SecProbe.io

CORRESP
1
filename1.htm

August 18, 2005

Mr. Rufus Decker

Accounting Branch Chief

Division of Corporation Finance

United States Securities and Exchange Commission

Washington, D.C. 20549

Re:          KMG
Chemicals, Inc.

Form 10-K for the fiscal year ended 2004

SEC File No. 0-29278

Dear Mr. Decker:

KMG
Chemicals, Inc. (“KMG”)
submits the following responses to your letter dated July 13, 2005,
containing comments from the staff of the Securities and Exchange Commission
relating to KMG’s Form 10-K for the year ended July 31, 2004.  This letter supplements our earlier responses
on July 1, 2005 and on May 6, 2005 to your original comment letter
dated March 31, 2005 and a subsequent comment letter dated June 7,
2005.  In this letter, KMG has reproduced
your comments in bold, italics typeface, and has made its responses in normal
typeface.

FORM 10-K FOR THE YEAR ENDED
JULY 31, 2004

Note 1. Summary of Significant Accounting Policies

Segment Reporting, page 31

1.     We note your response to
prior comment 1.  We remind you that
paragraph 10 of SFAS 131 defines an operating segment as a component of an
enterprise that engages in business activities from which it may earn revenues
and incur expenses, whose operating results are regularly reviewed by the
enterprise’s chief operating decision maker to make decisions about resources
to be allocated to the segment and assess its performance, and for which
discrete financial information is available.
Given that your response to prior comment 10 in your letter dated May 6,
2005 states that the results of the three product lines are evaluated regularly
by the chief operating decision maker in deciding how to allocate resources and
assessing performance as well as it appears that your product lines earn
revenues and incur expenses, and discrete financial information is available,
it is not clear how each of these product lines would not represent an
operating segment.

It appears that gross profit margins are
the strongest indicator of your product lines’ economic characteristics,
particularly in light of the fact that indirect general overhead expenses were
not allocated to the product lines.  For
the period from August 1, 2001 through January 31, 2005, the gross
profit margins of the wood treating chemicals product line ranged from 28% to
40%, with an average of 33%.  For this
same period, the gross profit margins of the rabon product line ranged from 37%
to 45%, with an average of 42%, and the gross profit margins of the MSMA
product line ranged from 1% to 59%, with an average of 16%.  Also, during this period, different product
lines exhibited differing gross profit margin trends from period to
period.  For example, from fiscal 2002 to
fiscal 2003,

the gross profit margin of the wood
treating chemical products line decreased by 8%, whereas the gross profit
margin of the MSMA product line decreased by 45%.  From fiscal 2003 to fiscal 2004, the gross
profit margin of the wood treating chemical products line decreased by 11%, the
gross profit margin of the rabon product line increased by 3%, and the gross
profit margin of the MSMA product line decreased by 7%.  It appears that the margins of these product
lines and the trends they depict are sufficiently varied as to preclude these
product lines from being considered economically similar.  It is not clear how you determined that these
three product lines have similar economic characteristics.

We remind you that the objective of
requiring disclosures about segments of an enterprise and related information
is to provide information about the different types of business activities in
which an enterprise engages and the different economic environments in which it
operates to help users of financial statements (a) better understand the
enterprise’s performance, (b) better assess its prospects for future net
cash flows and (c) make more informed judgments about the enterprise as a
whole.  Based on this stated objective
and the requirements set forth in paragraph 17 of SFAS 131, it appears to us
that you should present disaggregated information for your three product lines.

Response:  We manage our business as a single entity
with four primary product lines, and prepare monthly management reports for our
chief operating decision maker and our board of directors.  Those monthly reports focus primarily on
aggregate performance of the consolidated company, not individual product
lines.  While it is true that the report
contains some information on the profitability of product lines, information is
also available to look at profitability of individual products, and in some cases
by distribution points for individual products.
Our chief operating decision maker uses these reports on a monthly basis
primarily to make decisions with regards to pricing strategy for our various
products, to track the performance of our production facilities, and as an
important tool in our internal controls.
Resource allocation among our product lines is not a significant,
regular exercise for our chief operating decision maker, and our monthly
management reports are not regularly used for that purpose.  Information on relative gross profit margins
among the product lines, such as was provided in our July 1, 2005
response letter, is not a feature of our normal monthly management reporting
package.

A copy
of the monthly management report for the month ending April 2005 (the end
of our third quarter) is provided under a request for confidential
treatment.  Resource allocation among
product lines is not a focus of the monthly management report, and we track
relatively little discrete financial information by product lines.  The product line information in the monthly
management report is really more accurately viewed as a summation of individual
product information.  Our products
generally require only modest amounts of working capital, and our plant’s
normal capital expenditure level (excluding acquisitions-related expenditures)
is only approximately $300,000 per year.
Consequently, our product lines do not materially compete for company
resources or capital.

Below
the level of our chief operating decision maker, our business is managed as a single
segment as well.  The sales force for all
products reports to a single vice president-sales, and manufacturing personnel
report to a single manager of operations.
Similarly, regulatory matters are managed for all products by the vice
president and general counsel.  There are
no dedicated product managers with profit and loss responsibility for any one
product line, and certain of our products utilize the same production
facilities and employees.  Manpower at
our plant is directed to the manufacture of the various products by the plant
management.  The impact and effectiveness
of those plant-scheduling decisions is monitored by the chief operating
decision maker through the reports provided in the monthly management package.

Paragraph
13 of SFAS 131 advises that the nature of the business

activity,
and the existence of a manager, should be considered when defining an operating
segment.  Our chief operating decision
maker has profit and loss responsibilities for all product lines.  There are no dedicated managers assigned to
any of our product lines, and no dedicated product managers reporting to the
chief operating decision makers.  Also,
the nature of the product lines would indicate one operating segment since they
are similar products (pesticides) and share management, production facilities
and employees.  We believe these are
indicators of a single operating segment.

Paragraph
14 provides further clarification for paragraph 10, saying that the chief operating
decision maker could be the segment manager, and if section 10 applies to
more than one component, the set of components that the segment manager is held
responsible for is the operating segment.
Our chief operating decision maker is held responsible for the profit
and loss of all product lines as one segment.
The individual performance of each product line, is not regularly
reviewed by the company’s board of directors in the monthly management reports,
to whom he reports.  We believe,
therefore, this also indicates that the business is a single operating segment.

Note 2. Acquisitions, page 32

2.     We note your response to
prior comments 2 and 3.  It appears that
the primary reason you used SFAS 141 to account for these acquisitions is that
the purchase price exceeded the estimated fair value of the assets acquired.

In your response to prior comment 11 in
your letter dated May 6, 2005, for the Wood Protections Products
acquisition, you stated that you primarily acquired WPP’s pesticide registrations
for penta products and a non-compete agreement from WPP and its principal
owner.  Also in your response to prior
comment 12 in this letter, you stated that for the Trenton Sales, Inc.
acquisition you did not acquire any physical assets in this transaction; you
identified the product registration and non-compete agreements as the only
intangible assets that had been acquired.

We remind you that paragraph 6 of EITF 98-3
states that a business consists of (a) inputs, (b) processes applied
to those inputs, and (c) resulting outputs that are used to generate
revenues.  In order for a transferred set
of activities and assets to be a business, it must contain all of the inputs
and processes necessary for it to continue to conduct normal operations after
the transferred set is separated from the transferor, which includes the
ability to sustain a revenue stream by providing its outputs to customers.  Your response indicates that the transferred
assets contain no processes necessary to continue to conduct normal operations
as well as no outputs.  Aside from the
product registrations, the remaining inputs obtained appear to be minor.  Given this, it remains unclear how you
determined you acquired a business pursuant to EITF 98-3.

Response:  Wood Protection Products (WPP) and Trenton
Sales (Trenton) were distributors of wood treating products, and competed with
us immediately prior to the acquisitions.
WPP was a distributor of pentachlorophenol (penta) and Trenton was a
distributor of creosote.  Neither
business was complex.  The primary asset
in each business was an EPA product registration which is required in order to
sell or distribute pesticides like wood treating products in the U.S.  These registrations are expensive and time
consuming to obtain.  All other components
of the two businesses are relatively easy to obtain.

WPP
purchased truckloads of penta from a single source, and Trenton purchased
creosote usually from not more than two sources, most recently by truckload
from a Mexico producer.  WPP dissolved
the solid penta it purchased into solution form, and sold it to customers in
truckload quantities.  Trenton’s creosote
sales were of truckload quantities,

but it
did no processing of the creosote it bought before it was resold.  Each company had temporary storage capacity
at one or more locations.  In each case,
almost all the sales were concentrated in fewer than 20 customers, and in the
case of Trenton a large portion of its sales were to a related company that
used creosote to treat utility poles.  In
evaluating our acquisitions of WPP and Trenton in accordance with paragraph 6
of EITF 98-3, we considered the following:

Wood
Protection Products

WPP
purchased solid penta from a single supplier, and dissolved it with a solvent
to form a liquid, penta concentrate.  It
sold the concentrate in bulk by tank truck to wood treating companies who used
it to treat utility poles, which are used primarily by telecommunication and
utility companies.  We evaluated our
acquisition of the WPP assets in accordance with paragraph 6 of EITF 98-3 as
follows:

Inputs:

•              Long-lived
assets - WPP’s long-lived assets consisted of trucks/trailers, formulation
equipment (including storage tanks) and their building and formulating facility
site in Charlotte, SC.  We acquired WPP’s
delivery trucks/trailers in the acquisition, which supplemented the fleet we
already possessed.  We also acquired WPP’s
formulation equipment, which we dismantled and removed from their
facility.  We did not acquire and did not
need their building or facility in order to continue the penta distribution
business.  We used some of the
formulating equipment to upgrade our facility in Tuscaloosa, Alabama, some of
the equipment was used elsewhere in the company, and the remainder of the
equipment was sold for scrap.  EITF 98-3
instructs that the determination of whether a set of transferred assets
constitutes a business should be made without regard to how the transferee
intends to use the transferred set.  In
determining whether a business was acquired, we did not deem it relevant that
the WPP formulation equipment was dismantled.

•              Intellectual
property – The key asset and principal intellectual property of WPP was its
U.S. EPA and Canada penta registrations.
The registrations are necessary to lawfully sell penta in the U.S. and
Canada.  The registrations and test
studies were acquired in the acquisition.
Other intellectual property was not material to the business.

•              Ability
to obtain access to materials or rights – We purchased WPP’s entire penta
inventory in the acquisition.  WPP was
purchasing penta from a single supplier under a long-term relationship, without
a written contract.  We obtained a long
term penta supply agreement with that supplier in December 2003 after we
purchased WPP.  WPP did not have
contracts to purchase the solvents used to dissolve penta and make penta
solutions.  We already had sources for
the solvents, and the additional solvent volume needed after the acquisition
was easily obtained by us from those sources.

•              Employees
– WPP’s employees were truck drivers, formulation facility operators, sales
personnel and office staff, none of which is a highly complex or technical job.  We did not hire any of these employees in the
acquisition, although one sales person was hired subsequently.  We easily obtained one additional truck
driver and one production person in Tuscaloosa (where our facility is located)
to handle the increased volume.  Though
not included in the acquisition, the additional personnel were readily
available and easily obtained at low cost.

Processes:

•              Production
process - WPP’s production process consisted of dissolving solid penta with
solvent to produce a liquid penta concentrate.
WPP’s process was not complicated; it was a simple bulk materials
handling/dissolving operation.  Their
process was similar to the process we already used to dissolve our own solid
penta to produce solutions, except that WPP started with solid penta flakes and
our process started with solid penta blocks.
We did purchase all the WPP equipment and used some of it to upgrade
aspects of our facility, and improve our process.

Outputs:

•              Product
inventory -We purchased WPP’s product inventory at their cost of
production.  WPP also processed raw
materials on hand into finished product under a processing agreement with us
for about three weeks.

•              Ability
to access customers - The customer base is a very concentrated group of wood
treating companies.  Almost all the penta
sold in the U.S. goes to not more than about 20 customers.  Prior to the acquisition, WPP was the only
other distributor of penta solutions.
Given the limited number of customers and distributors, access to
customers was easily obtained.  We did
obtain a consulting and non-competition agreement with WPP and its principal
owner.  The non-competition agreement
generally prohibits WPP from re-entering the penta business for five years,
which enhances our ability to access the customer base.  WPP’s customers naturally migrated to us, and
we concluded that it was not material to the EITF 98-3