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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2003

OR

For the transition period from                    to

Commission File Number 0-19371

Registrant’s telephone number, including area code: (817) 605-5300

     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 report(s), and (2) has been subject to such filing requirements for the past 90 days. Yes   þ   No o

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes o No   þ

     As of April 30, 2003, the registrant had outstanding 5,852,593 shares of Common Stock, $0.001 par value.

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PHARMCHEM, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

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PART I. Financial Information

Item 1. Condensed Consolidated Financial Statements

     The condensed consolidated financial statements of PharmChem, Inc. (the “Company”) included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that the condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2002 included in the Company’s Annual Report on Form 10-K.

     These financial statements have been prepared in all material respects in conformity with the standards of accounting measurements set forth in Accounting Principles Board Opinion No. 28, “Interim Financial Reporting,” and the rules and regulations as specified by the Securities and Exchange Commission and reflect all adjustments, consisting only of normal recurring adjustments which, in the opinion of management, are necessary to summarize fairly our consolidated financial position and the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of the results to be expected for the full year.

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except par value)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(In thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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PHARMCHEM, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation, General and Business

     PharmChem, Inc. (the “Company”) is a leading independent laboratory that provides integrated drug testing services. Our customers include private and public employers, criminal justice agencies and drug treatment programs in the United States who seek to detect and deter the use of illegal drugs and alcohol. The consolidated financial statements include the accounts of PharmChem and Medscreen Limited (“Medscreen”), a United Kingdom company. Medscreen was sold on March 25, 2002 and, as a result, is presented as discontinued operations in the accompanying financial statements for all periods presented. Medscreen’s financial statements were translated based on the month-end spot rate for the balance sheets and a weighted average of the spot rates for the statements of operations.

     The accompanying condensed consolidated financial statements are prepared in accordance with the instructions to Form 10-Q, are unaudited and do not include all the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. We have made certain reclassifications to prior year amounts to conform to current year presentation. All adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim periods have been made and are of a recurring nature unless otherwise disclosed herein. The results of operations for such interim periods are not necessarily indicative of results of operations for a full year.

     In the first quarter of 2002, we implemented Financial Accounting Standards Board Statement No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 requires goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. This Statement further requires intangible assets with definite useful lives to be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As permitted by SFAS 142, we implemented the impairment provisions in the second quarter of 2002. On an ongoing basis, the amortization of goodwill noted in the Condensed Consolidated Statements of Operations was eliminated beginning January 1, 2002.

Stock Based-Compensation

     In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS No. 123.” This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of

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accounting for stock-based employee compensation and the effect of the method used on reported results. We continue to account for stock-based compensation using Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and have not adopted the recognition provisions of SFAS No. 123, as amended by SFAS No. 148. However, we have adopted the disclosure provisions for the current fiscal year. The exercise price of options granted under our stock option plans is equal to the market price of our stock on the date of grant. Therefore, we have not recorded compensation cost under APB No. 25.

     We continue to apply APB No. 25 in accounting for our stock-based compensation plans. Accordingly, no compensation cost has been recorded in the consolidated statements of operations for the stock option plans. If we had determined compensation cost for all of our stock based compensation plans in accordance with the fair value method prescribed by SFAS No. 123, our proforma net income (loss) and income (loss) per share for the three months ended March 31 would have been as follows (in thousands, except per share amounts):

2. Discontinued Operations

     On March 25, 2002, we completed the sale of Medscreen for approximately $10.0 million. In connection with the sale, Medscreen’s two loan facilities totaling approximately $1,663,000 were fully repaid. Closing and other settlement costs totaled approximately $324,000 and approximately $929,000 was used to repay a portion of our revolving line of credit. In April 2002, we fully repaid the term loan ($989,000) with our primary bank.

     Net sales of the discontinued operations were $1,786,000 for the three months ended March 31, 2002. We recorded a gain on the sale of Medscreen of $4,277,000, or $0.73 per share.

3. Net Income (Loss) per Share

     We compute and disclose our income (loss) per share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” which requires the presentation of basic and diluted income per share. Basic income (loss) per share is calculated using the weighted average number of common shares outstanding during the period. Diluted income per share is calculated using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares represent shares issuable upon the exercise of outstanding options and warrants and are calculated using the treasury stock method.

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     Options and warrants to purchase 1,155,000 and 1,132,000 shares of our common stock for the three months ended March 31, 2003 and 2002, respectively, were not included in the computation of diluted income per share because their effect would have been anti-dilutive.

4. Inventory

     Inventory includes laboratory materials, collection materials and products and is stated at the lower of cost or market. Cost is determined using standard costs, including freight, that approximate actual costs on a first-in, first-out basis. Inventory consisted of the following at March 31, 2003 and December 31, 2002 (in thousands):

5. Debt

     Our debt at March 31, 2003 and December 31, 2002 consisted of the following (in thousands):

          On July 31, 2002, the Company entered into a Second Amended and Restated Loan and Security Agreement (the “Agreement”) with its principal lender whereby the line of credit is $4,250,000, the maturity date is June 30, 2003, interest is at the prime rate plus one-half percent (4.75% as of March 31, 2003), and the annual fee is 0.10% of the credit line, payable quarterly. The July 31, 2002 Agreement permits borrowings on eligible receivables up to 85% thereof and is secured by a lien on a significant portion of our assets. It also permits up to $2,000,000 of the revolving line of credit to be used to repurchase our common stock under our common stock repurchase program and permits the declaration and distribution of a dividend in connection with our stockholder rights plan.

     As of March 31, 2003, the calculated maximum that could be borrowed and the amount outstanding were $3,164,643 and $3,129,147 respectively. We were in compliance with all covenants as of March 31, 2003, except for the 2003 profitability covenant for which we are discussing a waiver from the lender. In addition, the Company is currently negotiating a new line of credit to replace its existing credit agreement.

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6. Restructuring Charge

     During the second quarter of 2001, our Board of Directors approved a plan to close our Menlo Park, California corporate headquarters, main laboratory and distribution center and relocate these operations to Texas. These expenses were accrued and recorded in continuing operations for the three months ended June 30, 2001. Detail of the payment activity and ending accrual balance related to the restructuring is presented in the following table (in thousands):

     The restructuring plan was designed to provide for costs associated with leaving our facilities in Menlo Park, California. The restructuring expenses represent estimated and actual costs related to workforce reductions, clean-up, repairs and legal services. As part of the workforce reduction, we recorded severance and related fringe benefits costs for approximately 160 employees from operations and administration, of which 157 employees were terminated as of March 31, 2003. The clean-up and remediation includes removal of a previously unknown storage vault and potential restoration of the facility per the lease agreement. Repairs expense includes sewer line repair or replacement as contractually provided for in the lease agreement. The accrual balance of $229,000 is classified as a component in “Accrued collectors and other liabilities” on the balance sheet. Costs for relocation were expensed as incurred.

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     On September 19, 2002, the Company’s attorneys received a letter from counsel for the landlord of the Company’s former Menlo Park, California facility claiming damages in the amount of $4.7 million. This amount is based primarily on the landlord’s claim for lost and reduced rent arising from the Company’s alleged failure to vacate the Menlo Park premises timely under the terms of the lease. On April 30, 2003, the Company’s attorneys received a second letter together with a draft complaint from the landlord’s counsel reiterating these allegations and requesting that the parties meet and confer to resolve the matter; otherwise the complaint will be filed. The Company and its counsel are continuing to review the details of this claim and the Company will defend itself vigorously.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

     “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933, which are subject to the “safe harbor” created by these Sections. Our actual future results could differ materially from those projected in the forward-looking statements. Some factors which could cause future actual results to differ materially from our recent results and those projected in the forward-looking statements are described in our Annual Report on Form 10-K for the year ended December 31, 2002. We assume no obligation to update the forward-looking statements or such factors.

Recent Events

     The Company has not been in compliance with the $1.00 minimum bid price as required for listing on the Nasdaq SmallCap Market. The Company has since been granted a waiver until July 7, 2003 to comply with this rule. In addition,–the Company’s common stock has not maintained a minimum market value of publicly held shares of $1 million as required for inclusion by Marketplace Rule 4310(c)(7). The Company has until May 21, 2003 to attain this minimum for ten consecutive trading days. Otherwise, the Company’s securities will be delisted. At that time, the Company may appeal to a Listing Qualifications Panel.

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Critical Accounting Policies and Estimates

     The discussion and analysis of our financial condition and results of operations are based upon PharmChem’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to bad debts, inventories, goodwill, restructuring accruals, contingencies, revenue recognition, specimen collector accruals and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     PharmChem believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of the consolidated financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We estimate the quantity and value of our unused specimen collection kit inventory existing at our customer and contract specimen collector field locations using a model that considers actual shipments to these locations, specimens returned to our laboratory for processing, replacement costs and estimates of shrinkage. If the estimated value of this inventory decreases beyond our expectations of recovery, additional inventory write-downs may be required.

     Continued adverse changes in market conditions or poor operating results of our operations could result in additional losses or an inability to recover the carrying value of the related goodwill, thereby possibly requiring an impairment charge in the future. Revenue is recognized upon the communication of results from laboratory analysis of specimens submitted by our customers, at the time of shipment for products and at the completion of rendered services. We accrue expected payments to specimen collectors who perform specimen collection services on behalf of our managed customers. The specimen collector accrual calculation is based on a combination of our reporting of results from laboratory analysis of specimens and cost information maintained in our internal systems for each specimen collector. We include in the accrual estimates of retroactive rate increases and services performed but not reported to customers.

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Results of Operations

     Refer to Note 2, “Discontinued Operations”, to the accompanying Notes to Condensed Consolidated Financial Statements for further information on the sale of Medscreen in March 2002. The following table sets forth for the periods indicated certain financial data (dollars in thousands):

     Net sales for the three months ended March 31, 2003 were $6,335,000, a decrease of $1,141,000 (15.3%) from last year’s first quarter sales of $7,476,000. In this year’s first quarter, laboratory specimen volume fell by 20.8% from the same period a year ago. Overall, laboratory analysis sales were down by $1,116,000 (18.1%), with workplace lower by $536,000 (23.9%) and criminal justice by $616,000 (15.8%). The continued slowdown in pre-employment testing by workplace customers, resulting from the stagnant economy, and a drop in most governmental testing due to budgetary constraints, have both adversely impacted the Company’s revenues. The lower specimen volume was also affected by severe weather in the east and midwest. Product and other sales were down by only $25,000 (1.9%) from the same period last year. Average selling prices for laboratory analyses were up in all customer categories, primarily due to a change of customer mix.

     Cost of sales for the three months ended March 31, 2003 was $5,125,000 (80.9% of net sales), a decrease of $543,000 (9.6%) from last year’s first quarter cost of sales of $5,668,000 (75.8% of net sales). Decreases in labor, inventory usages, transportation and collection service fees were in line with the

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decreased number of specimens processed in the first quarter. Fixed costs increased by $143,000, caused mainly by an increase in depreciation expense on newly developed software and higher business insurance expense. Accordingly, gross profit as a percentage of sales decreased to 19.1% from 24.2% in the prior year.

     Selling, General & Administrative (SG&A) expenses for the three months ended March 31, 2003 decreased $215,000 (10.7%) to $1,798,000 in 2003 from $2,013,000 in 2002. Sales and marketing expense was lower by $179,000, consisting of lower bad debt expense of $83,000, lower payroll cost of $60,000 and reduced spending on promotions and advertising. Research and development costs were lower by $38,000 in the first quarter as compared to last year.

     Discontinued Operations for the three months ended March 31, 2002 generated income of $359,000, or $0.06 per diluted share. There were no discontinued operations in the first quarter of 2003.

     Net loss from continuing operations for the three months ended March 31, 2003 was $733,000 or $0.13 per share compared to a net loss of $310,000 or $0.05 per share in 2002. The net income in 2002, after the inclusion of income from discontinued operations, was $4,326,000, or $0.74 per share. The gain on the sale of Medscreen was $4,277,000, net of tax effect of $1,116,000.

Liquidity and Capital Resources

     Our continuing operations during the three-month periods ended March 31 used cash of $612,000 and provided cash of $481,000 in 2003 and 2002, respectively. The decrease in cash flow from operations between 2003 and 2002 reflects a larger loss from continuing operations in 2003. Days sales outstanding at the end of the first quarter 2003 was 58 days compared to 64 days at the end of March 2002. Decreases in accounts payable and related accruals in the first quarter of both years reflect the declining business volume and ongoing cost containment measures. As of March 31, 2003, we had $2,417,000 in unrestricted cash and cash equivalents, and $500,000 in restricted cash. During the three months ended March 31, 2003, we used approximately $156,000 in cash to purchase property and equipment, principally for information systems development.

     On July 31, 2002, the Company entered into a Second Amended and Restated Loan and Security Agreement (the “Agreement”) with its principal lender whereby the line of credit is $4,250,000, the maturity date is June 30, 2003, interest is at the prime rate plus one-half percent (4.75% as of March 31, 2003), and the annual fee is 0.10% of the credit line, payable quarterly. The July 31, 2002 Agreement permits borrowings on eligible receivables up to 85% thereof and is secured by a lien on a significant portion of our assets. It permits up to $2,000,000 of the revolving line of credit to be used to repurchase our common stock under our common stock repurchase program and permits the declaration and distribution of a dividend in connection with our stockholder rights plan.

     As of March 31, 2003, the calculated maximum that could be borrowed was $3,164,643 and the amount outstanding was $3,129,147. We were in compliance with all covenants as of March 31, 2003, except for the 2003 profitability covenant for which we are discussing a waiver from the lender. In addition, the Company is currently negotiating a new line of credit to replace its existing credit agreement.

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     We anticipate the existing cash balances, amounts available under existing and future credit agreements and funds to be generated from future operations will be sufficient to fund operations and forecasted capital expenditures for the next twelve months.

Impact of Recent Accounting Pronouncements

     In June 2001, the FASB issued Statement No. 143 (SFAS 143), “Accounting for Asset Retirement Obligations.” SFAS 143 requires liability recognition for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. We adopted the provisions of SFAS 143 effective January 1, 2003. The adoption of this standard did not have a material effect on our consolidated financial position or results of operations.

     In November 2002, the FASB issued FASB Interpretation No. 45 (FIN45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees. FIN 45 also requires disclosure about certain guarantees that an entity has issued. The Company has implemented the disclosure requirements required by FIN 45, which were effective for fiscal years ending after December 15, 2002. The Company will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The Company does not expect FIN 45 to have a material effect on its financial condition and results of operations.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

     We are subject to market risk with respect to our debt outstanding. Our revolving credit agreement carries interest at the prime rate plus 0.50%. As the prime rate increases, we will incur higher relative interest expense and similarly, a decrease in the prime rate will reduce relative interest expense. A 1.0% change in the prime rate would not materially change interest expense assuming levels of debt consistent with historical amounts. The market risks are not considered significant and, therefore, we do not intend to engage in significant hedging transactions.

Item 4. Controls and Procedures

     Within the 90 days prior to the date of this report, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us required to be included in our periodic SEC filings. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation.

PART II. Other Information

Item 6. Exhibits and Reports on Form 8-K

(a)      Exhibits:

			(b)      Reports on Form 8-K:
			Press release reporting 2002 financial results issued on Form 8-K, dated March 20, 2003.

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Signature

     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.

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Joseph W. Halligan, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of PharmChem, Inc.;

2.     Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.     Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.     The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

			a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
			b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
			c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.     The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

			a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
			b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.     The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, David A. Lattanzio, certify that:

1.     I have reviewed this quarterly report on Form 10-Q of PharmChem, Inc.;

2.     Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.     Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.     The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

			a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
			b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
			c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.     The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

			a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
			b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.     The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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EXHIBIT INDEX