** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 

**(MarkOne)**

 

| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|-------------------------------------------------------------------------------------------|

 

**For theFiscal Year Ended December 31, 2001**

 

**OR**

 

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**For thetransition period from              to              .**

 

**Commission File No. 1-12714**

** **

 

**OSMONICS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Minnesota**                                                   |                                          | **41-0955959**                               |
|-----------------------------------------------------------------|-----------------------------------------------|----------------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |                                          | (I.R.S. Employer  Identification No.)        |
|                                                            |                                          |                                         |
| **5951  Clearwater Drive, Minnetonka, Minnesota**               |                                          | **55343**                                    |
| (Address of  principal executive offices)                       |                                          | (Zip Code)                                   |
|                                                            |                                          |                                         |
| **(952)  933-2277**                                             |
| (Registrant’s  telephone number)                           |
|                                                            |                                          |                                         |
| Securities  registered pursuant to Section 12(b) of the Act:    |
|                                                            |                                          |                                         |
|                                                            | **Common  Shares, par value $0.01 per share** |                                         |   |   | **New  York Stock Exchange** |   |
| (Title of each  class)                                          |                                          | (Name of each  exchange on which registered) |
|                                                            |                                          |                                         |
| Securities registered  pursuant to Section 12(g) of the Act:    |
| None.                                                           |
|                                                                 |                                               |                                              |  |  |  |  |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.

 

Yes  ý                                      No  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this form 10-K.  ý.

 

 

As of March 20,2002, 14,538,884 Common Shares were outstanding.  The aggregate market value of the Common Shares held bynon-affiliates of the Registrant on such date (based upon the closing price ofsuch shares on the New York Stock Exchange on March 20, 2002) was$209,359,930.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of theAnnual Report to Shareholders for the fiscal year ended December 31, 2001 (the“Annual Report to Shareholders”), are incorporated by reference into Parts IIand IV.  Portions of the definitiveProxy Statement for the Annual Meeting of Shareholders to be held on May 8,2002 (the “Proxy Statement”), and to be filed within 120 days after theRegistrant’s fiscal year ended December 31, 2001, are incorporated byreference into Part III.

 

PART I

 

ITEM 1.  BUSINESS

 

*The following discussion containscertain information and other forward-looking statements that involve a numberof risks and uncertainties.  The actualresults of Osmonics could differ materially from the Company’s historicalresults of operations and those discussed in the forward-lookingstatements.  See “Certain Factors” andother portions of this Form 10-K for discussion of some of these risks anduncertainties.*

 

Osmonics, Inc.,founded in 1969, and its wholly-owned subsidiaries (the “Company”) design,manufacture and market a wide range of products used in the filtration,separation and processing of fluids ranging from complete fluid processingsystems to replaceable components used in purification, filtration, andseparation equipment.  The Companyclassifies its products into three segments, namely Filtration and Separations,Process Water and Household Water.

 

*Development of Business*

 

In addition todeveloping the Company’s product line through internal research anddevelopment, the Company has expanded its business through a series ofacquisitions.  Recent major acquisitionsin the last five years include:

 

•                  AquaMatic - In February 1997,the Company acquired AquaMatic, Inc., a Rockford, Illinois-based companyoffering a line of specialty valves and controllers for the water conditioningmarket, which are sold through the Company’s existing distribution channels.

 

•                  Micron Separations, Inc. - InFebruary 1998, the Company acquired Micron Separations, Inc. (“MSI”), aWestborough, Massachusetts-based developer and manufacturer of microfiltermembrane and membrane products for diagnostic, laboratory and industrial use.These products expand the Company’s range of nylon and cellulosic membraneapplications.  The products are soldthrough the Company’s existing distribution channels.

 

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•                  Membrex Corp. - In April 1998,the Company acquired Membrex Corp. of Fairfield, New Jersey.  The acquisition gives the Company the mosthydrophilic UF membrane in the market. This patented membrane is primarily used to separate oil from water andis also used in a variety of applications in biotechnology, laboratory andpetrochemical processes. Membrex also has a patented machine using its UFmembrane, which separates oil from aqueous chemical cleaners, used in partscleaning and other industrial and commercial applications.  Some Membrex products are sold through anexclusive agreement with Safety-Kleen Corp. and the remainder through theCompany’s existing distribution channels. In December 2001, the Company signed a new agreement with Safety-KleenCorp., which continues the business relationship on a non-exclusive basis.

 

•                  ZyzaTech Water Systems, Inc. -In July 1999, the Company acquired ZyzaTech Water Systems, Inc. (ZyzaTech), aSeattle, Washington-based manufacturer of medical and pharmaceutical waterpurification and fluid handling products. ZyzaTech products are being sold through their existing distributionchannels, offering a broadened line of hemodialysis products.

 

## *Business Segments*

 

The Company’sproducts are divided into three primary business segments, namely, Filtrationand Separations, Process Water and Household Water.

 

Filtration andSeparations:

 

The Company’sFiltration and Separations group consist primarily of membranes, filter media,membrane elements and filter cartridges. The filtration media and membrane are produced primarily from polymersor polymer-based compounds.

 

Membranes aregenerally sheets of material that, due to their unique characteristics, canseparate various materials from a fluid. Membrane elements are the combination of membrane, support materials andconnections, which allows the membrane to be broadly utilized.

 

Membrane elementsare typically replaced every 6 to 60 months, depending upon the severity of theapplication.  The Company manufacturesmost of the membrane material and membrane elements used in its own systems,and also manufactures membrane and membrane elements for other originalequipment manufacturers (OEM’s) who include them as component parts in theirproducts.

 

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The Company’scrossflow membranes are used in many bioengineering processes such as theproduction of high fructose corn sugar, enzyme purification, and purificationof pharmaceuticals produced by biological processes.  Other uses include water purification applications inhemodialysis, semiconductor manufacturing, production of pure water for beverages,production of ultrapure pharmaceutical and boiler feed water, industrial waterpurification, oil/water separation and waste removal for pollution controlcompliance.

 

The Company isregistered with the United States Food and Drug Administration (FDA) for themanufacture and sale of certain membrane elements used in biologicalpreparations.

 

The Companymarkets its microfiltration normal flow membrane for use in a variety oflaboratory and medical diagnostic applications.  Numerous applications exist for the Company’s microfiltersbecause of unique features, including use in diagnostics, air monitoring and inlaboratory procedures for cancer and other research.

 

The Companymarkets several types of replaceable cartridge filters. Cartridge filtersconsist of the various membranes and filtration media manufactured by theCompany and third parties together with various end caps and other parts thatallow them to be used and replaced in filtration equipment and systems.  These cartridge filters include depth cartridgefilters, pleated cartridge filters, and rolled cartridge filters.

 

Cartridge filtersare manufactured in a range of pore sizes and particulate retentionratings.  Cartridge filters are designedto retain particles in the filters.  Asa result, cartridge filters are typically replaced at intervals of eight hoursto four weeks, depending on the particular application.

 

Process Water:

 

The Company’sProcess Water group manufactures and sells a broad range of equipment productsranging from large independent fluid treatment systems custom designed for aparticular customer and its related filtration requirements to instruments usedto determine the amount of a particular substance in a fluid.  The Company’s filtration equipment utilizesa wide range of filtration techniques including: crossflow filtration (whichincludes reverse osmosis, nanofiltration, ultrafiltration and microfiltration),normal filtration (which includes microfiltration and particle filtration),coalescing filtration, ion exchange, clarification, chromatography, ozonation anddistillation.  As a result, theCompany’s equipment is used in a broad range of applications from completefluid processing systems used in beverage production to water for highperformance boilers used in power generation. The Company’s equipment products are manufactured in two locations inthe United States.

 

The Companymanufacturers and sells crossflow and normal filtration machines.  Such machines are comprised of one or moremembrane elements, cartridge filters, pumps, valves, controls, transformers,heat exchangers, pipes and a steel frame on which the components aremounted.  The size and number ofmembrane elements and filters can vary greatly.  Pumps, pipes and frames of various sizes can be combined andconfigured to accommodate the membrane elements or filters required for variousfluid handling or separation tasks.

 

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The systems soldby the Company are comprised of one or more machines or pieces of equipmentdesigned and manufactured by the Company as well as ancillary equipment, suchas additional pumps, heat exchangers and holding tanks.  The type, size and number of machines andthe ancillary equipment included in a system will vary with the nature and sizeof the fluid separation task.

 

The Company is amajor manufacturer and marketer of machines and systems used for the productionof pure water for artificial kidney dialysis and is registered with the FDA forthe manufacture of Class II medical devices used to purify and process water forhemodialysis.

 

The Companymanufactures and sells a line of multi-stage centrifugal pumps.  These pumps were developed by the Company tomeet the need for dependable high pressure pumps and are available in 60standard sizes with flows ranging from 3 gallons per minute to 500 gallons perminute and pressure capabilities from 25 pounds per square inch (psi) to500 psi.  The pumps are capable ofoperating in series to obtain 1000 psi for seawater desalting and other highpressure applications.  The Companyrecently developed an energy recovery turbine that complements its centrifugalpumps primarily for use in desalting seawater with reverse osmosis.

 

The Companymanufactures and markets equipment to generate ozone from electricity usingcorona discharge.  Ozone is becomingincreasingly important as a bactericide and water purifier because it killsbacteria, virus and giardia cysts 10 to 300 times faster thanchlorine.  Ozone is also effective inoxidizing trace organic materials in water which are precursors of thecarcinogenic trihalomethanes.  Ozone canalso be used to purify solvent-contaminated groundwater and is often used tode-color water and wastewater.

 

The Company alsomanufactures and markets electronic controllers to operate precision valves forwater conditioning; flow control and measuring devices and instrumentation;housings and specialty holders and devices for containing and retaining variousmembranes and filters; analog and digital products for chemical water treatmentand monitoring; and instruments used to measure and control conductivity, pH,ORP, chlorine and specific ions.  Theinstruments are capable of being used in local operating network (LON)communications and data acquisition.

 

Household Water:

 

The Company is aleader in the manufacture of the controllers and valves used to effect ionexchange technology.  The most commonlyused ion exchange process is for water softening where the ions of calcium andmagnesium are replaced with sodium to reduce soap usage, improve boiler operationand improve cleaning.  Ion exchangetechnology is also used to polish ultrapure water for electronics manufactureand high-pressure boiler feed.

 

The Company alsomanufactures and sells automated chlorination units for residential and farmwater system disinfection.

 

In addition, theCompany manufactures and sells home reverse osmosis (HRO) membrane elements andcartridge filters to OEM’s who package them into systems for use in homes,offices and retail vending establishments to produce purified drinking water.

 

5

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# Segment Sales

 

For the twelvemonths of 2001, Filtration and Separations was 40% of total sales, ProcessWater was 42% of total sales and Household Water made up 18% of totalsales.  For the twelve months of 2000,Filtration and Separations was 40% of total sales, Process Water was 40% oftotal sales and Household Water made up 20% of total sales.  For the twelve months of 1999, Filtrationand Separations was 42% of total sales, Process Water was 38% of total salesand Household Water made up 20% of total sales.

 

Sales andMarketing

 

The Company’sbroad range of products are used in the purification of water and industrialsolutions, dewatering and recycling of commercial and industrial fluids, pollutioncontrol and seawater desalting.  TheCompany’s principal domestic and international markets, from which it derivesmore than 50% of its sales, include healthcare, household, food and beverage,municipal, power and industrial, and microelectronics.

 

The Companyfocuses the marketing of its products through targeted selling efforts in fourmain regions of the world:

 

1.  USA and Canada

 

2.  Mexico, Central and South America

 

3.  Euro/Africa

 

4.  Asia/Pacific

 

These salesefforts are supported by application engineers and customer service personnel.

 

Filtration andSeparations products are sold through a worldwide network of independentdistributors and OEM’s.  Some sales aremade directly to certain of the Company’s largest customers and to other manufacturersof filtration equipment and systems. The Company markets its engineered systems and equipment through itsdirect sales force and third-party integrators.  The Company’s other equipment products in the Process Water andHousehold Water products are marketed to a network of independent distributorsand value-added resellers with the help of Company district managers.  These value-added resellers provideworldwide installation service and stocking of a wide range of the Company’sequipment.

 

The Company’smarketing activities include appearances at trade shows, direct marketingcampaigns, advertisements in professional and trade journals and appearancesbefore professional organizations.  TheCompany participates with its customers in planning the systems in which itsproducts are to be used, particularly if new applications are involved.  In some cases, the sale of a system designedfor a particular customer may result from an engineering and service relationshipwhich has extended over several years.

 

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Research andDevelopment

 

Research anddevelopment activities emphasize product development and applied research, withthe goal of developing proprietary products. Such expenditures totaled $7,743,000 in 2001, $7,886,000 in 2000, and$7,694,000 in 1999.

 

Patents andTrademarks

 

The Company hasbeen granted domestic and certain foreign trademarks on numerous product names,and on its logotypes.  The Company holdsdomestic and foreign patents on certain of its filter media, membranes,filters, controlling valves, machine designs and other products.  The Company has also from time to timeacquired businesses that own patents and trademarks.  Although the Company believes that its patents have value, the Company’sbusiness as a whole is not dependent on any patent or group of related patentsbecause the Company considers its technological position to be based primarilyon its proprietary manufacturing methods, innovative engineering and marketingexpertise.  However, the loss of patentsrelating to certain specialized membranes and related products could have asignificant effect on the Company’s future revenues.

 

Employees

 

As of December 31,2001, the Company employed 1,318 persons, including 191 employees who holdengineering or technical degrees.

 

Competition

 

The Companyexperiences competition from a variety of sources with respect to virtually allof its products, although the Company knows of no single entity that competeswith it across the full range of its products and systems.  Competition in the markets served by theCompany is based on a number of factors, which may include price, technology,applications experience, know-how, availability of financing, reputation,product warranties, reliability, service and distribution.

 

With respect tothe Company’s membrane and related water treatment equipment business activity,there are a number of companies, including several sizable chemical companiesthat manufacture membranes, but not equipment. There are numerous smaller companies, primarily fabricators, that buildwater treatment and desalination equipment, but which generally do not havetheir own proprietary membrane technology. A limited number of companies manufacture both membranes and equipment.  In ozone equipment, there are both large andsmall competitors with no single dominant competitor.  In water softener controls and valves, the Company has threeprimary and numerous secondary competitors. Some competitors sell only controller valves and some sell completesofteners.  The Company has numerouscompetitors in its conventional water treatment and filtration product businessactivities.

 

With respect tothe Company’s disposable filter and lab products, two larger companies dominatethe industry with several smaller companies competing in selected productlines.

 

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With respect tothe Company’s pump and fluid handling products, there are numerous competitorsof larger size and with greater resources than the Company.  Some competitors have significantly broaderproduct lines than the Company.

 

The Company isunable to state with certainty its relative market position in all aspects ofits business.  Many of its competitorshave financial and other resources greater than those of the Company.

 

Raw Materials

 

The principal rawmaterials used by the Company are various plastic materials including polyvinylchloride, polypropylene, Noryl PPO, Nylon, cellulose acetate, polycarbonate,polyester, polysulfone, polyacrylonitrile; stainless steel, steel, brass,copper, and various other synthetic materials, all of which are normallyavailable from sources within the continental United States.  Most raw materials used by the Company areavailable from multiple sources of supply. A limited number of materials are proprietary products of majorcompanies which, if not available, would have a material effect on theCompany’s sales and profits.  TheCompany believes it could find substitutes for these materials if they shouldbecome unavailable, but has no assurance that the substitute would perform aswell or be priced as favorably.

 

In 2001 and 2000,the Company experienced no difficulty in securing any of its needed rawmaterials and components.

 

Customers

 

No one customeraccounted for 10 percent or more of the Company’s consolidated revenue in 2001,2000, or 1999.

 

Backlog

 

The dollar amountof the Company’s backlog of orders considered to be firm at December 31, 2001,was $21.1 million.  The comparable backlogat December 31, 2000, was $26.6 million. The Company expects that nearly all orders included in the backlog atDecember 31, 2001 will be filled during the 2002 fiscal year.  The Company does not believe that itsbacklog at any time is necessarily indicative of annual sales.  The business of the Company is not subjectto significant seasonal variations.

 

GovernmentalRegulation

 

Certainapplications of the Company’s reverse osmosis and ultrafiltration products andfluid handling equipment are subject to governmental regulation.  Products used for fractionation of cheesewhey for human consumption are subject to regulation by the United StatesDepartment of Agriculture.  Reverseosmosis, ultrafiltration and fluid handling systems used in medical applications,particularly the systems used in artificial kidney dialysis equipment andpharmaceutical water for injection, are subject to regulation by the FDA.  Ultrafiltration and microfiltration productsused for biological separations are subject to regulation by the FDA.

 

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Foreign Operations

 

Substantially allof the Company’s operations and assets are located in the United States.  The Company has sales offices anddistribution facilities in France, Thailand, Switzerland, Germany, Hong Kong,Japan, Singapore and China.  Limitedassembly is conducted in Europe and Asia. The profitability of domestic and foreign sales is substantiallyequal.  Sales to Canada are made on thesame trade terms as are available to customers in the United States.

 

The Companytransacts business with certain international customers under defined creditterms and in U.S. dollars.  Large exportequipment and system sales are primarily made on the basis of confirmedirrevocable letters of credit or time drafts to selected customers in U.S.dollars.  The Company believes thatcurrency fluctuation related to these sales do not constitute substantialrisks.

 

The Company’soperation in France sells to foreign customers primarily in euros.   The Company also has certain raw materialsourcing arrangements transacted in foreign currencies. In 2001, the Companyentered into a hedge contract to help offset foreign currency risk related toits European foreign subsidiary.  Theinstrument hedges certain levels of the subsidiary’s local euro currencyexposure to the U.S. dollar and expires in June 2002. The Company believesthese transactions do constitute some level of risk and adverse currencyfluctuations may occur.  See Note 12 ofNotes to Consolidated Financial Statements for a breakdown of the Company’sforeign operations and export sales by geographic area.

 

Certain Factors

 

*In addition to the factors discussedelsewhere in the Company’s Annual Report to Shareholders or this Form 10-K,such as intellectual property and other technological risks, regulatory risks,and environmental risks, the following are some important factors that couldcause actual results or events to differ materially from those contained in anyforward-looking statements made by or on behalf of the Company.*

 

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EARNINGSVARIATIONS

 

The sale ofcapital equipment within the water purification and fluid filtration industryis cyclical and influenced by various economic factors including interest ratesand general fluctuations of the business cycle.  A significant portion of the Company’s revenues is derived fromcapital equipment sales.  While theCompany sells capital equipment to customers in diverse industries and inglobal markets, cyclicality of capital equipment sales and instability ofgeneral economic conditions, including those in the United States, Europe,Asia, Latin America and certain other markets, could have a material adverseeffect on the Company’s revenues and profitability.

 

Operating resultsfrom the sale of water purification and fluid filtration systems also can beexpected to fluctuate significantly as a result of the limited pool of existingand potential customers for these systems, the timing of new contracts,possible deferrals or cancellations of existing contracts and the evolving andunpredictable nature of the markets for water purification systems.  As a result of these and other factors, theCompany’s operating results may be subject to quarterly or annualfluctuations.  There can be no assurancethat at any given time the Company’s operating results will meet or exceedstock market analysts’ expectations.

 

COMPETITION

 

All of the marketsin which the Company competes are highly competitive, and most are fragmented,with numerous regional and local participants. There are competitors of the Company in certain markets that aredivisions or subsidiaries of companies that have significantly greaterresources than the Company.  Competitivefactors include price, technical expertise, product quality and responsivenessto customer needs, including service and technical support.  The Company competes not only with a largenumber of independent wholesalers and with other distribution chains similar tothe Company, but also with manufacturers who sell directly to customers.  The Company’s HRO business also competeswith companies with national distribution networks, businesses with regionalscope, and local product assemblers or service companies, as well as retailoutlets.  The Company believes thatthere are thousands of participants in the residential water business.  The HRO business competes principally on thebasis of price, product quality and “taste,” service, distributioncapabilities, geographic presence and reputation.  Competitive pressures, including those described above, and otherfactors could cause the Company to lose market share or could result insignificant price erosion, either of which could have a material adverse effectupon the Company’s financial position, results of operations and cash flows.

 

INTEREST RATE RISK

 

The Company hasinterest rate risk associated with its debt instruments.  These debt instruments are both fixed andvariable in nature.  Also, the Companyhas some debt instruments denominated in currency other than the U.S.dollar.  See Note 8 of Notes toConsolidated Financial Statements for a breakdown of the Company’s debtinstruments.  The following is a futurematurity schedule by debt instrument category which can be used to assess theCompany’s level of interest rate exposure as of December 31, 2001:

 

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|                 | **Weighted** |   |         |   |                   |
|----------------------|--------------|--------|--------------|--------|------------------------|
|                 | **Average**  |   |         |   | **Future  Maturities** |   |
|                 | **Interest** |   | **Balance**  |   |                   | **2006 and** |   |
|                 | **Rate**     |   | **12/31/01** |   | **2002**               |   | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **Beyond** |   |
| Variable  Rate Debt: |         |   |         |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.  dollar-based   |         | 4.5    | %            | 27,150 |                   | 11,864 |   | 2,365 |   | 2,365 |   | 2,365 |   | 2,365 |   | 5,826 |   |
| Euro-based           |         |   |         | — |                   | — |   | — |   | — |   | — |   | — |   | — |   |
| Total                |         |   |         | 27,150 |                   | 11,864 |   | 2,365 |   | 2,365 |   | 2,365 |   | 2,365 |   | 5,826 |   |
|                 |         |   |         |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed  Rate Debt:    |         |   |         |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.  dollar-based   |         | 7.1    | %            | 5,845  |                   | 1,437 |   | 1,212 |   | 591 |   | 580 |   | 574 |   | 1,451 |   |
| Euro-based           |         | 4.5    | %            | 1,073  |                   | 318 |   | 237 |   | 248 |   | 259 |   | 11 |   | — |   |
| Total                |         |   |         | 6,918  |                   | 1,755 |   | 1,449 |   | 839 |   | 839 |   | 585 |   | 1,451 |   |
|                 |         |   |         |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  Debt          |         | 4.9    | %            | 34,068 |                   | 13,619 |   | 3,814 |   | 3,204 |   | 3,204 |   | 2,950 |   | 7,277 |   |
|                      |              |        |              |        |                        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

FOREIGN CURRENCYRISK

 

The Company in theordinary course of business enters into sales and purchase activity at theCorporate and Subsidiary level in currency other than the functional currencyof the reporting entity (U.S. dollar) and such activity exposes the Company toforeign exchange rate risk.  In the yearended December 31, 2001, the Company transacted sales and purchase transactionsin a currency other than U.S. dollars of approximately $16,200,000 and$7,200,000, respectively.

 

RISKS RELATED TOACQUISITIONS

 

The Company hasacquired a number of United States-based companies and product lines.  The Company plans to continue to considerand potentially pursue acquisitions that expand the segments of the water,wastewater treatment and water-related industries in which it participates;complement its technologies, products or services; broaden its customer baseand geographic areas served; expand its global distribution network; andprovide opportunities. The Company’s acquisition strategy entails the potentialrisks inherent in assessing the value, strengths, weaknesses, contingent orother liabilities and potential profitability of acquisition candidates and inintegrating the operations of acquired companies.  Although the Company believes that it has generally beensuccessful in pursuing acquisitions, there can be no assurance that acquisitionopportunities will continue to be available, that the Company will have accessto the capital required to finance potential acquisitions, that the Companywill continue to acquire businesses or that any business acquired will beintegrated successfully or prove profitable.

 

PROFIT UNCERTAINTYIN FIXED-PRICE CONTRACTS

 

A significantportion of the Company’s revenues is generated under fixed pricecontracts.  To the extent that originalcost estimates are inaccurate, scheduled deliveries are delayed or progressunder a contract is otherwise impeded, revenue recognition and profitabilityfrom a particular contract may be adversely affected.

 

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RISKS OF DOINGBUSINESS IN OTHER COUNTRIES

 

The Company sellsa significant amount of its product in markets outside the United States.  While these activities provide importantopportunities for the Company to offer its products and servicesinternationally, they also entail the risks associated with conducting businessinternationally, including the risk of currency fluctuations, slower payment ofinvoices, the lack in some jurisdictions of well-developed legal systems,nationalization and possible social, political and economic instability.

 

ITEM 2.  PROPERTIES

 

The executiveoffices and principal manufacturing facilities of the Company are located inMinnetonka, Minnesota, a suburb of Minneapolis.

 

A summary of theCompany’s main operating facilities is as follows:

 
| **Location**           |   | **Status** |   | **Size**      |   | **Function**                     |
|------------------------|--------|------------|--------|---------------|--------|----------------------------------|
| Minnetonka, MN         |   | Owned      |   | 309,600 sq ft |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Vista, CA              |   | Owned      |   | 110,000 sq ft |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Milwaukee, WI          |   | Owned      |   | 103,700 sq ft |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Rockford, IL           |   | Owned      |   | 58,400 sq ft  |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Westborough, MA        |   | Leased     |   | 44,000 sq ft  |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Kent, WA               |   | Leased     |   | 50,000 sq ft  |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Syracuse, NY           |   | Owned      |   | 48,500 sq ft  |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Le Mée, France    |   | Owned      |   | 36,900 sq ft  |   | Sales, Manufacturing,  Warehouse |
|                   |   |       |   |          |   |                             |
| Cedar Grove, NJ        |   | Leased     |   | 4,000 sq ft   |   | Research &  Development      |
|                   |   |       |   |          |   |                             |
| Escondido, CA          |   | Leased     |   | 12,700 sq ft  |   | Manufacturing                    |
|                   |   |       |   |          |   |                             |
| Emmetsburg, IA         |   | Leased     |   | 8,800 sq ft   |   | Manufacturing,  Warehouse        |
|                   |   |       |   |          |   |                             |
| Bryan, TX              |   | Owned      |   | 2,500 sq ft   |   | Manufacturing,  Warehouse        |
|                   |   |       |   |          |   |                             |
| Total Owned            |   |       |   | 669,600 sq ft |   |                             |
|                   |   |       |   |          |   |                             |
| Total Leased           |   |       |   | 119,500 sq ft |   |                             |
|                   |   |       |   |          |   |                             |
| Total Owned and Leased |   |       |   | 789,100 sq ft |   |                             |

 

Certain borrowingsof the Company are collateralized by real property of the Company.

 

The currentmanufacturing facilities are adequate for intermediate-term operations.  In addition, the Company leases space inThailand, China, Germany, Japan, Hong Kong, Switzerland and Singapore that isused primarily for sales activities.

 

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ITEM 3.  LEGAL PROCEEDINGS

 

The Company iscurrently involved in several lawsuits incidental to its business. Managementdoes not believe that any of the lawsuits will have a material adverse effecton the Company’s financial position or results of operations.

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

 

No matter wassubmitted to a vote of the Company’s security holders during the fourth quarterof the fiscal year that ended December 31, 2001.

 

EXECUTIVE OFFICERS OF THEREGISTRANT

 
| **Name and Age**          |   | **Position  with Company**                                     |   | **Officer  Since** |
|---------------------------|--------|----------------------------------------------------------------|--------|--------------------|
| D. Dean Spatz (57)        |   | Chief Executive Officer  and Chairman of the Board             |   | 1969               |
|                      |   |                                                           |   |               |
| Ruth Carol Spatz (57)     |   | Secretary                                                      |   | 1969               |
|                      |   |                                                           |   |               |
| Roger S. Miller (43)      |   | Sr. Vice President                                             |   | 1998               |
|                      |   |                                                           |   |               |
| Phillip M. Rolchigo  (40) |   | Chief Technology  Officer                                      |   | 1998               |
|                      |   |                                                           |   |               |
| Edward J. Fierko (60)     |   | President and Chief  Operating Officer                         |   | 1999               |
|                      |   |                                                           |   |               |
| Keith B. Robinson (47)    |   | Chief Financial Officer  and Sr. Vice President Administration |   | 1999               |

 

All of theexecutive officers have been officers of the Company for more than five yearsexcept the following:

 

Mr. Miller joinedOsmonics in 1993 as a product manager for pumps.  Previously, Mr. Miller managed sales and marketing for KurtManufacturing, a machine tool manufacturer, and was a general manager for acapital equipment manufacturer in the water treatment industry.

 

Dr. Rolchigo cameto Osmonics from Membrex Corp., which Osmonics acquired in 1998.  Dr. Rolchigo is the principal inventor ofadvanced vortex flow filtration technology. His technical expertise spans diverse industries from environmentalwaste to pharmaceutical processing.  Hehas served as a research affiliate in chemical engineering for MIT, and belongsto numerous industry organizations.

 

Mr. Fierko joinedOsmonics in 1998 as a Vice President and General Manager of two Global BusinessUnits.  Previously, Mr. Fierko served asPresident and CEO of EcoWater

 

13

----

 

International, Inc.  Before that, he served as President ofEcoWater Systems and was with General Electric Company for 23 years prior tojoining EcoWater in 1987.

 

Mr. Robinsonjoined Osmonics in 1999 as Chief Financial Officer and Senior Vice PresidentAdministration.  Previously, Mr. Robinsonserved as Senior Director of Planning and Finance at West Group.  Before that, he served as Chief FinancialOfficer of The Thompson Corporation.

 

All executiveofficers are elected annually by, and serve at the direction of, the Board ofDirectors.  D. Dean Spatz and Ruth CarolSpatz are husband and wife.

 

PART II

 

ITEM 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITYAND RELATED SHAREHOLDER MATTERS

 

“Common StockData,” and “Notes to Consolidated Financial Statements,” pages 25-33 of theAnnual Report to Shareholders, are incorporated herein by reference.  As of March 20, 2002 there were 1,821shareholders of record.

 

The Company hasnot paid cash dividends on its common shares. The Board of Directors currently intends to retain its earnings for theexpansion of the Company’s business. The Company has issued promissory notesthat contain a covenant limiting the payment of dividends to shareholders.  At December 31, 2001, approximately$13,632,000 of retained earnings was eligible for dividend distribution underthis covenant.

 

ITEM 6.  SELECTED FINANCIAL DATA

 

“SelectedFinancial Data,” pages 40-41 of the Annual Report to Shareholders, isincorporated herein by reference.

 

ITEM7.  MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

“Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”pages 34-39 of the Annual Report to Shareholders, is incorporated herein byreference.

 

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

Informationrequired by this Item is under the heading Foreign Operations, Interest RateRisk and Foreign Currency Risk of Item 1 of this Form 10-K.

 

14

----

 

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA

 

The followingconsolidated financial information of the Registrant and its subsidiaries,included in the Annual Report to Shareholders, is incorporated herein byreference:

 
| Independent Auditors’  Report                               |
|------------------------------------------------------------------|
|                                                             |
| Consolidated  Statements of Operations                           |
|                                                             |
| Consolidated Balance Sheets                                      |
|                                                             |
| Consolidated  Statements of Cash Flow                            |
|                                                             |
| Consolidated  Statements of Changes in Shareholders’ Equity |
|                                                             |
| Notes to  Consolidated Financial Statements                      |
|                                                             |
| Quarterly  Financial Data                                        |

 

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

 

Not Applicable.

 

PART III

 

ITEM 10.  DIRECTORS

 

The informationrequired by this item is incorporated herein by reference to the definitiveProxy Statement to be filed with the Securities and Exchange Commission within120 days after the close of the Company’s fiscal year ended December 31, 2001and forwarded to shareholders prior to the Company’s 2002 Annual Meeting ofShareholders (the “2002 Proxy Statement”).

 

ITEM 11.  EXECUTIVE COMPENSATION

 

The informationrequired by this Item is incorporated herein by reference to the 2002 ProxyStatement.

 

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT

 

The informationrequired by this Item is incorporated herein by reference to the2002 Proxy Statement.

 

15

----

 

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

 

The informationrequired by this Item is incorporated herein by reference to the 2002 ProxyStatement.

 

PART IV

 

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULE,AND REPORTS ON FORM 8-K

 

(a) (1)           Financial Statements

 

The consolidatedfinancial statements of the Registrant and its subsidiaries, included in theAnnual Report to Shareholders, are incorporated by reference in Item 8, and arealso incorporated herein by reference.

 

(a) (2)           Financial Statement Schedule

 

Reports of IndependentPublic Accountants on Supplemental Schedule to the Consolidated FinancialStatements.

 

Valuation and qualifyingaccounts.

 

Schedules not listedabove have been omitted because they are either not applicable, not material orthe required information has been given in the financial statements or in thenotes to the financial statements.

 

  (2)                                     Agreement and Planof Merger among Desalination Systems, Inc., Osmonics, Inc. and DSI AcquisitionCorp. dated May 17, 1996. (Incorporated herein by reference to Exhibit 2 to Registration Statementon Form S-3, File No. 33-05029.)

 
| (3)A.     | Certificate of Incorporation of the Registrant, as  amended.  (Incorporated herein by  reference to Exhibit 3.1 to Registration Statement on Form S-2, File No.  33-336.)  Certificate of  Amendment.  (Incorporated herein by  reference to Exhibit (3)A on Form 10-K for fiscal year ended December 31,  1987, File No. 0–8282.) |
|-----------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |                                                                                                                                                                                                                                                                                                                                                   |
|   B. | By-Laws of the Registrant.  (Incorporated herein by reference to  Exhibit 3.2 to Registration Statement on Form S-2, File No. 33-336.)                                                                                                                                                                                                            |
|      |                                                                                                                                                                                                                                                                                                                                                   |
| (4)A.     | Note Purchase Agreement dated July 12, 1991.  (Incorporated herein by reference to  Annual Report on Form 10-K for fiscal year ended December 31, 1991.)                                                                                                                                                                                          |

 

16

----

 
| (10)A.*   | 1993 Stock Option Plan and related form of stock  option agreement.  (Incorporated  herein by reference to Annex C of the Registrant’s Joint Proxy  Statement/Prospectus dated September 10, 1993.) |
|-----------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |                                                                                                                                                                                                          |
|   B. | Stock Option Agreement  with Michael L. Snow, Director.   (Incorporated herein by reference to Annual Report on Form 10-K for  fiscal year ended December 31, 1993.)                                |
|      |                                                                                                                                                                                                          |
|   D. | 1995 Employee Stock Purchase Plan.  (Incorporated herein by reference to the  Registrant’s Proxy Statement dated March 27, 1995.)                                                                   |
|      |                                                                                                                                                                                                          |
|  E.* | 1995 Director Stock Option Plan.  (Incorporated herein by reference to the  Registrant’s Proxy Statement dated March 27, 1995.)                                                                     |
|      |                                                                                                                                                                                                          |
|      | * Denotes Executive Compensation Plan.                                                                                                                                                                        |
|      |                                                                                                                                                                                                          |
| (10)      | (a)                                                                                                                                                                                                           | Letter Agreement dated as of May 15, 2001 by and  between MLS and the Corporation (terminated August 13, 2002)(rescinded April  1, 2002)(portions of this exhibit were omitted and filed separately with the  Securities and Exchange Commission pursuant to an application requesting  confidential treatment in accordance with Rule 24b-2 of the Securities  Exchange Act of 1934.) |
|      |                                                                                                                                                                                                          |
|      | (b)                                                                                                                                                                                                           | Stock Option Agreement with Michael L. Snow,  Director. |
|      |                                                                                                                                                                                                          |
|      | (c)                                                                                                                                                                                                           | Change of Control Agreement dated April 26, 2001  with D. Dean Spatz (schedule attached listing executives / officers with  substantially identical change in control agreements). |
|      |                                                                                                                                                                                                          |
|      | (d)                                                                                                                                                                                                           | Non-compete Agreement with Phil M. Rolchigo dated  October 5, 2001. |
|      |                                                                                                                                                                                                          |   |
|      | (e)                                                                                                                                                                                                           | Letter agreement of April 1, 2002 by and between MLS  and the Company rescinding Letter Agreement dated May 15, 2001. |
|      |                                                                                                                                                                                                          |
|      | 2001 Annual Report to Shareholders.  (Only those portions incorporated herein  by reference shall be deemed filed with the Commission.)                                                                  |
| (13)      |
|      |                                                                                                                                                                                                          |
| (21)      | Subsidiaries of the Registrant.                                                                                                                                                                               |
|      |                                                                                                                                                                                                          |
| (23)      | Consent of Deloitte & Touche LLP.                                                                                                                                                                         |

 

17

----

 

(b)                Reports on Form 8-K

 

No reports on Form 8-Kwere filed during the quarter ended December 31, 2001.

 

18

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|   | OSMONICS, INC.     |
|--------|--------------------|
|   |
|   | By                 | /s/ D. Dean Spatz |   |
|   | D. Dean Spatz, CEO |

 

Dated:  April 1, 2002

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated:

 
|   | **Signatures**     |                                        | **Title**                                |          | **Date** |
|--------|--------------------|---------------------------------------------|------------------------------------------|---------------|----------|
|   |               |                                        |                                     |
| /s/    | Keith B. Robinson  |                                        | Chief Financial Officer                  | April 1, 2002 |
|   | Keith B. Robinson  | (Principal Finance and  Accounting Officer) |                                     |
|   |               |                                        |                                     |
| /s/    | Ruth Carol Spatz   |                                        | Director                                 | April 1, 2002 |
|   | Ruth Carol Spatz   |                                        |                                     |
|   |               |                                        |                                     |
|   |               |                                        | Director                                 | April 1, 2002 |
|   | Michael L. Snow    |                                        |                                     |
|   |               |                                        |                                     |
| /s/    | Ralph E. Crump     |                                        | Director                                 | April 1, 2002 |
|   | Ralph E. Crump     |                                        |                                     |
|   |               |                                        |                                     |
| /s/    | Charles W. Palmer  |                                        | Director                                 | April 1, 2002 |
|   | Charles W. Palmer  |                                        |                                     |
|   |               |                                        |                                     |
| /s/    | William Eykamp     |                                        | Director                                 | April 1, 2002 |
|   | William Eykamp     |                                        |                                     |
|   |               |                                        |                                     |
| /s/    | Charles M. Brennan |                                        | Director                                 | April 1, 2002 |
|   | Charles M. Brennan |                                        |                                     |
|   |               |                                        |                                     |
| /s/    | D. Dean Spatz      |                                        | CEO, Chairman of the  Board and Director | April 1, 2002 |
|   | D. Dean Spatz      | (Principal Executive  Officer)              |                                     |
|        |                    |                                             |                                          |               |          |  |  |

 

19

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OSMONICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 
|                                                    |   | **Year Ended  December 31,** |    |
|---------------------------------------------------------|--------|------------------------------|---------|
|                                                    |   | **2001**                     |    | **2000** |   | **1999** |   |
| Sales                                                   |   | $                            | 207,439 |   | $ | 200,139 |   | $ | 187,028 |   |
|                                                    |   |                         |    |   |   |   |   |
| Cost  of sales                                          |   | 141,896                      |    | 139,733 |   | 128,608 |   |
|                                                    |   |                         |    |   |   |   |   |
| Gross  profit                                           |   | 65,543                       |    | 60,406 |   | 58,420 |   |
|                                                    |   |                         |    |   |   |   |   |
| Operating expenses:                                     |   |                         |    |   |   |   |   |
|                                                    |   |                         |    |   |   |   |   |
| Selling,  general and administrative                    |   | 44,806                       |    | 44,195 |   | 43,720 |   |
| Research,  development and engineering                  |   | 7,743                        |    | 7,886 |   | 7,694 |   |
| Special  charges                                        |   | 1,700                        |    | 250 |   | 2,575 |   |
|                                                    |   | 54,249                       |    | 52,331 |   | 53,989 |   |
| Income  from operations                                 |   | 11,294                       |    | 8,075 |   | 4,431 |   |
|                                                    |   |                         |    |   |   |   |   |
| Other  income (expense), net:                           |   |                         |    |   |   |   |   |
|                                                    |   |                         |    |   |   |   |   |
| Interest  income                                        |   | 116                          |    | 397 |   | 612 |   |
| Interest  expense                                       |   | (2,555                       | )       | (4,337 | ) | (4,053 | ) |
| Other                                                   |   | 507                          |    | 3,947 |   | 2,058 |   |
|                                                    |   | (1,932                       | )       | 7 |   | (1,383 | ) |
| Income  before income taxes                             |   | 9,362                        |    | 8,082 |   | 3,048 |   |
|                                                    |   |                         |    |   |   |   |   |
| Income  taxes (Note 10)                                 |   | 3,183                        |    | 2,663 |   | 2,084 |   |
|                                                    |   |                         |    |   |   |   |   |
| Net  income                                             |   | $                            | 6,179   |   | $ | 5,419 |   | $ | 964 |   |
|                                                    |   |                         |    |   |   |   |   |
| Earnings  per share – basic (Note 15)              |   | $                            | 0.43    |   | $ | 0.38 |   | $ | 0.07 |   |
|                                                    |   |                         |    |   |   |   |   |
| Earnings  per share – assuming dilution  (Note 15) |   | $                            | 0.42    |   | $ | 0.38 |   | $ | 0.07 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

20

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OSMONICS, INC.

CONSOLIDATEDBALANCE SHEETS

 

(In thousands, except share data)

 
|                                                                                                      |   | **December  31,** |    |
|-----------------------------------------------------------------------------------------------------------|--------|-------------------|---------|
|                                                                                                      |   | **2001**          |    | **2000** |   |
| ASSETS                                                                                                    |   |              |    |   |   |
| Current  assets:                                                                                          |   |              |    |   |   |
| Cash  and cash equivalents                                                                                |   | $                 | —  |   | $ | 21 |   |
| Marketable  securities (Note 3)                                                                           |   | 52                |    | 1,889 |   |
| Trade  accounts receivable, net of allowance for doubtful accounts of $963 in 2001  and $1,008 in 2000    |   | 34,890            |    | 36,765 |   |
| Inventories  (Note 4)                                                                                     |   | 32,094            |    | 32,758 |   |
| Deferred  tax assets (Note 11)                                                                            |   | 4,867             |    | 4,314 |   |
| Other  current assets                                                                                     |   | 2,041             |    | 2,487 |   |
| Total  current assets                                                                                     |   | 73,944            |    | 78,234 |   |
| Property  and equipment, at cost:                                                                         |   |              |    |   |   |
| Land  and land improvements                                                                               |   | 5,366             |    | 5,056 |   |
| Buildings                                                                                                 |   | 30,830            |    | 30,283 |   |
| Machinery  and equipment                                                                                  |   | 76,282            |    | 76,943 |   |
|                                                                                                      |   | 112,478           |    | 112,282 |   |
| Accumulated  depreciation                                                                                 |   | (53,314           | )       | (55,381 | ) |
|                                                                                                      |   | 59,164            |    | 56,901 |   |
| Cash  restricted for purchase and construction of equipment (Note 5)                                      |   | 325               |    | 325 |   |
| Goodwill,  net of accumulated amortization of $8,340 in 2001 and $6,478 in 2000                           |   | 44,295            |    | 46,310 |   |
| Long-term  investments                                                                                    |   | 2,617             |    | 2,688 |   |
| Other  assets, net of accumulated amortization of intangible assets of $1,910 in  2001 and $1,428 in 2000 |   | 4,453             |    | 4,234 |   |
| Total  assets                                                                                             |   | $                 | 184,798 |   | $ | 188,692 |   |
|                                                                                                      |   |              |    |   |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                |   |              |    |   |   |
| Current  liabilities:                                                                                     |   |              |    |   |   |
| Accounts  payable                                                                                         |   | $                 | 11,860  |   | $ | 15,262 |   |
| Line  of credit advances (Note 6)                                                                         |   | 9,500             |    | 15,000 |   |
| Notes  payable and current portion of long-term debt (Note 8)                                             |   | 4,119             |    | 4,759 |   |
| Accrued  compensation and employee benefits                                                               |   | 4,282             |    | 3,391 |   |
| Other  accrued liabilities (Note 7)                                                                       |   | 12,428            |    | 10,393 |   |
| Total  current liabilities                                                                                |   | 42,189            |    | 48,805 |   |
| Long-term  debt (Note 8)                                                                                  |   | 20,449            |    | 24,603 |   |
| Deferred  income taxes (Note 11)                                                                          |   | 6,763             |    | 6,335 |   |
| Other  liabilities                                                                                        |   | —            |    | 4 |   |
| Commitments  and contingencies (Note 13)                                                                  |   |              |    |   |   |
| Shareholders’  equity (Note 9):                                                                      |   |              |    |   |   |
| Common  stock, $0.01 par value                                                                            |   |              |    |   |   |
| Authorized  – 50,000,000 shares                                                                      |   |              |    |   |   |
| Issued  – 2001:  14,523,579 and 2000:  14,408,634 shares                                   |   | 145               |    | 144 |   |
| Preferred  stock:  Authorized - 500,000 shares;  outstanding – none                             |   | —            |    | — |   |
| Capital  in excess of par value                                                                           |   | 24,701            |    | 23,818 |   |
| Retained  earnings                                                                                        |   | 91,637            |    | 85,458 |   |
| Total  other comprehensive loss                                                                           |   | (1,086            | )       | (475 | ) |
| Total  shareholders’ equity                                                                          |   | 115,397           |    | 108,945 |   |
| Total  liabilities and shareholders’ equity                                                          |   | $                 | 184,798 |   | $ | 188,692 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

21

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OSMONICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 
|                                                               |   | **Year Ended  December 31,** |       |
|--------------------------------------------------------------------|--------|------------------------------|------------|
|                                                               |   | **2001**                     |       | **2000** |   | **1999** |   |
| **Cash  flows from operations:**                                   |   |                         |       |   |   |   |   |
| Net  income                                                        |   | $                            | 6,179      |   | $ | 5,419 |   | $ | 964 |   |
| Non-cash items included in net income:                             |   |                         |       |   |   |   |   |
| Depreciation  and amortization                                     |   | 10,340                       |       | 10,139 |   | 8,772 |   |
| Deferred  income taxes                                             |   | 93                           |       | 1,609 |   | 3,227 |   |
| Gain  on sale of land and investments                              |   | (972                         | )          | (3,788 | ) | (2,625 | ) |
| Loss  on sale of property and equipment                            |   | 35                           |       | — |   | — |   |
| Special  charges                                                   |   | 1,574                        |       | — |   | 3,610 |   |
| Changes  in assets and liabilities (net of business acquisitions): |   |                         |       |   |   |   |   |
| Accounts  receivable                                               |   | 2,133                        |       | (1,205 | ) | (357 | ) |
| Inventories                                                        |   | 664                          |       | (8,158 | ) | 5,372 |   |
| Other  current assets                                              |   | 446                          |       | (366 | ) | 2,464 |   |
| Accounts  payable and accrued liabilities                          |   | (2,054                       | )          | (1,255 | ) | (1,338 | ) |
| **Net cash provided by  operations**                               |   | **18,438**                   | ** ** | **2,395** | ** ** | **20,089** |   |
|                                                               |   |                         |       |   |   |   |   |
| **Cash  flows from investing activities:**                         |   |                         |       |   |   |   |   |
| Cash paid for acquisitions (net of cash acquired)                  |   | —                       |       | — |   | (6,846 | ) |
| Purchase  of investments                                           |   | —                       |       | (1,178 | ) | (3,603 | ) |
| Maturities  and sales of investments                               |   | 2,188                        |       | 14,029 |   | 6,409 |   |
| Purchase  of property and equipment                                |   | (10,430                      | )          | (7,058 | ) | (8,323 | ) |
| Proceeds  from sale of property and equipment                      |   | 575                          |       | 367 |   | 747 |   |
| Other                                                              |   | (1,174                       | )          | (1,322 | ) | (728 | ) |
| **Net cash (used in)  provided by investing activities**           |   | **(8,841**                   | **)**      | **4,838** | ** ** | **(12,344** | ) |
|                                                               |   |                         |       |   |   |   |   |
| **Cash  flows from financing activities:**                         |   |                         |       |   |   |   |   |
| (Payments)  proceeds from notes payable and current debt           |   | (6,140                       | )          | (1,553 | ) | 9,000 |   |
| Reduction  of long-term debt                                       |   | (4,154                       | )          | (8,434 | ) | (17,061 | ) |
| Cash  restricted for purchase and construction of equipment        |   | —                       |       | — |   | 235 |   |
| Issuance  of common stock                                          |   | 884                          |       | 1,207 |   | 1,882 |   |
| **Net cash (used in)  financing activities**                       |   | **(9,410**                   | **)**      | **(8,780** | **)** | **(5,944** | ) |
|                                                               |   |                         |       |   |   |   |   |
| Effect  of exchange rate changes on cash                           |   | (208                         | )          | (239 | ) | (570 | ) |
| (Decrease)  increase in cash and cash equivalents                  |   | (21                          | )          | (1,786 | ) | 1,231 |   |
| Cash  and cash equivalents - beginning of year                     |   | 21                           |       | 1,807 |   | 576 |   |
| **Cash  and cash equivalents - end of year**                       |   | $                            | —     |   | $ | 21 |   | $ | 1,807 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

22

----

 

OSMONICS, INC.

CONSOLIDATED STATEMENTSOF CHANGES IN SHAREHOLDERS’ EQUITY

(In thousands,except share data)

 
|                                   | **Accumulated** |              |         |
|----------------------------------------|-----------------|-------------------|--------------|
|                                   | **Capital**     |              | **Other**    |   | **Total** |   |
|                                   |            | **Common  Stock** |         | **in Excess  of** |   | **Retained** |   | **Comprehensive** |   | **Shareholders’** |   |
|                                   |            | **Shares**        |         | **Amount** |   | **Par Value** |   | **Earnings** |   | **Income(2)** |   | **Equity** |   |
| ***Balance – January 1, 1999***   |            | ***13,991,291***  | *** *** | ***140*** | *** *** | ***20,733*** | *** *** | ***79,075*** | *** *** | ***2,207*** | *** *** | ***102,155*** | *** *** |
| Comprehensive  income                  |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Net  income                            |            | —            |         | — |   | — |   | 964 |   | — |   | 964 |   |
| Other  comprehensive income (loss) (1) |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Translation  adjustment                |            | —            |         | — |   | — |   | — |   | (570 | ) | (570 | ) |
| Marketable  securities adjustment (3)  |            | —            |         | — |   | — |   | — |   | 111 |   | 111 |   |
| Other  comprehensive (loss)            |            | —            |         | — |   | — |   | — |   | (459 | ) | (459 | ) |
| Total  comprehensive income            |            | —            |         | — |   | — |   | — |   | — |   | 505 |   |
| Employee  stock purchase plans         |            | 69,209            |         | 1 |   | 555 |   | — |   | — |   | 556 |   |
| 401(k)  stock match                    |            | 51,078            |         | 1 |   | 483 |   | — |   | — |   | 484 |   |
| Stock  options exercised               |            | 150,552           |         | 1 |   | 841 |   | — |   | — |   | 842 |   |
| ***Balance - December 31, 1999***      |            | ***14,262,130***  | *** *** | ***143*** | *** *** | ***22,612*** | *** *** | ***80,039*** | *** *** | ***1,748*** | *** *** | ***104,542*** | *** *** |
| Comprehensive  income                  |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Net  income                            |            | —            |         | — |   | — |   | 5,419 |   | — |   | 5,419 |   |
| Other  comprehensive (loss) (1)        |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Translation  adjustment                |            | —            |         | — |   | — |   | — |   | (239 | ) | (239 | ) |
| Marketable  securities  adjustment (3) |            | —            |         | — |   | — |   | — |   | (1,984 | ) | (1,984 | ) |
| Other  comprehensive (loss)            |            | —            |         | — |   | — |   | — |   | (2,223 | ) | (2,223 | ) |
| Total  comprehensive income            |            | —            |         | — |   | — |   | — |   | — |   | 3,196 |   |
| Employee  stock purchase plans         |            | 74,017            |         | 1 |   | 522 |   | — |   | — |   | 523 |   |
| 401(k)  stock match                    |            | 59,748            |         | — |   | 498 |   | — |   | — |   | 498 |   |
| Other                                  |            | —            |         | — |   | 136 |   | — |   | — |   | 136 |   |
| Stock  options exercised               |            | 12,739            |         | — |   | 50 |   | — |   | — |   | 50 |   |
| ***Balance - December 31, 2000***      |            | ***14,408,634***  | *** *** | ***$*** | ***144*** | *** *** | ***$*** | ***23,818*** | *** *** | ***$*** | ***85,458*** | *** *** | ***$*** | ***(475*** | ***)*** | ***$*** | ***108,945*** | *** *** |
| Comprehensive  income                  |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Net  income                            |            | —            |         | — |   | — |   | 6,179 |   | — |   | 6,179 |   |
| Other  comprehensive (loss) (1)        |            |              |         |   |   |   |   |   |   |   |   |   |   |
| Translation  adjustment                |            | —            |         | — |   | — |   | — |   | (208 | ) | (208 | ) |
| Marketable  securities  adjustment (3) |            | —            |         | — |   | — |   | — |   | (403 | ) | (403 | ) |
| Other  comprehensive (loss)            |            | —            |         | — |   | — |   | — |   | (611 | ) | (611 | ) |
| Total  comprehensive income            |            | —            |         | — |   | — |   | — |   | — |   | 5,568 |   |
| Employee  stock purchase plans         |            | 52,300            |         | 1 |   | 432 |   | — |   |   |   | 433 |   |
| 401(k)  stock match                    |            | 45,447            |         | — |   | 472 |   | — |   | — |   | 472 |   |
| Other                                  |            | —            |         | — |   | (136 | ) | — |   | — |   | (136 | ) |
| Stock  options exercised               |            | 17,198            |         | — |   | 115 |   | — |   | — |   | 115 |   |
| ***Balance - December 31, 2001***      |            | ***14,523,579***  | *** *** | ***$*** | ***145*** | *** *** | ***$*** | ***24,701*** | *** *** | ***$*** | ***91,637*** | *** *** | ***$*** | ***(1,086*** | ***)*** | ***$*** | ***115,397*** | *** *** |

 

----

(1)             All items included inother comprehensive income (loss) are shown net of taxes.  The tax effect for the marketable securitiesadjustment was $(134), $(1,051) and $43 for 2001, 2000 and 1999, respectively.

(2)             Accumulated othercomprehensive income (loss) is comprised of accumulated currency translation of$(1,045), $(837) and $(598) and marketable securities adjustment of $(32), $362and $2,346 at December 31, 2001, 2000 and 1999, respectively.

(3)             Marketable securitiesreclassification adjustment for gains realized in net income (net of tax) was$642, $2,542 and $1,617 for 2001, 2000 and 1999, respectively.

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

23

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FIVE-YEAR RESULTS

(In thousands,except per share amounts)

 

**INCOME DATA:**

 
|                                                          |     | **Year Ended  December 31,** |     |
|---------------------------------------------------------------|----------|------------------------------|----------|
|                                                          | **2001** |                         | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
| Sales                                                         |     | $                            | 207,439  |   | $ | 200,139 |   | $ | 187,028 |   | $ | 179,742 |   | $ | 164,905 | (a) |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Income  (loss) from continuing operations                     |     | 6,179                        |     | 5,419 |   | 964 |   | (1,053 | ) | 8,643 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Net  income (loss)                                            |     | 6,179                        |     | 5,419 |   | 964 |   | (1,053 | ) | 9,793 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share – basic (Note 15)             |     |                         |     |   |   |   |   |   |   |   |   |
| Income  (loss) from continuing operations                     |     | $                            | 0.43     |   | $ | 0.38 |   | $ | 0.07 |   | $ | (0.08 | ) | $ | 0.60 |   |
| Net  income (loss)                                            |     | $                            | 0.43     |   | $ | 0.38 |   | $ | 0.07 |   | $ | (0.08 | ) | $ | 0.70 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share – assuming dilution (Note 15) |     |                         |     |   |   |   |   |   |   |   |   |
| Income  (loss) from continuing operations                     |     | $                            | 0.42     |   | $ | 0.38 |   | $ | 0.07 |   | $ | (0.08 | ) | $ | 0.59 |   |
| Net  income (loss)                                            |     | $                            | 0.42     |   | $ | 0.38 |   | $ | 0.07 |   | $ | (0.08 | ) | $ | 0.68 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Average  shares outstanding                                   |     |                         |     |   |   |   |   |   |   |   |   |
| Basic                                                         |     | 14,464                       |     | 14,329 |   | 14,162 |   | 13,976 |   | 14,031 |   |
| Assuming  dilution                                            |     | 14,686                       |     | 14,404 |   | 14,252 |   | 13,976 |   | 14,313 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| **BALANCE  SHEET DATA**                                       |     |                         |     |   |   |   |   |   |   |   |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Total  assets                                                 |     | $                            | 184,798  |   | $ | 188,692 |   | $ | 194,366 |   | $ | 194,049 |   | $ | 164,483 |   |
|                                                          |     |                         |     |   |   |   |   |   |   |   |   |
| Long-term  debt                                               |     | 20,449                       |     | 24,603 |   | 32,201 |   | 31,665 |   | 13,792 |   |

 

----

(a) Excludes impact of EITF 00-10 discussed in Note 1.

 

TWELVE-YEAR RESULTS

(In thousands, except per share amounts)

 

SUPPLEMENTARY DATA

 

These schedulespresent the prior twelve-year results of the Company as originally reported,before restatement of prior period data for those acquisitions accounted for aspoolings-of-interests, to show the effect of the Company’s acquisitionactivity.

 

**INCOME DATA:**  (As originally reported)

 
|                                                   |     | **Year Ended  December 31,** |     |
|--------------------------------------------------------|----------|------------------------------|----------|
|                                                   | **2001** |                         | **2000** |   | **1999** |   | **1998** |   | **1997** |   | **1996** |   | **1995** |   | **1994** |   | **1993** |   | **1992** |   | **1991** |   | **1990** |   |
| Sales                                                  |     | $                            | 207,439  |   | $ | 200,139 |   | $ | 187,028 |   | $ | 179,742 |   | $ | 164,905 | (e) | $ | 155,946 | (e) | $ | 111,610 | (e) | $ | 96,180 | (e) | $ | 89,043 | (e) | $ | 50,541 | (e) | $ | 46,738 | (e) | $ | 43,553 | (e) |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                             |     | 7,301                        | (f)      | 5,419 |   | 4,533 | (d) | 6,516 | (c) | 9,452 | (b) | 13,467 |   | 11,212 |   | 9,955 |   | 7,895 |   | 4,528 | (a) | 3,902 |   | 3,714 |   |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **BALANCE SHEET DATA:**  (As originally reported) |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                           |     | $                            | 184,798  |   | $ | 188,692 |   | $ | 194,366 |   | $ | 194,049 |   | $ | 164,483 |   | $ | 152,176 |   | $ | 125,058 |   | $ | 102,035 |   | $ | 88,826 |   | $ | 60,300 |   | $ | 54,931 |   | $ | 54,370 |   |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Working capital                                        |     | 31,755                       |     | 29,429 |   | 32,161 |   | 33,976 |   | 45,273 |   | 54,006 |   | 54,224 |   | 55,995 |   | 45,281 |   | 29,471 |   | 25,955 |   | 21,692 |   |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Long-term debt                                         |     | 20,449                       |     | 24,603 |   | 32,201 |   | 31,665 |   | 13,792 |   | 15,900 |   | 12,441 |   | 14,050 |   | 13,913 |   | 13,221 |   | 13,697 |   | 13,761 |   |
|                                                   |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’                                     |     |                         |     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| equity                                                 |     | 115,397                      |     | 108,945 |   | 104,542 |   | 102,155 |   | 102,375 |   | 97,943 |   | 78,471 |   | 63,751 |   | 52,070 |   | 33,793 |   | 28,891 |   | 24,720 |   |

 

----

(a)             Includes an increasein earnings of $420 ($0.05 per share) as a result of adopting the FinancialAccounting Standards Board Statement No. 109, “Accounting for Income Taxes.”

(b)            Excludes impact ofDecember 1997 special charge of $1,448 and 1997 recovery on discontinuedoperations of $1,330 net of taxes.

(c)             Excludes impact ofJune 1998 special charge of $9,988.

(d)            Excludes impact ofSeptember and December 1999 special charge of $3,610.

(e)             Excludes impact ofEITF 00-10 discussed in Note 1.

(f)               Excludes impact ofDecember 2001 special charge of $1,700.

 

24

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QUARTERLY FINANCIALDATA

(In thousands, except per share amounts)

 

QuarterlyFinancial Data - 2001

 
|                                           |         | **Quarter  Ended** |        |
|------------------------------------------------|--------------|--------------------|-------------|
|                                           | **March 31** |               | **June 30** |   | **September  30** |   | **December  31(a)** |   |
| Sales                                          |         | $                  | 53,302      |   | $ | 51,721 |   | $ | 48,372 |   | $ | 54,044 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Gross  profit                                  |         | 17,698             |        | 16,244 |   | 13,911 |   | 17,690 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income                                    |         | 2,731              |        | 1,161 |   | 1,139 |   | 1,148 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income per share – basic             |         | 0.19               |        | 0.08 |   | 0.08 |   | 0.08 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income per share – assuming dilution |         | $                  | 0.19        |   | $ | 0.08 |   | $ | 0.07 |   | $ | 0.08 |   |

 

----

(a)             Special charges of$1,700 ($0.08 per share after taxes assuming dilution) were recorded during thefourth quarter of 2001.

 

QuarterlyFinancial Data - 2000

 
|                                           |         | **Quarter  Ended** |        |
|------------------------------------------------|--------------|--------------------|-------------|
|                                           | **March 31** |               | **June 30** |   | **September  30** |   | **December  31** |   |
| Sales                                          |         | $                  | 51,095      |   | $ | 50,110 |   | $ | 48,463 |   | $ | 50,471 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Gross  profit                                  |         | 16,284             |        | 15,888 |   | 14,100 |   | 14,134 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income                                    |         | 1,592              |        | 1,848 |   | 1,019 |   | 960 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income per share – basic             |         | 0.11               |        | 0.13 |   | 0.07 |   | 0.07 |   |
|                                           |         |               |        |   |   |   |   |   |   |
| Net  income per share – assuming dilution |         | $                  | 0.11        |   | $ | 0.13 |   | $ | 0.07 |   | $ | 0.07 |   |

 

25

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(Dollars in thousands, except share data)

 

1.             Summary ofSignificant Accounting Policies

 

Osmonics, Inc. is a manufacturer and marketer of hightechnology water purification, fluid filtration, fluid separation, and fluidtransfer equipment and instruments, as well as the replaceable components usedin purification, filtration and separation equipment.  These products are used by a broad range of industrial, commercial,consumer and institutional customers.

 

The consolidatedfinancial statements include the accounts of Osmonics, Inc. and its wholly andmajority owned subsidiaries (the Company). Significant intercompany accounts and transactions have been eliminated.

 

Beginning in 2001, salesunder long-term contracts for which the Company acts as the general contractorfor the installation, are recorded on a percentage-of-completion methodmeasured on the cost-to-cost basis for contracts.  Provisions for anticipated losses on such long-term contracts arerecorded in full when such losses become evident.

 

All of the Company’sother product and service sales are recognized when an agreement of salesexists, product delivery has occurred or services have been rendered, pricingis fixed or determinable, and collection is reasonably assured.  Sales revenue associated with the initialstart-up or installation of the equipment is deferred until the service hasbeen completed and the associate costs incurred.

 

The estimated cost ofwarranty obligations is accrued at the time revenue is recognized.

 

The estimated fair value for notes payable andlong-term debt approximates carrying value due to the relatively short-termnature of the instruments and/or due to the short-term floating interest rateson the borrowing.  The estimated fairvalue of notes receivable approximates the net carrying value, as managementbelieves the respective interest rates are commensurate with the credit, interestrate and repayment risks involved.

 

The Company considers highly liquid debt instrumentspurchased with maturity of three months or less to be cash equivalents.

 

Inventories are stated at lower of cost (first-in,first-out method) or market for all operations except for two plants, which arevalued using the last-in, first-out method.

 

26

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Property and equipment are recorded at cost lessaccumulated depreciation.  For financialreporting, the straight-line method of depreciation is used over the estimateduseful lives of 10 to 40 years for buildings and improvements and 3 to 10 yearsfor machinery and equipment.

 

Deferred income taxes have been provided for incomeand expenses which are recognized in different accounting periods for financialreporting purposes rather than for income tax purposes.

 

Foreign currency assets and liabilities are translatedinto U.S. dollars using the exchange rates in effect at the balance sheetdate.  Results of operations aretranslated using the average exchange rates throughout the period.

 

The excess of cost over the fair market value ofassets acquired in acquisitions is amortized over not more than 40 years, withthe majority at 30 years.  Otherintangibles are carried at cost and amortized using the straight–linemethod over their estimated lives of 5 to 20 years.  In 1999, the estimated life of 40 years for the recordedAquaMatic goodwill was reduced to 10 years based on the maturity of the productline and continued softness of the Asia/Pacific market.  In accordance with Statement of FinancialAccounting Standards (SFAS) No. 121 on impairment of long-lived assets, thecarrying values of these intangibles are reviewed quarterly for impairmentusing discounted cash flows when events or circumstances warrant such a review(see Note 16).

 

On October 3, 2001, the Financial Accounting StandardsBoard approved its proposed FAS No. 144 (FAS 144), “Accounting for Impairmentor Disposal of Long-Lived Assets.”  FAS144 prescribes a consistent accounting model for long-lived assets to bedisposed of by other than a sale, regardless of whether the asset waspreviously held and used or newly acquired. The provisions of FAS 144 will be effective for fiscal years beginningafter December 15, 2001.  The Company isevaluating the impact of the adoption of this Standard and has not yetdetermined the effect of adoption on its financial position and results ofoperations.

 

In June 2001, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 143 (FAS 143), “Accounting for Asset RetirementObligations.”  FAS 143 requires entitiesto recognize the fair value of a liability for tangible long-lived assetretirement obligations in the period incurred, if a reasonable estimate of fairvalue can be made.  The provisions ofFAS 143 will be effective for fiscal years beginning after June 15, 2002.  The Company is evaluating the impact of theadoption of this standard and has not yet determined the effect of adoption onits financial position and results of operations.

 

On June 29, 2001,the Financial Accounting Standards Board approved its proposed Statements ofFinancial Accounting Standards No. 141 (FAS 141), “Business Combinations,” andNo. 142 (FAS 142), “Goodwill and Other Intangible Assets.”  FAS 141 requires that all businesscombinations subsequent to June 30, 2001 be

 

27

----

 

accounted forunder the purchase method of accounting. FAS 142 requires cessation of goodwill amortization and periodicevaluation of the goodwill carrying value. The provisions of FAS 142 will be effective for fiscal years beginningafter December 15, 2001.  The Company isevaluating the impact of the adoption of these standards and has not yetdetermined the effect of adoption on its financial position and results ofoperations.

 

On January 1,2001, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 133, “Accounting for Derivative Instruments and Hedging Activities,” asamended by SFAS No. 138, “Accounting for Certain Derivative Instruments andCertain Hedging Activities.”  SFAS No.133 establishes accounting and reporting standards for derivative instrumentsand for hedging activities.  It requiresthat all derivatives, including those embedded in other contracts, berecognized as either assets or liabilities and that those financial instrumentsbe measured at fair value.  Theaccounting for changes in the fair value of derivatives depends on theirintended use and designation. Management has reviewed the requirements of SFAS No. 133 and hasdetermined that they have no embedded derivatives.  All contracts that contain provisions meeting the definition of aderivative, except for one described below, also meet the requirements of, andhave been designated as, normal purchases or sales.  The Company’s general policy is to not enter into contractscontaining derivatives with terms that cannot be designated as normal purchasesor sales.

 

In 2001, theCompany entered into a hedge contract to help offset foreign currency riskrelated to its European foreign subsidiary. The instrument hedges certain levels of the subsidiary’s local eurocurrency exposure to the U.S. dollar and expires in June 2002.  The Company has chosen, as permitted by FAS133, to record the changes in the fair value of the instrument in other income(expense) in the period of change.

 

In May 2000, theEmerging Issues Task Force in EITF 00-10 reached a consensus on the issue of“How a seller of goods should classify in the income statement amounts billedto a customer for shipping and handling.” The consensus was that all amounts billed to a customer in a salestransaction related to shipping and handling, if any, represent revenues earnedfor the goods provided and should be classified as revenue.  The Company adopted EITF 00-10 in the fourthquarter 2000.  Comparative financialstatements for prior periods have been reclassified to comply with theclassification guidelines of this issue. Freight revenue added to sales and cost of goods sold were $3,586,$3,104 and $2,357 in 2001, 2000 and 1999, respectively.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesthat affect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from those estimates.

 

28

----

 

Certainreclassifications have been made to prior year amounts to conform with currentyear presentations.

 

2.             BusinessAcquisitions

 

On July 1, 1999, the Company acquired all of theequity interest of ZyzaTech Water Systems, Inc. (ZyzaTech) of Seattle,Washington.  The purchase price wasapproximately $10,000 and included $8,600 of goodwill, which is being amortizedon the straight-line method over 20 years. ZyzaTech products are being sold through their existing distributionchannels, offering a broadened line of hemodialysis products. The acquisition,included in the Process Water segment, was recorded under the purchase methodof accounting.

 

Theresults of operations of ZyzaTech are included in the consolidated statementsof operations from the date of acquisition.

 

Pro forma 1999 combined financial results of Osmonics,Inc. and ZyzaTech would be as follows:

 
| **1999**                                  |   | **Osmonics** |    | **ZyzaTech** |   | **Combined** |   |
|-------------------------------------------|--------|--------------|---------|--------------|--------|--------------|--------|
| Sales                                     |   | $            | 187,028 |         | $      | 5,826        |   | $ | 192,854 |   |
| Income  from operations                   |   | 4,431        |    | 397          |   | 4,828        |   |
| Acquisition  interest expense             |   | 320          |    | 320          |   | 640          |   |
| Net  income                               |   | 964          |    | 57           |   | 1,021        |   |
| Net  income per share - assuming dilution |   | $            | 0.07    |         |   |         | $      | 0.07 |   |
|                                           |        |              |         |              |        |              |        |  |  |  |

 

The Company has $13,700 of goodwill recorded asof December 31, 2001 associated with the 1998 acquisition of Membrex Corp.(Membrex).  Safety Kleen (SK), theprincipal customer for the Membrex products, filed for Chapter 11 bankruptcy inJune 2000.  As a result, 2001 sales toSK of $1,878 were $1,909 below same period 2000 sales of $3,787.  SK has continued to order product and partsat reduced levels to support its installed base.  Future sales levels are uncertain and could be minimal.

 

On December 21,2001, the Company signed a new agreement with SK, which continues the businessrelationship on a non-exclusive basis. This new agreement enables the Company to actively market its productthrough other sales channels.  TheCompany has developed a business plan and hired a sales and technical supportstaff dedicated to pursuing sales in such channels in 2002 and beyond.

 

In February 2002,it was announced that Clean Harbors, Inc. (Nasdaq: CLHB), an industry-leadingenvironmental services provider, has entered a definitive agreement to acquireSafety-Kleen’s Chemical Service Division, subject to approval by the BankruptcyCourt and various regulatory agencies. At this point, Management is unable to determine the financial impact ofsuch a transaction to the Company.

 

29

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The Company ismonitoring the Chapter 11 bankruptcy proceedings to determine any furtherfinancial impact to the Company.

 

TheCompany has determined that two-thirds ($9,100) of the Membrex goodwill isassociated with these products.  TheCompany has concluded there was no impairment of goodwill at December 31,2001.  In its analysis, management useda discounted cash flow model in accordance with current accountingguidelines.  This analysis includes adetailed sales plan with sales of product through new sales channels andanticipates an ongoing business relationship with SK while it proceeds throughand comes out of bankruptcy.  Theongoing business relationship assumes that SK will continue to purchasereplacement membrane for existing product installations.

 

Managementbelieves it will be capable of selling and marketing these products throughother sales channels in a manner that will support the goodwill value.  The Company is continuing to investigate newapplications for the technology acquired from Membrex.  The Company believes the patented technologyassociated with Membrex brings a cost-effective solution to hazardous wastedisposal, which could become a required environmental standard.

 

3.             MarketableSecurities

 

TheCompany considers all of its marketable securities available-for-sale.

 

Marketablesecurities at December 31, 2001 consisted of the following:

 
|                                                    |   | **Amortized  Cost** |   | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |   |
|---------------------------------------------------------|--------|---------------------|--------|-----------------------|--------|--------------------------|--------|-----------------|--------|
| Corporate  debt securities and other 0-5 year maturity  |   | 100                 |   | —                |   | (48                      | )      | 52              |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Total  before-tax effect                                |   | $                   | 100    |                  | — |                     | (48    | )               | $      | 52 |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Deferred  tax effect of unrealized (gains) losses       |   |                |   | —                |   | 16                       |   |            |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Net  unrealized gains (losses) on marketable securities |   |                |   | $                     | — |                     | $      | (32             | )      |   |   |
|                                                         |        |                     |        |                       |        |                          |        |                 |        |  |  |  |  |

 

30

----

 

Marketablesecurities at December 31, 2000 consisted of the following:

 
|                                                    |   | **Amortized  Cost** |   | **Unrealized  Gains** |   | **Unrealized  (Losses)** |   | **Fair  Value** |   |
|---------------------------------------------------------|--------|---------------------|--------|-----------------------|--------|--------------------------|--------|-----------------|--------|
| Municipal  bonds 0-5 year maturity                      |   | 100                 |   | —                |   | —                   |   | 100             |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Corporate  debt securities and other 0-5 year maturity  |   | 100                 |   | —                |   | (1                       | )      | 99              |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Equity  securities                                      |   | 919                 |   | 815                   |   | (44                      | )      | 1,690           |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Total  before-tax effect                                |   | $                   | 1,119  |                  | 815    |                     | (45    | )               | $      | 1,889 |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Deferred  tax effect of unrealized (gains) losses       |   |                |   | (432                  | )      | 24                       |   |            |   |
|                                                    |   |                |   |                  |   |                     |   |            |   |
| Net  unrealized gains (losses) on marketable securities |   |                |   | $                     | 383    |                     | $      | (21             | )      |   |   |
|                                                         |        |                     |        |                       |        |                          |        |                 |        |  |  |  |  |

 

Proceeds fromsales of available-for-sale securities for the years ended December 31, 2001,2000 and 1999 were $2,188, $13,740 and $6,409, respectively.  The gains and losses on these sales,determined on the specific identification method, were $972 and $0 in 2001,$4,102 and $314 in 2000, and $2,813 and $442 in 1999 and are included in OtherIncome.

 

Market values arebased on quoted market prices.

 

4.                             Inventories

 

Inventoriesconsist of the following:

 
|                                                                                                   |   | **December  31,** |   |
|--------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                   |   | **2001**          |   | **2000** |   |
| Finished  goods                                                                                        |   | $                 | 9,353  |   | $ | 8,013 |   |
| Work  in process                                                                                       |   | 9,415             |   | 8,775 |   |
| Raw  materials                                                                                         |   | 14,958            |   | 17,695 |   |
|                                                                                                   |   | 33,726            |   | 34,483 |   |
| Adjustment  to reduce inventories of $9,487 and $11,643 to the last-in, first-out method  (see Note 1) |   | (1,632            | )      | (1,725 | ) |
|                                                                                                   |   | $                 | 32,094 |   | $ | 32,758 |   |

 

Pretax income(expense) realized from changes in LIFO inventory valuations for the yearsended December 31, 2001, 2000 and 1999 were $84, ($206) and $449,respectively.  

 

31

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5.          Restricted Cash

 

Cash restrictedfor purchase and construction of equipment at December 31, 2001 and 2000represents proceeds received from the issuer of Industrial Development RevenueBonds (see Note 8) restricted to the purchase and construction of property andequipment used in one of the Company’s operations.

 

6.          Line of Credit

 

The Company, atDecember 31, 2001, had an unsecured revolving line of credit of $24,000.  The revolving line of credit matures onMarch 31, 2003, and borrowings bear a variable interest rate related to LIBOR(London Interbank Offer Rate) or prime. The terms of the credit agreement contain certain restrictions relatedto financial ratios, indebtedness, tangible net worth and capital expenditures.  As of December 31, 2001, the Company was incompliance with all debt covenants.  Asof December 31, 2001, the Company had borrowings outstanding under the line of$9,500 and the interest rate was 3.03%. At December 31, 2000, the Company had borrowings outstanding under theline of $15,000 and the interest rate was 8.25%.

 

7.                             OtherAccrued Liabilities

 

Other accruedliabilities consist of the following:

 
|                                   |   | **December  31,** |   |
|----------------------------------------|--------|-------------------|--------|
| **2001**                               |   | **2000**          |   |
| Warranty  and start-up                 |   | $                 | 2,196  |   | $ | 2,222 |   |
| Professional  fees and other accruals  |   | 3,556             |   | 3,249 |   |
| Taxes                                  |   | 2,038             |   | 1,428 |   |
| Deferred  acquisition-related payments |   | —            |   | 53 |   |
| Corporate  restructuring               |   | 1,389             |   | 160 |   |
| Customer  deposits                     |   | 3,249             |   | 3,281 |   |
|                                   |   | $                 | 12,428 |   | $ | 10,393 |   |

 

32

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8.                             Debt

 

Long-term debt is as follows:

 
|                                                                                                                                                                                                                                    |   | **December  31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                                                                                                                                                    |   | **2001**          |   | **2000** | ** ** |
| Promissory  notes; interest payable quarterly at the three-month LIBOR plus 125 b.p.; due  through 2001.  The interest rate on  December 31, 2000 was 7.91%.                                                                       |   | $                 | — |   | $ | 2,875 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Industrial  development revenue bonds (IDRBs), principal due in varying annual payments  through 2007; interest payable monthly at a variable rate determined  periodically by the bond remarketing agent (6.45% at December 31, 2001). |   | 5,650             |   | 6,300 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Promissory  notes; interest payable quarterly at fixed rate of 6.72%; due through 2008.                                                                                                                                                 |   | 4,000             |   | 4,000 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Promissory  notes; interest payable quarterly at the three-month LIBOR plus 75 b.p.; due  through 2008.  The interest rate on  December 31, 2001 was 3.40%.                                                                        |   | 12,000            |   | 12,000 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Mortgage  notes payable to two French banks; interest payable monthly at PIBOR (Paris  Interbank Offer Rate) plus 40 b.p.; due through 2001.  The interest rate on December 31, 2000 was  5.34%.                                   |   | —            |   | 108 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Mortgage  notes payable to two French banks; interest payable monthly at fixed rate of  4.45%; due through 2006.                                                                                                                        |   | 1,073             |   | 1,373 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Promissory  notes; interest payable annually at fixed rate of 8.00%; due through 2003.                                                                                                                                                  |   | 966               |   | 1,583 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Other  notes                                                                                                                                                                                                                            |   | 879               |   | 1,123 |   |
|                                                                                                                                                                                                                                    |   | 24,568            |   | 29,362 |   |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
| Current  portion                                                                                                                                                                                                                        |   | (4,119            | )      | (4,759 | ) |
|                                                                                                                                                                                                                                    |   |              |   |   |   |
|                                                                                                                                                                                                                                    |   | $                 | 20,449 |   | $ | 24,603 |   |

 

33

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The IDRB debt andthe mortgage notes payable to French banks are collateralized by real andpersonal property of the Company.

 

Aggregatematurities of long-term debt outstanding at December 31, 2001 are: 

 

2002 - $3,832;2003 - $3,680; 2004 - $3,186; 2005 - $3,197; 2006 - $2,949; beyond 2006 -$7,276.

 

*Capital Leases* –The Company leases its vehicles under noncancelable capital leases expiring in2004.  The total leased assets were$1,361, and related accumulated amortization was $834 as of December 31,2001.  Depreciation charged on assetsunder capital lease during 2001 was $282. These amounts are included in the Company’s operating expenses.  Minimum future lease obligations under thecapital lease for the Company’s vehicles as of December 31, 2001 are asfollows:

 
| **Year ending December 31:**             |   |   |   |
|------------------------------------------|--------|--------|--------|
| 2002                                     |   | $      | 316    |   |
| 2003                                     |   | 140    |   |
| 2004                                     |   | 14     |   |
| 2005                                     |   | 2      |   |
| 2006                                     |   | — |   |
| Total minimum lease payments             |   | 472    |   |
| Less  amount representing interest       |   | 24     |   |
| Present  value of minimum lease payments |   | 448    |   |
| Less  current portion                    |   | 287    |   |
| Long-term  portion                       |   | $      | 161    |   |

 

The Company’spromissory notes contain a covenant, which limits the payment of dividends toshareholders.  At December 31, 2001approximately $13,632 of retained earnings was eligible for dividenddistribution under this covenant.  TheCompany’s various debt agreements contain certain restrictions related tofinancial ratios, indebtedness, tangible net worth and capitalexpenditures.  As of December 31, 2001the Company was in compliance with all debt covenants.  

 

The Company alsohas an unsecured standby letter of credit of $5 million with a large financialinstitution.  As of December 31, 2001 noamount was outstanding.

 

Cash payments forinterest related to all debts of the Company were $2,695, $4,169 and $4,086 forthe years ended December 31, 2001, 2000 and 1999, respectively.

 

9.                             StockOptions

 

The Company’s 1993Stock Option Plan, with 950,000 reserved common shares, is intended to facilitateownership and increase the interest of key employees in the growth andperformance of the Company, thus enhancing the value of the Company for thebenefit of the shareholders.  Optionsare granted at a price not less than fair 

 

34

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market value on thedate of the grant and become exercisable over a period of up to ten years,after which they expire.  The 1993 StockOption Plan terminates on September 1, 2003.

 

The Company’s 1995Director Stock Option Plan, with 250,000 reserved common shares, provides thateach director of the Company shall automatically receive, as of the date ofeach Annual Meeting of Shareholders, a non-qualified option to purchase 3,000shares of the Company’s common stock. The options have a ten-year term and are exercisable one year after thegrant date at an exercise price equal to the fair market value of the shares onthe grant date.  The 1995 Director StockOption Plan terminates on May 17, 2005.

 

Shares reservedfor future issuance under all of the Company’s plans totaled approximately1.899 million at December 31, 2001.

 

The Companyapplies Accounting Principles Board (APB) Opinion No. 25 “Accounting for StockIssued to Employees” and related interpretations in accounting for itsplans.  No compensation cost has beenrecognized for its stock-based compensation plans as the exercise price of thestock option grants was equal to the fair market value of the shares on thegrant date.  Had compensation costs beendetermined based on the fair value of the 2001, 2000 and 1999 stock optiongrants consistent with the requirements of SFAS No. 123, “Accounting forStock-Based Compensation,” net income and earnings per share would have beenreported as the following pro forma amounts: 

 
|                                         |   | **2001** |   | **2000** |   | **1999** |   |
|----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net  income                                  |   |     |   |     |   |     |   |
| As  reported                                 |   | $        | 6,179  |     | $      | 5,419    |   | $ | 964 |   |
| Pro  forma                                   |   | 5,979    |   | 5,200    |   | 738      |   |
|                                         |   |     |   |     |   |     |   |
| Earnings  per share – assuming dilution |   |     |   |     |   |     |   |
| As  reported                                 |   | $        | 0.42   |     | $      | 0.38     |   | $ | 0.07 |   |
| Pro  forma                                   |   | $        | 0.41   |     | $      | 0.36     |   | $ | 0.05 |   |

 

The fair value ofthe stock options used to calculate the pro forma net income and earnings pershare amounts above is estimated using the Black-Scholes options pricing modelwith the following weighted average assumptions:

 

35

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|                     |   | **2001** |   | **2000** |   | **1999** |   |
|--------------------------|--------|----------|--------|----------|--------|----------|--------|
| Dividend  yield          |   | 0        | %      | 0        | %      | 0        | %      |
| Expected  volatility     |   | 55.1     | %      | 30.0     | %      | 46.9     | %      |
| Risk-free  interest rate |   | 5.5      | %      | 7.0      | %      | 6.5      | %      |
| Expected  life           |   | 5.0      |   | 5.0      |   | 5.0      |   |

 

Informationrelated to stock options at December 31 under the aforementioned stock optionplans is as follows:

 
| **Stock Options**                                               |              | **2001** |                                   | **2000** |              | **1999** |                                     |
|-----------------------------------------------------------------|-------------------|----------|----------------------------------------|----------|-------------------|----------|------------------------------------------|
|                                                            | **Shares  (000)** |     | **Weighted  Average  Exercise  Price** |     | **Shares  (000)** |     | **Weighted  Average****Exercise  Price** |   | **Shares  (000)** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at  beginning of year                               |              | 1,212    |                                   | $        | 9.85              |     | 1,025                                    |   | $ | 10.76 |   | 947 |   | $ | 10.21 |   |
| Granted                                                         |              | 213      |                                   | 11.32    |              | 353      |                                     | 7.77 |   | 255 |   | 8.93 |   |
| Exercised                                                       |              | (17      | )                                      | 6.66     |              | (13      | )                                        | 3.92 |   | (151 | ) | 3.76 |   |
| Forfeited                                                       |              | (77      | )                                      | 9.86     |              | (153     | )                                        | 11.66 |   | (26 | ) | 12.71 |   |
| Outstanding at  end of year                                     |              | 1,331    |                                   | 10.12    |              | 1,212    |                                     | 9.85 |   | 1,025 |   | 10.76 |   |
| Options  exercisable at year-end                                |              | 754      |                                   | 10.50    |              | 592      |                                     | 10.75 |   | 487 |   | 10.64 |   |
| Weighted average  fair value of options granted during the year |              | $        | 6.55                                   |     |              |     | $                                        | 3.11 |   |   |   | $ | 4.44 |   |   |   |
|                                                                 |                   |          |                                        |          |                   |          |                                          |  |  |  |  |  |  |  |  |  |  |  |  |

 

The followingtable summarizes information about stock options outstanding at December 31,2001:

 
| **Options  Outstanding**       |     | **Options  Exercisable**                    |   |
|--------------------------------|----------|---------------------------------------------|--------|
| **Range of  Exercise  Prices** |     | **Shares  Outstanding  at 12/31/01  (000)** |   | **Remaining  Contractual  Life** |   | **Weighted  Average  Exercise  Price** |   | **Shares  Exercisable  at 12/31/01  (000)** |   | **Weighted  Average  Exercise  Price** |   |
| $                              | 5.86     | -  6.72                                     |   | 202 |   | 2.1 yrs |   | $ | 5.95 |   | 202 |   | $ | 5.95 |   |
| 6.73                           | -  8.95  |                                        | 512    |   | 8.1 yrs |   | 7.96 |   | 159 |   | 8.02 |   |
| 8.96                           | -  13.42 |                                        | 392    |   | 7.4 yrs |   | 11.32 |   | 190 |   | 10.67 |   |
| 13.43                          | -  17.90 |                                        | 194    |   | 5.6 yrs |   | 16.24 |   | 172 |   | 16.28 |   |
| 17.91                          | -  22.38 |                                        | 31     |   | 4.5 yrs |   | 19.57 |   | 31 |   | 19.57 |   |
|                                |          |                                             |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

In 1998, theCompany adopted a Stock Match Plan under which the Company matches, in the formof company common stock, certain eligible U.S. employee 

 

36

----

 

savings plancontributions.  Employees are vested inthe shares immediately.  Shares issuedunder the Stock Match Plan were 45,447, 59,748 and 51,078 shares at a cost ofapproximately $472,000, $498,000 and $483,000 in 2001, 2000 and 1999,respectively.  At December 31, 2001,there were approximately 220,260 shares reserved for future issuance.

 

The Company has anEmployee Stock Purchase Plan which allows eligible employees to purchase commonshares of the Company at 85% of market price. During 2001, 52,300 shares were issued at prices ranging from $6.21 to$11.90 per share.  During 2000, 74,017shares were issued at prices ranging from $5.84 to $7.86 per share.  During 1999, 69,209 shares were issued atprices ranging from $6.80 to $9.99 per share. At December 31, 2001, there were approximately 417,600 shares reserved forfuture issuance.

 

The Company had500,000 authorized and unissued shares of preferred stock at December 31, 2001and 2000.

 

10.        Income Taxes

 

Income tax expense(benefit) consists of:

 
|                                                                               |   | **Year ended  December 31,** |   |
|------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                               |   | **2001**                     |   | **2000** |   | **1999** |   |
| Current:                                                                           |   |                         |   |   |   |   |   |
| Federal                                                                            |   | $                            | 2,637  |   | $ | 1,339 |   | $ | 300 |   |
| State                                                                              |   | 81                           |   | 133 |   | (213 | ) |
| Foreign                                                                            |   | (38                          | )      | 61 |   | 162 |   |
| Deferred:                                                                          |   |                         |   |   |   |   |   |
| Losses  and credits not usable in current year, carried forward to future years    |   | (110                         | )      | (29 | ) | (1,319 | ) |
| Depreciation                                                                       |   | 69                           |   | 89 |   | (26 | ) |
| Amortization  of intangibles                                                       |   | 262                          |   | 298 |   | 1,635 |   |
| Net  operating loss usage                                                          |   | 695                          |   | 712 |   | 512 |   |
| Allowance  for doubtful accounts, start-up, warranty, inventory and other accruals |   | (729                         | )      | 520 |   | 424 |   |
| Deduction  for unqualified option exercise                                         |   | —                       |   | — |   | 251 |   |
| Other                                                                              |   | 316                          |   | (460 | ) | 358 |   |
| Total  provision                                                                   |   | $                            | 3,183  |   | $ | 2,663 |   | $ | 2,084 |   |

 

Other deferredincome tax expense (benefit) includes multiple items with no one item exceeding5% of income before income taxes.

 

Cash payments forincome taxes were $2,460, $1,344 and $1,155 for the years ended December 31,2001, 2000 and 1999, respectively.

 

37

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When Osmonics,Inc. acquired MSI, on February 17, 1998, MSI had incurred $11,827 of taxlosses, which had not yet been offset against previous or subsequent years’taxable income of MSI.  In 1999, MSIfiled a refund request that offset $8,684 of these losses against income of MSIfor the years from 1988 to 1995, under the “Claim of Right” rule.  All of the taxes claimed in this refundrequest were received in 1999.  Theremaining losses of $3,143 were carried forward, for offset against MSI incomein years after the acquisition.  $1,989,$0 and $1,154 of these losses were offset against MSI income for the years of2000, 1999 and 1998, respectively. After the 2000 offset, there were no more remaining losses available forcarryforward.  

 

Osmonics generateda net operating loss (NOL) of $1,639 in 1999. The entire loss was used as an offset against income generated in 1997,which resulted in a refund of $556 received in 2000. The net operating loss andcredit carryforwards that remain have expiration dates will expire in yearsranging from the year 2003 to the year 2020.

 

The tax effects ofthe distributing of the foreign subsidiaries’ accumulated earnings to theUnited States parent are not reflected on the financial statements.  This has not been included because it is theintent of the Company to reinvest all foreign subsidiaries’ earnings outsidethe United States.  The cumulative totalof undistributed earnings for which deferred tax has not been included are$1,981.

 

A reconciliationof the income taxes computed at the federal statutory rate to the Company’sincome tax expense is as follows:

 
|                                                                 |   | **Year Ended  December 31,** |   |
|----------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                 |   | **2001**                     |   | **2000** |   | **1999** |   |
| Taxes  at federal rate (35%)                                         |   | $                            | 3,276  |   | $ | 2,829 |   | $ | 1,067 |   |
| Increase  (decrease) resulting from:                                 |   |                         |   |   |   |   |   |
| State  taxes, net of federal tax benefit                             |   | (111                         | )      | 217 |   | 6 |   |
| Foreign  Sales Corp. benefit                                         |   | (746                         | )      | (571 | ) | (615 | ) |
| Tax  credits                                                         |   | (109                         | )      | (109 | ) | (227 | ) |
| Tax-exempt  interest/dividend deduction                              |   | —                       |   | (55 | ) | (100 | ) |
| Effect  of foreign affiliates with different tax rates or net losses |   | (109                         | )      | 119 |   | 15 |   |
| Nondeductibility  of intangible write-offs and amortization          |   | 464                          |   | 469 |   | 1,547 |   |
| Other                                                                |   | 518                          |   | (236 | ) | 391 |   |
| Total  provision                                                     |   | $                            | 3,183  |   | $ | 2,663 |   | $ | 2,084 |   |

 

Other adjustmentsincrease (decrease) includes multiple items with no one item exceeding 5% ofincome before income taxes.  

 

38

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11.                       DeferredTax Assets and Liabilities

 

Temporarydifferences which give rise to deferred tax assets and liabilities are asfollows as of December 31:

 
|                                                                    |   | **2001** |   | **2000** |   |
|-------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Current  assets:                                                        |   |     |   |     |   |
| Allowance  for doubtful accounts, start-up, warranty and other accruals |   | $        | 3,960  |     | $      | 3,192 |   |
| Unrealized  gain on marketable securities                               |   | 7        |   | (408     | )      |
| Inventory  costs capitalized for tax                                    |   | 39       |   | 66       |   |
| Net  operating losses available for carryback or carryforward           |   | 928      |   | 1,400    |   |
| Other                                                                   |   | (67      | )      | 64       |   |
| Total  current deferred assets                                          |   | $        | 4,867  |     | $      | 4,314 |   |
| Noncurrent  liabilities:                                                |   |     |   |     |   |
| Depreciation                                                            |   | $        | 4,033  |     | $      | 3,932 |   |
| Amortization  of intangibles                                            |   | 2,350    |   | 2,165    |   |
| Other                                                                   |   | 380      |   | 238      |   |
| Total  noncurrent deferred tax liabilities                              |   | $        | 6,763  |     | $      | 6,335 |   |

 

12.                       Salesand Segment Information

 

The Companydesigns, manufactures and markets equipment, systems and components used in theprocessing and handling of fluids.  In2000, the Company changed the focus of its reporting structure from atwo-segment, product-focused structure to a three-segment, market-focusedstructure.

 

Thethree-market-segment structure was established to provide strategic leadershipwithin the three major market segments in which the Company conductsbusiness.  The new structure wasimplemented on January 1, 2000. Restatement of 1999 financial results under this method of reporting hasbeen completed and is disclosed comparatively in financial reports.

 

The Filtration andSeparations segment includes products such as filter cartridges, membraneelements, membranes, instruments and laboratory products.  The Process Water segment includes productssuch as pumps, housings, valves, controls, reverse osmosis/ultrafiltration(RO/UF) machines, ozonators and water treatment systems used for industrial,commercial and municipal applications. The Household Water segment includes products such as valves, controlsand home reverse osmosis membranes and filters used for the residential waterpurification and water softening markets. Each segment is currently supported by several manufacturing facilities,a sales force and various corporate functions. The segments do not have separate accounting, administration or researchand development functions.

 

The reportablesegment information for 2001, 2000 and 1999 is as follows (all segmentinformation excludes the impact of special charges):

 

39

----

 
|                        |   | **Year Ended****December  31,** |   |
|-----------------------------|--------|---------------------------------|--------|
|                        |
|                        |   | **2001**                        |   | **2000** |   | **1999** |   |
| Sales:                      |   |                            |   |   |   |   |   |
| Filtration and Separations  |   | $                               | 83,208 |   | $ | 79,977 |   | $ | 78,640 |   |
| Process Water               |   | 87,152                          |   | 80,647 |   | 71,306 |   |
| Household Water             |   | 37,079                          |   | 39,515 |   | 37,082 |   |
| Net Sales                   |   | 207,439                         |   | 200,139 |   | 187,028 |   |
| Gross Profit:               |   |                            |   |   |   |   |   |
| Filtration and Separations  |   | 30,447                          |   | 27,526 |   | 30,315 |   |
| Process Water               |   | 23,504                          |   | 20,141 |   | 17,078 |   |
| Household Water             |   | 11,592                          |   | 12,489 |   | 12,062 |   |
| Gross Profit                |   | 65,543                          |   | 60,156 |   | 59,455 |   |
| Operating  Income:          |   |                            |   |   |   |   |   |
| Filtration and  Separations |   | 7,518                           |   | 4,986 |   | 7,159 |   |
| Process Water               |   | 3,485                           |   | (191 | ) | (1,299 | ) |
| Household Water             |   | 1,991                           |   | 3,280 |   | 2,181 |   |
| Operating Income            |   | $                               | 12,994 |   | $ | 8,075 |   | $ | 8,041 |   |

 

Management doesnot report the balance sheet or any cash-generating measurements by suchsegments.

 

All operations forwhich geographic data is presented below are in one principal industry (design,manufacture and marketing of machines, systems, instruments and components usedin the processing of fluids).

 

40

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|                                                |   | **2001** |    | **2000** |   | **1999** |   |
|-----------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| Sales  to unaffiliated customers from:              |   |     |    |     |   |     |   |
|                                                |   |     |    |     |   |     |   |
| United  States                                      |   | $        | 189,854 |     | $      | 182,324  |   | $ | 172,194 |   |
| Foreign  operations                                 |   | 17,585   |    | 17,815   |   | 14,834   |   |
|                                                |   |     |    |     |   |     |   |
| Transfers  from (to) geographic areas:              |   |     |    |     |   |     |   |
|                                                |   |     |    |     |   |     |   |
| United  States                                      |   | 12,334   |    | 15,253   |   | 10,142   |   |
| Foreign  operations                                 |   | (12,234  | )       | (15,253  | )      | (10,142  | )      |
|                                                |   |     |    |     |   |     |   |
|                                                |   | $        | 207,439 |     | $      | 200,139  |   | $ | 187,028 |   |
|                                                |   |     |    |     |   |     |   |
| Income  (loss) from operations before income taxes: |   |     |    |     |   |     |   |
|                                                |   |     |    |     |   |     |   |
| United  States                                      |   | $        | 9,526   |     | $      | 7,952    |   | $ | 2,681 |   |
| Foreign  operations                                 |   | (164     | )       | 130      |   | 367      |   |
|                                                |   |     |    |     |   |     |   |
|                                                |   | $        | 9,362   |     | $      | 8,082    |   | $ | 3,048 |   |
|                                                |   |     |    |     |   |     |   |
| Tangible  assets:                                   |   |     |    |     |   |     |   |
|                                                |   |     |    |     |   |     |   |
| United  States                                      |   | $        | 129,868 |     | $      | 130,445  |   | $ | 135,138 |   |
| Foreign  operations                                 |   | 8,462    |    | 9,872    |   | 9,028    |   |
|                                                |   | $        | 138,330 |     | $      | 140,317  |   | $ | 144,166 |   |

 

NOTE:  Transfers are made at fair market value.

 

Sales by UnitedStates operations to unaffiliated customers in foreign geographic areas are asfollows:

 
|         |   | **Year Ended  December 31,** |   |
|--------------|--------|------------------------------|--------|
|         |   | **2001**                     |   | **2000** |   | **1999** |   |
| Asia/Pacific |   | $                            | 21,509 |   | $ | 22,653 |   | $ | 17,953 |   |
| Euro/Africa  |   | 16,761                       |   | 14,771 |   | 18,437 |   |
| Americas     |   | 14,538                       |   | 15,297 |   | 10,491 |   |
|         |   | $                            | 52,808 |   | $ | 52,721 |   | $ | 46,881 |   |

 

41

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Sales tounaffiliated customers in foreign geographic areas are as follows:

 
|         |   | **2001** |   | **% of  Total  Sales** |   | **2000** |   | **% of  Total  Sales** |   | **1999** |   | **% of  Total  Sales** |   |
|--------------|--------|----------|--------|------------------------|--------|----------|--------|------------------------|--------|----------|--------|------------------------|--------|
| Asia/Pacific |   | $        | 21,509 |                   | 10.4   |     | $      | 22,653                 |   | 11.3     |   | $                      | 17,953 |   | 9.6 |   |
| Euro/Africa  |   | 34,346   |   | 16.5                   |   | 32,586   |   | 16.3                   |   | 33,271   |   | 17.8                   |   |
| Americas     |   | 14,538   |   | 7.0                    |   | 15,297   |   | 7.6                    |   | 10,491   |   | 5.6                    |   |
| Total  Sales |   | $        | 70,393 |                   | 33.9   |     | $      | 70,536                 |   | 35.2     |   | $                      | 61,715 |   | 33.0 |   |

 

13.        Commitments and Contingencies

 

*Operating Leases* -The Company leases facilities for sales, service, or manufacturing purposes inIowa, Massachusetts, New Jersey, Washington and Wisconsin in the United States,as well as in China, Germany, Hong Kong, Japan, Singapore, Switzerland andThailand.  

 

Future minimumlease payments on all operating leases of $2,892 are payable as follows:  2002 - $1,251; 2003 - $891; 2004 - $365;2005 - $243 and 2006 - $142.  Rentexpense for the three years ended December 31 was:  2001 - $1,871; 2000 - $1,942; and 1999 - $2,316.

 

The Company’saggregate outstanding capital expenditure commitments were less than $1,00 asof December 31, 2001.

 

The Company isinvolved in certain legal actions arising in the ordinary course ofbusiness.  In the opinion of management,based on the advice of legal counsel, such litigation and claims will beresolved without a material effect on the Company’s financial position orresults of operations.  

 

14.                       EmployeeBenefit Plan

 

The Company has anoncontributory discretionary profit sharing plan covering certain employeesmeeting age and length of service requirements.  The Company contributes annually to the plan an amountestablished at the discretion of the Board of Directors.  

 

Total expenserecognized by the Company under this plan amounted to $360, $300 and $284 in2001, 2000 and 1999, respectively.

 

42

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15.        Earnings Per Share

 

The followingtable reflects the calculation of basic and diluted earnings per share fromoperations.  

 
|                                                               |   | **2001** |   | **2000** |   | **1999** |   |
|--------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Earnings  per share - basic                                        |   |     |   |     |   |     |   |
| Income  from operations available to common stockholders           |   | $        | 6,179  |     | $      | 5,419    |   | $ | 964 |   |
| Weighted  average shares outstanding                               |   | 14,464   |   | 14,329   |   | 14,162   |   |
| Income  from operations per share – basic                     |   | $        | 0.43   |     | $      | 0.38     |   | $ | 0.07 |   |
| Earnings per share – assuming dilution                        |   |     |   |     |   |     |   |
| Income  from operations available to common stockholders           |   | $        | 6,179  |     | $      | 5,419    |   | $ | 964 |   |
| Weighted  average shares outstanding                               |   | 14,464   |   | 14,329   |   | 14,162   |   |
| Dilutive  impact of stock options outstanding                      |   | 222      |   | 75       |   | 90       |   |
| Weighted  average shares and potential dilutive shares outstanding |   | 14,686   |   | 14,404   |   | 14,252   |   |
| Income  from operations per share – assuming dilution         |   | $        | 0.42   |     | $      | 0.38     |   | $ | 0.07 |   |

 

Additionally,options to purchase 594,000 shares of common stock at a range of $11.62 to$19.88 were outstanding during 2001 but were not included in the computation ofdiluted earnings per share because the options’ exercise price was greater thanthe average market price of the common share.

 

16.        Special Charges

 

Special charges in2001 included $1,100 related to the closure of the Company’s Syracuse, New Yorkmanufacturing facility and $600 in corporate restructuring.  Closure costs include asset write-downs,workforce reduction severance, and facility closing/consolidation costs.  Certain manufacturing efforts will berelocated to another existing location while others will be exited as a resultof the facility closure.  Discontinuanceand relocation of such manufacturing has risks associated with potentialproduction interruptions; however, management’s current assessment is thatthese risks can be effectively managed to minimize impact to sales.  Corporate restructuring costs includeworkforce reduction severance and asset write-downs costs.

 

43

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Workforcereductions of 50 employees with expected severance/outplacement costs of $235related to the Company’s Syracuse, New York facility were included in the 2001special charge.  Workforce reductions of34 employees with expected severance/outplacement costs of $405 related to thecorporate restructurings were included in the 2001 special charge.

 

Special chargeexpenditures in 2001 were $126 for workforce reductions and $185 for corporaterestructuring asset write-downs.

 

In 2000, theCompany recorded a $250 recovery of 1999 special charge inventory accrualsprimarily due to gains recognized on the sale of inventory at the Company’sRockland, Massachusetts manufacturing facility, which reduced cost of goodssold.  The special charge of $250related to workforce reduction severance costs.  Workforce reductions of 75 employees with expectedseverance/outplacement costs of $250 related to the first quarter 2000restructuring of several corporate functions and the planned third quarter 2000closure of the Company’s Phoenix, Arizona facility.

 

Special chargeexpenditures in 2000 were $329 for workforce reductions.  The remaining negative accrual balance of$79 was offset by a like amount of overage in the 1999 special charge accruals.

 

In 1999, theCompany recorded net special charges of $3,610 ($3,569 net-of-tax or $0.25 pershare assuming dilution).  Chargesincluded a $3,500 asset impairment charge for non-deductible goodwillassociated with the acquisition of AquaMatic, Inc. in 1997, a $1,035 charge tocost of sales for inventory related to plant closings and a $1,233 charge tooperating expense for corporate restructuring and consolidation ofoperations.  Operating expenserecoveries included a $1,943 gain on the sale of operations and $215 recoveryon second quarter 1998 special charges.

 

Asset impairmentcharges of $3,500 in 1999 relate to the AquaMatic acquisition in 1997 by theCompany (see Note 1).  The impairmentcharge was based on the 1999 operating results and the estimated discountedfuture cash flows of the products.  

 

Inventory chargesof $1,035 in 1999 represent the net book value of inventory at two manufacturinglocations that will not be utilized in ongoing production of the Company’sproducts or be recovered through other methods of disposal.  

 

44

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Corporaterestructuring and consolidation of operations costs of $1,233 in 1999 primarilyinclude facility closing/consolidation, asset write-downs and workforcereduction severance costs. Facility-related costs relate to closing two manufacturing facilitiesand relocating certain manufacturing-related activities to other existinglocations.

 

Workforcereductions of 30 employees with expected severance/outplacement costs of $75related to the December 31, 1999 closure of the Company’s Rockland,Massachusetts facility were included in the 1999 special charge.  Workforce reductions of 50 employees with expectedseverance/outplacement costs of $200 related to the planned third quarter 2000closure of the Company’s Phoenix, Arizona facility were not included in the1999 special charge since the plan was not announced to the employees atDecember 31, 1999.

 

Special chargeexpenditures in 1999 were $850 for inventory costs, $164 for workforcereductions and $830 for facility closing/consolidation costs in 2000.  In 2000, $79 of the 1999 special chargeaccrual was used to offset the 2000 special charges accrual shortfall.  The remaining accrual balance of $160related to costs incurred in January 2001 to exit the Company’s Rockland,Massachusetts manufacturing facility.  

 

45

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**INDEPENDENT AUDITORS’ REPORT**

 

Osmonics, Inc.

Board of Directors and Shareholders

Minnetonka, Minnesota

 

We have audited the accompanying consolidated balancesheets of Osmonics, Inc. and Subsidiaries (the Company) as of December 31,2001 and 2000 and the related consolidated statements of operations, changes inshareholders’ equity, and cash flows for each of the three years in the periodended December 31, 2001.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon the financial statements based on our audits.

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States of America.  Those standards require that we plan andperform the audit to obtain reasonable assurance that the financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of the Company at December 31, 2001 and 2000 and the results ofits operations and its cash flows for each of the three years in the periodending December 31, 2001, in conformity with accounting principlesgenerally accepted in the United States of America.

 

Minneapolis, Minnesota

March 1, 2002

 

46

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**MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL**

**CONDITIONSAND RESULTS OF OPERATIONS**

 

(Dollars in thousands, except share data)

 

The following discussion should be read in conjunctionwith the Company’s Consolidated Financial Statements and Notes included in thisreport.

 

**Results of Operations**

 

The following table sets forth certain statements ofoperations data as a percentage of net sales for the periods indicated.

 
|                                   |   |                          |   | **Increase  (Decrease)** |   |
|----------------------------------------|--------|-------------------------------|--------|--------------------------|--------|
|                                   |   | **Years  Ended December 31,** |   | **2001 vs.**             |   | **2000 vs.** |   |
|                                   |   | **2001**                      |   | **2000**                 |   | **1999** |   | **2000** |   | **1999** |   |
| Net sales                              |   | 100.0                         | %      | 100.0                    | %      | 100.0 | % | 3.6 | % | 7.0 | % |
| Cost of goods  sold                    |   | 68.4                          |   | 69.8                     |   | 68.8 |   | 1.5 |   | 8.7 |   |
| Gross profit                           |   | 31.6                          |   | 30.2                     |   | 31.2 |   | 8.5 |   | 3.4 |   |
| Selling, general  and administrative   |   | 21.7                          |   | 22.2                     |   | 23.3 |   | 1.4 |   | 1.1 |   |
| Research,  development and engineering |   | 3.7                           |   | 3.9                      |   | 4.1 |   | (1.8 | ) | 2.5 |   |
| Special charges                        |   | 0.8                           |   | 0.1                      |   | 1.4 |   | 580.0 |   | (90.3 | ) |
| Operating profit                       |   | 5.4                           |   | 4.0                      |   | 2.4 |   | 39.9 |   | 82.2 |   |
| Other income  (expense)                |   | (0.9                          | )      | —                   |   | (0.7 | ) | n/a |   | 100.5 |   |
| Income taxes                           |   | 1.5                           |   | 1.3                      |   | 1.2 |   | 19.5 |   | 27.8 |   |
| Net income  (loss)                     |   | 3.0                           |   | 2.7                      |   | 0.5 |   | 14.0 |   | 462.1 |   |

 

**Comparisonof Years Ended December 31, 2001 and December 31, 2000**

** **

**NetSales** for 2001 increased $7,300 or 3.6% to $207,439 ascompared to net sales of $200,139 for 2000. The 2001 sales increase was the result of organic sales growth as therewere no acquisitions in 2001.  Sales in2001 increased in both the Filtration and Separations and Process Watersegments while the Household Water segment sales decreased.  Segment results are discussed later in thissection.  Overall, international salesdecreased $143 (0.2%).  The deteriorationof the euro in comparison to the U.S. dollar negatively impacted 2001 and 2000sales by approximately $977 (0.5% of net sales) and $580 (0.3% of net sales),respectively.  2001 sales to customersin Euro/Africa improved $1,760 (5.4%) while sales to customers in Asia/Pacificand the Americas declined $1,144 (5.1%) and $759 (5.0%), respectively. 

 

1

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**GrossProfit** for 2001 increased $5,137 or 8.5% to $65,543 ascompared to $60,406 in 2000.  As apercentage of net sales, gross profit increased to 31.6% from 30.2% in2000.  2000 gross profit includes $250(0.1% of net sales) of a special inventory recovery related to a plant closingrecorded in the first quarter 2000.  Theincrease in gross profit percentage is primarily due to higher sales volume,better utilization of factories, and tight cost control.

 

To further reduce manufacturing capacity and costs inorder to improve gross margins, the Company announced in December 2001 theclosure of the Syracuse, New York facility scheduled for mid 2002.  This is a continuation of a Company-widerestructuring plan initiated two years ago that has included the closure of onefacility (Rockland, Massachusetts) on December 31, 1999, another (Denver,Colorado) in September 2000, and a third facility (Phoenix, Arizona) in October2000.

 

2001 gross margins benefited from five relocations ofcertain production capabilities completed in 2000 related to efforts to focusits factories and eliminate duplicate capabilities and the associated cost andoverhead structures.  One-time costs ofphysically moving the manufacturing efforts and near-term inefficienciesinherent with such changes negatively impacted margins of the Company during2000.  In 2001, additional productioncapabilities were relocated with little impact to margins.  With the planned closure of the Syracusefacility in mid 2002, additional one-time costs of physically movingmanufacturing efforts and near-term inefficiencies inherent with such changesare anticipated in 2002.

 

Through improvements made in certain manufacturingprocesses and a better understanding of various chemical processes, the Companywas able to achieve certain scrap reduction targets in 2001.  In addition, many 2001 and planned 2002capital expenditures are focused on membrane and filtration technologymanufacturing equipment which should further reduce scrap.

 

Material and energy costs remained relatively flat in2001 after notable increases experienced in 2000.  The largest raw material impacts in 2000 were improved in 2001 assurcharges on stainless steel were reduced and polypropylene costs returned tomore historical levels.  Energy costs atthe Company’s Vista, California facility approximated the increased levelsexperienced in the second half of 2000 when the state of California entered itsenergy crisis.  This resulted inincreased 2001 utility costs of approximately $600 compared to those incurredin the first half of 2000.  Thereduction of manufacturing scrap and the improvement in raw material sourcingcontinue to be Company priorities in Year 2002.

 

The deterioration of the euro in comparison to theU.S. dollar negatively impacted 2001 and 2000 gross margin by approximately$977 (0.5% of net sales) and $580 (0.3% of net sales), respectively. 

 

2

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**Selling,General and Administrative Expenses** increased $611 or 1.4% to$44,806 in 2001 as compared to $44,195 in 2000.  As a percentage of sales, SG&A decreased from 22.2% to 21.7%in 2001.  The 2001 increase is primarilyattributed to increased general and administrative costs primarily associatedwith legal and professional fees.  TheCompany has attempted to manage expenses through various efforts to restructurethe Company, improve the utilization of the Company’s ERP (Enterprise ResourcePlanning) system and focus the number of products sold and the markets servedby the Company.  Also, the Companycontinues to centralize its sales efforts within business segments to focusresponsibility for customer relationships. 

 

**Research,Development and Engineering Expenses** decreased $143 or 1.8%to $7,743 in 2001, compared to $7,886 in 2000. As a percentage of sales, the R&D expenses were 3.7% and 3.9% in2001 and 2000, respectively.  Thedecrease as a percent of sales is the result of the Company continuing to focusits R&D efforts to eliminate duplication, to concentrate on new productdevelopment and improve timeliness to market. The Company believes the current level of funding is adequate to supportits product development priorities throughout 2002. 

** **

**SpecialCharges** of $1,700 ($1,122 net-of-tax or $0.08 per dilutedshare) were recorded in the fourth quarter of 2001.  Charges included $1,100 related to the closure of the Company’sSyracuse, New York manufacturing facility and $600 related to corporaterestructuring.  The special charges aresummarized below:

 
| Plant closure            |   | $   | 1,100  |   |
|--------------------------|--------|-----|--------|--------|
| Corporate  restructuring |   | 600 |   |
| Special charges          |   | $   | 1,700  |   |

 

**OtherExpense** includes interest income, interest expense, gains onasset sales and other miscellaneous items. This increased $1,939 to $1,932 in 2001, compared to income of $7 in2000.  The 2001 change is primarily theresult of $3,788 pretax gains ($0.18 per diluted share after tax) recognized onthe sale of securities during 2000 compared to $972 pretax gains ($0.04 perdiluted share after tax) in 2001.  Netinterest expense decreased $1,501 to $2,439 in 2001 compared to $3,940 in2000.  2001 interest expense decreased$1,782 as a result of lower overall debt levels and lower interest rates.  Also, 2001 interest income decreased $281resulting from the liquidation of marketable securities in 2000 and 2001.

 

**IncomeTaxes** increased $520 to $3,183 in 2001 compared to $2,663 in2000.  The effective tax rate for theyear ended December 31, 2001 was 34.0% compared to 32.9% for the same period in2000.

 

3

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**NetIncome** increased $760 to $6,179 ($0.42 per diluted share) in2001, compared to $5,419 ($0.38 per diluted share) in 2000.  Net income in 2001 was negatively impactedby special charges totaling $1,700 ($0.08 per diluted share).  Without the special charges, 2001 net incomewould have been $7,301 ($0.50 per diluted share).  There were no net special charges in 2000.

 

**Comparisonof Years Ended December 31, 2000 and December 31, 1999**

** **

**NetSales** for 2000 increased $13,111 or 7.0% to $200,139 ascompared to net sales of $187,028 for 1999. The 2000 sales increase was primarily the result of renewed organicsales growth of 6%.  Sales in 2000benefited from the full year impact of ZyzaTech ($6,500), acquired in thirdquarter 1999, and were negatively impacted by product lines that were exited asa result of closing certain manufacturing facilities ($4,900).  Sales in 2000 increased in all segments ofthe Company.  Overall, internationalsales increased $8,821 (14.3%).  Thedeterioration of the euro in comparison to the U.S. dollar negatively impactedYear 2000 sales by approximately $580 (0.3% of net sales).  2000 sales to customers in the Americas andAsia/Pacific improved $4,806 (45.8%) and $4,700 (26.2%), respectively, whilesales to customers in Euro/Africa declined $685 (2.1%).  

** **

**GrossProfit** for 2000 increased $1,986 or 3.4% to $60,406 ascompared to $58,420 in 1999.  As apercentage of net sales, gross profit decreased to 30.2% from 31.2% in1999.  2000 gross profit includes $250(0.1% of net sales) of a special inventory recovery related to a plant closingrecorded in the first quarter 2000. 1999 gross profit includes $1,035 (0.6% of net sales) of specialinventory charges related to plant closings. The decrease in gross profit percentage is primarily due to lowerutilization and production issues at certain manufacturing facilities.  To reduce excess manufacturing capacity andcosts in order to improve gross margins, one facility (Rockland, Massachusetts)was closed on December 31, 1999, another (Denver, Colorado) was closed inSeptember 2000 and another facility (Phoenix, Arizona) was closed in October2000.

 

The Company relocated certain production capabilitiesthroughout the year as it continued its efforts to focus its factories andeliminate duplicate capabilities and the associated cost and overheadstructures.  Five such relocations werecompleted during 2000.  One-time costsof physically moving the manufacturing efforts and near-term inefficienciesinherent with such changes negatively impacted margins of the Company duringthe year.  

 

In the process of relocating production capabilities,the Company was unable to achieve its expected scrap reduction targets.  The Company experienced increasing rawmaterial and energy costs in 2000 and was unable to offset such costs withprice increases.  Specifically,surcharges on stainless steel and increased polypropylene costs were thelargest raw material impacts.  Whileenergy costs increased throughout the Company, the increases were moresubstantial at the Company’s Vista, California facility.  Should the energy costs in 2001 remain atlevels experienced in California during the second half of 2000, the Companyanticipates approximately $600 of additional costs that it may not be

 

4

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able to pass on to its customers.  The reduction of manufacturing scrap and theimprovement in raw material sourcing remain continuing priorities in Year 2001.

 

The deterioration of the euro in comparison to theU.S. dollar negatively impacted Year 2000 gross margin by approximately $580(0.3% of net sales).  

 

**Selling,General and Administrative Expenses** increased $475 or 1.1% to$44,195 in 2000 as compared to $43,720 in 1999.  As a percentage of sales, SG&A decreased from 23.3% to 22.2%in 2000.  The 2000 increase isattributed to the acquisition of ZyzaTech Water Systems in July 1999 and offsetby expense control efforts of the Company.

 

The Company continues to centralize its sales effortswithin business segments to focus responsibility for customerrelationships.  The Company hasincreased its efforts to better understand its customers’ requirements andbelieves it has made progress toward improving performance and service levelsto meet those requirements. 

 

**Research,Development and Engineering Expenses** increased $192 or 2.5%to $7,886 in 2000, compared to $7,694 in 1999. As a percentage of sales, the R&D expenses were 3.9% and 4.1% in2000 and 1999, respectively.  The Companybelieves the current level of funding is adequate to support its productdevelopment priorities. 

** **

**SpecialCharges (Recovery)** were recorded in the first quarter of 2000that netted to zero.  Special chargesincluded a $250 recovery of inventory accruals primarily due to gainsrecognized on the sale of inventory at the Company’s Rockland, Massachusettsmanufacturing facility.  The specialcharges also included $250 of workforce reduction severance costs related tothe first quarter 2000 restructuring of several corporate functions.  The special charges (recovery) aresummarized below:

 
| Corporate restructuring                              |   | $    | 250    |   |
|------------------------------------------------------|--------|------|--------|--------|
| Special inventory recovery related to plant closings |   | (250 | )      |
| Gross special  charges (recovery)                    |   | $    | — |   |
| Less special  inventory recovery – in COS       |   | (250 | )      |
| Special charge  in Operating Expense                 |   | $    | 250    |   |

 

**OtherExpense** decreased $1,390 to income of $7 in 2000, compared toexpense of $1,383 in 1999.  The 2000change is primarily the result of gains on the sale of investment securities of$3,788 in 2000 compared to $2,371 in 1999. Net interest expense increased $499 to $3,940 in 2000 compared to $3,441in 1999.  This resulted from a $215decrease in interest income during 2000 resulting from the liquidation ofmarketable securities in 2000.  Also,2000 interest expense increased $284 as interest rate increases negativelyimpacted the reduced average debt carrying balance of the Company.

 

**IncomeTaxes** increased $579 to $2,663 in 2000 compared to $2,084 in1999.  The effective tax rate for theyear ended December 31, 2000 was 32.9% compared to 31.8% for the same period in1999.  The 1999 effective tax rate wascomputed after excluding 

 

5

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the non-deductible $3,500 goodwill asset impairmentspecial charge related to AquaMatic products.

 

**NetIncome** increased $4,455 to $5,419 ($0.38 per diluted share)in 2000, compared to $964 ($0.07 per diluted share) in 1999.  Net income in 1999 was negatively impactedby special charges.  Without the specialcharges, 1999 net income would have been $4,533 ($0.32 per diluted share).

 

**Liquidity and Capital Resources**

 

At December 31, 2001, the Company had cash andmarketable securities of $52 as compared to $1,910 at December 31, 2000.  The decrease in cash and marketablesecurities was primarily the result of the Company liquidating $2,188 of itsmarketable securities portfolio during 2001. This compares to $13,740 and $6,409 of marketable securities liquidatedin 2000 and 1999, respectively.

 

Cash provided by operations was $18,438, $2,395 and$20,089 for the years ended December 31, 2001, 2000 and 1999,respectively.  The increase in cashprovided by operating activities during 2001 was principally due to improvedearnings and reductions in accounts receivable and inventory.  The reduction in cash provided by operatingactivities during 2000 was principally due to the Company’s decision tostrategically build inventory levels of high volume items to better serve itscustomers.  The combination of Year 2000inventory increase of $8,158 and a 1999 inventory decrease of $5,372 resultedin total cash flow from operations impact change of $13,530.

 

Capital expenditures for the years ended December 31,2001, 2000 and 1999 were $10,430, $7,058 and $8,323, respectively.  Depreciation for the same time periods was$7,557, $7,300 and $6,632, respectively. The Company anticipates increasing its investment in capital assets in2002.  At December 31, 2001, theCompany’s aggregate commitments for capital expenditures were less than $1,000.

 

In the first quarter of 2000, the Company amended itsloan agreement and reduced the Company’s unsecured revolving line of credit to$30,000 from $35,000.  In the secondquarter 2000, the Company negotiated the release of collateral arrangementswith its lenders associated with $10,000 of its marketable securitiesportfolio.  As a result, the Companyliquidated that portion of its marketable securities portfolio and used theproceeds to reduce aggregate debt levels, fund current operations and enterinto a loan agreement amendment that reduced the Company’s unsecured revolvingline of credit to $24,000 from $30,000. At December 31, 2001, the Company had $14,500 available under therevolving line of credit, compared to $9,000 as of December 31, 2000.

 

The Company’s operating cash requirements consistprincipally of working capital requirements, capital expenditures and scheduledpayments of principal on outstanding indebtedness.  The Company believes that its cash and marketable securities,cash flow from operating activities and borrowings under its bank facility willbe adequate to meet the Company’s liquidity and capital investment requirementsin the foreseeable future.

 

6

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**New Accounting Standards**

 

On October 3, 2001, theFinancial Accounting Standards Board approved its proposed FAS No. 144 (FAS144), “Accounting for Impairment or Disposal of Long-Lived Assets.”  FAS 144 prescribes a consistent accountingmodel for long-lived assets to be disposed of by other than a sale, regardlessof whether the asset was previously held and used or newly acquired.  The provisions of FAS 144 will be effectivefor fiscal years beginning after December 15, 2001.  The Company is evaluating the impact of the adoption of thisstandard and has not yet determined the effect of adoption on its financialposition and results of operations.  

 

In June 2001, the Financial Accounting Standards Boardissued Statement of Financial Accounting Standards No. 143 (FAS 143),“Accounting for Asset Retirement Obligations.” FAS 143 requires entities to recognize the fair value of a liability fortangible long-lived asset retirement obligations in the period incurred, if areasonable estimate of fair value can be made. The provisions of FAS 143 will be effective for fiscal years beginningafter June 15, 2002.  The Company isevaluating the impact of the adoption of this standard and has not yetdetermined the effect of adoption on its financial position and results ofoperations.

 

On June 29, 2001, theFinancial Accounting Standards Board approved its proposed Statements ofFinancial Accounting Standards No. 141 (FAS 141), “Business Combinations,” andNo. 142 (FAS 142), “Goodwill and Other Intangible Assets.”  FAS 141 requires that all businesscombinations subsequent to June 30, 2001 be accounted for under the purchasemethod of accounting.  FAS 142 requirescessation of goodwill amortization and periodic evaluation of the goodwillcarrying value.  The provisions of FAS142 will be effective for fiscal years beginning after December 15, 2001.  The Company is evaluating the impact of theadoption of these standards and has not yet determined the effect of adoptionon its financial position and results of operations.

 

On January 1, 2001, the Company adopted Statement ofFinancial Accounting Standards (SFAS) No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” as amended by SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities.”  SFAS No. 133 establishes accounting andreporting standards for derivative instruments and for hedging activities.  It requires that all derivatives, includingthose embedded in other contracts, be recognized as either assets orliabilities and that those financial instruments be measured at fairvalue.  The accounting for changes inthe fair value of derivatives depends on their intended use anddesignation.  Management has reviewedthe requirements of SFAS No. 133 and has determined that they have no embeddedderivatives.  All contracts that containprovisions meeting the definition of a derivative, except for one describedbelow, also meet the requirements of, and have been designated as, normalpurchases or sales.  The Company’sgeneral policy is to not enter into contracts containing derivatives with termsthat cannot be designated as normal purchases or sales.

 

7

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In 2001, the Companyentered into a hedge contract to help offset foreign currency risk related toits European foreign subsidiary.  Theinstrument hedges certain levels of the subsidiary’s local euro currencyexposure to the U.S. dollar and expires in June 2002.  The Company has chosen, as permitted by FAS 133, to record thechanges in the fair value of the instrument in other income (expense) in theperiod of change.    

 

The Company adopted EITF 00-10 “Accounting forShipping and Handling Fees and Costs” issued by the Emerging Issues Task Forcein 2000.  Comparative financialstatements for prior periods have been reclassified to comply with theclassification guidelines.  The freightamounts included in revenues were $3,586, $3,104 and $2,357 for the years endedDecember 31, 2001, 2000 and 1999, respectively.

 

**Reviewof Industry Segments**

 

As discussed in Note 12 to the consolidated financialstatements, in 2000 the Company changed the focus of its reporting structurefrom a two-segment, product-focused structure to a three-segment,market-focused structure.  Certainfinancial results for the 12 months ended December 31, 2001, 2000, and 1999 arepresented below as a percentage of net sales by segment (all segmentinformation excludes the impact of special charges):

 

8

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|                         |     | **Years  Ended December 31,** |     | **Increase  (Decrease)** |     |
|------------------------------|----------|-------------------------------|----------|--------------------------|----------|
|                         | **2001** |                          | **2000** |                     | **1999** |   | **2001 vs.  2000** |   | **2000 vs.  1999** |   |
| Filtration and  Separations: |     |                          |     |                     |     |   |   |   |   |   |   |
| Sales                        |     | 100.0                         | %        | 100.0                    | %        | 100.0 | % | 4.0 | % | 1.7 | % |
| Gross Profit                 |     | 36.6                          |     | 34.4                     |     | 38.5 |   | 10.6 |   | (9.2 | ) |
| Operating Income             |     | 9.0                           |     | 6.2                      |     | 9.1 |   | 50.8 |   | (30.4 | ) |
|                         |     |                          |     |                     |     |   |   |   |   |   |   |
| Process Water:               |     |                          |     |                     |     |   |   |   |   |   |   |
| Sales                        |     | 100.0                         | %        | 100.0                    | %        | 100.0 | % | 8.1 | % | 13.1 | % |
| Gross Profit                 |     | 27.0                          |     | 25.0                     |     | 24.0 |   | 16.7 |   | 17.9 |   |
| Operating Income  (Loss)     |     | 4.0                           |     | (0.2                     | )        | (1.8 | ) | n/a |   | (85.3 | ) |
|                         |     |                          |     |                     |     |   |   |   |   |   |   |
| Household Water:             |     |                          |     |                     |     |   |   |   |   |   |   |
| Sales                        |     | 100.0                         | %        | 100.0                    | %        | 100.0 | % | (6.2% | ) | 6.6 | % |
| Gross Profit                 |     | 31.3                          |     | 31.6                     |     | 32.5 |   | (7.2 | ) | 3.5 |   |
| Operating Income             |     | 5.4                           |     | 8.3                      |     | 5.9 |   | (39.3 | ) | 50.4 |   |

 

Sales to unaffiliated customers in foreign geographicareas are as follows:

 
|         |   | **2001** |   | **% of  Total  Sales** |   | **2000** |   | **% of  Total  Sales** |   | **1999** |   | **% of  Total  Sales** |   |
|--------------|--------|----------|--------|------------------------|--------|----------|--------|------------------------|--------|----------|--------|------------------------|--------|
| Asia/Pacific |   | $        | 21,509 |                   | 10.4   |     | $      | 22,653                 |   | 11.3     |   | $                      | 17,953 |   | 9.6 |   |
| Euro/Africa  |   | 34,346   |   | 16.5                   |   | 32,586   |   | 16.3                   |   | 33,271   |   | 17.8                   |   |
| Americas     |   | 14,538   |   | 7.0                    |   | 15,297   |   | 7.6                    |   | 10,491   |   | 5.6                    |   |
| Total Sales  |   | $        | 70,393 |                   | 33.9   |     | $      | 70,536                 |   | 35.2     |   | $                      | 61,715 |   | 33.0 |   |

 

**Filtrationand Separations**

 

Net sales in the Filtration and Separations segmentincreased 4.0% to $83,208 in 2001 compared to $79,977 in 2000.  The 2001 sales increase is primarily relatedto improved sales in membrane element products offset by some reduction in theCompany’s filtration products.

 

Gross margin improved 10.6% to $30,447 (36.6% of netsales) in 2001 compared to $27,526 (34.4% of net sales) in 2000.  The improved gross margin is primarily theresult of improved utilization of the Company’s membrane manufacturingfacilities in 2001.  In addition,improvements in certain manufacturing processes and improved awareness of thechemical processes in membrane manufacturing contributed to the gross marginimprovement in 2001. 

 

The operating income improvement of $2,532 to $7,518(9.0% of net sales) in 2001 compared to $4,986 (6.2% of net sales) in 2000 wasprimarily the result of improved 

 

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gross profits. Operating expenses declined as a percent of net sales in 2001 as theCompany continued to focus on expense control. 

 

**ProcessWater**

 

Net sales in the Process Water segment increased 8.1%to $87,152 in 2001 compared to $80,647 in 2000.  The 2001 sales increase is primarily related to improved sales onengineered systems and products.

 

Gross margin improved 16.7% to $23,504 (27.0% of netsales) in 2001 compared to $20,141 (25.0% of net sales) in 2000.  The improved gross margin is largely theresult of improved utilization of capacity, standardization of product lines,new product releases, cost control, and focused factory initiatives.

 

The operating income improvement of $3,676 to $3,485(4.0% of net sales) in 2001 compared to a loss of $191 (-0.2% of net sales) in2000 was primarily the result of improved gross profits.  Operating expenses declined as a percent ofnet sales in 2001 as the Company continued to focus on expense control.

 

**HouseholdWater**

 

Net sales in the Household Water segment decreased6.2% to $37,079 in 2001 compared to $39,515 in 2000.  The 2001 sales decrease was primarily related to reduced demandfor the Company’s residential valves and controls products.  This segment was negatively impacted by thegeneral economic slowdown and customer inventory adjustments throughout 2001.

 

Gross margin declined 7.2% to $11,592 (31.3% of netsales) in 2001 compared to $12,489 (31.6% of net sales) in 2000.  The reduced gross margin is primarily theresult of lower utilization of fixed manufacturing capacity driven by reducedsales.  Throughout 2001, managementfocused efforts on cost reductions to match the level of economic activity.

 

The operating income decline of $1,289 to $1,991 (5.4%of net sales) in 2001 compared to $3,280 (8.3% of net sales) in 2000 wasprimarily the result of reduced gross profits. Operating expenses increased $392 and as a percent of net sales in2001.  The segment incurred one-timeseparation charges of $250 in the second quarter of 2001 resulting from effortsto reduce staff and management levels to match the current and near-termanticipated business requirements.

 

Management does not report the balance sheet or anycash-generating measurements by such segments.

 

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**Bankruptcy of Major Customer**

 

The Company has $13,700 of goodwill recorded as ofDecember 31, 2001 associated with the second quarter 1998 acquisition ofMembrex Corp. (Membrex).  Safety Kleen(SK), the principal customer for the Membrex products, filed for Chapter 11bankruptcy in June of 2000.  As aresult, 2001 sales to SK of $1,878 were $1,909 below the same period 2000 salesof $3,787.  SK has continued to orderproduct and parts at reduced levels to support its installed base.  Future sales levels are uncertain and couldbe minimal.  Inventory related to theMembrex products for SK was $1,600 while net receivables from SK were currentat December 31, 2001.  

 

On December 21, 2001, the Company signed a newagreement with SK, which continues the business relationship on a non-exclusivebasis.  This new agreement enables theCompany to actively market its product through other available saleschannels.  The Company has developed abusiness plan and hired a sales and technical support staff dedicated topursuing sales in such channels in 2002 and beyond.

 

In February 2002, it was announced that Clean Harbors,Inc. (Nasdaq: CLHB), an industry-leading environmental services provider, hasentered a definitive agreement to acquire Safety-Kleen’s Chemical ServiceDivision, subject to approval by the Bankruptcy Court and various regulatoryagencies.  At this point, Management isunable to determine the financial impact of such a transaction to theCompany.  The Company is monitoring theChapter 11 bankruptcy proceedings to determine any further financial impact tothe Company.

 

The Company has determined that two-thirds ($9,100) ofthe Membrex goodwill is associated with these products.  The Company has concluded there was noimpairment of goodwill at December 31, 2001. In its analysis, management used a discounted cash flow model inaccordance with current accounting guidelines. This analysis includes a detailed sales plan with sales of productthrough new sales channels and anticipates an ongoing business relationshipwith SK while it proceeds through and comes out of bankruptcy.  The ongoing business relationship assumesthat SK will continue to purchase replacement membrane for existing productinstallations.

 

Management believes it will be capable of selling andmarketing these products through other sales channels in a manner that willsupport the goodwill value.  The Companyis continuing to investigate new applications for the technology acquired fromMembrex.  The Company believes thepatented technology associated with Membrex brings a cost-effective solution tohazardous waste disposal, which could become a required environmental standard.

 

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**Private Securities Litigation ReformAct**

 

The Private Securities Litigation Reform Act providesa “safe harbor” for forward-looking statements.  Certain information included in this Annual Report and othermaterials filed or to be filed with the Securities and Exchange Commission (aswell as information included in statements made or to be made by the Company)contains statements that are forward-looking. Such statements may relate to plans for future expansion and marketpenetration, sales, business development activities, capital expenditures andspending, financing, product reorganizations, plant rationalizations, scrapreductions, contract negotiations, the bankruptcy of SK or the effects ofregulation, competition and foreign exchange. Such information involves important risks and uncertainties that couldsignificantly affect results in the future. Such results may differ from those expressed in any forward-lookingstatements made by the Company.  Theserisks and uncertainties include, but are not limited to, those relating toproduct development, computer systems development, dependence on existing management,energy availability and costs, global economic and market conditions andchanges in federal or state laws.

 

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