Water Industry News

ZENON Reports Disappointing Fourth Quarter and Year-End Results

OAKVILLE, Ontario, March 7, 2006 – ZENON, the leading innovator of membrane-based water filtration technologies, reported a disappointing quarter that was in line with the company’s statements made earlier in December 2005.




"There is no question that 2005 has been a challenging year for ZENON," said Andrew Benedek, Chairman and CEO of ZENON. "The manufacturing changes we started earlier in the year extended far beyond our estimation and we were faced with a number of unexpected issues in the fourth quarter that resulted in a net loss of $6.3 million for the quarter and contributed to a net loss of $8.4 million for the year.

"For the ZeeWeed 1000 version 3 product," continued Mr. Benedek, "our targeted production rates continued to improve during the first two months of this year and this month we expect to be close to our planned production volume and product rejection rate. The quality of our products throughout this period was never compromised and we are meeting all of our established quality standards."

The ZeeWeed 1000 version 3 is the company’s latest innovation to treat cleaner waters and its commercialization will allow ZENON to remain a competitive player in the drinking water segment of the market. During the quarter, ZENON received seven orders for drinking water systems incorporating this membrane and the company expects this to grow in 2006.

Demand for ZENON’s premier product, the ZeeWeed 500 series of membranes, is also growing as the company’s commitment to innovation continues. Production of the next generation of this product will be underway in 2006, which is expected to increase capacity by an additional 50% by year-end.

Due to the company’s significant technological advances, ZENON continues to be the global leader in membrane based water and wastewater treatment. The company reported a number of significant new orders received in December, which brought the total bookings for the quarter to $74 million and resulted in a backlog of $385 million, up from $301 million at the end of 2004.


The following is a discussion of the consolidated financial condition and results of operations of ZENON Environmental Inc. for the period ended December 31, 2005. This discussion should be read in conjunction with: the Unaudited Interim Consolidated Financial Statements of the company and notes thereto for March 31, 2005, June 30, 2005 and September 30, 2005; "Management’s Discussion and Analysis" for December 31, 2004, included in the Annual Report of the company for the year ended December 31, 2004; and with the Audited Consolidated Financial Statements and notes thereto for the year ended December 31, 2004. ZENON’s auditors have not carried out a review of the quarterly financial information.

Certain information contained in this "Management’s Discussion and Analysis" contains forward-looking statements based on the company’s estimates and assumptions, which are subject to risks and uncertainties. This could cause the company’s actual results to differ materially from the forward-looking statements contained in this discussion.

Operating Results

The net loss in the quarter of $6.3 million was significantly above management’s expectations at the beginning of the quarter, when it was believed that the production problems relating to the ZeeWeed® 1000 version 3 (V3) had been resolved and that production was beginning to ramp up to meet our customer demands. Unfortunately, we were plagued with intermittent problems that were eventually worked through in December. We have been continuing to ramp up production since then and rejection levels have been reduced significantly. Current production levels are meeting our target levels and we expect to be at our full targeted production capacity by the end of March 2006.

In addition to our V3 problems, the fourth quarter was further impacted by a $2.7 million loss relating to two orders for which sub-contract costs exceeded expectations. In addition, the company incurred additional losses due to the reorganization of manufacturing lines between Hungary and Canada, disappointing Homespring™ sales, and orders delayed by customers.

Total new bookings in the quarter were $74 million, which increased our backlog to $385 million. During the quarter, we reduced our opening backlog by $7 million relating to the cancellation of an order. Revenue for the quarter at $66.9 million was only 2.3 % above last year (1.9% for the full year). Our lower than expected membrane production and certain order delays resulted in a revenue shortfall of approximately $20 million.

Revenue in both our North American and International systems businesses was flat compared to last year with North America being 2.6% below last year for the quarter and International being up 2.5%. Revenue from direct membrane shipments was $2 million higher than last year for the quarter and offset the slight decrease in the North American systems business.

Gross profit for the quarter was disappointing as a result of the problems that were experienced in the quarter. The major contributors to the shortfall in gross profit were, as previously stated, the V3 production issues, which reduced the gross margin by $3.5 million and the higher sub-contract and project cost overruns that reduced the gross margin by an additional $3.3 million.

The impact of these issues decreased the gross margin by over 9.0%. The gross margin was also lower than our historical margin due to a higher proportion of revenue realized from third party parts and components for systems as compared to internally generated revenue relating to membranes and labour costs. The strength of the Canadian dollar as it relates to export sales also impacted our margin in the quarter.

Selling, general and administrative (SG&A) costs at 32.1% of revenue for the quarter (31.2% YTD) were higher than management’s expectations as a result of the low revenue. As previously mentioned in prior quarter discussions, we also invested in new sales offices that are not fully recovering their costs at this time. Management continues to be committed to achieving 25% or lower SG&A as a percent of revenue. To improve our SG&A performance, we have undertaken a program to reduce administrative and sales costs in 2006.

Also included in SG&A costs for the quarter is the legal cost for the U.S. Filter lawsuit of $194,000 (2004 - $1.8 million) and for the year of $1.9 million (2004 - $3.0 million). As advised in prior quarters, the Enviroquip Inc. lawsuit has been settled. The total cost incurred for the year relating to this suit is $1.6 million.

Compared to the third quarter, amortization expense increased in the fourth quarter by $1.4 million. The increase resulted from the commercialization of the V3 product line and the restructuring of our product lines between our two manufacturing facilities in Hungary and Canada.

The tax rate for the quarter was 44.4% and 39.4% for the year. In the fourth quarter, the company favourably resolved some tax issues which enabled the release of certain reserves in the year, resulting in a tax recovery in the quarter of $1.7 million. The tax rate prior to this adjustment was 29.8% for the quarter and 27.3% for the year. The rate was higher than our expected 20% rate due to the significant losses incurred in a higher tax rate jurisdiction in the fourth quarter. As a result, our net loss in the quarter was $6.3 million ($0.19 per share).

With our production issues now under control, we are focused on returning the company to profitability in 2006.

Liquidity and Capital Expenditures

Overall, cash and marketable securities decreased in the quarter by $20.8 million and $74.7 million on a year-to-date basis. Working capital in the quarter improved mainly as a result of an increase in customer advances of $10.3 million and a decrease in inventory of $3.7 million. These working capital reductions were offset by an increase in accounts receivable of $7.0 million relating to year-end billings to our customers.

The major uses of funds in the quarter were: 1) the purchase of fixed assets of $13.9 million relating to membrane production additions both in Hungary and Canada, as well as further additions to pilots and our mobile plant units; 2) the initial payment of $6.0 million for the acquisition of Alpha Plan and 3) the net loss of $6.3 million.

The acquisition of Alpha Plan, which was accounted for in the first quarter of 2005, is structured so that there could be future payments made depending on certain valuations of building and inventory. As at December 31, 2005 the outcome cannot be reasonably determined. The value placed on these payments for accounting purposes is approximately $7 million.

In part due to an operating loss, the company utilized a significant amount of cash and marketable securities in the year. However, $38 million or 50% of the total approximate usage of $75 million has been used to invest in capital and other assets to support our production growth and new product development, and $9 million (12.1%) has been invested in acquisitions to both enhance our product offerings and develop additional technologies. An additional $12 million was invested in working capital during the year. The competitiveness in the marketplace is not only being felt through lower prices, it is also being seen in delayed payment terms. We do not see this correcting in the near term however, we are confident that over the long term the industry will revert to more normalized payment terms over the term of customer contracts.

Although our operating issues have impacted our cash generation this year, we remain confident that the company is well positioned to realize its growth and performance targets going forward in 2006 and future years. Our balance sheet continues to support the business with minimal long-term debt and cash and marketable securities in excess of $40 million.

Accounting Policies

There has been no change to accounting policies throughout 2005 and the consolidated financial statements have been prepared using the same accounting policies as described in the company’s 2004 annual report.


As a result of the difficulties faced by the company in 2005, management has implemented a number of cost control initiatives to focus on profitability in 2006. The mistakes of 2005 will not be repeated but management does anticipate competitive market pressures to continue to affect the company’s margins, at least in the short to mid-term.

The demand for membrane based water treatment systems is growing and ZENON will ensure that it has the technology, the manufacturing capability and the financial strength to be a supplier of choice in this market.

The company is continually monitoring the fluctuations among the US dollar, Canadian dollar, and other currencies. ZENON has natural and financial hedges in place to protect margins on existing orders. Management continues to assess these changes in currency and to react to minimize the financial impact to the company.