##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-QSB þ     Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended October 31, 2004 OR o     Transition Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from  to Commission file number: 1-31642 INTERNATIONAL ABSORBENTS INC. (Exact name of small business issuer as specified in its charter)
 Province of British Columbia, Canada(State or other jurisdiction of incorporation or organization)
    
    None(IRS Employer Identification Number)
 1569 Dempsey Road
North Vancouver, British Columbia
Canada V7K 1S8 (Address of principal executive offices)
 (604) 681-6181 (Issuers telephone number, including area code)
 Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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 the past 90 days.     Yes  þ          No  o State the number of shares outstanding of each of the issuers classes of
common stock, as of December 3, 2004. Title of Class
    
    No. of SharesCommon Shares, no par value
    
    6,106,388
 Transitional Small Business Disclosure Format (check one)          Yes  o          No  þ




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##### 



PART I  FINANCIAL INFORMATION ITEM 1.     FINANCIAL STATEMENTS INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(US dollars, in thousands) As at
    
    As atOctober 31,
    
    January 31,2004
    
    2004(unaudited)
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    2,087
    
    
    $
    1,453Restricted cash
    
    
    1,507
    
    
    
    432Short term investments
    
    
    215
    
    
    
    211Accounts receivable, net
    
    
    2,149
    
    
    
    1,525Inventories, net
    
    
    1,302
    
    
    
    1,335Prepaid expenses
    
    
    172
    
    
    
    148Income taxes receivable
    
    
    26
    
    
    
    271Deferred income tax asset
    
    
    31
    
    
    
    31Total current assets
    
    
    7,489
    
    
    
    5,406Property, plant and equipment
    
    
    15,153
    
    
    
    10,348Intangible assets
    
    
    13
    
    
    
    39Other assets, net
    
    
    293
    
    
    
    150Total assets
    
    $
    22,948
    
    
    $
    15,943Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    1,589
    
    
    $
    1,976Related party payable
    
    
    5
    
    
    
    4Current portion of long-term debt
    
    
    326
    
    
    
    142Total current liabilities
    
    
    1,920
    
    
    
    2,122Deferred income tax liability
    
    
    784
    
    
    
    384Long-term debt
    
    
    7,298
    
    
    
    2,934Total liabilities
    
    
    10,002
    
    
    
    5,440Stockholders equity:Common stock, no par value;Authorized - 100,000,000 shares6,080,588 and 5,773,970 issued and outstanding at
October 31, 2004 and January 31, 2004, respectively
    
    
    7,846
    
    
    
    7,256Additional paid in capital
    
    
    557
    
    
    
    489Retained earnings
    
    
    4,543
    
    
    
    2,758Total stockholders equity
    
    
    12,946
    
    
    
    10,503Total liabilities and stockholders equity
    
    $
    22,948
    
    
    $
    15,943
 Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 2




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##### 



INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(US dollars, in thousands, except for per share amounts) Nine Months Ended
    
    Three Months EndedOctober 31,
    
    October 31,
    
    October 31,
    
    October 31,2004
    
    2003
    
    2004
    
    2003Sales
    
    $
    16,995
    
    
    $
    15,012
    
    
    $
    5,999
    
    
    $
    5,663Cost of goods sold
    
    
    10,072
    
    
    
    9,229
    
    
    
    3,568
    
    
    
    3,416Gross profit
    
    
    6,923
    
    
    
    5,783
    
    
    
    2,431
    
    
    
    2,247Corporate and administrative expenses:Marketing and sales
    
    
    2,557
    
    
    
    2,192
    
    
    
    808
    
    
    
    810General and administrative
    
    
    1,651
    
    
    
    1,688
    
    
    
    511
    
    
    
    5524,208
    
    
    
    3,880
    
    
    
    1,319
    
    
    
    1,362Income from operations
    
    
    2,715
    
    
    
    1,903
    
    
    
    1,112
    
    
    
    885Interest expense
    
    
    (113
    )
    
    
    (51
    )
    
    
    (37
    )
    
    
    (51
    )Interest income
    
    
    15
    
    
    
    26
    
    
    
    9
    
    
    
    8Income before provision for income taxes
    
    
    2,617
    
    
    
    1,878
    
    
    
    1,084
    
    
    
    842Income taxes
    
    
    (832
    )
    
    
    (675
    )
    
    
    (348
    )
    
    
    (295
    )Net income
    
    $
    1,785
    
    
    $
    1,203
    
    
    $
    736
    
    
    $
    547Basic earnings per share
    
    $
    .30
    
    
    $
    .21
    
    
    $
    .12
    
    
    $
    .10Fully diluted earnings per share
    
    $
    .29
    
    
    $
    .20
    
    
    $
    .12
    
    
    $
    .09Weighted average number of shares outstanding
(in thousands)Basic
    
    
    5,915
    
    
    
    5,679
    
    
    
    6,011
    
    
    
    5,689Diluted
    
    
    6,237
    
    
    
    5,943
    
    
    
    6,269
    
    
    
    6,005
 INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(US dollars, in thousands) Nine Months EndedOctober 31,
    
    October 31,2004
    
    2003Cash flows from operating activities
    
    
    2,367
    
    
    
    1,313Cash flows from investing activities
    
    
    (6,871
    )
    
    
    (5,454
    )Cash flows from financing activities
    
    
    5,138
    
    
    
    3,014Net change in cash
    
    $
    634
    
    
    $
    (1,127
    )Cash and cash equivalents, beginning of period
    
    $
    1,453
    
    
    $
    3,051Cash and cash equivalents, end of period
    
    $
    2,087
    
    
    $
    1,924Cash paid for interest
    
    $
    198
    
    
    $
    97Cash paid for income taxes
    
    $
    150
    
    
    $
    247
 Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 3




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##### 



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  1.
    
    Significant Accounting Policies Basis of consolidation and presentation The consolidated financial statements include the accounts of International
Absorbents Inc. (the Company) and its wholly owned subsidiary Absorption Corp
(Absorption), a Nevada corporation doing business in Washington State. These unaudited interim condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles in the
United States and include the accounts of the Company and its wholly owned
subsidiary. All significant inter-company transactions and balances have been
eliminated upon consolidation. Our accompanying interim condensed consolidated
financial statements do not include all notes normally included in our audited
annual financial statements, and therefore should be read in conjunction with
our annual financial statements and 10-KSB. The accompanying financial
statements include all normal recurring adjustments, which, in the opinion of
management, are necessary to make the financial statements not misleading and
to present fairly the Companys financial position at October 31, 2004 and
January 31, 2004, its results of operations for the three and nine months ended
October 31, 2004 and 2003, and the statement of cash flows for the nine months
ended October 31, 2004 and 2003. Stock-based employee compensation Statement of Financial Accounting Standards No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure, an Amendment of FASB
Statement No. 123, amends the disclosure requirements of Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation (SFAS 123), to require more prominent disclosures in both
annual and interim financial statements regarding the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company accounts for stock-based employee and non-employee directors
compensation arrangements in accordance with the provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
(APB No. 25), and complies with the disclosure provisions of Statement of
Financial Accounting Standards No. 123 Accounting for Stock-Based
Compensation (SFAS No. 123). Under APB No. 25, compensation expense is
recognized based on the difference, if any, on the date of grant between the
fair value of the Companys common stock and the amount the employees and
non-employee directors must pay to acquire the common stock. Compensation
expense is recognized ratably over the option-vesting period. Compensation expense recognized under APB No. 25 for the grant of options to
employees and non-employee directors was $-0- during the nine months ended
October 31, 2004 and 2003. Had the Company determined compensation costs based
on fair value at the date of grant for its awards under the method prescribed
by SFAS No. 123, the Companys net income and earnings per share would be as
follows (in thousands, except per share amounts): Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 4




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##### 



Nine months ended
    
    Three months endedOctober 31,
    
    October 31,
    
    October 31,
    
    October 31,2004
    
    2003
    
    2004
    
    2003Net earnings
    
    $
    1,785
    
    
    $
    1,203
    
    
    $
    736
    
    
    $
    547Stock based compensation recognized
under APB No. 25, net of related tax effects
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Compensation expense calculated in accordance
with SFAS 123, net of related tax effects
    
    
    (540
    )
    
    
    (220
    )
    
    
    (216
    )
    
    
    (70
    )Pro forma net earnings
    
    $
    1,245
    
    
    $
    983
    
    
    $
    520
    
    
    $
    477Basic earnings per shareAs reported
    
    $
    0.30
    
    
    $
    0.21
    
    
    $
    0.12
    
    
    $
    0.10Pro forma
    
    $
    0.21
    
    
    $
    0.17
    
    
    $
    0.08
    
    
    $
    0.09Diluted earnings per shareAs reported
    
    $
    0.29
    
    
    $
    0.20
    
    
    $
    0.12
    
    
    $
    0.09Pro forma
    
    $
    0.20
    
    
    $
    0.16
    
    
    $
    0.08
    
    
    $
    0.08
 The pro forma compensation expense reflected above has been estimated using the
Black-Scholes option-pricing model. Assumptions used in the pricing model
included: Year Ended January 31,2005
    
    2004a) risk free interest rate
    
    
    2.44
    %
    
    
    2.00
    %b) expected volatility
    
    
    109.1
    %
    
    
    103.5
    %c) expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %d) estimated average life (in years)
    
    
    4.23
    
    
    
    3.00
 Other stock based compensation The Company accounts for equity instruments issued in exchange for the receipt
of goods or services from other than employees and non-employee directors in
accordance with SFAS No. 123 and the conclusions reached by the Emerging Issues
Task Force in Issue No. 96-18, Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring or in Conjunction with Selling,
Goods or Services (EITF 96-18). Costs are measured at the estimated fair
market value of the consideration received or the estimated fair value of the
equity instruments issued, whichever is more reliably measurable. The value of
equity instruments issued for consideration other than employee services is
determined on the earlier of a performance commitment or completion of
performance by the provider of goods or services as defined by EITF 96-18.
Stock based compensation recognized under SFAS No. 123 and EITF 96-18 was
$14,000 and $4,000 during the three months ended October 31, 2004 and 2003,
respectively. Stock based compensation recognized under SFAS No. 123 and EITF
96-18 was $33,000 and $8,000 during the nine months ended October 31, 2004 and
2003, respectively.  2.
    
    Share Capital Common Shares (in thousands) Shares
    
    CapitalCommon shares outstanding, October 31, 2004
    
    
    6,081
    
    
    $
    7,846Common shares outstanding, January 31, 2004
    
    
    5,774
    
    
    $
    7,256
 Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 5




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##### 



Options Stock options outstanding at October 31, 2004 and January 31, 2004 were 705,540
and 679,088, respectively. During the nine months ended October 31, 2004 the
Company issued 325,800 options and had 284,398 options exercised. Warrants During the nine months ended October 31, 2004, a warrant was exercised to
acquire 22,220 common shares at $2.25 per share. Warrants outstanding at
October 31, 2004 and January 31, 2004 were nil and 22,220, respectively. No
stock-based compensation expense was recognized as no warrants were granted for
both nine-month periods ended October 31, 2004 and 2003.  3.
    
    Segmented Information The Company is involved primarily in the development, manufacture, distribution
and sale of absorbent products. Its assets are located and its operations are
primarily conducted in the United States. The Company defines its business segments primarily based upon the market in
which its customers sell products, as well as how the Company internally
manages its various business activities. The Company operates principally in
two business segments: the animal care industry and the industrial/commercial
industry. Management decisions on resource allocation and performance
assessment are made currently based on these two identifiable segments. As a
result, management has elected to combine what historically were the Companys
two smallest segments into one new segment, the industrial/commercial segment,
effective with this quarterly report. Comparative amounts for prior periods
have been similarly combined. Management of the Company evaluates these segments based upon the operating
income before depreciation and amortization generated by each segment.
Depreciation, amortization, and interest expense are managed on a consolidated
basis and as such are not allocated to individual segments. There are no
inter-segment transactions or significant differences between segment
accounting and corporate accounting basis. Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 6




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##### 



Business Segment Data  Nine Months Ended October 31, 2004 (in thousands) AnimalCare
    
    Industrial
    
    ConsolidatedRevenues
    
    $
    16,003
    
    
    $
    992
    
    
    $
    16,995Operating cost and expenses
    
    
    12,774
    
    
    
    1,016
    
    
    
    13,790Operating
income (loss) before depreciation and amortization
    
    
    3,229
    
    
    
    (24
    )
    
    
    3,205Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (490
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    (113
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    15Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    2,617Capital expenditures
    
    $
    5,236
    
    
    $
    24
    
    
    $
    5,260
 Business Segment Data  Nine Months Ended October 31, 2003 (in thousands) AnimalCare
    
    Industrial
    
    ConsolidatedRevenues
    
    $
    13,837
    
    
    $
    1,175
    
    
    $
    15,012Operating cost and expenses
    
    
    11,598
    
    
    
    1,228
    
    
    
    12,826Operating
income (loss) before depreciation and amortization
    
    
    2,239
    
    
    
    (53
    )
    
    
    2,186Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (283
    )Interest Expense
    
    
    
    
    
    
    
    
    
    
    (51
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    26Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    1,878Capital expenditures
    
    $
    4,515
    
    
    $
    1,178
    
    
    $
    5,693
 Business Segment Data  Three Months Ended October 31, 2004 (in thousands) AnimalCare
    
    Industrial
    
    ConsolidatedRevenues
    
    $
    5,689
    
    
    $
    310
    
    
    $
    5,999Operating cost and expenses
    
    
    4,438
    
    
    
    281
    
    
    
    4,719Operating
income (loss) before depreciation and amortization
    
    
    1,251
    
    
    
    29
    
    
    
    1,280Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (168
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    (37
    )Interest income
    
    
    
    
    
    
    
    
    
    
    9Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    1,084Capital expenditures
    
    $
    1,806
    
    
    $
    3
    
    
    $
    1,809
 Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 7




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##### 



Business Segment Data  Three Months Ended October 31, 2003 (in thousands) AnimalCare
    
    Industrial
    
    ConsolidatedRevenues
    
    $
    5,210
    
    
    $
    453
    
    
    $
    5,663Operating cost and expenses
    
    
    4,158
    
    
    
    515
    
    
    
    4,673Operating
income (loss) before depreciation and amortization
    
    
    1,052
    
    
    
    (62
    )
    
    
    990Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (105
    )Interest Expense
    
    
    
    
    
    
    
    
    
    
    (51
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    8Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    842Capital expenditures
    
    $
    1,386
    
    
    $
    646
    
    
    $
    2,032
 Assets (in thousands) AnimalCare
    
    Industrial
    
    ConsolidatedAt October 31, 2004
    
    $
    21,016
    
    
    $
    1,932
    
    
    $
    22,948At January 31, 2004
    
    $
    13,881
    
    
    $
    2,062
    
    
    $
    15,943
 Approximately 4.7% and 5.1% of our sales during the nine months ended October
31, 2004 and 2003, respectively, were to customers outside of the United
States. Approximately 4.8% and 5.1% of our sales during the three months ended
October 31, 2004 and 2003, respectively, were to customers outside of the
United States.  4.
    
    Inventories components (in thousands) October 31,
    
    January 31,2004
    
    2004Raw materials and supplies
    
    $
    783
    
    
    $
    498Finished goods
    
    
    519
    
    
    
    837$
    1,302
    
    
    $
    1,335
 Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 8




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##### 



5.
    
    Property, Plant and Equipment (in thousands) October 31,
    
    January 31,2004
    
    2004Property, plant and equipmentLand
    
    $
    1,626
    
    
    $
    1,626Buildings
    
    
    4,723
    
    
    
    4,657Leasehold improvements
    
    
    629
    
    
    
    629Equipment
    
    
    4,945
    
    
    
    4,616Construction in progress
    
    
    6,161
    
    
    
    1,297$
    18,084
    
    
    $
    12,825Less: Accumulated depreciation
    
    
    (2,931
    )
    
    
    (2,477
    )$
    15,153
    
    
    $
    10,348
 During the nine months ended October 31, 2004, we incurred interest costs of
$162,000, of which $49,000 was capitalized as part of the new facility located
in Jesup, Georgia and $113,000 was interest expense. Total project cost for
the new facility in Jesup, Georgia is estimated at $6,650,000. Of the total
cost, approximately $4,700,000 is being financed through a long-term debt
instrument.  6.
    
    Long-term debt In March 2003, we completed a $2,910,000 bond financing. The proceeds of the
financing were used for the construction of the facility in Whatcom County,
Washington, which houses production lines, warehouse space and corporate
offices. The bonds are comprised of $2,355,000 as tax exempt and $555,000 as
taxable. The bonds were issued through the Washington Economic Development
Finance Authority in Washington State. The purchaser and holder of the bonds
is GE Capital Public Finance. The tax exempt bonds have a fixed rate of 5.38%.
The term of these bonds is 190 months, with interest-only payments for the
first 52 months. The taxable bonds have a fixed rate of 5.53%. The term of
these bonds is 52 months. The indebtedness underlying our bonds is secured by
a mortgage on our real property located in Whatcom County, Washington and a
security interest in our equipment assets located on that property. At October
31, 2004 the balance outstanding was $2,355,000 on the tax-exempt and $369,000
on the taxable bonds. On August 20, 2003 we entered into a loan agreement with Branch Banking & Trust
Co. to borrow up to $4,691,500 to be used for the construction and equipping of
our new facility in Jesup, Georgia. The loan agreement allows for up to 85% of
the appraised value of property and plant to be borrowed and up to 80% of the
value of equipment to be borrowed. The interest rate for the credit facility
is the one-month LIBOR rate plus 2.25%. At October 31, 2004, this loan had
been repaid in full from the proceeds of the tax-exempt bond financing
discussed in the following paragraph. In September of 2004, the Company completed a $4,900,000 tax-exempt bond
financing. Of the total proceeds from the financing, $2,099,000 were used to
pay off the loan held by Branch Banking &Trust Co., $98,000 was paid for costs
of issuance and the remaining proceeds of $2,703,000 were placed in a trust
account to be used to finish the construction of the new production facility
located in Jesup, Georgia. The bonds were issued by Wayne County Industrial
Development Authority in the state of Georgia. The bonds have a variable rate
equal to Branch Banking & Trust Co.s Variable Rate Demand Bond VRDB rate
(1.7% as of December 8, 2004) plus a letter of credit fee of .95%, a
remarketing fee of .125% and a $2,000 annual trustee fee. The term of these
bonds is 7 years for the equipment portion and 15 years for the real estate
portion. At October 31, 2004, $1,507,000 remained in the trust account. Unaudited (all amounts in U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 9




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##### 



ITEM 2.     MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion is intended to further the readers understanding of the
consolidated financial statements, financial condition, and results of
operations of International Absorbents Inc. and its subsidiaries. It should be
read in conjunction with the consolidated financial statements, notes and
tables which are included elsewhere in this quarterly report. Some statements and information contained in this Managements Discussion and
Analysis of Financial Condition and Results of Operations are not historical
facts but are forward-looking statements. For a discussion of these
forward-looking statements and of important factors that could cause results to
differ materially from the forward-looking statements, see Risk Factors and
Forward-Looking Statements below. Overview International Absorbents Inc. is the parent company of its wholly owned
subsidiary Absorption Corp. International Absorbents Inc. is a holding company
and Absorption Corp is its operating entity. Management divides the activities
of the operating company into two segments: animal care products and industrial
absorbent products. We manufacture, distribute and sell this spectrum of
products to both distributors and direct buying retailers. Absorption Corp is a leading manufacturer and seller of premium small animal
bedding in North America. The primary product that it sells in this market is a
small animal bedding sold under the brand name CareFRESH®. We consider the
activities that surround the manufacture and distribution of CareFRESH®to be
our core business. Our business strategy is to promote and grow our core
business, and to create diversification in our market channels, our production
methods, and our product lines in an effort to add strength and breadth to our
business structure. As a result, we are dedicating significant resources to
both building infrastructure for the support of our core business and to
creating more product and customer diversification. We believe that this
strategy has started to provide results. Specifically, we continue to grow
sales in our core business and improve the production process of our core
CareFRESH®product while expanding sales of new products and existing products
in new market channels. Even though we are currently experiencing significant
infrastructure-related costs, we believe our progress with the sales of new
product lines will continue to move us toward developing multiple sources of
income, which we anticipate will help reduce the risks associated with a
substantial reliance on sales from only one significant product. Results of Operations The following tables
illustrates our financial results for the third quarter and first nine
months of fiscal year 2005 as compared to the third quarter and first nine
months of fiscal year 2004: Third Quarter of Fiscal Year 2005 and 2004(dollar amounts in thousands of U.S. dollars) October 31,
    
    Percent
    
    October 31,
    
    Percent
    
    Percentage2004
    
    of Sales
    
    2003
    
    of Sales
    
    ChangeSales
    
    
    5,999
    
    
    
    100
    %
    
    
    5,663
    
    
    
    100
    %
    
    
    6
    %Cost of Goods Sold
    
    
    3,568
    
    
    
    59
    %
    
    
    3,416
    
    
    
    60
    %
    
    
    4
    %Gross Profit
    
    
    2,431
    
    
    
    41
    %
    
    
    2,247
    
    
    
    40
    %
    
    
    8
    %Corporate &
Administrative ExpensesMarketing & sales
    
    
    808
    
    
    
    13
    %
    
    
    810
    
    
    
    14
    %
    
    
    0
    %General & Administrative
    
    
    511
    
    
    
    9
    %
    
    
    552
    
    
    
    10
    %
    
    
    -7
    %1,319
    
    
    
    22
    %
    
    
    1,362
    
    
    
    24
    %
    
    
    -3
    %Income from operations
    
    
    1,112
    
    
    
    19
    %
    
    
    885
    
    
    
    16
    %
    
    
    26
    %Interest Income
    
    
    9
    
    
    
    0
    %
    
    
    8
    
    
    
    0
    %
    
    
    13
    %Interest Expense
    
    
    (37
    )
    
    
    -1
    %
    
    
    (51
    )
    
    
    -1
    %
    
    
    -27
    %Income before provision
for income taxes
    
    
    1,084
    
    
    
    18
    %
    
    
    842
    
    
    
    15
    %
    
    
    29
    %Income taxes
    
    
    (348
    )
    
    
    -6
    %
    
    
    (295
    )
    
    
    -5
    %
    
    
    18
    %Net Income
    
    
    736
    
    
    
    12
    %
    
    
    547
    
    
    
    10
    %
    
    
    35
    %
 10




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First Nine Months of Fiscal Year 2005 and 2004(dollar amounts in thousands of U.S. dollars) October 31,
    
    Percent
    
    October 31,
    
    Percent
    
    Percentage2004
    
    of Sales
    
    2003
    
    of Sales
    
    ChangeSales
    
    
    16,995
    
    
    
    100
    %
    
    
    15,012
    
    
    
    100
    %
    
    
    13
    %Cost of Goods Sold
    
    
    10,072
    
    
    
    59
    %
    
    
    9,229
    
    
    
    61
    %
    
    
    9
    %Gross Profit
    
    
    6,923
    
    
    
    41
    %
    
    
    5,783
    
    
    
    39
    %
    
    
    20
    %Corporate &
Administrative ExpensesMarketing & sales
    
    
    2,557
    
    
    
    15
    %
    
    
    2,192
    
    
    
    15
    %
    
    
    17
    %General & Administrative
    
    
    1,651
    
    
    
    10
    %
    
    
    1,688
    
    
    
    11
    %
    
    
    -2
    %4,208
    
    
    
    25
    %
    
    
    3,880
    
    
    
    26
    %
    
    
    8
    %Income from operations
    
    
    2,715
    
    
    
    16
    %
    
    
    1,903
    
    
    
    13
    %
    
    
    43
    %Interest Income
    
    
    15
    
    
    
    0
    %
    
    
    26
    
    
    
    0
    %
    
    
    -42
    %Interest Expense
    
    
    (113
    )
    
    
    -1
    %
    
    
    (51
    )
    
    
    0
    %
    
    
    122
    %Income before provision
for income taxes
    
    
    2,617
    
    
    
    15
    %
    
    
    1,878
    
    
    
    13
    %
    
    
    39
    %Income taxes
    
    
    (832
    )
    
    
    -5
    %
    
    
    (675
    )
    
    
    -4
    %
    
    
    23
    %Net Income
    
    
    1,785
    
    
    
    11
    %
    
    
    1,203
    
    
    
    8
    %
    
    
    48
    %
 Revenues Our sales grew from $5,663,000 in the third quarter of fiscal year 2004 to
$5,999,000 during the same period in fiscal year 2005. Our sales for the first
nine months of fiscal year 2005 reached $16,995,000, which was a 13% increase
over sales of $15,012,000 for the first nine months of fiscal year 2004. Our
core product, CareFRESH®, continues to gain market share in the pet specialty
market channel. Our strategy of diversification also showed some success with
the continued growth of pet products such as CareFRESH® Ultra and Critter
Care, due to increased shelf facings since mid-year. Our strategy in regard
to our industrial line of products has remained the same, which is to
effectively service existing customers while focusing growth on
consumer products. Consequently industrial sales remained flat for the first nine
months of fiscal year 2005 as compared to the first nine months of fiscal year
2004. 11




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During the last quarter of fiscal year 2005, sales of CareFRESH®are expected
to continue to grow at or near the rate at which they grew during the first
nine months of the fiscal year. This is because our biggest retail partners
are carrying lower inventories and due to new software are better able to
forecast seasonal buying needs. Therefore they did not over buy in the third
quarter of the current fiscal year, which should smooth out their purchases if
retail sales remain constant. We anticipate that CareFRESH®will continue to
represent the majority of our sales through the balance of the current fiscal
year. We also expect that during the balance of fiscal year 2005 we will
experience flat to limited expansion in sales of our new bedding lines in the
pet specialty channel. The main contributor to our not meeting expectations
will be the sales in our shavings line of products. Where the shavings product
is on the shelf it is selling well; however, we have not achieved the level of
placement that we had previously forecast, because our expectation that
customers would replace competitive product lines with our brand for the ease
of vendor consolidation has not proven to be accurate. We still expect
increased sales of bedding lines introduced recently in the mass merchandise
and grocery channels. We will continue to look for opportunities to diversify
our small animal product lines. Sales of our industrial line of products are
expected to remain flat due to the anticipated maintenance of our existing
strategy. The hydro-mulch portion of industrial sales will be significantly
below our expectations, as a result of lower municipal spending in the
northwest region of the country. Because neither shavings nor hydro-mulch will
meet our annual sales expectations we are revising our annual net revenue
growth rate for fiscal year 2005 from 15% to 20% down to 10% to 13%. Gross Profit By focusing on the operations portion of our business plan we have
significantly improved our year to date gross margin (gross profit divided by
sales). Three areas of focus are the primary factors for this improvement.
First, by moving into our new Ferndale facility we eliminated approximately
$450,000 in annual lease payments. Second, we have successfully encouraged
customers to purchase products in package sizes that utilize more
labor-efficient methods and are more cost-effective to ship. Third, we have
continued to increase production rates while reducing some of the associated
fixed costs. The result is that our gross margin increased from 39% in the
first nine months of fiscal year 2004 to 41% in the first nine months of fiscal
year 2005, while gross profit increased from $5,783,000 for the first nine
months of fiscal year 2004 to $6,923,000 for the first nine months of fiscal
year 2005. A significant factor that reduced our potential improvement in
gross profits during the third quarter of fiscal 2005 was the increased cost of
our raw material, waste wood fiber. Over the past year our production rate has
grown to the point that we use 100% of the fiber from our main suppliers. As a
result, when our suppliers have a maintenance shutdown, either scheduled or
not, we have to supplement our fiber supplies with more expensive raw
materials. To mitigate this issue, we are actively pursuing new raw material
sources. When our new production facility in Jesup, Georgia comes on line
during the fourth quarter of the current fiscal year, we anticipate that the
availability of this raw material will not restrict future growth. We also
continued to experience general cost increases in the areas of materials,
labor, utilities, maintenance and, more recently, transportation, due to higher
fuel costs. However, we believe that our ability to improve our gross margin
during the third quarter of fiscal year 2005 while experiencing higher costs is
an indicator of the success of our facilities expansion and improvement
program. We expect that our gross profit percentage will decrease slightly during the
final quarter of fiscal year 2005 for a number of reasons. First, recent
petroleum and natural gas price increases will continue to add to our
manufacturing expenses by increasing material, transportation and utility
costs. Second, we expect to incur higher raw material costs for the next three
months while we supplement our feed stock with more expensive materials.
Third, we expect to incur costs to bring our new Jesup, Georgia facility up to
an efficient level of production. These costs are currently estimated to be as
much as $500,000, the majority of which will occur in the fourth quarter of
fiscal year 2005. Because this facility will not be in full production until
near the end of fiscal year 2005, these commissioning costs are not projected
to be offset by freight savings this year. Fourth, as stated in the revenues
section above, we are projecting limited increases in the sale of our non-core
products, including small animal diets, alternative beddings and hydro-mulch.
As such, even though these products will contribute positively to gross
profits, they will reduce the gross margin as they are generally lower margin
products. Moreover, because some of these products are relatively new to their
markets, we cannot predict how much sales growth they will experience. In
response to these cost increases, we have been implementing a small price
increase during the second half of the year. However, we believe that the 12




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maturity of the market for our core product will limit our ability to
increase prices to fully mitigate these costs increases. Sales and Marketing During the first nine months of fiscal year 2005 we continued to invest in
marketing activities to support the diversification aspect of our business
plan. We have also grown to the point that our competition has taken notice of
us and our products. As such, we have had to invest in marketing programs
focused on protecting the growing market share of our core product. These two
areas of marketing investment have resulted in an overall increase in marketing
expenses in the first nine months of fiscal year 2005 as compared to the same
nine month period of the previous year. Our marketing and sales expenses
increased from $2,192,000 in the first nine months of fiscal year 2004 to
$2,557,000 in the first nine months of fiscal year 2005. Comparing the third
quarter of fiscal years 2004 to 2005, our sales and marketing expenses
decreased from $810,000 to $808,000. During the balance of the year, we will continue our marketing initiatives. We
also intend to expand our sales staff to provide more regional exposure at the
retail store level, which we believe will increase both retail placement of new
products and sales velocity for all pet products. As such, our sales and
marketing costs will increase as we invest in our future. General and Administrative Our general and administrative expenses have decreased slightly during the
first nine months of fiscal year 2005 as compared to the first nine months of
fiscal year 2004. Even though we have had an increase in costs related to
additional requirements recently imposed on public companies, we have been able
to control the balance of our general and administrative costs. These expenses
were $1,688,000 in the first nine months of fiscal year 2004 and $1,651,000 in
the first nine months of fiscal year 2005. They decreased from $552,000 in the
third quarter of fiscal year 2004 to $511,000 in the third quarter of fiscal
year 2005. These general and administrative expenses (net of depreciation) are anticipated
to remain relatively flat during the remainder of fiscal year 2005. We
anticipate that any additional savings we might generate will be offset by
additional overhead resulting from the Jesup, GA facility. Also attempts to
reduce general and administrative expenses will likely be mitigated by rising
costs of being a publicly held company. Interest Expense We started expensing the interest on our bonds in Whatcom County, WA during the
third quarter of fiscal year 2004. Fiscal year 2005 will be our first full
year of interest expense on our Washington facility. Interest expense will be
incurred on the debt for the Jesup, GA facility when that facility becomes
operational. This is scheduled to occur sometime during the fourth quarter of
the current fiscal year. Income Taxes Since fiscal year 1999, Absorption has been profitable for income tax purposes
and has been able to offset the payment of income taxes in the United States
with the accumulated losses from previous years. Absorption has, for its U.S.
operations, fully utilized as of the second quarter of fiscal 2004 all of its
U.S. tax net operating losses. Over the next quarter, this provision is
expected to continue to be partially deferred due to accelerated tax deductions
related to our investment in new production facilities. The Company has
recorded a valuation allowance for the parent companys Canadian income tax
losses. Net Income We believe that our strong results for the first nine months of fiscal year
2005 will help us absorb the significant start up costs which will result from
the Jesup, Georgia production facility later this year. We estimate that our
net income for fiscal year 2005 will be within the trend of net income
increases over the past several years. We currently believe that our net
income will increase for the fiscal year ending January 31, 2005 as compared to
the fiscal year ended January 31, 2004. The amount of increase will be affected by the cost of commissioning our new production facility in Jesup, GA.
We are continuing to pursue new 13




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##### 



sales and marketing initiatives with the objective to increase both sales and
net income during fiscal year 2005. Over the past year we have been putting into place components of
our business plan. These include investments in capital infrastructure, sales
and marketing programs, and cost management controls. We believe that the
results for the first nine months of fiscal year 2005 show the effects of
having successfully completed the implementation of these components of our
business plan. We feel that the increase in net income from $1,203,000 during
the first nine months of fiscal year 2004 to $1,785,000 in the first nine
months of fiscal year 2005 was the result of our employees being able to
successfully execute on the plan. Net income also increased for the third
quarter from $547,000 in fiscal year 2004 to $736,000 in fiscal year 2005.
Implementation of the key components of our business plan has resulted in the
continued increases in net revenues, improvements in gross profits and
continued controls over overhead expenses. These steps have allowed us to
continue to invest in sales and marketing activities and capital
infrastructure, which we anticipate will strengthen the Company in the future. LIQUIDITY AND CAPITAL RESOURCES We are currently in the middle of the second phase of our three-phase capital
expansion plan. This three-phase plan includes: the building of the new
manufacturing and warehousing facility in Ferndale, Washington, which is now
complete; the building of a new production facility in Jesup, Georgia,
construction of which has now been completed and is now being commissioned; and
the move of the Bellingham, Washington manufacturing facility to the Ferndale
location, which we currently project to be completed in approximately nine
months. The intent of this capital expansion plan is first, to protect our
core business by reducing our production costs and decreasing the cost of
shipping product to our customers, and second, to give us the ability to
manufacture, warehouse and distribute a wider diversity of products. The table below illustrates the effects this capital expansion plan has had on
our financial statements (dollars in thousands of U.S. dollars): As ofOctober 31,
    
    As ofJanuary 31,2004
    
    2004Financial ConditionTotal Assets
    
    $
    22,948
    
    
    $
    15,943Total Liabilities
    
    
    10,002
    
    
    
    5,440Total Equity
    
    $
    12,946
    
    
    $
    10,503Debt/equity ratio
    
    
    0.77
    
    
    
    0.52Assets/debt ratio
    
    
    2.29
    
    
    
    2.93Working CapitalCurrent assets
    
    $
    7,489
    
    
    $
    5,406Current liabilities
    
    $
    1,920
    
    
    $
    2,122Current ratio
    
    
    3.90
    
    
    
    2.55Cash PositionCash, restricted cash & short term investments
    
    $
    3,809
    
    
    $
    2,096Cash generated from operations
    
    $
    2,367
    
    
    $
    1,769
    *
   *
    
    for the entire fiscal year ended January 31, 2004 Financial Condition During the first nine months of fiscal year 2005, our assets continued to
increase as we built capital infrastructure, a portion of which was paid for
through long-term debt and a portion through cash, and as we 14




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##### 



continued to generate cash from operations. Our total assets increased from
$15,943,000 at January 31, 2004 to $22,948,000 at October 31, 2004. We also
had an increase in total liabilities from $5,440,000 at January 31, 2004 to
$10,002,000 at October 31, 2004 as we increased our outstanding long-term debt
to finance a portion of the new Jesup, Georgia facility by issuing industrial
revenue bonds. On September 2, 2004, the Company, through Absorption, entered into a Letter of
Credit and Reimbursement Agreement with Branch Banking & Trust Co. (BB&T),
pursuant to which the Company requested that (a) the Wayne County Industrial
Development Authority (Wayne County IDA) issue $4,900,000 aggregate principal
amount of Wayne Countys tax exempt bond pursuant to an indenture by and
between BB&T, as trustee, and Wayne County and (b) BB&T issue to Absorption an
irrevocable letter of credit naming the trustee as beneficiary in the amount of
$4,900,000. Of the total proceeds from the financing, $2,099,000 were used to
pay off the Companys current indebtedness to BB&T, $98,000 was paid for costs
of issuance and the remaining proceeds of $2,703,000 were placed in a trust
account to be used to finish the construction of the Companys new production
facility located in Jesup, Georgia. For the issued bond to receive tax exempt
status, Wayne County IDA purchased Absorptions real property in Jesup, Georgia
from Absorption, and is leasing the real property back to Absorption at a lease
rate equal to the bond payments, with the lease payments payable directly to
BB&T. Upon repayment of the bond in full, Wayne County IDA will transfer all
right, title and interest in the real property and related production facility
to Absorption for no additional consideration. While the bonds remain
outstanding, as security for the indebtedness underlying the letter of credit,
BB&T will hold a mortgage on the real property and a security interest in the
equipment assets located on that property. The bond has a variable rate equal
to BB&Ts Variable Rate Demand Bond VRDB rate
(1.7% as of December 8,
2004), and Absorption is also required to pay an annual letter of credit fee
equal to .95% of the initial amount of the letter of credit, an annual
remarketing fee equal to .125% of the initial amount of the letter of credit
and a $2,000 annual trustee fee. The term of the bond is 15 years, maturing on
September 1, 2019, and the term of the letter of credit is seven year, maturing
on September 2, 2011. The equipment portion of the bond is amortized over
seven years and the real estate portion is amortized over 15 years. In
addition, amounts owing under the letter of credit may be accelerated upon an
event of default, including Absorptions failure to pay any amount when due or
failure to perform any of its obligations or breach of any of its
representations or covenants under the Agreement. In connection with this
financing, the Company has agreed to unconditionally guarantee all of
Absorptions indebtedness to BB&T. On October 31, 2004, there were no remaining purchase obligations relating to
outstanding contracts for building the new facility in Jesup, Georgia. Working Capital We believe that our existing cash on hand, long-term debt and available line of
credit currently provides us with enough cash to meet our existing needs for
the foreseeable future. Our balance of cash and cash equivalents, restricted
cash and short term investments increased between January 31, 2004 and October
31, 2004 from $2,096,000 to $3,809,000. Current liabilities, mostly in the
area of construction related obligations, decreased between January 31, 2004
and October 31, 2004, while current assets increased during the same period.
This resulted in our current ratio increasing during the first nine months of
fiscal year 2005 as compared to the first nine months of fiscal year 2004. Our
current ratio is expected to remain relatively flat during the balance of
fiscal year 2005. Cash Position Cash, restricted cash, and short-term investments increased during the first
nine months of fiscal year 2005 from $2,096,000 at January 31, 2004 to
$3,809,000 at October 31, 2004 primarily as a result of cash generated from
operations and restricted cash from the issuance of our Georgia Industrial
Revenue bonds. We expect to continue to use cash in expanding our production
infrastructure, mainly in Jesup, Georgia, during fiscal year 2005. Because
cash generated from operations is expected to be greater than the amount of
cash we will need to complete our capital expansion and commissioning, we
expect to maintain our strong cash position over the balance of the current
fiscal year. We will continue to closely monitor both current liabilities and
current assets as they relate to the generation of cash with an emphasis on
maximizing potential sources of cash. 15




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##### 



Cash Generated from Operations We continued to generate cash from operations during the first nine months of
fiscal year 2005. Our generation of cash was primarily the result of increased
sales, improved gross profit margins and continued cost control. We were able
to continue to limit the growth of our inventories, but due to increases in
accounts receivable (a result of strong sales in the final month of the
quarter) our growth in cash from operations was limited. If our sales continue
to increase and we are able to continue to profitably produce our product, we
should be able to continue to generate cash from operating activities, although
it cannot be assured that this will be the case. Financing and Investing Activities Cash from financing activities during the first nine months of fiscal year 2005
was $5,138,000. The Company borrowed $4,639,000 (net) from BB&T and paid
principal of $91,000 to GE Capital. Proceeds from the BB&T loan were used to
pay for a portion of the construction in Jesup, Georgia. The balance of cash
received of $590,000 was from the issuance of shares as a result of the
exercise of stock options and warrants. A significant amount of cash was used
in the first nine months of fiscal year 2005 for investing activities that were
a result of our capital expansion plan. Cash used in investing activities for
the nine months just completed totaled $6,871,000. The majority of the cash
was used to purchase property, plant and equipment for our new production
facility located in Jesup, Georgia. During the fiscal year ended January 31, 2004, the Company renewed its
short-term bank line of credit for up to $1,500,000, which is secured by the
accounts receivable and inventory of Absorption. Interest is payable on funds
advanced at the U.S. rate of prime plus 0.75%. The line of credit matures in
January 2005. The funds available for advance to the Company by the lender is
limited to 75% of Absorptions eligible accounts receivable and 40% of
Absorptions eligible inventory. To date the Company has not drawn any funds
from the line of credit. During the balance of fiscal year 2005, we plan to continue the implementation
of the second phase of our three-phase production expansion plan. We
anticipate that the funding necessary to complete this portion of the plan will
come from cash on hand, cash generated from operations and cash generated from
the issuance of an Industrial Revenue Bond (secured by a Letter of Credit
issued by BB&T) as described under Financial Condition in this management
discussion and analysis. The first phase of our production expansion plan was substantially completed
during the third quarter of fiscal year 2004. This was the construction of our
new west coast facility located in Whatcom County, Washington. We had been
operating in five separate leased facilities in Whatcom County. This new
facility, which was financed approximately half through debt and half through
cash, has consolidated four of these leased facilities, resulting in what we
anticipate to be an annual saving in cost of goods sold and general and
administrative expenses of approximately $450,000 in lease payments. The
consolidation of these facilities has also provided us with savings in other
expenses caused by inefficient logistics. We expect that interest on the debt
for the balance of fiscal year 2005 will be approximately $110,000. Phase two of our production expansion plan is a second production facility
located in Jesup, Georgia. We purchased approximately fifteen acres of real
property in Jesup, Georgia, with an existing 41,000 square foot facility,
during August 2003 for $140,000. We began construction during the fourth
quarter of fiscal year 2004 on this property. The total project cost is
estimated at $6,650,000. Of the total cost, approximately $4,900,000 is being
financed through a long-term bank debt instrument and we anticipate that the
balance will be financed with cash on hand. The annual interest expense of the
debt used to finance this facility is estimated to be approximately $115,000 a
year when the project is completed. By having production on the east coast, we
will expect to have cost savings in excess of additional overhead expenses and
interest on the debt facilities. In addition, we believe that we will better
be able to service our east coast customers and will have added long-term
production security as a result of this diversification of manufacturing
plants. The third phase of our production expansion plan will occur in approximately
nine months when we plan to move the Bellingham, Washington production facility
to the new Whatcom County plant. The final decision on whether to undertake
this move will depend upon the then-current conditions. 16




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##### 



We believe that this three-phase plan will give us the ability to achieve
significant cost savings, better serve our customers, expand our production
lines, diversify our production capacity and physically move manufacturing in a
manner which is transparent to the users of our products. Environmental Matters We are committed to being an environmentally friendly company and to
manufacturing products which benefit the quality of the environment. Hazardous
wastes are not produced, treated, or stored at any company-owned or operated
facilities. State, federal, and local laws all have jurisdiction over
production activities. We believe we are currently in compliance with these
laws and expect to remain so for the foreseeable future. Critical Accounting Policies Introduction In preparing our financial statements in conformity with accounting principles
generally accepted in the United States, judgments and estimates are made that
affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
reported amounts of revenues and expenses during the reporting period. We
believe that the material estimates that are particularly susceptible to
significant change relate to the determination of the allowance for doubtful
accounts and finance charges, deferred income taxes valuation allowance and
sales incentives. As part of the financial reporting process, our management
collaborates to determine the necessary information on which to base judgment
and develop estimates used to prepare the financial statements. Historical
experience and available information is used to make these judgments and
estimates. However, different amounts could be reported using different
assumptions and in light of different facts and circumstances. Therefore,
actual amounts could differ from the estimates reflected in the financial
statements. In addition to the significant accounting policies described in Note 2 of the
Consolidated Financial Statements of the January 31, 2004 10-KSB, the Company
believes that the following discussion addresses its critical accounting
policies. Inventory Finished goods inventory are valued at the lower of cost (determined on the
first-in, first-out basis) or net realizable value. Cost includes direct
materials, labor and overhead allocation. Raw materials and supplies are valued
at the lower of cost (determined on the first-in, first-out basis) or net
realizable value. Accounts Receivable and Allowance for Doubtful Accounts We typically offer credit terms to our customers without collateral. Finance
charges of 1.5% are assessed when a customer receivable balance becomes 30 days
past due. We record accounts receivable at the face amount less an allowance
for doubtful accounts and an allowance for finance charges. On a regular
basis, we evaluate our accounts receivable and establish these allowances based
on a combination of specific customer circumstances, as well as credit
conditions and the history of write-offs and collections. Where appropriate,
we obtain credit rating reports and financial statements of the customer to
initiate and modify their credit limits. We obtain credit insurance for
certain accounts that qualify for coverage in order to minimize credit risk
exposure. If circumstances related to specific customers change, our estimates
of the recoverability of receivables could materially change. At October 31,
2004 and January 31, 2004, management considered accounts receivable in excess
of the allowances for doubtful accounts and finance charges to be fully
collectible. Property, plant and equipment Property, plant and equipment assets are recorded at cost. The Companys
building and equipment are located on owned and leased land. Buildings are
depreciated on a straight line basis over a period of 40 years. Leasehold
improvements are depreciated on a straight line basis over the life of the
lease agreement for 17




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##### 



property located on leased land. Most of the Companys equipment is
depreciated over its estimated useful life using a 15% declining balance
method, the remainder is depreciated using a straight line method over 5 years. Revenue recognition Revenue from the sale of products is recognized at the time title passes to the
purchaser, which is generally when the goods are conveyed to a carrier.
Promotional allowances are recorded as a reduction of sales, the recognition of
which is determined in accordance with the provisions of EITF 01-9 Accounting
for Consideration Given by a Vendor to a Customer. Income taxes We account for income taxes on the liability method. The liability method
recognizes the amount of tax payable at the date of the financial statements as
a result of all events that have been recognized in the financial statements,
as measured by the provisions of currently enacted tax laws and rates. The
accumulated tax effect of all temporary differences is presented as deferred
federal income tax assets and liabilities within the balance sheet. Impairment of long lived assets We review the carrying amount of long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount may not be
recoverable. The determination of any impairment would include a comparison of
estimated future operating cash flows anticipated to be generated during the
remaining life with the net carrying value of the asset. RISK FACTORS The following risk factors and other information included in this Quarterly
Report should be carefully considered. The risks and uncertainties described
below are not the only ones we face. Additional risks and uncertainties not
presently known to us or that we currently deem immaterial also may impair our
business operations. If any of the following risks occur, our business,
financial condition, operating results and cash flows could be materially
adversely affected. We are still building our market presence and are subject to substantial
competition that could inhibit our ability to succeed as planned. We are one of many companies that compete in the animal care market. We
are still attempting to build and maintain our market presence as we compete
with both domestic and foreign companies. Any reputation that we may
successfully gain with retailers for quality product does not necessarily
translate into name recognition or increased market share with the end
consumer. Our products may not be well received by the pet owners, or other
companies may surpass us in product innovations. We may be adversely affected by trends in the retail industry. With the growing trend towards retail trade consolidation, we are increasingly
dependent upon key retailers whose bargaining strength is growing. Our
business may be negatively affected by changes in the policies of our retailer
customers, such as inventory delisting, limitations on access to shelf space,
price demands and other conditions. In addition, as a result of the desire of
retailers to more closely manage inventory levels, there is a growing trend
among retailers to make purchases on a just-in-time basis. This requires us
to shorten our lead time for production in certain cases and more closely
anticipate demand, which could in the future require the carrying of additional
inventories and increase our working capital and related financing requirement. A significant deterioration in the financial condition of one of our major
customers could have a material adverse effect on our sales, profitability and
cash flow. We continually monitor and evaluate the credit status 18




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of our customers and attempt to adjust sales terms as appropriate. Despite
these efforts, a bankruptcy filing by a key customer could have a material
adverse effect on our business, results of operations and financial condition. We depend on a few customers for a significant portion of our business. Our largest customer accounted for approximately 24% and 18% of our net sales
in the first nine months of fiscal year 2005 and 2004, respectively, while our
second largest customer accounted for approximately 19% and 21% of our net
sales in the first nine months of fiscal year 2005 and 2004, respectively. The loss of, or significant adverse change in, our relationship with any of
these key retailers could cause our net sales, income from operations and cash
flow to decrease substantially. The loss of, or reduction in, orders from any
significant customer, losses arising from customer disputes regarding
shipments, fees, merchandise condition or related matters, or our inability to
collect accounts receivable from any major customer could reduce our income
from operations and cash flow. Competition in our industries may hinder our ability to execute our business
strategy, achieve profitability, or maintain relationships with existing
customers. We operate in highly competitive industries. We compete against numerous other
companies, some of which are more established in their industries and have
substantially greater revenue or resources than we do. Our products compete
against national and regional products and private label products produced by
various suppliers. To compete effectively, among other things, we must:  
    
    maintain our relationships with key retailers;
    
    continually develop innovative new products that appeal to consumers;
    
    maintain strict quality standards; and
    
    deliver products on a reliable basis at competitive prices. Competition could cause lower sales volumes, price reductions, reduced profits
or losses, or loss of market share. Our inability to compete effectively could
have a material adverse effect on our business, results of operations and
financial condition. Any increase in the costs, or decreases in the supply, of the raw materials
necessary for our business could have an adverse effect on our financial
condition. Our business places heavy reliance on raw materials being readily available.
Although we believe that there are a number of pulp and paper mills in British
Columbia, Canada and in the State of Washington that can provide us with the
raw materials necessary to conduct our business, any significant decreases in
supplies, or any increase in costs or a greater increase in delivery costs for
these materials, could result in a further decrease in our margins, which would
harm our financial condition. For example, in the second quarter of fiscal year
2005, we experienced a decreased availability of our main raw material, waste
wood fiber, which resulted in downward pressure on our gross profits for the
period. We currently do not have contracts for all of our needed primary raw
material, waste wood pulp, to be supplied to our Jesup, GA facility. Although
we believe we will be able to obtain the required material in the region, any
significant shortfall of material would result in a significant increase in the
cost of producing our primary products. We have significant indebtedness. As of October 31, 2004, we had total long-term and current indebtedness under
our bonds, capitalized-lease obligations and other asset financings of
$7,624,000. We make interest payments (and principal payments on the taxable
bond) on the indebtedness under our bonds, which are due in 2007 and 2019. In
addition, in September 2004, we completed a $4,900,000 tax-exempt bond
financing. We may incur substantial additional debt in the future. Our
indebtedness could limit our ability to obtain necessary additional financing
for working capital, capital expenditures, debt service requirements or other
purposes in the future; plan for, or react to, changes in technology and in our
business and competition; and react in the event of an economic downturn.
There is no guarantee that we will be able to meet our debt service
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generate sufficient cash flow or obtain funds for required payments, or if we
fail to comply with covenants in our indebtedness, we will be in default. The
indebtedness underlying our bonds is secured by a mortgage on our real property
and a security interest in our assets. If we are in default under the
agreements governing our indebtedness, the creditors may be able to foreclose
on our property and assets, which would substantially harm our business and
financial condition. If we fail to maintain an effective system of internal and disclosure controls,
we may not be able to accurately report our financial results or prevent fraud.
As a result, current and potential shareholders could lose confidence in our
financial reporting, which would harm our business and the trading price of our
securities. Effective internal and disclosure controls help us to provide reliable
financial reports and effectively prevent fraud and to operate successfully as
a public company. If we cannot provide reliable financial reports or prevent
fraud, our reputation and operating results would be harmed. We have in the
past discovered, and may in the future discover, deficiencies in our internal
controls as defined under interim standards adopted by the Public Company
Accounting Oversight Board (PCAOB) that require remediation. Furthermore, our
independent auditor has, in the past, advised us that it had noted certain
deficiencies in our internal financial reporting and accounting controls and we
have also noted deficiencies. Additionally, it is possible that as we continue
our ongoing review and analysis of internal controls over financial reporting
for Sarbanes-Oxley compliance, additional weaknesses in internal controls may
be discovered. The ownership of real property and the building of our own manufacturing
facilities expose us to certain risks that could harm our business. We are currently in the process of building a manufacturing facility on real
property in Wayne County, Georgia. Although we believe that we have sufficient
funds to finance this build-out, we may exceed our capital expenditure budget
substantially as a result of project delays, construction cost overruns and
other factors, and we may be required to seek additional sources of funds for
our planned expansion. We cannot assure you that such funds will be available
on satisfactory terms. Failure to obtain such financing could delay or prevent
our planned expansion, which could harm our operating results. In addition, we
cannot assure you that there will not be a decline in the market value of our
properties, which could also have an adverse effect on our financial condition.
Moreover, ownership of real property could expose us to additional
environmental regulations, the noncompliance with which could substantially
harm our business. Our business is subject to many regulations and noncompliance is costly. The manufacture, marketing and sale of our products are subject to the rules
and regulations of various federal, provincial, and state agencies, including,
without limitation, the air emission standards enforced by the Northwest Air
Pollution Authority and regulations promulgated by the U.S. Department of
Agriculture and state departments of agricultures. If a regulatory authority
finds that a current or future product or production run is not in compliance
with any of these regulations, we may be fined, production may be stopped or
our product may be pulled from the shelves, any of which could adversely affect
our financial conditions and operations. Similarly, any adverse publicity
associated with any noncompliance may damage our reputation and our ability to
successfully market our products. Furthermore, the rules and regulations are
subject to change from time to time and while we closely monitor developments
in this area, we have no way of anticipating whether changes in these rules and
regulations will impact our business adversely. Additional or revised
regulatory requirements, whether labeling, environmental, tax or otherwise,
could have a material adverse effect on our financial condition and results of
operations. If we need to raise additional capital for our operating plan, our business
would be harmed if we were unable to do so on acceptable terms. We currently anticipate that our existing capital resources and cash flows from
operations will enable us to maintain our currently planned operations for the
foreseeable future. However, our current operating plan may change as a result
of many factors, including general economic conditions affecting the U.S.
economy which are beyond our control. If we are unable to generate and
maintain positive operating cash flows and operating income in the future, we
may need additional funding. We may also choose to raise additional capital
due to market conditions or strategic considerations even if we believe that we
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for our current or future operating plans. If additional capital were needed,
our inability to raise capital on favorable terms would harm our business and
financial condition. To the extent that we raise additional capital through
the sale of equity or debt securities convertible into equity, the issuance of
these securities could result in dilution to our stockholders. The indentures governing our bonds and bank debt financing includes financial
covenants that restrict certain of our activities and impose certain financial
tests that we must meet in order to be in compliance with their terms. The terms of the indentures governing our bonds and bank debt financing
restrict our ability to, among other things, incur additional indebtedness, pay
dividends or make other restricted payments on investments, consummate asset
sales or similar transactions, create liens, or merge or consolidate with any
other person or sell, assign, transfer, lease, convey or otherwise dispose of
all or substantially all of our assets. The terms also contain covenants that
require us to meet financial tests. We currently are in compliance with these
restrictions and covenants and expect that we will continue to comply. If we
were not able to do so, we could be materially and adversely affected. The loss of key senior management personnel could negatively affect our
business. We depend on the continued services and performance of our senior management
and other key personnel. We do not have key person life insurance policies.
The loss of any of our executive officers or other key employees could harm our
business. We cannot be certain that our product innovations and marketing successes will
continue. We believe that, to an extent, our past performance has been based upon, and
our future success will partially depend upon, our ability to continue to
improve our existing products through product innovation and to develop, market
and produce new products. We cannot assure you that we will be successful in
the introduction, marketing and production of any new products or product
innovations, or develop and introduce in a timely manner innovations to our
existing products which satisfy customer needs or achieve market acceptance.
Our failure to develop new products and introduce them successfully and in a
timely manner could harm our ability to grow our business and could have a
material adverse effect on our business, results of operations and financial
condition. The inability to successfully obtain or protect our patents could harm our
competitive advantage. Our success will depend, in part, on our ability to maintain protection for our
products under U.S. patent laws, to preserve our trade secrets and to operate
without infringing the proprietary rights of third parties. We have three U.S.
patents issued (and corresponding Canadian patents and patent applications) and
one U.S. patent application pending. Patent applications may not successfully
result in an issued patent. Issued patents are still subject to challenges and
infringements. Furthermore, others may independently develop similar products
or otherwise circumvent our patent protection. Should we fail to obtain and
protect our patents, our competitive advantage will be harmed. The products that we manufacture could expose us to product liability claims. Our business exposes us to potential product liability risks that are inherent
in the manufacture and distribution of certain of our products. Although we
generally seek to insure against such risks, there can be no assurance that
such coverage is adequate or that we will be able to maintain such insurance on
acceptable terms. A successful product liability claim in excess of our
insurance coverage could have a material adverse effect on us and could prevent
us from obtaining adequate product liability insurance in the future on
commercially reasonable terms. The price for our common shares may continue to be volatile. The market price of our securities, like that of many other emerging companies,
has been highly volatile, experiencing wide fluctuations not necessarily
related to the operating performance of such companies. Factors such as our
operating results, announcements by us or our competitors concerning
innovations and 21




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new products or systems may have a significant impact on the market price of
our securities. In addition, we have experienced limited trading volume in our
common shares. The liquidity of our stock depends in part on our continued listing with the
American Stock Exchange. In March 2003, we received official notice from the American Stock Exchange
(AMEX) that our securities had been approved for listing. In order to
continue to have our common shares listed, we must remain in compliance with
the AMEX listing standards, including standards related to stock price, market
capitalization and corporate governance. If we are unable to do so, AMEX could
delist our stock, in which event the liquidity and the value of our shares
could be adversely impacted. FORWARD-LOOKING STATEMENTS This report contains forward-looking statements. They can be identified by the
use of forward-looking words such as believes, expects, plans, may,
will, would, could, should or anticipates or other comparable words,
or by discussions of strategy, plans or goals that involve risks and
uncertainties that could cause actual results to differ materially from those
currently anticipated. You are cautioned that any forward-looking statements
are not guarantees of future performance and involve risks and uncertainties,
including those set forth above under Risk Factors and as described from
time to time in our reports filed with the Securities and Exchange Commission,
including this Quarterly Report on Form 10-QSB and our Annual Report on Form
10-KSB. Forward-looking statements include, but are not limited to, statements
referring to our future growth strategies, prospects for the future, potential
financial results, market and product line growth, abilities to enter new
markets, ability to introduce new products, benefits from infrastructure
improvements and our competitiveness and profitability as a result of new sales
and marketing programs. ITEM 3.     CONTROLS AND PROCEDURES As of the end of the period covered by this report, we performed an evaluation
under the supervision and with the participation of our management, including
the Chief Executive Officer and Chief Financial Officer, of the effectiveness
of our disclosure controls and procedures. Based upon that evaluation, our
management, including the Chief Executive Officer and Chief Financial Officer,
concluded that our disclosure controls and procedures were effective as of the
end of the period covered by this report. Except as discussed below, there has been no change in our internal control
over financial reporting during the third quarter of fiscal year 2005 that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting. During the evaluation of our internal control over financial reporting during
the third quarter of fiscal year 2005, we identified certain internal control
deficiencies. These deficiencies relate to specific functions and procedures
that are not processed by our current financial accounting software and instead
require manual input and/or oversight. We intend to address these issues by
implementing a new financial accounting software system during the third
quarter of fiscal year 2006, which will provide enhanced functionality. In the
interim, we intend to establish an additional level of management review over
these specific procedures. In addition, we also discovered deficiencies
related to our analysis of new accounting pronouncements and preparation of our
tax provision. In order to address these issues, we intend to engage an
independent third party to review new accounting pronouncements and analyze
their impact on us and also to prepare our tax provision. We are committed to strengthening our internal controls over financial
reporting and are currently documenting and testing our internal controls and
considering whether any improvements are necessary for maintaining an effective
control environment at our company. The evaluation of our internal controls is
being conducted under the direction of our senior management in consultation
with independent third party consulting firms. In addition, our management is
regularly discussing the results of our testing and any proposed improvements
to our control environment with our audit committee. We expect to assess our 22




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controls and procedures on a regular basis and we may identify additional
deficiencies in our system of internal controls that either individually or in
the aggregate may represent a material weakness requiring additional
remediation efforts. We will continue to work to improve our controls and
procedures, and to educate and train our employees on our existing controls and
procedures in connection with our efforts to maintain an effective controls
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PART II  OTHER INFORMATION ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USES OF PROCEEDS On September 30, 2004, Wall Street Consultants, Inc., one of the Companys
former consultants, exercised an option to purchase 97,833 Common Shares,
at an average exercise price of $2.04 per Common Share for a total purchase
price of $199,124. The Common Shares issued upon exercise of the option
represent 1.6% the Companys outstanding securities. This issuance was a
private placement to a single investor and was exempt from registration
pursuant to Section 4(2) of the Securities Act. The number of
outstanding options to individuals who are not employees or directors
is 11,000 as of October 31, 2004. ITEM 6.     EXHIBITS ExhibitNumber
    
    Exhibit Description3.1
    
    Altered Memorandum of Company (Amended) (incorporated by reference to
Exhibit 3.1 to the Companys Form 10-KSB filed on April 3, 2003).3.2
    
    Articles of the Company (incorporated by reference to the exhibits to the
Companys registration statement filed on February 24, 1992, as amended
(No. 33-45020)).10.14
    
    Wayne County Industrial Development Authority Tax-Exempt Industrial
Development Revenue Bonds (Absorption Corp. Project), Series 2004 dated
September 2, 2004 (incorporated by reference to
Exhibit 10.14 to the
Companys Form 10-QSB filed on September 9, 2004).10.15
    
    Letter of Credit and Reimbursement Agreement between Absorption Corp.
and Branch Banking and Trust Company dated September 1, 2004
(incorporated by reference to Exhibit 10.15 to the
Companys Form 10-QSB filed on September 9, 2004).10.16
    
    BB&T Security Agreement dated September 1, 2004 between Absorption Corp.
and Branch Banking and Trust Company (incorporated by reference to
Exhibit 10.16 to the
Companys Form 10-QSB filed on September 9, 2004).10.17
    
    BB&T Guaranty Agreement between Branch Banking and Trust Company and
International Absorbents Inc. dated September 1, 2004
(incorporated by reference to Exhibit 10.17 to the
Companys Form 10-QSB filed on September 9, 2004).10.18
    
    Lease Agreement dated September 1, 2004 by and between Wayne County
Industrial Development Authority and Absorption Corp. (incorporated by
reference to Exhibit 10.18 to the
Companys Form 10-QSB filed on September 9, 2004).31.1
    
    Certification of Gordon Ellis, President and Chief Executive Officer of
International Absorbents Inc., pursuant to Rule 13a-14(a) under the
Securities Exchange Act of 1934.31.2
    
    Certification of David Thompson, Chief Financial Officer of International
Absorbents Inc., pursuant to Rule 13a-14(a) under the Securities Exchange
Act of 1934.32.1
    
    Certification of Gordon Ellis, President and Chief Executive Officer of
International Absorbents Inc., pursuant to 18 U.S.C. Section 1350.32.2
    
    Certification of David Thompson, Chief Financial Officer of International
Absorbents Inc., pursuant to 18 U.S.C. Section 1350.
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SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized. INTERNATIONAL ABSORBENTS INC.
(Registrant)Date: December 8, 2004
    
    /s/ GORDON L. ELLISGordon L. EllisPresident & CEO(Principal Executive Officer) 25