THE COMPANY

GENERAL

KMG Chemicals, Inc., a Texas corporation (the "Company"), was incorporated in the State of Texas in 1992 under the name Water Point Manufacturing, Inc. In connection with the acquisition in 1996 of KMG-Bernuth, Inc., a Delaware corporation ("KMG"), the Company changed its name to KMG-B, Inc. In 1997 the Company changed its name to KMG Chemicals, Inc. The Company's principal executive office is located at 10611 Harwin Drive, Suite 402, Houston, Texas 77036 and its telephone number is (713) 988-9252.

ACQUISITION OF KMG-BERNUTH, INC.

In October 1996, the Company acquired all of the issued and outstanding stock of KMG in exchange for 6,510,000 shares of the common stock, par value $.01 per share ("Common Stock"), of the Company. After giving effect to a 1 for 1.5 reverse split of Common Stock outstanding immediately prior to the acquisition of KMG, the former stockholders of KMG became owners of approximately 93% of the issued and outstanding shares of Common Stock. See "Item 11. Security Ownership of Certain Beneficial Owners and Management."

Unless the context otherwise requires, references hereinafter to the "Company" shall mean KMG Chemicals, Inc. and any of its subsidiaries. All references hereinafter to share amounts reflect the reverse split of Common Stock.

BUSINESS OF THE COMPANY

GENERAL

The Company manufactures, markets and distributes specialty, niche chemicals. At the present time, the Company manufactures, markets and distributes three wood preserving chemicals, pentachlorophenol ("penta"), creosote and sodium pentachlorophenate ("sodium penta"), to industrial customers engaged in the wood preserving business. The Company's customers use these preservatives to treat wood and supply the treated wood products to end-users in a variety of industries, principally the railroad, utility and construction industries.

The Company acquired a penta manufacturing and distribution business in 1988 from an affiliated company that had been engaged in the penta business since the early 1970's. The Company made several acquisitions after 1988 to expand its wood preserving product lines and distribution network. It acquired a creosote distribution business in early 1991 and a sodium penta distribution business late that same year. In 1998, the Company acquired from AlliedSignal, Inc. ("AlliedSignal") certain assets pertaining to the sale of creosote and entered into a long-term creosote supply contract with that firm. In 1999 Reilly Industries, Inc. ("Reilly") acquired AlliedSignal's carbon products business, including its creosote production and the creosote supply contract with the Company. After the end of fiscal 2000, a subsidiary

of the Company acquired an herbicide product line from an affiliate of Zeneca Ag Products, Inc. ("Zeneca"). See "-New Developments."

The Company's strategy is to continue to expand through acquisitions and internal development. The Company intends to seek, on a selective basis, acquisitions of businesses that have product lines that complement and expand its existing product lines, desirable new product lines, strategic distribution locations or attractive customer bases. The ability of the Company to implement its growth strategy will be dependent on its ability to identify, consummate and assimilate acquisitions on desirable economic terms, to successfully integrate new product lines and expand its existing product lines. There can be no assurance that the Company will be successful in implementing its growth strategy. Furthermore, the Company's ability to implement its growth strategy may be dependent to a certain extent upon obtaining financing for expansion, and there can be no assurance that financing will be available on acceptable terms.

NEW DEVELOPMENTS

The Company acquired an herbicides product line from Zeneca, monosodium and disodium methanearsonic acid herbicides ("MSMA products"), on October 3, 2000 for $2.3 million plus the payment of an earnout on adjusted net sales of the herbicides over five years. The acquisition was financed out of Company working capital. MSMA products are sold under the name Bueno(R) 6 and used in the United States and elsewhere in the world primarily as a cotton crop herbicide. For several years, however, cotton farmers in the United States have been planting genetically modified cotton seed that is resistant to the herbicide Roundup(R) and other glyphosate herbicides. As farmers converted to that seed and to glyphosate, MSMA products became niche products used primarily by farmers who are sensitive to the higher cost of the genetically modified seed program. The Company believes that its sales of MSMA products in fiscal 2001 will be approximately $5-7 million.

The Company's acquisition of the MSMA product line included the purchase of pesticide registrations, product trademarks and the manufacturing equipment necessary to make MSMA products. For the balance of calendar 2000, a Zeneca affiliate will continue to manufacture MSMA products for the Company in order to build the inventory that will be needed by customers in the 2001 growing season. The Company intends to begin moving the purchased manufacturing equipment to its facility in Matamoros, Mexico in January 2000, to reassemble it and restart production late in calendar 2001.

MSMA products are sold in the United States by the Company and Drexel Chemical Company, Luxembourg-Pamol, Inc. and Albaugh, Inc., primarily in the southern cotton-growing states and in California. Those same companies also sell MSMA products in other countries. The Company will be dependent in its production of MSMA products on outside suppliers for its raw material requirements. The Company does not intend to enter into long term supply contracts with those suppliers. MSMA products are subject to extensive federal, state and local laws and regulations, including environmental laws and regulations that require the Company to research and test the chemistry and toxicology of MSMA products. The Company has joined an industry group that is conducting that testing. See "-Environmental and Safety Matters-Licenses, Permits and Product Registrations."

WOOD PRESERVATIVES OVERVIEW

The Company produces and sells several wood preservative products that prolong the useful life of treated wood by protecting the wood from mold, mildew, fungus and insects. The three primary chemicals used by the United States wood preserving industry are penta, creosote and chromated copper arsenate ("CCA"). Penta is used primarily to treat electric and telephone utility poles while creosote is used for railroad cross-ties, bridge timbers and utility poles. CCA is used for utility poles and lumber. The Company believes that wood preserving chemicals are used to treat approximately 600 million cubic feet of wood each year in the United States and that 6% of that wood is treated with penta, 15% with creosote and 80% with CCA. CCA is used more widely than penta and creosote principally because CCA-treated lumber has a dry, non-oily appearance that makes it more suitable for the fences, decks and the other home applications that comprise the largest part of the treated wood market. The Company currently supplies the United States wood treating industry with penta and creosote but not with CCA. The Company also supplies sodium penta, a wood preserving product used primarily to treat freshly-cut lumber, to customers outside the United States. See "-Competition."

PRODUCTS AND SERVICES

PENTACHLOROPHENOL AND SODIUM PENTACHLOROPHENATE. Penta is formed through the reaction of phenol with chlorine. The Company manufactures penta in Matamoros, Mexico through KMG's subsidiary, KMG de Mexico, S.A. de C.V. ("KMEX."), formerly known as Productos de Preservacion, S.A. de C.V., a Mexican maquiladora corporation that began operations in 1986. The Company arranges for the required phenol and chlorine to be supplied to KMEX, which in turn sells the penta it produces to the Company for sale and distribution to the Company's customers. As a by-product of the penta manufacturing process, the Matamoros facility also produces hydrochloric acid which is sold to distributors for use in the steel and oil well service industries in the United States and Mexico.

The Matamoros facility produces both solid penta blocks and penta flakes. Those penta products are sold by the Company to its customers or made into a liquid solution of penta concentrate at the Matamoros facility or at the Company's blending and distribution facility in Tuscaloosa, Alabama. The penta blocks, flakes and solutions are sold to the Company's customers in the United States, primarily in Washington, Oregon, Oklahoma, Missouri, Arkansas, Mississippi, Alabama and Georgia. In addition, a portion of the flaked penta is reacted with caustic soda to produce sodium penta. The Company sells the sodium penta, which is not registered for use in the United States, to customers primarily in France, Spain, Portugal, England, Peru, Ecuador, Venezuela and Brazil.

CREOSOTE. Creosote is produced by the distillation of coal tar, a by-product of the transformation of coal into coke. The Company has two primary sources of supply for the creosote it sells in the United States -- Reilly and Rutgers VFT AG ("Rutgers"). The Company believes that Reilly and Rutgers are among the world's largest manufacturers of creosote and other coal tar products. Creosote is sold by the Company to customers throughout the United States.

SUPPLIERS

The Company is dependent upon outside suppliers for all of its raw material requirements for its penta and sodium penta manufacturing operations and, therefore, is subject to fluctuations in the price of

those materials. The principal raw materials used in those operations are phenol, chlorine, solvent and caustic, each of which the Company purchases from a limited number of suppliers. The Company does not maintain supply contracts with any of its suppliers of those raw materials, which include Aristech Chemical Corporation, CYDSA, Eastman Chemical Co., Fenoquimia, S.A. de C.V., Pennwalt De Mexico and Advanced Aromatics, Inc. However, the Company believes that these raw materials are each readily available from a variety of sources and the loss of any of the Company's raw material suppliers would not have a material adverse effect on its business, financial condition or results of operations.

The Company has two suppliers of the creosote it sells. The Company's supply contract with Reilly has an initial term ending in 2008 and thereafter may be renewed annually. The Company must purchase all of the creosote produced at certain facilities, subject to annual maximum and minimum quantities, at varying prices per pound. If Reilly's actual production exceeds the maximum, the Company has the option to purchase that additional production.

The Company's creosote supply contract with Rutgers has an initial term ending December 31, 2001 and is then renewable annually. The Company must purchase an agreed minimum volume in each calendar year. The purchase price for creosote is fixed for calendar year 2000 and is subject to escalation thereafter during the term.

CUSTOMERS

The Company sells its wood preservative products to approximately 80 customers. One customer, Kerr McGee Chemical Corp., accounted for approximately 12% of the Company's revenues in fiscal 2000 and 15% in fiscal 1999. No other customer accounted for 10% or more in either fiscal year.

MARKETING

The Company markets its wood preservatives in the United States through four employees and one independent commissioned sales agent. Outside the United States, the Company sells its penta and sodium penta directly and through sales agency contracts to local lumber producers or to chemical companies for those producers in over 20 countries.

COMPETITION

The Company is one of only two companies producing penta for sale in the United States. The Company believes that it currently supplies almost half of the penta sold in the United States. The other penta producer in the United States is Vulcan Chemicals, Inc. It is headquartered in Birmingham, Alabama and produces penta at its facility in Wichita, Kansas. The Company believes that Vulcan Chemicals, Inc. has larger sales volumes and greater financial and other resources than the Company. The Company competes internationally with suppliers from Mexico, China and India.

The Company believes that there are four firms that compete with it in creosote sales in the United States. The Company's principal competitor is Koppers Industries, Inc. located in Pittsburgh, Pennsylvania. The Company believes that Koppers Industries, Inc. has larger sales volumes and greater financial and other resources than the Company. The Company believes that it currently supplies approximately one third of the creosote sold in the United States.

The Company does not supply CCA, the most widely-used wood preservative. The Company believes that there are three suppliers of CCA in the United States, Hickson Corporation, Chemical Specialties, Inc. and Osmose Wood Preserving, Inc. Each of those companies has larger sales volume and greater financial resources than the Company.

Penta and creosote are pesticides that must be registered prior to sale under United States law. See "-Environmental and Safety Matters-Licenses, Permits and Product Registrations." As a condition to registration, any company wishing to manufacture and sell penta or creosote must provide to the EPA substantial scientific research and testing data regarding the chemistry and toxicology of the products. That data must be generated by the applicant or the applicant must compensate other data providers for relying on their information. The Company believes that the cost of satisfying the data submission requirement serves as an impediment to the entry of new competitors in the United States market, particularly those with lesser financial resources. While the Company has no reason to believe that the registration requirement will be discontinued or materially modified, there can be no assurances as to the effect of such a discontinuation or modification on the Company's competitive position.

The Company believes that its ability to compete effectively is dependent upon providing its products at competitive prices, anticipating new markets and distribution channels for its products and maintaining a strong commitment to product quality and customer service.

EMPLOYEES

As of the end of fiscal 2000, the Company had a total of 70 full-time employees and one temporary employee. Ten of the Company's employees worked at the Company's corporate offices in Houston, Texas, 51 at the Matamoros facility, eight at the Tuscaloosa facility and one worked in Louisiana. None of the employees in the United States are represented by a labor union but 29 of KMEX's employees in Mexico are represented under a labor contract. The Company believes that it has good relations with its employees.

ENVIRONMENTAL AND SAFETY MATTERS

The Company's operations are subject to extensive federal, state and local laws, regulations and ordinances in the United States and abroad relating to the generation, storage, handling, emission, transportation and discharge of certain materials, substances and waste into the environment, and various other health and safety matters. Governmental authorities have the power to enforce compliance with their regulations, and violators may be subject to fines, injunctions or both. The Company believes that it is currently in substantial compliance with all such applicable laws and regulations. The Company must devote substantial financial resources to ensure such compliance. For a discussion of the Company's expenditures regarding environmental matters, see "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources."

The Company anticipates that the regulation of its business operations under federal, state and local environmental regulations in the United States and abroad will increase over time. The Company cannot at this time estimate the impact of increased regulation on the Company's operations, future capital expenditure requirements or the cost of compliance.

UNITED STATES REGULATION. Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA") and comparable state laws, an owner or operator of property from which releases of hazardous substances have occurred may be liable for investigation and remediation of any resulting contamination. In addition, the generator of hazardous substances may be responsible for all or a portion of any required investigation or remediation at offsite disposal locations. Under the Resource Conservation and Recovery Act, as amended ("RCRA"), a facility that treats, stores or disposes of hazardous wastes on-site may be liable for corrective action costs. In addition to CERCLA and RCRA, state laws and regulations may impose the same or broader liability.

The Company's operations also are governed by laws and regulations relating to workplace safety and worker health, principally the Occupational Safety and Health Act and the regulations thereunder.

MEXICO REGULATION. The Company's Matamoros facility and its operations in Mexico are subject to various environmental laws, regulations and ordinances promulgated by governmental authorities in Mexico. The Secretariat of Environment, Natural Resources and Fisheries (SECRETARIATE DE MEDIO AMBIENTE, RECURSOS NATURALES Y PESCA: "SEMARNAP") is given overall responsibility for environmental regulation in Mexico. SEMARNAP's responsibilities include enforcement of Mexico's laws and regulations concerning air and water emissions and hazardous waste treatment, storage and disposal. SEMARNAP is given broad authority to enforce compliance with environmental laws and regulations and can require that operations be suspended pending completion of required remedial action.

LICENSES, PERMITS AND PRODUCT REGISTRATIONS. Certain licenses, permits and product registrations are required for the Company's products and operations in the United States, Mexico and other countries in which the Company does business. Such licenses, permits and product registrations are subject to revocation, modification and renewal by governmental authorities. In the United States in particular, producers of pesticides such as penta and creosote are required to obtain a registration for their products under the Federal Insecticide, Fungicide and Rodenticide Act ("FIFRA") from the EPA in order to sell those products in the United States. Compliance with the registration system under FIFRA has had and will in the future have a material effect on the Company's business, financial condition and results of operations. The registration system requires an ongoing submission to the EPA of substantial scientific research and testing data regarding the chemistry and toxicology of pesticide products by manufacturers. Under an agreement reached with the other industry participant, the Company shares research and testing costs pertaining to penta based on its relative market share. Since the beginning of fiscal 1999 when it first acquired certain creosote labels, the Company has participated as a member in a similar industry group funding a creosote research and testing program. The Company incurred expenses of approximately $756 thousand and $721 thousand in connection with the FIFRA research and testing program in fiscal 2000 and fiscal 1999, respectively.