10-Q 1 l10117ae10vq.txt HMI INDUSTRIES ================================================================================ 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, 2004 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 Number 2-30905 HMI INDUSTRIES INC. ------------------------------------------------------ (Exact name of Registrant as Specified in Its Charter) DELAWARE 36-1202810 -------------------------------------------------------------------------------------------------- (State or Other Jurisdiction of Incorporation or Organization) (IRS Employer Identification No.) Genesis Building, 6000 Lombardo Center, Suite 500, Seven Hills, Ohio 44131 -------------------------------------------------------------------------------------------------- (Address of Principal Executive Offices) (Zip Code)

Registrant's Telephone Number, Including Area Code: (216) 986-8008 ________________________________________________________________________________ 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 ninety (90) days. Yes [ ] No [X] 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 Outstanding at September 30, 2004 ------------------------------------ --------------------------------- Common stock, $1 par value per share 6,745,609 ================================================================================ PART I. FINANCIAL INFORMATION........................................................................................... 3 ITEM 1. FINANCIAL STATEMENTS......................................................................................... 3 Consolidated Condensed Balance Sheets............................................................................. 3 Consolidated Condensed Statements of Operations................................................................... 4 Consolidated Condensed Statements of Cash Flow.................................................................... 5 Notes to Consolidated Condensed Financial Statements (unaudited).................................................. 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS........................... 16 Critical Accounting Policies...................................................................................... 16 Results of Operations............................................................................................. 16 Liquidity and Capital Resources................................................................................... 19 Cautionary Statement for "Safe Harbor" Purposes Under the Private Securities Litigation Reform Act of 1995........ 22 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................................... 22 ITEM 4. CONTROLS AND PROCEDURES...................................................................................... 22 (A) Evaluation of Disclosure Controls and Procedures.............................................................. 22 (B) Changes in Internal Controls.................................................................................. 23 PART II. OTHER INFORMATION.............................................................................................. 23 ITEM 1. LEGAL PROCEEDINGS............................................................................................ 23 ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.................................................................... 23 ITEM 3. DEFAULTS UPON SENIOR SECURITIES.............................................................................. 23 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................................... 23 ITEM 5. OTHER INFORMATION............................................................................................ 23 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................................................................. 23 (a) Index to Exhibits............................................................................................. 23 (b) Reports on Form 8-K........................................................................................... 24 SIGNATURES........................................................................................................... 24

2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED CONDENSED BALANCE SHEETS Dollars and shares in thousands, except par values

See notes to consolidated condensed financial statements. 3 CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (Unaudited) Dollars and shares in thousands, except per share data

See notes to consolidated condensed financial statements. 4 CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOW (Unaudited)

See notes to consolidated condensed financial statements. 5 NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT SHARES AND PER SHARE DATA) 1. Summary of Significant Accounting Policies The interim consolidated condensed financial statements included in this report have been prepared, without audit, by HMI Industries Inc. from our consolidated statements and those of our subsidiaries, pursuant to the rules and regulations of the Securities and Exchange Commission. Although we believe that the disclosures are adequate to make the information presented not misleading, certain information and footnote disclosures, including significant accounting policies, normally included in the annual financial statements have been condensed or omitted pursuant to such rules and regulations. In the opinion of our management, the unaudited financial information for the interim periods presented reflects all adjustments (which include only normal, recurring adjustments) necessary for a fair presentation. These consolidated condensed financial statements and related notes should be read in conjunction with the consolidated condensed financial statements and related notes included in our Annual Report on Form 10-K/A for the fiscal year ended September 30, 2003. Operating results for interim periods are not necessarily indicative of operating results for an entire fiscal year. 2. Restatement The accompanying balance sheet as of September 30, 2003, and the accompanying statements of operations and of cash flows for the three and nine months ended June 30, 2003 have been restated. The adjustments associated with the restatement related to the following: Accrued Distributor Development Liabilities Pursuant to EITF 01-9, "Accounting for Consideration Given by a Vendor to a Customer", which was issued in 2001, we changed the way we account for the potential one million dollar award associated with our Distributor Development Program, otherwise known as our Edge Success Program ("Program"). Prior to the adoption of EITF 01-9, we utilized the services of an independent actuary who developed a model based on our historical sales and other factors that identified, in aggregate, the probability of distributors reaching the goal (earning 30,000 credits for sales of our product units) thereby triggering our cash payment obligation. We recognized expense and recorded a liability based on that model. The original intentions of the Program were to aid Master Distributors in their retirement/succession plan and promote growth and retention within the new distributor network. Because of these original intentions and the long-term nature of this Program (fifteen years), management did not consider the implications of this pronouncement to the award associated with the Program and therefore EITF 01-9 was not adopted in 2001 as required. Accordingly, we have restated our revenues to properly reflect the accrual for this award as a reduction of revenues, not as a selling and administrative expense. We have determined that for purposes of EITF 01-9 it is not possible to reasonably estimate such a liability. We have therefore accrued such awards assuming a maximum accrual rate whereby we assume each eligible distributor will earn the award. In other words, for each qualifying sale, we have recorded a liability by reducing revenue. Such a liability will only be derecognized (i.e. the accrual eliminated) when (i) the award is paid out or (ii) when a distributor is no longer eligible for the award. For the three and nine months ended June 30, 2003, this adjustment (i) decreased sales by $1,072 and $3,300, respectively, and (ii) decreased selling, general and administrative expenses by $198 and $532, respectively. 6 Tooling Assets In 2003, we performed an analysis on the potential impairment of certain tooling assets. We concluded from our analysis, which was based upon the held and used model that the tooling assets were fully impaired and accordingly we recorded an impairment charge of $1,613 as of September 30, 2003. We inadvertently omitted impairment charges of $98 for patents and trademarks relating to these tooling assets and have reflected such additional impairment in the restated 2003 Consolidated Condensed Balance Sheet for the year ended September 30, 2003. Deferred Tax Asset In 2003, we provided a full valuation allowance on our deferred tax assets. As a result of the restatement related to the Distributor Development Program, our recorded income in 2001 changed to a loss and caused a significant cumulative loss for financial statement purposes. Accordingly, we determined that the impairment of our deferred tax assets should be reflected in the second quarter of fiscal 2001, when we first reflected the adoption of EITF 01-9. As a result we reversed the original impairment recorded in fiscal 2003. For the three and nine months ended June 30, 2003, the adjustments decreased the provision for income taxes by $15 and $43, respectively. Summary of Restatement Adjustments The following table summarizes the effects of the restatement adjustments on certain of our previously issued financial statements by type of adjustment and by the affected captions in our Statement of Operations. The various adjustments recorded to prior years as part of the restatement have no effect on our cash flows.

7 Summary of Restated Financial Data The following tables present a summary of our balance sheet, statements of operations and of cash flows as previously reported, and as restated as a result of the restatement adjustments summarized above. CONSOLIDATED CONDENSED BALANCE SHEETS

8 CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (Unaudited) Dollars and shares in thousands, except per share data

9 CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOW (Unaudited)

10 3. Other Intangible Assets Total amortization expense for trademarks and patents was $35 and $32, for the nine months ended June 30, 2004, and 2003, respectively. Amortization expense for trademarks and patents is estimated for the remainder of fiscal 2004 and for the next four fiscal years ending September 30, 2005 through 2008, as $39, $15, $13, $11, and $10. 4. Guarantees We have guaranteed repayment to a finance company for certain events of default by some of our Canadian distributors. The finance company purchases the installment sales contracts that the distributors entered into with their customers for the sale of products manufactured by HMI. Our obligation to repurchase any contracts is limited to situations in which the borrower has any valid defense, right of set-off or counterclaim regarding the loan; the loan does not comply with all applicable laws and regulations; or the loan is not a binding obligation of the borrower. For example, we would be required to purchase from the finance company a contract entered into by an end consumer to finance the purchase of our product if the finance company believes that the contract has been improperly obtained. We require the participating Canadian distributors to provide us with cash reserves, which are held as liabilities on our records, in order to provide a fund for the payments of any defaults by the participating Canadian distributors. We had $83 and $65 of cash reserves we had received from Canadian Distributors as of June 30, 2004 and 2003, respectively. These amounts were included in the accrued expenses and other liabilities line item of our Consolidated Condensed Balance Sheets. We expect to hold them for at least a period approximating the term of the finance contracts with the end consumers, which typically have a 36 month term. Although it is not practical for us to estimate future cash payments on possible repurchases; the maximum potential of future payments that we could be required to make under the guarantee is the total contracts outstanding of $607 and $931 at June 30, 2004 and 2003, respectively. However, from the commencement of the contract in July 2002 we have repurchased only one contract approximating $3 under this guarantee. Moreover, we are permitted pursuant to agreements with our Canadian distributors to be reimbursed from the cash reserves referred to above for the costs and expenses incurred in fulfilling our guarantee to the finance company. In addition, we formed a wholly owned subsidiary, Advantage Credit Management Services ("ACMS") during the third quarter to provide brokerage services for the sourcing of consumer credit by assisting our U.S. based independent distributor network in securing third party financing of our products that they sell to end consumers. ACMS has guaranteed repayment to various finance companies for certain events of default by some of our U.S. distributors in a manner similar to our guarantee with the aforementioned Canadian Finance Company. The maximum potential of future payments that ACMS could be required to make under the guarantees is associated with the total contacts outstanding at one finance company in particular of $763 at June 30, 2004 as there were no contracts outstanding at the other two. We have not been required to repurchase any contracts pursuant to this guarantee. Warranty We warrant our surface cleaner for a two-year period from the date of purchase and offer a lifetime service benefit for the replacement of the surface cleaner's motor at a price not to exceed $99 (Dollar's not in thousands). On occasion, we also support a five-year optional extended warranty on the portable surface cleaner offered by our U.S. Distributors to the end user as a sales promotion during an in home product 11 demonstration. As an enticement to the end user to buy our product during that demonstration, the five year optional extended warranty is offered to them at no cost; accordingly no revenue for this optional warranty is recognized by HMI. Outside the U.S. we offer a two-year warranty for our high filtration portable surface cleaner. The portable room air cleaner is warranted for renewable one-year periods so long as the main air filter is replaced annually. A five-year warranty is offered for our built-in vacuum system. Our policy is to record a provision for the expected cost of warranty-related claims at the time of the sale and adjust the provision to reflect actual experience quarterly. The amount of warranty liability accrued reflects management's best estimate of the expected future cost of honoring our obligations under the warranty plans. Historically, the cost of fulfilling our warranty obligations has principally involved replacements parts, labor and sometimes travel. Our estimates are based on historical experience, the number of units involved, and the extent of features/components included in product models. Changes in our warranty liability were as follows:

5. Earnings Per Share The denominators for calculating our basic and diluted earnings per share were identical for the quarter ended June 30, 2004, as the 917 outstanding options were not included in the calculation of diluted shares outstanding as the result would have been anti-dilutive. The exercise prices of these options range from $1.00 to $7.50 per share and they expire between January 4, 2005, and August 29, 2010. All 1,165 stock options outstanding for the quarter ended June 30, 2003, were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market prices of the common stock during the period and, therefore, the effect would be anti-dilutive. 6. Long-term Compensation Plan We record stock-based compensation expense using the intrinsic value method on the date of grant in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and its related interpretations. Because we establish the exercise price based on the greater of fair market or par value of our stock at the date of grant, the options have no intrinsic value upon grant, and therefore no expense is recorded. Each quarter, we report the potential dilutive impact of stock options in our diluted earnings per share. As allowed by SFAS 148, we have elected to continue to apply 12 the intrinsic value-based method of accounting and have adopted the disclosure requirements of SFAS 123. If we had measured compensation cost for stock options granted under the fair value based method prescribed by SFAS 123, net income would have changed to the pro forma amounts set forth below:

7. Executive Compensation On February 2, 2004, the Board of Directors accepted the resignation and retirement of James R. Malone, Chief Executive Officer, triggering certain benefit payments. Consequently, compensation expense approximating $200 was recorded in the second quarter of fiscal 2004 in accordance with Mr. Malone's provisions of resignation. 8. Debt On February 20, 2004, an amendment of our $3,000 credit facility agreement was executed with our lender. The credit facility expired October 15, 2004. The amended agreement carries the same interest rate and similar covenants as the previous amended loan agreement, with the exception of the interest coverage ratio which was amended to exclude non-cash expenses from the 5.0 to 1.0 ratio, including but not limited to, the impairment of tooling assets and associated inventory, and the tangible net worth covenant in which the minimum amount was reset from $7,400 to $2,400. The cumulative effect of the adjustments on our statement of operations associated with the restatement of our financial statements was a $12,856 reduction in our net earnings over the period from January 1, 2001 through December 31, 2003. Such an earnings reduction caused us to be in default of our $2,400 tangible net worth covenant. In addition we have violated our financial reporting requirements to the bank as the restatement process has delayed any subsequent filings of our public statements with the Securities and Exchange Commission since our first fiscal quarter of 2003. Our credit agreement covenants require that our statements be filed quarterly with the bank within 45 days of the end of each quarter. On October 15, 2004, an amendment of our $3,000 credit facility agreement was executed with our lender. The bank has agreed to extend the maturity date of the loan until December 31, 2004. In addition the bank provided a waiver for the aforementioned covenant and financial reporting violations. The amended agreement carries an interest rate of prime plus one percent and covenants similar to the previous amended loan agreement, with the exception of the tangible net worth covenant which was eliminated through the maturity date of the loan. 13 As of September 30, 2004, there was $962 borrowed on the $3,000 credit facility. 9. Commitments and Contingencies Bliss Technologies, Inc. ("Bliss"), the company formed from the 1998 sale of the subsidiary of HMI, filed for bankruptcy in January 2000 in the United States Bankruptcy Court, Eastern District of Michigan. In a separate action filed in 2002, the Official Committee of Unsecured Creditors of Bliss alleges a fraudulent conveyance claim against us asserting that the sale of Bliss in 1998 was a fraudulent transfer insofar as we received more for Bliss than it was worth and that Bliss was insolvent from its inception. Former directors of Bliss, Mark Kirk and Carl Young, are also named as defendants in the action. Claims pending against them allege that in their capacity as Bliss directors they breached fiduciary duties to Bliss creditors. The complaint seeks damages in an unspecified sum. In September 2004 the parties conducted a mediation session with an agreed-upon mediator which did not result in a settlement. Although we may continue to pursue the settlement discussions that began at the mediation we are also continuing to move forward in court with the vigorous defense of the claims against us and the claims against Mr. Kirk and Mr. Young. CONET Industries, Inc., Royal Queen Club International Limited, Chang-whan Chang and Young-so Song ("Plaintiffs") filed a complaint against HMI on or about February 18, 2001, in the Seoul, Korea District Court. It was served by Registered Mail upon HMI at our corporate offices in Seven Hills, Ohio, on or around April 10, 2002. The complaint was filed as a result of lawsuits by us against Mr. Song, a former HMI Distributor in Korea, and Royal Queen Club concerning Mr. Song's CYVAC product. In our lawsuits, we sought and were granted preliminary injunctions against Plaintiffs that prohibited Plaintiffs from manufacturing and selling the old model CYVAC for 311 days and the new model CYVAC for 209 days until the Seoul High Court issued a declaration of suspension of the injunctions. Despite the fact that Plaintiffs had been enjoined by the Courts, Plaintiffs allege that we should compensate them for actual damages for sale discontinuance, supplemental managerial costs, and new mold fabrication costs due to the interruption in the manufacturing and marketing of each product during that period. Plaintiffs also claim that we tortuously interfered with Plaintiffs' business advantages, caused irreparable harm to Plaintiffs' normal business activities, and damaged Plaintiffs' reputation and standing. Chang-whan Chang and Young-so Song allege that they have been critically damaged personally due to the accusations, improper provisional seizure and criminal allegations alleged by us, which they assert resulted in disturbance to business, reputation, and credit. All matters are pending. The Plaintiffs originally alleged damages in excess of U.S. $21,894. After several hearings the court ruled in our favor and against the Plaintiffs on all counts. We were then notified that the Plaintiffs appealed this decision in accordance with Korean law. On August 16, 2004 we were notified by our Korean counsel that the appeal filed by the Plaintiff before the Supreme Court had been dismissed in favor of HMI, effectively terminating the litigation. Claims arising in the ordinary course of business are also pending against us. In the third quarter of fiscal 2004 we increased reserves by $500 to provide for any contingent liabilities associated with various litigation and contingent claims. There can be no assurance that an unfavorable outcome in these various litigation and contingent claims would not have a material adverse effect on our consolidated financial position, results of operations, or cash flow. Included in the accompanying Consolidated Condensed Balance Sheets at June 30, 2004, and 2003, were accruals of $515 and $15, respectively, relating to litigation and contingent reserves. 14 10. Related Party Transactions James R. Malone, our former Chairman and Chief Executive Officer, Darrell Weeter, President of the Company's Americas division, and John Glomb, a Regional Vice President of the Company, each own 31.67% of the membership interests in a Company called Vision Capital Logistics, LLC ("VCL"). VCL, a brokerage service provider for sourcing consumer credit, assists its clients in securing third party financing for its clients' customers to purchase products, including products manufactured by us and sold by our Distributors. VCL charges additional fees to our Distributors for these financing services. VCL's client list also includes a number of other "direct sales" companies, including other floor care companies. In securing such financing, VCL may guarantee the legal compliance obligations (but not any payment obligations) of our Distributors to a third party lender. The third party lender pays VCL a participation fee for such financing services, a part of which (twelve percent (12%)) VCL pays to us. During the quarters ended June 30, 2004, and 2003, no monies were paid by VCL to HMI in connection with such financing services. Additionally, in certain cases a Distributor may not be able to complete a sale because of the substandard credit status of the retail customer. In such cases VCL may provide the Distributor with financing for this sale. We entered into an arrangement with VCL known as a Swap Program under which VCL will purchase the contract of the retail customer from the Distributor and arrange for the financing of the contract at a significant discount. To replace the product sold by our Distributor and for which the Distributor received only a portion of the consumer sale price, VCL will purchase a replacement product from us at the same price paid by our Master Distributors and we will ship it to the Distributor to replace the product the Distributor just sold. During the quarters ended June 30, 2004, and 2003, VCL purchased an aggregate of $2 and $6, respectively of our products under the Swap Program. Under the terms of our credit facility in place from time to time, we were prohibited from engaging in certain of the financing activities provided by VCL. During the third quarter of fiscal 2004 we ended our arrangement with VCL. At such time Mr. Weeter and Mr. Glomb sold their membership interests to Mr. Malone. In February 2003 we began subleasing office space in Naples, Florida from VCL for $3 per month, which amount was based upon an allocation of VCL's total monthly lease payments to the amount of space that we utilize. For the quarter ended June 30, 2003 we paid VCL a total of $8 in lease payments. The sublease was terminated in February, 2004. Darrell Weeter, an executive officer of the Company, has served for many years as President of FVS, Inc., a distributor of products manufactured by HMI, and which is owned by Mr. Weeter and his wife. For the quarters ended June 30, 2004, and 2003, FVS, Inc. purchased, at Master Distributor pricing, a total of $16 and $16, respectively, in products from us. Mr. Weeter also received amounts due to him under our Career Development Program of $12 and $38 for the three months ended June 30, 2004, and 2003, respectively. The amounts paid were distributor paid overrides ("DPO's") collected by us from distributors that were brought into the Filter Queen business by Mr. Weeter. DPO's are a unit price override charged on top of our standard unit sales price for which we, HMI, act as a pass through, meaning that we collect the DPO from the promoted distributor and disburse it to the promoting distributor upon their request; accordingly these DPO's are not reflected in our income statement as revenue. The total DPO's still owed to Mr. Weeter were $10 and $10 as of June 30, 2004, and 2003, respectively. This payable to Mr. Weeter was recorded on the other accrued expense and liabilities line item of our Consolidated Condensed Balance Sheets as of June 30, 2003 and 2002. 15 Derek Hookom, an employee of HMI, is President of Summit Air, a distributor of products manufactured by HMI. For the quarters ended June 30, 2004, and 2003, Summit Air purchased, at Master Distributor pricing, a total of $0, and $74, respectively, in products from us. Mr. Hookom became an employee of HMI on January 1, 2003 and under the terms of his employment agreement; Mr. Hookom remains eligible to receive the Millionaires Club Award associated with the Edge Success Program through sales generated by his personally developed sales network. The Company incurred $55 and $43, respectively, of distributor development program revenue reduction associated with Mr. Hookom's participation in the Program for the quarters ended June 30, 2004, and 2003. Mr. Hookom also received DPO's due to him under our Career Development Program of $23 and $24 for the three months ended June 30, 2004, and 2003, respectively. The amounts paid were distributor paid overrides collected by us from distributors that were brought into the Filter Queen business by Mr. Hookom. The total DPO's still owed to Mr. Hookom were $32 and $33 as of June 30, 2004, and 2003, respectively. This payable to Mr. Hookom was recorded on the other accrued expense and liabilities line item of our Consolidated Condensed Balance Sheets as of June 30, 2004, and 2003. The above amounts are not considered to be significant to the financial statements as a whole and therefore have not separately identified in the Consolidated Condensed Balance Sheets, Statements of Operations or Statements of Cash Flow. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS) CRITICAL ACCOUNTING POLICIES Our discussion and analysis of our financial condition and results of operations are based upon the consolidated condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated condensed financial statements required us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the consolidated condensed financial statements. Actual results may differ from those estimated under different assumptions or conditions. Critical accounting policies are defined as those that are reflective of significant judgment and uncertainties, and potentially may result in materially different outcomes under different assumptions and conditions. For a more complete description of our critical accounting policies please refer to our Annual Report on Form 10-K/A for the fiscal year ended September 30, 2003. RESULTS OF OPERATIONS Product Sales THIRD QUARTER OF FISCAL 2004 COMPARED TO THIRD QUARTER OF FISCAL 2003 Product sales, net of returns and allowances and before distributor development program revenue reduction ("Product Sales") for the quarter ended June 30, 2004, were $8,275. This represents a decrease of $598 or 6.7% when compared to the prior year product sales of $8,873. The decrease in sales was largely attributable to losses in Europe and the Americas of $591 and $480, respectively, offset by increased revenues in Asia of $470. 16 Decreased European sales were largely associated with larger than normal prior year sales to Portugal and Spain, which were made in connection with the prior year launch of The Edge Success Program by these importers in their respective territories. The sales decline in the Americas was primarily attributable to two sales divisions. Our divisional director for these territories is working with key distributors in these territories on their businesses as well as assisting them with recruiting and retention issues. Asian sales increased primarily as a result of Defender shipments to a new customer in Malaysia and improved Defender sales to Japan and Hong Kong. FIRST NINE MONTHS OF FISCAL 2004 COMPARED TO FIRST NINE MONTHS OF FISCAL 2003 Product sales of $27,433 for the nine months ended June 30, 2004, were $439 or 1.6% higher when compared to the prior year sales of $26,994. The increased sales were largely attributable to increased sales in Asia of $2,426, offset by decreased revenues in the Americas and Europe of $1,236 and $772, respectively. Asian sales increased primarily as a result of shipments to Malaysia and improved sales to Japan, Hong Kong and Korea. The largest increase was associated with Malaysia, a new customer whose first shipment was in December 2003. The sales decline in the Americas (although impacted by the third quarter results as stated above) was driven by with the first two quarters of the year and was related to office closings in a sales division different than the aforementioned two. A new divisional director has been assigned to this territory to provide the additional support that has been requested and we are hopeful that we will rebuild this territory. The sales decline was in Europe and was driven by reduced sales to Spain, Portugal and Denmark. It was attributable to the ongoing challenges of lead generation, the recruiting of new sales associates and the retention of existing associates within these importer's territories as well the prior year Spain and Portugal sales discussed above. Distributor Development Program THIRD QUARTER OF FISCAL 2004 COMPARED TO THIRD QUARTER OF FISCAL 2003 The sales reduction associated with the distributor development program for the quarter ended June 30, 2004 was $974 compared to $1,072 for the same quarter ended in the prior year. The decrease of $98 was driven by the decreased sales in the Americas offset by an increase in the number of international countries participating in the program. See Note 2 to the Consolidated Condensed Financial Statements for further information on the accounting associated with this Program. FIRST NINE MONTHS OF FISCAL 2004 COMPARED TO FIRST NINE MONTHS OF FISCAL 2003 The year-to-date sales reduction associated with the distributor development program was $2,671 compared to $3,300 for the same period in the prior year. This decrease of $629 was driven by termination gains which were largely attributable to one established U.S. distributor who left the business during the second quarter and consequently lost his eligibility to participate in the Program so we derecognized his specific accrued liability. The overall decrease was offset by increased international sales volume as well as the number of international countries participating in the program. Other Revenues We formed a wholly owned subsidiary, Advantedge Credit Management Services ("ACMS") during the third quarter. ACMS is a brokerage service provider for sourcing consumer credit and assists its clients, our Americas distribution network, in securing third party financing for end consumer who purchase 17 products manufactured by HMI. We earned $25 in brokerage service revenue during the third quarter for these services. Gross Margin, exclusive of distributor development program THIRD QUARTER OF FISCAL 2004 COMPARED TO THIRD QUARTER OF FISCAL 2003 The gross margin exclusive of the impact of the distributor development program revenue reduction ("Product Gross Margin") for the quarter ended June 30, 2004, was $2,773 or 33.5% of sales. This represents a decrease in gross margin of $844 when compared to the prior year gross margin of $3,617 or 40.8% of sales. As a result of the discontinuance of our Central Vac product and the abandonment of a potential new product during the quarter we recorded charges of $357 to fully impair the associated tooling, molds and inventory as their estimated net realizable value was considered to be nominal. The remaining difference of $487 was largely driven by an unfavorable sales volume variance. FIRST NINE MONTHS OF FISCAL 2004 COMPARED TO FIRST NINE MONTHS OF FISCAL 2003 The product gross margin of $10,572 or 38.5% of sales for the nine months ended June 30, 2004, was $332 or 3.0% lower when compared to the prior year gross margin of $10,904 or 40.4% of sales. The decrease was primarily due to the aforementioned impairment of tools, molds and inventory. The remaining difference was largely associated with an unfavorable material variance as discussed above, partially offset by a favorable sales volume variance largely associated with the aforementioned increased Asian sales. Selling, General, and Administrative ("SG&A") THIRD QUARTER OF FISCAL 2004 COMPARED TO THIRD QUARTER OF FISCAL 2003 SG&A expenses of $3,754 or 51.2% of sales for the quarter ended June 30, 2004, were $414 higher when compared to the same period in fiscal 2003 of $3,340 or 42.3% of sales. This increase was driven by a $590 increase in litigation and audit expense related to pending legal proceedings and the restatement of our prior years' financial statements in connection with the adoption of EITF 01-9. The increased level of expense was offset by sales commissions which followed the lower level of sales and a variety of other individually insignificant items. FIRST NINE MONTHS OF FISCAL 2004 COMPARED TO FIRST NINE MONTHS OF FISCAL 2003 SG&A expenses of $10,805 or 43.6% of sales for the nine months ended June 30, 2004 were $594 higher when compared to the same period in fiscal 2003 of $10,211 or 43.1% of sales. In addition to the increased expense as discussed above, the year to date increase was impacted by $240 expenses associated with certain independent professionals who were engaged by a Special Committee of the Board of Directors to review relationships we had with certain affiliates, as well as by the February 2, 2004 resignation and retirement of James R. Malone, the former Chairman and Chief Executive Officer. Additionally, we recorded $200 of compensation expense in association with Mr. Malone's resignation; the remaining difference was largely the result of increased corporate insurance expenses of $108 and reductions of $539 related to commissions and compensation related expenses which followed the lower sales in the Americas and Europe, and the decreased level of earnings. Liquidation of Foreign Subsidiary During the second quarter of fiscal 2003, after reviewing possible future options for our Canadian subsidiary, we chose to liquidate the entity and therefore recorded a loss on disposal of $905 for cumulative translation adjustments associated with this subsidiary. 18 Interest Expense Interest expense was $18 and $52 for the quarter and nine months ended June 30, 2004, respectively, compared to $12 and $32 for the same periods in 2003. The increased expense primarily reflects the increased borrowings on our line of credit when compared to the prior year. Other (income) expense, net For the quarter and nine months ended June 30, 2004 other expense (income), net, decreased $7 and $36, respectively, and was attributable to a variety of individually insignificant items. Income Taxes The effective tax rate for the quarter and nine months ended June 30, 2004 was 0.0% and (0.2%), respectively, compared to effective rates of (0.5%) and 0.0% for the same period in fiscal 2003. The differences from the prior year were associated with state franchise taxes. Cumulative Effect of Accounting Change On October 1, 2002, we adopted SFAS 142. Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. During the second quarter of fiscal 2003, we completed our initial impairment test as of October 1, 2002, and recorded a non-cash charge of $5,451 to fully eliminate the carrying value of our goodwill. There was no tax effect related to this item as this charge is a permanent difference for income tax purposes. This amount is reflected, in this Form 10-Q, as a deduction from results of operations for the nine months ended June 30, 2003. Inflation and Pricing Product sales and income from continuing operations were not materially impacted by inflation or changing prices. LIQUIDITY AND CAPITAL RESOURCES Operating Activities Cash flows from operating activities used net cash of $98 for the nine months ended June 30, 2004, principally due to cash outflows resulting from net losses of $2,887, as well as increases in receivables of $733 and inventories of $363, offset by increases in distributor development liabilities, and accrued expenses and other liabilities of $200 and $329, respectively. Offsetting the cash outflows were non-cash expenses of $2,824, of which $2,130 is attributable to the new accounting associated with our distributor development program and $523 is related to depreciation and amortization. Decreases in prepaid expenses and other assets of $217 and $162, respectively, also offset the cash outflows. The increase in the receivables balance is largely attributable to sales volume increases related to several international customers who all receive credit terms to assist with the time delay in shipping products overseas. Additional increases are associated with our newly formed subsidiary Advantedge Credit Management Services Inc. ("ACMS"). ACMS, formed in the third quarter of fiscal 2004, is a brokerage service provider for sourcing consumer credit and assists its clients, our Americas distribution network, in securing third party financing for end consumer who purchase products manufactured by HMI. The ACMS receivable balance at June 30, 2004 represents monies owed to them from the third party financing companies. The inventory increase was largely a result of finished goods safety stock that was built to prevent any shipping interruptions to the distribution network for a planned one-week plant shutdown in July 2004. 19 The increase in our distributor development liability is associated with the amount to be paid in fiscal 2005 to our second Edge Program achiever. Accrued expenses and other liabilities increased as a result of a $500 accrual recorded in the third quarter of fiscal 2003 to provide for reasonably estimated and probable obligations associated with current litigation issues, offset by payments on behalf of our Americas distribution network associated with liabilities previously recorded in fiscal 2003. Amortization of prepaid risk insurance was the contributing factor to the decrease in prepaid expenses while the decrease in other net assets related to the utilization and/or refund of deposits associated with our leased facilities and furniture. Investing Activities Capital expenditures of $81 represent the entire net cash used in investing activities for the nine months ended June 30, 2004, which relates to engineering testing equipment, computer hardware, and tooling associated with our current product line. Financing Activities Net cash provided by financing activities for the nine months ended June 30, 2004 was $407, which included $424 for net borrowings under the credit facility and $17 for payment of long-term debt. Our $3,000 credit facility agreement includes various covenants that limit our ability to incur additional indebtedness, restricts paying dividends and limits capital expenditures, and requires we maintain a minimum net worth. As of September 30, 2003, we were not in compliance with our interest coverage ratio, and net worth covenants; however, we obtained a waiver on these covenants which was effective until the February 20, 2004 amendment of the credit facility. We were required to maintain an interest coverage ratio of greater than or equal to 5.0 to 1.0 interest to earnings before interest, taxes, depreciation and amortization ("EBITDA") and a net worth of at least $7,400, calculated quarterly and increasing by 50% of net income annually. On February 20, 2004, an amendment of our credit facility agreement was executed with our lender. The expiration date was extended to October 15, 2004. The amended agreement carried the same interest rate and similar covenants as the previous amended loan agreement, with the exception of the interest coverage ratio which was amended to exclude non-cash expenses from the 5.0 to 1.0 ratio, including but not limited to, the impairment of tooling assets and associated inventory, and the tangible net worth covenant in which the minimum amount was reset to $2,400. The cumulative effect of the adjustments on our statement of operations associated with the restatement of our financial statements was a $12,856 reduction in our net earnings over the period from January 1, 2001 through December 31, 2003. Such an earnings reduction caused us to be in default of our $2,400 tangible net worth covenant. In addition we have violated our financial reporting requirements to the bank as the restatement process has delayed any subsequent filings of our public statements with the Securities and Exchange Commission since our first fiscal quarter of 2003. Our credit agreement covenants require that our statements be filed quarterly with the bank within 45 days of the end of each quarter. 20 On October 15, 2004, an amendment of our $3,000 credit facility agreement was executed with our lender. The bank has agreed to extend the maturity date of the loan until December 31, 2004. In addition the bank provided a waiver for the aforementioned covenant and financial reporting violations. The amended agreement carries an interest rate of prime plus one percent and covenants similar to the previous amended loan agreement, with the exception of the tangible net worth covenant which was eliminated through the maturity date of the loan. We are actively seeking finance sources to replace the credit facility prior to its expiration. If we cannot replace the credit facility prior to December 31, 2004, we currently anticipate that we will have sufficient liquidity to repay the credit facility and cover all our cash needs through March 31, 2005. As of September 30, 2004, there was $962 borrowed on the $3,000 credit facility. Cash Obligations There have been no material changes outside the ordinary course of our business with regards to cash obligations that have not been previously disclosed in our fiscal 2003 Annual Report on Form 10-K/A. ACCRUED DISTRIBUTOR DEVELOPMENT LIABILITIES We account for a certain Distributor Development Program pursuant to EITF 01-9 "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor's Products)". The accounting associated with this Program requires us to record a liability related to every qualifying sale and only derecognizing such liability (i.e. the accrual is eliminated) when (i) the award is paid out or (ii) when a distributor is no longer eligible for the award. The application of EITF 01-9 requires a $15,288 accrual at June 30, 2004, to reflect the future obligation associated with the Program. This amount was determined by multiplying the percentage of attainment of the 30,000 unit goal for every eligible distributor and sales associate by the present value of five payments of $200,000, discounted at a risk adjusted interest rate. We have been operating with a distributor network for over seventy years and we implemented the Program in 1997. During those periods we have closely monitored the distributor network and the turnover rate in the network. Based on that accumulated knowledge, we believe that application of EITF 01-9, which requires accruing on each sale as if every distributor involved with the sale was going to earn the $1 million award, results in the recognition of an obligation we believe will be significantly in excess of the payouts from the Program for the foreseeable future. This is due to the assumption inherent in the maximum accrual calculation that every distributor involved with a sale will qualify to earn the award. Our history shows this not to be the case. During the twelve quarters ended September 30, 2003, our turnover rate was, on average, more than 50%. For example, the participants in the Program from the Americas network who left the Program during the twelve months ended September 30, 2003 represented an accrual of over $2,000 and that period was not a period of extraordinary turnover. Because we measure the accrual quarterly, departures may cause quarterly results to vary greatly. In addition, the criteria for derecognizing the accrual for any distributor requires that the distributor has lost eligibility to participate in the Program. We have been funding the actuarially determined present value of total award payouts calculated on an aggregate basis under this program since September 2000 and such fund had a balance of $1,111 as of June 30, 2004. It is our intention to continue to fund the projected stream of cash payouts subject to our 21 cash flow model based on the aggregate actuarial model, which will continue to be updated annually by our independent actuaries based on our experience. These funds are maintained in a short term investment account and recorded as cash and cash equivalents in our Consolidated Condensed Balance Sheets. Please refer to our Annual Report on Form 10-K/A for the fiscal year ended September 30, 2003 for a complete discussion of our accounting associated with this Program. CAUTIONARY STATEMENT FOR "SAFE HARBOR" PURPOSES UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This report, including Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Federal securities laws. As a general matter, forward-looking statements are those focused upon future plans, objectives or performance as opposed to historical items and include statements of anticipated events or trends and expectations and beliefs relating to matters not historical in nature, including by way of example, but not limited to, the statements made in "Product Sales" regarding the hope to rebuild a certain sales territory in the Americas, and "Liquidity" regarding anticipated cash requirements and the adequacy of our current ability to meet those requirements. Such forward-looking statements are subject to uncertainties such as difficulty in protecting our intellectual property rights in a particular foreign jurisdiction; dependency on key personnel and the ability to retain them; recessions in economies where we sell our products; longer payment cycles for and greater difficulties collecting accounts receivable; export controls, tariffs and other trade protection measures; social, economic and political instability; changes in United States and foreign countries laws and policies affecting trade; anticipated sales trends; the ability to attract and retain Distributors and Importers; improved lead generation and recruiting; and the ability to obtain financing for the end consumer through consumer financing companies, including ACMS. Such uncertainties are difficult to predict and could cause our actual results of operation to differ materially from those matters expressed or implied by such forward-looking statements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to interest rate risk is related to our borrowings. Fixed rate borrowings may have their fair market value adversely impacted from changes in interest rates. Variable rate borrowings will lead to additional interest expense if interest rates increase. As of June 30, 2004, we had $1,807 outstanding under our credit facility bearing interest at the prime rate. If interest rates were to increase 50 basis points (0.5%) from the June 30, 2004, rates and assuming no changes in outstanding debt levels from June 30, 2004 levels, we would realize an increase in our annual interest expense of approximately $9. ITEM 4. CONTROLS AND PROCEDURES (A) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES We evaluated the design and operation of our disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely and made in accordance with the Exchange Act and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including our principal executive officer and principal financial officer within the 90-day period prior to the filing of this Form 10-Q. The principal executive officer and principal financial officer have concluded, based on their review, that our disclosure controls and procedures, as defined at Exchange Act Rules 13a-14(c) and 15d-14(c), are effective to ensure that information required to be disclosed by us in reports that we file 22 under the Exchange Act is recorded, processed, summarized and reported accurately and within the time periods specified in Securities and Exchange Commission rules and forms. (B) CHANGES IN INTERNAL CONTROLS No significant changes were made to our internal controls or other factors that could significantly affect these controls during the last fiscal quarter of their evaluation referenced in paragraph (A) above. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Note 9 for applicable information. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION Our Common Stock was quoted in the over-the-counter market on the OTC Bulletin Board under the symbol "HMII.OB" until February 19, 2004, the date it was removed. The removal occurred because we were no longer current with regards to our SEC filings, primarily our Form 10-K for the year ended September 30, 2003, and therefore the members of the OTC Bulletin Board could no longer quote our shares. It is now quoted in the Pink Sheets. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) INDEX TO EXHIBITS 3.1 Certificate of Incorporation~ Incorporated by reference from Annual Report on form 10-K for the year ended September 30, 1995 3.2 Bylaws~ Incorporated by reference from Form 10-Q for the quarter ended June 30, 2003 10.01 Material Contracts~ U.S. Bank N.A. Waiver Letter and Amendment to Revolving Credit Note dated February 20, 2004, incorporated by reference from Annual Report on Form 10-K for the year ended September 30, 2003 23 10.02 Material Contracts~ U.S. Bank N.A. Waiver Letter and Amendment to Revolving Credit Note, dated October 15, 2004, incorporated by reference from Form 8-K filed on October 21, 2004 31.1 Rule 13a-14(a)/15d-14(a) Certification~ Certification Pursuant to 15 U.S.C. Section 7241 for Kirk W. Foley, attached 31.2 Rule 13a-14(a)/15d-14(a) Certification~ Certification Pursuant to 15 U.S.C. Section 7241 for Julie A. McGraw, attached 32.1 Section 1350 Certification~ Certification for Kirk W. Foley Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), attached 32.2 Section 1350 Certification~ Certification for Julie A. McGraw Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), attached (b) REPORTS ON FORM 8-K No report on Form 8-K was filed during the quarter ended June 30, 2004. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HMI Industries Inc. (Registrant) Date: October 22, 2004 /s/ Julie A. McGraw --------------------------------- Julie A. McGraw Vice President - Chief Financial Officer 24

HMI INDUSTRIES INC 10-Q