Oil-Dri Corp of America: Form 10-Q for the period ended Jan 31, 2018

The following discussion and analysis of our financial condition and results of operations should be read together with the financial statements and the related notes included herein and our Consolidated Financial Statements, accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the fiscal year ended July 31, 2017. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under “Forward-Looking Statements” and Item 1A, Risk Factors, of our Annual Report on Form 10-K for the fiscal year ended July 31, 2017.

OVERVIEW

We develop, mine, manufacture and market sorbent products principally produced from clay minerals and, to a lesser extent, other clay-like sorbent materials. Our principal products include agricultural and horticultural chemical carriers, animal health and nutrition products, bleaching clay and fluid purification aids, cat litter, industrial and automotive floor absorbents and sports field products. Our products are sold to two primary customer groups, including customers who resell our products as originally produced to the end consumer and those who use our products as part of their production process or use them as an ingredient in their final finished product. We have two reportable operating segments based on the different characteristics of our two primary customer groups: Retail and Wholesale Products Group and Business to Business Products Group, as described in Note 7 of the Notes to Condensed Consolidated Financial Statements.

RESULTS OF OPERATIONS

SIX MONTHS ENDED JANUARY 31, 2018 COMPARED TO

SIX MONTHS ENDED JANUARY 31, 2017

CONSOLIDATED RESULTS

Consolidated net sales for the six months ended January 31, 2018 were $135,540,000, compared to net sales of $131,786,000 for the six months ended January 31, 2017. Net sales were up for our Business to Business Products Group and were flat for our Retail and Wholesale Products Group. Both operating segments also reported higher operating income, as discussed further below.

Consolidated net income for the first six months of fiscal year 2018 was $1,954,000, a 69% decrease from net income of $6,259,000 for the first six months of fiscal year 2017. The reduction in net income was significantly impacted by a one-time $5,091,000 tax expense adjustment recorded in the second quarter of fiscal 2018 to reflect the impact on deferred income tax assets under the 2017 Tax Act. Diluted net income per share was $0.26 for the first six months of fiscal year 2018, compared to $0.86 for the first six months of fiscal year 2017. The tax expense adjustment effectively reduced diluted net income per share by $0.69 for the first six months of fiscal year 2018.

Consolidated gross profit as a percentage of net sales for the first six months of fiscal year 2018 was 28.5%, compared to 30.2% for the first six months of fiscal year 2017. Gross profit in fiscal year 2018 was negatively impacted by higher natural gas and other manufacturing costs, as well as by increased freight and packaging costs. The cost of natural gas per manufactured ton was approximately 11% higher than the prior year. Other manufacturing costs per ton produced were up approximately 8% compared to the same period in the prior fiscal year, including higher expenses for salaries, wages, repairs and depreciation. Freight costs per ton increased approximately 5% due primarily to rising rates as demand for freight services exceeded capacity. Packaging costs were approximately 10% higher compared to the prior fiscal year. Significant amounts of our packaging purchases are subject to contractual price adjustments throughout the year based on underlying commodity prices, including both resin and paper-based packaging. The impact of these higher costs was partially offset by increased selling prices and a favorable product sales mix.

Total selling, general and administrative expenses were 4% lower for the first six months of fiscal year 2018 compared to the first six months of fiscal year 2017. The decrease was driven by lower advertising expense in the Retail and Wholesale Products Group. The discussion of the segments' operating incomes below describe the changes in the selling, general and administrative expenses that were allocated to the operating segments. The remaining unallocated corporate expenses in the first six months of fiscal year 2018 included higher costs for research and development, implementation of our new enterprise resource planning software and outside legal fees associated with ongoing litigation, as described further in Part II. Item 1. “Legal Proceedings” of this Quarterly Report on Form 10-Q. These higher corporate expenses were partially offset by a lower estimated annual incentive bonus accrual compared to the prior year. The incentive bonus accruals were based on performance targets established for each fiscal year.

Tax expense for the first six months of fiscal year 2018 was $6,956,000, compared to $1,664,000 for the first six months of fiscal year 2017. Excluding the one-time $5,091,000 tax expense adjustment to reflect the provisions of the 2017 Tax Act, the effective tax rate for the first six months of fiscal year 2018 would have been 21%, the same as the first six months of fiscal year 2017. We used an estimated annual effective tax rate in determining our quarterly provision for income taxes, which is based on expected annual taxable income and the assessment of various tax deductions, including depletion. In addition, the effective tax rate for the first six months of fiscal year 2018 included a reduction of approximately 2% under new accounting guidance for the recognition of excess tax benefits for share-based compensation. See Notes 2 and 10 of the Notes to Condensed Consolidated Financial Statements for more information about new accounting pronouncements and income taxes, respectively.

BUSINESS TO BUSINESS PRODUCTS GROUP

Net sales of the Business to Business Products Group for the first six months of fiscal year 2018 were $54,442,000, an increase of $3,708,000, or 7%, from net sales of $50,734,000 for the first six months of fiscal year 2017. Net sales of our traditional and engineered agricultural chemical granules increased approximately 19% due primarily to new customers and higher sales to existing customers. Net sales of our fluids purification products were up approximately 6%. Sales increased due to normal ordering fluctuations of petroleum oil and biodiesel processors. Net sales of our animal health and nutrition products were 2% higher than the first six months of fiscal year 2017, driven by increased sales in Latin America. Lower sales of animal health and nutrition products by our subsidiary in China partially offset this increase, as described in “Foreign Operations” below. Sales of our co-packaged cat litter were down slightly compared to the prior year.

Selling, general and administrative expenses for the Business to Business Products Group were approximately 2% lower due primarily to lower costs to promote our animal health and nutrition products.

The Business to Business Products Group’s operating income for the first six months of fiscal year 2018 was $18,635,000, an increase of $1,412,000, or 8%, from operating income of $17,223,000 for the first six months of fiscal year 2017. Higher sales and lower selling, general and administrative expenses more than offset increased natural gas, manufacturing, freight and packaging costs. See “Consolidated Results” above for further discussion of manufacturing, freight and packaging costs.

RETAIL AND WHOLESALE PRODUCTS GROUP

Net sales of the Retail and Wholesale Products Group for the first six months of fiscal year 2018 of $81,098,000 were essentially flat with net sales of $81,052,000 for the first six months of fiscal year 2017. Total cat litter net sales were even with the first six months of the prior year. Branded litter sales were negatively impacted by a change in the mix and amount of products sold to a major customer. However, higher e-commerce sales of our branded litter and litter box liners lessened the overall decline. Private label coarse sales declined due primarily to the loss of a customer. Sales of our private label lightweight scoopable litter continued to grow compared to the same quarter of the prior year, due primarily to new distribution and increased sales to current customers.

Net sales of industrial and automotive absorbent products were flat compared to the first six months of fiscal year 2017. Six month sales for our subsidiary in the United Kingdom were higher, while sales for our subsidiary in Canada were slightly lower than the prior year. See “Foreign Operations” below for further discussion about the sales and types of products sold by these foreign subsidiaries.

Selling, general and administrative expenses for the Retail and Wholesale Products Group were 20% lower compared to the first six months of fiscal year 2017. The decrease was driven by approximately $2,100,000 lower advertising expense to promote our Fresh & Light lightweight cat litter. We plan to continue promoting lightweight litter through the remainder of fiscal year 2018 and we expect advertising expense for the full year of fiscal year 2018 to be less than in fiscal year 2017.

The Retail and Wholesale Products Group's operating income for the first six months of fiscal year 2018 was $4,787,000, an increase of $307,000, or 7%, from operating income of $4,480,000 for the first six months of fiscal year 2017. The reduction in selling, general and administrative expenses, as discussed above, more than offset increased natural gas, manufacturing, freight and packaging costs. See “Consolidated Results” above for further discussion of manufacturing, freight and packaging costs.

FOREIGN OPERATIONS

Foreign operations include our subsidiaries in Canada and the United Kingdom, which are included in the Retail and Wholesale Products Group, and our subsidiary in China, which is included in the Business to Business Products Group. Net sales by our foreign subsidiaries during the first six months of fiscal year 2018 were $6,047,000, a 7% decrease compared to net sales of $6,475,000 during the first six months of fiscal year 2017. This decrease was driven by approximately 22% fewer tons of animal health and nutrition products sold by our subsidiary in China, primarily as the result of lower sales to the succeeding business after the merger of two customers. Partially offsetting these lower sales were increased sales of fluids purification products by our subsidiary in the United Kingdom. Sales by our subsidiary in Canada were essentially even with the same period of the prior year. Net sales by our foreign subsidiaries represented 4% and 5% of our consolidated net sales during the first six months of fiscal years 2018 and 2017, respectively.

Our foreign subsidiaries reported net income of $635,000 for the first six months of fiscal 2018 compared to net income of $298,000 for the first six months of fiscal 2017. The improved profitability was driven primarily by both a favorable product sales mix and positive changes in foreign currency exchange rates.

Identifiable assets of our foreign subsidiaries as of January 31, 2018 were $8,343,000, compared to $7,822,000 as of January 31, 2017. The increase was due primarily to higher cash, cash equivalents and accounts receivable.

THREE MONTHS ENDED JANUARY 31, 2018 COMPARED TO

THREE MONTHS ENDED JANUARY 31, 2017

CONSOLIDATED RESULTS

Consolidated net sales for the three months ended January 31, 2018 were $68,894,000, compared to $65,174,000 for the three months ended January 31, 2017. Net sales were up for the Business to Business Products Group, but were down for the Retail and Wholesale Products Group. Second quarter operating income increased for the Business to Business Products Group, but decreased for the Retail and Wholesale Products Group, as discussed further below.

A consolidated net loss of $1,096,000 was reported for the second quarter of fiscal year 2018, compared to net income of $4,250,000 for the second quarter of fiscal year 2017. The results for the second quarter of fiscal 2018 were significantly impacted by a one-time $5,091,000 tax expense adjustment to reflect the impact on deferred income tax assets under the 2017 Tax Act. A diluted net loss per share of $0.15 was reported for the second quarter of fiscal year 2018, compared to diluted net income per share of $0.58 for the second quarter of fiscal year 2017. The tax expense adjustment effectively reduced diluted net income per share by $0.69 for the second quarter of fiscal year 2018.

Consolidated gross profit as a percentage of net sales for the second quarter of fiscal year 2018 was 28.5%, which was slightly lower than the 29.3% for the second quarter of fiscal year 2017. Gross profit was negatively impacted by higher natural gas and other manufacturing costs, as well as by increased freight and packaging costs. The cost per manufactured ton for natural gas used to operate kilns that dry our clay was approximately 11% higher in the second quarter of fiscal year 2018 compared to the second quarter of fiscal year 2017. Other manufacturing costs per ton produced were up approximately 9%, including higher expenses for salaries, wages, benefits, repairs and depreciation. Freight costs per ton increased approximately 10% due primarily to rising rates as demand for freight services exceeded capacity. Packaging costs were approximately 7% higher compared to the second quarter of the prior fiscal year. Significant amounts of our packaging purchases are subject to contractual price adjustments throughout the year based on underlying commodity prices, including both resin and paper-based packaging. The impact of these higher costs was partially offset by increased selling prices and a favorable product sales mix.

Total selling, general and administrative expenses were 10% higher for the second quarter of fiscal year 2018 compared to the second quarter of fiscal year 2017. The discussion below describes the selling, general and administrative expenses allocated to the operating segments, particularly higher advertising expense in the Retail and Wholesale Products Group. The remaining unallocated corporate expenses in the second quarter of fiscal year 2018 included higher costs for research and development, implementation of our new enterprise resource planning software and outside legal fees associated with ongoing litigation, as described further in Part II. Item 1. “Legal Proceedings” of this Quarterly Report on Form 10-Q. These higher corporate expenses were partially offset by a lower estimated annual incentive bonus accrual for the second quarter of fiscal year 2018 compared to the same period of fiscal year 2017. The bonus accruals were based on performance targets established for each fiscal year.

Tax expense for the second quarter of fiscal year 2018 was $6,167,000, compared to $994,000 for the second quarter of fiscal year 2017. Excluding the one-time $5,091,000 tax expense adjustment to reflect the provisions of the 2017 Tax Act, the effective tax rate for the second quarter of fiscal year 2018 would have been 21%, compared to 19% for the same period of the prior year. We used an estimated annual effective tax rate in determining our quarterly provision for income taxes, which is based on expected annual taxable income and the assessment of various tax deductions, including depletion. See Note 10 of the Notes to Condensed Consolidated Financial Statements for more information about income taxes.

BUSINESS TO BUSINESS PRODUCTS GROUP

Net sales of the Business to Business Products Group for the second quarter of fiscal year 2018 were $27,355,000, an increase of $4,094,000, or 18%, from net sales of $23,261,000 for the second quarter of fiscal year 2017. Net sales of our traditional and engineered granules used as agricultural chemical carriers increased approximately 50% due primarily to new customers and higher sales to existing customers. Net sales of fluids purification products were up approximately 12%, including increased sales to edible oil producers and higher sales to petroleum oil and biodiesel processors due to normal ordering fluctuations. Net sales of our animal health and nutrition products were approximately 15% higher than the second quarter of the prior year, driven primarily by sales in Latin America. Sales of animal health and nutrition products by our subsidiary in China are described in “Foreign Operations” below. Sales of our co-packaged cat litter were slightly lower than the prior year.

Selling, general and administrative expenses for the Business to Business Products Group were 5% higher compared to the second quarter of fiscal year 2017. Expenditures increased for travel and advertising costs to promote our products.

The Business to Business Products Group’s operating income for the second quarter of fiscal year 2018 was $9,759,000, an increase of $1,944,000, or 25%, from operating income of $7,815,000 in the second quarter of fiscal year 2017. Higher sales more than offset increased natural gas, manufacturing, freight, packaging and selling, general and administrative costs. See “Consolidated Results” above for further discussion of manufacturing, freight and packaging costs.

RETAIL AND WHOLESALE PRODUCTS GROUP

Net sales of the Retail and Wholesale Products Group for the second quarter of fiscal year 2018 were $41,539,000, a small decrease of $374,000, or 1%, from net sales of $41,913,000 for the second quarter of fiscal year 2017. Total cat litter net sales were slightly lower compared to the second quarter of fiscal year 2017. Lower sales of branded litters were partially offset by higher sales of private label litter. Branded litter sales were negatively impacted by a change in the mix and amount of products sold to a major customer. However, growth in e-commerce sales lessened the overall branded litter decline. Sales of our private label lightweight scoopable litter continued to grow compared to the same quarter of the prior year, due primarily to new distribution and increased sales to current customers. Private label coarse sales declined to a lesser extent due to the loss of a customer.

Net sales of industrial and automotive absorbent products were also slightly lower compare to the second quarter of fiscal year 2017. Sales for our subsidiary in the United Kingdom were slightly higher, while sales for our subsidiary in Canada were lower than the second quarter of the prior year. See “Foreign Operations” below for further discussion about the sales and types of products sold by these foreign subsidiaries.

Selling, general and administrative expenses for the Retail and Wholesale Products Group were 27% higher compared to the second quarter of fiscal year 2017. The increase was driven by approximately $1,100,000 higher advertising expense to promote our Fresh & Light lightweight cat litter. We plan to continue promoting lightweight litter through the remainder of fiscal year 2018; however, we expect advertising expense for the full year of fiscal year 2018 to be less than in fiscal year 2017.

The Retail and Wholesale Products Group's operating income for the second quarter of fiscal year 2018 was $2,422,000, a decrease of $2,565,000, or 51%, compared to operating income of $4,987,000 for the second quarter of fiscal year 2017. The decrease in operating income was driven by increased natural gas, manufacturing, freight and packaging costs, as well as the higher selling, general and administrative expenses discussed above. See “Consolidated Results” above for further discussion of manufacturing, freight and packaging costs.

FOREIGN OPERATIONS

Foreign operations include our subsidiaries in Canada and the United Kingdom, which are included in the Retail and Wholesale Products Group, and our subsidiary in China, which is included in the Business to Business Products Group. Net sales by our foreign subsidiaries during the second quarter of fiscal year 2018 were $3,110,000, a 6% decrease compared to net sales of $3,324,000 in the second quarter of fiscal year 2017. This decrease was driven by approximately 13% fewer tons of animal health and nutrition products sold by our subsidiary in China, primarily as the result of lower sales to the succeeding business after the merger of two customers. Sales were also lower for cat litter and industrial absorbent products sold by our subsidiary in Canada. Partially offsetting these lower sales were increased sales of fluids purification products by our subsidiary in the United Kingdom. Net sales by our foreign subsidiaries represented approximately 5% of consolidated net sales during the second quarters of both fiscal years 2018 and 2017.

Our foreign subsidiaries reported net income of $436,000 for the second quarter of fiscal year 2018 compared to net income of $267,000 for the second quarter of fiscal year 2017. The improved profitability was driven primarily by both a favorable product sales mix and positive changes in foreign currency exchange rates.

LIQUIDITY AND CAPITAL RESOURCES

Our principal capital requirements include: funding working capital needs; purchasing and upgrading equipment, facilities, information systems and real estate; supporting new product development; investing in infrastructure; repurchasing Common Stock; paying dividends; and business acquisitions. During the first six months of fiscal year 2018, we principally used cash generated from operations to fund these requirements. We also have the ability to borrow under our revolving credit agreement with BMO Harris Bank N.A. (“BMO Harris”), as described further below, however we have not borrowed under the credit agreement in recent years.

The following table sets forth certain elements of our unaudited Condensed Consolidated Statements of Cash Flows (in thousands):

Net cash provided by operating activities

Both net income and the adjustment to net income for deferred income taxes reflect a one-time, non-cash $5,091,000 adjustment recorded in the second quarter of fiscal 2018 to reflect the provisions of the 2017 Tax Act. See Note 10 of the Notes to Condensed Consolidated Financial Statements for more information about income taxes.

In addition to net income, as adjusted for depreciation and amortization and other non-cash operating activities, the primary sources and uses of operating cash flows for the first six months of fiscal years 2018 and 2017 were as follows:

Accounts receivable, less allowance for doubtful accounts, decreased $517,000 in the first six months of fiscal year 2018 compared to an increase of $1,698,000 in the first six months of fiscal year 2017. The change in accounts receivable balances reflected differences in the level and timing of sales and collections, as well as the payment terms provided to various customers.

Prepaid expenses increased $51,000 in the first six months of fiscal year 2018 compared to an increase of $3,784,000 in the first six months of fiscal year 2017. Prepayments of annual insurance premiums and computer software licenses contributed to the increase in both fiscal years. The increase in the first six months of fiscal year 2018 was moderated by a decrease in prepaid advertising expense, but higher prepaid advertising expenses contributed to the increase in the first six months of fiscal year 2017.

Accounts payable decreased $743,000 in the first six months of fiscal year 2018 compared to an increase of $852,000 in the first six months of fiscal year 2017. Trade and freight payable varied in both periods due to timing of payments, fluctuations in the cost of goods and services we purchased, production volume levels and vendor payment terms. Current accrued estimated income taxes are also included in accounts payable balances for both years.

Accrued expenses decreased $3,637,000 in the first six months of fiscal year 2018 compared to a decrease of $1,698,000 in the first six months of fiscal year 2017. The payout of the prior fiscal year's discretionary incentive bonus drove lower accrued salaries in the first six months of both fiscal years 2018 and 2017. Accrued plant expenses fluctuated in the first six months of both fiscal years due to timing of payments, changes in the cost of goods and services we purchased, production volume levels and vendor payment terms. In addition, accrued trade promotions and advertising varied due to the timing of marketing programs.

Net cash used in investing activities

Cash used in investing activities was $5,100,000 in the first six months of fiscal year 2018 compared to cash used in investing activities of $4,446,000 in the first six months of fiscal year 2017. Cash used for capital expenditures was $6,850,000 and $7,279,000 in the first six months of fiscal years 2018 and 2017, respectively. Capital expenditures in both periods included spending for an enterprise resource planning system implementation, as well as equipment additions and replacement at our manufacturing facilities. Net dispositions of short-term investments provided cash of $1,739,000 and $2,831,000 in the first six months of fiscal years 2018 and 2017, respectively. Purchases and dispositions of investment securities in both periods are impacted by variations in the timing of investment maturities, the operating cash needs of the Company and the availability of investment options.

Net cash used in financing activities

Cash used in financing activities was $6,222,000 in the first six months of fiscal year 2018 compared to cash used in financing activities of $5,784,000 in the first six months of fiscal year 2017. Scheduled payments on long-term debt were $3,083,000 in the first six months of both fiscal years 2018 and 2017. Dividend payments in the first six months of fiscal year 2018 were $3,112,000 compared to $2,956,000 paid during the same period of fiscal year 2017 due to a dividend increase.

Other

Total cash and investment balances held by our foreign subsidiaries of $2,000,000 as of January 31, 2018 were higher than the January 31, 2017 balances of $1,653,000. See further discussion in “Foreign Operations” above.

We have a $25,000,000 unsecured revolving credit agreement with BMO Harris which expires on December 4, 2019. The agreement also provides for a maximum of $5,000,000 for foreign letters of credit. Under the agreement we may select a variable interest rate based on either the BMO Harris prime rate or a LIBOR-based rate, plus a margin which varies depending on our debt to earnings ratio, or a fixed rate as agreed between us and BMO Harris. At January 31, 2018, the variable rates would have been 4.50% for the BMO Harris prime-based rate or 2.73% for the LIBOR-based rate. The credit agreement contains restrictive covenants that, among other things and under various conditions, limit our ability to incur additional indebtedness or to dispose of assets. The agreement also requires us to maintain a minimum fixed coverage ratio and a minimum consolidated net worth. We did not borrow under the credit agreement during the six months ended January 31, 2018 and 2017, and we were in compliance with its covenants.

As of January 31, 2018, we had remaining authority to repurchase 300,822 shares of Common Stock under a repurchase plan approved by our Board of Directors. These repurchases may be made on the open market (pursuant to Rule 10b5-1 plans or otherwise) or in negotiated transactions. The timing and number of shares repurchased will be determined by our management.

We believe that cash flow from operations, availability under our revolving credit facility, current cash and investment balances and our ability to obtain other financing, if necessary, will provide adequate cash funds for foreseeable working capital needs, capital expenditures at existing facilities, deferred compensation payouts, dividend payments and debt service obligations for at least the next 12 months. We plan to continue promoting our lightweight products, although we expect advertising expense in fiscal year 2018 to be less than in fiscal year 2017. We anticipate that our capital expenditures in fiscal year 2018 will be higher than in fiscal year 2017, including costs related to our enterprise resource planning software implementation. In addition, approximately $5,996,000 of deferred compensation is payable within the next year. We do not believe that these increased cash outflows will dramatically impact our cash position; however our cash requirements are subject to change as business conditions warrant and opportunities arise.

We continually evaluate our liquidity position and anticipated cash needs, as well as the financing options available to obtain additional cash reserves. Our ability to fund operations, to make planned capital expenditures, to make scheduled debt payments and to remain in compliance with all financial covenants under debt agreements, including, but not limited to, the current credit agreement, depends on our future operating performance, which, in turn, is subject to prevailing economic conditions and to financial, business and other factors. The timing and size of any new business ventures or acquisitions that we complete may also impact our cash requirements.

The following tables summarize our contractual obligations and commercial commitments (in thousands) as of January 31, 2018 for the time-frames indicated.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

We made total contributions to our defined benefit pension plan of $770,000 during the first six months of fiscal year 2018. We estimate contributions of approximately $1,372,000 will be made during the remainder of fiscal year 2018. We have not presented this obligation for future years in the table above because the funding requirement can vary from year to year based on changes in the fair value of plan assets and actuarial assumptions. See “Item 3. Quantitative and Qualitative Disclosures About Market Risk” below for a discussion of the potential impact of financial market fluctuations on pension plan assets and future funding contributions.

The other commercial commitments in the table above represent open purchase orders, including blanket purchase orders, for items such as packaging, additives and pallets used in the normal course of operations. The expected timing of payments for these obligations is estimated based on current information. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services, or changes to agreed-upon amounts for some obligations.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

This discussion and analysis of financial condition and results of operations is based on our unaudited Condensed Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP for interim financial information and in compliance with instructions to Form 10-Q and Article 10 of Regulation S-X. The preparation of these financial statements requires the use of estimates and assumptions related to the reporting of assets, liabilities, revenues, expenses and related disclosures. In preparing these financial statements, we have made our best estimates and judgments of certain amounts included in the financial statements. Estimates and assumptions are revised periodically. Actual results could differ from these estimates. See the information concerning our critical accounting policies included under “Management’s Discussion of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended July 31, 2017.

We are exposed to interest rate risk and employ policies and procedures to manage our exposure to changes in the market risk of our cash equivalents and short-term investments. We believe that the market risk arising from holdings of our financial instruments is not material.

We are exposed to foreign currency fluctuation risk, primarily the U.S. Dollar relative to the British Pound, Euro, Canadian Dollar and Chinese Yuan. This risk is related to our foreign subsidiaries' financial results, to certain accounts receivable and to our ability to sell in foreign markets. We are subject to the impact of currency fluctuation upon translation of our foreign subsidiaries’ financial statements from local currencies to U.S. Dollars. In recent years, our foreign subsidiaries have not generated a substantial portion of our consolidated net sales or net income. In addition, the portion of our consolidated accounts receivable denominated in foreign currencies has not been significant. Finally, foreign sales of our products may be influenced by the relative strength of the U.S. dollar compared to various other currencies, which makes our products relatively more or less expensive than our foreign competitors' products in local marketplaces. Foreign currency fluctuations had some bearing on our operating results in the first six months of fiscal year 2018; however, historically the overall foreign currency fluctuation risk has not been material to our Consolidated Financial Statements. During the first six months of fiscal year 2018, we did not enter into any hedge contracts to offset any adverse effect of changes in currency exchange rates.

We are exposed to market risk as it relates to the investments of plan assets under our defined benefit pension plan. The fair value of these assets is subject to change due to fluctuations in the financial markets. A lower asset value may increase our pension expense and may increase the amount and accelerate the timing of future funding contributions.

We are exposed to regulatory risk in the fluid purification, animal health and agricultural markets, principally as a result of the risk of increasing regulation of the food chain throughout the world, but particularly in the United States and Europe. We actively monitor developments in this area, both directly and through trade organizations of which we are a member.

We are exposed to commodity price risk with respect to fuel. Factors that could influence the cost of natural gas used in the kilns to dry our clay include the creditworthiness of our natural gas suppliers, the overall general economy, developments in world events, general supply and demand for natural gas, seasonality and the weather patterns throughout the United States and the world. We monitor fuel market trends and, consistent with our past practice, we may contract for a portion of our anticipated fuel needs using forward purchase contracts to mitigate the volatility of our kiln fuel prices. As of January 31, 2018, we have not purchased any natural gas contracts for our planned kiln fuel needs for the remainder of fiscal year 2018.

Evaluation of Disclosure Controls and Procedures

Management conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q. The controls evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”). Based upon the controls evaluation, our CEO and CFO have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC, and that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the fiscal quarter ended January 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Our management, including the CEO and CFO, do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

PART II – OTHER INFORMATION

Items 1A, 2, 3 and 5 of this Part II are either inapplicable or are answered in the negative and are omitted pursuant to the instructions to Part II.