Back to GetFilings.com
1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998; OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NO. 0-22623
OCULAR SCIENCES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 94-2985696
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
475 ECCLES AVENUE 94080
SOUTH SAN FRANCISCO, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (650) 583-1400
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $0.001 PER SHARE
(TITLE OF CLASS)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based upon the closing sale price of the Registrant's Common
Stock on March 1, 1999 ($25.25) as reported on the Nasdaq National Market, was
approximately $389,485,618.20.
As of Monday, March 1, 1999, Registrant had outstanding 22,626,855 shares
of Common Stock.
Part III incorporates by reference from the Registrant's definitive Proxy
Statement for its 1999 Annual Meeting of Stockholders to be filed with the
Commission not later than 120 days after the end of the fiscal year covered by
this Form 10-K.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2
OCULAR SCIENCES, INC.
1998 FORM 10-K
TABLE OF CONTENTS
PAGE
----
PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 29
Item 3. Legal Proceedings........................................... 30
Item 4. Submission of Matters to a Vote of Security Holders......... 30
PART II
Item 5. Market for the Registrant's Common Equity and Related Stock
Holder Matters.............................................. 30
Item 6. Selected Consolidated Financial Data........................ 32
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 34
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 43
Item 8. Financial Statements and Supplementary Data................. 44
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 66
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 66
Item 11. Executive Compensation...................................... 66
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 66
Item 13. Certain Relationships and Related Transactions.............. 66
PART IV
Item 14. Exhibits, Financial Statement Schedule and Reports on Form
8-K......................................................... 66
Signatures............................................................. 70
Index to Exhibits......................................................
This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
and Section 27A of the Securities Act of 1933, as amended. These statements
involve risks and uncertainties, including the impact of intense competition,
risks of expansion and automation of manufacturing facilities, risks of trade
practice litigation, fluctuations in operating results, risks of international
operations, the management of growth and the other risks discussed in the
sections entitled "Item 1, Business -- Risk Factors" and "Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
elsewhere in this Annual Report on Form 10-K. The actual results that the
Company achieves may differ materially from the results discussed or implied in
such forward-looking statements due to such risks and uncertainties. Words such
as "believes," "anticipates," expects," future," "intends," "may" and similar
expressions are intended to identify forward-looking statements, but are not the
exclusive means of identifying such statements. The Company undertakes no
obligation to revise any of these forward-looking statements.
i
3
PART I
ITEM 1. BUSINESS
Ocular Sciences, Inc. (the "Company") is a rapidly growing manufacturer and
marketer of soft contact lenses. The Company manufactures a broad line of soft
contact lenses marketed for annual and disposable replacement regimens. The
Company believes that its lens designs provide wearers with a higher level of
comfort and greater ease of handling than those of its leading competitors. The
Company's manufacturing technologies permit consistent, cost-effective
reproduction of these designs, allowing the Company to offer its lenses at
competitive prices. In addition, the Company has implemented marketing
strategies designed to assist eyecare practitioners, both in independent
practice and in retail chains, in retaining their patients and monitoring their
patients' ocular health. These strategies provide a significant incentive for
practitioners to prescribe the Company's lenses. Furthermore, the Company has
continuously focused on lowering its non-manufacturing costs, or
"cost-to-serve," enabling it to increase its profitability and its flexibility
to reduce prices. To minimize its cost-to-serve, the Company utilizes a
telemarketing sales force and directs its marketing efforts toward eyecare
practitioners rather than consumers.
The Company believes that practitioners can increase their patient
retention and provide better ongoing patient care by providing
competitively-priced, high-quality products that are differentiated by brand
from those offered by competing distribution channels. Accordingly, the Company
has successfully implemented a strategy to address the needs of eyecare
practitioners. The Company markets its lenses solely to eyecare practitioners,
both in private practice and in retail optical chains, rather than to consumers.
The Company believes that focusing on the eyecare practitioner, who
significantly influences the selection of the brand of contact lenses worn by
the patient, is critical to its ability to market contact lenses successfully.
The Company does not sell to mail-order companies, pharmacies or other
distribution channels that do not provide the regular eye examinations necessary
to maintain overall ocular health.
Over the last five years, the Company has established itself as a leader in
the spherical annual replacement segment of the United States market with a
market share estimated at approximately 21% in the fourth quarter of 1998, based
on unit sales. Since its introduction of lenses marketed for weekly disposable
replacement regimens in 1993, the Company has steadily increased its share of
this growing market, reaching approximately 16% of total unit sales in the
United States during the fourth quarter of 1998, based on data published by the
Contact Lens Institute, an industry trade organization. The Company's overall
unit sales have increased at a compound annual growth rate of approximately 60%
from 1994 to 1998, primarily due to increased sales of its lenses marketed for
weekly disposable replacement regimens. During the same period, while the
overall average selling prices of all of the Company's lenses declined
approximately 48%, the Company reduced its per unit production costs by
approximately 53% by spreading its relatively fixed manufacturing and operating
costs over higher production volumes, and by improving its manufacturing and
packaging processes. As a result, from 1994 to 1998, the Company's net sales and
operating income have increased at compound annual growth rates of approximately
33% and 49%, respectively, while its operating margins have improved from 17.4%
to 27.5%.
INDUSTRY OVERVIEW
The soft contact lens industry is characterized by increasing lens
consumption declining unit prices and intense competition among the eyecare
practitioners and retail chains that fit, prescribe and sell contact lenses.
Industry analysts estimate that approximately 50% of the world's population
needs some type of vision correction. In the United States alone, over 130
million people require some form of vision correction. Approximately 26 million
people in the United States, or 20% of those requiring vision correction, wear
contact lenses according to estimates by industry analysts, making the United
States the world's largest market for contact lenses. While contact lenses have
been available for decades, the advent of soft lenses in 1971 changed the
industry substantially and stimulated significant penetration of the eyeglass
market by dramatically reducing the discomfort of earlier rigid lenses.
The first soft contact lenses were generally prescribed for replacement
every one to two years. Although they were significantly more comfortable than
hard contact lenses, they required an extensive cleaning routine,
1
4
consisting of daily cleaning with a surfactant cleanser and an additional weekly
enzymatic cleaning to reduce protein accumulation. Even with this cleaning
program, these lenses often became progressively less comfortable to wear over
time. Additionally, the long replacement schedule of the lenses increased the
likelihood of ocular health problems if the wearer did not follow the required
cleaning program. In response to these and other factors, soft contact lenses
marketed for disposable replacement regimens were introduced in 1988. These
replacement regimens, in which lenses are to be replaced daily, weekly or
monthly, have spurred a rapid increase in contact lens consumption in the United
States. While contact lenses marketed for disposable replacement regimens are
often made from the same or similar polymers and can have the same or similar
designs as lenses marketed for annual replacement regimens, they are generally
produced at substantially higher volumes, sold in larger quantities and packaged
in less expensive materials. These factors allow the lenses to be sold at
substantially reduced per unit prices, making more frequent lens replacement
economically feasible for the consumer.
Largely as a result of this increased frequency of lens replacement, the
number of soft contact lenses sold in the United States has increased at a
compound annual growth rate of approximately 18% from 1994 through 1998,
according to the Contact Lens Institute. This increase in unit sales has
provided increased manufacturing economies of scale that, together with
increased competition in distribution channels, has led to significant
reductions in average retail prices per unit. The Company believes that this, in
turn, has led to further increases in lens consumption. Despite the decline in
per unit prices, as wearers switch to more frequent replacement regimens, their
annual expenditures for lenses increase. For example, the Company's annual sales
are from five to seven times higher for a wearer following a bi-weekly
replacement regimen than they are for a wearer following an annual replacement
regimen. As a result, total dollar sales of contact lenses in the U.S. have
increased at a compound annual growth rate of approximately 9% per year from
1994 through 1998. The Company believes that the United States market for
contact lenses will continue to grow, although at a slower rate, as wearers
continue to shift towards more frequent lens replacement regimens. In addition,
according to industry studies, while the United States and Canadian market
represented approximately 50% of worldwide contact lens unit sales volumes in
1996, market growth rates outside the United States now exceed those in the
United States. The Company believes that international contact lens sales will
continue to increase as low-priced contact lenses become increasingly available
in many international markets.
Most contact lenses are purchased from optometrists, either in private
practice or in retail chains, and from ophthalmologists in private practice. The
Company believes, based on a 1994 study sponsored by the American Academy of
Ophthalmology and management's experience in the eyecare industry, that the
eyecare profession suffers from a surplus of eyecare practitioners and believes
that the resulting competitive pressure has been exacerbated by the increased
prevalence of retail optical chains and mass merchandisers that provide eyecare
services. Eyecare practitioners in retail chains offer services and products
similar to those provided by practitioners in private practice but offer longer
hours in more convenient locations, such as shopping malls and other
high-traffic areas. Retail chains generally require higher patient volumes and
accordingly rely heavily on consumer advertising and promotional pricing to
generate sales. Consequently, the Company believes that competition to acquire
and retain patients has intensified.
The typical eyecare practitioner in both the private practice and retail
chain channels depends heavily on sales of products, such as contact lenses and
eyeglasses. The Company believes, based on a 1996 industry survey, that the
typical optometric practice or retail optical chain realizes approximately
two-thirds of its revenue from sales of corrective products, such as contact
lenses and eyeglasses, and approximately one-third of its revenue from
professional services such as eye examinations. Since the need for vision
correction is chronic, repeat sales of contact lenses can provide the
practitioner with a recurring, predictable revenue base.
While the introduction of disposable lens replacement regimens has led to
growth in the contact lens market, it has placed additional competitive pressure
on practitioners. Traditionally, patients purchased new lenses annually in
connection with their eye examinations. Today, a patient is still required to
see an eyecare practitioner initially to be fitted for contact lenses and to
receive a prescription. After the initial fitting, however, while the patient
may see the practitioner annually to monitor eye health, he or she may purchase
new contact lenses to refill the prescription three or four times per year. Most
patients select contact lenses based on the recommendation of their eyecare
practitioners, and accordingly practitioners have significant
2
5
influence in determining the brands of contact lenses worn by their patients. In
addition, because contact lens prescriptions are generally brand-specific,
patients typically continue to purchase the same brand for their prescription
refills. However, the prescribing practitioner risks losing the recurring sales
represented by prescription refills as nationally advertised lens brands are now
available through virtually every possible channel of distribution, including
mail-order companies and pharmacies.
The Company believes that practitioners can increase their patient
retention and provide better ongoing patient care by providing
competitively-priced, high-quality products that are differentiated by brand
from those offered by competing distribution channels. As a result, the Company
believes that there exist significant opportunities for manufacturers of contact
lenses that can effectively address these needs. Moreover, the Company believes
that the increased frequency of lens purchases resulting from the shift to
disposable replacement regimens can provide significant recurring revenues for
manufacturers that are able to produce and distribute large quantities of
high-quality lenses on a cost-effective basis.
STRATEGY
The Company has successfully implemented a strategy based on addressing the
needs of eyecare practitioners. The principal elements of the Company's strategy
include:
Produce Superior Performing Products. The Company believes that its contact
lenses are superior in performance to those of its major competitors in terms of
comfort and ease of handling. The Company's advanced dry cast molding process
and sophisticated lens designs maximize wearers' comfort and improve shape
retention of lenses, making them easier for wearers to handle. In addition, the
Company's lenses are designed and manufactured to provide fitting
characteristics similar to competitors' lenses. In general, this
interchangeability enables the practitioner to switch a patient to the Company's
lenses without extensive refitting time. These advantages enable the Company to
market its lenses to eyecare practitioners for both existing, as well as new,
contact lens wearers.
Employ Brand Segmentation by Channel. The high-volume use of lenses
marketed for disposable replacement regimens has resulted in increased
mass-market advertising of competing products and intensified competition across
distribution channels. Unlike its larger competitors, which promote nationally
advertised consumer brands across multiple distribution channels, the Company
advertises and promotes its lenses marketed for disposable replacement regimens
under specific brand names for the private practice channel and other brand
names for the retail chain channel. The Company also provides private label
brands for its larger customers. Branding by distribution channel creates brand
exclusivity and allows practitioners to differentiate lenses sold by them from
those sold through competing channels, providing them with a greater ability to
retain their patients' prescription refill business. The Company believes that,
as a result, its channel-specific branding has become increasingly valuable to
eyecare practitioners. By promoting the repeat purchase of lenses from the
prescribing practitioner, the Company believes that its marketing strategies
increase patient satisfaction and thereby encourage long-term loyalty to its
products, while also motivating practitioners to prescribe its lenses.
Expand Internationally Through Strategic Relationships. The Company
believes that many international markets for soft contact lenses will grow at
faster rates than the United States market and that this growth will be driven
by increased availability of low-priced lenses marketed for disposable
replacement regimens in developed markets such as Europe, Japan and Canada and
by increased disposable income in emerging markets in Asia and Latin America.
However, many markets outside the United States do not have the level of demand
necessary for local manufacturers to achieve the economies of scale required for
low-cost lens production. Consistent with its strategy of minimizing
cost-to-serve, the Company's primary international growth strategy is to
establish strategic distribution and marketing relationships with regional
optical companies, such as the contact lens division of Carl Zeiss Company
("Zeiss") in Europe and Seiko Contactlens, Inc. ("Seiko") in Japan, to
capitalize on their existing market presence, customer relationships and local
infrastructure. In early 1999, Seiko received approval to sell certain of the
Company's contact lenses marketed for daily and weekly replacement regimens in
Japan. The Company has also established distribution relationships with other
soft contact lens distributors in a number of other countries throughout the
world. The
3
6
Company believes that, as a result, it can target growing international markets
effectively without significant investment in direct operations.
Emphasize Low-Cost Efficient Manufacturing. With the growth of the
high-volume disposable market segment, low-cost, scaleable manufacturing has
become increasingly important. The Company's dry cast molding technology allows
it to manufacture high-quality lenses efficiently. As a result, the Company has
been able to reduce its per unit production costs by approximately 53% over the
last five years while increasing its production volumes by approximately 489%.
The Company is currently implementing highly automated production lines in its
U.K. manufacturing facility and plans to relocate its Puerto Rican manufacturing
operations to a substantially larger new facility, which is expected to also
include these highly automated production lines, in the 1999 - 2000 time period.
The Company believes that the increased unit volumes resulting from the growing
disposable replacement market and this continued investment in automation and
capacity will enable it to further reduce per unit production costs and increase
production volumes.
Minimize Cost-to-Serve. A substantial portion of the Company's costs
consists of the costs required to sell and market lenses and to take and fill an
order. The Company focuses on lowering these non-manufacturing costs, or
"cost-to-serve," in order to increase its profitability and its flexibility to
reduce prices. The Company's primary means of minimizing cost-to-serve are its
use of telemarketing rather than a traditional direct sales organization and its
use of advertising targeted to practitioners rather than to consumers. This
strategy differentiates the Company from its competitors, and the Company
believes that the cost of its average sales call is substantially lower than
that of its competitors that rely on field sales representatives, as the
Company's inside sales personnel can make more calls per day at a lower annual
cost per salesperson. Unlike its leading competitors, which market their
products to consumers through expensive mass-media campaigns, the Company
further controls its operating expenses by directing its marketing solely to the
eyecare practitioners who prescribe contact lenses. In addition, the Company
continues to invest in increased automation in its distribution operations in
order to maintain its low cost-to-serve.
Focus Marketing on Eyecare Practitioners. The Company's sales and marketing
efforts are directed at eyecare practitioners because the practitioner strongly
influences the brand of lenses purchased by the patient. The Company advertises
and promotes its products solely to practitioners rather than to consumers. In
addition, the Company does not sell its lenses to mail-order companies,
pharmacies and other distribution channels that do not provide the eyecare
services necessary to confirm lens fit and monitor ocular health. By bar-coding
each unit shipped for disposable replacement regimens, the Company can identify
diversion of its lenses to non-eyecare practitioner channels. The Company
structures its branding and marketing strategies so that the patient will be
more likely to refill prescriptions from the practitioner or retail chain from
whom he or she received the initial prescription. As a result, the Company
believes that it assists eyecare practitioners in retaining patient reorders and
improves practitioners' ability to monitor their patients' ongoing ocular
health, thereby providing a significant incentive for practitioners to prescribe
the Company's lenses.
PRODUCTS
The Company manufactures a broad line of soft contact lenses that it
believes provide superior performance to other leading products at competitive
prices. Soft contact lens performance is defined primarily by comfort (how the
lens feels on the eye), handling (ease of placement and removal), acuity of
vision and physiological response. These qualities, in turn, are determined
primarily by lens design and the manufacturing process. The Company's lenses
incorporate sophisticated designs, including extremely thin edges, a
lenticulated carrier and a low-edge apex, that provide a high level of comfort,
enhanced shape retention and ease of handling. The Company's dry cast molding
process further improves handling and comfort by consistently and accurately
reproducing these designs. In addition, the Company's lenses are designed and
manufactured to provide fitting characteristics similar to those of competitors'
lenses. In general, these characteristics enable the practitioner to switch a
patient to the Company's lenses without extensive refitting time. The Company
believes that this, together with its lenses' performance and price, allows
practitioners to easily prescribe the Company's lenses to existing, as well as
new, contact lens wearers.
4
7
The Company's contact lenses are made from flexible polymers containing 38%
or 55% water. The Company offers different brands for different replacement
regimens, from weekly and monthly replacement (and recently daily replacement in
Japan) to annual replacement. A wearer's replacement regimen is generally based
on the recommendation of his or her eyecare practitioner, who typically
prescribes a lens brand targeted to that regimen and who advises the wearer on
the appropriate lens care procedures for that regimen. However, the wearer may
actually replace his or her lenses on a more or less frequent basis. Given the
basic functional similarity of lenses marketed for different replacement
regimens, many of the Company's lenses marketed for annual and disposable
replacement regimens are made from the same or similar polymers and have the
same or similar design specifications. Most of the Company's lenses contain a
light blue bulk-applied visibility tint that enables the wearer to see and
handle the lenses more easily, although some of the Company's more expensive
lenses marketed for annual replacement contain a more expensive, individually
applied masked tint that improves handling and is less noticeable in the eye,
and some of the Company's lenses are untinted. In addition, some of the
Company's lenses marketed in Europe contain an ultraviolet absorber and the
Company is considering including such feature in some lenses sold in the U.S. in
the future. The Company's lenses marketed for disposable and annual replacement
regimens are generally packaged in different quantities and priced differently.
See "-- Risk Factors -- Risk of Trade Practice Litigation; Changes in Trade
Practices."
Within different replacement regimens, the Company offers daily-wear
lenses, to be removed, cleaned and disinfected each night, and extended-wear
lenses that may be worn continuously, night and day, for up to seven days. In
addition, within each replacement regimen, the Company offers lenses having
different design parameters, diameters and base curves to enable practitioners
to fit their patients better.
DISPOSABLE REPLACEMENT REGIMENS
Lenses marketed for disposable replacement regimens accounted for 84.7% of
the Company's net sales in 1998. See "-- Risk Factors -- Dependence on Single
Product Line; Need to Increase Sales of Lenses for Disposable Replacement
Regimens."
Weekly Replacement Regimens. The Company entered the growing weekly
disposable segment of the soft contact lens market with a 38% water content lens
in September 1993. The Company's introduction of a 55% water content lens in the
first quarter of 1995 provided a product directly competitive with the market
leader, Acuvue, which was the first soft contact lens to be marketed broadly in
the United States for weekly replacement. These lenses are marketed for
replacement every one to two weeks. The Company believes that its 55% water
lenses marketed for weekly replacement can provide handling and comfort superior
to that provided by Acuvue, at a competitive price. The design and water content
of the 55% water lens permit a high level of oxygen transmissibility and provide
increased comfort for overnight wear. A May 1998 independent study comparing the
Company's 55% water lens marketed for weekly replacement to a wide variety of
competing contact lens brands, including Acuvue, found that a substantial
majority of the 289 patients studied preferred the Company's lens for ease of
use and comfort. This study reported that overall, 86% of these patients
preferred the Company's lens over their habitual lens. The Company believes that
its lenses marketed for weekly replacement regimens have demonstrated strong
market acceptance, gaining U.S. market share steadily since their introduction
and representing approximately 16% of total unit sales in the weekly disposable
market segment in the United States in the fourth quarter of 1998. The Company
sells its lenses marketed for weekly disposal to independent practitioners under
the Hydron Biomedics, Clinasoft, Procon Softview, Flexvue and Mediflex brands
and to retail chains under the UltraFlex 7/14 brand and private label brands.
The Company packages its lenses for weekly replacement in boxes, each containing
six identical blister-packed lenses.
Monthly Replacement Regimens (Planned Replacement Lenses). The Company's
lenses marketed for monthly replacement regimens are sold primarily under the
Hydron ProActive 55, Edge III ProActive and UltraFlex SmartChoice brands. These
lenses are marketed for replacement every one to three months. This replacement
regimen provides a lower cost alternative to weekly replacement.
5
8
Daily Replacement Regimens (Recently Introduced). The Company has recently
introduced a low-priced lens to be marketed for daily replacement in Japan. The
Company expects to introduce a lens marketed for daily disposal in Europe in
1999 and is evaluating introduction of such a product in the United States. The
product would be packaged in boxes of 30 or more lenses. The Company believes
that there may be substantial demand for the convenience of a lens for
single-day wear. However, the Company believes that the level of demand for
lenses marketed for daily disposal is still uncertain. Certain of the Company's
competitors, including the Vistakon division of Johnson & Johnson ("Johnson &
Johnson") and, more recently, the Ciba Vision division of Novartis ("Ciba"),
have introduced, and certain others plan to introduce, lower-priced lenses
marketed for daily replacement in the United States. The Company intends to
evaluate the market response to competitors' offerings, as well as the response
to its own lenses marketed for daily disposal in Europe and Japan, before
introducing its own lens marketed for daily disposal in the United States. In
addition, because of the substantially greater volume requirements and lower
selling prices that the Company believes will be required to support daily
replacement, the Company does not intend to offer lenses for this replacement
regimen in the United States until it has significantly increased its
manufacturing capacity and decreased its per unit production costs. See "-- Risk
Factors -- Intense Competition" and "-- Risk Factors -- Manufacturing Capacity
Constraints; Risks Associated with Expansion and Automation of Manufacturing
Operations."
ANNUAL REPLACEMENT REGIMENS
The Company is a leading provider of soft lenses marketed for annual
replacement regimens in the United States. Lenses marketed for annual
replacement regimens accounted for 14% of the Company's net sales in 1998. These
lenses must be cleaned nightly, with an additional weekly enzymatic cleaning to
reduce protein accumulation. Patients generally wear these lenses until they
become dirty or uncomfortable (usually a year for 38% water products and about
nine months for 55% water products). The Company markets its lenses for annual
replacement regimens primarily under three brand names, Edge III, UltraFlex and
Hydron. These product lines include a number of lens designs to allow
practitioners to choose the lens that best meets their patients' needs. Under
both the Edge III and UltraFlex brands, the Company offers a low-priced,
daily-wear product, a thinner product, a product that is both thinner and larger
in diameter and a product that may be utilized as an extended-wear lens. The
Company packages its lenses marketed for annual replacement regimens in
single-lens vials or blister packs.
SPECIALTY LENSES
Specialty lenses accounted for 1.3% of the Company's net sales in 1998.
Toric lenses are designed to correct vision for people with astigmatism, which
is characterized by an irregularly shaped cornea. The Company offers daily-wear
toric lenses under the Ultra T brand that are manufactured for the Company by a
third party. Bifocal contact lenses can help to correct presbyopia, or
age-related difficulty in focusing on near objects. The Company offers
daily-wear bifocal lenses under the Echelon brand that are cast-molded by the
Company. In addition, the Company produces its Versa-Scribe tinted lenses, sold
in blue, aqua and green, to enhance the color of the eye.
SALES AND MARKETING
In the United States and the United Kingdom, the Company's products are
sold primarily by its 66-person inside sales force (as of December 31, 1998),
based in South San Francisco and the United Kingdom. In order to maintain a low
cost-to-serve, the Company has utilized an inside sales force since its
inception. This inside sales force relies on telemarketing to sell the Company's
products to practitioners, both in independent practice and retail chains. With
over 40,000 practitioners in the United States, the Company believes that this
market can be reached effectively and frequently through telemarketing,
mailings, trade journals and trade shows, at a relatively low cost. The
Company's inside sales personnel can make presentations to a significantly
greater number of practitioners per day than the traditional field sales
representatives used by the Company's principal competitors, at a lower annual
cost per salesperson. The
6
9
Company believes that this sales efficiency provides it with a competitive
advantage and contributes to its low cost-to-serve. For larger national
accounts, senior management also frequently makes outside sales calls.
In recruiting its sales personnel, the Company seeks well-educated
candidates who it believes will be capable of both discussing technical
information and developing relationships with practitioners. As part of a
continuing effort to ensure the motivation, professionalism and effectiveness of
its sales representatives, the Company provides each sales representative with
substantial training in a program that was developed by the Company and has been
used since its inception. This program typically includes two weeks of initial
training and at least two hours a week of continuing instruction. This training
emphasizes the development of personal relationships with customers and the
technical aspects of contact lens fitting and design. The Company's current
sales representatives average approximately three years with the Company,
providing a level of experience that the Company believes enables them to work
effectively with optometrists and ophthalmologists. Each salesperson is assisted
by a computer database that maintains each practitioner's profile, monitors
ongoing activities and orders, allows sales personnel to enter information for
follow-up calls and highlights dates for return calls.
The Company also utilizes distributors that resell the Company's contact
lenses primarily to independent practitioners. In 1998, sales through
distributors represented approximately 10% of the Company's United States sales
and a substantial majority of its international sales. The Company believes that
by using distributors, it increases the availability of its lenses to many
practitioners who prefer to utilize a single source for several brands of lenses
and manages the costs involved in numerous small orders. In addition, the
Company utilizes advertising targeted to practitioners, such as direct-mail and
advertisements in professional journals, to generate leads for its inside sales
force. The Company also provides customers with substantial merchandising
allowances and has developed a variety of promotional programs to offer lenses
at significantly reduced prices in order to encourage trial of its products.
As a matter of policy, the Company does not sell lenses to mail-order
companies because to do so would be inconsistent with its strategy of focusing
on the practitioner and because they do not provide the regular eye examinations
necessary to check the fit of the lenses and monitor overall ocular health. To
control the distribution of its lenses marketed for disposable replacement
regimens, the Company places serialized bar-codes on each disposable product box
and blister pack and routinely monitors product availability at mail-order
companies. The Company has a policy of terminating the supply of lenses marketed
for disposable replacement regimens to its customers who are found to have
diverted products to a mail-order company. See "-- Risk Factors -- Risk of Trade
Practice Litigation; Changes in Trade Practices."
In 1998, the Company sold its products to approximately 14,000 independent
practitioner accounts and approximately 90 retail chains. The Company's
customers in each of the past three years have included 19 of the top 20 United
States optical retailers. Fourteen of these top 20 U.S. retailers, as well as
key international corporate accounts such as Synsam in Scandinavia, have
selected the Company's lenses for their private label. America's Best Contacts
and Eyeglasses, Inc., and its affiliates, accounted for approximately 11% of the
Company's net sales in 1998, and the Company's ten largest customers in 1998
represented approximately 25% of the Company's net sales in that year.
Product Branding. The Company has developed many different trademarked
brands for its lenses marketed for disposable replacement regimens. Certain
brands are offered only to independent practitioners. Other brands are offered
only to retail chains. In addition, private label brands are offered to certain
high-volume customers that wish to develop their own brand recognition and
loyalty, and private practitioners (or groups of private practitioners) meeting
certain volume criteria can similarly purchase "semi-exclusive" brands that are
not widely offered to other practitioners in their local market. The Company
believes that this approach differentiates the Company from its leading
competitors, which typically rely heavily on expensive consumer advertising and
promotion of national brands to generate brand awareness and demand. With the
same nationally advertised and promoted brands of lenses marketed for disposable
replacement regimens available in a number of major distribution channels, often
including mail-order companies and pharmacies, patients can bypass their
original eyecare provider when purchasing replacement lenses. By marketing its
lenses under different brands, segmented by distribution channel, the Company
believes that it can assist
7
10
eyecare professionals in retaining their patients and improve patients'
long-term eyecare. See "-- Risk Factors -- Risk of Trade Practice Litigation;
Changes in Trade Practices."
The following table summarizes the brands under which the Company's current
lenses marketed for disposable replacement regimens are offered in the
independent practitioner and retail chain channels:
- -------------------------------------------------------------------------------------------
INDEPENDENT
REPLACEMENT PRACTITIONER RETAIL CHAIN
REGIMEN BRANDS BRANDS
- -------------------------------------------------------------------------------------------
Monthly Disposable Hydron ProActive 55 UltraFlex SmartChoice 55
Edge III ProActive UltraFlex SmartChoice
Clinasoft (semi-exclusive) Private labels
Procon (semi-exclusive)
Mediflex (semi-exclusive)
Softview (semi-exclusive)
Flexvue (semi-exclusive)
- -------------------------------------------------------------------------------------------
Weekly Disposable Hydron Biomedics 38 UltraFlex 7/14 38
Hydron Biomedics 55 UltraFlex 7/14 55
Clinasoft (semi-exclusive) Private labels
Procon (semi-exclusive)
Mediflex (semi-exclusive)
Softview (semi-exclusive)
Flexvue (semi-exclusive)
- -------------------------------------------------------------------------------------------
International Markets. The Company anticipates that many international
markets for soft contact lenses will grow at faster rates than the United States
market, driven by increased availability of low-priced lenses in developed
markets such as Europe, Japan and Canada and by increased disposable income in
emerging markets in Asia and Latin America. However, many markets outside the
United States do not have the volume of demand necessary for local manufacturers
to achieve the economies of scale required for low cost lens production. As a
result, the Company's international strategy is to enter into strategic
distribution and marketing relationships with established regional optical
companies. The Company offers these companies lower cost lenses afforded by its
volume production efficiencies and the marketing benefits of a private label
brand, and they provide the Company with the benefits of their existing market
presence, customer relationships and local infrastructure. The Company believes
that this strategy permits it to target growing international markets
effectively without significant investment in direct operations. See "-- Risk
Factors -- Risks Relating to International Operations; Need to Increase Sales in
International Markets" and Note 17 of Notes to Consolidated Financial
Statements. The following summarizes the Company's international sales
operations:
Europe. To expand its penetration of this growing market, the Company
has developed strategic partnerships with a number of regional and local
contact lens distributors including Zeiss. In this relationship, Zeiss
sells the Company's contact lenses marketed for disposable replacement
regimens under its brand names on a non-exclusive basis throughout Europe.
The Company also currently has distribution relationships in Europe and the
Middle East serving a number of countries, as well as an inside sales
organization based in Southampton, England that uses telemarketing and
other sales methods in the United Kingdom similar to those used by the
Company in the United States.
Canada. The Company has a direct selling organization based in Ontario
that uses field sales representatives as well as direct mail, journal
promotion and cooperative merchandising allowance programs similar to those
used by the Company in the United States. The Company also utilizes a small
number of Canadian distributors to resell its products, primarily to
independent eyecare practitioners.
Latin America. Although the Company expects unit growth in the
disposable segment of this emerging market, it also believes that unit
sales of lenses marketed for annual replacement regimens will grow at a
much faster pace than in North America or Europe because of the lower level
of consumer disposable income. To expand the Company's penetration of this
growing market, the Company has entered into a number of non-exclusive
distribution arrangements in Latin America.
8
11
Asia. The Company believes that the growth of unit sales in this
market will be driven primarily by sales of contact lenses marketed for
disposable replacement regimens, particularly in Japan. Unit sales of
lenses marketed for annual replacement regimens in East Asia are also
expected to grow at a faster rate than in North America or Europe due to
comparatively low levels of consumer disposable income. To capitalize on
expected growth in the Japanese market, the Company has formed a strategic
distribution relationship with Seiko, which is responsible for obtaining
local regulatory approvals and will distribute the Company's lenses to
Japanese eyecare practitioners through its network of approximately 69
direct sales representatives. In early 1999, Seiko received Japanese
government approval to sell certain of the Company's contact lenses
marketed for disposable replacement regimens in Japan. The Company has also
established distribution relationships with other soft contact lens
distributors in a number of countries in the Asian market.
DISTRIBUTION
The Company's distribution operations provide its customers with rapid and
reliable deliveries of its products in a cost-effective manner. Because the
Company's customers place both small orders for individual patients and large
inventory stocking orders, the Company's fulfillment system has the flexibility
to receive, fill and ship orders as small as a single lens and as large as tens
of thousands of lenses. Customers may place orders by toll-free telephone call
or by facsimile. Certain of the Company's larger customers use the Company's
electronic data interchange ("EDI") services to place orders and receive order
acknowledgments, invoices, inventory status reports and customized pricing
information online, improving efficiency and timeliness for both the Company and
the customer. If the product is in stock, customer orders received by 2:00 p.m.
local time are generally shipped the same day.
The Company maintains its primary warehouse and distribution facilities in
South San Francisco, California; Romsey, United Kingdom; and Markham, Ontario.
The largest and most sophisticated of these distribution centers is the South
San Francisco location, which primarily serves customers in the United States
and Latin America. Customers in Europe and Asia are primarily served from the
Romsey, United Kingdom facility and customers in Canada are primarily served
from the Markham, Ontario facility. Lenses are labeled and boxed at the
distribution center based on actual and anticipated customer orders. In 1998, an
average of approximately 2,680 orders were placed daily at the South San
Francisco facility from customers in North and Latin America and downloaded to
the distribution center for picking and shipping.
To further reduce its cost-to-serve and improve customer service, the
Company has implemented a highly computerized and automated retrieval system at
its South San Francisco facility. This system incorporates advanced handling
processes such as automatic dispensing, automated conveyors and radio frequency
dispatch. These processes are integrated by software that, in turn, is
integrated into the Company's order entry system, allowing orders to be
downloaded, stocking locations determined and fulfillment instructions delivered
automatically. The Company intends to implement a similar system in the United
Kingdom.
MANUFACTURING
Substantially all of the Company's products are manufactured in facilities
in Santa Isabel, Puerto Rico and in Eastleigh, United Kingdom. The Company
produces its lenses primarily through a manufacturing process known as dry cast
molding. This process uses a single use, two-part plastic mold that is
manufactured by injection-molding machines utilizing high-precision optical
tooling that is also made by the Company. A liquid monomer mixture is dispensed
into the mold and polymerized to form a finished dry lens. The mold containing
the polymerized lens can be inventoried for an extended period under proper
conditions. The dry lens, once removed from the mold, is immersed in a fluid
bath to extract unreacted monomer and to be hydrated and is then inspected,
packaged and sterilized. Each of the Puerto Rico and United Kingdom plants can
generally hydrate dry lenses manufactured by the other. These capabilities
substantially increase the efficiency and flexibility of the Company's
manufacturing operations.
The Company's dry cast molding process enables the Company to reproduce
consistently the sophisticated designs of its lenses, including the lenticulated
carrier and low-edge apex that provide enhanced shape
9
12
retention and superior handling characteristics. In addition, the Company
believes that this process allows the reproduction of lenses that are designed
to provide fitting characteristics similar to those of leading competitors'
lenses, regardless of their manufacturing process. The Company also believes
that the dry cast molding process provides advantages over certain alternate
production methods in yield, throughput efficiency and performance. For example,
each dry lens in the Company's cast molding process emerges from the mold
completely finished, eliminating the need for additional polishing. This cast
molding process reduces manufacturing steps and facilitates automated handling
and inspection. The Company relies on a non-exclusive, perpetual, irrevocable
patent license for a significant element of its dry cast molding technology. See
"-- Trademarks, Trade Secrets and Patent Licenses." In addition to dry cast
molding, certain of the Company's competitors utilize wet cast molding, lathing
or spin-casting processes.
The Company believes that dry cast molding is a highly scaleable process,
which makes it well suited to address the high-volume requirements of the
growing disposable replacement market. Using this technology, the Company has
been able to increase production volumes by approximately 489% from 1994 to
1998. The disposable replacement market, however, is relatively price-sensitive,
and lenses marketed for disposable replacement regimens generally have
significantly lower selling prices than lenses marketed for annual replacement
regimens. The Company believes that its ability to compete effectively in this
growing market will depend on its ability to continue to reduce its per unit
production costs while increasing manufacturing capacity and maintaining the
high quality of its products.
The Company believes that reducing its manufacturing costs requires
increased automation to further improve manufacturing efficiencies and yields,
improved packaging designs that utilize lower cost materials and larger
production volumes to take advantage of economies of scale. While the Company
has implemented a number of cost reduction measures, such as blister packaging,
hot water extraction, automatic demolding and in-monomer tinting over the past
several years, the most significant improvements are expected to come from the
planned implementation of additional production lines incorporating a new
automated process based on the Company's current dry cast molding technology.
This automated process is currently being implemented in a joint effort between
the Company and an engineering consulting firm. An initial validation of the dry
portion of the manufacturing process has recently been completed at the
Company's United Kingdom facility and the Company expects this portion of the
line to commence commercial production in the second quarter of 1999. Initial
validation of the wet portion of the process has started, and the Company
anticipates that this portion of the line will commence commercial production
towards the end of the second quarter of 1999. After the new process is
operational it is anticipated that up to an additional year may be required
before the line can operate at expected yields and production levels. The
Company anticipates installing additional automated lines in both the United
Kingdom and Puerto Rico. The Company believes that, as the new automated lines
are implemented and their production volumes increased, they will reduce
significantly the labor content of production as well as unit packaging costs
while increasing yields and efficiencies through improved controls and
consistency of environment. The Company believes that the automated production
lines will be capable of manufacturing considerably greater volumes while
occupying less space than the Company's existing lines. The Company currently
expects that from 1999 through the end of 2000, it will invest approximately
$46.5 million in capital expenditures on these automated production lines, and
the Company expects to continue to invest in additional automated production
lines after this period. See "-- Risk Factors -- Manufacturing Capacity
Constraints; Risks Associated with Expansion and Automation of Manufacturing
Operations."
The Company has previously experienced significant backorders for certain
of its products, including lenses for disposable replacement regimens. These
backorders resulted primarily from customer demand for certain products being in
excess of the Company's inventory and short-term production capabilities as well
as the Company's inability to gain timely FDA clearance or approval for certain
products. The level of backorders is currently minimal and is limited to certain
low-volume products.
The Company's success will depend in part upon its ability to increase its
production volume on a timely basis while maintaining product quality, reducing
per unit production costs and complying with the FDA's quality system (including
GMP) regulations. There can be no assurance that the Company will not encounter
difficulties in expanding and automating its manufacturing facilities and
increasing production, including
10
13
problems involving production yields, quality control, construction delays and
shortages of qualified personnel. The Company's failure to reduce per unit
production costs and maintain product quality could have a material adverse
effect on the Company's business, financial condition and results of operations.
See "-- Risk Factors -- Manufacturing Capacity Constraints; Risks of Expansion
and Automation of Manufacturing Operations" and "-- Risk Factors -- Risks
Associated with Interruption of Manufacturing Operations."
INFORMATION SYSTEMS
The Company believes that its information systems are an integral component
of its strategy to minimize its cost-to-serve and improve customer service. The
Company is in the process of replacing its information systems with new systems.
The new systems will significantly affect many aspects of the Company's
business, including its manufacturing, sales and marketing, distribution and
accounting functions, and the successful implementation and integration of these
applications will be important to facilitate future growth. Worldwide
applications for forecasting and demand management, purchasing, account payable,
general ledger and labeling were completed in 1998, and the Company anticipates
implementing applications providing the remaining planned functions
(telemarketing and order entry) by the end of 1999. However, the Company could
experience unanticipated delays in the implementation of the new systems and
implementation of the new information systems could cause significant disruption
in operations. See "-- Risk Factors -- Uncertain Ability to Manage Growth; Risks
Associated with New Management Information Systems," and "Management's
Discussion and Analysis of Financial Condition and Results of Operation -- Year
2000."
RESEARCH AND DEVELOPMENT
The Company's research and development efforts are focused primarily on the
development of automated manufacturing processes to increase the efficiency and
capacity of the manufacturing operation. See "-- Manufacturing." In addition,
the Company is engaged to a limited extent in development of new soft contact
lens products and additional features. The Company's product development efforts
are currently focused on the development of a new toric product to be marketed
for disposable replacement regimens. During the years ended December 31, 1998,
1997 and 1996, expenditures for research and development (including obtaining
regulatory approvals) were approximately $2.2 million, $2.4 million and $1.1
million, respectively. See "-- Risk Factors -- Risk of New Products and
Technological Change."
TRADEMARKS, TRADE SECRETS AND PATENT LICENSES
The Company believes that its trademarks are among its most valuable assets
and has numerous trademark registrations in the United States, Europe and other
foreign countries. The Company's channel-specific branding strategy is dependent
on the Company's strategic use of its trademark portfolio, as the trademark for
each product brand is generally registered. The Company licenses the Hydron
trademarks under a license agreement that prohibits the use of those trademarks
outside of the Americas. The Company believes that there are no currently
pending challenges to the use or registration of any of the Company's material
trademarks. There can be no assurance, however, that the Company's trademarks do
not or will not violate the proprietary rights of others, that they would be
upheld if challenged or that the Company would, in such an event, not be
prevented from using its trademarks, any of which could have a material adverse
effect on the Company and its business.
The Company has obtained non-exclusive licenses from third parties to
patents for certain contact lens designs and manufacturing technologies used in
the production of its products. Pursuant to a patent license agreement with
several parties, including Geoffrey and Anthony Galley, who were significant
stockholders of the Company prior to its initial public offering and adverse
parties in the U.K. Litigation, the Company has obtained a perpetual, fully
paid, worldwide, non-exclusive, irrevocable license to certain patents and
patent applications covering technology that is significant in the Company's dry
cast molding processes. See "-- Risk Factors -- Intense Competition." The
Company has recently filed a patent application on certain aspects of its new
automated manufacturing process. The Company has also obtained non-exclusive,
fully paid, perpetual, worldwide licenses to use certain technology relating to
the tinting of lenses and to manufacture a monomer used to produce certain of
its lenses. In addition, the Company licenses technology used in manufacturing
its
11
14
toric and bifocal contact lenses under non-exclusive license agreements that
limit the sales of products manufactured using the licensed technology to the
Americas. If the Company desires or is required to obtain additional licenses to
patents or proprietary rights of others, there can be no assurance that any such
licenses will be available on terms acceptable to the Company, if at all.
In addition to trademarks and patent licenses, the Company owns certain
trade secrets, copyrights, know-how and other intellectual property. The Company
seeks to protect these assets, in part, by entering into confidentiality
agreements with certain of its business partners, consultants and vendors. There
can be no assurance that these agreements will not be breached, that the Company
will have adequate remedies for any such breach or that the Company's trade
secrets and other intellectual property will not otherwise become known or be
independently developed by others and thereby become unprotected. Furthermore,
no assurance can be given that competitors will not independently develop
substantially equivalent proprietary information and techniques or otherwise
gain access to the Company's proprietary technology or that the Company can
meaningfully protect its rights in unpatented proprietary technology.
The defense and prosecution of intellectual property suits and related
administrative proceedings are both costly and time-consuming. There can be no
assurance that the prosecution and defense of the Company's intellectual
property will be successful or that the Company will be able to secure adequate
intellectual property protections in the future. The protection of intellectual
property in certain foreign countries is particularly uncertain. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent the Company from manufacturing and selling its
products, and such events would have a material adverse effect on the Company's
business, financial condition and results of operations. See "-- Risk
Factors -- Dependence on Trademarks, Patent Licenses and Trade Secrets; Risk of
Intellectual Property Infringement" and "Item 13 -- Certain Transactions -- OSL
Acquisition and Related Litigation."
COMPETITION
The market for soft contact lenses is intensely competitive and is
characterized by decreasing prices for many products. As the number of wearers
of soft contact lenses in the U.S. has not grown significantly in recent years,
increased U.S. market penetration by the Company will require wearers of
competing products to switch to the Company's products. The Company's products
compete with products offered by a number of larger companies including Johnson
& Johnson, Ciba, Bausch & Lomb, Inc. ("Bausch & Lomb"), Wesley Jessen Vision
Care, Inc. ("Wesley Jessen") and The Cooper Companies, Inc. ("Cooper"). Many of
the Company's competitors have substantially greater financial, manufacturing,
marketing and technical resources, greater market penetration and larger
manufacturing volumes than the Company. Among other things, these advantages may
afford the Company's competitors greater ability to manufacture large volumes of
lenses, reduce product prices and influence customer buying decisions. The
Company believes that certain of its competitors are expanding, or are planning
to expand, their manufacturing capacity, and are implementing new, more
automated manufacturing processes, in order to support anticipated increases in
volume. As many of the costs involved in producing contact lenses are relatively
fixed, if a manufacturer can increase its volume, it can generally reduce its
per unit costs and thereby increase its flexibility to reduce prices. The
Company's largest competitor reduced its U.S. prices during the second quarter
of 1998 and further restructured its pricing in the fourth quarter of 1998. The
Company matched these changes in most respects in the third and four quarters of
1998. The Company's competitors may continue to reduce prices to achieve the
sales volumes necessary to utilize their increased capacity, or for other
reasons. Future price reductions by competitors could make the Company's
products less competitive, and there can be no assurance that the Company would
be able to reduce its prices in response. The Company's ability to respond to
competitive pressures by decreasing its prices without adversely affecting its
gross margins and operating results will depend on its ability to decrease its
costs per lens. Any significant decrease in the Company's costs per lens will
depend, in part, on the Company's ability to increase its sales volume and
production capacity. There can be no assurance that the Company will be able to
continue to increase its sales volume or reduce its per unit production costs.
In response to competition, the Company may also increase cooperative
merchandising allowances or otherwise increase spending, which may adversely
affect its business, financial condition and results of operations. The failure
of the Company to respond to competitive pressures, and particularly
12
15
price competition, in a timely manner would have a material adverse effect on
the Company's business, financial condition and results of operations. See "--
Manufacturing Capacity Constraints; Risks Associated with Expansion and
Automation of Manufacturing Operations."
The market for contact lenses is shifting from lenses marketed for annual
replacement regimens to lenses marketed for disposable replacement regimens. The
weekly disposable replacement market is particularly competitive and
price-sensitive and is currently dominated by the Acuvue product produced by
Johnson & Johnson. The Company believes that the per unit production costs of
Johnson & Johnson and certain of the Company's other competitors are currently
lower than those of the Company. In addition, the lenses currently offered in
the United States by the Company in the disposable replacement market are
marketed for weekly and monthly replacement regimens. Certain of the Company's
competitors, including Johnson & Johnson, Ciba and Bausch & Lomb have introduced
lenses marketed for daily replacement at lower prices than their lenses
currently marketed for weekly and bi-weekly disposal. The Company has recently
introduced a lens marketed for daily disposal in Japan, and plans to introduce a
lens marketed for daily disposal in Europe and possibly the U.S. The Company's
ability to enter and to compete effectively in the market for daily disposable
lenses will depend in large part upon the Company's ability to expand its
production capacity and reduce its per unit production costs. See "-- Dependence
on Single Product Line; Need to Increase Sales of Lenses for Disposable
Replacement Regiments."
Soft contact lens manufacturers have generally sought to differentiate
themselves from their competitors on the basis of product performance,
marketing, distribution channels and price. In addition, the Company believes
that its manufacturing process technology, lens designs and marketing strategies
differentiate it from its leading competitors. Since the purchase of contact
lenses requires a prescription in the United States, the Company also competes
on the basis of its relationships and reputation with eyecare practitioners.
There can be no assurance that the Company will be able to continue to so
distinguish its products or that competitors will not adopt technologies, lens
designs or marketing strategies that are similar to those used by the Company.
Any such action by competitors could have a material adverse effect on the
Company's business, results of operations and financial condition. In this
regard, Cooper's acquisition of Aspect Vision Care Ltd. in December 1997 has
given them the ability to market in the U.S. a new line of contact lenses for
weekly and monthly replacement regimens that utilize a manufacturing process
technology that is based in part on technology also licensed to and used by the
Company. The Company also encounters competition from manufacturers of
eyeglasses and from alternative technologies, such as surgical refractive
procedures (including new refractive laser procedures such as PRK, or
photorefractive keratectomy, and LASIK, or laser in situ keratomileusis). If
surgical refractive procedures become increasingly accepted as an effective and
safe technique for permanent vision correction, they could substantially reduce
the demand for contact lenses by enabling patients to avoid the ongoing cost and
inconvenience of contact lenses. Accordingly, there can be no assurance that
these procedures, or other alternative technologies that may be developed in the
future, will not cause a substantial decline in the number of contact lens
wearers and thus have a material adverse effect on the Company's business,
financial condition and results of operations. See "-- Intense Competition" and
"-- Risk of New Products and Technological Change."
GOVERNMENT REGULATION
The U.S. Federal Food, Drug and Cosmetic Act (the "FDC Act"), other
statutes, regulations of the U.S. Food and Drug Administration (the "FDA") and
other agencies as well as state laws govern the preclinical and clinical
testing, manufacture, labeling, distribution, sale, marketing, advertising and
promotion of medical devices such as contact lenses. Noncompliance with
applicable regulations can result in, among other things, fines, injunctions,
product recall or product seizures, operating restrictions (including suspension
of production and distribution), refusal of the FDA to grant approval of a
Pre-Market Approval Application ("PMA") or clearance of a Section 510(k)
Pre-Market Notification ("a 510(k) Notification"), withdrawal of previously
granted marketing approvals or clearances, and criminal prosecution. Sales of
the Company's products outside the U.S. are subject to regulatory requirements
that, while generally comparable to those in the U.S., vary widely from country
to country.
13
16
FDA Regulation. For purposes of the applicable statutes and regulations,
the Company's products are generally treated as "medical devices." With
exceptions for certain medical devices first marketed before May 28, 1976, prior
to their commercial sale in the United States, medical devices must be cleared
by the FDA, exempted from the requirement of FDA clearance, or approved by the
FDA. In general, the regulatory process can be lengthy, expensive and uncertain,
and securing FDA clearances or approvals may require the submission of extensive
clinical data together with other supporting information to the FDA.
In the United States, medical devices are classified as Class I, II or III,
on the basis of the controls deemed by the FDA to be necessary to reasonably
ensure their safety and effectiveness. Class I devices are subject to general
controls (e.g., labeling and adherence to FDA-mandated quality system (including
current GMP) requirements and, in some cases, 510(k) notification), and Class II
devices are subject to general controls including, in most cases, 510(k)
notification and special controls (e.g., performance standards). Generally,
Class III devices are those that must receive premarket approval by the FDA to
ensure their safety and effectiveness (e.g., life-sustaining, life-supporting
and implantable devices) and also include most devices that were not on the
market before May 28, 1976 ("new medical devices") and for which the FDA has not
made a finding of "substantial equivalence" based on a 510(k). Class III devices
usually require clinical testing and FDA approval prior to marketing and
distribution.
The Company's daily-wear products have been classified as Class II devices
subject to the 510(k) pre-market notification process, while the Company's
extended-wear products have been classified as Class III devices subject to the
PMA requirements. Regulation of the Company's daily-wear products under the pre-
market notification process requires that new product introductions in this
category be preceded by FDA clearance of a 510(k) pre-market notification
containing information which establishes the new product as substantially
equivalent to a legally marketed Class I or II medical device or to a legally
marketed Class III device that does not itself require an approved PMA prior to
marketing ("predicate device"). A 510(k) must contain information to support a
claim of substantial equivalence, and this information may include laboratory
test results or the results of clinical studies of the device in humans. The FDA
may determine that a device is not "substantially equivalent" to a predicate
device or that additional information is needed before a substantial equivalence
determination can be made. The premarket notification process generally takes
five to twelve months without clinical data, or twelve to eighteen months or
more if clinical data are required to be included in the notifications but it
may take longer, and 510(k) clearance may never be obtained. The range of
clinical data required to be included in a 510(k), if any, or a PMA application
varies depending on the nature of the new product or product modification.
Generally, the 510(k) notifications filed by the Company do not require clinical
data, and, if clinical data are required, the necessary clinical trials are
short-term. If the Company is unable to establish to the FDA's satisfaction that
a new product is substantially equivalent to a predicate device, extensive
preclinical and clinical testing will be required, additional costs will be
incurred, and FDA approval of a PMA for the product will be required prior to
market entry. Such approval, which cannot be assured in a timely manner or at
all, generally takes at least eighteen to twenty-four months, and can take
substantially longer.
Regulation of the Company's extended-wear products as Class III devices
requires that the Company submit a PMA to the FDA and obtain its approval of the
application prior to marketing such products in the United States. A PMA must be
supported by valid scientific evidence that typically includes extensive data,
including data from preclinical testing and human clinical trials to demonstrate
the safety and effectiveness of the device. The FDA ordinarily requires the
performance of at least two independent, statistically significant human
clinical trials that must demonstrate the safety and effectiveness of the device
in order to obtain FDA approval of the PMA. If the device presents a
"significant risk," the sponsor of the trial (usually the manufacturer or the
distributor of the device) is required to file an investigational device
exemption ("IDE") application with the FDA prior to commencing human clinical
trials. The IDE application must be supported by data, typically including the
results of animal and laboratory testing. If the IDE application is approved by
the FDA and the study protocol is approved by one or more appropriate
institutional review boards ("IRBs"), human clinical trials may begin at a
specific number of investigational sites with a specific number of patients, as
approved by the FDA. If the device presents a "nonsignificant risk" to the
patient, a sponsor may begin the human clinical trials after obtaining approval
of the study protocol by one or more appropriate IRBs, but FDA
14
17
approval of an IDE is not necessary unless the FDA notifies the sponsor that an
IDE application is required. An IDE supplement must be submitted to, and
approved by, the FDA before a sponsor or an investigator may make a change to
the investigational plan that may affect its scientific soundness or the rights,
safety or welfare of human subjects. The FDA has the authority to re-evaluate,
alter, suspend or terminate clinical testing based on its assessment of data
collected throughout the trials.
The PMA must also contain the results of all relevant bench tests,
laboratory and animal studies, a complete description of the device and its
components, and a detailed description of the methods, facilities and controls
used to manufacture the device. In addition, the submission must include the
proposed labeling and promotional labeling. Once the FDA accepts a PMA
submission for filing, the FDA begins an in-depth review of the PMA. An FDA
review of a PMA generally takes from twelve to eighteen months from the date the
PMA is accepted for filing, but may take significantly longer if the FDA
requests additional information and if the sponsor files any major amendments to
the PMA. The review time is often significantly extended by the FDA's request
for clarification of information already provided in the submission. Toward the
end of the PMA review process, the FDA generally will conduct an inspection of
the manufacturer's facilities to ensure that the facilities are in compliance
with the quality system (including current GMP) requirements.
If the FDA's evaluations of both the PMA and the manufacturing facilities
are favorable, the FDA will issue either an approval letter (order) or an
"approvable letter" containing a number of conditions that must be met in order
to secure approval of a PMA. When and if those conditions have been fulfilled to
the satisfaction of the FDA, the agency will issue an order approving the PMA
and authorizing commercial marketing of the device for certain indications. If
the FDA's evaluation of the PMA or manufacturing facilities is not favorable,
the FDA will deny approval of the PMA or issue a "not approvable letter." The
FDA may also determine that additional preclinical testing or human clinical
trials are necessary, in which case approval of the PMA could be delayed for
several years while additional testing or trials are conducted and submitted in
an amendment to the PMA. The PMA process can be expensive, uncertain and
lengthy, and a number of devices for which FDA approval has been sought by other
companies have never been approved for marketing.
Even if 510(k) clearance or PMA approval is obtained, this clearance or
approval can be withdrawn by the FDA due to the failure to comply with
regulatory requirements or the occurrence of unforeseen problems following
initial clearance or approval. Modifications to existing 510(k)-cleared devices,
including changes in design, material, or manufacturing process that could
significantly affect safety or effectiveness, require submission and clearance
of new 510(k) notifications as do significant changes in labeling, e.g., a
change in indications for use. Modifications to a device that is the subject of
an approved PMA, its labeling, or manufacturing process ordinarily require
approval by the FDA of PMA supplements or new PMAs. Supplements to a PMA
typically require the submission of similar information as is required for an
initial PMA, except that the supplement is generally limited to that information
needed to support the proposed change from the product covered by the original
PMA. The approval of supplemental PMAs requires approximately one to two years.
All of the products currently marketed by the Company have received 510(k)
clearance or PMA approval. The Company anticipates that its contemplated lens to
be marketed for daily disposal will be regulated as a Class II medical device,
requiring submission and clearance of a 510(k), and that its planned
ultraviolet-absorbing extended-wear lens will be regulated as a Class III
medical device, requiring submission and approval of a PMA supplement. There can
be no assurance that these planned products or any other future products will
receive FDA marketing clearance or approval on a timely basis or at all, or that
its new daily wear lens will not be subjected to the PMA process. The Company
has made minor modifications to its lenses which it believes do not require the
submission and clearance of new 510(k) notifications or the submission and
approval of PMA supplements. There can be no assurance, however, that the FDA
will agree with any of the Company's determinations not to submit new 510(k)
notifications or PMA supplements for these changes, that the FDA will not
require the Company to cease sales and distribution while seeking clearances of
510(k) notifications or approvals of PMA supplements for the changes, or that
such clearances and approvals, if required, will be obtained in a timely manner
or at all.
15
18
The FDC Act requires that medical devices, including contact lenses, be
manufactured in accordance with the FDA's quality system ("QS") regulation,
which includes, among other things, the FDA's GMP requirements. This regulation
requires, among other things, that (i) the manufacturing process be regulated,
controlled and documented by the use of written procedures, and (ii) the ability
to produce devices which meet the manufacturer's specifications be validated by
extensive and detailed testing of every aspect of the process. The regulation
also requires (i) investigation of any deficiencies in the manufacturing process
or in the products produced, (ii) purchasing controls, (iii) detailed
record-keeping including the maintenance of service records and (iv)
pre-production design controls. Manufacturing facilities are subject to FDA
inspection on a periodic basis to monitor compliance with QS (including current
GMP) requirements. If violations of the applicable regulations are noted during
FDA inspections of manufacturing facilities, the FDA can prohibit further
manufacturing, distribution and sale of the devices until the violations are
cured. The Company believes that its facilities are in compliance with the FDA's
QS regulations and that the planned automation of its manufacturing facilities
will not require clearance or approval.
In March 1996, the Company received a warning letter from the FDA regarding
certain procedures used in manufacturing products at its facilities in Puerto
Rico. The Company took steps to address the FDA's concerns, and after
reinspecting the facilities, the FDA notified the Company that its concerns were
satisfactorily addressed. In February and March 1998, the FDA again inspected
the Company's facilities in Puerto Rico for compliance with quality system
(including GMP) requirements. The Company has received a summary of certain
deficiencies observed by the FDA inspector, primarily related to complaint
handling. The Company is addressing these concerns and believes that its
response will be satisfactory to the FDA. However, there can be no assurance
that the FDA will accept the Company's responses or that the Company will be
found in compliance with quality system (including GMP) requirements in this
inspection or in future inspections by regulatory authorities. Any actions
required by the FDA as a result of its recent inspection or future inspections
could involve significant costs or disruption to the Company's operations, which
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, noncompliance with quality
system (including GMP) requirements could result in the cessation or reduction
of the Company's production volume, which would have a material adverse effect
on the Company's business, financial condition and results of operations.
The Company is also required to register as a medical device manufacturer
and to list its products with the FDA. Devices marketed in the United States are
subject to pervasive and continuing regulatory oversight by the FDA and other
agencies, and the Company is subject to periodic inspection and record-keeping
requirements. As a medical device manufacturer, the Company is further required
to comply with FDA requirements regarding the reporting of allegations of death
or serious injury associated with the use of its medical devices, as well as
product malfunctions that would likely cause or contribute to death or serious
injury if the malfunction were to recur. Other FDA requirements govern product
labeling and prohibit a manufacturer from marketing a device with a cleared
510(k) or an approved PMA for an uncleared or unapproved indication. Failure to
comply with applicable regulatory requirements can result in a wide variety of
severe administrative, civil, and criminal sanctions and penalties. See "--
Risks of Regulatory Action."
International Regulation. Sales of medical devices outside the U.S. are
subject to foreign regulatory requirements that vary widely from country to
country. These laws and regulations range from simple product registration
requirements in some countries to complex clearance and production controls such
as those described above in others. As a result, the processes and time periods
required to obtain foreign marketing approval may be longer or shorter than
those necessary to obtain FDA approval. These differences may affect the
efficiency and timeliness of international market introduction of the Company's
products, and there can be no assurance that the Company will be able to obtain
regulatory approvals or clearances for its products in foreign countries.
Medical devices sold or marketed in the European Union ("EU") are subject
to the EU's medical devices directive. Under this directive, CE mark
certification procedures became available for medical devices, and the
successful completion of such procedures would allow certified devices to be
marketed in all EU countries. In order to obtain the right to affix the CE mark
to its products, medical device companies must obtain certification that its
processes meet European quality standards and establish that the product is
16
19
considered safe and fit for its intended purpose. Medical devices other than
active implants and in vitro diagnostic products may not be sold in EU countries
unless they display the CE mark. Although member countries must accept for
marketing medical devices bearing a CE marking without imposing further
requirements related to product safety and performance, each country may require
the use of its own language or labels and instructions for use.
The Company may also have to obtain additional approvals from foreign
regulatory authorities in order to sell its products in non-EU countries. Some
countries have historically permitted human studies earlier in the product
development cycle than regulations in the United States permit. Other countries,
such as Japan, have requirements similar to those of the United States. This
disparity in the regulation of medical devices may result in more rapid product
clearance in certain countries than in the United States, while approvals in
countries such as Japan may require longer periods than in the United States.
Seiko Contactlens Inc., the Company's distributor in Japan, will be responsible
for management of clinical trials and obtaining regulatory approval for the
Company's products, and such approval will therefore be outside the Company's
control. Accordingly, there can be no assurance as to when or whether such
approval will be received.
Other Regulation. The Company is also subject to numerous federal, state
and local laws relating to such matters as safe working conditions,
manufacturing practices, environmental protection, fire hazard control and
disposal of hazardous or potentially hazardous substances. There can be no
assurance that the Company will not be required to incur significant costs to
comply with such laws and regulations in the future or that compliance with such
laws or regulations will not have a material adverse effect upon the Company's
ability to do business.
The Company's success depends to a significant extent upon the success of
its customers in the retail optical industry. These customers are subject to a
variety of federal, state and local laws, regulations and ordinances, including
those regarding advertising, location and design of stores, products sold and
qualifications and practices of the industry. The state and local legal
requirements vary widely among jurisdictions and are subject to frequent change.
Furthermore, numerous health-care related legislative proposals have been made
in recent years in the United States Congress and in various state legislatures.
The potential impact of these proposals with respect to the business of the
Company's customers is uncertain, and there is no assurance that the proposals,
if adopted, would not have a material adverse impact on the Company.
There is substantial United States federal and state governmental
regulation related to the prescribing of contact lenses. These regulations
relate to who is permitted to prescribe and fit contact lenses, the prescriber's
obligation to provide prescriptions to its patients, the length of time a
prescription is valid, the ability or obligation of prescribers to prescribe
lenses by brand rather than by generic equivalent or specification, and other
matters. Although these regulations primarily affect contact lens prescribers,
and not manufacturers or distributors of lenses such as the Company, changes in
these regulations, or their interpretation or enforcement, could adversely
affect the effectiveness of the Company's marketing strategy to eyecare
practitioners, most notably the effectiveness of the Company's channel-specific
and private label branding strategies. Additionally, given the Company's
strategic emphasis on focusing its marketing efforts on eyecare practitioners
rather than consumers, the Company may be more vulnerable than its competitors
to changes in current trade practices. Adverse regulatory or other decisions
affecting eyecare practitioners, or material changes in the selling and
prescribing practices for contact lenses, could have a material adverse affect
on the Company's business, operating results and financial condition.
PRODUCT LIABILITY AND INSURANCE
The Company has in the past been, and continues to be, subject to product
liability claims and lawsuits. Because contact lenses are medical devices, the
Company faces an inherent risk of exposure to product liability claims in the
event that the use of its products results in personal injury. The Company also
faces the possibility that defects in the design or manufacture of its products
might necessitate a product recall. From time to time, the Company has received,
and may continue to receive, complaints of significant patient discomfort,
including corneal scarring and complications, while using the Company's contact
lenses. In certain cases, the reasons for the problems have never been
established. In addition, on two occasions, in 1995 and
17
20
1997, the Company has recalled limited volumes of certain of its product because
certain labels on the vial or blister did not match the enclosed lens. Although
the Company has not experienced material losses to date due to product liability
claims or product recalls, there can be no assurance that the Company will not
experience such losses in the future, that insurance coverage will be adequate
to cover such losses, or that insurance coverage will be available on acceptable
terms or at all. The Company maintains product liability insurance with coverage
of $1 million per occurrence and an annual aggregate maximum of $2 million with
umbrella coverage of $20 million. A product liability or other judgment against
the Company in excess of the Company's insurance coverage or a product recall
could have a material adverse effect on the Company's business, financial
condition and results of operations.
EMPLOYEES
As of December 31, 1998, the Company had 1438 full-time employees,
including 332 in the United States, 547 in the United Kingdom, 526 in Puerto
Rico, 26 in Canada and 7 in Hungary. Of the Company's full-time employees, 145
are engaged in sales and marketing, 1,109 in manufacturing, 94 in distribution,
14 in process development and 76 in finance and administration. The Company also
utilizes a number of part-time employees in its manufacturing and distribution
operations to supplement its full-time workforce. The Company's success is
dependent in part on its ability to attract and retain qualified employees. In
particular, the loss of John D. Fruth, the Company's founder and Chief Executive
Officer, would have a material adverse effect on the Company's development and
marketing efforts. None of the Company's employees is represented by a labor
union or is the subject of a collective bargaining agreement with respect to his
or her employment by the Company. The Company has never experienced a work
stoppage and believes that its employee relations are good. See "-- Dependence
on Key Personnel".
18
21
RISK FACTORS
This Form 10-K contains forward-looking statements that involve risks and
uncertainties. The Company's actual results may differ materially from the
results discussed or implied in such forward-looking statements due to such
risks and uncertainties. Factors that may cause such a difference include, but
are not limited to, those discussed below, in the section entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
elsewhere in this Form 10-K.
Intense Competition. The market for soft contact lenses is intensely
competitive and is characterized by decreasing prices for many products. The
Company's products compete with products offered by a number of larger companies
including the Vistakon division of Johnson & Johnson ("Johnson & Johnson"), the
Ciba Vision division of Novartis ("Ciba"), Bausch & Lomb, Inc. ("Bausch &
Lomb"), Wesley Jessen VisionCare, Inc. ("Wesley Jessen") and The Cooper
Companies, Inc. ("Cooper"), which recently acquired Aspect Vision Care Ltd. Many
of the Company's competitors have substantially greater financial,
manufacturing, marketing and technical resources, greater market penetration and
larger manufacturing volumes than the Company. Among other things, these
advantages may afford the Company's competitors greater ability to manufacture
large volumes of lenses, reduce product prices and influence customer buying
decisions. The Company believes that certain of its competitors are expanding,
or are planning to expand their manufacturing capacity, and are implementing
new, more automated manufacturing processes, in order to support anticipated
increases in volume. As many of the costs involved in producing contact lenses
are relatively fixed, if a manufacturer can increase its volume, it can
generally reduce its per unit costs and thereby increase its flexibility to
reduce prices. In addition, the Company's largest competitor reduced its U.S.
prices during the second quarter of 1998, and further restructured its pricing
plan in the fourth quarter of 1998. The Company matched these changes in most
respects in the third and fourth quarters of 1998. The Company's competitors may
continue to reduce prices to achieve the sales volumes necessary to utilize
their increased capacity, or for other reasons. Future price reductions by
competitors could make the Company's products less competitive, and there can be
no assurance that the Company would be able to either match the competitor's
pricing plan or reduce its prices in response. The Company's ability to respond
to competitive pressures by decreasing its prices without adversely affecting
its gross margins and operating results will depend on its ability to decrease
its costs per lens. Any significant decrease in the Company's costs per lens
will depend, in part, on the Company's ability to increase its sales volume and
production capacity. There can be no assurance that the Company will be able to
continue to increase its sales volume or reduce its per unit production costs.
In response to competition, the Company may also increase cooperative
merchandising allowances or otherwise increase spending, which may adversely
affect its business, financial condition and results of operations. The failure
of the Company to respond to competitive pressures, and particularly price
competition, in a timely manner would have a material adverse effect on the
Company's business, financial condition and results of operations. See
"-- Manufacturing Capacity Constraints; Risks Associated with Expansion and
Automation of Manufacturing Operations."
The market for contact lenses is shifting from lenses marketed for annual
replacement regimens to lenses marketed for weekly and daily disposable
replacement regimens. The weekly disposable replacement market is particularly
competitive and price-sensitive and is currently dominated by the Acuvue product
produced by Johnson & Johnson. The Company believes that the per unit production
costs of Johnson & Johnson and certain of the Company's other competitors are
currently lower than those of the Company. The Company has recently introduced a
lens marketed for daily disposal in Japan, and plans to introduce a lens for
such market in Europe and possibly the U.S. The Company's ability to enter and
to compete effectively in the daily market will depend in large part upon the
Company's ability to expand its production capacity and reduce its per unit
production costs. Additionally, over the past few quarters, the rate of U.S.
market demand has slowed. Should such trend continue, it could have a material
adverse effect on the Company's business, financial condition and results of
operations.
The Company believes that its manufacturing process technology, lens
designs and marketing strategies differentiate it from its leading competitors.
However, there can be no assurance that competitors will not adopt technologies,
lens designs or marketing strategies that are similar to those used by the
Company. Any such action by competitors could have a material adverse effect on
the Company's business, results of
19
22
operations and financial condition. In this regard, Cooper's acquisition of
Aspect Vision Care Ltd. in December 1997 has given them the ability to market in
the U.S. a new line of contact lenses for weekly and monthly replacement
regimens that utilize a manufacturing process technology that is based in part
on technology also licensed to and used by the Company.
The Company also encounters competition from manufacturers of eyeglasses
and from alternative technologies, such as surgical refractive procedures
(including new refractive laser procedures such as PRK, or photorefractive
keratectomy, and LASIK, or laser in situ keratomileusis). If surgical refractive
procedures become increasingly accepted as an effective and safe technique for
permanent vision correction, they could substantially reduce the demand for
contact lenses by enabling patients to avoid the ongoing cost and inconvenience
of contact lenses. Accordingly, there can be no assurance that these procedures,
or other alternative technologies that may be developed in the future, will not
cause a substantial decline in the number of contact lens wearers and thus have
a material adverse effect on the Company's business, financial condition and
results of operations.
Manufacturing Capacity Constraints; Risks Associated with Expansion and
Automation of Manufacturing Operations. The Company's success will depend upon
its ability to increase its production volume on a timely basis while
maintaining product quality and lowering per unit production costs.
Manufacturers often encounter difficulties in increasing production volumes,
including problems involving delays, quality control and shortages of qualified
personnel. The Company is currently operating close to capacity, and while
incremental increases in capacity are implemented by the Company in the ordinary
course, the Company expects to need more significant increases in capacity in
the foreseeable future.
To this end, the Company intends to add new, highly automated production
technology at its facilities in the United Kingdom and Puerto Rico to increase
its manufacturing capacity and reduce its per unit manufacturing costs. However,
there can be no assurance that the Company will be able to implement this
automated technology on a timely basis or that the automated technology will
operate as efficiently as expected. The Company has encountered delays in
implementing the first line of this automated technology, has had to write off
the cost of a custom made piece of equipment, and there can be no assurance that
it will not encounter significant delays and difficulties in the future. For
example, suppliers could miss their equipment delivery schedules, the efficiency
of the new production lines and facility could improve less rapidly than
expected, if at all, or the equipment or processes could require longer design
time than anticipated, or redesigning after installation. In addition, the new
production technology will involve processes and equipment with which the
Company and its personnel are not experienced. Difficulties experienced by the
Company in automating its manufacturing process could impair the Company's
ability to reduce its per unit production costs and to compete in the weekly and
daily disposable replacement market and, accordingly, could have a material
adverse effect on the Company's business, financial condition and results of
operations.
The Company currently expects that through the end of 2000, it will invest
approximately $46.5 million in capital expenditures on automated production
lines in the United Kingdom and Puerto Rico and expects to continue to invest in
additional automated production lines after this period. The Company intends to
finance these capital expenditures with net cash provided by operating
activities, existing cash balances and borrowings under its credit facilities.
No assurances can be given as to the availability of such net cash from
operations or borrowings, and if such funds are not available, the Company could
be required to curtail the installation of the automated lines.
The Company is currently experiencing space constraints at its Puerto Rican
facility. As a result, the Company intends to relocate its Puerto Rican
manufacturing operations to a substantially larger new facility being
constructed to the Company's specifications and leased to the Company by the
Puerto Rico Industrial Development Company. The development and construction of
a new manufacturing facility is subject to significant risks and uncertainties,
including cost estimation errors and overruns, construction delays, weather
problems, equipment delays or shortages, production start-up problems and other
factors. As many of such factors are beyond the Company's control, the Company
cannot predict the length of any such delays, which could be substantial.
Construction of the new facility began during the fourth quarter of 1997 and is
expected to be completed during the second quarter of 1999, with occupancy in
the new facility expected to be phased
20
23
in over a nine month period. There can be no assurances as to when the Company
will complete construction and begin production. Before this new facility begins
production, it must be inspected by the U.S. Food and Drug Administration (the
"FDA") for compliance with current good manufacturing practices ("GMP"), and the
inspection and approval process could significantly delay the Company's ability
to begin production in this new facility.
The Company's development of a new facility and implementation of the new
automated production technology will result in new fixed and operating expenses,
including substantial increases in depreciation expense that will increase the
Company's cost of sales. If revenue levels do not increase sufficiently to
offset these new expenses, the Company's operating results could be materially
adversely affected. There can be no assurance that the Company will not
encounter unforeseen difficulties, costs or delays in automating its production
process, in constructing and equipping the new manufacturing facility in Puerto
Rico or in commencing production on the new lines and at the new facility. Any
such difficulties or delays would limit the Company's ability to increase
production volume and lower per unit costs (and consequently prices), would
limit the Company's ability to compete in the weekly and daily disposable
replacement regimen markets and, accordingly, could have a material adverse
effect on the Company's business, financial condition and results of operations.
Risk of Trade Practice Litigation; Changes in Trade Practices. The contact
lens industry has been the subject of a number of class action and government
lawsuits and government investigations in recent years. In December 1996, over
twenty states sued three of the Company's largest competitors, as well as
certain eyecare practitioners and trade organizations. The lawsuit alleges,
among other things, a conspiracy among such persons to violate antitrust laws by
refusing to sell contact lenses to mail order and other non-practitioner contact
lens providers, so as to reduce competition in the contact lens industry. A
similar lawsuit was filed by the State of Florida in 1994 and several similar
class action lawsuits were also filed in 1994. One of the defendants has agreed
to settle the lawsuits as to itself by agreeing to sell contact lenses to
mail-order and other alternative distribution channels, and to make substantial
cash and product rebates available to consumers.
In an unrelated matter, one of the Company's largest competitors was sued
in a national class action lawsuit brought in the Federal District Court in the
Northern District of Alabama in 1994 (the "Alabama Lawsuit"). This suit alleged
that the defendant engaged in fraudulent and deceptive practices in the
marketing and sale of contact lenses by selling identical contact lenses, under
different brand names and for different replacement regimens, at different
prices. The defendant subsequently modified certain of its marketing practices
and ultimately settled the lawsuit in August 1996 by making substantial cash and
product payments available to consumers. In August 1997, such competitor also
settled an investigation by 17 states into similar matters by agreeing to
certain restrictions on its future contact lens marketing practices and making
certain payments to each of the states. In October 1996, a class action lawsuit
was brought against another of the Company's largest competitors in the Superior
Court of New Jersey-Camden (the "New Jersey Lawsuit"). This suit alleges that
the defendant engaged in fraudulent and deceptive practices in the marketing and
sale of contact lenses by selling interchangeable contact lenses, under
different brand names and for different replacement regimens, at different
prices. The suit was certified as a national class action in December 1997.
Although the Company has not been named in any of the foregoing lawsuits,
the Company from time to time receives claims or threats similar to those
brought against its competitors, and in one circumstance a suit was filed
against the Company making allegations similar to those made in the Alabama and
New Jersey Lawsuits, which suit was dismissed without prejudice for
non-substantive reasons. There can be no assurance that the Company will not
face similar actions relating to its marketing and pricing practices or other
claims or lawsuits in the future. The defense of any such action, lawsuit or
claim could result in substantial expense to the Company and significant
diversion of attention and effort by the Company's management personnel. There
can be no assurance that any such lawsuit would be settled or decided in a
manner favorable to the Company, and a settlement or adverse decision in any
such action, lawsuit or claim could have a material adverse effect on the
Company's business, financial condition and results of operations.
21
24
In addition to the foregoing lawsuits, there is substantial federal and
state governmental regulation related to the prescribing of contact lenses.
These regulations relate to who is permitted to prescribe and fit contact
lenses, the prescriber's obligation to provide prescriptions to its patients,
the length of time a prescription is valid, the ability or obligation of
prescribers to prescribe lenses by brand rather than by generic equivalent or
specification, and other matters. Although these regulations primarily affect
contact lens prescribers, and not manufacturers or distributors of lenses such
as the Company, changes in these regulations, or their interpretation or
enforcement, could adversely affect the effectiveness of the Company's marketing
strategy to eyecare practitioners, most notably the effectiveness of the
Company's channel-specific and private label branding strategies. Additionally,
given the Company's strategic emphasis on focusing its marketing efforts on
eyecare practitioners, the Company may be more vulnerable than its competitors
to changes in current trade practices. Finally, although cost controls or other
requirements imposed by third party health-care payors such as insurers and
health maintenance organizations have not historically had a significant effect
on contact lens prices or distribution practices, this could change in the
future, and could adversely affect the Company's business, financial condition
and results of operations. Adverse regulatory or other decisions affecting
eyecare practitioners, or material changes in the selling and prescribing
practices for contact lenses, could have a material adverse effect on the
Company's business, financial condition and results of operations.
Fluctuations in Operating Results; Decreasing Average Sales Prices. The
Company's quarterly operating results have varied significantly in the past and
are likely to vary significantly in the future based upon a number of factors.
The Company's quarterly results can be affected significantly by pricing changes
by the Company or its competitors, the Company's ability to increase
manufacturing capacity efficiently and to reduce per unit manufacturing costs,
the time and costs involved in expanding existing distribution channels and
establishing new distribution channels, discretionary marketing and promotional
expenditures such as cooperative merchandising allowances paid to the Company's
customers, timing of the introduction of new products by the Company or its
competitors, inventory shortages, timing of regulatory approvals and other
factors. The Company's customers generally do not have long-term commitments to
purchase products and products are generally shipped as orders are received.
Consequently, quarterly sales and operating results depend primarily on the
volume and timing of orders received during the quarter, which are difficult to
forecast. A significant portion of the Company's operating expenses is
relatively fixed, and planned expenditures are based on sales forecasts. If
sales levels fall below expectations, operating results are likely to be
materially adversely affected. In particular, net income may be
disproportionately affected because only a small portion of the Company's
expenses varies with net sales in the short term. In response to competition,
the Company may reduce prices, increase cooperative merchandising allowances or
otherwise increase marketing expenditures, and such responses may adversely
affect the Company's business, financial condition and results of operations.
Due to the foregoing factors, the Company believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance. Further, it is
likely that in some future quarter the Company's net sales or operating results
will be below the expectations of public market analysts and investors. In such
event, the price of the Company's Common Stock would likely be materially
adversely affected.
The Company expects that the overall average selling price that it realizes
across its products will decline over time because of (i) shifts in the
Company's product mix from lenses marketed for annual replacement regimens to
lenses marketed for daily and weekly disposable replacement regimens, (ii)
further decreases in the prices of lenses marketed for weekly disposable
replacement regimens, and (iii) increases in products sold internationally
through distributors at prices lower than direct sales prices in the United
States.
The Company does not expect there to be significant growth in its sales of
lenses marketed for annual or monthly replacement. Accordingly, the Company will
need to continue to reduce its per unit production costs through increased
automation, increased volume and reduced packaging costs in order to improve, or
even to maintain, its gross margins.
Risks Relating to International Operations; Need to Increase Sales in
International Markets. In 1996, 1997 and 1998, the Company's international sales
represented approximately 18.2%, 21.0% and 21.5%, respectively, of the Company's
net sales. In addition, a substantial portion of the Company's products is
manufactured in the United Kingdom. As a result, the Company's business is
subject to the risks generally
22
25
associated with doing business abroad, such as foreign consumer preferences,
disruptions or delays in shipments, changes in currency exchange rates, longer
accounts receivable payment cycles and greater difficulties in collecting
accounts receivable, foreign tax laws or tariffs, political unrest and changing
economic conditions in countries in which the Company's products are sold or
manufacturing facilities are located. These factors, among others, could
materially adversely affect the Company's ability to sell its products in
international markets, as well as its ability to manufacture its products. If
any such factors were to render the conduct of business in a particular country
undesirable or impractical, there could be a material adverse effect on the
Company's business, financial condition and results of operations. The Company
and its representatives, agents and distributors are also subject to the laws
and regulations of foreign jurisdictions in which they operate or in which the
Company's products are sold. The regulation of medical devices in a number of
jurisdictions, particularly in the European Union, continues to develop, and
there can be no assurance that new laws or regulations will not have a material
adverse effect on the Company's business, financial condition and results of
operations.
A substantial portion of the Company's sales and expenditures are collected
or paid in currencies other than the U.S. dollar. Therefore, the Company's
operating results are affected by fluctuations in foreign currency exchange
rates. In 1998 the Company had an exchange loss of $913,000, primarily relating
to changes in exchange rate between the U.S. dollar, British Pound and the
Canadian dollar. The Company does not generally hedge its currency risk, and
accordingly there can be no assurance that in the future exchange rate movements
will not have a material adverse effect on the Company's sales, gross profit,
operating expenses or foreign currency exchange gains and losses.
The Company's continued growth is dependent on the expansion of
international sales of its products. This expansion will involve operations in
markets with which the Company is not experienced and there can be no assurance
that the Company will be successful in capturing a significant portion of these
markets for contact lenses. In addition, the Company will not be able to market
and sell its products in certain international markets until it obtains
regulatory approval. The Company has recently received regulatory approval to
have certain of its products sold in Japan and has forecast significant sales in
that country. However, the Company's products are new to Japan and there can be
no assurance that such sales will occur. The failure of the Company to increase
its international sales substantially could have a material adverse effect on
the Company's business, financial condition and results of operations.
Uncertain Ability to Manage Growth; Risks Associated with Implementation of
New Management Information Systems and Year 2000 Related Problems. The Company
has experienced rapid growth in recent years. Continued rapid growth may place a
significant strain on management, operational infrastructure, working capital
and financial and management control systems. Growth in the Company's business
has required, and is expected to continue to require, significant personnel
management and other infrastructure resources. The Company's ability to manage
any future growth effectively will require it to attract, train, motivate and
manage new employees successfully, to integrate new employees into its overall
operations and to continue to improve its operational, financial and management
information systems.
The Company is also in the process of replacing its business control
information systems with new systems that are expected to include a number of
integrated applications, including order entry, billing and labeling. The new
systems will significantly affect many aspects of the Company's business,
including its manufacturing, sales and marketing and accounting functions, and
the successful implementation and integration of these applications will be
important to facilitate future growth. The Company has implemented several of
these applications, and anticipates implementing the other planned applications
by the middle of 1999. However, the Company could experience unanticipated
delays in the implementation of the new systems and implementation of the new
information systems could cause significant disruption in operations. If the
Company is not successful in implementing its new systems or if the Company
experiences difficulties in such implementation, the Company could experience
problems with the delivery of its products or an adverse impact on its ability
to access timely and accurate financial and operating information.
The Company's business is dependent on the operation of numerous systems
that could potentially be impacted by Year 2000 related problems. Those systems
include, among others: hardware and software
23
26
systems used by the Company to manufacture and deliver products and services to
its customers; the internal systems of the Company's customers and suppliers;
the hardware and software systems used internally by the Company in the
management of its business; and non-information technology systems and services
used by the Company in the management of its business, such as telephone systems
and building systems.
In early 1998, the Company's Board of Directors named its Chief Information
Officer ("CIO") to head up a compliance project to identify all information
technology ("IT"), non-IT systems and third party related issues. The CIO or
other appropriate person will make presentations on the Company's compliance
program at each Board of Directors meeting until the year 2000. At present, the
Company has completed an inventory of all IT and non-IT systems and has assessed
the requirements for modifications. The Company believes that correction and
testing will be completed by the third quarter of 1999 and implementation by
October of 1999. However, there can be no assurance that the Company will be
successful in its correction, testing and implementation, or that the Company
will not be materially adversely affected by Year 2000 related problems of third
parties such as suppliers, service providers and customers. See "-- Management's
Discussion and Analysis of Financial Condition and Results of Operation -- Year
2000."
Risk of New Products and Technological Change. The Company does not
allocate substantial resources to new product development and has historically
leveraged or licensed the technology developments of others. The Company
believes that many of its competitors have invested, and will continue to
invest, substantial amounts in developing new products and technologies, and
there can be no assurance that the Company's competitors do not have or will not
develop new products and technologies that could render the Company's products
less competitive. For example, Bausch & Lomb has received FDA approval to market
a contact lens based on a new polymer for seven day continuous wear, and it has
been reported that it will seek approval for longer continuous wear. It has also
been reported that Ciba is developing a similar lens. Additionally, certain of
the Company's competitors have or are believed to be developing a toric lens
marketed for weekly disposal. There can be no assurance that the Company will be
able to develop its own technology or utilize technology developed by third
parties in order to remain competitive. Any failure by the Company to stay
current with its competitors with regard to new product offerings and
technological changes and to offer products that provide performance that is at
least comparable to competing products would have a material adverse effect on
the Company's business, financial condition and results of operations. See
"-- Dependence on Single Product Line; Need to Increase Sales of Lenses Marketed
for Disposable Replacement Regimens" and "-- Research and Development."
Risks Associated with Interruption of Manufacturing Operations. The Company
manufactures substantially all of the products it sells. As a result, any
prolonged disruption in the operations of the Company's manufacturing
facilities, whether due to technical or labor difficulties, destruction of or
damage to any facility or other reasons, could have a material adverse effect on
the Company's business, financial condition and results of operations. In this
regard, one of the Company's principal two manufacturing facilities is located
in Puerto Rico and is thus exposed to the risks of damage from hurricanes. If
this facility were to be out of production for an extended period, the Company's
business, financial condition and results of operation would be materially
adversely affected. See "-- Manufacturing."
Dependence on Trademarks, Patent Licenses and Trade Secrets; Risk of
Intellectual Property Infringement. The Company has numerous trademark
registrations in the United States, Europe and other foreign countries. The
Company believes that its trademarks have significant value and are instrumental
to its ability to create and sustain demand for its products and to implement
its channel-based branding strategy. The Company believes that there are no
currently pending challenges to the use or registration of any of the Company's
material trademarks. There can be no assurance, however, that the Company's
trademark's do not or will not violate the proprietary rights of others, that
they would be upheld if challenge or that the Company would, in such an event,
not be prevented from using its trademarks, any of which could have a material
adverse effect on the Company's business, financial condition and results of
operations. Additionally, the Company may discover products in the marketplace
that infringe on trademark rights held by the Company. If the Company is
unsuccessful in challenging a third party's trademark infringement, continued
sales of such product could adversely affect the Company's marketing strategy,
which relies heavily on the Company's
24
27
proprietary trademarks, and could have a material adverse effect on the
Company's business, financial condition and results of operations.
The Company currently relies on a licensed patent for a portion of the dry
cast molding technology used in the production of its products. This license is
non-exclusive, and therefore this patented process may be licensed to the
Company's competitors. The Company believes that Cooper is currently also using
this technology as a result of its acquisition of Aspect Vision Care Ltd. The
Company also relies on non-exclusive licenses to certain design patents for its
toric and bifocal contact lenses, and these licenses limit the Company's sales
of products using the licensed technology to the Americas. The Company owns no
patents and has only one patent application pending. Certain of the Company's
competitors have significant patent portfolios. To the extent the Company
desires or is required to obtain additional licenses to patents or proprietary
rights of others, there can be no assurance that any such licenses will be
available on terms acceptable to the Company, if at all. The inability of the
Company to obtain any of these licenses could result in an inability to make or
sell products or reductions or delays in the introduction of new products to
meet consumer preferences. Any such prohibitions, reductions or delays in the
introduction of such products could have a material adverse effect on the
Company's business, financial condition and results of operations.
In addition to trademarks and patent licenses, the Company owns certain
trade secrets, copyrights, know-how and other intellectual property. The Company
seeks to protect these assets, in part, by entering into confidentiality
agreements with certain of its business partners, consultants and vendors. There
can be no assurance that these agreements will not be breached, that the Company
will have adequate remedies for any such breach or that the Company's trade
secrets and other intellectual property will not otherwise become known or
independently developed by others and thereby become unprotected. Furthermore,
no assurance can be given that competitors will not independently develop
substantially equivalent proprietary information and techniques or otherwise
gain access to the Company's proprietary technology or that the Company can
meaningfully protect its rights in unpatented proprietary technology.
The defense and prosecution of intellectual property suits and related
administrative proceedings are both costly and time-consuming. Litigation may be
necessary to protect trade secrets or know-how owned by the Company or to
determine the enforceability, scope and validity of the proprietary rights of
others. Any litigation or administrative proceedings will likely result in
substantial expense to the Company and significant diversion of effort by the
Company's technical and management personnel. The prosecution and defense of
intellectual property rights, as with any lawsuit, are inherently uncertain and
carry no guarantee of success. The protection of intellectual property in
certain foreign countries is particularly uncertain. An adverse determination in
litigation or administrative proceedings to which the Company may become a party
could subject the Company to significant liabilities to third parties, require
the Company to seek licenses from third parties, prevent the Company from
selling its products or require the Company to modify its products. Although
patent and intellectual property disputes regarding medical devices are often
settled through licensing and similar arrangements, costs associated with such
arrangements may be substantial and could include ongoing royalties.
Furthermore, there can be no assurance that any necessary licenses would be
available to the Company on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent the Company from manufacturing and selling its
products, and such events would have a material adverse effect on the Company's
business, financial condition and results of operations. See "-- Trademarks,
Trade Secrets and Patent Licenses."
Risks of Regulatory Action. The Company's products and manufacturing
facilities are subject to stringent regulation by the FDA and by various
governmental agencies for the states and localities in which the Company's
products are manufactured and/or sold, as well as by governmental agencies in
certain foreign countries in which the Company's products are manufactured
and/or sold. Pursuant to the FDC Act, and the regulations promulgated
thereunder, the FDA regulates the preclinical and clinical testing, manufacture,
labeling, distribution, sale, marketing, advertising and promotion of medical
devices such as contact lenses. The process of obtaining FDA and other required
regulatory clearances or approvals can be lengthy, expensive and uncertain.
Failure to comply with applicable regulatory requirements can result in, among
other things, fines, suspensions or withdrawals of regulatory clearances or
approvals, product recalls, operating restrictions (including suspension of
production, distribution, sales and marketing), product seizures and criminal
25
28
prosecution of a company and its officers and employees. In addition,
governmental regulations may be established that could prevent or delay
regulatory clearances or approval of the Company's products. Delays in receiving
necessary U.S. or foreign regulatory clearances or approvals, failure to receive
clearances or approvals, or the loss of previously received clearances or
approvals could have a material adverse effect on the Company's business,
financial condition and results of operations.
In general, the FDC Act requires that a new medical device be cleared by
the FDA prior to introducing such product to the U.S. market through the
submission of a 510(k) notification; exempted from the requirement of such
clearance; or approved by the FDA prior to introducing such product to the
market through the submission of a PMA. The process of obtaining clearance of a
510(k) notification typically takes five to twelve months without clinical data,
or twelve to eighteen months or more if clinical data are required to be
included in the notification, but it may take longer, and 510(k) clearance may
never be obtained. Approval through the PMA process, which likewise may never be
obtained, generally takes at least eighteen to twenty-four months and can take
substantially longer, is more expensive and requires the submission of extensive
preclinical and clinical data and manufacturing information, among other things.
The soft contact lenses currently marketed by the Company have received FDA
clearance through the 510(k) process or approval through the PMA process. In
addition, the Company has made modifications to its products that the Company
believes do not require the submission of new 510(k) notifications or PMA
supplements. There can be no assurance, however, that the FDA will agree with
any of the Company's determinations not to submit new 510(k) notifications or
PMA supplements for these changes, that the FDA will not require the Company to
cease sales and distribution while seeking clearances of 510(k) notifications
and approvals of PMA supplements for the changes, or that such clearances and
approvals, if required, will be obtained in a timely manner or at all. In
addition, there can be no assurance that any future products developed by the
Company or any modifications to current products will not require additional
clearances or approvals from the FDA, or that such approvals, if necessary, will
be obtained in a timely manner or at all.
The Company's manufacturing facilities are subject to periodic GMP and
other inspections by the FDA. In March 1996, the Company received a warning
letter from the FDA regarding certain procedures used in manufacturing products
at its facilities in Puerto Rico. The Company took steps to address the FDA's
concerns, and, after reinspecting the facilities, the FDA notified the Company
that its concerns were satisfactorily addressed. In February and March 1998, the
FDA again inspected the Company's facilities in Puerto Rico for compliance with
quality system (including GMP) requirements. The Company has received a summary
of certain deficiencies observed by the FDA inspector, primarily related to
complaint handling. The Company is addressing these concerns and believes that
its response will be satisfactory to the FDA. However, there can be no assurance
that the FDA will accept the Company's responses or that the Company will be
found in compliance with quality system (including GMP) requirements in this
inspection and in future inspections by regulatory authorities. Any actions
required by the FDA as a result of its recent inspection or future inspections
could involve significant costs or disruption to the Company's operations, which
could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, noncompliance with quality
system (including GMP) requirements could result in the cessation or reduction
of the Company's production volume, which would have a material adverse effect
on the Company's business, financial condition and results of operations.
Sales of medical devices outside the U.S. are subject to foreign regulatory
requirements that vary widely from country to country. These laws and
regulations range from simple product registration requirements in some
countries to complex clearance and production controls in others. Some countries
have historically permitted human studies earlier in the product development
cycle than regulations in the United States permit. Other countries have
requirements similar to those of the United States. This disparity in the
regulation of medical devices may result in more rapid product clearance in
certain countries than in the United States, while approvals in countries such
as Japan may require longer periods than in the United States. These differences
may also affect the efficiency and timeliness of international market
introduction of the Company's products, and there can be no assurance that the
Company will be able to obtain regulatory approvals or clearances for its
products in foreign countries in a timely manner or at all. See "-- Government
Regulation."
26
29
Product Liability; Insurance. The Company has in the past been, and
continues to be, subject to product liability claims and lawsuits. Because
contact lenses are medical devices, the Company faces an inherent risk of
exposure to product liability claims in the event that the use of its products
results in personal injury. The Company also faces the possibility that defects
in the design or manufacture of its products might necessitate a product recall.
From time to time, the Company has received, and may in the future receive,
complaints of significant patient discomfort, including corneal scarring and
complications, while using the Company's contact lenses. In certain cases, the
reasons for the problems have never been established. In addition, on two
occasions, in 1995 and 1997, the Company has recalled certain of its products
due to labeling errors. Although the Company has not experienced material losses
to date due to product liability claims or product recalls, there can be no
assurance that the Company will not experience such losses in the future, that
insurance coverage will be adequate to cover such losses or that insurance
coverage will be available on acceptable terms or at all. A product liability or
other judgment against the Company in excess of the Company's insurance coverage
or a product recall could have a material adverse effect upon the Company's
business, financial condition and results of operations. See "-- Product
Liability and Insurance."
Environmental Regulations. Federal, state and local regulations impose
various controls on the storage, handling, discharge and disposal of certain
substances used in the Company's manufacturing processes and on the Company's
facilities. The Company believes that its activities conform to present
governmental regulations applicable to its current operations and facilities,
including those related to environmental, land use, public utility utilization
and fire code matters. There can be no assurance that the governmental
regulations will not in the future impose the need for additional capital
equipment or other process requirements upon the Company or restrict the
Company's ability to expand its operations. The adoption of such measures or any
failure by the Company to comply with applicable environmental and land use
regulations or to restrict the discharge of hazardous substances could subject
the Company to future liability or could cause its manufacturing operations to
be curtailed or suspended.
Dependence on Key Personnel. The Company is dependent upon a limited number
of key management and technical personnel. The Company's future success will
depend in part upon its ability to attract and retain highly qualified
personnel. The Company competes for such personnel with other companies,
academic institutions, government entities and other organizations. There can be
no assurance that the Company will be successful in retaining or hiring
qualified personnel. The loss of any of the Company's senior management or other
key research, clinical, regulatory, or sales and marketing personnel,
particularly to competitors, could have a material adverse effect on the
Company's business, financial condition and results of operations. In
particular, the loss of John D. Fruth, the Company's founder and Chief Executive
Officer, could have a material adverse effect on the Company. See "-- Employees"
and "Item 10 -- Directors and Executive Officers of the Registrants."
Influence by Existing Stockholders. Directors, officers and principal
stockholders of the Company, in the aggregate, beneficially own approximately
33% of the Company's outstanding Common Stock. As a result, these stockholders,
acting together, possess significant voting influence over the election of the
Company's Board of Directors and the approval of significant corporate
transactions, among other matters. Such influence could have the effect of
delaying, deferring or preventing a change in control of the Company. See "Item
12 -- Security Ownership of Certain Beneficial Owners and Management."
Certain Anti-Takeover Provisions. The Company's Board of Directors has the
authority to issue up to 4,000,000 shares of Preferred Stock and to determine
the price, rights, preferences, privileges and restrictions, including voting
rights, of those shares without any further vote or action by the stockholders.
The rights of the holders of Common Stock are subject to, and may be adversely
affected by, the rights of the holders of any Preferred Stock that may be issued
in the future. The issuance of Preferred Stock, while providing flexibility in
connection with possible financings or acquisitions or other corporate purposes,
could have the effect of making it more difficult for a third party to acquire a
majority of the outstanding voting stock of the Company. The Company has no
current plans to issue shares of Preferred Stock. The Company's Bylaws and
indemnity agreements provide that the Company will indemnify officers and
directors against losses they may incur in legal proceedings resulting from
their service to the Company. Further, the Company's charter documents contain a
provision eliminating the ability of the Company's stockholders to take action
by written consent.
27
30
This provision is designed to reduce the vulnerability of the Company to an
unsolicited acquisition proposal and to render the use of stockholder written
consents unavailable as a tactic in a proxy fight. However, such provision could
have the effect of discouraging others from making tender offers for the
Company's shares, thereby inhibiting increases in the market price of the
Company's shares that could result from actual or rumored takeover attempts.
Such provision also may have the effect of preventing changes in the management
of the Company. In addition, Section 203 of the Delaware General Corporation
Law, to which the Company is subject, restricts certain business combinations
with any "interested stockholder" as defined by such statute. This statute may
delay, defer or prevent a change in control of the Company.
Volatility of Stock Price. The market price of Company's Common Stock is,
and is likely to continue to be, volatile and may be significantly affected by
factors such as actual or anticipated fluctuations in the Company's operating
results or those of its competitors, competitive factors, trade practice
litigation, new products offered by the Company or its competitors, developments
with respect to patents or proprietary rights, conditions and trends in its
industry and other related industries, regulatory actions, adoption of new
accounting standards, changes in financial estimates by securities analysts,
general market conditions and other factors. In addition, the stock market has
from time to time experienced significant price and volume fluctuations that may
adversely affect the market price of the Company's Common Stock. In the past,
following periods of volatility in the market price of a particular company's
securities, securities class action litigation has often been brought against
that company. Such litigation, if brought against the Company, could result in
substantial costs and a diversion of management's attention and resources. See
"Item 5 -- Market of Registrant's Common Equity and Related Stock Holder
Matters."
28
31
ITEM 2. PROPERTIES
The Company's principal administrative, sales, marketing, customer service,
packaging and distribution facility is located in South San Francisco,
California. The Company's principal manufacturing facilities are located near
Southampton, United Kingdom, and in Santa Isabel, Puerto Rico. The Company also
maintains sales offices in Canada, Hungary and the United Kingdom.
Rapid growth in sales volumes has required that the Company increase its
capacity by adding manufacturing space. The Company's first United Kingdom
manufacturing facility was established in 1988 and operated by Precision Lens
Laboratories Ltd. ("PLL") until 1992, when it was acquired by the Company. The
Company opened its second United Kingdom manufacturing facility in 1996. The
Company's Puerto Rican manufacturing facility was acquired in late 1992 as part
of the American Hydron acquisition. See "Management's Discussion and Analyses of
Financial Conditions and Results of Operations -- Overview." This facility is
currently operating at or near capacity (based on a single production shift per
work day). As part of the Company's plan to increase its manufacturing capacity,
it intends to relocate its Puerto Rican manufacturing facilities to a
substantially larger new facility which is currently being constructed to the
Company's specifications to be leased to the Company by the Puerto Rico
Industrial Development Company upon completion. Construction of this new
facility began during the first quarter of 1998 and is expected to be completed
by the second quarter of 1999, and begin occupancy of the building over the
following nine months. Until the new Puerto Rican facility is completed, the
Company intends to maximize its capacity in the United Kingdom, or increase
capacity in Puerto Rico through additional production shifts, to meet any
requirements for increased volumes of lens production. See
"Business -- Manufacturing" and "Business -- Risk Factors -- Manufacturing
Capacity Constraints; Risks Associated with Expansion and Automation of
Manufacturing Operations."
The following table describes the Company's principal facilities as of
December 31, 1998:
APPROXIMATE
LOCATION FUNCTION SQUARE FEET OWNED/LEASED
-------- -------- ----------- ------------
South San Francisco, California(1) Corporate
Headquarters/Sales/
Distribution 122,000 Leased
Eastleigh, United Kingdom(2) Manufacturing/Sales 66,000 Leased
Eastleigh, United Kingdom(3) Warehouse 10,000 Leased
Romsey, United Kingdom(4) Distribution/Warehouse 23,000 Leased
Nursling, United Kingdom(5) Manufacturing 14,900 Leased
Santa Isabel, Puerto Rico(6) Manufacturing 34,372 Leased
Juana Diaz, Puerto Rico(7) Manufacturing 119,348 Leased
Markham, Ontario(8) Sales/Marketing 4,217 Leased
Markham, Ontario(9) Distribution/Warehouse 2,940 Leased
Budapest, Hungary Sales/Distribution 775 Leased
- ---------------
(1) The Company's lease for this facility expires on October 30, 2002, and the
Company has an option to extend the lease until 2007 and to lease an
additional 30,000 square feet.
(2) The Company's lease for this facility expires on December 23, 2010.
(3) The Company occupies this facility under a three-month rolling lease.
(4) The Company's lease for this facility expires August 18, 2007, and the
Company has an option to break the lease from August 18, 2003.
(5) Represents three separate buildings. One is leased under a lease that
expires March 24, 2011, and is sub-let under a sublease that expires March
21, 2011. The second building, which is currently vacant, is leased under a
lease that expires January 31, 2000. The third building is leased on a
six-month rolling license and is currently used for storage.
(6) Represents three separate buildings. Two buildings are leased under leases
that expire January 1, 2001. The third building is leased under a lease that
expires July 1, 2000. The Company is constructing a
29
32
substantially larger facility in Juana Diaz, Puerto Rico, and began to
relocate from this facility to its new facilities beginning in March of
1999. When the Company has completely relocated to its new facilities, the
leased buildings will be returned to the lessor and the Company will not
incur penalties for early termination.
(7) The Company began construction of this new facility during the first quarter
of 1998 and expects to complete construction by the second quarter of 1999.
The lease commences the first day of the month following completion,
inspection and acceptance of the constructed building, for a period of ten
years.
(8) The Company's lease for this facility expires October 31, 2007, and the
Company has an option to extend the lease to 2012.
(9) The Company's lease for this facility expires October 31, 1999 and the
Company has an option to extend the lease to 2000.
ITEM 3. LEGAL PROCEEDINGS
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCK HOLDER
MATTERS
PRICE RANGE OF COMMON STOCK
The Common Stock of the Company began trading publicly on the Nasdaq
National Market on August 5, 1997 under the symbol "OCLR." Prior to that date,
there was no public market for the Common Stock. The following table sets forth
for the periods indicated the high and low sale prices of the Company's Common
Stock as reported by Nasdaq.
HIGH LOW
------- -------
YEAR ENDED DECEMBER 31, 1998:
Fourth Quarter..................................... $ 29.50 $ 16.00
Third Quarter...................................... $34.875 $17.687
Second Quarter..................................... $35.125 $ 25.50
First Quarter...................................... $32.375 $ 22.00
YEAR ENDED DECEMBER 31, 1997:
Fourth Quarter..................................... $28.125 $ 19.25
Third Quarter (since August 5, 1997)............... $23.375 $ 16.50
As of December 31, 1998, there were approximately 89 holders of record of
the Company's Common Stock, although the Company believes that there is a larger
number of beneficial owners.
DIVIDEND POLICY
The Company has never declared or paid any cash dividends on its Common
Stock, and the payment of cash dividends on its Common Stock is prohibited under
the Company's Amended and Restated Credit Agreement with Comerica
Bank -- California (the "Comerica Credit Agreement"). The Company currently
expects to retain all future earnings for use in the operation and expansion of
its business and does not anticipate paying any cash dividends on its capital
stock in the foreseeable future.
30
33
CHANGES IN SECURITIES AND USE OF PROCEEDS
The Company's registration statement (the "Registration Statement") on Form
S-1, registering the offer and sale of an aggregate of 8,280,000 shares of the
Company's common stock in connection with the Company's initial public offering
(Securities and Exchange Commission File No. 333-27421) was declared effective
by the Securities and Exchange Commission on August 4, 1997, the offering date
for the initial public offering. The managing underwriters for the offering were
Morgan Stanley Dean Witter Incorporated, Bear, Stearns & Co. Inc. and Cowen and
Company.
In August 1997, the Company completed its initial public offering in which
8,280,000 shares of its Common Stock were sold to the public at a price of
$16.50 per share (including shares sold pursuant to the underwriters'
over-allotment option). The shares sold consisted of 3,600,000 shares sold by
the Company at an aggregate public offering price of $59.4 million and 4,680,000
shares sold by selling stockholders at an aggregate public offering price of
$77.2 million. Effective immediately prior to the closing of the initial public
offering, all outstanding shares of the Company's then outstanding preferred
stock were automatically converted into shares of common stock.
The aggregate net offering proceeds to the Company from the initial public
offering after deducting the total expenses associated with the offering was
$53.7 million.
From the effective date of the Registration Statement through December 31,
1998, such proceeds were used for the following purposes:
Construction of plant, building and facilities.............. $ 7,397,000
Purchase and installation of machinery and equipment........ 24,890,000
Repayment of indebtedness................................... 14,728,000
Final payment pursuant to UK settlement agreement........... 6,685,000
-----------
Total expenses.............................................. $53,700,000
===========
None of such payments were direct or indirect payments to directors or
officers of the Company or any of their associates, to persons holding ten
percent or more of any class of equity securities of the Company or to
affiliates of the Company, except that $2,895,000 of the net proceeds were used
to repay indebtedness owed to John Fruth, the Company's Chief Executive Officer
and a Director and holder of in excess of ten percent of the Company's common
stock.
31
34
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data should be read in
conjunction with the Company's consolidated financial statements and the notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" appearing elsewhere in this Form 10-K. The selected data
presented below under the captions "Consolidated Statement of Income" and
"Consolidated Balance Sheet Data" for, and as of the end of, each of the years
in the five-year period ended December 31, 1998 are derived from the
consolidated financial statements of the Company, which consolidated financial
statements have been audited by KPMG LLP, independent certified public
accountants. The consolidated financial statements as of December 31, 1998 and
1997, and for each of the years in the three-year period ended December 31,
1998, and the KPMG LLP report thereon, are included in Item 8 starting on page
44 of this Form 10-K.
YEAR ENDED DECEMBER 31,
-------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF INCOME DATA:
Net sales...................................... $151,908 $118,605 $90,509 $68,087 $48,503
Cost of sales.................................. 48,307 41,066 36,553 26,820 22,553
-------- -------- ------- ------- -------
Gross profit................................. 103,601 77,539 53,956 41,267 25,950
Selling and marketing expenses................. 40,445 27,139 18,101 11,728 6,405
General and administrative expenses............ 21,351 20,470 18,420 14,287 11,087
-------- -------- ------- ------- -------
Income from operations....................... 41,805 29,930 17,435 15,252 8,458
Interest expense............................... (308) (1,387) (3,216) (3,024) (3,128)
Interest income................................ 2,870 939 132 280 123
Other (expense) income, net.................... (1,134) (6) (186) 151 (416)
-------- -------- ------- ------- -------
Income before taxes.......................... 43,233 29,476 14,165 12,659 5,037
Income taxes................................... (12,670) (8,843) (3,989) (3,869) --
Net income................................... 30,563 20,633 10,176 8,790 5,037
Preferred stock dividends...................... -- (49) (82) (82) (82)
-------- -------- ------- ------- -------
Net income applicable to common Stockholders... $ 30,563 $ 20,584 $10,094 $ 8,708 $ 4,955
======== ======== ======= ======= =======
Net income per share (basic)(1)................ $ 1.37 $ 1.10 $ 0.61 $ 0.55 $ 0.38
======== ======== ======= ======= =======
Net income per share (diluted)(1).............. $ 1.31 $ 0.98 $ 0.52 $ 0.46 $ 0.27
======== ======== ======= ======= =======
Shares used in computing net income per share
(basic)(1)................................... 22,293 18,722 16,445 15,791 13,067
======== ======== ======= ======= =======
Shares used in computing net income per share
(diluted)(1)................................. 23,276 21,107 19,439 19,194 18,578
======== ======== ======= ======= =======
OTHER DATA:
Lenses marketed for disposable replacement
regimens as a percentage of total lenses
sold......................................... 93.7% 89.6% 83.5% 73.4% 53.0%
Depreciation and amortization.................. $ 5,950 $ 6,863 $ 4,904 $ 2,578 $ 2,137
Capital expenditures........................... 32,706 16,156 12,256 13,558 2,153
32
35
AS OF DECEMBER 31,
-------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- ------- ------- -------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents, restricted cash and
short-term and long-term investments......... $ 57,249 $ 47,429 $ 5,541 $ 5,346 $ 9,639
Working capital................................ 70,578 60,914 15,118 11,913 17,305
Total assets................................... 176,570 132,835 63,503 50,874 35,645
Total debt..................................... 3,464 3,879 22,740 22,911 22,863
Stockholders' equity........................... 142,949 106,104 23,889 13,292 4,447
- ---------------
(1) For an explanation of the determination of the number of shares used in
computing net income per share (basic and diluted) see Notes 2 and 14 of
Notes to Consolidated Financial Statements.
33
36
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
OVERVIEW
Since the Company was incorporated in 1985, its strategy has been to market
high-quality contact lenses to eyecare practitioners at competitive prices using
a low cost-to-serve operating structure. Until 1992, the Company was principally
a distributor of contact lenses. In September 1992, the Company became an
integrated contact lens company by acquiring the primary supplier of its lenses,
Precision Lens Laboratories Ltd. ("PLL"), a United Kingdom-based company now
called Ocular Sciences Ltd. ("OSL"). In October 1992, the Company acquired the
North and South American contact lens business of Allergan, Inc. ("Allergan"),
which had been operating under the name American Hydron. This acquisition
provided the Company with a significantly expanded customer base, an additional
line of contact lens products to a manufacturing facility in Puerto Rico. The
purchase price was $24.5 million, including acquisition costs of $1.2 million.
The American Hydron acquisition resulted in goodwill and other intangible assets
of $3.4 million, all of which were fully amortized by the end of 1997.
Prior to the summer of 1993, the Company derived a substantial majority of
its sales from lenses marketed for annual replacement regimens and the remainder
of its sales from lenses marketed for monthly replacement regimens. In the third
quarter of 1993, the Company began selling lenses marketed for weekly disposable
replacement regimens. Since that time, substantially all of the Company's growth
in net sales has resulted from sales of lenses marketed for disposable
replacement regimens, primarily weekly disposable replacement regimens. The
Company's lenses marketed for disposable replacement regimens historically have
had lower selling prices and gross margins and are sold in much greater volumes
than its lenses marketed for annual replacement regimens. In 1998, lenses
marketed for disposable replacement regimens accounted for 93.7% of the
Company's unit volume and 84.7% of net sales. See "Business -- Risk Factors." In
1998, approximately 50% of the Company's U.S. net sales came from sales to
optometrists, ophthalmologists, and the distributors that sell to such
practitioners, and approximately 50% of the Company's U.S. net sales came from
sales to chain stores and mass merchants.
RESULTS OF OPERATIONS
All results of operations data in the following tables is presented in
thousands.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Net Sales
YEARS ENDED DECEMBER 31,
--------------------------------
1998 % CHANGE 1997
-------- -------- --------
U.S......................................... $119,215 27.2% $ 93,711
International............................... 32,693 31.3% 24,894
-------- --------
Net sales................................... $151,908 28.1% $118,605
======== ========
As a percentage of net sales
U.S....................................... 78.5% 79.0%
International............................. 21.5% 21.0%
Net sales represents gross sales less allowances for returns, trial set and
prompt payment discounts. The Company recognizes sales upon shipment of products
to its customers. Discounts and allowances for sales returns are accrued at the
time sales are recognized. Net sales increased 28.1% to $151.9 million in 1998
from $118.6 million in 1997. This growth resulted from increased sales of the
Company's lenses marketed for weekly disposable replacement regimens in both the
U.S. and international markets. Unit sales of the Company's lenses marketed for
weekly disposable replacement regimens increased 58.7% from 1997 to 1998.
International sales revenue growth continued to be strong, with revenue growth
of 31.3% and unit growth of 63.9% from 1997 to 1998. In 1998, 93.7% of all
lenses sold by the Company were marketed for use in disposable replacement
regimens, compared to 89.6% in 1997. The Company's overall average selling price
34
37
declined approximately 14.2% from 1997 to 1998, primarily as a result of a
continued shift in product mix towards sales of lower priced products for weekly
disposable replacement regimens, price reductions on the weekly disposable
products in the U.S., and geographic mix towards lower priced international
distributors. The price reductions on the Company's lenses marketed for weekly
replacement took place during the second half of 1998 in response to price
changes by the Company's largest competitor, and were offset in part by
reductions in cooperative merchandising allowances described in "Selling and
Marketing Expenses", below. The Company expects that the overall average selling
price that it realizes across its products will continue to decline over time,
and may decline at a greater rate than in the past, because of (i) shifts in the
Company's product mix from lenses marketed for annual replacement regimens to
lenses marketed for weekly and daily disposable replacement regimens, (ii)
further decreases in the average per unit selling prices of lenses marketed for
disposable replacement regimens, and (iii) increases in products sold
internationally to distributors at prices lower than direct sales prices in the
United States. The Company does not expect there to be any growth in its sales
of lenses for annual replacement as a result of the continuing shift in consumer
demand towards more frequent replacement regimens. The Company has recently
introduced a low priced lens to be marketed for daily replacement in Japan,
expects to introduce a lens marketed for daily replacement in Europe later in
1999 and is evaluating the introduction of such a lens in the United States. The
Company expects that introduction of the new lenses marketed for daily disposal
will result in increased unit and revenue growth due to the more frequent
replacement of such lenses. Historically, the Company's first quarter net sales
have been lower than its fourth quarter net sales, and the Company expects that
its net sales for the quarter ending March 31, 1999 will be lower than its net
sales for the quarter ended December 31, 1998.
Gross Profit
YEARS ENDED DECEMBER 31,
-------------------------------
1998 % CHANGE 1997
-------- -------- -------
Gross profit................................. $103,601 33.6% $77,539
As a percentage of net sales................. 68.2% 65.4%
Cost of sales is comprised primarily of the labor, overhead and material
costs of production and packaging, freight and duty, inventory reserves,
royalties to third parties and amortization of certain intangible assets. A
substantial portion of the Company's cost of sales is fixed and therefore
declines as a percentage of net sales as volume increases. Gross profit
increased 33.6% to $103.6 million, or 68.2% of net sales in 1998, from $77.5
million, or 65.4% of net sales, in 1997. The increase in gross profit from 1997
to 1998 was due primarily to increased net sales, and to decreases in per unit
production costs resulting from the implementation of certain process
improvements and increases in manufacturing volume. The Company expects cost
reductions resulting from improvements in the Company's current production
process to be less significant in the future. The Company intends to add new,
automated production technology at its United Kingdom and Puerto Rico
facilities, and is currently validating the first of these automated production
lines, and anticipates commencing production on these new lines in the first
half of 1999. The new manufacturing technology is designed to further reduce the
Company's per unit cost of production over time, although such cost reductions
may not be seen until future periods and are dependent in part on increases in
production volume to offset the higher depreciation costs (which are a component
of cost of goods sold) associated with the new production lines. In addition, as
described above in "Net Sales", the Company expects that its overall average
selling price on its current products will continue to decline over time, and
that accordingly, the Company will need to continue to reduce its per unit
production costs through increased automation, increased volume and reduced
packaging costs in order to improve, or even maintain, its gross margins on such
products. See "Factors That May Affect Future Results -- Manufacturing Capacity
Constraints; Risks Associated With Expansion and Automation of Manufacturing
Operations." The Company expects that the introduction of a lower priced lens
marketed for the daily disposable replacement regimen will result in a decline
in the average selling price of the Company's products, while reductions in
costs of sales will likely not reach comparable levels until subsequent periods,
if at all. Accordingly, the Company expects its gross margins to decrease, at
least in the first several quarters following the introduction of lenses
marketed for daily replacement regimens and also expects that gross margins may
fluctuate more significantly than in the past. See "Factors That May Affect
Future Results -- Fluctuations in Operating Results; Decreasing Average Sales
Prices."
35
38
In the fourth quarter of 1997, the Company finalized plans to change the
packaging component of its manufacturing process in late 1998, resulting in an
$824,000 write-down in 1997 of certain of its manufacturing assets to estimated
fair value and a corresponding $824,000 increase in cost of sales. See Note 6 of
Notes to Consolidated Financial Statements.
Selling and Marketing Expenses
YEARS ENDED DECEMBER 31,
------------------------------
1998 % CHANGE 1997
------- -------- -------
Selling and marketing expenses................ $40,445 49.0% $27,139
As a percentage of net sales.................. 26.6% 22.9%
Selling and marketing expenses are comprised primarily of cooperative
merchandising allowances, sample diagnostic products provided to eyecare
practitioners without charge, salaries, commissions and benefits for selling and
marketing personnel and postage and freight charges not billed to customers.
Cooperative merchandising allowances are reimbursements made principally to
chain stores and mass merchants for items such as advertising, displays and
mailings that are intended to encourage the fitting and wearing of the Company's
lenses marketed for disposable replacement regimens. These allowances are
limited to a percentage of purchases of lenses marketed for disposable
replacement regimens from the Company. Selling and marketing expenses increased
49.0% to $40.4 million, or to 26.6% of net sales, in 1998 from $27.1 million, or
22.9% of net sales, in 1997. The increase, both in absolute dollars and as a
percentage of net sales from 1997 to 1998 resulted primarily from an increase in
cooperative merchandising allowances, increases in the size of the U.S. sales
force and increases in royalties which are due on certain U.K. sales. See Note
16 of Notes to Consolidated Financial Statements. The increase in cooperative
merchandising allowances was primarily attributable to the 58.7% unit growth in
lenses marketed for weekly disposable replacement regimens as well as the growth
in sales to the optical retail channel which tends to carry a higher level of
these allowances. In connection with the price reductions discussed in "Net
Sales", the Company realized a reduction of its cooperative merchandising
allowances of 14% in the fourth quarter of 1998 compared to the third quarter of
1998. The Company expects that for the next four quarters, the rate of growth in
cooperative merchandising allowances will slow, and as a result expects that the
rate of growth of sales and marketing expenses, will also slow. However, if the
Company is required to respond to pricing and promotional pressures from
competitors, its rate of spending on cooperative merchandising allowances could
increase in the future.
General and Administrative Expenses
YEARS ENDED DECEMBER 31,
------------------------------
1998 % CHANGE 1997
------- -------- -------
General and administrative expenses........... $19,117 5.7% $18,085
As a percentage of net sales.................. 12.6% 15.2%
General and administrative expenses are comprised primarily of salaries and
benefits for general and administrative, distribution, non-manufacturing
facilities costs, professional services, and consultants' fees. General and
administrative expenses increased 5.7% to $19.1 million in 1998 from $18.1
million in 1997, but declined as a percentage of net sales from 15.2% to 12.6%.
Included in the 1998 expense, is a charge of $586,000 related to a custom-built
packaging machine which failed factory acceptance tests and Company
specifications. The Company did not take delivery of this custom-built machine
nor used it in its production. This amount represented cumulative payments to
the vendor, which had been recorded in construction in progress and subsequently
charged to general and administrative expense. See Note 6 of Notes to
Consolidated Financial Statements. Without this one-time expense, general and
administrative expenses would have increased 2.5% from 1997 to 1998. The
increase in absolute dollars was due primarily to the additional infrastructure
related to the requirements of being a publicly held company, partially offset
by provisions for sales and use taxes recorded in 1997. The decrease in general
and administrative expenses as a percentage of net sales resulted primarily from
expenses growing at a slower rate than revenues, automation of the Company's
distribution centers and the leverage from utilizing the infrastructures of the
Company's international partners rather than establishing direct operations
overseas. For example, worldwide unit sales
36
39
increased 49.8% from 1997 to 1998 while worldwide distribution expenses
increased only 8.1% during this period. The Company believes that as net sales
grow, its general and administrative expenses will increase in absolute dollars,
but decrease as a percentage of net sales.
Research and Development Expenses
YEARS ENDED DECEMBER 31,
----------------------------
1998 % CHANGE 1997
------ -------- ------
Research and development expenses............... $2,234 (6.3)% $2,385
As a percentage of net sales.................... 1.5% 2.0%
Research and development expenses are comprised primarily of consulting
costs for research and development and in-house engineering and process
development labor related to the Company's ongoing focus on reducing per unit
costs of production. The decrease from 1997 to 1998, both in dollars and as a
percentage of revenue, was primarily due to the fact that the Company completed
the research and development phase related to its new automated production
technology during the third quarter of 1998 and commenced installation and
validation of equipment utilizing this technology. Installation and validation
expenditures are capitalized rather than expensed. The Company expects its
research and development expenses to increase, both in absolute amount and as a
percentage of net sales in 1999. Research and development expenses may fluctuate
as the Company undertakes new engineering projects and new products.
Interest and Other Income (Expenses), Net
YEARS ENDED DECEMBER 31,
---------------------------
1998 % CHANGE 1997
------ -------- -----
Interest and other income (expenses), net....... $1,428 414.5% $(454)
As a percentage of net sales.................... 0.9% (0.4)%
Interest and other income (expenses), net increased 414.5% to $1.4 million,
or to 0.9% of net sales, in 1998 from an expense of $454,000, or 0.4% of net
sales, in 1997. This increase primarily resulted from a reduction in interest
expense as the aggregate amount of the Company's borrowings was reduced
following its initial public offering in August 1997 and an increase in interest
earned as a result of the investment of a portion of the net proceeds from the
Company's initial public offering.
Income Taxes
YEARS ENDED DECEMBER 31,
-----------------------------
1998 % CHANGE 1997
------- -------- ------
Income taxes................................... $12,670 43.3% $8,843
Effective tax rate............................. 29.3% 30.0%
Income taxes were $12.7 million in 1998 and $8.8 million in 1997. The
Company's effective tax rate decreased from 30% in 1997 to 29.3% in 1998 as a
result of an increase in the earnings from the Company's Puerto Rican
operations, which are partially exempt from U.S. taxation. The Company
anticipates that it will continue to benefit from the favorable effect of this
partial exemption through 2001, with limited exemption during the transition
period from 2002 through 2006, when the benefit will expire under the current
provisions of the Internal Revenue Code. The Company has implemented a new
corporate structure that is likely to result in an increase in its foreign
earnings. As a result, the Company believes that its effective tax rate will
decrease, so long as the Company maintains its policy of reinvesting its foreign
earnings overseas.
37
40
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Net Sales
YEARS ENDED DECEMBER 31,
-------------------------------
1997 % CHANGE 1996
-------- -------- -------
U.S.......................................... $ 93,711 26.6% $74,004
International................................ 24,894 50.8% 16,505
-------- -------
Net sales.................................... $118,605 31.0% $90,509
======== =======
As a percentage of net sales
U.S........................................ 79.0% 81.8%
International.............................. 21.0% 18.2%
Net sales increased 31.0% to $118.6 million in 1997 from $90.5 million in
1996. Substantially all of this growth resulted from increased sales of the
Company's lenses marketed for weekly disposable replacement regimens. The
Company's international sales as a percentage of total sales increased from
18.2% in 1996 to 21.0% in 1997 primarily as a result of increased demand
experienced by the Company's international distributors and new partnering and
distributor relationships established by the Company abroad. In 1997, 89.6% of
all lenses sold by the Company were marketed for use in disposable replacement
regimens, compared to 83.5% in 1996. The Company's overall average selling price
declined approximately 11.2% from 1996 to 1997, primarily as a result of a shift
in product mix from lenses marketed for annual replacement regimens to lower
priced lenses marketed for disposable replacement and, to a lesser extent, as a
result of an increase in the percentage of the Company's products sold
internationally to distributors at prices lower than direct sales prices in the
United States. Within each principal distribution channel, the average selling
price of each of the Company's primary products remained relatively stable from
1996 to 1997.
Gross Profit
YEARS ENDED DECEMBER 31,
------------------------------
1997 % CHANGE 1996
------- -------- -------
Gross profit.................................. $77,539 43.7% $53,956
As a percentage of net sales.................. 65.4% 59.6%
Gross profit increased 43.7% to $77.5 million, or 65.4% of net sales in
1997, from $54.0 million, or 59.6% of net sales, in 1996. The increase in gross
profit from 1996 to 1997 was due primarily to increased net sales, and to
decreases in per unit production costs resulting from the implementation of
certain process improvements and increases in manufacturing volume.
In 1998, the Company changed the packaging component of its manufacturing
process, resulting in an $824,000 write-down in 1997 of certain of its
manufacturing assets to estimated fair value and a corresponding $824,000
increase in cost of sales. See Note 6 of Notes to Consolidated Financial
Statements. In addition, cost of sales in 1997 included approximately $690,000
for amortization of intangible assets acquired in connection with the February
1997 settlement of certain U.K. litigation (the "U.K. Litigation"). See Note 18
of Notes to Consolidated Financial Statements.
Selling and Marketing Expenses
YEARS ENDED DECEMBER 31,
------------------------------
1997 % CHANGE 1996
------- -------- -------
Selling and marketing expenses................ $27,139 49.9% $18,101
As a percentage of net sales.................. 22.9% 20.0%
Selling and marketing expenses increased 49.9% to $27.1 million, or 22.9%
of net sales, in 1997 from $18.1 million, or 20.0% of net sales, in 1996. The
increase, both in absolute dollars and as a percentage of net sales from 1996 to
1997 resulted primarily from an increase in cooperative merchandising allowances
and, to a lesser extent, an increase in the shipment of sample diagnostic
products.
38
41
General and Administrative Expenses
YEARS ENDED DECEMBER 31,
------------------------------
1997 % CHANGE 1996
------- -------- -------
General and administrative expenses........... $18,085 4.3% $17,332
As a percentage of net sales.................. 15.2% 19.1%
General and administrative expenses increased 4.3% to $18.1 million in 1997
from $17.3 million in 1996, but declined as a percentage of net sales from 15.2%
to 19.1%. The dollar increase was due primarily to increased salaries and other
personnel-related benefits to employees, sales and use tax provisions,
relocation and recruiting fees associated with the hiring of a new chief
operating officer, and increased depreciation, partially offset by reductions in
legal and professional fees as a result of the settlement of the U.K. Litigation
in February 1997. The decrease in general and administrative expenses as a
percentage of net sales resulted from the limited growth in distribution and
administrative expenses relative to the growth in net sales.
Research and Development Expenses
YEARS ENDED DECEMBER 31,
----------------------------
1997 % CHANGE 1996
------ -------- ------
Research and development expenses............... $2,385 119% $1,088
As a percentage of net sales.................... 2.0% 1.2%
The increase in research and development expenses from 1996 to 1997, both
in dollars and as a percentage of revenue, was primarily a result of increased
costs related to the Company's continuing effort to development its new
automated production technology.
Interest and Other (Expenses), Net
YEARS ENDED DECEMBER 31,
----------------------------
1997 % CHANGE 1996
----- -------- -------
Interest and other (expenses), net............. $(454) (86.1)% $(3,270)
As a percentage of net sales................... (0.4)% (3.6)%
Interest and other expense, net decreased 86.1% to $454,000, or 0.4% of net
sales, in 1997 from $3.3 million, or 3.6% of net sales, in 1996. This decrease
primarily resulted from a reduction in interest expense as the aggregate amount
of the Company's borrowings was reduced following its initial public offering in
August 1997 and an increase in interest earned as a result of the investment of
a portion of the net proceeds from the Company's initial public offering.
Income Taxes
YEARS ENDED DECEMBER 31,
----------------------------
1997 % CHANGE 1996
------ -------- ------
Income taxes.................................... $8,843 121.7% $3,989
Effective tax rate.............................. 30% 28.2%
Income taxes were $8.8 million in 1997 and $4.0 million in 1996. The
Company's effective tax rate increased from 28.2% in 1996 to 30.0% in 1997 as a
result of an increase in the percentage of international earnings, which are
subject to full U.S. taxation, as compared to earnings attributable to the
Company's Puerto Rican operations, which are partially exempt from U.S.
taxation.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENT
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133") which will be effective for
all fiscal quarters of fiscal years beginning after June 15, 1999. SFAS No. 133
establishes accounting and reporting standards for derivatives instruments and
for hedging activities. The statement requires that an entity recognize all
derivatives as either assets or
39
42
liabilities in the statement of financial position and measure those instruments
at fair value. The statement generally provides for matching the timing of gain
or loss recognition on the hedging instrument with the recognition of (a) the
changes in the fair value of the hedged asset or liability that are attributable
to the hedged risk or (b) the earnings effect of the hedged forecasted
transaction. The Company anticipates that adoption of this Statement will not
have a material effect on the Company's financial position or results of
operations.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents at December 31, 1998 of $26.5 million decreased
from a December 31, 1997 balance of $27.9 million. Working capital increased
from $60.9 million at December 31, 1997 to $70.6 million at December 31, 1998.
The decrease in cash and cash equivalents was due primarily to the purchase of
capital equipment and net purchases of short-term and long-term investments in
excess of cash generated from operations. The increase in working capital was
due primarily to the increase in short-term investments and accounts receivable.
The Company had $19.1 million in short-term and long-term investments as of
December 31, 1997, compared to $30.2 million as of December 31, 1998. The
Company's short-term and long-term investments may be easily liquidated at
minimal cost.
From January 1, 1996 to December 31, 1998, the Company's cash flows from
operating activities and the Company's initial public offering have been
sufficient to fund substantially all of the Company's cash requirements. Over
this three-year period, the Company generated cash-based earnings (net income
plus depreciation and amortization) of $79.1 million. This operating cash, along
with the proceeds from the initial public offering of $53.7 million, were
primarily used to purchase property, plant and equipment of $61.1 million, to
purchase intangible assets of $8.8 million as part of the settlement of the U.K.
Litigation, to make short and long-term investments of $30.2 million and to
effect net repayment of long-term debt of $19.8 million.
Net cash provided by operating activities was $41.4 million, $31.6 million
and $12.7 million in 1998, 1997 and 1996, respectively, primarily representing
net income of $30.6 million, $20.6 million and $10.2 million, respectively,
increased for depreciation and amortization of $6.0 million, $6.9 million and
$4.9 million, respectively. The increase in cash in 1998 and 1997 was also
attributable to a tax benefit of $4.5 million and $7.9 million, respectively,
from a gain related to an employee stock option exercise, and an increase in
accrued liabilities, offset by increases in accounts receivables and inventory.
Net cash used in investing activities in 1998, 1997 and 1996 was $43.5
million, $42.5 million and $11.5 million, respectively. In 1996, substantially
all of this net cash was used to purchase property and equipment. In 1997, the
Company used $16.1 million to purchase property and equipment, $8.8 million to
purchase intangible assets as part of the settlement of the U.K. Litigation and
$19.1 million to purchase short and long-term investments. In 1998, the Company
doubled its investment in property and equipment to $32.7 million, as the
Company continued to invest in the development and implementation of automated
production technology at its manufacturing facilities and the development and
construction of the new Puerto Rican manufacturing facility, and used $32.1
million to purchase short and long-term investments.
Net cash provided by financing activities in 1998 and 1997 was $1.5 million
and $35.2 million, respectively, and net cash used by financing activities in
1996 was $0.3 million. In each of these years, net cash was used primarily for
repayments of long-term debt. Net cash provided by financing activities in 1997
was due primarily to net proceeds to the Company from its August 1997 initial
public offering of $53.7 million, Net cash provided in 1998 was primarily from
proceeds from issuance of common stock from employee stock option exercises.
In addition to cash, cash equivalents, short-term investments and long-term
investments, the Company has a credit facility with Comerica Bank -- California.
Under the Comerica Credit Agreement, the Company and its subsidiary Ocular
Sciences Puerto Rico, Inc. ("Ocular Sciences Puerto Rico") can borrow up to an
aggregate of $30.0 million. The Comerica Credit Agreement provides for up to
$20.0 million of revolving credit loans to the Company and up to $10.0 million
of term loans to Ocular Sciences Puerto Rico. Revolving credit borrowings under
the Comerica Credit Agreement bear interest at the bank's base rate or at 1.00%
to
40
43
1.25% above the eurodollar rate, and term loans bear interest at the bank's base
or at 1.25% to 1.50% above the eurodollar rate, in each case with the applicable
margin over the eurodollar rate depending on the Company's ratio of debt to
tangible net worth. As of December 31, 1998, there were no revolving credit
loans outstanding under the Comerica Credit Agreement. $2.4 million of term
loans were borrowed on November 7, 1997 and used to repay outstanding loans from
the Banco Bilbao de Vizcaya, and the remaining $7.6 million of term loans are
available to finance the construction and development of the Company's planned
new Puerto Rican manufacturing facility. The revolving credit loans will be
available through June 30, 2000 and the term loan facility provides for advances
through April 30, 1999, at which time the principal amount outstanding will
become payable over twenty-two quarterly principal installments, with a final
maturity date of October 31, 2004. The Company is required to maintain minimum
ratios of debt to tangible net worth and of current assets to current
liabilities, and a minimum tangible net worth. Borrowings under the Comerica
Credit Agreement are secured by a pledge of 100% of the outstanding common stock
of Ocular Sciences Puerto Rico and 65% of the outstanding capital stock of the
Company's United Kingdom and Canadian subsidiaries. In addition, the Company and
Ocular Sciences Puerto Rico have each guaranteed the other's borrowings under
the Comerica Credit Agreement. See Note 8 of Notes to Consolidated Financial
Statements. In February 1999, the Company finalized an agreement with the Puerto
Rico Industrial Development Company, ("PRIDCO"), effective June 1998, to manage
on PRIDCO's behalf the construction of the planned new Puerto Rico facility.
Ocular Sciences Puerto Rico plans to initially finance the building construction
as well as the leasehold improvements with existing cash and then borrow against
the remaining balance available under this term loan. Under this agreement, at
the end of the construction project, PRIDCO will reimburse Ocular Sciences
Puerto Rico for up to a maximum of $3,470,000 for certain structural
construction costs of the facility, and the Company will lease this
manufacturing facility from PRIDCO at annual rental payments of approximately
$489,000 commencing four months after completion of the project, for a period of
ten years. See Note 20 of Notes to Consolidated Financial Statements.
The Company is obligated to make minimum base payments on noncancelable
operating leases of $2.6 million, $1.7 million and $1.6 million in 1999, 2000
and 2001, respectively, and has existing commitments to make capital
expenditures of $13.1 million. The Company currently expects to make capital
expenditures of approximately $53.0 million in 1999 (including the $13.1
million), primarily related to the development and implementation of automated
production lines at its manufacturing facilities and the development and
construction of a new Puerto Rican manufacturing facility. However, the amount
of capital expenditures may increase or decrease, as the Company may accelerate
or delay the implementation of the automated production lines based on market
conditions and demand for its products. See "Business -- Risk Factors --
Manufacturing Capacity Constraints; Risks Associated With Expansion and
Automation of Manufacturing Operations."
The Company believes that its current cash and cash equivalents, borrowings
available under its credit facilities and its anticipated net cash flow from
operations will be sufficient to meet its anticipated cash needs for working
capital, contractual commitments and capital expenditures for at least the next
12 months. If cash generated from operations proves insufficient to satisfy the
Company's liquidity requirements, the Company may seek to sell additional equity
or debt securities or obtain further credit facilities. The sale of additional
equity or convertible debt securities could result in additional dilution to the
Company's stockholders. The sale of additional debt or further bank borrowings
could subject the Company to additional restrictive financial covenants and
restrictions on the payment of dividends. There can be no assurance that
financing will be available to the Company in amounts or on terms acceptable to
the Company, if at all.
EURO CONVERSION
On January 1, 1999, eleven European Union member countries established
fixed conversion rates between their existing currencies ("legal currencies")
and one common currency, the Euro. The Euro is currently traded on currency
exchanges and can be used in business transactions. The Company does not
anticipate any material impact from the Euro conversion on its financial
information systems nor its financial condition and results of operations.
41
44
YEAR 2000
Many currently installed computer systems and software products are unable
to distinguish between twentieth century dates and twenty-first century dates
because such systems may have been developed using two digits rather than four
to determine the applicable year. For example, computer programs that have date-
sensitive software may recognize a date using "00" as the year 1900 rather than
the year 2000. This error could result in system failures or miscalculations
causing disruptions of operations, including among other things, a temporary
inability to process transactions, send invoices or engage in similar normal
business activities. As a result, many companies' software and computer systems
may need to be upgraded or replaced to comply with such "Year 2000"
requirements.
The Company's business is dependent on the operation of numerous systems
that could potentially be impacted by Year 2000 related problems. Those systems
include, among others: hardware and software systems used by the Company to
manufacture and deliver products and services to its customers; the internal
systems of the Company's customers and suppliers; the hardware and software
systems used internally by the Company in the management of its business; and
non-information technology systems and services used by the Company in the
management of its business, such as telephone systems and building systems.
In early 1998, the Company's Board of Directors named it's Chief
Information Officer ("CIO") to head up a compliance project to identify all
information technology ("IT"), non-IT systems and third party related issues.
The CIO or other appropriate person will make presentations on the Company's
compliance program at each Board of Directors meeting until the year 2000. At
present, the Company has completed an inventory of all IT and non-IT systems and
has assessed the requirements for modifications. The Company believes that
correction and testing will be completed by the third quarter of 1999 and
implementation by October 1999. To date, the Company's expenditures to review
and remedy Year 2000 compliance problems have not been material, and the Company
does not expect such expenditures to be material in the future.
The Company is also in the process of replacing its business control
information systems with new systems that function properly with respect to
dates in the Year 2000 and thereafter. The Company has implemented several of
these applications and anticipates implementing the other planned applications
by the middle of 1999. The Company expects that, with the new information
system, the Year 2000 issue will not pose significant operational problems for
the Company's computer system, however, there can be no assurance there will not
be a delay in, or increased costs associated with, the implementation of the new
information system and the Company's inability to install such a system could
have a material adverse effect on future results of operations. If this project
is delayed, the Company believes that it can modify its current systems at a
cost of approximately $750,000 to handle Year 2000 dates.
The Company has developed contingency plans to address and mitigate
potential Year 2000 problems that may arise. As part of the Company's
contingency plans, the Company is developing specific plans for each critical
system to allow for interrupted operations to resume in a timely manner.
However, contingency planning for Year 2000 issues is complicated due to the
possibility of multiple and simultaneous incidents, some of which may be outside
of the Company's control, for example, noncompliance of third party systems.
There can be no assurances that if these scenarios do occur, the Company will be
able to respond in a timely manner and resume normal business.
The Company has not fully determined the extent to which it may be impacted
by third parties' systems, which may not be Year 2000-compliant. The Year 2000
computer issue creates risk for the Company from third parties with whom the
Company works on business transactions worldwide. Given the Company's
significant operations in the United Kingdom and Puerto Rico, the Company may be
especially susceptible to Year 2000 problems of third parties in those regions,
as well as in the United States. While the Company has begun efforts to seek
reassurance from its suppliers and service providers, there can be no assurance
that the systems of other companies that the Company works with or on which the
Company's systems rely will be timely converted, or that any such failure to
convert by another company could not have an adverse effect on the Company.
42
45
The Company believes that its internal operating systems will be Year 2000
compliant before December 31, 1999. Therefore, the Company believes that the
most reasonably likely worst-case scenario will be that one or more of third
parties with which the Company has a material business relationship will not
have successfully dealt with its Year 2000 issues. A critical third party
failure (such as telecommunication, utilities or financial institutions) could
have a material adverse affect on the Company by adversely affecting the
Company's ability to manufacture and distribute its products, order and pay for
production materials from suppliers and receive orders and payments from
customers. Additionally, Year 2000 problems at customers may result in reduced
purchasing by such customers. It is also possible that one or more of the
Company's internal operating systems will not function properly and make it
difficult to complete routine tasks, such as accounting and other record keeping
duties. Based on information currently available, the Company does not believe
that it will experience any long-term operating systems failures. However, there
can be no assurance of this, and the Company intends to continue to monitor
these issues as part of its Year 2000 project and to concentrate its efforts on
minimizing their impact.
The foregoing discussion of the Company's Year 2000 readiness includes
forward-looking statements, including estimates of the time frames and costs for
addressing the known Year 2000 issues confronting the Company, and is based on
management's current estimates, which were derived using numerous assumptions.
There can be no assurance that these estimates will be achieved, and actual
events and results could differ materially from those anticipated. Specific
factors that might cause such material differences include, but are not limited
to, the availability of personnel with required remediation skills, the ability
of the Company to identify and correct or replace all relevant computer code and
other systems affected by the Year 2000 problem, and the success of third
parties with whom the Company does business in addressing their Year 2000
issues. See "-- Risk Factors -- Uncertain Ability to Manage Growth: Risks
Associated with Implementation of New Management Information Systems."
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The Company's investments consist of interest-bearing investment-grade
instruments that meet high quality standards consistent with the Company's
investment policy. The Company's investment policy requires that the portfolio's
average maturity shall not exceed one year, and the maximum maturity of any
investment shall not exceed three years. Due to the short maturities of its
investment portfolio, the Company believes that the impact of the fluctuation in
interest rate to the carrying value is not material (see Note 4 to the
Consolidated Financial Statements). In addition, the Company does not hold
derivative financial instruments in its investment portfolio, nor does the
Company utilize risk-sensitive market instruments, positions or transactions in
any material fashion.
The Company has long-term debt outstanding, which is carried at cost (see
Note 8 to the Consolidated Financial Statements), with an interest rate which is
referenced to market rates. Interest rate changes generally do not affect the
fair value of variable rate debt instruments, but do impact future earnings and
cash flows. Holding debt levels constant, a one percentage point increase in
interest rates would decrease earnings and cash flows for variable rate debt by
approximately $23,000.
IMPACT OF FOREIGN CURRENCY RATE CHANGES
The Company operates two foreign subsidiaries that manufacture and sell its
products primarily in the United Kingdom and to a lesser extent in Canada.
Therefore, its earnings, cash flows and financial position are exposed to
foreign currency risk from foreign-currency-denominated receivables and
payables, forecasted sales transactions, as well as net investment in certain
foreign operations. The Company's foreign currency transactional exposures exist
primarily with the U.K. pound and Canadian dollar. The Pound Sterling and
Canadian dollar exchange rates fluctuated approximately 5% to 10%, respectively
during 1998, from its highest to lowest point. As a result of this fluctuation,
the Company recorded an exchange loss of $913,000 in 1998. During 1998, the
Company did not engage in foreign currency hedging activities.
43
46
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
OCULAR SCIENCES, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
ASSETS
DECEMBER 31,
--------------------
1998 1997
-------- --------
Current Assets:
Cash and cash equivalents................................... $ 26,520 $ 27,895
Restricted cash............................................. 486 464
Short-term investments...................................... 19,036 10,000
Accounts receivable, less allowance for sales returns and
doubtful accounts of $2,085 and $1,655 for 1998 and 1997,
respectively.............................................. 25,126 18,785
Inventories................................................. 12,460 12,941
Deferred income taxes....................................... 4,638 3,100
Loans to officers and employees............................. 263 927
Prepaid expenses and other current assets................... 6,495 5,173
-------- --------
Total Current Assets.............................. 95,024 79,285
Property and equipment, net................................. 62,966 36,248
Intangible assets, net...................................... 7,216 8,137
Long-term investments....................................... 11,207 9,070
Other assets................................................ 157 95
-------- --------
Total Assets...................................... $176,570 $132,835
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable............................................ $ 6,003 $ 3,723
Accrued liabilities......................................... 10,512 9,354
Accrued cooperative merchandise allowances.................. 5,854 4,238
Current portion of long-term debt........................... 929 445
Deferred income taxes....................................... -- 333
Income and other taxes payable.............................. 1,148 278
-------- --------
Total Current Liabilities......................... 24,446 18,371
Deferred income taxes....................................... 6,640 4,926
Long-term debt, less current portion........................ 2,535 3,434
-------- --------
Total Liabilities................................. $ 33,621 $ 26,731
-------- --------
Commitments, contingencies and subsequent events
Stockholders' Equity:
Common Stock, $0.001 par value; 80,000,000 shares
authorized; 22,588,118 and 21,738,166 shares issued and
outstanding for 1998 and 1997, respectively............... 23 22
Additional paid-in capital.................................. 76,741 70,438
Retained earnings........................................... 66,727 36,164
Accumulated other comprehensive income...................... (542) (520)
-------- --------
Total Stockholders' Equity........................ 142,949 106,104
-------- --------
Total Liabilities and Stockholders' Equity........ $176,570 $132,835
======== ========
See accompanying notes to consolidated financial statements.
44
47
OCULAR SCIENCES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31,
-----------------------------------------
1998 1997 1996
----------- ----------- -----------
Net sales........................................... $ 151,908 $ 118,605 $ 90,509
Cost of sales....................................... 48,307 41,066 36,553
----------- ----------- -----------
Gross profit........................................ 103,601 77,539 53,956
Selling and marketing expenses...................... 40,445 27,139 18,101
General and administrative expenses................. 19,117 18,085 17,332
Research and development expenses................... 2,234 2,385 1,088
----------- ----------- -----------
Income from operations.............................. 41,805 29,930 17,435
Interest expense.................................... (308) (1,387) (3,216)
Interest income..................................... 2,870 939 132
Other (expense) income, net......................... (1,134) (6) (186)
----------- ----------- -----------
Income before taxes................................. 43,233 29,476 14,165
Income taxes........................................ (12,670) (8,843) (3,989)
----------- ----------- -----------
Net income.......................................... 30,563 20,633 10,176
Preferred stock dividends........................... -- (49) (82)
----------- ----------- -----------
Net income applicable to common stockholders........ $ 30,563 $ 20,584 $ 10,094
=========== =========== ===========
Net income per share data:
Net income per share (basic)........................ $ 1.37 $ 1.10 $ 0.61
=========== =========== ===========
Net income per share (diluted)...................... $ 1.31 $ 0.98 $ 0.52
=========== =========== ===========
Weighted average common shares outstanding.......... 22,292,632 18,721,749 16,445,404
Weighted average common and dilutive potential
common shares outstanding......................... 23,276,088 21,107,440 19,439,457
=========== =========== ===========
See accompanying notes to consolidated financial statements.
45
48
OCULAR SCIENCES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
ACCUMULATED
OTHER
PREFERRED STOCK COMMON STOCK ADDITIONAL COMPREHENSIVE TOTAL
----------------- ------------------- PAID-IN RETAINED INCOME STOCKHOLDERS'
SHARES AMOUNT SHARES AMOUNT CAPITAL EARNINGS (LOSS) EQUITY
-------- ------ ---------- ------ ---------- -------- ------------- -------------
BALANCES AS OF DECEMBER 31,
1995.......................... 118,168 $ 1 15,854,864 $16 $ 7,859 $ 5,486 $ (70) $ 13,292
Exercise of employee stock
options....................... -- -- 679,140 -- 200 -- -- 200
Directors' compensation......... -- -- 5,566 -- 28 -- -- 28
Income tax benefits from stock
options exercised............. -- -- -- -- 273 -- -- 273
Comprehensive income:
Net income.................... -- -- -- -- -- 10,176 -- 10,176
Other comprehensive income
(loss)...................... -- -- -- -- -- -- 2 2
--------
Comprehensive income............ 10,178
Preferred stock dividends....... -- -- -- -- -- (82) -- (82)
-------- --- ---------- --- ------- ------- ----- --------
BALANCES AS OF DECEMBER 31,
1996.......................... 118,168 1 16,539,570 16 8,360 15,580 (68) 23,889
Exercise of employee stock
options....................... -- -- 1,359,600 1 494 -- -- 495
Directors' compensation......... -- -- 2,660 -- 22 -- -- 22
Conversion of preferred stock to
common stock.................. (118,168) (1) 236,336 1 -- -- -- --
Sale of common stock in initial
public, offering, net of
issuance costs of $1,545...... -- -- 3,600,000 4 53,693 -- -- 53,697
Income tax benefits from stock
options exercised............. -- -- -- -- 7,869 -- -- 7,869
Comprehensive income:
Net income.................... -- -- -- -- -- 20,633 -- 20,633
Other comprehensive income
(loss)...................... -- -- -- -- -- -- (452) (452)
--------
Comprehensive income............ 20,181
Preferred stock dividends....... -- -- -- -- -- (49) -- (49)
-------- --- ---------- --- ------- ------- ----- --------
BALANCES AS OF DECEMBER 31,
1997.......................... -- -- 21,738,166 22 70,438 36,164 (520) 106,104
Exercise of employee stock
options....................... -- -- 819,952 1 1,701 -- -- 1,702
Sale of common stock in
secondary public offering, net
of issuance costs of $645..... -- -- 30,000 -- 139 -- -- 139
Comprehensive income:
Net income.................... -- -- -- -- -- 30,563 -- 30,563
Other comprehensive income
(loss)...................... -- -- -- -- -- -- (22) (22)
--------
Comprehensive income............ 30,541
Income tax benefits from stock
options exercised............. -- -- -- -- 4,463 -- -- 4,463
-------- --- ---------- --- ------- ------- ----- --------
BALANCES AS OF DECEMBER 31,
1998.......................... -- $-- 22,588,118 $23 $76,741 $66,727 $(542) $142,949
======== === ========== === ======= ======= ===== ========
See accompanying notes to consolidated financial statements.
46
49
OCULAR SCIENCES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.................................................. $ 30,563 $ 20,633 $ 10,176
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization............................... 5,950 6,863 4,904
Amortization of loan to officer............................. 150 38 --
Income tax benefits from stock options exercised............ 4,463 7,869 --
Provision for sales returns and doubtful accounts........... 880 968 193
Provision for excess and obsolete inventory................. 1,129 893 605
Provision for damaged and scrap products.................... 744 729 548
Impairment loss on fixed asset revaluation.................. 586 824 --
Loss (gain) on sale of property and equipment............... 10 (165) (35)
Exchange loss (gain)........................................ 913 9 (49)
Deferred income taxes....................................... (157) 1,014 932
CHANGES IN OPERATING ASSETS AND LIABILITIES:
Accounts receivable......................................... (7,330) (3,859) (4,339)
Inventories................................................. (1,497) (1,792) (1,259)
Prepaid expenses, other current and non-current assets...... (1,844) (3,474) (164)
Accounts payable............................................ 2,310 (269) (973)
Accrued liabilities......................................... 2,765 2,899 3,183
Income and other taxes payable.............................. 867 (664) (1,024)
-------- -------- --------
Net cash provided by operating activities................... 40,502 32,516 12,698
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment.......................... (32,706) (16,156) (12,256)
Purchase of short-term and long-term investments............ (32,122) (19,059) --
Purchase of marketing rights and license agreement.......... -- (8,817) --
Loans to officers and employees............................. (185) (930) --
Collection of loans to officers and employees............... 1,113 3 --
Sales and maturities of short-term and long-term
investments............................................... 20,937 -- --
Proceeds from liquidation of property and equipment......... 368 308 55
(Deposits to) payments from restricted cash................. (21) 1,217 730
-------- -------- --------
Net cash used in investing activities....................... (42,616) (43,434) (11,471)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of long-term debt.................... -- 5,951 19,343
Repayment of long-term debt................................. (390) (24,867) (19,805)
Proceeds from initial public offering, net.................. -- 53,697 --
Proceeds from secondary public offering, net................ 139 -- --
Preferred stock dividends................................... -- (63) (82)
Proceeds from issuance of common stock...................... 1,701 517 228
-------- -------- --------
Net cash (used in) provided by financing activities......... 1,450 35,235 (316)
-------- -------- --------
Effect of exchange rate changes on cash and cash
equivalents............................................... (711) (217) (141)
-------- -------- --------
Net (decrease) increase in cash and cash
equivalents..................................... (1,375) 24,100 770
Cash and cash equivalents at beginning of year.............. 27,895 3,795 3,025
-------- -------- --------
Cash and cash equivalents at end of year.................... $ 26,520 $ 27,895 $ 3,795
======== ======== ========
SUPPLEMENTAL CASH FLOW DISCLOSURES:
CASH PAID DURING THE YEAR FOR:
Interest.................................................... $ 312 $ 1,439 $ 3,561
Income taxes................................................ $ 7,936 $ 2,911 $ 3,393
See accompanying notes to consolidated financial statements.
47
50
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
NOTE 1. NATURE OF BUSINESS
Formation and Business of the Company
O.S.I. Corporation ("the Company") was incorporated in California in 1985.
On July 31, 1997, the Company effected a reincorporation into the state of
Delaware and changed its name to Ocular Sciences, Inc. The Company is engaged in
the design, manufacture and distribution of contact lenses and conducts business
under the name of Ocular Sciences/American Hydron.
The Initial Public Offering
On August 8, 1997, the Company closed its initial public offering of
8,280,000 shares of its Common Stock at an initial public offering price of
$16.50 per share. Of the 8,280,000 shares, 3,600,000 shares were sold by the
Company and the remaining 4,680,000 were sold by certain selling shareholders.
The net proceeds to the Company were $53.7 million, after deducting underwriting
discounts and commissions and other offering expenses payable by the Company.
The Company utilized $11.6 million of the proceeds to repay all of the debt
outstanding under the Company's Credit Agreement with Comerica
Bank -- California, $2.9 million of the proceeds to repay subordinated debt owed
to the Company's Chief Executive Officer, $6.7 million of the proceeds as final
payment pursuant to the settlement agreement of certain U.K. litigation (Note
18) and $400,000 for the construction of the new Puerto Rican manufacturing
facility.
The Secondary Public Offering
On March 19, 1998, the Company completed a secondary offering in which
5,343,381 shares of its Common Stock were sold to the public at a price of
$27.50 per share (including shares sold pursuant to the underwriters'
over-allotment option). The shares sold consisted of 30,000 shares sold by the
Company and 5,313,381 shares sold by selling stockholders. The Company incurred
aggregate expenses of $645,000 in connection with the secondary offering
(excluding underwriting discounts and commissions paid by the Company and the
selling stockholders).
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Consolidation
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries, Ocular Sciences Ltd. ("OSL")
(formerly Precision Lens Laboratories Ltd.), Ocular Sciences Puerto Rico, Inc.,
Ocular Sciences Canada Corporation, Precision Lens Manufacturing and Technology,
Inc., and Ocular Sciences Hungary. All significant intercompany balances and
transactions have been eliminated in consolidation.
Accounting Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the reported
period. Actual results could differ from these estimates.
Reclassifications
Certain prior period amounts have been reclassified to conform to the
current year presentation.
48
51
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
Cash and Cash Equivalents
Cash equivalents consist of commercial paper, money market funds, United
States government debt securities and certificates of deposits with original
maturities of three months or less.
Financial Instruments
All of the Company's short-term and long-term investments are classified as
"available-for-sale" and recorded at fair value, under the provisions of
Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for
Certain Investments in Debt and Equity Securities." The amortized costs of
available-for-sale debt securities are adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization is included in net
investment income. Unrealized gains and losses, net of tax, are reported as a
component of other comprehensive income. Realized gains and losses, and declines
in value judged to be other than temporary on available-for-sale securities, are
included in other (expense) income, net. The cost of securities sold is based on
the specific identification method. Interest and dividends on securities
classified as available-for-sale are included in interest income.
Restricted Cash
Restricted cash consists of cash held in an escrow account related to
leased facilities occupied by the Company's United Kingdom subsidiary.
Inventories
Inventories are recorded at the lower of cost (first-in, first-out method)
or market. Cost includes material, labor and applicable factory overhead.
Provision for potentially obsolete or slow moving inventory is made based upon
management's analysis of inventory levels and forecasted sales.
Revenue Recognition
The Company recognizes sales upon shipment of products to its customers.
Allowances for sales returns and discounts are accrued at the time sales are
recognized.
Cooperative Merchandise Allowances
The Company offers a cooperative merchandise program to certain of its
customers whereby the Company reimburses these customers for items such as
advertising, displays and mailings that are intended to encourage the fitting
and wearing of the Company's lenses marketed for disposable replacement
regimens. The Company records the provisions for cooperative merchandising at
the time of sale to the customers and as a component of selling and marketing
expenses.
Advertising Costs
Advertising and promotion costs are expensed as incurred.
Foreign Currencies
The functional currencies of the Company's United Kingdom, Canadian and
Hungarian subsidiaries are the respective local currencies. Accordingly, the
subsidiaries translate all asset and liability accounts at current exchange
rates in effect at the balance sheet date and statement of income accounts at
average exchange rates during the period. Translation adjustments arising from
differences in exchange rates from period to period are included in the
consolidated financial statements as a component of other comprehensive income.
49
52
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
Concentration of Credit Risk
The Company sells its products to a diverse group of optometrists, optical
retailers, optical product distributors and ophthalmologists, and therefore the
concentration of credit risk with respect to accounts receivable is limited due
to the large number and diversity of customers across broad geographic areas.
Accounts receivable from customers are uncollateralized. As of December 31,
1998, approximately 19% of accounts receivable and 11% of consolidated net sales
were concentrated in one customer, while, as of December 31, 1997, approximately
16% of accounts receivable and 8% of consolidated net sales were concentrated in
one customer. To reduce credit risk, the Company performs ongoing credit
evaluations of its significant customers' respective financial conditions. The
Company establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of specific customers, historical trends and other
information.
Property and Equipment
Property and equipment are recorded at cost and depreciated using the
straight-line method over the respective estimated useful lives of the assets as
follows: equipment and machinery, 3 to 7 years; furniture and fixtures, 3 - 5
years; vehicles, 4 - 7 years; buildings, 10 - 14 years; and leasehold
improvements, over the shorter of the respective lease terms or the respective
estimated useful lives of the leasehold improvements. Normal repairs and
maintenance are expensed as incurred. Expenditures which materially increase
values, change capacities or extend useful lives are capitalized.
Long-Lived Assets, Including Intangible Assets
The Company accounts for long-lived assets under SFAS No. 121, "Accounting
for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of." SFAS No. 121 requires that long-lived assets and certain identifiable
intangibles be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of assets may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment loss to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to
sell. The Company estimates fair value based on the best information available,
making judgments and projections as considered necessary.
Marketing rights, trademarks, licenses and covenants not to compete are
carried at cost less accumulated amortization, which is calculated on a
straight-line basis over the estimated useful lives of the respective assets,
which are typically five to ten years.
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Under SFAS No. 109, deferred income taxes are
recognized for tax consequences in future years of differences between the tax
bases of assets and liabilities and their financial reporting amounts at each
balance sheet date based on enacted tax laws and statutory tax rates expected to
apply in the periods in which the differences are expected to affect taxable
income.
Earnings Per Share
The Company computes and presents its net income per share in accordance
with SFAS No. 128, "Earnings per Share." Net income per share (basic) is
computed based on the weighted average number of
50
53
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
common shares outstanding, and net income per share (diluted) is computed based
on the weighted average number of common shares and dilutive potential common
shares outstanding during the period. Dilutive potential common shares include
the conversion of stock options using the treasury stock method. In the year
ended December 31, 1997, conversion of the shares of Series A Preferred Stock
into 236,336 shares of common stock was included in the weighted average
dilutive potential common shares outstanding figures during the period prior to
the conversion and the related common shares issued upon conversion are included
for the period after the date of the conversion. In the year ended December 31,
1996, the conversion of the Series A Preferred Stock is included in the weighted
average dilutive potential common shares outstanding figures as if converted at
the beginning of the period. All prior period net income per share data was
restated by the Company upon adoption of SFAS No. 128.
Stock-Based Compensation
The Company follows the provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation," and has elected to continue to account for
stock-based compensation using methods prescribed in Accounting Principles Board
Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations.
The Company follows the practice of recording amounts received upon the
exercise of options by crediting common stock and additional paid-in capital.
The Company realizes an income tax benefit from the exercise and early
disposition of certain stock options and the exercise of other stock options.
The benefit results in a decrease in current income taxes payable and an
increase in additional paid-in capital.
Segment Information
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 131, "Disclosures about Segments of an Enterprise and Related Information"
effective in the year ending December 31, 1998. The standard establishes
requirements for reporting information about operating segments and disclosures
relating to products and services, geographic areas and major customers.
Operating segments are components of an enterprise about which separate
financial information is available and which is used regularly by its chief
decision maker in allocation of resources. The Company adopted SFAS No. 131
effective for the year ended December 31, 1998 and operates in a single
operating segment and follows the requirements of SFAS No. 131.
New Accounting Standards
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" which will be effective for all fiscal
quarters of fiscal years beginning after June 15, 1999. SFAS No. 133 establishes
accounting and reporting standards for derivatives instruments and for hedging
activities. The statement requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. The statement generally provides for matching
the timing of gain or loss recognition on the hedging instrument with the
recognition of (a) the changes in the fair value of the hedged asset or
liability that are attributable to the hedged risk or (b) the earnings effect of
the hedged forecasted transaction. The Company anticipates that adoption of this
Statement will not have a material effect on the financial position or results
of operations of the Company.
NOTE 3. ACCUMULATED OTHER COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income", which establishes new rules for the reporting and display
of comprehensive income and its components. The adoption of SFAS No. 130 had no
impact on the Company's financial position or results of operations.
51
54
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
Accumulated other comprehensive income or loss includes primarily foreign
currency translation adjustment and unrealized gains and losses on investments.
The change in unrealized gains (losses) on securities includes reclassification
adjustments for gains (losses) in income from the sale of securities. Realized
gains (losses) and the related tax effects are not material. The following table
reflects the changes in accumulated balances of other comprehensive income (in
thousands):
ACCUMULATED
FOREIGN OTHER
CURRENCY UNREALIZED COMPREHENSIVE
TRANSLATION GAINS (LOSSES) INCOME
ADJUSTMENT ON SECURITIES (LOSS)
----------- -------------- -------------
Balance at December 31, 1996.......... $ (68) $ -- $ (68)
Current year change................. (463) 11 (452)
----- ---- -----
Balance at December 31, 1997.......... (531) 11 (520)
Current year change................. (10) (12) (22)
----- ---- -----
Balance at December 31, 1998.......... $(541) $ (1) $(542)
===== ==== =====
NOTE 4. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's short-term and long-term investments in marketable equity
securities are carried at fair value, based on quoted market prices for these or
similar investments. The carrying amounts reported in the balance sheet for
cash, receivables, related party loans, accounts payable, accrued liabilities
and short-term debt approximates fair values due to their short-term maturities.
Long-term debt is carried at cost, which approximates fair value as the interest
rate on the debt is referenced to market rates.
As of December 31, 1998, short-term investments, due in one year or less,
and long-term investments, due in one to three years, amounted to approximately
$19,036,000 and $11,207,000, respectively. Short-term and long-term investments
have been classified as available-for-sale and consisted of the following (in
thousands):
DECEMBER 31,
------------------
1998 1997
------- -------
Tax-exempt municipal funds............................... $20,780 $ 8,779
United States government debt securities................. 1,001 8,285
Foreign debt securities.................................. 2,006 --
Corporate notes.......................................... 6,456 2,006
------- -------
$30,243 $19,070
======= =======
The Company's available-for-sale securities are carried at market value
and, as of December 31, 1998, and 1997 included an unrealized gain (loss) of
approximately $(700) and $11,000, respectively, net of tax, consisting
principally of tax-exempt municipal funds and United States government
securities.
52
55
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
NOTE 5. INVENTORIES
Inventories consisted of the following (in thousands):
DECEMBER 31,
------------------
1998 1997
------- -------
Raw materials............................................ $ 2,867 $ 2,767
Work in process.......................................... 1,252 812
Finished goods........................................... 8,341 9,362
------- -------
$12,460 $12,941
======= =======
NOTE 6. PROPERTY AND EQUIPMENT, NET
Property and equipment, net consisted of the following (in thousands):
DECEMBER 31,
--------------------
1998 1997
-------- --------
Equipment and machinery................................ $ 25,814 $ 22,485
Furniture and fixtures................................. 2,800 2,416
Vehicles............................................... 138 248
Building and leasehold improvements.................... 9,665 10,304
Construction in progress............................... 42,847 14,824
-------- --------
81,264 50,277
Less accumulated depreciation and amortization......... (18,298) (14,029)
-------- --------
$ 62,966 $ 36,248
======== ========
In the fourth quarter of 1997, the Company finalized plans to change the
packaging component of its manufacturing process which was implemented in late
1998, which will render certain of the Company's existing manufacturing
equipment obsolete. In accordance with SFAS No. 121, the Company recorded a
pretax charge to cost of sales of $824,000 in 1997 related to this impairment
loss and reduced the carrying amount of this asset by a corresponding amount.
The amount of impairment loss is the excess of the carrying amount of the
impaired asset over the fair value of the asset. The fair value was determined
by computing the present value of estimated expected cash flows using a discount
rate commensurate with the risks involved.
In the second quarter of 1998, the Company recorded a charge of $586,000
related to a custom-built packaging machine that failed the factory acceptance
test and Company specifications. The Company did not take delivery of this
custom-built machine nor used it in its production. This amount represents
cumulative payments to the vendor, which was recorded in construction in
progress and charged to general and administrative expenses.
NOTE 7. INTANGIBLE ASSETS, NET
Intangible assets, net consisted of the following (in thousands):
DECEMBER 31,
----------------
1998 1997
------- ------
Marketing rights, trademarks, licenses and covenants not to
compete................................................... $ 8,921 $8,921
Less accumulated amortization............................... (1,705) (784)
------- ------
$ 7,216 $8,137
======= ======
53
56
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
NOTE 8. LONG-TERM DEBT
Long-term debt consisted of the following (in thousands):
DECEMBER 31,
---------------
1998 1997
------ ------
Term loan to a bank, principal payments due quarterly from
July 31, 1999 through October 31, 2004, bearing interest
at the bank's Eurodollar rate plus 1.25%.................. 2,218 2,183
Capital lease obligations, bearing an effective interest
rate of 10.54%, 10.19%, and 10.5%, respectively, for 1998,
1997 and 1996, secured by certain equipment............... 1,246 1,696
------ ------
Total long-term debt.............................. 3,464 3,879
Less current portion of long-term debt...................... (929) (445)
------ ------
$2,535 $3,434
====== ======
On November 7, 1997 the Company amended its credit agreement (the "Amended
Credit Agreement"). On August 5, 1998, the interest rate options were modified
and the interest rates were reduced by 0.25%, prospectively. Under the new
agreement, the Company and its subsidiary, Ocular Sciences Puerto Rico, Inc.
("Ocular Sciences Puerto Rico") can borrow up to an aggregate of $30,000,000.
The Amended Credit Agreement provides for a revolving line of credit of up to
$20,000,000 to the Company and up to $10,000,000 of term loans to Ocular
Sciences Puerto Rico.
Under the revised terms of the Amended Credit Agreement, the revolving line
of credit has two interest rate options -- interest at the bank's base rate or
at 1.00% to 1.25% above the rate at which deposits in eurodollars are offered to
the bank by other prime banks in the eurodollar market, with the applicable
margin over the eurodollar rate depending on the Company's ratio of debt to
tangible net worth. The Company pays commitment fees of 0.250% on the revolving
line of credit, with percentages varying based on the Company's ratio of debt to
tangible net worth. Loans under the revolving line of credit are due in full on
June 30, 2000. The Company may elect to prepay any principal due under the
revolving line of credit but would be required to reimburse the lending bank for
any breakage costs with respect to prepayment of any eurodollar rate loan prior
to the end of an applicable interest period. At December 31, 1998 and 1997, the
Company had no borrowings under the revolving line of credit and thus the full
$20,000,000 remained available.
Under the term loan facility, $10,000,000 is available to finance the
construction and development of Ocular Sciences Puerto Rico's new manufacturing
facility. The term loan provides for three interest rate options -- interest at
the bank's base rate, interest at 1.25% to 1.50% above the rate at which
deposits in eurodollars are offered to the bank by other prime banks in the
eurodollar market, or interest at 1.25% to 1.50% above the negotiated rate,
defined as the lending bank's cost of funds (after reserve requirements) plus
its FDIC insurance rate. The negotiated rate option is available only after
April 30, 1999. There are no commitment fees on the term loan. On April 30,
1999, the then outstanding term loan will become payable in twenty-two quarterly
principal installments beginning July 31, 1999, $250,000 each quarter with any
balance to be paid on October 31, 2004. The Company may elect to prepay the
principal due under the term loan but would be required to reimburse the lending
bank for any breakage costs with respect to prepayment of any eurodollar rate
loan prior to the end of an applicable interest period. The balances outstanding
under the term loan was $2,218,000 and $2,183,000 as of December 31, 1998 and
1997, respectively. The effective interest rate of the term loan as of December
31, 1998 and 1997 was 6.5625% and 7.1875%, respectively.
Borrowings by the Company under the Amended Credit Agreement are guaranteed
by Ocular Sciences Puerto Rico, and borrowings by Ocular Sciences Puerto Rico,
under the Amended Credit Agreement are guaranteed by the Company. Borrowings
under the Amended Credit Agreement are secured by a pledge of
54
57
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
100% of the outstanding common stock of Ocular Sciences Puerto Rico and 65% of
the outstanding capital stock of the Company's United Kingdom and Canadian
subsidiaries. The Company is also required under the Amended Credit Agreement to
maintain minimum ratios of debt to tangible net worth, and of current assets to
current liabilities, and a minimum tangible net worth, and the Amended Credit
Agreement places certain limitations on debts, liens, contingent obligations,
investments and cash dividends on common stock.
The Long-term debt, including current portion, is due in aggregate annual
installments of: $436,000 in 1999, $935,000 in 2000, and $847,000 in 2001.
NOTE 9. LEASES
The future minimum annual lease payments under noncancelable lease
obligations with an initial term in excess of one year, as of December 31, 1998,
are as follows (in thousands):
CAPITALIZED OPERATING
LEASES LEASES
----------- ---------
Year Ending December 31,
1999................................................. $ 602 $ 2,572
2000................................................. 552 1,676
2001................................................. 264 1,592
2002................................................. -- 1,559
2003................................................. -- 649
Thereafter........................................... -- 3,499
------ -------
Total Minimum lease payments................. $1,418 $11,547
=======
Imputed interest....................................... (172)
------
Present value of minimum lease payments................ 1,246
Current portion........................................ (494)
------
Long-term capitalized lease obligations................ $ 752
======
Rent expense on operating leases for the Company's offices, warehouse
facilities and certain equipment was approximately $2,584,000, $2,301,000 and
$1,643,000 for the years ended December 31, 1998, 1997 and 1996, respectively.
The Company leases a portion of its machinery and equipment under long-term
capital leases, and has the option to purchase these assets for fair market
value at the termination of the lease. Included in property and equipment, net
are the following leased assets (in thousands):
DECEMBER 31,
----------------
1998 1997
------ ------
Equipment and machinery.................................... $2,468 $3,233
Furniture and fixtures..................................... 142 205
Vehicles................................................... -- 161
------ ------
2,610 3,599
Less accumulated depreciation and amortization............. (1,100) (910)
------ ------
$1,510 $2,689
====== ======
Depreciation and amortization expense on machinery and equipment and
vehicles under long-term capital leases was approximately $395,000, $478,000 and
$148,000 for the years ended December 31, 1998, 1997 and 1996.
55
58
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
NOTE 10. STOCK SPLIT
On August 4, 1997, the Company effected a two-for-one stock split of the
Company's common stock. All applicable share and per share amounts have been
retroactively adjusted to reflect both stock splits.
NOTE 11. PREFERRED STOCK AND ACCRUED DIVIDENDS
Each share of preferred stock outstanding at December 31, 1996
automatically converted into two shares of common stock upon the consummation of
the Company's initial public offering. Cumulative dividends were paid on a
quarterly basis from January 1995 to August 1997.
NOTE 12. COMMON STOCK
Certain Anti-Takeover Provisions
The Company's Board of Directors has the authority to issue up to 4,000,000
shares of Preferred Stock and to determine the price, rights, preferences,
privileges and restrictions, including voting rights, of those shares without
any further vote or action by the stockholders.
Stock-based Compensation Plans
The Company has the following stock-based compensation plans:
(i) 1989 Stock Option Plan
The 1989 Stock Option Plan provided for the grant to employees, directors
and consultants of incentive stock options, exercisable at a price not less than
the fair market value of the shares on the grant date, or for non-qualified
options, exercisable at a price not less than 85% of the fair market value of
the shares on the date of grant. The options generally were granted for a six
year-term and vested over a five year period. This plan was terminated upon the
effective date of the Company's initial public offering on August 4, 1997. Any
authorized shares not issued or subject to outstanding grants under this plan on
August 4, 1997 and any shares that are issuable upon exercise of options granted
pursuant to this plan that expire or become unexercisable for any reason without
having been exercised in full will be available for future grant and issuance
under the 1997 Equity Incentive Plan. As of December 31, 1998, options to
purchase a total of 895,374 shares are outstanding under this plan.
(ii) 1992 Officers and Directors Stock Option Plan
The 1992 Officers and Directors Stock Option Plan provided for the grant of
incentive stock options exercisable at a price not less than the fair market
value of the Company's common stock on the grant date or nonqualified stock
options exercisable at a price not less than 85% of the fair market value of the
Company's common stock on the grant date. A total of 1,280,000 shares of common
stock were reserved for issuance under this plan. In 1992 the Company's Chief
Executive Officer was granted an option to purchase the 1,280,000 shares of
common stock reserved under this plan. This option was exercised, in full,
during 1997 at an exercise price of $0.29365 per share. This Plan was terminated
upon the effective date of the Company's initial public offering.
(iii) 1997 Equity Incentive Plan
The 1997 Equity Incentive Plan provides for grants of incentive stock
options to employees (including officers and employee directors) and
nonqualified stock options to employees, officers, directors, consultants,
independent contractors and advisors of the Company. The exercise price of all
incentive stock options must be no less than the fair market value of the
Company's Common Stock on the date of grant and the exercise price of all
nonqualified stock options must be at a price not less than 85% of such fair
market value. The
56
59
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
options generally are granted for a ten-year term and vest over a five-year
period. Any authorized shares not issued or subject to outstanding grants under
the 1989 Plan on August 4, 1997 and any shares that are issuable upon exercise
of options granted pursuant to the 1989 Plan that expire or become unexercisable
for any reason without having been exercised in full are available for future
grant and issuance under the 1997 Equity Incentive Plan. As of December 31,
1998, a total of 2,333,422 shares of common stock were reserved for issuance
under this plan.
(iv) 1997 Directors Stock Option Plan
The 1997 Directors Stock Option Plan provides for grants of nonqualified
stock options to certain non-employee directors of the Company. The exercise
price per share of all options granted under the plan must be equal to the fair
market value of the Company's common stock on the date of grant. The options
generally are granted for a ten-year term and vest over a three-year period. As
of December 31, 1998, a total of 300,000 shares of common stock were reserved
for issuance under this plan.
(v) 1997 Employee Stock Purchase Plan
The 1997 Employee Stock Purchase Plan (the "Purchase Plan") permits
employees to purchase common stock at a price equal to 85% of fair market value
of the Company's common stock. A total of 400,000 shares of common stock are
reserved for issuance under the Purchase Plan. The Purchase Plan was not
effective as of December 31, 1998 and accordingly, no shares of common stock
have been purchased under the Purchase Plan.
A summary of stock option transactions under the plans indicated at (i),
(iii) and (iv) follows:
WEIGHTED
AVERAGE
RANGE OF NUMBER OF EXERCISED
EXERCISE PRICES OPTIONS PRICE
---------------- --------- ---------
Outstanding as of December 31, 1995.......... $ 0.27 to $ 3.04 2,221,170 $ 1.30
Exercised.................................... 0.27 to 3.04 (679,140) 0.30
Granted...................................... 5.03 to 7.36 395,534 5.82
Canceled..................................... 0.27 to 7.36 (133,260) 2.48
---------------- --------- ------
Outstanding as of December 31, 1996.......... $ 0.27 to $ 7.36 1,804,304 $ 2.58
Exercised.................................... 0.27 to 8.09 (79,600) 1.50
Granted...................................... 8.09 to 25.38 575,150 19.74
Canceled..................................... 1.47 to 14.00 (80,400) 3.61
---------------- --------- ------
Outstanding as of December 31, 1997.......... $ 0.27 to $25.38 2,219,454 $ 7.03
Exercised.................................... 0.27 to 26.38 (819,952) 2.08
Granted...................................... 17.69 to 31.75 1,667,200 26.31
Canceled..................................... 1.47 to 29.63 (161,778) 20.69
---------------- --------- ------
Outstanding as of December 31, 1998.......... $ 1.47 to $31.75 2,904,924 $18.73
================ ========= ======
Total number of shares exercisable
at December 31, 1998............. $ 1.47 to $28.75 539,713 $ 8.15
================ ========= ======
The weighted average grant date fair value of the options granted in 1998,
1997 and 1996 was $9.45, $5.80, and $0.95, respectively. At December 31, 1998,
622,272 options were available for grant.
Pursuant to SFAS No. 123, "Accounting for Stock-Based Compensation," the
Company is required to disclose the pro forma effects on net income and net
income per share as if the Company had elected to use the fair value approach to
account for all of its employee stock-based compensation plans. Had compensation
cost for the Company's plans been determined in a manner consistent with the
fair value approach enumerated
57
60
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
in SFAS No. 123, the Company's pro forma net income and pro forma net income per
share for the years ended December 31, 1998, 1997 and 1996, would have been
reduced to the pro forma amounts indicated below (in thousands):
DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
Pro forma net income:
As reported................................. $30,563 $20,633 $10,176
Adjusted pro forma.......................... 28,873 20,487 10,157
Net income per common share (basic):
As reported................................. $ 1.37 $ 1.10 $ 0.61
Adjusted pro forma.......................... 1.30 1.09 0.62
Net income per common share (diluted):
As reported................................. $ 1.31 $ 0.98 $ 0.52
Adjusted pro forma.......................... 1.24 0.97 0.52
In 1996, the Company calculated the fair value of options using the minimum
value method, which applies a dividend rate and expected volatility of zero. In
1998 and 1997, the Company calculated the fair value of options using the
Black-Scholes option-pricing model. The assumptions used were as follows:
1998 1997
---- ----
Weighted-average risk free interest rate............... 5.31% 5.94%
Expected life (years).................................. 3 3
Volatility............................................. 45.0% 35.3%
Dividend yield......................................... -- --
The following table summarizes information about stock options outstanding
as of December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------- --------------------------
NUMBER WEIGHTED-AVERAGE NUMBER
OF REMAINING WEIGHTED-AVERAGE OF WEIGHTED-AVERAGE
RANGE OF EXERCISE PRICES OPTIONS CONTRACTUAL LIFE EXERCISE PRICE OPTIONS EXERCISE PRICE
------------------------ --------- ---------------- ---------------- ------- ----------------
$ 1.47 - 8.09................ 865,854 2.3 $ 3.54 384,497 $ 2.88
$14.00 - 31.75................ 2,039,070 8.3 25.18 155,216 21.20
--------- --- ------ ------- ------
$ 1.47 - 31.75................ 2,904,924 6.5 $18.73 539,713 $ 8.15
========= === ====== ======= ======
NOTE 13. RETIREMENT SAVINGS PLAN
In October 1998, the Company established a defined-contribution savings
plan under Section 401K of the Internal Revenue Code. This savings plan allows
eligible U.S. employees to contribute up to 15% of their compensation on a
pre-tax basis. The Company matches 50% of the first four percent of the
employees' contribution. Such matching Company contributions are vested
incrementally over five years. All of the Company's subsidiaries have similar
retirement savings plans in the respective Countries. The charge to operating
income for the Company's matching contribution was approximately $520,000 in
1998.
58
61
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
NOTE 14. NET INCOME PER SHARE
The following table reconciles net income per share (basic) to net income
per share (diluted):
DECEMBER 31,
---------------------------------------
1998 1997 1996
----------- ----------- -----------
Net income used in the net income per share (basic)
calculation........................................... $ 30,563 $ 20,584 $ 10,094
Preferred stock dividends............................... -- 49 82
----------- ----------- -----------
Net income used in the net income per share (diluted)
calculation........................................... $ 30,563 $ 20,633 $ 10,176
=========== =========== ===========
Weighted average common shares outstanding.............. 22,292,632 18,721,749 16,445,404
Weighted average dilutive potential common shares....... 983,456 2,385,691 2,994,053
----------- ----------- -----------
Weighted average common and dilutive potential common
shares outstanding.................................... 23,276,088 21,107,440 19,439,457
=========== =========== ===========
Net income per share (basic)............................ $ 1.37 $ 1.10 $ 0.61
=========== =========== ===========
Net income per share (diluted).......................... $ 1.31 $ 0.98 $ 0.52
=========== =========== ===========
NOTE 15. INCOME TAXES
Deferred taxes are provided, where warranted, to reflect the future tax
consequences of differences between the financial reporting and tax reporting of
various assets and liabilities; these differences will be either taxable or
deductible when the related assets and liabilities are recovered or settled. The
income tax benefits related to the exercise of stock options reduces taxes
currently payable and is credited to additional paid-in capital. Such amounts
approximated $4,463,000, $7,869,000 and $273,000 for 1998, 1997 and 1996,
respectively.
Income before income tax expense includes the following components (in
thousands):
1998 1997 1996
------- ------- -------
United States......................... $40,220 $28,580 $12,993
Foreign............................... 3,013 896 1,172
------- ------- -------
Total....................... $43,233 $29,476 $14,165
======= ======= =======
Income tax expense (benefit) for the years ended December 31, 1998, 1997
and 1996, consisted of (in thousands):
1998 1997 1996
---------------------------- --------------------------- ---------------------------
CURRENT DEFERRED TOTAL CURRENT DEFERRED TOTAL CURRENT DEFERRED TOTAL
------- -------- ------- ------- -------- ------ ------- -------- ------
Federal.............. $ 8,509 $(209) $ 8,300 $5,866 $(231) $5,635 $1,963 $(648) $1,315
State................ 2,048 17 2,065 1,729 (402) 1,327 627 389 1,016
Foreign.............. 2,270 35 2,305 963 918 1,881 706 952 1,658
------- ----- ------- ------ ----- ------ ------ ----- ------
$12,827 $(157) $12,670 $8,558 $ 285 $8,843 $3,296 $ 693 $3,989
======= ===== ======= ====== ===== ====== ====== ===== ======
59
62
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
The total income tax expense differed from the amount computed by applying
the federal statutory income tax rate of 35% for 1998 and 1997 and 34% for 1996
to income before taxes as a result of the following (in thousands):
YEAR ENDED DECEMBER 31,
----------------------------
1998 1997 1996
------- ------- ------
Computed tax expense at federal statutory
rate......................................... $15,132 $10,317 $4,816
Foreign tax rate differential.................. 214 44 (4)
Puerto Rico possessions tax credit............. (3,999) (2,554) (1,135)
State taxes.................................... 1,366 719 367
Amortization of goodwill....................... -- 124 168
Other permanent differences.................... (43) 193 (223)
------- ------- ------
$12,670 $ 8,843 $3,989
======= ======= ======
The tax effects of temporary differences that gave rise to significant
portions of the deferred tax assets and deferred tax liabilities are as follows
(in thousands):
DECEMBER 31,
------------------
1998 1997
------- -------
Deferred tax assets:
Net operating loss carryforwards....................... $ 1,312 $ 295
Accounts receivable, principally due to allowance for
doubtful accounts................................... 800 939
Inventories, principally due to reserves and additional
costs capitalized for tax purposes.................. 2,401 1,300
State taxes............................................ 717 --
Other accrued liabilities.............................. 442 1,312
------- -------
Total gross deferred tax assets................ 5,672 3,846
Deferred tax liabilities:
Investment in subsidiaries............................. (438) (448)
Puerto Rico tollgate tax............................... (716) (1,400)
Puerto Rico profit split and basis difference.......... (907) (926)
Other basis differences................................ (2,059) (1,348)
Depreciation of property and equipment................. (3,554) (1,821)
State taxes............................................ -- (62)
------- -------
Total gross deferred tax liabilities........... (7,674) (6,005)
------- -------
Net deferred tax asset (liability)............. $(2,002) $(2,159)
======= =======
As of December 31, 1998, deferred taxes were not provided on a cumulative
earnings approximately equal to $6,143,000 of consolidated foreign subsidiaries
that are designated as permanently invested. For tax purposes, the Company had
available, as of December 31, 1998, foreign net operating loss carry forwards of
approximately $4,376,000 which have an indefinite life.
NOTE 16. RELATED PARTY TRANSACTIONS
In 1996, the Company operated under three agreements with a related party
and certain stockholders which had been originally entered into on September 30,
1992. In February 1997, all of these agreements were
60
63
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
terminated as a part of a litigation settlement (see Note 18). There were no
royalties paid, lenses sold or consulting services provided under these
agreements in 1998, 1997 or 1996. A summary of these agreements are as follows:
i. A non-exclusive patent license agreement, which granted the Company
the right to manufacture, use and sell products and processes covered by
patents and patent applications owned by certain former stockholders of
OSL, some of whom were stockholders of the Company prior to the initial
public offering. The agreement required the Company to pay royalties to the
patent owners of $0.50 per lens, with a minimum $1,000,000 per royalty year
(from July 1 to June 30).
ii. A purchase and supply agreement with Aspect Vision Care Ltd.
("AVCL"), an entity affiliated with certain stockholders of the Company.
The agreement provided that the Company would sell lenses to AVCL at a
purchase price equal to the Company's direct and indirect costs of
processing lenses, plus 20%.
iii. Consulting agreements with two stockholders that called for an
aggregate of approximately $7,000 per month to be paid for consulting
services rendered.
As of December 31, 1996, the Company had a $2,895,000 long-term junior
subordinated note payable due to the Company's Chief Executive Officer bearing
interest at the prime rate plus 3% (11.25% as of December 31, 1996). An
agreement was signed by the Chief Executive Officer on October 30, 1996 that
provided for subordination of this junior subordinated note to debt outstanding
to a major commercial bank (see Note 8). This note was amended on June 1, 1997
whereby provisions of the subordination were removed and all principal and
unpaid interest was payable to him on November 1, 1997. The Chief Executive
Officer had advanced the Company funds periodically, prior to 1993, to meet
certain short-term operating cash requirements. Accrued interest on this debt
totaled $54,000 as of December 31, 1996. The debt was repaid in full during
1997. The Chief Executive Officer had the right to exercise stock options held
by reducing the principal balance owed on the note payable in lieu of providing
cash payments upon exercise. The Chief Executive Officer exercised options to
purchase 1,280,000 shares of Common Stock with an exercise price of $0.29365 per
share during 1997.
In April 1997, the Company loaned a total of $892,195 to certain employees
of the Company, of which $550,923 was loaned to the Company's Vice President,
U.S. Sales under a full-recourse promissory note. Total accrued interest at
December 31, 1997 included in loans to officers and employees amounted to
$35,128, of which $23,456 related to this officer's loan. All the loans, except
for the loan to this officer, were non-recourse but were secured by a total of
228,846 shares of the Company's Common Stock, 102,212 of which have been pledged
by the officer. The interest rate on these loans was 6%, payable on or before
the earliest to occur of the one year anniversary of each loan, respectively,
termination of employment, liquidation or dissolution of the Company or, under
certain circumstances, merger or consolidation of the Company. The principal and
related interest on these loans were repaid to the Company in the third quarter
of 1998.
Under an employment agreement, the Company extended a $450,000 loan to the
Company's President and Chief Operating Officer in January 1998 in connection
with his purchase of a new residence (the "Loan"). The Loan is interest free and
is secured by a purchase money second deed of trust on the new residence and by
a security interest in certain stock options granted to the Company's President
and Chief Operating Officer to purchase 300,000 shares of the Company's Common
Stock and any securities issuable upon exercise of such options. The Loan is due
and payable in full on the earlier of (i) October 15, 2002; (ii) six (6) months
after the Company's President and Chief Operating Officer's voluntary
resignation or termination by the Company for Cause (as defined in the
employment agreement); or (iii) upon the Company's President and Chief Operating
Officer's agreement to sell, convey, transfer, or dispose of, or further
encumber the new residence. Under the terms of the employment agreement, the
Company has agreed
61
64
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
to forgive the Loan in its entirety (and return any payments received in
connection therewith), in the event that the Company's President and Chief
Operating Officer remains continuously employed with the Company from October
15, 1997 through October 15, 2000. The Company has also agreed to forgive 50% of
the loan in the event that the President and Chief Operating Officer is
terminated by the Company by written notice without cause. The Company is
amortizing the loan amount to compensation expense over the three-year period.
A director of the Company, who is also the brother of the Chief Executive
Officer, is a partner in a law firm, which has provided legal services to the
Company since its formation. The Company made payments for legal services of
$27,000, $77,000 and $284,000 in the years ended December 31, 1998, 1997 and
1996, respectively.
NOTE 17. ENTERPRISE WIDE SEGMENT DISCLOSURES
The Company, which operates in a single operating segment, designs,
manufactures and distributes contact lenses. Sales to one major customer
amounted to approximately 11%, 8% and 9% of total net sales for the years ended
December 31, 1998, 1997 and 1996, respectively. United States export sales
approximated 3.0%, 2.8% and 2.5% of net sales for the years ended December 31,
1998, 1997 and 1996, respectively. The geographic presentation of net sales is
based on the origin of the sale. The geographic distributions of the Company's
net sales, income from operations, and identifiable net assets are as follows
(in thousands):
UNITED UNITED
STATES CANADA KINGDOM ELIMINATIONS CONSOLIDATED
-------- ------ -------- ------------ ------------
December 31, 1998
Sales to unaffiliated customers........... $123,907 $8,837 $ 19,164 $ -- $151,908
Intercompany sales........................ 35,972 -- 18,847 (54,819) --
-------- ------ -------- -------- --------
Total net sales........................... $159,879 $8,837 $ 38,011 $(54,819) $151,908
======== ====== ======== ======== ========
Income from operations.................... $ 38,932 $1,089 2,771 $ (987) $ 41,805
======== ====== ======== ======== ========
Total long-lived assets................... $147,221 $2,663 $ 54,227 $(27,541) $176,570
======== ====== ======== ======== ========
December 31, 1997
Sales to unaffiliated customers........... $ 97,011 $9,273 $ 12,321 $ -- $118,605
Intercompany sales........................ 32,492 -- 19,918 (52,410) --
-------- ------ -------- -------- --------
Total net sales........................... $129,503 $9,273 $ 32,239 $(52,410) $118,605
======== ====== ======== ======== ========
Income from operations.................... $ 27,844 $ (528) $ 4,037 $ (1,423) $ 29,930
======== ====== ======== ======== ========
Total long-lived assets................... $122,941 $2,875 $ 33,628 $(26,609) $132,835
======== ====== ======== ======== ========
December 31, 1996
Sales to unaffiliated customers........... $ 76,309 $7,700 $ 6,500 $ -- $ 90,509
Intercompany sales........................ 29,554 -- 20,345 (49,899) --
-------- ------ -------- -------- --------
Total net sales........................... $105,863 $7,700 $ 26,845 $(49,899) $ 90,509
======== ====== ======== ======== ========
Income from operations.................... $ 16,384 $ 203 $ 1,523 $ (675) $ 17,435
======== ====== ======== ======== ========
Total long-lived assets................... $ 68,535 $2,731 $ 20,795 $(25,672) $ 66,389
======== ====== ======== ======== ========
NOTE 18. LITIGATION
In 1994, litigation was commenced by the Company and OSL, its United
Kingdom subsidiary, against former employees and a former director of OSL, its
United Kingdom distributor (AVCL) and certain related
62
65
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
parties. The claims by the Company were essentially for misappropriation of
intellectual property, breach of contract and nonpayment of accounts. In a
related matter, there was also a patent infringement action against OSL, which
involved the validity of a certain molding patent that was licensed by OSL from
certain of the defendants. The Company also brought an action in federal court
in California against certain of the same individuals who were sued in the
United Kingdom. The California action was essentially one for breach of
employment, breach of contract and violation of securities laws.
In November 1996, judgment was rendered in the United Kingdom actions. In
February 1997, prior to the determination of any costs or damages by the United
Kingdom courts, the parties to the above litigations entered into a settlement
agreement for total monetary consideration of $10,000,000. The settlement
agreement provided for, among other things, (i) a mutual release and termination
of all pending litigation; (ii) the replacement of the September 30, 1992 patent
license agreement (See Note 16) with a new, fully paid-up, non-exclusive, patent
license, that did not contain any restrictions on the Company's ability to sell
contact lenses to other contact lens manufacturers; (iii) the termination of the
Company's obligation to supply contact lenses under the September 30, 1992
purchase and supply agreement (See Note 16); and (iv) the termination of a
limitation on the Company's right to sell certain contact lenses directly into
the United Kingdom and a limitation on AVCL's right to sell certain contact
lenses in North and South America. The Company paid $3,333,000 to the defendants
upon consummation of the settlement agreement and an additional $6,667,000 upon
the closing of the Company's initial public offering in August, 1997.
The Company engaged a third party valuation firm to value the United
Kingdom marketing rights and the prepaid patent license agreement acquired as a
result of the settlement agreement and assigned values to the liabilities
identified as a result of the court judgment. The Company then allocated the
$10,000,000 of consideration to the liabilities identified and the intangible
assets acquired on a pro rata basis. As a result of this allocation and in
accordance with APB Opinion No. 17, "Intangible Assets," the Company allocated
$8,800,000 of the consideration to the United Kingdom marketing rights and the
prepaid patent license agreement acquired. The Company has assigned an estimated
useful life of 10 years to the United Kingdom marketing rights and the prepaid
patent license agreement. The Company incurred legal expenses, which were
included in general and administrative expenses in 1997 and 1996 of $56,000 and
$2,513,000, respectively, related to this litigation.
Various other legal actions arising in the normal course of business have
been brought against the Company and certain of its subsidiaries. Management
believes that the ultimate resolution of these actions will not have a material
adverse effect on the Company's financial position or results of operations.
NOTE 19. OTHER COMMITMENTS
Commitments for the remodeling of existing facilities, construction of new
facilities and purchase of capital equipment over the next year were
approximately $13,068,000 and $8,592,000, respectively, as of December 31, 1998
and 1997.
NOTE 20. SUBSEQUENT EVENTS
Financing
In February 1999, Ocular Sciences Puerto Rico finalized an agreement,
effective June 1998, with the Puerto Rico Industrial Development Company
("PRIDCO"), effective June 1998, to manage on PRIDCO's behalf the construction
of a new building in Puerto Rico that will be leased by Ocular Sciences Puerto
Rico as its manufacturing facility, upon completion of construction. Ocular
Sciences Puerto Rico plans to initially finance the building construction as
well as the leasehold improvements with existing cash and then borrow against
the remaining balance available under its term loan with a major bank upon
completion of
63
66
OCULAR SCIENCES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
construction. Under the anticipated agreement, PRIDCO would reimburse Ocular
Sciences Puerto Rico for up to a maximum of $3,470,000 for certain structural
construction costs of the facility at the end of the construction project, as
specified in the agreement. Annual rental payments of approximately $489,000
would be due to PRIDCO to commence the first day of the following month, after
completion, inspection and acceptance of the constructed building, for a period
of ten years. This transaction will be accounted for as a financed purchase of
the building.
64
67
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Ocular Sciences, Inc.:
We have audited the accompanying consolidated balance sheets of Ocular
Sciences, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of income, stockholders' equity and cash flows
for each of the years in the three-year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Ocular
Sciences, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1998, in conformity with generally accepted
accounting principles.
KPMG LLP
San Francisco, California
January 27, 1999
65
68
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
Not Applicable
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item with respect to the directors of the
Company is incorporated by reference from the definitive proxy statement for the
Company's 1999 annual meeting of stockholders to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report (the "Proxy Statement") under the caption "Proposal
No. 1 -- Election of Directors." The information relating to the executive
officers of the Company is set forth in the Proxy Statement under the caption
"Executive Officers."
Information required by this item with respect to compliance with Section
16(a) of the Securities Exchange Act of 1934 is incorporated by reference from
the Proxy Statement under the caption "Section 16(a) Beneficial Ownership
Reporting Compliance."
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the
Proxy Statement under the captions "Executive Compensation," "Proposal No.
1 -- Election of Directors -- Director Compensation" and "Compensation Committee
Interlocks and Insider Participation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the
Proxy Statement under the caption "Security Ownership of Certain Beneficial
Owners and Management."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference from the
Proxy Statement under the caption "Certain Relationships and Related
Transactions."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
(A) The following documents are filed as part of this Report:
(1) Financial Statements. The following Consolidated Financial
Statements of Ocular Sciences, Inc. are incorporated by reference
from Part II, Item 8 of this Form 10-K:
PAGE
----
Consolidated Balance Sheets -- December 31, 1998 and 1997... 44
Consolidated Statements of Income -- Years Ended December
31, 1998, 1997 and 1996................................... 45
Consolidated Statements of Stockholders' Equity -- Years
Ended December 31, 1998, 1997 and 1996.................... 46
Consolidated Statements of Cash Flows -- Years Ended
December 31, 1998, 1997 and 1996.......................... 47
Notes to Consolidated Financial Statements.................. 48
Report of KPMG LLP.......................................... 65
66
69
(2) Financial Statement Schedule. The following financial statement
schedule of Ocular Sciences, Inc. for the years ended December 31,
1998, 1997 and 1996 is filed as part of this Report and should be
read in conjunction with the Consolidated Financial Statements of
Ocular Sciences, Inc.
SCHEDULE PAGE
-------- ----
II. Valuation and Qualifying Accounts....................... 69
Report of KPMG LLP.......................................... 71
Other financial statement schedules are omitted because the information
called for is not required or is shown either in the Consolidated Financial
Statements or the Notes thereto.
(B) Reports on Form 8-K:
None.
(1) Exhibits
EXHIBIT
NUMBER DESCRIPTION
------- ------------------------------------------------------------
2.01 Form of Agreement and Plan of Merger by and between O.S.I.
Corporation, a California corporation, and Registrant+
3.01 Registrant's Certificate of Incorporation+
3.03 Form of Registrant's Restated Certificate of Incorporation+
3.04 Registrant's Bylaws+
4.01 Registration Rights Agreement dated as of October 30, 1992
by and among the Registrant and the other parties listed on
the signature pages thereto+
4.02 Amendment to Registration Rights Agreement and Shareholders'
Agreement dated as of February 27, 1997 by and among the
Registrant and the other parties listed on the signature
pages thereto+
10.01 Registrant's 1989 Stock Option Plan adopted July 21, 1989,
as amended November 30, 1994+*
10.02 Registrant's 1997 Equity Incentive Plan+*
10.03 Registrant's 1997 Directors Stock Option Plan+*
10.04 Registrant's 1997 Employee Stock Purchase Plan+*
10.05 Form of Indemnity Agreement entered into by Registrant with
each of its directors and executive officers+*
10.06 Settlement Agreement and Release dated as of February 27,
1997 between Aspect Vision Care Ltd., New Focus Health Care
Ltd., Geoffrey Galley, Anthony Galley, Barrie Bevis, Albert
Morland, Ivor Atkinson and Wilfred Booker, Sciences Ltd.,
O.S.I. Corporation and John Fruth+#
10.07 Amendment to Settlement Agreement and Release dated as of
February 27, 1997 between the parties to the Settlement
Agreement and Contact Lens Technologies Ltd+
10.08 Patent License Agreement dated February 27, 1997 by and
between Ocular Sciences Ltd. and certain persons referred to
therein as the Patent Owners+
10.09 Employment Agreement dated March 27, 1996 by between John
Lilley and O.S.I. Corporation+*
10.10 Lease for 475 -- 479 Eccles Avenue dated May 18, 1995,
between Stanley D. McDonald, Norman H. Scherdt, Herbert A.
West and McDonald Ltd. as "Landlord" and O.S.I. Corporation
as "Tenant"+
10.11 Lease for Santa Isabel, Puerto Rico Kingdom dated September
14, 1984, between The Puerto Rico Industrial Development
Company as "Landlord" and O.S.I. Puerto Rico Corporation as
"Tenant," as amended+
67
70
EXHIBIT
NUMBER DESCRIPTION
------- ------------------------------------------------------------
10.12 Counterpart Underlease of Distribution Depot dated November
30, 1995 among Boots the Chemist Limited as "Landlord,"
Ocular Sciences Limited as "Tenant" and O.S.I. Corporation
as "Guarantor"+
10.13 Amended and Restated Credit Agreement among Ocular Sciences,
Inc., Ocular Sciences Puerto Rico, Inc. and Comerica Bank --
California dated November 7, 1997 and exhibits thereto[X]
10.14 Employment Agreement dated October 15, 1997 between Norwick
Goodspeed and the Company[X]*
10.15 Lease of Unit 10 The Quadrangle Abbey Park Industrial Estate
Romsey Hampshire dated August 19, 1997 between Ocular
Sciences Limited and The Royal Bank of Scotland plc[X]
10.16 Construction and Lease Contract dated June 29, 1998 between
Ocular Sciences Puerto Rico, Inc. and Puerto Rico Industrial
Development Company
11.01 Statement regarding computation of pro forma net income per
share (basic and diluted)
21.01 List of Subsidiaries
24.01 Power of Attorney (see page 70 of this Form 10-K))
23.02 Consent of KPMG LLP, Independent Certified Public
Accountants
27.01 Financial Data Schedule
- ---------------
# Confidential treatment has been requested from the Securities and Exchange
Commission with respect to certain portions of this exhibit. Omitted
portions have been filed separately with the Commission.
+ Incorporated by reference from the Company's registration statement on Form
S-1, file no. 333-27421.
[X] Incorporated by reference from the Company's registration statement on Form
S-1, file no. 333-46669.
* Management contract or compensatory arrangement.
68
71
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING COSTS AND OTHER END
OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD
---------- ---------- ---------- ---------- ----------
YEAR ENDED DECEMBER 31, 1998
Allowance for sales returns and doubtful
accounts receivable..................... 1,655 880 -- (450)(1) 2,085
Provision for excess and obsolete
inventory............................... 2,171 1,873 -- (1,392)(2) 2,652
YEAR ENDED DECEMBER 31, 1997
Allowance for sales returns and doubtful
accounts receivable..................... 1,451 968 -- (764)(1) 1,655
Provision for excess and obsolete
inventory............................... 2,242 893 -- (964)(2) 2,171
YEAR ENDED DECEMBER 31, 1996
Allowance for sales returns and doubtful
accounts receivable..................... 1,930 193 -- (672)(1) 1,451
Provision for excess and obsolete
inventory............................... 2,341 605 -- (704)(2) 2,242
- ---------------
(1) Uncollectible accounts written off, net of recoveries.
(2) Discontinued, expired, damaged and scrap inventory.
69
72
SIGNATURES
Pursuant to the requirements of the Securities Act, the Registrant has duly
caused this Report on Form 10-K to be signed on its behalf by the undersigned,
thereunto duly authorized, in the City of South San Francisco, State of
California, on the 25th day of March, 1999.
OCULAR SCIENCES, INC.
By: /s/ GREGORY E. LICHTWARDT
--------------------------------------
Gregory E. Lichtwardt
Vice President, Finance and
Chief Financial Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS that each individual whose signature
appears below constitutes and appoints John D. Fruth and Gregory E. Lichtwardt,
and each of them, his true and lawful attorneys-in-fact and agents, with full
power of substitution, for him and in his or her name, place and stead, in any
and all capacities to sign any and all amendments to this Report on Form 10-K,
and to file the same, with all exhibits thereto and all documents in connection
therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he or she might
or could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents or any of them, or his, her or their substitute or
substitutes, may lawfully do or cause to be done by virtue hereof
In accordance with the requirements of the Securities Act, this Report on
Form 10-K was signed by the following persons in the capacities and on the dates
indicated.
NAME TITLE DATE
---- ----- ----
PRINCIPAL EXECUTIVE OFFICER:
/s/ JOHN D. FRUTH Chief Executive Officer and March 25, 1999
- -------------------------------------------------------- Chairman of the Board of
John D. Fruth Directors
PRINCIPAL FINANCIAL AND PRINCIPAL ACCOUNTING OFFICER:
/s/ GREGORY E. LICHTWARDT Vice President, Finance and March 25, 1999
- -------------------------------------------------------- Chief Financial Officer
Gregory E. Lichtwardt
DIRECTORS:
/s/ NORWICK B.H. GOODSPEED Director; President and Chief March 25, 1999
- -------------------------------------------------------- Operating Officer
Norwick B.H. Goodspeed
/s/ EDGAR J. CUMMINS Director March 25, 1999
- --------------------------------------------------------
Edgar J. Cummins
/s/ TERENCE M. FRUTH Director March 25, 1999
- --------------------------------------------------------
Terence M. Fruth
/s/ WILLIAM R. GRANT Director March 25, 1999
- --------------------------------------------------------
William R. Grant
/s/ DANIEL J. KUNST Director March 25, 1999
- --------------------------------------------------------
Daniel J. Kunst
/s/ FRANCIS R. TUNNEY, JR. Director March 25, 1999
- --------------------------------------------------------
Francis R. Tunney, Jr.
70
73
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Ocular Sciences, Inc.:
Under date of January 27, 1999 we reported on the consolidated balance
sheets of Ocular Sciences, Inc. and subsidiaries as of December 31, 1998 and
1997, and the related consolidated statements of income, stockholders' equity
and cash flows for each of the years in the three-year period ended December 31,
1998. In connection with our audits of the aforementioned consolidated financial
statements we also audited the related consolidated financial statement schedule
included in this Form 10-K. This financial statement schedule is the
responsibility of the Company's management. Our responsibility is to express an
opinion on this financial statement schedule based on our audits.
In our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
KPMG LLP
San Francisco, California
January 27, 1999
71
74
EXHIBIT INDEX
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER DESCRIPTION PAGE
------- ----------- ------------
10.16 Construction and Lease Contract dated June 29, 1998 between
Ocular Sciences Puerto Rico, Inc. and Puerto Rico Industrial
Development Company.........................................
21.01 List of Subsidiaries........................................
23.02 Consent of KPMG LLP, Independent Certified Public
Accountants.................................................
27.01 Financial Data Schedule.....................................