% in the third quarter of fiscal year 2013, while gross profit as a percentage of sales was flat for the nine month periods ended April 30, 2014 and 2013. The increase in consolidated gross profit in the quarterly and nine month comparisons came from increased gross profit in our electronic chemicals segment, despite declines of about 13.0% in gross profits for each of the comparable periods in our wood treating chemicals business.

Other companies may include certain costs that we record in cost of sales as distribution expenses or selling, general and administrative expenses, and may include certain of the costs that we record in distribution expenses or selling, general and administrative expenses as a component of cost of sales, resulting in a lack of comparability between our gross profit and that reported by other companies.


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Distribution Expenses

Distribution expenses were up by $5.6 million in the third quarter of fiscal year 2014 to $12.0 million from $6.4 million in the prior year period, an 87.1% increase. Distribution expenses were approximately 14.2% and 10.7% of net sales for the third quarter of fiscal years 2014 and 2013, respectively. Distribution expenses for the nine month periods ending April 30, 2014 and 2013 were $37.0 million and $19.4 million, respectively, an increase of $17.6 million, or 90.9%, in fiscal year 2014 over the prior year period. Distribution expense as percent of revenue of the nine month periods ending April 30, 2014 and 2013 were 14.1% and 10.6% of net sales, respectively. Distribution expense is heavily concentrated in our electronic chemicals business, and the increases in the quarterly and nine month comparisons for that expense in fiscal year 2014 reflect greater volume shipments from UPC-related sales and from expenses for chemical management operations in Singapore. Distribution expense in our Singapore operations were 34.0% of sales in the three months ended April 30, 2014, due to personnel costs in chemical management operations.

Selling, General and Administrative Expenses

Selling, general, and administrative expenses increased $3.2 million, or 58.0%, to $8.8 million in the third quarter of fiscal year 2014 from $5.6 million in the same quarter of fiscal year 2013. Those expenses were 10.4% and 9.3% of net sales in the third quarter of fiscal years 2014 and 2013, respectively. For the nine month period, those expenses increased $11.0 million, or 60.6%, to $29.1 million from $18.1 million. Approximately 49.0% and 43.0% of the increase in selling, general and administrative expense in the three and nine months ending April 30, 2014, respectively, as compared with the prior year periods, was attributable to the acquired UPC business, and approximately 31.0% and 27.0% of the increase in the fiscal year 2014 periods over the prior year periods was due to higher professional services, employee-related costs and integration expenses for our UPC acquisition. For the nine months ended April 30, 2014, approximately 12.0% of the increase over the prior year period was due to CEO transition expense. For the first nine months of fiscal year 2014 selling, general and administrative expenses increased over the prior year period, by $1.5 million in professional services, $1.3 million of stock-based compensation expense related to our new CEO, and by $2.0 million of other employee related costs. In the third quarter and first nine months of fiscal year 2013, we incurred $80,000 and $1.4 million, respectively, of acquisition-related expense for the UPC acquisition that we were then pursuing.

Segment Income from Operations

In the third quarter of fiscal year 2014, operating income in the electronic chemicals segment was $3.2 million, an increase of $197,000, or 6.1%, as compared to $3.0 million for the prior year period. The improvement in the quarterly comparison was due to the effect of the UPC acquisition electronic chemicals business. This increase was partially offset by higher depreciation and amortization expenses of approximately $1.6 million. For the nine month period, operating income in the electronic chemicals segment decreased $971,000, or 9.3%, to $9.5 million from $10.5 million. The decrease in the nine month comparison was due primarily to increased depreciation and amortization of $5.0 million, partially offset by operating profits from the acquired UPC business.

In our wood treating chemicals segment, operating income decreased approximately $454,000, or 17.8%, to $2.1 million in the third quarter of fiscal year 2014 as compared to $2.6 million for the prior year period. For the nine month period, operating income in the wood treating segment decreased $2.4 million or 29.8%, to $5.7 million from $8.1 million. Operating income in wood treating chemicals was down in the third quarter of fiscal year 2014 and for the nine months due to lower pricing of the hydrochloric acid that is a byproduct of penta production and lower penta sales in the Southeast. Although creosote volume improved in the quarter and in the nine month period over the prior year, we experienced lower pricing and higher logistics costs, including cleaning costs in the second quarter for a barge that was returned to its owner.

Other corporate expenses are not allocated to segments in calculating a segment's income from operations. Other corporate expense primarily represents employee stock-based compensation expenses and those public entity expenses such as board compensation, audit expense, fees related to the listing of our stock, and expenses incurred to pursue potential acquisition opportunities. See Note 9 to the financial statements included in this report. For the three and nine months ended April 30, 2014, respectively, other corporate expense includes $1.5 million and $3.3 million for professional services, $300,000 and $1.5 million for stock based compensation. For the three and nine months ended April 30, 2013, respectively, other corporate expense includes $750,000 and $2.0 million for professional services and $50,000 and $100,000 for stock based compensation

Interest Expense, net

Interest expense was $926,000 and $388,000 in the third quarter of fiscal years 2014 and 2013, respectively, and was $2.3 million and $1.2 million for the first nine months of fiscal year 2014 and 2013, respectively. The increases in the periods were due to greater amounts outstanding on our revolving loan facility borrowed to consummate our UPC acquisition in May 2013.


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Income Taxes

The overall effective income tax rate for the three and nine month period ended April 30, 2014 was 34.9% and 110.5%, respectively, primarily due to restructuring charges and operational results in Italy for which we will not be able to realize a tax benefit. With the consolidation of our European manufacturing facilities, it is more likely than not that our subsidiary in Italy will not generate a sufficient profit in the near future to recover the restructuring charges. The impact on our Italian subsidiary's tax provision was approximately $1.4 million, and was recorded in the second quarter of fiscal year 2014. Excluding the Italian results, the estimated annual effective tax rate on ordinary income was 31.3% and 32.0% for the three and nine months ended April 30, 2014. The overall effective rate for continuing operations was 26.2% and 34.1% for the three and nine months ended April 30, 2013, respectively.

Discontinued Operations

Discontinued operations reflected a loss before income taxes of $33,000 and $187,000 for the third quarter and first nine months of fiscal year 2013, respectively. Those costs were related to the animal health business that was discontinued in March 2012, and to dismantling equipment relating to the agricultural chemicals business that was discontinued in fiscal year 2008.

Liquidity and Capital Resources

Cash Flows

For the nine months ended April 30, 2014, operating cash flows were favorably impacted by an increase in accrued liabilities of $5.4 million and a decrease of $7.4 million in inventories, primarily in our wood treating chemicals business. Accrued liabilities increased primarily due to recognition of restructuring charges and bonus accruals. Operating cash flows were negatively impacted by a decrease in accounts payable of $3.5 million primarily in connection with our wood treating segment from the timing of payments for creosote purchases. Net borrowings decreased by $13.0 million, because of payments on our revolving line of credit.

Working Capital

We have a revolving line of credit of $110.0 million under an amended and restated credit agreement. At April 30, 2014, we had $52.0 million outstanding under the revolving facility, and an additional $3.5 million was reserved for outstanding letters of credit, with up to an additional $54.5 million of additional borrowing capacity. However, the amount that may be borrowed under the revolving facility is limited by a covenant for funded debt to pro-forma earnings before interest, taxes and depreciation ("EBITDA"), and at April 30, 2014 that limitation restricted our borrowing capacity to $19.9 million. We reduced the principal outstanding on our revolving loan by payments of $7.0 million and $13.0 million in the three and nine month periods ended April 30, 2014. Management believes that our current revolving credit facility, combined with cash flows from operations, will adequately provide for our working capital needs for current operations for the next twelve months, and to extend or replace $20.0 million of indebtedness that matures on December 31, 2014. Management is in the process of accomplishing that extension or replacement, and is reviewing several viable alternatives.

Long Term Debt

To finance the acquisition of the electronic chemicals business in December 2007, we entered into an amended and restated credit agreement and a note purchase agreement. The amended and restated credit agreement is now with Wells Fargo Bank, National Association, and with Bank of America, N.A. The note purchase agreement is now with The Prudential Insurance Company of America and Pruco Life Insurance Company.

Initially, the amended and restated credit agreement included a revolving loan facility and a term loan facility. The term loan was paid off in fiscal year 2012, and that aspect of the facility has been removed. We amended the facilities and the note purchase agreement several times, most recently in April and in May 2013 to increase the amount that may be borrowed under the revolving loan up to $110.0 million, to include an accordion feature that allows for an additional revolving loan increase of up to $25.0 million from current or additional lenders willing to participate, to extend the maturity date to April 30, 2018, and to include a mandatory reduction in revolving loan commitment of $10.0 million each year from September 30, 2014 to September 30, 2017 totaling $40.0 million. The matrix for the calculation of interest payable on the revolving loan facility and the method for the calculation of the fixed charge coverage ratio were also revised.


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The revolving loan matures April 30, 2018, and bears interest at a varying rate of LIBOR plus a margin based on our funded debt to EBITDA ratio, as described below.

     Ratio of Funded Debt to EBITDA                                  Margin
     Equal to or greater than 2.5 to 1.0                                2.25 %
     Equal to or greater than 2.0 to 1.0, but less than 2.5 to 1.0      2.00 %
     Equal to or greater than 1.5 to 1.0, but less than 2.0 to 1.0      1.75 %
     Less than 1.5 to 1.0                                               1.50 %

Advances under the revolving loan bear interest at 2.15% and 1.69% as of April 30, 2014 and July 31, 2013, respectively. At April 30, 2014, $52.0 million was outstanding on the revolving loan, and an additional $3.5 million was reserved for outstanding letters of credit.

The note purchase agreement is for $20.0 million. Advances under the note purchase agreement mature on December 31, 2014, and bear interest at 7.43% per annum. Principal is payable at maturity. At April 30, 2014, $20.0 million was outstanding under the note purchase agreement.

Loans under the amended and restated credit agreement and the note purchase agreement are secured by our assets, including stock in subsidiary inventory, accounts receivable, equipment, intangible assets and real property. The credit facility and the note have restrictive covenants, including that the Company must maintain a fixed charge coverage ratio of 1.5 to 1.0 or greater, and funded debt to EBITDA (as adjusted for extraordinary items, with lender consent) of no more than 3.0 to 1.0, and a current ratio of at least 1.5 to 1.0. On April 30, 2014, we were in compliance with all of our debt covenants.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements, such as financing or unconsolidated variable interest entities, other than operating leases.

Disclosure Regarding Forward Looking Statements

We are including the following discussion to inform our existing and potential security holders generally of some of the risks and uncertainties that can affect us and to take advantage of the "safe harbor" protection for forward-looking statements that applicable federal securities law affords. From time to time, our management or persons acting on our behalf make forward-looking statements to inform existing and potential security holders about our company. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as future capital expenditures, business strategy, competitive strengths, goals, growth of our business and operations, plans and references to future successes may be considered forward-looking statements. Also, when we use words such as "anticipate," "believe," "estimate," "intend," "plan," "project," "forecast," "may," "should," "budget," "goal," "expect," "probably" or similar expressions, we are making forward-looking statements. Many risks and uncertainties may impact the matters addressed in these forward-looking statements. Our forward-looking statements speak only as of the date made and we will not update forward-looking statements unless the securities laws require us to do so.

Some of the key factors which could cause our future financial results and performance to vary from those expected include:

the loss or significant reduction in business from primary customers;

the loss of key suppliers;

the integration of our UPC acquisition taking longer or being more costly than currently believed, or the failure to achieve all the planned benefits of that integration;

penta being banned or restricted as a persistent organic pollutant under the Stockholm Convention Treaty;

the implementation of a new enterprise resource planning system taking longer or being more costly than currently believed;

our ability to implement productivity improvements, cost reduction initiatives or facilities expansions;

market developments affecting, and other changes in, the demand for our products and the entry of new competitors or the introduction of new competing products;


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availability or increases in the price of energy, our primary raw materials and active ingredients;

the timing of planned capital expenditures;

our ability to identify, develop or acquire, and market additional product lines and businesses necessary to implement our business strategy and our ability to finance such acquisitions and development;

the condition of the capital markets generally, which will be affected by interest rates, foreign currency fluctuations and general economic conditions;

cost and other effects of legal and administrative proceedings, settlements, investigations and claims, including environmental liabilities which may not be covered by indemnity or insurance;

the effects of weather, earthquakes, other natural disasters and terrorist attacks;

the ability to obtain registration and re-registration of our products under applicable law;

the political and economic climate in the foreign or domestic jurisdictions in which we conduct business; and

other United States or foreign regulatory or legislative developments which affect the demand for our products generally or increase the environmental compliance cost for our products or impose liabilities on the manufacturers and distributors of such products.

The information contained in this report, including the information set forth under the heading "Risk Factors", identifies additional factors that could cause our results or performance to differ materially from those we express in our forward-looking statements. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of these assumptions and, therefore, the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements which are included in this report and the exhibits and other documents incorporated herein by reference, our inclusion of this information is not a representation by us or any other person that our objectives and plans will be achieved.

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