##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-QSB [X]   Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act
of 1934 For the quarterly period ended July 31, 2004 OR [   ]   Transition Report Under Section 13 or 15(d) of the
Securities Exchange Act of 1934 
 Commission file number: 1-31642 INTERNATIONAL ABSORBENTS INC.  Province of British Columbia, Canada
    
    None(State or other jurisdiction of incorporation or organization)
    
    (IRS Employer Identification Number)
 1569 Dempsey Road
North Vancouver, British Columbia 
Canada V7K 1S8  (604) 681-6181  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
[X] No [   ] State the number of shares outstanding of each of the issuers classes of
common equity, as of September 3, 2004. Title of Class
    
    No. of SharesCommon Shares, no par value
    
    5,975,185




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##### 



INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(US dollars, in thousands) As at
    
    As atJuly 31,
    
    January 31,2004
    
    2004(unaudited)
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    2,146
    
    
    $
    1,453Restricted cash
    
    
    
    
    
    
    432Short term investments
    
    
    215
    
    
    
    211Accounts receivable, net
    
    
    1,511
    
    
    
    1,525Inventories, net
    
    
    1,416
    
    
    
    1,335Prepaid expenses
    
    
    158
    
    
    
    148Income taxes receivable
    
    
    149
    
    
    
    271Deferred income tax asset
    
    
    31
    
    
    
    31Total current assets
    
    
    5,626
    
    
    
    5,406Property, plant and equipment
    
    
    13,500
    
    
    
    10,348Intangible assets
    
    
    21
    
    
    
    39Other assets, net
    
    
    145
    
    
    
    150Total assets
    
    $
    19,292
    
    
    $
    15,943Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    1,936
    
    
    $
    1,976Related party payable
    
    
    5
    
    
    
    4Current portion of long-term debt
    
    
    472
    
    
    
    142Total current liabilities
    
    
    2,413
    
    
    
    2,122Deferred income tax liability
    
    
    559
    
    
    
    384Long-term debt
    
    
    4,323
    
    
    
    2,934Total liabilities
    
    
    7,295
    
    
    
    5,440Stockholders equity:Common stock, no par value;Authorized  100,000,000 shares5,974,135 and 5,773,970 issued and outstanding at July 31, 2004 and January 31, 2004, respectively
    
    
    7,647
    
    
    
    7,256Additional paid in capital
    
    
    543
    
    
    
    489Retained earnings
    
    
    3,807
    
    
    
    2,758Total stockholders equity
    
    
    11,997
    
    
    
    10,503Total liabilities and stockholders equity
    
    $
    19,292
    
    
    $
    15,943
 Unaudited (all dollar
amounts in thousands of 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) Six Months Ended
    
    Three Months EndedJuly 31,
    
    July 31,
    
    July 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Sales
    
    $
    10,996
    
    
    $
    9,349
    
    
    $
    5,495
    
    
    $
    4,831Cost of goods sold
    
    
    6,504
    
    
    
    5,813
    
    
    
    3,348
    
    
    
    2,884Gross profit
    
    
    4,492
    
    
    
    3,536
    
    
    
    2,147
    
    
    
    1,947Corporate and administrative expenses:Marketing and sales
    
    
    1,749
    
    
    
    1,382
    
    
    
    993
    
    
    
    773General and administrative
    
    
    1,140
    
    
    
    1,136
    
    
    
    533
    
    
    
    6562,889
    
    
    
    2,518
    
    
    
    1,526
    
    
    
    1,429Income from operations
    
    
    1,603
    
    
    
    1,018
    
    
    
    621
    
    
    
    518Interest expense
    
    
    (76
    )
    
    
    
    
    
    
    (38
    )
    
    
    Interest income
    
    
    6
    
    
    
    18
    
    
    
    3
    
    
    
    10Income before provision for income taxes
    
    
    1,533
    
    
    
    1,036
    
    
    
    586
    
    
    
    528Income taxes
    
    
    (484
    )
    
    
    (380
    )
    
    
    (139
    )
    
    
    (190
    )Net income
    
    $
    1,049
    
    
    $
    656
    
    
    $
    447
    
    
    $
    338Basic earnings per share
    
    $
    .18
    
    
    $
    .12
    
    
    $
    .08
    
    
    $
    .06Fully diluted earnings per share
    
    $
    .17
    
    
    $
    .11
    
    
    $
    .07
    
    
    $
    .06Weighted average number of shares outstanding
(in thousands)Basic
    
    
    5,867
    
    
    
    5,679
    
    
    
    5,931
    
    
    
    5,689Diluted
    
    
    6,162
    
    
    
    5,943
    
    
    
    6,172
    
    
    
    6,005
 INTERNATIONAL ABSORBENTS INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  Six Months EndedJuly 31,
    
    July 31,2004
    
    2003Cash flows from operating activities
    
    
    2,036
    
    
    
    527Cash flows from investing activities
    
    
    (3,453
    )
    
    
    (4,449
    )Cash flows from financing activities
    
    
    2,110
    
    
    
    2,931Net change in cash
    
    $
    693
    
    
    $
    (991
    )Cash and cash equivalents, beginning of period
    
    $
    1,453
    
    
    $
    3,051Cash and cash equivalents, end of period
    
    $
    2,146
    
    
    $
    2,060Cash paid for interest
    
    $
    92
    
    
    $
    26Cash paid for income taxes
    
    $
    150
    
    
    $
    167
 Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 3




---



##### 



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 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 July 31, 2004 and January
31, 2004, its results of operations for the three and six months ended July 31,
2004 and 2003, and the statement of cash flows for the six months ended July
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 $nil during the six months ended July
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
(dollars in thousands, except per share amounts): Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 4




---



##### 



Six months ended
    
    Three months endedJuly 31,
    
    July 31,
    
    July 31,
    
    July 31,2004
    
    2003
    
    2004
    
    2003Net earnings
    
    $
    1,049
    
    
    $
    656
    
    
    $
    447
    
    
    $
    338Stock 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
    
    
    (326
    )
    
    
    (150
    )
    
    
    (198
    )
    
    
    (87
    )Pro forma net earnings
    
    $
    723
    
    
    $
    506
    
    
    $
    249
    
    
    $
    251Basic earnings per shareAs reported
    
    $
    0.18
    
    
    $
    0.12
    
    
    $
    0.07
    
    
    $
    0.06Pro forma
    
    $
    0.12
    
    
    $
    0.09
    
    
    $
    0.04
    
    
    $
    0.04Diluted earnings per shareAs reported
    
    $
    0.17
    
    
    $
    0.11
    
    
    $
    0.07
    
    
    $
    0.06Pro forma
    
    $
    0.12
    
    
    $
    0.09
    
    
    $
    0.04
    
    
    $
    0.04
 The pro forma compensation expense reflected above has been estimated
using the Black-Scholes option-pricing model. Assumptions used in the
pricing model included: 2005
    
    2004a) risk free interest rate
    
    
    2.37
    %
    
    
    2.00
    %b) expected volatility
    
    
    108.3
    %
    
    
    103.5
    %c) expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %d) estimated average life (in years)
    
    
    4.40
    
    
    
    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 $0 during the three months ended July 31, 2004 and 2003,
respectively. Stock based compensation recognized under SFAS No. 123 and EITF
96-18 was $19,000 and $4,000 during the six-month period ended July 31, 2004
and 2003, respectively. 2. Share Capital Common Shares Shares
    
    CapitalCommon shares outstanding, July 31, 2004
    
    
    5,974
    
    
    $
    7,647Common shares outstanding, January 31, 2004
    
    
    5,774
    
    
    $
    7,256
 Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 5




---



##### 



Options Stock options outstanding at July 31, 2004 and January 31, 2004 were 681,360
and 581,255, respectively. During the six months ended July 31, 2004 the
Company issued 285,800 options and had 177,945 options exercised. Stock
options vested were 394,560 and 427,365 at July 31, 2004 and January 31, 2004,
respectively. Warrants During the six months ended July 31, 2004, a warrant was exercised to acquire
22,220 common shares at $2.25 per share. Warrants outstanding at July 31,
2004 and January 31, 2004 were nil and 22,220, respectively. No stock-based
compensation expense was recognized in connection with warrants as no
warrants were granted for both six-month periods ended July 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 based upon the market in which its
customers sell products. The Company operates principally in three business
segments: the animal care industry, the industrial cleanup industry and the
hydro-mulch industry. 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 dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 6




---



##### 



Business Segment Data  Six Months Ended July 31, 2004 Animal
    
    
    
    
    
    Hydro-Care
    
    Industrial
    
    Mulch
    
    ConsolidatedSales
    
    $
    10,314
    
    
    $
    486
    
    
    $
    196
    
    
    $
    10,996Operating cost and expenses
    
    
    8,336
    
    
    
    435
    
    
    
    300
    
    
    
    9,071Operating
income (loss) before depreciation and amortization
    
    
    1,978
    
    
    
    51
    
    
    
    (104
    )
    
    
    1,925Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (322
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (76
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Net income before taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    1,533Capital expenditures
    
    $
    3,430
    
    
    $
    18
    
    
    $
    3
    
    
    $
    3,451
 Business Segment Data  Six Months Ended July 31, 2003 Animal
    
    
    
    
    
    Hydro-Care
    
    Industrial
    
    Mulch
    
    ConsolidatedSales
    
    $
    8,627
    
    
    $
    497
    
    
    $
    225
    
    
    $
    9,349Operating cost and expenses
    
    
    7,440
    
    
    
    439
    
    
    
    274
    
    
    
    8,153Operating
income (loss) before depreciation and amortization
    
    
    1,187
    
    
    
    58
    
    
    
    (49
    )
    
    
    1,196Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (178
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18Net income before taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    1,036Capital expenditures
    
    $
    3,129
    
    
    $
    165
    
    
    $
    367
    
    
    $
    3,661
 Business Segment Data  Three Months Ended July 31, 2004 Animal
    
    
    
    
    
    Hydro-Care
    
    Industrial
    
    Mulch
    
    ConsolidatedSales
    
    $
    5,154
    
    
    $
    231
    
    
    $
    110
    
    
    $
    5,495Operating cost and expenses
    
    
    4,358
    
    
    
    221
    
    
    
    131
    
    
    
    4,710Operating
income (loss) before depreciation and amortization
    
    
    796
    
    
    
    10
    
    
    
    (21
    )
    
    
    785Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (164
    )Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (38
    )Interest income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3Net income before taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    586Capital expenditures
    
    $
    1,450
    
    
    $
    16
    
    
    $
    2
    
    
    $
    1,468
 Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 7




---



##### 



Business Segment Data  Three Months Ended July 31, 2003 Animal
    
    
    
    
    
    Hydro-Care
    
    Industrial
    
    Mulch
    
    ConsolidatedSales
    
    $
    4,478
    
    
    $
    232
    
    
    $
    121
    
    
    $
    4,831Operating cost and expenses
    
    
    3,884
    
    
    
    194
    
    
    
    144
    
    
    
    4,222Operating
income (loss) before depreciation and amortization
    
    
    594
    
    
    
    38
    
    
    
    (23
    )
    
    
    609Depreciation and amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (91
    )Interest Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Net income before taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    528Capital expenditures
    
    $
    1,657
    
    
    $
    74
    
    
    $
    346
    
    
    $
    2,077
 Assets Animal
    
    
    
    
    
    Hydro-Care
    
    Industrial
    
    Mulch
    
    ConsolidatedAt July 31, 2004
    
    $
    17,373
    
    
    $
    705
    
    
    $
    1,214
    
    
    $
    19,292At January 31, 2004
    
    $
    13,881
    
    
    $
    731
    
    
    $
    1,331
    
    
    $
    15,943
 Approximately 4.7% and 3.8% of our sales during the six months ended July 31,
2004 and 2003, respectively, were to customers outside of the United
States.
Approximately 4.7% and 2.7% of our sales during the three months ended July 31,
2004 and 2003, respectively, were to customers outside of the United
States. 4. Inventories components July 31,
    
    January 31,2004
    
    2004Raw materials and supplies
    
    $
    686
    
    
    $
    498Finished goods
    
    
    730
    
    
    
    837$
    1,416
    
    
    $
    1,335
 Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 8




---



##### 



5. Property, Plant and Equipment July 31,
    
    January 31,2004
    
    2004Property, plant and equipmentLand
    
    $
    1,626
    
    
    $
    1,626Buildings
    
    
    4,709
    
    
    
    4,657Leasehold improvements
    
    
    629
    
    
    
    629Equipment
    
    
    4,892
    
    
    
    4,616Construction in progress
    
    
    4,420
    
    
    
    1,297$
    16,276
    
    
    $
    12,825Less: Accumulated depreciation
    
    
    (2,776
    )
    
    
    (2,477
    )$
    13,500
    
    
    $
    10,348
 During the six months ended, July 31, 2004, we incurred interest costs of
$92,000, of which $16,000 was capitalized as part of the new facility located
in Jesup, Georgia and $76,000 was interest expense. Total project cost for the
new facility in Jesup, Georgia is estimated at $6,155,000. Of the total cost,
approximately $4,900,000 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 (GE Capital). 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 July 31, 2004 the balance outstanding was $2,355,000 on the
tax-exempt and $399,000 on the taxable bonds. On August 20, 2003 we signed a loan agreement with Branch Banking & Trust Co.
(BB&T) 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 (1.5037% on July 31, 2004) plus 2.25%. The property and
plant portion of this loan is being amortized over 15 years with a five-year
balloon payment on the outstanding balance due August 20, 2009. The equipment
portion of this loan is being amortized over seven years with a five-year
balloon payment on the outstanding balance due on August 20, 2009. Funds are
drawn on the account as construction takes place. At July 31, 2004, $2,040,000
had been drawn on this loan. 7. Subsequent Event On September 2, 2004, the Company, through Absorption, entered into a Letter of Credit and Reimbursement
Agreement with BB&T, pursuant to which the Company has 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, $2,090,000 will be used to pay off the Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted).
The accompanying notes are an integral part of these consolidated financial
statements. 9




---



##### 



Companys current
indebtedness to BB&T, $98,000 to pay for costs of issuance and the remaining proceeds
of $2,810,000 will be 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 (1.45% as of
September 2, 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. Unaudited (all dollar
amounts in thousands of U.S. dollars except where otherwise noted). The
accompanying notes are an integral part of these consolidated financial
statements. 10




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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. Overview International Absorbents Inc. is the parent company of its wholly owned
subsidiary Absorption Corp. International Absorbents is a holding company and
Absorption Corp is its operating entity. Management divides the activities of
the operating company into three segments: animal care products, industrial
absorbent products and hydro-mulch 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 illustrate our financial results for the first six months
and second quarter of fiscal year 2005 as compared to the first six months and
second quarter of fiscal year 2004: First Six Months of Fiscal
Year 2005 and 2004(dollar amounts in thousands of U.S. dollars) July 31,
    
    Percent
    
    July 31,
    
    Percent
    
    Percentage2004
    
    of Sales
    
    2003
    
    of Sales
    
    ChangeSales
    
    $
    10,996
    
    
    
    100
    %
    
    $
    9,349
    
    
    
    100
    %
    
    
    18
    %Cost of Goods Sold
    
    
    6,504
    
    
    
    59
    %
    
    
    5,813
    
    
    
    62
    %
    
    
    12
    %Gross Profit
    
    
    4,492
    
    
    
    41
    %
    
    
    3,536
    
    
    
    38
    %
    
    
    27
    %Corporate & Administrative ExpensesMarketing & sales
    
    
    1,749
    
    
    
    16
    %
    
    
    1,382
    
    
    
    15
    %
    
    
    27
    %General & Administrative
    
    
    1,140
    
    
    
    10
    %
    
    
    1,136
    
    
    
    12
    %
    
    
    0
    %2,889
    
    
    
    26
    %
    
    
    2,518
    
    
    
    27
    %
    
    
    15
    %Income from operations
    
    
    1,603
    
    
    
    15
    %
    
    
    1,018
    
    
    
    11
    %
    
    
    57
    %Interest Income
    
    
    6
    
    
    
    0
    %
    
    
    18
    
    
    
    0
    %
    
    
    67
    %Interest Expense
    
    
    (76
    )

    
    
    1
    %
    
    
    0
    
    
    
    0
    %
 11




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##### 



July 31,
    
    Percent
    
    July 31,
    
    Percent
    
    Percentage2004
    
    of Sales
    
    2003
    
    of Sales
    
    ChangeIncome before provision
for income taxes
    
    
    1,533
    
    
    
    14
    %
    
    
    1,036
    
    
    
    11
    %
    
    
    48
    %Income taxes
    
    
    (484
    )
    
    
    4
    %
    
    
    (380
    )
    
    
    4
    %
    
    
    27
    %Net Income
    
    $
    1,049
    
    
    
    10
    %
    
    $
    656
    
    
    
    7
    %
    
    
    60
    %
 Second Quarter of Fiscal Year 2005 and 2004(dollar amounts in thousands of U.S. dollars) July 31,
    
    Percent
    
    July 31,
    
    Percent
    
    Percentage2004
    
    of Sales
    
    2003
    
    of Sales
    
    ChangeSales
    
    $
    5,495
    
    
    
    100
    %
    
    $
    4,831
    
    
    
    100
    %
    
    
    14
    %Cost of Goods Sold
    
    
    3,348
    
    
    
    61
    %
    
    
    2,884
    
    
    
    60
    %
    
    
    16
    %Gross Profit
    
    
    2,147
    
    
    
    39
    %
    
    
    1,947
    
    
    
    40
    %
    
    
    10
    %Corporate & Administrative ExpensesMarketing & sales
    
    
    993
    
    
    
    18
    %
    
    
    773
    
    
    
    16
    %
    
    
    28
    %General & Administrative
    
    
    533
    
    
    
    10
    %
    
    
    656
    
    
    
    14
    %
    
    
    19
    %1,526
    
    
    
    28
    %
    
    
    1,429
    
    
    
    30
    %
    
    
    7
    %Income from operations
    
    
    621
    
    
    
    11
    %
    
    
    518
    
    
    
    11
    %
    
    
    20
    %Interest Income
    
    
    3
    
    
    
    0
    %
    
    
    10
    
    
    
    0
    %
    
    
    70
    %Interest Expense
    
    
    (38
    )
    
    
    1
    %
    
    
    0
    
    
    
    0
    %Income before provision
for income taxes
    
    
    586
    
    
    
    11
    %
    
    
    528
    
    
    
    11
    %
    
    
    11
    %Income taxes
    
    
    (139
    )
    
    
    3
    %
    
    
    (190
    )
    
    
    4
    %
    
    
    27
    %Net Income
    
    $
    447
    
    
    
    8
    %
    
    $
    338
    
    
    
    7
    %
    
    
    33
    %
 Revenues Our sales grew from $4,831,000 in the second quarter of fiscal year 2004 to
$5,495,000 during the same period in fiscal year 2005. Our sales revenues for
the first six months of fiscal year 2005 reached $10,996,000, which was an 18%
increase over sales revenues of $9,349,000 for the first six months of fiscal
year 2004. Our core product, CareFRESH®, showed significant growth during this
period due to a new promotion schedule and the additional package sizes being
offered. Our strategy of diversification also showed some success with the
continued growth of pet products such as CareFRESH® Ultra and Critter Care.
Our strategy in regard to our industrial line of products has remained the
same, which is basic maintenance of existing sales as such sales remained flat
for the first six months of fiscal year 2005 as compared to the first six
months of fiscal year 2004. Sales of our hydro-mulch product were lower during
the second quarter of fiscal year 2005 than during the same period in fiscal
year 2004 due to a dry planting season in the Northwest United States and
reduced budgets for municipal authorities responsible for planting during
fiscal year 2005. During the next 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 six
months of the fiscal year. We anticipate that CareFRESH® 12




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##### 



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 expansion in sales of our new bedding lines in the pet
specialty channel as well as 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. As we enter the second half
of the current fiscal year we are adjusting our expectations of sales levels of
our hydro mulch product. Unless there is a significant change in the market in
the next three months we estimate that our sales of this product will be
slightly lower than they were during the previous year. Overall, we are
currently projecting annual net sales for fiscal year 2005 to increase 15% to
20% over our annual net sales for fiscal year 2004. 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 38% in the
first six months of fiscal year 2004 to 41% in the first six months of fiscal
year 2005, while gross profit increased from $3,536,000 for the first six
months of fiscal year 2004 to $4,492,000 for the first six months of fiscal
year 2005. A significant factor that reduced our potential improvement in
gross profits during the second 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 latter half 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 second 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
balance 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 to six 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 being estimated at
approximately $500,000, the majority of which will occur in the third fiscal
quarter of fiscal year 2005, with the balance occurring in the fourth fiscal
quarter. 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 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 intend to implement a small price increase during the
second half of the year. However, we believe that the 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 six 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 our growing market share. These two areas of marketing
investment have resulted in an overall increase in 13




---



##### 



marketing expenses in the first six months of fiscal year 2005 as compared to
the same six-month period of the previous year. Our marketing and sales
expenses increased from $1,382,000 in the first six months of fiscal year 2004
to $1,749,000 in the first six months of fiscal year 2005. Comparing the
second quarter of fiscal years 2004 to 2005, our sales and marketing expenses
increased from $773,000 to $993,000, respectively. 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 remained flat during the first six
months of fiscal year 2005 as compared to the first six months of fiscal year
2004. Even though we have had an increase in depreciation resulting from our
capital expansion and increased 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 $1,136,000 in the
first six months of fiscal year 2004 and $1,140,000 in the first six months of
fiscal year 2005. They decreased from $656,000 in the second quarter of fiscal
year 2004 to $533,000 in the second 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 year, 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 six 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. Importantly, we continue
to estimate that there will not be a significant increase in our net income
this year over the previous year. If the commissioning period of the new
production facility in Jesup, Georgia takes longer than we are currently
projecting, then the net income results for fiscal year 2005 could be lower
than they were for fiscal year 2004. We are continuing to pursue new 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 the following 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 six 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 $656,000 during the first
six months of fiscal year 2004 to $1,049,000 in the first six months of fiscal
year 2005 was the result of our employees being able to successfully execute on
the plan. Net income 14




---



##### 



also increased for the second quarter from $338,000 in fiscal year 2004 to
$447,000 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 is underway and is now estimated to be completed in
October 2004; and the move of the Bellingham manufacturing facility to the
Ferndale location, which we currently project to be completed in approximately
one year. 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
    
    As ofJuly 31,
    
    January 31,2004
    
    2004Financial ConditionTotal Assets
    
    $
    19,292
    
    
    $
    15,943Total Liabilities
    
    
    7,295
    
    
    
    5,440Total Equity
    
    $
    11,997
    
    
    $
    10,503Debt/equity ratio
    
    
    0.61
    
    
    
    0.52Assets/debt ratio
    
    
    2.64
    
    
    
    2.93Working CapitalCurrent assets
    
    $
    5,626
    
    
    $
    5,406Current liabilities
    
    $
    2,413
    
    
    $
    2,122Current ratio
    
    
    2.33
    
    
    
    2.55Cash PositionCash, restricted cash & short term investments
    
    $
    2,361
    
    
    $
    2,096Cash generated from operations
    
    $
    2,036
    
    
    $
    1,769
    *
  *
    
    for the entire year ended January 31, 2004 Financial Condition During the first six 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 continued to
generate cash from operations. Our total assets increased from $15,943,000 at
January 31, 2004 to $19,292,000 at July 31, 2004. We also had an increase in
total liabilities from $5,440,000 at January 31, 2004 to $7,295,000 at July 31,
2004 as we increased our outstanding long-term debt to finance a portion of the
new Jesup, Georgia facility by drawing on the existing loan as construction
progressed. This facility was put into place on August 20, 2003 when we signed
a loan agreement with BB&T to borrow up to $4,691,500 to be used for the
construction and equipping of our new facility in Jesup, Georgia. Of this
amount, $1,827,500 is to be used for property and plant. The balance of
$2,864,000 is for production equipment in the facility. 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 is the one month 15




---



##### 



LIBOR rate (1.5037 % on July 31, 2004) plus 2.25%. The property and plant
portion is amortized over 15 years with a five-year balloon payment on the
outstanding balance due August 20, 2009. Funds are drawn on the account as
construction takes place. At July 31, 2004, $2,041,000 had been drawn on this
loan. The equipment portion is amortized over seven years with a five-year
balloon payment on the outstanding balance due on August 20, 2009. 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. During the third quarter of the current
fiscal year we converted this loan (see note 7; subsequent events) to an
Industrial Revenue Bond and as such should be able to reduce the related
long-term interest expense. On July 31, 2004, the purchase obligations
relating to outstanding contracts for building the new facility in Jesup,
Georgia totaled $71,000. 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 July 31,
2004 from $2,096,000 to $2,361,000, respectively. Current liabilities, mostly
in the area of the current portion of our long term debt increased, while
current assets also increased. This resulted in our current ratio decreasing
slightly during the first six months of fiscal year 2005 as compared to the
first six months of fiscal year 2004, although the ratio remained at a
relatively high level. Our current ratio is expected to decrease during fiscal
year 2005 as additional investments are made in our new production facility
located in Jesup, Georgia. Cash Position Cash, restricted cash, and short-term investments increased during the first
six months of fiscal year 2005 from $2,096,000 at January 31, 2004 to
$2,361,000 at July 31, 2004 primarily as a result of cash generated from
operations. 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 will be less than the amount of cash we will
need to complete our capital expansion, we expect to use both a portion of our
cash on hand and debt to complete the current phase of our capital expansion
plan. 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. Cash Generated from Operations We continued to generate cash from operations during the first six months of
fiscal year 2005. This strong generation of cash was primarily the result of
increased sales, improved gross profit margins and continued control and
maintenance of both current assets and current liabilities. We were able to
continue to limit the growth of our accounts receivable and inventories, even
though we had a significant growth in sales, which resulted in additional cash.
We expect to see a significant cash increase in inventory during the fourth
quarter of the current fiscal year as a result of the start of operations at
the Jesup, Georgia facility. 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 six months of fiscal year 2005
was $2,110,000. The Company borrowed $1,779,000, from BB&T and paid principal
of $60,000 to GE Capital. Proceeds from the BB&T loan was used to pay for a
portion of the construction in Jesup, Georgia. The balance of cash received of
$391,000 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 six
months of fiscal year 2005 for investing activities that were a result of our
capital expansion plan. Cash used in investing activities for the quarter just
completed totaled $3,453,000. The majority of the cash was used to purchase
property, plant and equipment for our new east coast production facility
located in Jesup, Georgia. During the 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 16




---



##### 



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 below under Part II  Item 5 Other Information. 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 $6,155,000. Of the total cost, approximately $4,800,000 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
one year when we plan to move the Bellingham production facility to the new
Whatcom County plant. The final decision on whether to undertake this move
will depend upon the then-current economic conditions. 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 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 17




---



##### 



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 July 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 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 18




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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 small 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 destocking, 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 largest customer accounted for approximately 20% and 21% of our net sales
in the first six months of fiscal year 2005 and 2004, respectively, while our
second largest customer accounted for approximately 22% and 18% of our net
sales in the first six 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: 19




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
    
    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 have significant indebtedness. As of July 31, 2004, we had total long-term and current indebtedness under our
bonds, capitalized-lease obligations and other asset financings of $4,795,000.
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
August 2003, we entered into a loan agreement to borrow up to $4,691,000 which
has a balloon payment of the principal balance due in August of 2009. 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 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. 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, state and local health
agencies, including, without limitation, the air emission standards enforced by
the Northwest Air Pollution Authority and regulations promulgated by the U.S.
Food and Drug Administration. If a regulatory authority finds that a current
or future product or production run is not in 20




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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
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. 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 21




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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 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. 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. 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. 22




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PART II  OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the annual general meeting of shareholders held on June 8, 2004, the
following proposals were adopted by the margins indicated. 1.   A proposal to decrease the authorized number of directors to five (5) from
seven (7) was approved by the following vote: For  4,603,799; Against  343,404;
Withheld  2,715; Not Voted  368721. 2. The election of the following directors who will serve until their
successors are elected and qualified, or their earlier death or resignation: Number of SharesFor
    
    WithheldGordon Ellis
    
    
    4,557,734
    
    
    
    423,617Michael Bentley
    
    
    4,700,131
    
    
    
    284,890
 The Companys other directors include John Sutherland, Lionel Dodd and
Daniel Whittle, each of whose terms will expire in 2005 unless re-elected. 3.   The selection of Moss Adams, LLP to continue as the auditors for
International Absorbents, Inc., was approved by the following vote: For
 4,755,006; Against  50; Withheld  177,128. 4.   The proposal to amend and restate each of the Companys 2003 Stock Option
Plan  U.S. Participants and the 2003 Equity Incentive Stock Option Plan into
one plan named the 2003 Omnibus Incentive was approved by the following vote:
For  1,616,583; Against  433,458; Withheld  159,600; Not Voted  3,108,998. ITEM 5. OTHER INFORMATION On September 2, 2004, the Company, through Absorption, entered into a Letter of
Credit and Reimbursement Agreement with BB&T, pursuant to which the Company has
requested that (a) the Wayne County Industrial Development Authority (Wayne
County IDA) issue $4,900,000 aggregate principal amount of Wayne County IDAs
tax exempt bond pursuant to an indenture by and between BB&T, as trustee, and
Wayne County IDA 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, $2,090,000 will be used to pay off the
Companys current indebtedness to BB&T, $98,000 to pay for costs of issuance
and the remaining proceeds of $2,810,000 will be 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 (1.45% as of September 2, 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 23




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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 August 20, 2003 the Company signed a loan agreement with BB&T to borrow up
to $4,691,500 to be used for the construction and equipping of the Companys
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 LIBOR rate plus 2.25%. The property and plant portion of this loan
was being amortized over 15 years with a five-year balloon payment on the
outstanding balance due August 20, 2009. The equipment portion of this loan
was being amortized over seven years with a five-year balloon payment on the
outstanding balance due on August 20, 2009. At July 31, 2004, $2,040,000 had
been drawn on this loan. As described above, as of September 2, 2004, this
loan to BB&T was paid in full and the loan agreement was terminated in its
entirety. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a)   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, 2004.10.15
    
    Letter of Credit and Reimbursement Agreement between Absorption Corp.
and Branch Banking and Trust Company dated September 1, 2004.10.16
    
    BB&T Security Agreement dated September 1, 2004 between Absorption Corp.
and Branch Banking and Trust Company.10.17
    
    BB&T Guaranty Agreement between Branch Banking and Trust Company and
International Absorbents Inc. dated September 1, 2004.10.18
    
    Lease Agreement dated as September 1, 2004 by and between Wayne County
Industrial Development Authority and Absorption Corp.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.
 b)   Reports on Form 8-K  1)
    
    A Form 8-K was filed on June 8, 2004 announcing the
Companys financial results for the first quarter ended April 30,
2004. 24




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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: September 9, 2004
    
    /s/ GORDON L. ELLISGordon L. Ellis
President & CEO(Principal Executive Officer)
 25