QEPC Q E P Company Inc (QX)

Executive Overview

The Company is a worldwide leader in the manufacturing, marketing and distribution of a broad line of specialty tools and flooring related products, marketing over 3,000 specialty tools and related products used primarily for surface preparation and installation of ceramic tile, carpet, vinyl and wood flooring. The Company’s products are sold to home improvement retailers, specialty distributors to the hardware, construction, flooring and home improvement trades, chain or independent hardware, tile and carpet retailers for use by the do-it-yourself consumer as well as the construction or remodeling professional, and original equipment manufacturers. The Company has executed a growth strategy intended to improve overall performance and profitability of operations that includes acquisitions, dispositions and consolidations, the reduction of risk associated with certain large customer concentrations and the enhancement of cross selling of product among our channels of distribution.

The Company operates in five business segments: Domestic, Canada, Europe, Australia/New Zealand and Other. Management has chosen to organize the segments into geographic areas, with each segment being the responsibility of a segment manager. Each segment markets and sells flooring-related products to the residential, new construction, do-it-yourself and professional remodeling and renovation markets and home centers. The European segment is made up of the Company’s operations in the UK and France. The Other segment is made up of operations in Latin America and other geographic areas.

In the second quarter of fiscal 2008, the Company experienced an increase in sales of approximately $2.8 million or 5% over the same period in the previous fiscal year. The increase in sales was 4% in the combined Domestic and Canadian segments, resulting primarily from sales growth within several product categories, including underlayment and wet saws. The sales growth of underlayment was the result of continued sales penetration of this product line into one of the Company’s large home center customers. The sales growth of wet saws reflects the expansion of the Company’s direct ship program with one of its major home center customers. Sales increased 1% in the Company’s Europe segment, due primarily to improved sales in the Company’s U.K. operation that offset lost sales due to the disposition of our direct operations in Holland in the second quarter of fiscal 2007. Sales increased in the Company’s Australia/New Zealand segment by 20%, primarily due to the foreign currency translation effect of the appreciated Australian Dollar. Sales increased in the Other segment by 7% due to improving sales performance in the Company’s Chile, Argentina and Mexico operations.

For the six months ended August 31, 2007, sales increased by $5.7 million or 5% compared to the same period in the previous year. The combined Domestic and Canada segments increased sales by 5% and contributed $4.2 million to the overall sales increase.

Gross profit increased in the three and six months ended August 31, 2007 compared to the same periods in the previous fiscal year due to additional sales volume and favorable changes in product mix resulting from the increased sales of higher margin underlayment and wet saws, the introduction of higher margin adhesives and other price increases that were passed on to the Company’s customers. In the second quarter of fiscal 2008, compared to the second quarter of fiscal 2007, gross profit as a percent of sales increased to 28.3% from 27.2%. In the six months ended August 31, 2007 compared to the six months ended August 31, 2006, gross profit as a percentage of sales increased to 28.7% from 27.6%.

Recent Developments

Sale of Business

On July 18, 2007, the Company entered into an asset purchase agreement with ParexLahabra, a manufacturer of premixed mortars for the construction industry, for the sales of the business, accounts receivable, inventory and certain intangible assets of the Company’s Stone Holdings operation. The sale proceeds were approximately $2.4 million in cash and the Company recorded a gain on the sale of the Stone Holdings operation of approximately $0.6 million in the second quarter of fiscal 2008, which is recorded in other income. This transaction was not disclosed as a discontinued operation due to the immateriality of the transaction to the Company’s overall operation.

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Settlement of Put Warrant Obligation

On July 23, 2007, the Company received written notice from The HillStreet Fund, L.P. (“HillStreet”) of the exercise of their right to “put” to the Company the 325,000 put warrants pursuant to the Warrant Agreement dated April 5, 2001 (the “Warrant Agreement”). On July 31, 2007, the Company and HillStreet agreed upon a cash settlement value of $2.3 million for the put obligation. The Company paid the settlement out of funds available under its existing bank line of credit.

For accounting purposes, the Company has historically recorded the put warrant liability by calculating the difference between the closing stock price at the end of a reporting period and the exercise price of $3.63 per share multiplied by the 325,000 warrants outstanding. Based on this methodology, a liability of $0.9 million was reported for the put warrants as of the first quarter of fiscal 2007. As a result of the settlement, the Company reported a put warrant expense of $1.4 million for the three months ended August 31, 2007. No further income or expense will be recorded related to this Warrant Agreement.

Critical Accounting Policies and Estimates

Revenue Recognition

The Company recognizes revenue when products are shipped and title has passed to the customer, the selling price is fixed and determinable, and collectibility of the sales price is reasonably assured. The Company provides for estimated costs of future anticipated product returns based on historical experience, when the related revenues are recognized. The Company records estimated reductions to revenue for customer programs including volume-based incentives. Guaranteed discounts to our home center customers are recorded as a reduction in revenue.

Inventories

The Company records inventory at the lower of standard cost, which approximates actual cost, or market. The Company maintains reserves for excess and obsolete inventory based on market conditions and expected future demand. If actual market conditions were to be less favorable than those projected by management, additional inventory reserves could be required.

Accounts Receivable

The Company’s accounts receivable are principally due from home centers or flooring accessory distributors. Credit is extended based on an evaluation of a customer’s financial condition, and collateral is not required. Accounts receivable are due at various times based on each customer’s credit worthiness and selling arrangement. The outstanding balances are stated net of an allowance for doubtful accounts. The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the customer’s previous loss history, the customer’s ability to pay its obligations and the condition of the general economy and the industry as a whole.

Impairment Evaluations

The Company evaluates the recoverability of long-lived assets, including property, plant and equipment, and identifiable intangible assets, whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company performs indefinite-lived impairment tests on at least an annual basis and more frequently in certain circumstances. When the Company determines that the carrying amount of long-lived assets may not be recoverable based upon the existence of certain indicators, the assets are assessed for impairment based on the future undiscounted cash flows expected to result from the use of the asset. For goodwill and other indefinite-lived intangibles, impairment assessments are generally determined using the estimated future discounted cash flows of the asset’s reporting unit using a discount rate determined by management to be commensurate with the risk

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inherent in the current business model. In both instances, if the carrying amount of the asset being tested exceeds its fair value, an impairment of the value has occurred and the asset may be written down. The Company’s annual impairment assessment date is August 31 ^st .

Income Taxes

The Company is required to estimate income tax in each jurisdiction in which it operates. This process involves estimating actual current tax exposure and deferred income taxes to reflect the tax consequences on future years of differences between the tax basis of assets and liabilities and their financial reporting amounts each year-end. The Company must then consider the likelihood that any deferred tax assets will be recoverable from future taxable income and to the extent that it believes that recoverability is not likely, the Company establishes a valuation allowance.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”). On March 1, 2007, the Company adopted the provisions of FIN No. 48.

As a result of the implementation of FIN 48, the Company recognized an increase of approximately $0.4 million in the liability for unrecognized tax benefits associated with uncertain income tax positions, which was accounted for as a reduction to the March 1, 2007, balance of retained earnings. The amount of unrecognized tax benefits as of August 31, 2007, was approximately $1.0 million. Any benefit ultimately recognized will reduce the Company’s annual effective tax rate (see Note G of the Company’s Notes to Consolidated Financial Statements for further discussion).

Results of Operations

Sales

Net sales by segment for the three and six months ended August 31, 2007 (the second quarter and first six months of fiscal 2008, respectively) compared to the three and six months ended August 31, 2006 (the second quarter and first six months of fiscal 2007, respectively) is as follows (in thousands except percentages):

Domestic and Canada

The increase in sales in the Company’s Domestic and Canadian segments in the second quarter of fiscal 2008 compared with the second quarter of fiscal 2007, was primarily the result of the continued increases in sales of underlayment products to one of the Company’s home center customers of $1.1 million. Additionally, sales of wet saw products by the Domestic segment to another home center customer increased by $1.9 million due primarily to the expansion of direct ship program (direct from the Company’s suppliers to the customer with delivery being taken at the suppliers’ dock). Also, during the second quarter of fiscal 2008, the Company rolled-out a new ceiling tools line that increased sales by $0.5 million for the quarter. These increases were partially offset by the contraction of the Company’s distribution customer base as retail sales move from smaller specialty distributors to larger mass merchandisers. Additionally, sales decreased on certain carpet tools and tack strip products as compared with the same period in the previous year.

The increase in sales in the Company’s Domestic and Canadian segments for the six months ended August 31, 2007, compared to the same period in the previous year was the result of increased sales of underlayment products of $2.7 million, wet saw product of $2.8 million and adhesives products of $1.6 million. Once again, these sales increases were primarily to home center customers and were offset by declining sales to distributor customers.

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Overall sales to our home center customers increased approximately 13% and 14% in the three and six months ended August 31, 2007, compared to the same periods in the previous fiscal year. Increases in product sales in the fiscal 2008 periods compared to the fiscal 2007 periods were somewhat offset by higher sales rebates rates due to the additional sales volume projected for the fiscal 2008 period.

The Company expects to see increases in its sales volume in its Domestic and Canada segments in the fourth quarter of fiscal 2008 and the beginning of fiscal 2009 as a result of one of the Company’s major customers awarding the Company a substantial amount of new business on some of its higher margined products.

Other Segments

Sales in the Company’s international subsidiaries were positively affected in three and six months ended August 31, 2007, compared to the three and six months ended August 31, 2006, by the change in currency translation rates between the periods. Sales increased $1.4 million in the second quarter of fiscal 2008 and $2.5 million in the first six months of fiscal 2008 due to the effect of changes in currency translation rates, primarily generated by changes in the Australian Dollar, British Pound and Euro compared with the US Dollar.

The sales increase in the Company’s European segment in the second quarter of fiscal 2008 compared to the second quarter of fiscal 2007 was primarily due to currency translation gains of $0.4 million. Furthermore, sales were lower in the second quarter of fiscal 2008 as a result of the disposition on August 31, 2006, of the Company’s direct operations in Holland and the associated loss of sales of $0.3 million that was realized in the second quarter of fiscal 2007. This decline is partially offset by increased sales volume in the Company’s UK operation of $0.3 million. For the first six months of fiscal 2008 compared to the first six months of fiscal 2007, the sales decline in the European segment was primarily due to lost sales due to the disposition of the Holland operation of $1.1 million that was partially offset by currency translation gains of $0.8 million on sales in the UK and France.

The sales increase in the Australia/New Zealand segment in the three and six months ended August 31, 2007, compared to the same period in the previous year was primarily due to currency translation gains of $0.8 million and $1.3 million, respectively. Excluding the effect of currency translation, sales in this segment increased for the second quarter and first six months of fiscal 2008 by 6.3% and 4.9% compared to the same periods in the previous year. This increase reflects the continued steady growth in the region of both home center and distribution sales. The increase in sales in the Other segment for the second quarter and first six months of fiscal 2008 compared to the comparable periods in fiscal 2007 is due to a slight upturn in sales activity from the Company’s Chile, Argentina and Mexico operations during the periods.

Sales from the Company’s non-North American subsidiaries were 23% and 21% of total sales in second quarter of fiscal 2008 and 2007, respectively. For both the six months ended August 31, 2007 and 2006, sales from the Company’s non-North American subsidiaries were 22% of total sales.

Gross Profit

Gross profit by segment for the three and six months ended August 31, 2007, compared to the three and six months ended August 31, 2006, is as follows (in thousands, except percentages):

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Domestic and Canada

The increase in gross profit in the Domestic and Canadian segments in the second quarter of fiscal 2008 compared to the same period in fiscal 2007 was primarily the result of improved product sales mix resulting from sales increases in higher margin underlayment and wet saw products. In the second quarter of fiscal 2008, the underlayment sales and the direct ship program increased gross profit by $0.7 million and $0.6 million, respectively. These increases were partially offset by lower gross profit on certain carpet tools.

The increase in gross profit in the Domestic and Canadian segments for the six months ended August 31, 2007, compared to the same period in the previous year was due to increased sales volume of higher margin products. This resulted from the increase in underlayment, wet saws and adhesive sales that increased gross profit by $1.4 million, $0.7 million and $0.5 million, respectively.

Gross margin was positively affected in the three and six months ended August 31, 2007, compared to the three and six months ended August 31, 2006, by a change in currency translation rates between the periods. Gross margin increased $0.1 million in the both the three and six months ended August 31, 2007, compared to the same periods in fiscal 2007 due to the effect of changes in translation rates, primarily generated by changes in the Canadian Dollar compared with the US Dollar. Consequently, the positive effect on gross margin is primarily recorded in the Canada segment.

Gross profit as a percentage of sales in the Domestic segment increased to 27% in the second quarter of fiscal 2008 from 25% in the comparable period of fiscal 2007. For the six months ended August 31, 2007, gross profit as a percentage of sales in the Domestic segment was 27% compared to 26% in the same period in the previous year. This improvement is due to a favorable change in the Company’s sales mix through the sales growth of higher margin products, including the underlayment and recently introduced adhesive products. Also, the Company has continued to make improvements in its manufacturing processes and has had some success increasing selling prices on certain products to customers in response to increases in raw material and other product costs.

Gross profit as a percentage of sales in the Canadian segment increased to 37% in the second quarter of fiscal 2008 from 33% in the comparable period of fiscal 2007. For the six months ended August 31, 2007, gross profit as a percentage of sales in the Canadian segment was 37% compared to 32% in the same period in the previous year. This improvement is entirely due to the increased sales volume of the high margin underlayment and adhesive products previously discussed.

Other Segments

Gross margin of the segments outside of North America was positively affected in the three and six months ended August 31, 2007, compared to the three and six months ended August 31, 2006, by the change in currency translation rates between the periods. Gross margin increased $0.3 million in the second quarter of fiscal 2008 compared to the same period in fiscal 2007 and by $0.6 million in the six months ended August 31, 2007, compared to the same period in the previous year due to the effect of changes in currency translation rates, primarily generated by changes in the Australian Dollar, British Pound and Euro compared with the US Dollar.

As previously discussed, lower sales volume associated with the disposition of the Company’s Holland operation in the second quarter of fiscal 2007 was the main reason for the decrease in gross profit in the Europe segment in the three and six months ended August 31, 2007, compared to the same periods in the previous year. Gross profit as a percentage of sales in the Europe segment decreased to 23% in the second quarter of fiscal 2008 from 28% in the second quarter of fiscal 2007. For the six months ended August 31, 2007, gross profit as a percentage of sales in the Europe segment was 24% compared to 28% in the same period in the previous year. This decrease was due to cost increases in the UK operation that have not been passed on to customers through higher prices and the implementation of additional vendor rebate incentives as the operation attempts to remain competitive in its market.

The increase in gross profit in the Australia/New Zealand segment for the three and six months ended August 31, 2007, compared to the same periods in the previous year was primarily due to currency translation gains of $0.3 million and $0.4 million, respectively.

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Gross profit as a percentage of sales decreased to 34% in both the three and six months ended August 31, 2007, from 35% in both the three and six months ended August 31, 2006. This reduction is primarily due to product cost increases that have not been passed on to customers through higher selling prices.

Lower profit margin reported in the Company’s Mexican operation caused the reduction in gross profit and gross profit as a percentage of sales for the Other segment in the both the three and six months ended August 31, 2007, compared to the same periods in the previous year.

Operating Expenses

Operating expenses by segment for the three and six months ended August 31, 2007, compared to the three and six months ended August 31, 2006, are as follows (in thousands except percentages):

Shipping expenses for the three and six months ended August 31, 2007, were approximately $5.7 million and $11.8 million, respectively compared to approximately $6.0 million and $11.8 million for the same periods in fiscal 2007. The reduction in shipping expenses in the second quarter of fiscal 2008 compared to the second quarter of fiscal 2007 was primarily due to the sale of the O’Tool and Stone Holding operations that eliminated $0.2 million of shipping expenses. In addition, shipping expenses decreased in the Domestic and Canadian segments due to home center customer sales, which have lower freight cost, replacing distributor customer sales, which typically have higher freight cost. These reductions were offset by higher freight charges from common carriers arising from increased fuel costs. For the three and six months ended August 31, 2007, shipping expenses remained consistent as a percent of sales at approximately 10%, compared to 11% for both the comparable periods in fiscal 2007. The reduction of shipping expenses as a percentage of sales is primarily due to the expansion of the Company’s direct shipment program that does not incur any freight-out costs.

General and administrative expenses for the three months ended August 31, 2007, were $4.1 million compared to $5.1 million in the same period in the previous year, a decrease of 19%. For the six months ended August 31, 2007, general and administrative expenses were $8.8 million compared to $10.1 million in the same period in the previous year, a reduction of 13%. The reduction is primarily due to the disposition of the Company’s Holland subsidiary that eliminated $1.2 million and $1.4 million of general and administrative expenses that were included in the three and six months ended August 31, 2006, respectively. Excluding the Holland expenses, general and administrative expenses for the second quarter of fiscal 2008 and 2007 were consistent at 7% of sales and for the six months ended August 31, 2007 and 2006, general and administrative expenses were consistent at 8% of sales.

Selling and marketing expenses in the three months ended August 31, 2007, were $3.4 million compared to $3.3 million in the same period in the previous year, an increase of 5%. For the six months ended August 31, 2007, selling and marketing expenses were $6.5 million compared to $6.4 million in the same period in the previous year, an increase of 2%. As a percent of sales, selling and marketing expenses were 6% in all periods presented.

Other Income / Expense

On July 18, 2007, the Company entered into an asset purchase agreement with ParexLahabra, a manufacturer of premixed mortars for the construction industry, for the sales of the business, accounts receivable, inventory and certain intangible assets of the Company’s Stone Holdings operation. The sale proceeds were approximately $2.4 million. During the second quarter of fiscal 2008, the Company recorded a gain on the sale of the Stone Holdings operation of approximately $0.6 million as other income.

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On May 4, 2007, the Company entered into agreements with Bon Tool Co., a US supplier of construction tools, equipment and decorative concrete products, for the sale of the business, inventory and certain intangible assets of the Company’s O’Tool operation, and the sublease of the warehouse space previously occupied by the O’Tool operation. The assets sold consist mainly of inventory with a cost of approximately $1.1 million at May 30, 2007. During the first quarter of fiscal 2008, the Company recorded a loss on the sale of the O’Tool business of less than $0.1 million as other expense.

In connection with the disposition of the Company’s Holland operation in fiscal 2007, the Company receives royalty income in connection with the associated license and royalty agreement entered into with Estillon B.V. During the three and six months ended August 31, 2007, the Company recorded royalty income of less than $0.1 million and $0.1 million, respectively.

Impairment Loss on Goodwill and Other Intangibles

The Company performs an impairment test on goodwill during the second quarter of each fiscal year. The Company performed an impairment test during the second quarter of fiscal 2008 and determined that there was no impairment to goodwill as of August 31, 2007. The impairment test in the previous fiscal year led to the determination that the carrying amount of goodwill exceeded its fair value in the Company’s Mexico, UK and US reporting units. This resulted in an impairment charge of $7.6 million being recorded in the second quarter of fiscal 2007, which was subsequently adjusted to $7.5 million in the third quarter of fiscal 2007.

Changes in the Put Warrant Liability

On July 23, 2007, the Company received written notice from HillStreet of the exercise of their right to “put” to the Company the put warrants in the Company pursuant to the Warrant Agreement. On July 31, 2007, the Company and HillStreet agreed upon a cash settlement value of $2.3 million for the put obligation. The Company paid the settlement out of funds available under its existing bank line of credit.

For accounting purposes, the Company has historically recorded the put warrant liability by calculating the difference between the closing stock price at the end of a reporting period and the exercise price of $3.63 per share multiplied by the 325,000 warrants outstanding. Based on this methodology, a liability of $0.9 million was reported for the put warrants as of the first quarter of fiscal 2007. As a result of the settlement, the Company reported a put warrant expense of $1.4 million for the three months ended August 31, 2007. No further income or expense will be recorded related to this Warrant Agreement. For a more detailed discussion regarding the put warrants, see “Liquidity and Capital Resources”.

Interest Expense

Interest expense for the three and six months ended August 31, 2007, was approximately $0.6 million and $1.3 million, respectively. These amounts compare to $0.7 million and $1.5 million in the same periods in the previous fiscal year. Interest expense has declined in the comparable periods due to lower borrowings in the current period that has offset higher interest rates.

Income Taxes

The Company recorded a provision for income taxes in the three and six months ended August 31, 2007, of approximately $1.5 million and $2.6 million, respectively. This compares with a provision of $0.1 million and $0.3 million in the same periods in fiscal 2007. The provision for income taxes in the second quarter of fiscal 2008 includes $0.1 million of US taxes on foreign deemed dividends and a valuation allowance of $0.2 million on foreign net operating losses, which the Company determined are unlikely to provide a future benefit. The provision for income taxes for the six months ended August 31, 2007, includes $0.4 million of US tax credits and $0.2 million of valuation allowances on foreign net operating losses. In all periods presented, the change in the put warrant liability is non-deductible for tax purposes. After removing the put warrant expense, US taxes on foreign deemed dividend and the tax

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valuation allowance, the effective tax rate in the three and six months ended August 31, 2007, was 41% and 40%, respectively. The fiscal 2008 provision was based upon the statutory tax rates available in every jurisdiction in which we operate as adjusted for tax contingencies.

Net Income

Net income for the second quarter of fiscal 2008 was $0.1 million or $0.02 per diluted share compared with a net loss of $6.7 million or $1.99 per diluted share in the second quarter of fiscal 2007. For the six months ended August 31, 2007, net income was $0.9 million or $0.25 per diluted share compared to a net loss of $6.4 million or $1.89 per diluted share in the same period in fiscal 2007.

Non-GAAP Financial Measures - Reconciliation of Net Income to Net Income Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items and Earnings Per Share Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items

Net Income Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items and Earnings Per Share Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items are Non-GAAP financial measures. The Company has included these Non-GAAP financial measures because it believes that the measures provides an indicator of profitability and performance of the Company’s operations and provides a meaningful comparison of its current operating performance with its historical results. The Company uses Net Income Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items and Earnings Per Share Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items as internal measures of its business. Net Income Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items and Earnings Per Share Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items are not meant to be considered a substitute or replacement for Net Income and Earnings Per Share as prepared in accordance with generally accepted accounting principles.

The reconciliation of Net Income to Net Income Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items and Earnings Per Share to Earnings Per Share Adjusted for the Change in the Put Warrant Liability and Other Non-Recurring Items is as follows (in thousands except for per share data):

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Liquidity and Capital Resources

Working capital was approximately $8.7 million as of August 31, 2007, as compared to approximately $5.1 million at February 28, 2007, an increase of approximately $3.6 million.

Net cash provided by operating activities during the first six months of fiscal 2008 was approximately $2.4 million compared to less than $0.1 million for the comparable fiscal 2007 period. In the current fiscal year, net income as adjusted for depreciation, amortization, non-cash charges, gain on sale of business and changes in deferred taxes was $4.9 million as compared with $1.8 million in the same period in the previous year. During first six months of fiscal 2008, the Company used cash of $4.7 million to increase accounts receivable and inventory. For the same period in fiscal 2007, reductions in inventory and accounts receivable provided cash of $3.6 million. During the first six months of fiscal 2008, increases in accounts payable and accrued liabilities provided cash of $2.1 million, primarily due to increases in rebates and allowances that were not taken by the Company’s major customers. This compares with cash used by a reduction in accounts payable and accrued liabilities of $6.0 million in the same period of the previous fiscal year. The increase in inventory and accounts receivable is to support current and projected sales growth for fiscal 2008.

Net cash provided by investing activities was $0.5 million in the first six months in fiscal 2008, which is comprised of the sales proceed from the sale of the Company’s Stone Holding and O’Tool businesses of $3.1 million that was partially offset by the settlement of the Company’s put warrant obligation of $2.3 million and capital expenditures of $0.3 million. Cash used in investing activities in the first six months of fiscal 2007 was $0.3 million, which is exclusively made up of capital expenditures.

Net cash used by financing activities was approximately $2.6 million in the first six months of fiscal 2008 as compared to approximately $0.5 million in the same period in the previous year. During the first six months of fiscal 2008, the company repaid an

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additional $1.5 million on its lines of credit and $2.4 million on long-term and acquisition debt. This was partially offset by long-term borrowings of $1.4 million by the Company’s Australian subsidiary. For the comparable fiscal 2007 period, the Company borrowed $2.2 million on its line of credit and repaid $2.8 million of long-term and acquisition debt.

The Company has an asset based loan agreement with two domestic financial institutions to provide a revolving credit facility, mortgage and term note financing. In March 2005, the Company amended the facility to consolidate the Company’s term notes and increase the amount of borrowing capacity to $27 million through February 2006 and $29 million thereafter under the revolving facility using the same formula for eligible accounts receivable and inventory that previously existed for the Company. The revolving credit facility was extended to July 2008. These loans are collateralized by substantially all of the Company’s assets. The agreement also prohibits the Company from incurring certain additional indebtedness, limits certain investments, advances or loans, restricts substantial asset sales and capital expenditures and prohibits the payment of dividends, except for dividends due on the Company’s Series A and C preferred stock. The loan agreement contains a subjective acceleration clause and lockbox arrangement; therefore, the borrowing under this agreement is classified as a current liability.

On April 26, 2007, the loan agreement was amended to make certain financial covenants from February 28, 2007 through July 2008 less restrictive and to increase the ability of the Company to borrow against eligible inventory of raw material and finished goods of the Company and certain subsidiaries.

At August 31, 2007, the rate for the revolving loan facility was Libor (5.56%) plus 2.00% and the Company had borrowed approximately $22.5 million and had $5.8 million available for future borrowings under the revolving loan facility net of approximately $0.7 million in outstanding letters of credit.

The Company’s Australian subsidiary has a payment facility that allows it to borrow against a certain percentage of inventory and accounts receivable. In March 2007, this facility was amended to make the maximum permitted borrowing approximately $1.7 million of which $1.2 million was outstanding at August 31, 2007. The facility is considered a demand note and carries an interest rate of the Australian Commercial Bill Rate (6.90% as of August 31, 2007) plus 1.25%.

In connection with the purchase of the assets of Vitrex Ltd., the Company’s United Kingdom subsidiary entered into two financing arrangements with HSBC Bank in the United Kingdom. The first financing arrangement allows for borrowing up to £1.0 million (approximately US $2.0 million) based on the advancement of up to 80% of the value of accounts receivable. In addition, the subsidiary may borrow up to £0.4 million (approximately US $0.8 million) against the value of the inventory. Both of these facilities are collateralized by substantially all of the assets of the subsidiary (approximately $7.3 million) as well as a parent company guaranty. On August 31, 2007, $2.4 million was borrowed under these facilities. Both are considered short-term demand notes and have an interest rate of Libor (5.75% as of August 31, 2007) plus 2.00%.

The Company believes that its existing cash balances, internally generated funds from operations and available bank lines of credit will provide the liquidity necessary to satisfy its working capital needs, including changes in working capital balances, and will be adequate to finance anticipated capital expenditures and debt obligations for the next twelve months. There can be no assurance, however, that the assumptions upon which the Company bases its future working capital and capital expenditure requirements and the assumptions upon which it bases its belief that funds will be available to satisfy such requirements will prove to be correct. If these assumptions are not correct, the Company may be required to raise additional capital through loans or the issuance of debt or equity securities that would require the consent of the Company’s current lenders.

To the extent the Company were to raise additional capital by issuing equity securities or obtaining borrowings convertible into equity, ownership dilution to existing stockholders may result, and future investors may be granted rights superior to those of existing stockholders. Moreover, additional capital may be unavailable on acceptable terms to the Company, or may not be available at all.

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In connection with the subordinated loan agreement between the Company and HillStreet, entered into on April 5, 2001, the Company issued 325,000 10-year warrants (the “put warrants”) at an exercise price of $3.63 per share. Once the put warrants are put to the Company, the Company is required to pay the holder of the put warrants in cash in accordance with the warrant agreement. The payment is based on the determination of the Company’s entity value, which is defined in the warrant agreement as the greatest of: (1) the fair market value of the Company established as of a capital transaction or public offering; (2) a formula value based on a multiple of the trailing twelve month EBITDA; or (3) an appraised value as if the Company was sold as a going concern.

On July 23, 2007, the Company received written notice from HillStreet of the exercise of their right to “put” to the Company the put warrants pursuant to the warrant agreement. On July 31, 2007, the Company and HillStreet agreed upon a cash settlement value of $2.3 million for the put obligation. The Company paid the settlement out of funds available under its existing bank line of credit.

For accounting purposes, the Company historically recorded the put warrant liability by calculating the difference between the closing stock price at the end of a reporting period and the exercise price of $3.63 per share multiplied by the 325,000 warrants outstanding. Based on this methodology, a liability of $0.9 million was reported for the put warrants as of the first quarter of fiscal 2007. As a result of the settlement, the Company reported a put warrant expense of $1.4 million for the three months ended August 31, 2007.

Impact of Inflation and Changing Prices

During fiscal 2007 and continuing during fiscal 2008, the Company experienced price increases in certain key commodities and components related to the purchase of raw materials and finished goods. The Company believes that its level of gross profit as a percent of net sales is affected by these increases. Other than the changes described, the effect of inflation on our operations has been minimal.

Recently Issued Accounting Standards

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, SFAS No. 157 does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after December 15, 2007 (the Company’s fiscal year ending February 28, 2009). The Company is currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on the Company’s operating income or net earnings.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159 permits companies to choose to measure certain financial instruments and certain other items at fair value, and requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for the Company beginning in the first fiscal quarter of 2008 although earlier adoption is permitted. The Company expects that SFAS No. 159 will not have an impact on its consolidated financial statements.

Forward-Looking Statements

This report contains certain forward-looking statements that are made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. Forward-looking statements present our expectations or forecasts of future events. These statements can be identified by the fact that they do not relate strictly to historical or current facts. They are frequently accompanied by words such as “believe”, “intend”, “expect”, “anticipate”, “plan”, or “estimate” and other words of similar meaning, and include statements relating to the adequacy of our liquidity sources to meet our working capital needs and anticipated expenditures; the timing of the

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