CPAC INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2003

OR

[ ]

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

For the transition period from to

Commission File No. 0-9600

CPAC, INC.
(Exact name of registrant as specified in its charter)

New York
(State or other jurisdiction of
incorporation or organization)

16-0961040
(I.R.S. Employer Identification No.)

2364 Leicester Road
Leicester, New York 14481
(Address of principal executive offices and Zip Code)

(585) 382-3223
(Registrant's telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:

Class	Number of Shares Outstanding at June 30, 2003
Common Stock, $.01 par value	4,945,212

Options Outstanding & Not Exercised	Shares to cover the options will not be issued until they are exercised.
1,173,163

CPAC, INC. AND SUBSIDIARIES

INDEX

		Page No.
	PART I -- FINANCIAL INFORMATION
Item 1.	Financial Statements.
	CPAC, Inc. and Subsidiaries Consolidated Balance Sheets - June 30, 2003 (Unaudited), and March 31, 2003	3
	CPAC, Inc. and Subsidiaries Consolidated Statements of Operations and Comprehensive Income (Loss) -- Three Months Ended June 30, 2003, and June 30, 2002 (Unaudited)	4
	CPAC, Inc. and Subsidiaries Consolidated Statements of Cash Flows -- Three Months Ended June 30, 2003, and June 30, 2002 (Unaudited)	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations.	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	18
Item 4.	Controls and Procedures.	18

	PART II -- OTHER INFORMATION
Item 1.	Legal Proceedings.	19
Item 2.	Changes in Securities and Use of Proceeds.	19
Item 3.	Defaults Upon Senior Securities.	19
Item 4.	Submission of Matters to a Vote of Security Holders.	19
Item 5.	Other Information.	19
Item 6.	Exhibits and Reports on Form 8-K.	19
	SIGNATURE PAGE	21
	EXHIBIT INDEX	22

PART I -- FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS.
CPAC, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

		June 30, 2003 (Unaudited)		March 31, 2003 (Note)
ASSETS
Current assets:
	Cash and cash equivalents	$ 8,169,423		$ 9,866,539
	Accounts receivable (net of allowance for doubtful accounts of $1,571,000 and $1,527,000, respectively)	11,444,203		11,721,979
	Inventory, net	18,605,088		17,775,575
	Prepaid expenses and other current assets	1,670,689		1,362,312
	Deferred tax assets, current	1,043,790		957,790
	Total current assets	40,933,193		41,684,195
Property, plant and equipment, net		16,824,055		17,010,568
Goodwill		192,426		192,426
Other intangible assets (net of amortization of $1,354,215 and $1,314,973, respectively)		1,036,683		1,073,967
Deferred tax assets, long-term		3,538,411		3,597,309
Investment in affiliate		2,974,990		1,741,727
Other assets		2,972,959		2,941,083
		$ 68,472,717		$ 68,241,275

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
	Current portion of long-term debt	$ 700,016		$ 736,197
	Accounts payable	4,788,054		5,016,870
	Accrued payroll and related expenses	1,767,294		1,615,488
	Accrued income taxes payable	322,186		84,189
	Other accrued expenses and liabilities	2,121,570		2,277,772
	Total current liabilities	9,699,120		9,730,516
Long-term debt, net of current portion		7,209,217		7,242,204
Other long-term liabilities		5,013,262		4,834,438
Shareholders' equity:
	Common stock, par value $0.01 per share; Authorized 30,000,000 shares; Issued 5,030,519 shares	50,305		50,305
	Additional paid-in capital	9,605,984		9,605,984
	Retained earnings	38,051,881		38,075,232
	Accumulated other comprehensive income	(566,864	)	(707,216	)
		47,141,306		47,024,305
Less: Treasury stock, at cost, 85,307 shares		(590,188	)	(590,188	)
	Total shareholders' equity	46,551,118		46,434,117
		$ 68,472,717		$ 68,241,275

Note: The balance sheet at March 31, 2003 has been taken from the audited financial statements as of that date
and restated for the change in accounting for the investment in affiliate (see Note 3).

The accompanying notes are an integral part of the financial statements.

CPAC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

FOR THE THREE MONTHS ENDED

JUNE 30, 2003 AND JUNE 30, 2002

UNAUDITED

			2003		2002
Net sales			$ 23,180,154		$ 24,621,678
Costs and expenses:
	Cost of sales		12,678,406		13,370,645
	Selling, administrative and engineering expenses		9,385,318		9,834,615
	Research and development expense		168,282		164,978
	Restructuring expenses		180,000
	Interest expense		133,993		125,598
			22,545,999		23,495,836
Income before income tax, minority interests, equity in income (loss) of affiliate, and cumulative effect of change in accounting principle			634,155		1,125,842
Provision for income tax			177,000		374,000
Income before minority interests, equity income (loss), and cumulative effect of change in accounting principle			457,155		751,842
	Minority interests		(52,819	)	(41,115	)
	Equity in loss of affiliate		(81,414	)	(9,217	)
Income before cumulative effect of change in accounting principle			322,922		701,510
Cumulative effect of change in accounting principle					(6,281,251	)
		Net income (loss)	$ 322,922		$ (5,579,741	)
Net income (loss) per common share:
		Basic:
		Before cumulative effect of change in accounting principle	$ 0.07		$ 0.14
		Cumulative effect of change in accounting principle	$		$ (1.23	)
		Basic net income (loss) per share	$ 0.07		$ (1.09	)
		Diluted:
		Before cumulative effect of change in accounting principle	$ 0.07		$ 0.14
		Cumulative effect of change in accounting principle	$		$ (1.22	)
		Diluted net income per share	$ 0.07		$ (1.08	)
Average common shares outstanding:
		Basic	4,945,212		5,123,499
		Diluted	4,947,012		5,143,508
Comprehensive income (loss):
		Net income (loss)	$ 322,922		$ (5,579,741	)
		Other comprehensive income	125,675		103,112
		Comprehensive income (loss)	$ 448,597		$ (5,476,629	)

The accompanying notes are an integral part of the financial statements.

CPAC, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED

JUNE 30, 2003 AND JUNE 30, 2002

UNAUDITED

		2003		2002
Cash flows from operating activities:
	Net income (loss)	$ 322,922		$ (5,579,741	)
	Adjustments to reconcile net income to net cash provided by operating activities:
	Depreciation	618,533		608,361
	Amortization of intangible assets	38,541		45,546
	Minority interests in consolidated foreign subsidiaries	52,819		41,115
	Equity in loss of affiliate	81,414		9,217
	Cumulative effect of accounting change			6,281,251
	Changes in assets and liabilities net of effects of business acquisitions:
	Accounts receivable	296,812		(272,822	)
	Inventory	(798,566	)	(361,236	)
	Accounts payable	(220,852	)	451,298
	Accrued expenses and liabilities	392,743		(236,053	)
	Other changes, net	(400,511	)	(385,211	)
	Total adjustments	60,933		6,181,466
	Net cash provided by operating activities	383,855		601,725
Cash flows from investing activities:
	Purchase of property, plant, and equipment, net	(404,036	)	(461,891	)
	Investment in affiliate	(1,300,000	)
	Net cash used in investing activities	(1,704,036	)	(461,891	)
Cash flows from financing activities:
	Repayment of long-term borrowings	(33,424	)	(350,819	)
	Payment of cash dividends	(346,273	)	(358,753	)
	Net cash used in financing activities	(379,697	)	(709,572	)
	Effect of exchange rate changes on cash	2,762		1,401
	Net decrease in cash and cash equivalents	(1,697,116	)	(568,337	)
Cash and cash equivalents -- beginning of period		9,866,539		7,991,834
Cash and cash equivalents -- end of period		$ 8,169,423		$ 7,423,497

The accompanying notes are an integral part of the financial statements.

1 -- CONSOLIDATED FINANCIAL STATEMENTS

The consolidated balance sheets, the consolidated statements of operations and comprehensive income (loss), and the consolidated statements of cash flows for the interim periods presented have been prepared by the Company without audit. In the opinion of management, all adjustments necessary to present fairly the financial position, results of operations, and changes in cash flows for the interim periods presented (which include only normal recurring adjustments), have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company's March 31, 2003, Annual Report to Shareholders. The results of operations for the interim periods presented are not necessarily indicative of the operating results for the full year.

2 -- INVENTORY

Inventory is summarized as follows:

	June 30, 2003	March 31, 2003
Raw materials and purchased parts	$ 7,584,074	$ 7,251,465
Work-in-process	1,021,987	1,046,611
Finished goods	9,999,027	9,477,499
	$ 18,605,088	$ 17,775,575

3 -- INVESTMENT IN AFFILIATE

On April 8, 2003, the Company purchased an additional 21% ownership interest in TURA AG (TURA) of Duren, West Germany, for $1,300,000. Previously, the Company had purchased a 19% ownership interest for $1,890,742 in January 2002. Due to its cumulative ownership of 40%, the Company accounts for its investment under the equity method of accounting. Accounting Principles Board Opinion No. 18 requires use of the equity method of accounting, if the investment gives the Company the ability to exercise significant influence, but not control, over an investee. The Company will record its equity in the income or losses of TURA on a three-month lag. The Company has recorded its equity investment on the consolidated balance sheet in "Investment in affiliate" and its share of the TURA earnings and losses as "Equity in income (loss) of affiliate" on the consolidated statements of operations.

As a result of the additional equity ownership, the Company has treated this transaction as a change in reporting entity and has restated the prior period's financial statements, as if the equity method had been utilized at inception. In addition, the purchase price to acquire the cumulative 40% ownership share exceeded the Company's proportionate share of TURA's net assets, and as such, has been allocated as follows:

	Unaudited Three Months Ended June 30,
	2003	2002
CPAC, Inc.'s proportionate share of TURA net assets	$ 650,020	$ 371,165
Property, plant and equipment	375,000	195,000
Supply contracts	344,000	469,000
Goodwill	1,605,970	847,230
Net investment	$ 2,974,990	$ 1,882,395

The difference between the purchase price for the Company's equity interests in TURA and the net investment balance shown above at June 30, 2003 and 2002 represents the Company's recognition of the proportionate share of TURA's net income (loss), amortization of the purchase price allocation, and foreign currency translation adjustments.

Summarized, financial information for TURA for the three months ended March 31, 2003 and 2002 is shown below:

	Unaudited Three Months Ended
	March 31, 2003		March 31, 2002
Condensed Statement of Operations:
Net revenue	$ 4,214,000		$ 6,639,000
Cost of sales	3,276,000		5,033,000
Operating expenses	1,120,000		1,322,000
Operating income (loss)	(182,000	)	284,000
Interest expense	56,000		67,000
Taxes			74,000
Net income (loss)	$ (238,000	)	$ 143,000

Condensed Balance Sheet:
Current assets	$ 7,205,000		$ 8,264,000
Non-current assets	3,913,000		3,229,000
	$ 11,118,000		$ 11,493,000

Current liabilities	$ 8,707,000		$ 9,049,000
Non-current liabilities	786,000		491,000
Shareholders' equity	1,625,000		1,953,000
	$ 11,118,000		$ 11,493,000

As required by APB No. 18, the change in accounting for the TURA investment requires restatement of prior period financial statements. The following table presents the restated prior quarter earnings and earnings per share, as if the equity method of accounting had been applied in the first quarter of fiscal 2002:

	Unaudited Three Months Ended
	June 30, 2002
Reported CPAC, Inc. net loss	$ (5,570,524	)
Equity in income (loss) of TURA	(9,217	)
Adjusted CPAC, Inc. net loss	$ (5,579,741	)

Basic earnings per share before change in reporting entity:
Reported CPAC, Inc. basic earnings per common share	$ (1.09	)
Equity in income (loss) of TURA	0
Adjusted CPAC, Inc. basic earnings per common share	$ (1.09	)

Diluted earnings per share before change in reporting entity:
Reported CPAC, Inc. diluted earnings per common share	$ (1.08	)
Equity in income (loss) of TURA	0
Adjusted CPAC, Inc. diluted earnings per common share	$ (1.08	)

Reported CPAC, Inc. comprehensive loss	$ (5,468,281	)
Equity in income (loss) of TURA	(9,217	)
Adjusted CPAC, Inc. comprehensive loss	$ (5,477,498	)

The following table shows the restatement impact on the March 31, 2003 balance sheet for the change in the accounting for the TURA investment:

	Unaudited March 31, 2003

Investment in affiliate, as reported	$1,890,742
Investment in affiliate, as adjusted	1,741,727

Total assets, as reported	68,390,290
Total assets, as adjusted	68,241,275

Retained earnings, as reported	38,288,530
Retained earnings, as adjusted	38,075,232

Accumulated other comprehensive income, as reported	(771,499	)
Accumulated other comprehensive income, as adjusted	(707,216	)

Shareholders' equity, as reported	46,583,132
Shareholders' equity, as adjusted	46,434,117

Beginning in the Company's second quarter of fiscal 2004, the Company will recognize 40% of the income or loss of TURA, as it records its equity in TURA earnings on a three-month lag, adjusted for the purchase price allocation amortization. The amounts included in the quarters ended June 30, 2003 and 2002 represent 19% of the affiliate's losses, adjusted for the purchase price allocation of $36,250 in each quarter presented.

4 -- GUARANTEES

The Company guarantees the following debt and other obligations for some of its subsidiaries under agreements with banks:

-- A standby letter of credit issued by Bank of America for $6.2 million is used by the Company to collateralize the Fuller Brands' Industrial Revenue Bonds.

-- A standby letter of credit issued by HSBC Bank is used by the Company to guarantee the Company's majority-owned subsidiary CPAC Asia Imaging Products Limited's 20 million baht line of credit (approximately $467,000 based on the first quarter conversion rate in Thailand). At June 30, 2003, the outstanding line of credit was $18,145.

-- Standby letters of credit issued by HSBC Bank are used by the Company to guarantee the Company's majority-owned subsidiary CPAC Asia Imaging Products Limited's term note obligations. These obligations totaled approximately $867,000 at quarter end.

The Company has warranty obligations in connection with sales of its Imaging equipment. The warranty period generally ranges from 6 to 12 months. The costs incurred to provide for these warranty obligations are estimated and recorded as an accrued liability at the time of sale. The Company estimates its warranty cost at the time of sale for a given product based on historical failure rates and related costs to repair. The change in the Company's accrued warranty obligations from March 31, 2003 to June 30, 2003 was as follows (in thousands):

Accrued warranty obligations at March 31, 2003	$31
Accrued warranty experience April 1 to June 30, 2003	(1	)
April 1 to June 30, 2003 warranty provisions	4
Accrued warranty obligations at June 30, 2003	$34

5 -- IMAGING RESTRUCTURING

As previously disclosed, the Company announced on May 28, 2003 that it was consolidating its domestic manufacturing of imaging chemicals into its Norcross, Georgia, facility and that it would be curtailing manufacturing at its St. Louis, Missouri, facility during the second quarter of the fiscal year ending March 31, 2004. The physical move of manufacturing is still targeted for the September -- October 2003 timeframe with complete consolidation expected early in the fourth quarter. The majority of the 26 employees at its St. Louis facility will be given severance packages upon curtailing of operations.

The Company adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" effective January 1, 2003. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal plan be recognized when the liability is incurred. Under SFAS No. 146, an exit or disposal plan exists when the following criteria are met:

-- Management having the authority to approve the action commits to a plan of termination.

-- The plan identifies the number of employees to be terminated, their job classifications or functions and their locations, and the expected completion date.

-- The plan establishes the terms of the benefit arrangement, including the benefits that employees will receive upon termination (including but not limited to cash payments), in sufficient detail to enable employees to determine the type and amount of benefits they will receive if they are involuntarily terminated.

-- Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.

SFAS No. 146 establishes that fair value is the objective for initial measurement of the liability. In cases where employees are required to render service until they are terminated in order to receive termination benefits, a liability for termination benefits is recognized ratably over the future, service period.

During the first quarter of 2004, the Company began to implement its restructuring plan. Some of the employees affected by these restructuring efforts were offered severance packages, as appropriate, which included various financial components. To be eligible for severance benefits under the Imaging Restructuring plan, employees were required to render services until a specific date. Of the Company's total restructuring plan initiatives, certain components of these initiatives have met the criteria under SFAS No. 146. The total costs expected to be incurred for the components of the restructuring plan are approximately $1,250,000, of which approximately $180,000 was accrued during the first quarter of 2004.

The table below summarizes the total costs expected to be incurred for the components of the restructuring plan, which have met the criteria described in SFAS No. 146, the costs incurred to date, the balance of the accrued restructuring expenses, and the movement in that accrual, as of and for the three months ended June 30, 2003 (in thousands):

Cost Summary	Total Costs Expected To Be Incurred	Costs Incurred To Date	Payment
Severance pay and benefits	$ 665,000	$ 168,000	0
Other direct costs	685,000	12,000	0
Total	$ 1,350,000	$ 180,000	0

6 -- STOCK-BASED COMPENSATION

The Company accounts for its stock option plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25. Accordingly, no expense is charged to net income as all options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant. In accordance with SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure," the following table illustrates the effect on net income and earnings per share, as if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" to stock-based, employee compensation.

	Three Months Ended June 30,
	2003	2002
Net income (loss) as reported	$ 322,922	$ (5,579,741	)
Total stock-based compensation:
Expense determined under fair value method for all awards, net of tax	16,000	19,000
Proforma net income (loss)	$ 306,922	$ (5,598,741	)
Net income (loss) per common share:
Basic -- as reported	$0.07	$(1.09	)
Basic -- proforma	$0.06	$(1.09	)
Diluted -- as reported	$0.07	$(1.08	)
Diluted -- proforma	$0.06	$(1.09	)

The fair value of these options were estimated at grant date using the Black-Scholes option pricing model with the following weighted-average assumptions for June 30, 2003 and June 30, 2002:

	June 30, 2003	June 30, 2002
Expected life	4.7 years	5.0 years
Historical volatility	24%	38%
Risk-free rate of return	2.3%	4.6% -- 5.0%
Expected dividend yield	5.3%	4.4%
Annual forfeiture rate	0%	0%

There have been no charges to income in any of the periods above in connection with these options other than incidental expenses related to options.

7 -- EARNINGS PER SHARE

Basic earnings per share are based upon the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average common shares outstanding during the period plus the dilutive effect of shares issuable through stock options and warrants. The shares used in calculating basic and diluted earnings per share are reconciled as follows:

	Three Months Ended June 30,
	2003	2002
Basic weighted average number of shares outstanding	4,945,212	5,123,499
Effect of dilutive stock options	1,800	20,009
Dilutive shares outstanding	4,947,012	5,143,508

Unexercised stock options to purchase 1,107,792 and 612,686 shares of the Company's common stock as of June 30, 2003 and 2002, respectively, were not included in the computations of diluted earnings per share because the options' exercise prices were greater than the average market price of the Company's common stock during the respective periods. These options, issued at various dates from 1995 to 2003, are still outstanding at the end of the period.

8 -- COMPREHENSIVE INCOME

Other comprehensive income (loss) includes foreign currency translation adjustments.

9 -- SEGMENT INFORMATION

The Company operates in two industry segments: the Fuller Brands segment and the CPAC Imaging (Imaging) segment. Information concerning the Company's business segments' net sales and income before income taxes, minority interests, equity in income (loss) of affiliate, and cumulative effect of change in accounting principle for the quarter and three months ended June 30, 2003 and 2002 are as follows:

	Three Months Ended June 30,
	2003		2002
Net sales to customers:
Fuller Brands	$ 14,351,801		$ 15,026,653
Imaging	8,828,353		9,595,025
Total net sales to customers	$ 23,180,154		$ 24,621,678
Operating income:
Fuller Brands	$ 971,658		$ 919,764
Imaging	(158,932	)	359,366
	812,726		1,279,130
Corporate loss	(44,578	)	(27,690	)
Interest expense, net	(133,993	)	(125,598	)
Income before income taxes, minority interests, equity in income (loss) of affiliate, and cumulative effect of change in accounting principle	$ 634,155		$ 1,125,842

Sales between segments are not material.

Information concerning the Company's business segments' identifiable assets at June 30, 2003 and March 31, 2003 are as follows:

	June 30, 2003	March 31, 2003
Identifiable assets:
Fuller Brands	$ 29,392,519	$ 30,622,190
Imaging	27,111,733	25,100,604
Total identifiable assets of the segment	56,504,252	55,722,794
Corporate short-term investments	5,935,312	5,752,040
Deferred income tax assets	4,582,201	4,555,099
Other corporate assets	1,450,952	2,211,342
Total consolidated assets	$