##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended April 30, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO 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.  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) Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of
the Exchange Act). Yes o No þ State the number of shares outstanding of each of the issuers classes of common stock, as of the
latest practicable date. Title of Class
Common Shares, no par value
    
    No. of Shares as of June 3, 2005
6,256,888




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##### 



TABLE OF CONTENTS  ITEM 1     FINANCIAL STATEMENTSCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSRISK FACTORSFORWARD-LOOKING STATEMENTSITEM 4.     CONTROLS AND PROCEDURESITEM 5.     OTHER INFORMATIONPART II  OTHER INFORMATIONITEM 6.     EXHIBITSSIGNATURESExhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2 
 ITEM 1     FINANCIAL STATEMENTS 
 INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(US dollars, in thousands) As at
    
    
    As atApril 30,
    
    
    January 31,2005
    
    
    2005(unaudited)
    
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    2,583
    
    
    $
    3,520Restricted cash
    
    
    439
    
    
    
    437Short term investments
    
    
    219
    
    
    
    218Accounts receivable, net
    
    
    1,955
    
    
    
    1,523Inventories
    
    
    2,063
    
    
    
    1,408Prepaid expenses
    
    
    238
    
    
    
    161Income tax receivable
    
    
    
    
    
    
    28Deferred income tax asset
    
    
    40
    
    
    
    40Total current assets
    
    
    7,537
    
    
    
    7,335Property, plant and equipment, net
    
    
    15,942
    
    
    
    15,846Intangible assets, net
    
    
    4
    
    
    
    8Other assets, net
    
    
    281
    
    
    
    288Total assets
    
    $
    23,764
    
    
    $
    23,477Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    1,966
    
    
    $
    1,861Related party payable
    
    
    6
    
    
    
    5Income tax payable
    
    
    20
    
    
    
    Current portion of long-term debt
    
    
    331
    
    
    
    329Total current liabilities
    
    
    2,323
    
    
    
    2,195Deferred income tax liability
    
    
    685
    
    
    
    673Long-term debt
    
    
    7,229
    
    
    
    7,263Total liabilities
    
    
    10,237
    
    
    
    10,131Stockholders equity:Common stock, no par value;
100,000,000 shares authorized,
6,256,888 and 6,251,838 issued and outstanding at April 30, 2005 and January 31, 2005, respectively
    
    
    8,165
    
    
    
    8,154Additional paid in capital
    
    
    648
    
    
    
    644Retained earnings
    
    
    4,714
    
    
    
    4,548Total stockholders equity
    
    
    13,527
    
    
    
    13,346Total liabilities and stockholders equity
    
    $
    23,764
    
    
    $
    23,477
 2




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##### 



INTERNATIONAL ABSORBENTS INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(US dollars, in thousands, except for per share amounts) Three Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004(unaudited)
    
    
    (unaudited)Sales, net
    
    $
    5,892
    
    
    $
    5,501Cost of goods sold
    
    
    3,933
    
    
    
    3,1561,959
    
    
    
    2,345Selling, general and administrative expenses
    
    
    1,671
    
    
    
    1,363Income from operations
    
    
    288
    
    
    
    982Interest expense
    
    
    (78
    )
    
    
    (38
    )Interest income
    
    
    16
    
    
    
    3Income before provision for income tax
    
    
    226
    
    
    
    947Income tax provision
    
    
    (60
    )
    
    
    (345
    )Net income
    
    $
    166
    
    
    $
    602Basic earnings per share
    
    $
    .03
    
    
    $
    .10Fully diluted earnings per share
    
    $
    .03
    
    
    $
    .10Weighted average number of shares outstanding
(in thousands)Basic
    
    
    6,254
    
    
    
    5,802Diluted
    
    
    6,360
    
    
    
    6,146
 3




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##### 



INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(US dollars, in thousands) Three Months EndedApril 30,
    
    
    April 30,2005
    
    
    2004(unaudited)
    
    
    (unaudited)Cash flows from operating activitiesNet income
    
    $
    166
    
    
    $
    602Adjustments to reconcile net income to net cash
used for operating activitiesDepreciation and amortization
    
    
    312
    
    
    
    158Stock-based compensation
    
    
    4
    
    
    
    (22
    )Tax benefit from exercise of stock options
    
    
    
    
    
    
    35Deferred tax
    
    
    12
    
    
    
    70Changes in operating assets and liabilitiesAccounts receivable
    
    
    (432
    )
    
    
    (389
    )Inventory
    
    
    (655
    )
    
    
    (75
    )Prepaid expenses
    
    
    (77
    )
    
    
    (55
    )Accounts payable and accrued liabilities
    
    
    72
    
    
    
    244Income tax receivable/payable
    
    
    48
    
    
    
    265Due to related party
    
    
    1
    
    
    
    8Net cash flows from operating activities
    
    
    (549
    )
    
    
    841Cash flows from investing activitiesPurchase of short-term investments
    
    
    (108
    )
    
    
    (109
    )Proceeds from short-term investments
    
    
    107
    
    
    
    105Purchase of property, plant and equipment
    
    
    (364
    )
    
    
    (2,048
    )Investment in restricted cash
    
    
    (2
    )
    
    
    Proceeds from restricted cash
    
    
    
    
    
    
    432Net cash flows from investing activities
    
    
    (367
    )
    
    
    (1,620
    )Cash flows from financing activitiesProceeds from long-term debt
    
    
    
    
    
    
    1,011Repayment of long-term debt
    
    
    (32
    )
    
    
    (30
    )Proceeds from exercise of stock options
    
    
    11
    
    
    
    30Proceeds from exercise of common stock warrants
    
    
    
    
    
    
    50Net cash flows from financing activities
    
    
    (21
    )
    
    
    1,061Net change in cash
    
    
    (937
    )
    
    
    282Cash and cash equivalents, beginning of period
    
    
    3,520
    
    
    
    1,453Cash and cash equivalents, end of period
    
    $
    2,583
    
    
    $
    1,735Cash paid for interest
    
    $
    63
    
    
    $
    44Non-cash investing activitiesChange in property, plant and equipment and accounts
payable for purchase of plant and equipment
    
    $
    (33
    )
    
    $
    327
 4




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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (US dollars, in thousands, except where otherwise noted) 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 the states of Washington and Georgia. 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 10-KSB, and therefore should be read in conjunction with
our annual financial statements. The accompanying financial statements include all normal
recurring adjustments, which, in the opinion of management, are necessary to present fairly the
Companys financial position at April 30, 2005 and January 31, 2005, and its results of operations
and statement of cash flows for the three months ended April 30, 2005 and 2004. Use of estimates The preparation of financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and assumptions 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. Actual results could differ from those estimates. 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,
accrual for self-insured medical insurance plan, and sales incentives. New Accounting Pronouncements: On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share Based Payment (SFAS No.
123R). Under SFAS No. 123R, companies must calculate and record in the income statement the cost
of equity instruments, such as stock options, awarded to employees for services received; pro forma
disclosure will no longer be permitted. The cost of the equity instruments is to be measured based
on fair value of the instruments on the date they are granted (with certain exceptions) and is
required to be recognized over the period during which the employees are required to provide
services in exchange for the equity instruments. SFAS No. 123R provides two alternatives for adoption: (1) a modified prospective method in which
compensation cost is recognized for all awards granted subsequent to the effective date of this
statement as well as for the unvested portion of awards outstanding as of the effective date; or
(2) a modified retrospective method which follows the approach in the modified prospective
method, but also permits entities to restate prior periods to record compensation cost calculated
under Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation
(SFAS No. 123) for the pro forma disclosure. The Company plans to adopt SFAS No. 123R using the
modified retrospective method. Since the Company currently accounts for stock options granted to
employees and shares issued under employee stock purchase plans in accordance with the intrinsic
value method permitted under Accounting Principles Board (APB) No. 25, as described below, no
compensation expense is recognized. On April 14, 2005, the Securities and Exchange Commission (the
SEC) announced that it would delay the required implementation of SFAS No. 123R, allowing
companies that are not small business issuers to adopt the Statement no later than the beginning of
the first fiscal year beginning after June 15, 2005. The Company plans to adopt SFAS No. 123R as
of February 1, 2006. Stock-based employee compensation SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an Amendment of
FASB Statement No. 123, amends the disclosure requirements of SFAS No. 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. 5




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##### 



The Company accounts for stock-based employee and non-employee directors compensation arrangements
in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees
(APB No. 25), and complies with the disclosure provisions of 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 three months ended April 30, 2005 and 2004. 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: Three months endedApril 30,
    
    
    April 30,2005
    
    
    2004Net income
    
    $
    166
    
    
    $
    602Stock 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
    
    
    (84
    )
    
    
    (128
    )Pro forma net income
    
    $
    82
    
    
    $
    474Basic earnings per shareAs reported
    
    $
    0.03
    
    
    $
    0.10Pro forma
    
    $
    0.01
    
    
    $
    0.08Diluted earnings per shareAs reported
    
    $
    0.03
    
    
    $
    0.10Pro forma
    
    $
    0.01
    
    
    $
    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: 2006
    
    
    2005a) risk free interest rate
    
    
    3.70
    %
    
    
    2.37
    %b) expected volatility
    
    
    126.1
    %
    
    
    108.3
    %c) expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %d) estimated average life (in
years)
    
    
    7.00
    
    
    
    4.40
 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 (EITF) 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 $4,000 and $5,000 during the
three-month periods ended April 30, 2005 and 2004, respectively. 6




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##### 



2.     Share Capital Common Shares Shares
    
    CapitalCommon shares outstanding, January 31, 2005
    
    
    6,252
    
    
    $
    8,154Common shares outstanding, April 30, 2005
    
    
    6,257
    
    
    $
    8,165
 Options Stock options outstanding at April 30, 2005 and January 31, 2005 were 530,940 and 441,290,
respectively. During the three months ended April 30, 2005 the Company issued 100,000 options,
5,050 options were exercised and 5,300 options were forfeited. 3.     Segmented Information The Company is involved primarily in the development, manufacture, distribution and sale of
absorbent products. Its assets and operations are primarily conducted in the United States. The Company defines its business segments based upon the market in which its customers sell
products. 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 based on these two identifiable segments. As a result, management has elected
to combine what historically were the Companys two smallest segments (industrial cleanup and hydro
mulch) into one new segment, the industrial/commercial segment, effective during the third
quarterly report in fiscal year 2005. 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.
Certain segment information, including segment assets, asset expenditures and related depreciation
expense, is not presented as all of the Companys assets are commingled and are not available by
segment. There are no inter-segment transactions or significant differences between segment
accounting and corporate accounting basis. 7




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Business Segment Data  Three Months Ended April 30, 2005 AnimalCare
    
    
    Industrial
    
    
    ConsolidatedRevenues
    
    $
    5,548
    
    
    $
    344
    
    
    $
    5,892Operating cost and expenses
    
    
    4,880
    
    
    
    374
    
    
    
    5,254Operating
income (loss) before depreciation and amortization
    
    
    668
    
    
    
    (30
    )
    
    
    638Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (350
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    (78
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    16Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    226
 Business Segment Data  Three Months Ended April 30, 2004 AnimalCare
    
    
    Industrial
    
    
    ConsolidatedRevenues
    
    $
    5,160
    
    
    $
    341
    
    
    $
    5,501Operating cost and expenses
    
    
    3,978
    
    
    
    383
    
    
    
    4,361Operating income (loss) before depreciation
and amortization
    
    
    1,182
    
    
    
    (42
    )
    
    
    1,140Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    (158
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    (38
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    3Net income before taxes
    
    
    
    
    
    
    
    
    
    $
    947
 4.     Inventories components April 30,
    
    
    January 31,2005
    
    
    2005Raw materials and supplies
    
    $
    1,290
    
    
    $
    831Finished goods
    
    
    773
    
    
    
    577$
    2,063
    
    
    $
    1,408
 8




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##### 



5.     Property, Plant and Equipment April 30,
    
    
    January 31,2005
    
    
    2005Property, plant and equipment
    
    $
    1,547
    
    
    $
    1,547Land Buildings
    
    
    8,423
    
    
    
    8,420Leasehold improvements
    
    
    629
    
    
    
    629Equipment
    
    
    8,864
    
    
    
    8,470$
    19,463
    
    
    $
    19,066Less: Accumulated depreciation
    
    
    (3,521
    )
    
    
    (3,220
    )$
    15,942
    
    
    $
    15,846
 During the three months ended April 30, 2005, we incurred interest costs of $44,000, of which
$6,000 was capitalized as part of the new facility located in Jesup, Georgia and $38,000 was
interest expense. In April 2005, the Company purchased new enterprise resource planning (ERP) software from Ross
Systems for $186,000. 6.     Long-term debt In March 2003, the Company completed a $2,910,000 bond financing, 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% with a term of 190 months, maturing
February 2019, and with interest-only payments for the first 52 months. The taxable bonds have a
fixed rate of 5.53%, with a term of 52 months, maturing August 2007. The indebtedness underlying
the bonds is secured by a mortgage on the real property, and a security interest in the equipment
assets, located in Whatcom County, Washington. At April 30, 2005, the balance outstanding was
$2,355,000 on the tax-exempt and $305,000 on the taxable bonds, respectively. On August 20, 2003, the Company 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 the facility in Jesup,
Georgia. The loan agreement allowed 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 was the one-month London Interbank Offered Rate (LIBOR) rate plus 2.25%. During
September 2004, this loan was 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 ( 3.12 % as of April 28, 2005) plus a letter of credit fee of 0.95%, a
remarketing fee of 0.125% and a $2,000 annual trustee fee. The term of these bonds is seven years
for the equipment portion and 15 years for the real estate portion. At April 30, 2005, $437,000
remained in the trust account, and the debt outstanding was $4,900,000. 9




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7.     Earnings per share April 30, 2005Net Income
    
    
    Shares
    
    
    Per share(numerator)
    
    
    (denominator)
    
    
    amountBasic earnings per shareNet income available to stockholders
    
    $
    166,000
    
    
    
    6,253,598
    
    
    $
    0.03Effect of dilutive securitiesStock options to purchase common stock
    
    
    
    
    
    
    106,744Diluted earnings per sharesNet income available to stockholders
    
    $
    166,000
    
    
    
    6,360,342
    
    
    $
    0.03
 April 30, 2004Net Income
    
    
    Shares
    
    
    Per share(numerator
    
    
    (denominator)
    
    
    amountBasic earnings per shareNet income available to stockholders
    
    $
    602,000
    
    
    
    5,802,426
    
    
    $
    0.10Effect of dilutive securitiesWarrants to purchase common stock
    
    
    
    
    
    
    690Stock options to purchase common stock
    
    
    
    
    
    
    342,682Diluted earnings per sharesNet income available to stockholders
    
    $
    602,000
    
    
    
    6,145,798
    
    
    $
    0.10
 8.     Subsequent events On May 3, 2005 Absorption renewed the lease agreement with the Port of Bellingham, which extended
the lease on our Bellingham production facility until August of 2007. On May 23, 2005,
Absorption renewed a bank line of credit by entering into an agreement with Branch Banking &
Trust Co. for up to $2,000,000, which is secured by accounts receivable and inventory of
Absorption. Interest is payable on funds advanced at the LIBOR rate plus 2.5%. The line of credit
matures on May 23, 2007. 
 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 is the parent company of its wholly-owned U.S. subsidiary Absorption.
International Absorbents is a holding company and Absorption is its operating entity. Management
divides the activities of the operating company into
two segments: the animal care industry and the industrial/commercial industry. We manufacture,
distribute and sell this spectrum of products to both distributors and direct buying retailers. 10




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Absorption is a leading manufacturer and seller of premium small animal bedding in North America.
The primary product that it sells in this market is 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. During the second and third quarters of fiscal year 2006 we intend to introduce two new products to
the animal care market: Healthy Pet Cat Litter and CareFresh Colors. Healthy Pet Cat Litter is a
line of cat litters and our distributors will be offered a selection of five cat litters designed
to be displayed together in one section of shelf space. They are all made of natural products in
keeping with our corporate philosophy. CareFRESH®Colorsis a colored bedding offering
designed to fit into our product line as a step up from CareFRESH®Ultra, our white
small animal bedding offering. 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 more
diversified sources of income, which we anticipate will help reduce the risks associated with a
substantial reliance on sales from a significant product. RESULTS OF OPERATIONS The following table illustrates our financial results for the first quarter of fiscal year 2006 as
compared to the first quarter of fiscal year 2005 (U.S. dollars in thousands): April 30
    
    
    Percent
    
    
    April 30
    
    
    Percent
    
    
    Percentage2005
    
    
    of Sales
    
    
    2004
    
    
    of Sales
    
    
    ChangeSales
    
    
    5,892
    
    
    
    100
    %
    
    
    5,501
    
    
    
    100
    %
    
    
    7
    %Cost of Goods Sold
    
    
    3,933
    
    
    
    67
    %
    
    
    3,156
    
    
    
    57
    %
    
    
    25
    %Gross Profit
    
    
    1,959
    
    
    
    33
    %
    
    
    2,345
    
    
    
    43
    %
    
    
    -16
    %Selling,
administrative, &
general expenses
    
    
    1,671
    
    
    
    28
    %
    
    
    1,363
    
    
    
    25
    %
    
    
    23
    %Income from operations
    
    
    288
    
    
    
    5
    %
    
    
    982
    
    
    
    18
    %
    
    
    -71
    %Interest Income
    
    
    16
    
    
    
    0
    %
    
    
    3
    
    
    
    0
    %
    
    
    433
    %Interest Expense
    
    
    (78
    )
    
    
    -1
    %
    
    
    (38
    )
    
    
    -1
    %
    
    
    105
    %Income before
provision for income
tax
    
    
    226
    
    
    
    4
    %
    
    
    947
    
    
    
    17
    %
    
    
    -76
    %Income tax
    
    
    (60
    )
    
    
    -1
    %
    
    
    (345
    )
    
    
    -6
    %
    
    
    -83
    %Net Income
    
    
    166
    
    
    
    3
    %
    
    
    602
    
    
    
    11
    %
    
    
    -72
    %
 Revenues Our sales grew from $5,501,000 in the first quarter of fiscal year 2005 to $5,892,000 in the first
quarter of the current fiscal year, representing an increase of 7%. 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 and a reduction
in the price of CareFRESH® Ultra. Our strategy in regard to our industrial line of products has remained the same, which is
to effectively service 11




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existing customers while focusing growth on consumer products.
Consequently, industrial sales remained flat during the first quarter of fiscal year 2006 as
compared to the same period in fiscal year 2005. During fiscal year 2006, sales of CareFRESH® are expected to continue to grow at or
slightly below the rate at which they grew during fiscal year 2005. Although we anticipate that
CareFRESH® will continue to represent the majority of our sales through the 2006 fiscal
year, we do not expect significant growth in sales of CareFRESH® because we have now
reached significant levels of distribution throughout the United States. We expect that most of
the growth of our small animal bedding products will occur chiefly as a result of line extensions
like CareFRESH Ultra.We see growth opportunities for these bedding products in the mass
merchandiser and grocery market channels. Our products are selling well in these channels and are
becoming more accepted by the consumer. We also expect revenue growth from our lines of cat
litter, but believe that the growth rate will be tempered by our roll-out strategy. In fiscal year
2006, we expect overall annual sales to grow 10% to 15% over our fiscal year 2005 sales levels,
although we did not achieve that rate in the first quarter of 2006. Gross Profit Our Jesup, Georgia production facility continued to make progress during the first quarter of
fiscal year 2006 at increasing its production rate and efficiencies. This facility is close to, but
has not yet achieved, a break-even production rate, and thus it did not contribute to gross profits
for the first quarter. This factor, along with increased utility rates, increased depreciation,
and increased fuel surcharges on freight, have reduced our gross profit margin for the first
quarter of fiscal year 2006 as compared to the same quarter in the previous year. These increased
production costs, combined with increased promotional expenses, which reduced our net revenue,
resulted in decreased gross margin (gross profit divided by sales) for the first quarter of fiscal
year 2006, as compared to the same quarter in the prior fiscal year. Specifically, our gross
margin decreased from 43% in the first quarter of fiscal year 2005 to 33% in the first quarter of
fiscal year 2006, while gross profit decreased to $1,959,000 for the first quarter of fiscal year
2006 from $2,345,000 for the first quarter of fiscal year 2005. We expect that during the balance of fiscal year 2006 our gross margin will improve above first
quarter levels for a number of reasons. First, as production increases from our Jesup facility, we
will be able to service more of our east coast customers from that facility and as a result reduce
our transportation costs. Second, we expect to reduce the costs of some of the raw materials for
the products we will be producing at our Jesup facility. Third, due to automation and design
improvements at the Jesup facility relative to our Bellingham, Washington production facility, we
expect that our new Jesup facility will be more cost efficient to operate once it has achieved our
expected rate of production. We believe that these improved gross margins will not become evident
until at least the second half of fiscal year 2006 due to commissioning costs for our Jesup
facility which we incurred during the first quarter. We are also still studying whether to move
our Bellingham production facility to our new Ferndale, Washington location. If the move occurs
during fiscal year 2006, we would incur relocation and commissioning costs during the final quarter
of fiscal year 2006, which could reduce our gross margins. Additional depreciation charges,
resulting from our new production facilities, will also have a negative effect on our gross margin. Selling, General and Administrative Expenses During the first quarter of fiscal year 2006, our selling, general and administrative expenses
increased to $1,671,000 as compared to $1,363,000 in the first quarter of fiscal year 2005. We
continued to invest in sales and 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. In addition, costs resulting from our compliance with recent SEC
internal control requirements have started to have an impact on our general and administrative
expenses. Moreover, we now have overhead expenses related to operating our Jesup facility,
increased property taxes on both of our new facilities, and increased depreciation. During the balance of fiscal year 2006, we intend to 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, we expect our sales and marketing costs to increase as we invest in our future
growth. General and administrative expenses (net of depreciation) are anticipated to continue to increase
during fiscal year 2006 as we take steps to comply with the new regulatory requirements. 12




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Interest Expense Interest expense in the first quarter of fiscal year 2006 totaled $78,000 as compared to $38,000 in
the first quarter of fiscal year 2005. This increase was due to interest charges for the debt
facility for the Jesup plant that are no longer being capitalized, since construction is now
complete. Fiscal year 2006 will be our first full year of interest expense resulting from the
bonds for both our Washington facility and our Georgia facility. As a result, interest expense is
expected to increase above levels previously incurred. Income Tax 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. During fiscal year 2005 and the first quarter of fiscal 2006,
we also recorded a valuation allowance for International Absorbents Canadian income tax losses. Net Income Our net income for the quarter ended April 30, 2005 decreased to $166,000, as compared to $602,000
in the first quarter of fiscal year 2005, representing a 72% decrease. This decrease was the
result of increased promotional expenses, increased depreciation, costs related to the
commissioning of the Jesup production facility, increased energy and freight charges, increased
marketing, and increased general and administrative expenses related to our compliance with new
regulatory requirements. During the first quarter we continued to execute on the components of our
business plan, including investments in capital infrastructure, sales and marketing programs, and
cost management controls. We believe the results for the first quarter of fiscal year 2006 are
within managements expectations. We feel that implementation of the key components of our
business plan has resulted in the continued increases in production rates which help us to service
the increase in demand for our products and generate revenues. The increase in revenues has
allowed us to continue to invest in sales and marketing activities and capital infrastructure and
maintain profitability in the face of increased operating costs and administrative costs. Once the commissioning of our Jesup, Georgia production facility is completed, we expect to begin
to see an improved gross margin. This improvement is expected to come from reduced freight costs
as a result of being closer to our customers and improved production efficiencies resulting from
the facilitys new equipment, automation technology and reduced raw materials costs. We project
that selling and administrative costs will continue to grow. We will continue to invest in future
marketing programs to offset competitive pressures as necessary and anticipate additional
administrative costs resulting from new regulatory requirements, both of which may lead to
increased expenses and lower net income. The balance of fiscal year 2006 will also be the first
full year that we will be paying interest on our long-term debt, which will adversely impact our
net income. In addition, we anticipate that increased depreciation resulting from our investment in
plant and equipment will negatively affect our fiscal year 2006 net income. LIQUIDITY AND CAPITAL RESOURCES We are currently completing 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, Washington location. The
final phase will occur only if our economic analysis concludes that it is optimal. 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 of April 30,
    
    
    As of January 31,2005
    
    
    2005Financial ConditionTotal Assets
    
    $
    23,764
    
    
    $
    23,477Total Liabilities
    
    
    10,237
    
    
    
    10,131Total Equity
    
    $
    13,527
    
    
    $
    13,346Debt/equity ratio
    
    
    0.76
    
    
    
    0.76Assets/debt ratio
    
    
    2.32
    
    
    
    2.32
 13




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As of April 30,
    
    
    As of January 31,2005
    
    
    2005Working CapitalCurrent assets
    
    $
    7,537
    
    
    $
    7,335Current liabilities
    
    $
    2,323
    
    
    $
    2,195Current ratio
    
    
    3.24
    
    
    
    3.34Cash PositionCash, restricted cash & short term investments
    
    $
    3,241
    
    
    $
    4,175Cash generated from operations
    
    $
    (549
    )
    
    $
    3,693
    ** for the entire year ended January 31, 2005
 Financial Condition During the first quarter of fiscal year 2006, our assets increased as we completed the capital
infrastructure expansion for our facility in Jesup, Georgia, a portion of which was paid for
through long-term debt and a portion through cash. Our total assets increased from $23,477,000 at
January 31, 2005 to $23,764,000 at April 30, 2005. We also had an increase in total liabilities
from $10,131,000 at January 31, 2005 to $10,237,000 at April 30, 2005 as a result of a slight
increase in short-term accounts payable. On September 2, 2004, Absorption entered into a Letter of Credit and Reimbursement Agreement with
BB&T, pursuant to which we requested that (a) the 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 our prior 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 our 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
bonds 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
(3.12% as of April 28, 2005), and Absorption is also required to pay an annual letter of credit fee
equal to 0.95% of the initial amount of the letter of credit, an annual remarketing fee equal to
0.125% 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
years, 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 a breach of any of its
representations or covenants under the agreement. In connection with this financing, International
Absorbents agreed to unconditionally guarantee all of Absorptions indebtedness to BB&T. At April
30, 2005, the balance outstanding was $4,900,000. In March 2003, we completed a $2,910,000 bond financing, 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%, with a term of 190 months, maturing February
2019, and with interest-only payments for the first 52 months. The taxable bonds have a fixed rate
of 5.53%, with a term of 52 months, maturing August 2007. The indebtedness underlying the bonds is
secured by a mortgage on the real property, and a security interest in the equipment assets,
located in Whatcom County, Washington. At April 30, 2005, the balance outstanding was $2,355,000 on
the tax-exempt and $306,000 on the taxable bonds, respectively. Working Capital During the first quarter of fiscal year 2006, our working capital position remained relatively
flat. Current assets increased from $7,335,000 at the end of fiscal year 2005 to $7,537,000 at the
end of the first quarter of fiscal year 2006. The majority
of the increase in current assets occurred primarily because of increases in accounts receivable
and inventory. The accounts 14




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receivable increase resulted from higher sales, and the inventory
increased as a result of inventory purchased for the second quarter roll-out of our new line of cat
litter. Current liabilities increased slightly to $2,323,000 at April 30, 2005 as compared to
$2,195,000 at the end of fiscal year 2005. These changes resulted in our current ratio (current
assets divided by current liabilities) declining from 3.34 at the end of fiscal year 2005 to 3.24
at the end of the first quarter of fiscal year 2006. Cash Position We believe that our existing cash on hand, long-term debt and available line of credit currently
provide us with enough cash to meet our existing needs for the foreseeable future. Cash,
restricted cash, and short-term investments decreased during the first quarter of fiscal year 2006
from $4,175,000 at January 31, 2005 to $3,241,000 at April 30, 2005 primarily as a result of
increases in accounts receivable and inventory as discussed above. We expect to maintain our
strong cash position through fiscal year 2006. 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. On May 3, 2005 Absorption renewed the lease agreement with the Port of Bellingham, which extended
the lease on our Bellingham production facility until August of 2007. On May 23, 2005, Absorption entered into a bank line of credit agreement with Branch Banking &
Trust Co. for up to $2,000,000, which is secured by accounts receivable and inventory of
Absorption. Interest is payable on funds advanced at the LIBOR rate plus 2.5%. The line of credit
matures on May 23, 2007. Cash Used in Operations During the first quarter of the current fiscal year we did not generate cash from operations,
primarily for two reasons. First, we had an increase of approximately $400,000 in accounts
receivable during the final month of the first quarter. This increase was not accompanied by an
increase in the age of our receivables; it was the result of an unusual sales cycle. Second, we
increased inventory levels to support the launch of our new cat litter product line and to provide
a base of materials for our Jesup manufacturing operations. If our sales continue to increase and
we are able to continue to profitably produce our products, we should be able to once again
generate cash from operating activities, although it cannot be assured that this will be the case. Financing and Investing Activities Cash used in financing activities during the first quarter of fiscal year 2006 was $21,000. This
resulted from principal payments of $32,000 on long-term debt and cash received of $11,000 from the
issuance of shares as a result of the exercise of stock options. Cash was used during the first
quarter of fiscal year 2006 for investing activities that were a result of our capital expansion
plan. Cash used in investing activities for the fiscal quarter was approximately $367,000. The
majority of the cash was used to purchase equipment for both of our main production facilities. On May 23, 2005, Absorption entered a bank line of credit agreement with Branch Banking & Trust Co.
for up to $2,000,000, which is secured by accounts receivable and inventory of Absorption.
Interest is payable on funds advanced at the LIBOR rate plus 2.5%. The line of credit matures on
May 23, 2007. 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
Ferndale, Washington. We had been operating in five separate long-term leased facilities in
Whatcom County, Washington. 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. Phase two of our production expansion plan is a 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, which we subsequently sold to, and leased
back from, Wayne County IDA, as described above. We began construction during the fourth quarter
of fiscal year 2004 on this property. The total project was completed at a cost of $6,650,000. Of
the total cost, approximately $4,900,000 was financed through a long-term bank debt instrument and
the balance was 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. 15




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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. We expect the cost savings to include
reduced freight expense from shorter hauls to customers, lower production costs resulting from the
production efficiencies of new technology and higher production rates, and lower labor costs per
unit produced as a result of new automation. In addition, we believe that we will be better 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 is to move the Bellingham, Washington production
facility to the new Ferndale plant. We will undertake this move only if our economic analysis
concludes that it is optimal. 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. Critical Accounting Policies Introduction In preparing our consolidated 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,
income taxes, including deferred income taxes and the related valuation allowance, accrual for
self-insured medical insurance plans and sales incentives. As part of the financial reporting
process, our management collaborates to determine the necessary information on which to base
judgments 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 1 of our consolidated
financial statements included elsewhere in this Quarterly Report on Form 10-Q, we believe that the
following discussion addresses our 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% per
month 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 April 30, 2005 and January 31, 2005, management considered
accounts receivable in excess of the allowances for doubtful accounts and finance charges to be
fully collectible. 16




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Property, plant and equipment Property, plant and equipment assets are recorded at cost. Our 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 property located on leased land. Most of our equipment is depreciated over its
estimated useful life using a 15% declining balance method, the remainder is depreciated using a
straight line method over five 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. Sales incentives in accordance with the
provisions of EITF 01-9 Accounting for Consideration Given by a Vendor to a Customer. Income tax We account for income tax 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. Use of estimates The preparation of financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and assumptions 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. Actual results could differ from those estimates. 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,
accrual for self-insured medical insurance plan, and sales incentives. 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. Off-Balance Sheet Arrangements The SEC requires companies to disclose off-balance sheet arrangements. As defined by the SEC, an
off-balance sheet arrangement includes any contractual obligation, agreement or transaction
arrangement involving an unconsolidated entity under which a company 1) has made guarantees, 2) has
a retained or a contingent interest in transferred assets, 3) has an obligation under derivative
instruments classified as equity, or 4) has any obligation arising out of a material variable
interest in an unconsolidated entity that provides financing, liquidity, market risk or credit risk
support to the company, or that engages in leasing, hedging or research and development services
with the company. We have examined our contractual obligation structures that may potentially be impacted by this
disclosure requirement and have concluded that no arrangements of the types described above exist
with respect to our company. 
 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. 17




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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 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 three largest customers accounted for approximately 21%, 21%, and 11% of our net sales in the
first quarter of fiscal year 2006, while the same customers accounted for approximately 23%, 24%
and 6% of our net sales in the first quarter of fiscal year 2005. 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, the State of
Washington, the State of Georgia, and the State of Florida 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 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 18




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our Jesup,
Georgia 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 April 30, 2005, we had total long-term and current indebtedness under our bonds,
capitalized-lease obligations and other asset financings of $7,560,000. We make interest payments
(and principal payments on the taxable bond) on the indebtedness under our bonds, which are due in
2007 and 2019. 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; to plan for, or react to,
changes in technology and in our business and competition; and to react in the event of an economic
downturn. There is no guarantee that we will be able to meet our debt service obligations. If we
are unable to 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 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. Additionally, it
is possible that as we continue our ongoing review and analysis of internal control over financial
reporting for compliance with the Sarbanes-Oxley Act of 2002, additional weaknesses in internal
controls may be discovered. 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 agriculture. 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 a 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 be made that would 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 have sufficient funds 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. 19




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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 been issued three U.S. patents (and corresponding Canadian patents and
patent applications) and we have one U.S. patent application pending. Patent applications may not
successfully result in an issued patent. Issued patents may be 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 any successful material product
liability claim 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 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. 20




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As a result of our principal executive offices being located in Canada, and a majority of our
directors and certain of our officers residing in Canada, investors may find it difficult to
enforce, within the United States, any judgments obtained against our company or our directors or
officers. Our principal executive offices, a majority of our directors and certain of our officers are
located in and/or residents of Canada, and all or a substantial portion of such persons assets are
located outside the United States. As a result, it may be difficult for investors to obtain
jurisdiction over us or our directors or officers in courts in the United States in actions
predicated on the civil liability provisions of the U.S. federal securities laws; enforce against
us or our directors or officers judgments obtained in such actions; obtain judgments against us or
our directors or officers in actions in non-U.S. courts predicated solely upon the U.S. federal
securities laws; or enforce against us or our directors or officers in non-U.S. courts judgments of
courts in the United States predicated upon the civil liability provisions of the U.S. federal
securities laws. 
 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 SEC
and Form 10-QSB, including our Annual Report on Form 10-KSB and our Quarterly Reports on Form 10-Q
and Form 10-QSB. 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 4.     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. No change in our internal control over financial reporting occurred during our last fiscal quarter
that has materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting. 
 ITEM 5.     OTHER INFORMATION On May 3, 2005 Absorption renewed the lease agreement with the Port of Bellingham, which extended
the lease on our Bellingham production facility until August of 2007. On May 23, 2005,
Absorption renewed a bank line of credit by entering into an agreement with Branch Banking &
Trust Co. for up to $2,000,000, which is secured by accounts receivable and inventory of
Absorption. Interest is payable on funds advanced at the LIBOR rate plus 2.5%. The line of credit
matures on May 23, 2007. 21




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PART II  OTHER INFORMATION 
 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)).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.
 22




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SIGNATURES In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERNATIONAL ABSORBENTS INC.
(Registrant)Date: June 10, 2005
    /s/ GORDON L. ELLISGordon L. EllisPresident & CEO(Principal Executive Officer) Date: June 10, 2005
    /s/ DAVID H. THOMPSONDavid H. ThompsonSecretary and Chief Financial Officer 23