Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes included herein and our Consolidated Financial Statements, accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended July 31, 2020. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under “Forward-Looking Statements” and Item 1A, Risk Factors of our Annual Report on Form 10-K for the fiscal year ended July 31, 2020.
OVERVIEW
We develop, mine, manufacture and market sorbent products principally produced from clay minerals and, to a lesser extent, other clay-like sorbent materials. Our principal products include agricultural and horticultural chemical carriers, animal health and nutrition products, bleaching clay and fluid purification aids, cat litter, industrial and automotive floor absorbents and sports field products. Our products are sold to two primary customer groups, including customers who resell our products as originally produced to the end consumer and those who use our products as part of their production process or use them as an ingredient in their final finished product. We have two reportable operating segments based on the different characteristics of our two primary customer groups: Retail and Wholesale Products Group and Business to Business Products Group, as described in Note 10 of the Notes to unaudited Condensed Consolidated Financial Statements.
RESULTS OF OPERATIONS
OVERVIEW
In December 2019, COVID-19 was reported in China and has subsequently spread worldwide. In March 2020, the World Health Organization declared the COVID-19 outbreak a pandemic. While we saw changes to consumer purchasing patterns for certain products in response to the pandemic and certain increases in our costs arising out of the pandemic outbreak and continued spread of COVID-19, there has not, to date, been a significant impact to our business as a whole. All of our facilities, with the exception of our subsidiary in China (which, as noted below, has subsequently resumed operations), have continued to operate as essential businesses as permitted under exceptions in the applicable shelter-in-place mandates due to our inclusion in the Critical Manufacturing Sector as defined by the U.S. Department of Homeland Security and other functions defined as essential by government authorities. Our subsidiary in China, which experienced certain disruptions as a result of government restrictions at the onset of the pandemic, returned to operations in the third quarter of fiscal year 2020. Our top priority has been, and continues to be, the safety and health of our employees, contractors, and customers. We have adhered and continue to adhere to guidance from the U.S. Centers for Disease Control and Prevention (CDC) and local health and governmental authorities with respect to social distancing and physical separation. Additionally, we have increased cleaning and sanitation programs at each of our facilities. As a result, we have not experienced any shut downs due to workforce absences or illnesses.
As further discussed below, our consolidated net sales have increased in the first quarter of fiscal year 2021 compared to the first quarter of fiscal year 2020. Despite the increase in sales, we have not experienced any significant issues collecting amounts due from customers to date. However, parts of our business have been negatively impacted by the COVID-19 outbreak. Sales of our industrial and sports businesses declined as many businesses and sports fields remain shut down. In the long-term, we foresee that our sports product sales will improve back to pre-pandemic volumes with the expected re-opening of baseball and softball at all levels in 2021. As discussed below in "Foreign Operations," sales for our industrial granules in the United Kingdom are lower due to restrictions imposed by the United Kingdom government in response to COVID-19. In addition, while sales of our fluids purification products are higher in the first three months of fiscal year 2021 than fiscal year 2020, COVID-19 has, on a whole, negatively impacted the sales of these products. Reduced travel and, to a lesser extent, our inability due to COVID-19 to participate in our customer's plant tests of our fluids purification products has impeded our sales in recent months. Sales of our animal health products in Latin America, Africa and Asia have also been somewhat impacted as COVID-19 changed our customers' purchasing patterns.
Consolidated gross profit has not been significantly impacted by COVID-19. We did experience some delays of incoming materials from three suppliers due to COVID-19. However, it did not impact our ability to fulfill customer orders and we continue to monitor our suppliers. In general, our suppliers have either remained open or we have found new suppliers. While we have experienced some increase in transportation costs as discussed further below, we have been able to successfully navigate delays in overseas vessel deliveries of our products by increasing our safety stock as well as finding other providers. We have incurred additional cleaning and sanitation costs to comply with the CDC guidelines, but these costs did not have a
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significant impact on our consolidated gross profit. In addition, we have experienced a decrease in travel costs as our employees have not been traveling during the outbreak.
We are closely monitoring the continued spread and effects of the outbreak of COVID-19 on all aspects of our business, including how it has and may impact our suppliers and customers as well as the effects of the pandemic on economic conditions and the financial markets. We have not experienced any significant impacts or interruptions and we will continue to closely monitor our inventory levels to mitigate the risk of any potential supply interruptions or changes in customer demand. The impacts of COVID-19 and related economic conditions on our future results are uncertain at this time. The scope, duration and magnitude of the direct and indirect effects of COVID-19 continue to evolve (and in many cases, rapidly) and in ways that are difficult or impossible to anticipate. In addition, because COVID-19 did not materially impact our financial results to date and it remains uncertain whether and how consumers will modify their purchasing habits in response to COVID-19 and continued or reduced government restrictions, these results may not be indicative of the impact that COVID-19 may have on our results for the remainder of fiscal year 2021.
The impacts of COVID-19 to our specific operating segments are discussed below.
THREE MONTHS ENDED OCTOBER 31, 2020 COMPARED TO
THREE MONTHS ENDED OCTOBER 31, 2019
CONSOLIDATED RESULTS
Consolidated net sales for the three months ended October 31, 2020 were $76,097,000, a 7% increase compared to net sales of $71,122,000 for the three months ended October 31, 2019. Net sales increased for both our Retail and Wholesale Products Group and Business to Business Products Group. Segment results are discussed further below.
Consolidated gross profit for the first three months of fiscal year 2021 was $20,304,000, or 27% of net sales, compared to $19,935,000, or 28% of net sales, for the first three months of fiscal year 2020. While we incurred additional employee compensation costs to meet increased customer demand as well as cleaning and sanitation costs due to COVID-19, these costs did not have a significant impact on our consolidated gross profit. In addition, the majority of our suppliers have remained open and have been able to meet our increased demand. Higher freight, packaging, and to some extent, materials costs and non-fuel costs per manufactured ton, drove the decrease in gross profit. Freight costs per manufactured ton increased approximately 6% for the first three months of fiscal year 2021 compared to the same period in fiscal year 2020 as the result of higher transportation rates due to a national driver shortage and tight trucking capacity in part caused by the return of non-essential businesses and the pre-holiday build driven by both e-commerce and brick and mortar retailers. Our overall freight costs also vary between periods depending on the mix of products sold and the geographic distribution of our customers. Packaging costs per manufactured ton for the first three months of fiscal year 2021 were approximately 6% higher compared to the first three months of fiscal year 2020 due to product mix. Many of our contracts for packaging purchases are subject to periodic price adjustments, which trail changes in underlying commodity prices. Our materials costs per manufactured ton were also slightly higher compared to the first three months of the prior fiscal year. In contrast, the cost of natural gas used to operate kilns that dry our clay was approximately 9% lower per manufactured ton in the first three months of fiscal year 2021 compared to the first three months of fiscal year 2020.
Total SG&A expenses were $15,127,000 for the first three months of fiscal year 2021, a 4% decrease compared to $15,814,000 for the first three months of fiscal year 2020. The discussion of the segments' operating incomes below describes the changes in SG&A expenses that were allocated to the operating segments. The remaining unallocated corporate expenses were flat in fiscal year 2021 compared to fiscal year 2020.
Other expense of $422,000 for the first quarter of fiscal year 2021 included unfavorable exchange rate losses and higher interest expense due to the new debt agreement entered into in the third quarter of fiscal year 2020.
Consolidated net income before taxes for the first three months of fiscal year 2021 was $4,755,000, a 17% increase from net income before taxes of $4,077,000 for the first three months of fiscal year 2020. Results for the first three months of fiscal year 2021 were driven by the factors discussed above, including higher sales, lower natural gas costs and lower SG&A expenses, which more than offset the increase in freight and packaging costs.
The tax expense for the first three months of fiscal year 2021 was $806,000 (an effective tax rate of approximately 17%) compared to $617,000 for the first three months of fiscal year 2020 (an effective tax rate of approximately 15%). An estimated
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annual effective tax rate was used in both periods to determine the provision for income taxes, which is based on expected annual taxable income and the assessment of various tax deductions, including depletion.
BUSINESS TO BUSINESS PRODUCTS GROUP
Net sales of the Business to Business Products Group for the first three months of fiscal year 2021 increased compared to the first three months of fiscal year 2020. Net sales were $27,522,000, an increase of $1,044,000, or 4%, from net sales of $26,478,000 for the first three months of fiscal year 2020. Net sales of our agricultural and horticultural chemical carrier products increased approximately 22% for the first three months of fiscal year 2021 compared to the same period in fiscal year 2020. The increase in net sales was attributable to an expected shift in timing of sales to one of our largest customers from the last three months of fiscal year 2020 to the first three months of fiscal year 2021 due to that customer resuming its production schedule after it experienced various supplier delays due to COVID-19. Additionally, agricultural sales increased due to a new business application of our Agsorb product to an existing customer and increased sales to existing customers in the first three months of fiscal year 2021. Net sales of our fluids purification products increased approximately 3% compared to the first three months of the prior fiscal year. Net sales increased despite the negative impacts of COVID-19. Reduced travel due to COVID-19 decreased the sales of our jet fuel fluids purification products. However, we experienced sales improvement in Europe due to one of our significant customers increasing its purchases from us during the first three months of fiscal year 2021. Further, sales were stronger in Africa and Latin America due to increased sales by existing customers despite the currency rates in Brazil continuing to negatively impact our business in Latin America. The increases in net sales to Latin America and Europe were partially offset by lower sales to North America due to the high quality of oil and therefore less need for our clay products and lower sales to Asia due to price competition. Sales of our co-packaged coarse cat litter increased approximately 5% during the first months of fiscal year 2021 compared to the prior fiscal year as consumers continued to buy more cat litter. These higher sales were partially offset by lower sales of our animal health products. Net sales of our animal health and nutrition products decreased approximately 17% during the first three months of fiscal year 2021 compared to the first three months of the prior year. Net sales of our animal feed additives declined primarily in Latin America and Africa, while sales in China increased. See “Foreign Operations” below for a discussion of sales in China. Net sales were lower in Latin America compared to the same period in the prior fiscal year due to changes in a distributor while decreases in net sales in Africa changed due to timing of a key customer's purchasing due to COVID-19. We anticipate that sales to this key customer will resume over the next nine months of fiscal year 2021.
SG&A expenses for the Business to Business Products Group decreased approximately 5% for the first three months of fiscal year 2021 compared to the same period of the prior year. The decrease in SG&A is attributable to various expenses, but was particularly impacted by fewer travel costs due to COVID-19.
The Business to Business Products Group’s operating income for the first three months of fiscal year 2021 was $8,196,000, a decrease of $100,000, or 1%, from operating income of $8,296,000 for the first three months of fiscal year 2020. The decrease in operating income was driven primarily by the higher freight and packaging costs discussed in “Consolidated Results” above.
RETAIL AND WHOLESALE PRODUCTS GROUP
Net sales of the Retail and Wholesale Products Group for the first three months of fiscal year 2021 were $48,575,000, an increase of $3,931,000, or 9%, from net sales of $44,644,000 for the first three months of fiscal year 2020. Sales of cat litter drove the net sales increase. Total cat litter net sales were approximately 12% higher compared to the first three months of the prior fiscal year, with increased sales of both private label and branded scoopable litter. We gained business from both new customers and from new items sold to existing customers for both private label and branded scoopable litter. In addition, in-store promotions resulted in increased sales. Further, an increase in e-commerce sales, where the customer base differs from brick and mortar customers, continues to increase cat litter sales. The impact of COVID-19 on increased pet adoption continues to boost sales as well as the overall macro trend of increased spending on pets. Cat litter sales by our subsidiary in Canada further contributed to the sales increase, as discussed in “Foreign Operations” below. Also included in the Retail and Wholesale Products Group's results were lower sales of our industrial and sports products compared to the first three months of fiscal year 2020. Sales of our industrial and sports products decreased approximately 4% compared to the three months of fiscal year 2020, primarily driven by the continued impact of businesses and sports fields shutting down and/or reducing operations due to COVID-19.
SG&A expenses for the Retail and Wholesale Products Group were lower during the first three months of fiscal year 2021 compared to the first three months of fiscal year 2020 by approximately 9%. This decrease relates primarily to lower advertising expense during the first three months of fiscal year 2021 based on the timing our our strategic advertising programs. We expect that advertising expense for the remainder of fiscal year 2021 will be consistent with the prior fiscal year on an aggregate basis.
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The Retail and Wholesale Products Group's operating income for the first three months of fiscal year 2021 was $4,478,000, an increase of $1,118,000, or 33%, from operating income of $3,360,000 for the first three months of fiscal year 2020. The improved operating income was driven by the higher sales described above and by lower advertising and natural gas costs discussed in “Consolidated Results” which more than offset the higher freight and packaging costs which are also discussed in "Consolidated Results" above.
FOREIGN OPERATIONS
Foreign operations include our subsidiaries in Canada and the United Kingdom, which are reported in the Retail and Wholesale Products Group, and our subsidiaries in China, Mexico and Indonesia, which are reported in the Business to Business Products Group. Net sales by our foreign subsidiaries during the first three months of fiscal year 2021 were $4,136,000, an increase of $487,000, or 13%, compared to net sales of $3,649,000 during the first three months of fiscal year 2020. All of our foreign operations, with the exception of the United Kingdom, experienced an increase in net sales during the first three months of fiscal year 2021 compared to fiscal year 2020. Cat litter sales for our Canada subsidiary increased in the first three months of fiscal year 2021 due to new product sales; higher sales to existing customers; in-store promotions; and some pantry loading in eastern Canada due to a second COVID-19 wave. Despite the continued impacts of the African Swine Fever to pork consumption, sales of our animal health products in China were higher during the first three months of fiscal year 2021 compared to fiscal year 2020 due to a new contract with an existing customer. Higher sales for these subsidiaries were partially offset by lower net sales for our subsidiary in the United Kingdom. The effect of COVID-19 lockdowns and restrictions on the industry in Europe has, to some extent, reduced demand for our industrial floor granules. Net sales by our foreign subsidiaries represented 5% of our consolidated net sales during the first three months of both fiscal years 2021 and 2020.
Our foreign subsidiaries reported a net loss of $212,000 for the first three months of fiscal year 2021, compared to a net loss of $68,000 for the first three months of fiscal year 2020. The net loss was primarily driven by lower net sales for our subsidiary in the United Kingdom. In addition, the majority of our foreign subsidiaries experienced losses due to unfavorable exchange rates.
Identifiable assets of our foreign subsidiaries as of October 31, 2020 were $11,991,000, compared to $9,712,000 as of October 31, 2019. The increase was attributed primarily to working capital contributed to our subsidiary in Mexico during the third quarter of fiscal year 2020 that has not yet been used as well as an increase in inventory for our subsidiaries in Canada, China and Indonesia in anticipation of meeting customer needs and thwarting any potential supply chain disruptions due to COVID-19.
LIQUIDITY AND CAPITAL RESOURCES
Our principal capital requirements include: funding working capital needs; purchasing and upgrading equipment, facilities, information systems, and real estate; supporting new product development; investing in infrastructure; repurchasing stock; paying dividends; making pension contributions; and, from time to time, business acquisitions. During the first three months of fiscal year 2021, we principally funded these requirements using cash from current operations as well as cash generated in the fourth quarter of fiscal year 2020 from borrowings and a one-time receipt of cash related to licensing of certain of our patents.
To date, COVID-19 has not had a significant impact on our operations as a whole, and we anticipate cash flows from operations and our available sources of liquidity will be sufficient to meet our cash requirements. In addition, we are actively monitoring the timing and collection of our accounts receivable. Given the dynamic nature of COVID-19, we will continue to assess our liquidity needs and to actively manage our spending.
The following table sets forth certain elements of our unaudited Condensed Consolidated Statements of Cash Flows (in thousands):
For the Three Months Ended October 31,
2020 2019
Net cash (used in) provided by operating activities $ (3,435) $ 6,692
Net cash used in investing activities (3,565) (3,900)
Net cash used in financing activities (2,781) (5,344)
Effect of exchange rate changes on cash and cash equivalents 182 (50)
Net decrease in cash and cash equivalents $ (9,599) $ (2,602)
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Net cash (used in) provided by operating activities
In addition to net income, as adjusted for depreciation and amortization and other non-cash operating activities, the primary sources and uses of operating cash flows for the first three months of fiscal years 2021 and 2020 were as follows:
Accounts receivable, less allowance for doubtful accounts, increased $4,256,000 in the first three months of fiscal year 2021 compared to an increase of $791,000 in the first three months of fiscal year 2020. Higher sales in the first quarter of fiscal year 2021 compared to the first quarter of fiscal year 2020 drove the increase in accounts receivable as of October 31, 2020. The variation in accounts receivable balances also reflects differences in the level and timing of collections as well as the payment terms provided to various customers.
Inventory decreased $462,000 in the first three months of fiscal year 2021 compared to a decrease of $371,000 in the first three months of fiscal year 2020 due to decreases in other inventory and finished goods. Other inventory includes a variety of items including clay, additives, fragrances and other supplies. Other inventory decreased due to increased demand during the first three months of fiscal year 2021. Finished goods decreased during the first three months of fiscal year 2021 due to higher sales. Packaging and other purchased materials inventory decreased as of October 31, 2019 due to higher production and efforts to better manage our safety stock levels.
Prepaid expenses decreased $458,000 in the first three months of fiscal year 2021. Lower prepaid advertising costs partially offset by higher prepaid repairs drove the overall decrease in prepaid expenses. Lower prepaid advertising costs also drove the decrease of $1,578,000 in the first quarter of fiscal year 2020.
Other assets increased $985,000 in the first three months of fiscal year 2021 compared to a decrease of $316,000 in the first three months of fiscal year 2020. The increase in other assets relates to an increase in capitalized pre-production mining costs. The decrease during the first three months of fiscal year 2020 related to amortization of our operating lease right-of-use lease assets.
Accounts payable, including income taxes payable, decreased $1,435,000 in the first three months of fiscal year 2021 compared to an increase of $835,000 in the first three months of fiscal year 2020. Lower trade and freight payables drove the decrease in accounts payable in the first three months of fiscal year 2021. Trade and freight payables vary in both periods due to the timing of payments, fluctuations in the cost of goods and services we purchased, production volume levels and vendor payment terms. Higher accrued income taxes drove the increase in the first three months of fiscal year 2020.
Accrued expenses decreased $8,106,000 in the first three months of fiscal year 2021 compared to a decrease of $3,812,000 in the first three months of fiscal year 2020. The payout of the prior fiscal year's discretionary incentive bonus reduced accrued salaries in both fiscal years, but to a greater extent in fiscal year 2021 as the accrual was higher in the prior fiscal year. Accrued advertising also decreased in the first three months of fiscal year 2021. Theses decreases were partially offset by an increase in accrued freight. In contrast, the decrease in accrued expenses in the first three months of fiscal year 2020 related to a decrease in accrued freight. Accrued freight can vary with freight rates, timing of shipments, and production requirements. In addition, accrued plant expenses can also fluctuate due to timing of payments, changes in the cost of goods and services we purchase, production volume levels and vendor payment terms.
Other liabilities increased $1,135,000 in the first three months of fiscal year 2021 compared to a decrease of $474,000 in the first three months of fiscal year 2020. The increase in other liabilities for the first three months of fiscal year 2021 relates to the deferral of employer taxes under the CARES Act as further described in Note 1 of the Notes to unaudited Condensed Financial Statements. The decrease in fiscal year 2020 is due to a reclassification of the deferred lease liability to operating lease liabilities.
Net cash used in investing activities
Cash used in investing activities was $3,565,000 in the first three months of fiscal year 2021 compared to cash used in investing activities of $3,900,000 in the first three months of fiscal year 2020. Cash used for capital expenditures was slightly lower for the first three months of fiscal year 2021 than fiscal year 2020.
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Net cash used in financing activities
Cash used in financing activities of $2,781,000 in the first three months of fiscal year 2021 was lower than cash used in financing activities of $5,344,000 in the first three months of fiscal year 2020. The first three months of fiscal year 2020 included the semi-annual payment on the then existing notes payable. The remaining notes payable were paid in the fourth quarter of fiscal year 2020 and replaced by a new notes payable agreement as further described below. No payments on the new notes payable agreement are yet due.
Other
Total cash and investment balances held by our foreign subsidiaries of $3,221,000 as of October 31, 2020 were slightly higher than the October 31, 2019 balances of $3,042,000. See further discussion in “Foreign Operations” above.
On January 31, 2019, we signed a fifth amendment to our credit agreement with BMO Harris Bank N.A. (“BMO Harris”), which expires on January 31, 2024. The agreement provides for a $45,000,000 unsecured revolving credit agreement and a maximum of $10,000,000 for letters of credit. The agreement terms also state that we may select a variable interest rate based on either the BMO Harris prime rate or a LIBOR-based rate, plus a margin that varies depending on our debt to earnings ratio, or a fixed rate as agreed between us and BMO Harris. As of October 31, 2020, the variable rates would have been 3.50% for the BMO Harris prime-based rate or 1.47% for the three-month LIBOR-based rate. The credit agreement contains restrictive covenants that, among other things and under various conditions, limit our ability to incur additional indebtedness or to dispose of assets. The agreement also requires us to maintain a minimum fixed coverage ratio and a minimum consolidated net worth. As of October 31, 2020 and 2019, we were in compliance with the covenants. There were no borrowings during the first three months of either fiscal year 2020 or 2021.
On May 15, 2020, we entered into a new debt instrument pursuant to which, among other things, we issued $10,000,000 in aggregate principal amount of our 3.95% Series B Senior Notes due May 15, 2030 and entered into an amended note agreement that provides the Company with the ability to request, from time to time until May 15, 2023 (or such earlier date as provided for in the agreement), additional senior unsecured notes of the Company in an aggregate principal amount of up to $75,000,000 minus the aggregate principal amount of the notes then outstanding and the additional notes that have been accepted for purchase. The issuance of such additional notes is at the discretion of the noteholders and purchasers and on an uncommitted basis. As of October 31, 2020 outstanding notes payable were $9,857,000, net of $143,000 of unamortized debt issuance costs.
As of October 31, 2020, we had remaining authority to repurchase 871,616 shares of Common Stock and 278,250 shares of Class B Stock under a repurchase plan approved by our Board of Directors (the “Board”). Repurchases may be made on the open market (pursuant to Rule 10b5-1 plans or otherwise) or in negotiated transactions. The timing, number and manner of share repurchases will be determined by our management pursuant to the repurchase plan approved by our Board.
We believe that cash flow from operations, availability under our revolving credit facility, current cash and investment balances and our ability to obtain other financing, if necessary, will provide adequate cash funds for foreseeable working capital needs, capital expenditures at existing facilities, deferred compensation payouts, dividend payments and debt service obligations for at least the next 12 months. We expect capital expenditures in fiscal year 2021 to be greater than in fiscal year 2020. We do not believe that these increased expenditures will dramatically impact our cash position; however our cash requirements are subject to change as business conditions warrant and opportunities arise. Our anticipated advertising expense for fiscal year 2021 is expected to be flat as compared to fiscal year 2020.
We continually evaluate our liquidity position and anticipated cash needs, as well as the financing options available to obtain additional cash reserves. Our ability to fund operations, to make planned capital expenditures, to make scheduled debt payments, to contribute to our pension plan and to remain in compliance with all financial covenants under debt agreements, including, but not limited to, the current credit agreement, depends on our future operating performance, which, in turn, is subject to prevailing economic conditions and to financial, business and other factors. The timing and size of any new business ventures or acquisitions that we complete may also impact our cash requirements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This discussion and analysis of financial condition and results of operations is based on our unaudited Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP for interim financial information and in compliance with instructions to Form 10-Q and Article 10 of Regulation S-X. The preparation of these financial statements requires the use of estimates and assumptions related to the reporting of assets, liabilities, revenues, expenses and related
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disclosures. In preparing these financial statements, we have made our best estimates and judgments of certain amounts included in the financial statements. Estimates and assumptions are revised periodically. Actual results could differ from these estimates. See the information concerning our critical accounting policies included under “Management’s Discussion of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended July 31, 2020.