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United States Securities and Exchange Commission
Washington, D.C. 20549
Form 10-K
(Mark One)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
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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 number 0-22427
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Heska Corporation
(Exact name of Registrant as specified in its charter)
Delaware 77-0192527
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[State or other jurisdiction [I.R.S. Employer Identification No.]
of incorporation or organization]
1613 Prospect Parkway
Fort Collins, Colorado 80525
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[Address of principal executive offices] [Zip Code]
Registrant's telephone number, including area code: (970) 493-7272
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.001 par value
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 to Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $58,400,000 as of March 15, 1999 based upon the
closing price on the Nasdaq National Market reported for such date. This
calculation does not reflect a determination that certain persons are affiliates
of the Registrant for any other purpose.
26,676,327 shares of the Registrant's Common Stock, $.001 par value, were
outstanding at March 15,1999
DOCUMENTS INCORPORATED BY REFERENCE
Items 10 (as to directors), 11, 12 and 13 of Part III incorporate by reference
information from the Registrant's Proxy Statement to be filed with the
Securities and Exchange Commission in connection with the solicitation of
proxies for the Registrant's 1999 Annual Meeting of Stockholders.
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PART I
Item 1. Business.
When used in this Report on Form 10-K ("Form 10-K"), the words "expects,"
"anticipates," "estimates," "hopes," "intends" and similar expressions are
intended to identify forward-looking statements. Such statements, which include
statements concerning product development research activities, expected product
introductions and market opportunities, are subject to risks and uncertainties,
including those set forth under "Management's Discussion and Analysis of
Financial Condition and Results of Operation--Factors That May Affect Results"
and elsewhere in this Form 10-K, that could cause actual results to differ
materially from those projected. Readers are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of the date of
this Form 10-K. The Company expressly disclaims any obligation or undertaking
to release publicly any updates or revisions to any forward-looking statements
contained herein to reflect any change in the Company's expectations with regard
thereto or any change in events, conditions or circumstances on which any such
statement is based.
Heska Corporation ("Heska" or the "Company") is primarily focused on the
discovery, development and marketing of companion animal health products. In
addition to manufacturing certain of Heska's companion animal products, the
Company's primary manufacturing subsidiary, Diamond Animal Health, Inc.
("Diamond"), also manufactures bovine vaccine products and pharmaceutical and
personal healthcare products which are marketed and distributed by third
parties. In addition to manufacturing veterinary allergy products for marketing
and sale by Heska, Heska's subsidiaries, Center Laboratories, Inc. ("Center")
and CMG-Heska Allergy Products S.A. ("CMG"), a Swiss corporation, also
manufacture and sell human allergy products.
Animal Health Products
Heska presently sells more than 30 different companion animal health
products in the United States which fall generally into the categories described
below:
Date of U.S. Date of U.S.
Product Introduction Product Introduction
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DIAGNOSTICS EQUIPMENT
Canine Heartworm Diagnostics Monitoring Equipment
Veterinary Diagnostic Laboratory 1997 VET/OX(R) 4400 1998
Point-of-Care Diagnostic (Solo Step(TM) CH) 1999 VET/OX(R) 4403 1995
Feline Heartworm Diagnostics VET/OX(R) 4404 1998
Veterinary Diagnostic Laboratory 1997 VET/OX(R) 4700 1994
Point-of-Care Diagnostic (Solo Step(TM) FH) 1998 VET/ECG(TM) 2000 1997
Allergy Diagnostics (ALLERCEPT(TM) Detection System) VET/DOPP(TM) 100 1996
VET/BP(TM) 6000 1994
Canine; Veterinary Diagnostic Laboratory 1997 VET/BP(TM) 6500 1998
Feline; Veterinary Diagnostic Laboratory 1997 VET/CAP(R) 7000 1994
Canine Leishmaniosis Diagnostic VET/CAP(R) 7100 1998
Veterinary Diagnostic Laboratory 1997 VET/SENSOR(TM) ECG 1998
BIOLOGICS AND VACCINES Diagnostic Equipment
Canine Allergy Immunotherapy 1996 i-STAT(R) Portable Clinical
Analyzer (1) 1996
Feline Allergy Immunotherapy 1998 Vet ABC Hematology Analyzer 1998
Feline Trivalent Vaccine (HESKA(TM) Trivalent 1997 Reflovet(R) Chemistry Analyzer 1998
Intranasal/Intraocular Vaccine
Feline Bivalent Vaccine (HESKA(TM) Bivalent 1997 Other Equipment
Intranasal/Intraocular Vaccine) VET/IV(TM) 2.2 IV Pump 1998
Medfusion(TM) 2000 Syringe Pump(3) 1998
SAGA(TM) Anesthesia Machine 1996
PHARMACEUTICALS
Periodontal Disease Therapeutic for Dogs
(PERIOceutic(TM) Gel) 1997
Canine Thyroid Supplement 1998
NUTRITIONAL SUPPLEMENTS
F.A. Granules, Dietary Supplement 1998
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(1) i-STAT(R) is a registered trademark of i-STAT Corporation
(2) Reflovet(R) is a registered trademark of Boehringer Mannheim GmBH
(3) Medfusion(TM) is a trademark of Medex, Inc.
2
Diagnostics
Heartworm Diagnostics
Heartworm infections of dogs and cats are caused by the parasite
Dirofilaria immitis. This parasitic worm is transmitted in larval form to dogs
and cats through the bite of an infected mosquito. Larvae develop into adult
worms which live in the pulmonary arteries and heart of the host, where they can
cause serious cardiovascular, pulmonary, liver and kidney disease.
In January 1997, Heska introduced a new test in its veterinary diagnostic
laboratory for feline heartworm infections of cats which allowed veterinarians
for the first time to accurately establish the prevalence of heartworm exposure
in cats in their practices. This test is highly accurate and identifies
antibodies in cat serum that react with a recombinant heartworm antigen. In
1997, the Company introduced a rapid, point-of-care version of this test in
Italy. After receiving regulatory clearance, Heska introduced this point-of-
care feline heartworm test (Solo Step(TM) FH) in the United States in 1998.
Heska has also developed a diagnostic test for heartworm infection in dogs.
This test uses monoclonal antibodies reactive with heartworm antigens to detect
the presence of these antigens in the blood of the infected dog. This test was
first offered through Heska's veterinary diagnostic laboratory in 1997. A
simple, rapid, and easy to use point-of-care version of this test (Solo Step(TM)
CH) was introduced in Italy in 1998. Heska received regulatory clearance to sell
Solo Step(TM) CH in the United States in January 1999, and sales of the product
in the United States have commenced.
Allergy
Allergy is common in companion animals, and it is estimated to affect
approximately 10% to 15% of dogs. Clinical symptoms of allergy are variable,
but are often manifested as persistent and serious skin disease in dogs and
cats. Clinical management of allergic disease is problematic, as there are a
large number of allergens that may give rise to these conditions. Although skin
testing is often regarded as the most accurate diagnostic procedure, such tests
are painful, subjective and inconvenient. The effectiveness of the
immunotherapy that is prescribed to treat allergic disease is inherently limited
by inaccuracies in the diagnostic process.
Heska has developed more accurate in vitro technology to detect IgE, the
antibody involved in most allergic reactions. This technology permits the
design of tests that, in contrast to other in vitro tests, more specifically
identify the animal's allergic responses to particular allergens. During 1997,
Heska adapted this technology to a broad range of its canine and feline allergy
tests. This allergy testing is conducted in the HESKA(TM) Veterinary Diagnostic
Laboratories in the United States and the United Kingdom using an enzyme-linked
immunoassay ("ELISA") to screen the blood serum of potentially allergic dogs
against a panel of known allergens. A typical test panel includes 48 different
allergens, consisting primarily of various pollens, grasses, molds and insects.
Canine Leishmaniosis
Visceral leishmaniosis is a serious disease of dogs and humans caused by
the parasite Leishmania. These protozoan parasites are transmitted to humans
and dogs through the bite of sandflies. The disease causes profound suffering
and, if left untreated, infected dogs often die. While this disease is
generally not a problem in the United States, it is widespread in Mediterranean
and Middle Eastern countries and in South America. Dogs are believed to serve
as the primary reservoir of the parasites for transmission to other dogs and to
humans. Previously, reliable diagnosis of canine visceral Leishmania infections
was based on clinical symptoms, the finding of parasite-bearing cells in lymph
node aspirates and the use of a laboratory-based microscopy assay to detect
antibodies in the serum of dogs reactive with Leishmania antigens.
Using a proprietary molecule developed by Corixa Corporation ("Corixa"),
Heska has developed a sensitive immunoassay for the diagnosis of canine
Leishmania infection. The reference laboratory test version of this immunoassay
was introduced in the United States and Italy in 1997, and the point-of-care
version was introduced in Italy in 1998.
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Biologics and Vaccines
Allergy Immunotherapy
Veterinarians who use Heska's diagnostic laboratories for in vitro allergy
testing services often purchase immunotherapy treatment sets for those animals
with positive test results. These prescription treatment sets are formulated
specifically for each allergic animal and contain only the allergens to which
the animal has demonstrated significant levels of IgE antibodies. The
prescription formulations are administered in a series of injections, with doses
increasing over several months, to ameliorate the allergic condition of the
animal. Immunotherapy is generally continued for an extended time. Both canine
and feline immunotherapy treatment sets are offered by the Company in the United
States and the United Kingdom.
Feline Respiratory Disease
In 1997, Heska introduced in the United States a three-way modified live
vaccine (HESKA(TM) Trivalent Intranasal/Intraocular Vaccine) for the three most
common viral diseases of cats: calicivirus, rhinotracheitis virus and
panleukopenia virus. Heska also introduced in the United States a two-way
modified live vaccine (HESKA(TM) Bivalent Intranasal/Intraocular Vaccine) for
calicivirus and rhinotracheitis virus in 1997. These vaccines are administered
without needle injection by dropping the liquid preparation into the eyes and
nostrils of cats. While there is one competitive non-injectable two-way
vaccine, all other competitive products are injectable formulations. The use of
injectable vaccines in cats has become controversial due to the frequency of
injection site-associated side effects. The most serious of these side effects
are injection site sarcomas, tumors which, if untreated, are nearly always
fatal. The Company's vaccines avoid injection site side effects and are
believed by the Company to be very efficacious.
Pharmaceuticals
Dentistry
Dentistry for dogs is a growing market in companion animal health. Within
dentistry, the most prevalent issues are general dental hygiene and periodontal
disease. It is estimated that more than 80% of all dogs over three years old
exhibit symptoms of periodontal disease, which often manifests as bad breath.
Left untreated, periodontal disease can cause loss of teeth and systemic
bacterial infection. The most prevalent treatment is the cleaning and scaling
of the animal's teeth. Although periodic cleaning and scaling is recommended
for all dogs, this procedure alone does not adequately address the underlying
infection in dogs with periodontal disease. Systemic antibiotics to be
administered by the pet owner at home are widely prescribed but present
convenience and compliance issues.
In November 1997, Heska received United States Food and Drug Administration
("FDA") clearance to market and introduced its periodontal disease therapeutic
in the United States (PERIOceutic(TM)), an innovative product for the treatment
of periodontal disease in dogs. The product consists of a solution containing
the antibiotic doxycycline that is injected into the tooth pocket. The injected
material forms a biodegradable gel that releases the antibiotic gradually over
time, eliminating the need for repeated antibiotic administration by the pet
owner. Although the Company has experienced slow market acceptance of this
product, Heska's goal is to have this product administered by veterinarians on a
regular basis for dogs with periodontal disease concurrently with the regular
cleaning and scaling of the animal's teeth.
Canine Thyroid Supplement
Canine hypothyroidism is a serious disease that is usually caused by
abnormalities of the thyroid gland. It is estimated that 3% to 4% of all dogs
require thyroid hormone replacement therapy. Common clinical signs include dry,
coarse, thin hair, possibly with patches of hair loss and pigment changes. The
disease can affect multiple organ systems and cause recurrent infections.
In 1997, Heska introduced a thyroid supplement for dogs in the United
States, which it believes is the first and only vitamin-enriched, chewable
tablet for the treatment of hypothyroidism in dogs.
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These chewable tablets, which are administered daily for the life of the dog,
provide levothyroxine sodium, a replacement therapy for the hormone normally
produced by the body.
Nutritional Supplements
Arising partly from its allergy expertise, in 1998, Heska developed and
introduced in the United States a novel fatty acid supplement (HESKA(TM) F.A.
Granules). The unique source of the fatty acids in this product, flaxseed oil,
leads to high omega-3:omega-6 ratios of fatty acids. Diets high in omega-3
fatty acids are believed to lead to lower levels of inflammatory response. The
HESKA F.A. Granules include vitamins and are formulated in a palatable flavor
base that makes the product convenient and easy to administer.
Equipment
In March 1998, Heska acquired Sensor Devices, Inc. ("SDI"), a manufacturer
and marketer of patient monitoring and diagnostic equipment. During 1998, Heska
also completed the development and adaptation of certain other equipment
products and entered into agreements for the distribution of additional
equipment products. Heska currently offers a broad line of monitoring,
diagnostic and other equipment as described below.
Monitoring Equipment
The use by veterinarians of the types of patient monitoring products that
are taken for granted in human medicine is becoming the state of the art in
companion animal health. Heska offers what the Company believes is the
broadest line of these monitoring products presently available in the veterinary
market. The centerpiece of Heska's monitoring equipment product line is a
family of oxygen saturation monitors designed for monitoring animals under
anesthesia: the VET/OX(R) 4400, VET/OX(R) 4403, VET/OX(R) 4404 and VET/OX(R)
4700, each of which includes a variety of additional monitoring parameters, such
as pulse rate and strength, body temperature, respiration and ECG. The Company
also offers two monitors, the VET/CAP(R) 7000 and VET/CAP(R) 7001 for monitoring
CO2 for animals under anesthesia. Heska also offers its proprietary esophageal
ECG sensor for monitoring ECG, temperature and heart and breath sounds of
anesthetized dogs. The Company's monitoring line also includes the VET/DOPP(TM)
100, VET/BP(TM) 6000 and VET/BP(TM) 6500 blood pressure monitors and the
VET/ECG(TM) 2000 hand-held ECG monitor.
Diagnostic Equipment
Heska's line of diagnostic equipment was initiated with the i-STAT(R)
Portable Clinical Analyzer, a hand-held, portable clinical analyzer that
provides quick, easy analysis of blood gasses and other key analytes, such as
sodium, potassium and glucose, with whole blood. In the United States and the
United Kingdom, the Company also added the Vet ABC Hematology Analyzer, an easy
to use blood analyzer that measures such key parameters as white blood cell
count, red blood cell count and hemoglobin levels in animals. Heska also offers
the Reflovet(R) Clinical Analyzer, an easy to operate, cost effective blood
chemistry analyzer that measures a broad range of animal blood analytes, such as
amylase, creatinine, uric acid, bilirubin and glucose.
Other Equipment
Among the other items of equipment that Heska offers to its veterinary
customers is the Heska VET/IV(TM) 2.2 infusion pump. This compact, affordable IV
pump allows veterinarians to easily provide regulated infusion of blood or
nutritional products for their patients. Heska also offers the Medfusion(TM)
2010 syringe pump for regulated delivery of drugs held in syringes. The Company
also offers the SAGA(TM) anesthesia machine, an anesthesia machine for companion
animal applications, and associated accessories.
Veterinary Diagnostic Laboratories
In 1996, Heska established a veterinary diagnostic laboratory at its Fort
Collins facility. The diagnostic laboratory currently offers the Company's
allergy diagnostics, canine and feline heartworm
5
diagnostics and flea bite allergy assays, in addition to other diagnostic and
pathology services. The Fort Collins veterinary diagnostic laboratory is
currently staffed by four diplomates of the American College of Veterinary
Pathologists, medical technologists experienced in animal disease and several
additional technical staff.
Heska intends to continue to use its Fort Collins diagnostic laboratory
both as a stand-alone service center for its customers and as an adjunct to its
product development efforts. Many of the assays which the Company will develop
in a point-of-care format will initially be validated and made available in the
veterinary diagnostic laboratory and will also remain available there after the
introduction of the analogous point-of-care test.
In addition to the United States veterinary diagnostic laboratory, the
Company provides to veterinarians in the United Kingdom a full range of
diagnostic and pathology services, including the proprietary diagnostic
laboratory tests marketed by the Company through Heska UK Limited ("Heska UK",
formerly Bloxham Laboratories Limited), one of the largest veterinary diagnostic
laboratories in the United Kingdom. Heska UK was acquired by Heska in 1997.
Food Animal Products
In addition to manufacturing companion animal health products for marketing
and sale by Heska, Diamond, a wholly owned subsidiary of the Company, has
completed the research, development and testing of a new line of bovine vaccines
that were licensed by the United States Department of Agriculture ("USDA") in
the United States in 1998. Diamond has entered into an agreement with a food
animal products distributor, Agri Laboratories, Ltd. ("AgriLabs"), for exclusive
marketing and sale worldwide. Diamond is the sole manufacturer for these
products.
Diamond also manufactures bovine vaccines which are marketed and sold by
Bayer AG ("Bayer"), primarily in the United States, pursuant to a contract
which terminates in February 2000. While Diamond has had discussions with Bayer
about extending this supply relationship for bovine vaccines, there can be no
assurance that such an agreement will be reached. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations-Factors that May
Affect Results-Loss History and Accumulated Deficit; Uncertainty of Future
Profitability; Quarterly Fluctuations and Customer Concentration". Diamond also
manufactures vaccine products for a number of other animal health companies.
This ranges from providing bulk vaccine antigens which are included in the
vaccines which are manufactured by other companies to filling and finishing
final products using bulk antigens provided by other animal health companies.
In addition, Diamond manufactures a companion animal nutritional product that is
marketed and distributed by another animal health company.
Other Products
Human Allergy Products
In addition to manufacturing veterinary products for marketing and sale by
Heska, Center manufactures a broad line of allergenic extracts, such as pollens,
grasses and trees, for use in human allergy immunotherapy and diagnosis in the
United States. Center provides these allergenic extracts to human allergists
both in bulk form to those allergists who wish to mix their own allergenic
immunotherapy treatment sets and in the form of custom-made patient
immunotherapy treatment sets of multiple allergens.
In addition to manufacturing and marketing veterinary allergy products
primarily in Europe, CMG markets a broad range of human allergy diagnostic
products for use primarily by laboratories in Europe. These products are sold
primarily through distributors.
Personal Healthcare
Diamond also manufactures certain personal healthcare products for
marketing and sale by other companies. These products include antibacterial
soaps and medicated foot powders.
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Product Creation
Heska is committed to creating innovative products to address significant
unmet health needs of companion animals. The Company creates products both
through internal research and development and through external collaborations.
Internal research is managed by multidisciplinary product-associated project
teams consisting of veterinarians, biologists, molecular and cellular
biologists, biochemists and immunologists. Heska believes that it has one of
the largest and most sophisticated scientific efforts in the world devoted to
applying biotechnology to the creation of companion animal products.
Heska is also committed to identifying external product opportunities and
creating business and technical collaborations that lead to the creation of
other products. The Company is currently funding research at multiple academic
institutions. The Company believes that its active participation in scientific
networks and its reputation for investing in research enhances its ability to
acquire external product opportunities.
The vast majority of all research and development resources at Heska are
directed towards the development of new companion animal health products.
However, Diamond has undertaken a modest, but quite successful, research effort
to develop and improve its bovine line of vaccines. Most of Diamond's recent
research work has been funded by the marketing and distribution partners for the
products being developed. Diamond expects that it will continue to conduct
research to improve and expand its bovine vaccine line, and it expects that much
of this work will be at least partially funded by its distribution partners for
those vaccines. The Company incurred expenses of $12.0 million, $20.1 million
and $29.1 million in the years ended December 31, 1996, 1997 and 1998,
respectively in support of its research and development activities.
Set forth below are descriptions of some of the companion animal health
products the Company is working to develop. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Factors That May
Affect Results".
Equine Influenza Vaccine
Equine influenza is a common viral disease of horses and is similar to
human influenza. Horses have diminished performance and quality of life for an
extended period following infection. Currently available vaccines for equine
influenza are of limited efficacy and the effective duration of immunity for
existing vaccines is often measured in weeks or months. Heska has developed a
unique vaccine for equine influenza and believes its vaccine candidate will have
improved efficacy and duration of immunity. The vaccine is currently being
tested in horses for safety.
Bartonellosis (Cat Scratch Fever) Vaccine
Bartonella henselae is the causative agent of cat scratch fever. This
bacterium is transmitted from cats to humans by a cat's scratch and perhaps by
other means. The human disease is characterized by malaise, fever and swollen
lymph nodes, sometimes lasting several weeks and sometimes requiring
hospitalization. People with weak immune systems, such as HIV-positive
individuals, children and the elderly may develop very severe disease following
infection, and this organism is a cause of a significant number of opportunistic
infections in HIV-positive individuals. The Company is working with scientists
at the United States Centers for Disease Control and Prevention ("CDC") in
Atlanta, Georgia to develop a novel vaccine for cats. The vaccine is intended
to prevent cats from harboring Bartonella henselae in their blood, with the goal
of limiting transmission of the bacteria from cats to humans. Certain vaccine
formulations prepared at Heska have successfully protected cats from infection.
The vaccine is currently being tested in cats for safety and efficacy.
Canine Leishmaniosis Vaccine
Canine leishmaniosis is endemic in certain areas of Mediterranean Europe,
the Middle East and South America, and infected dogs may act as a reservoir for
the parasite. A vaccine to prevent disease or a novel therapeutic approach
would significantly improve the health of dogs in these areas and potentially
reduce transmission to humans. Candidate Leishmania vaccine antigens have been
identified by collaborators at Corixa, and leishmaniosis vaccine trials are
being conducted by Heska. Because little
7
is yet known of the natural progression of disease in Leishmania-infected dogs,
it is anticipated that this research effort, and any subsequent vaccine trials,
will not be completed for at least several years, if at all.
Feline Toxoplasmosis Vaccine
Toxoplasmosis is caused by a protozoan parasite, Toxoplasma gondii, that
infects cats and other mammals including humans, pigs and sheep. This disease
can be transmitted to humans through contact with the oocysts (eggs) of the
parasite, which are passed exclusively in the feces of infected cats. In
addition, consumption of contaminated undercooked lamb and pork is a common
means of transmission to humans. Toxoplasma infections are generally not a
serious concern for cats, as healthy cats generally tolerate the infection
without obvious disease. However, infections of other animals, including
humans, may have serious consequences. This is particularly true for
immunocompromised individuals, such as HIV-infected persons, and for unborn
fetuses. Such infections may be life threatening in the former case and lead to
birth defects or miscarriage in the latter. As a result of the risk of
transmission of this disease from cat feces, doctors sometimes advise
immunocompromised patients and women who are or may become pregnant to avoid or
give away their cats. For this reason, Heska believes that an appropriate
vaccine may encourage such individuals to keep their family pets, and it is
attempting to develop a recombinant vaccine intended to protect cats from
shedding Toxoplasma oocysts. The Company believes that such a vaccine, if widely
used, could help reduce the transmission of disease to humans and other animals.
The Company has identified and cloned the genes encoding many vaccine candidate
antigens from internally developed gene libraries. Testing of these antigens
for vaccine efficacy is ongoing. Commercialization of such a vaccine is not
expected for at least several years, if at all. If the Company succeeds in
creating such a Feline Toxoplasmosis Vaccine, it may be marketed by Bayer. See
"Collaborative Agreements".
Flea Control Vaccines and Pharmaceuticals
A number of proprietary and non-proprietary products are currently marketed
for flea control. Certain of the proprietary products introduced in the last
few years have been particularly successful. No single product, however, can
presently be considered to be completely safe and effective in flea control at
all flea life cycle stages. In addition, certain topical control chemicals,
such as those frequently included in sprays and collars, can be toxic and
present safety concerns for animals and humans. The use of certain flea control
chemicals may also, over time, result in fleas that are resistant to those
products.
One of Heska's goals is to develop vaccines that will produce an immune
response in the dog or cat that will kill fleas or reduce their reproduction.
Experimental studies with the first vaccine candidates are ongoing, but this is
a very difficult scientific challenge and commercial vaccines are not
anticipated for at least several years, if at all. If the Company succeeds in
creating such a flea control vaccine, it may be marketed by Novartis
Tiergesundheit AG ("Novartis" used herein means Novartis and/or its affiliates
or predecessors). See "Collaborative Agreements".
The Company's expertise in flea molecular physiology has also led to the
creation of in vitro tests amenable to chemical screening and in vivo tests that
measure the effect of compounds on fleas. Thousands of compounds have been
screened in vitro and hundreds of compounds have been tested for flea control
activity. The Company is attempting to identify a novel small molecule flea
pharmaceutical and, if successful, will initiate clinical trials in companion
animals.
Heartworm Vaccines
Heartworm infection is common throughout the world, particularly in warm
and humid climates. Dogs are especially susceptible to heartworm infection and
treatment is difficult, expensive and requires the use of toxic compounds with
serious adverse effects for the animal. Drugs to prevent heartworm infections
in dogs are generally available and widely prescribed, but require monthly or
daily administration during the heartworm transmission season.
Heartworm infections of cats represent a growing area of concern for
veterinary practitioners. Although cats are somewhat less susceptible to
heartworm infection than are dogs, infected cats may experience serious disease,
even death, from only a single adult worm. A drug to prevent heartworm
8
infections of cats, similar to the products available for dogs, was introduced
by Merial Ltd. in January 1997.
In order to avoid the need for repeated administration of drugs and the
resulting compliance and convenience problems, Heska's goal is to develop
vaccines for annual administration that would prevent cardiopulmonary infection
in dogs and cats caused by heartworms. The Company has identified many
candidate vaccine antigens and the genes encoding them have been cloned. Heska
is using these proprietary molecules in vaccination studies of dogs and cats,
including trials which involve delivering vaccine candidates using nucleic acids
and viral vectors. Each vaccination trial requires approximately one year to
complete. Accordingly, commercialization of vaccines for heartworm infections
of dogs and cats, if it occurs, is at least several years away. If the Company
succeeds in creating such vaccines to prevent heartworm infections in dogs and
cats, they may be marketed by Bayer and Novartis, respectively. See "-
Collaborative Agreements".
Oncology
With improved diet and medical care, dogs and cats are living longer lives
and, accordingly, developing more age-associated diseases such as cancer. In
fact, cancer is the leading cause of disease-associated death in dogs and cats.
Despite this, most cancer treatments are less than optimal and employ "off
label" therapeutic products developed for use in humans. The Company believes
that it is critical that a cancer therapeutic product not substantially decrease
the quality of life of the treated dog or cat. Accordingly, Heska is pursuing
an immunological approach to cancer therapy. Instead of systemically applying
toxins that kill rapidly growing cells (both tumor cells and normal cells),
Heska scientists are attempting to stimulate immune responses to a tumor through
gene therapy technology. Scientists at National Jewish Hospital in Denver,
Colorado first demonstrated that a combination of immune stimulatory genes, when
injected into canine melanomas, could stimulate the regression of the primary
tumor and could prevent subsequent metastatic disease. The Company is
collaborating with these scientists at National Jewish Hospital and with
scientists at GeneMedicine, Inc. to develop gene formulations that could be used
by the veterinarian for such treatments. Heska is currently testing these gene
formulations for safety and efficacy. The Company does not expect to have a
commercial product in this area for at least several years, if at all.
Osteoarthritis
Osteoarthritis is a common disease affecting approximately 20% of adult
dogs. Mildly affected animals may suffer only stiffness, soreness, lethargy or
reduced activity, while dogs with more severe disease may be unable to exercise
or even to rise without assistance. Treatment options include temporary
palliative relief of clinical signs by using pain relievers such as an oral non-
steroidal anti-inflammatory drug. These palliative drugs provide temporary
relief of pain but do not prevent the affected joints from suffering further
erosion of cartilage and destruction of bone.
Heska has acquired the rights to develop certain of CollaGenex
Pharmaceuticals' proprietary matrix metalloproteinase inhibitors for companion
animal health applications. Heska believes these compounds may be useful for
the prevention and treatment of tissue destruction and disease progression in a
variety of inflammatory and degenerative diseases. The Company is focusing its
initial development efforts in the prevention of osteoarthritis progression.
This research is still at an early stage, and a commercial product is not
anticipated for at least several years, if at all.
Sales and Marketing
The Company presently markets its products in the United States directly to
veterinarians through the use of its field sales force, inside customer
service/tele-sales force and veterinary distributors acting as contract sales
agents. As of February 1999, the Company had approximately 35 field sales
representatives and field sales supervisors and 19 customer service/tele-sales
representatives and supervisors. The 19 veterinary distributors with whom the
Company has entered into sales agency relationships employ approximately 700
field and customer service/tele-sales representatives, although some of these
distributors do not sell all of the Company's products. Internationally, the
Company markets its products to veterinarians primarily through distributors.
9
The Company estimates that there are approximately 30,000 veterinarians in
the United States whose practices are devoted principally to small animal
medicine. Those veterinarians practice in approximately 20,000 clinics in the
United States. The Company plans to market its products to these clinics
primarily through the use of its field and telephone sales force, sales agents,
trade shows and print advertising. During 1998, the Company sold its products
to more than 12,000 such clinics in the United States.
Certain of the products which the Company has under research and
development, if completed, may be marketed partially or wholly by parties with
whom it has collaborative agreements (See "Collaborative Agreements"). Center's
human allergy immunotherapy products are marketed and sold in the United States
by Center Pharmaceuticals, Inc., an unaffiliated sales and marketing company
that markets allergy related products primarily to human allergists in the
United States. Center Pharmaceuticals markets and sells Center's human allergy
products as a contract sales agent of Center.
Manufacturing
The Company's products are manufactured by its Diamond, SDI, Center and CMG
subsidiaries and/or by third-party manufacturers. Diamond's facility is a USDA
and FDA licensed biological and pharmaceutical manufacturing facility in Des
Moines, Iowa. The Company expects that it will manufacture most or all of its
biological products at this facility, as well as most or all of its recombinant
proteins and other proprietary reagents for its diagnostic products. All of the
Company's patient monitoring and diagnostic equipment, including its clinical
and hematology analyzers and veterinary sensors are either manufactured by SDI
at its Waukesha, Wisconsin facility or by third-party manufacturers. The Company
manufactures all of its allergy immunotherapy products at Center's USDA and FDA
licensed manufacturing facility in Port Washington, New York. CMG manufactures
its veterinary and human allergy diagnostic products at its leased facility in
Fribourg, Switzerland. Diamond and Center's facilities are subject to regulation
and inspection by the USDA and the FDA. See "Factors that May Affect Results-
Government Regulation; No Assurance of Obtaining Regulatory Approvals". The
Company's point-of-care diagnostic products are manufactured by Quidel
Corporation ("Quidel") and Diamond. The Company's periodontal disease
therapeutic is manufactured by Atrix Laboratories, Inc. ("Atrix"), the company
that developed this product for human use. The Company's reliance upon third-
party manufacturers poses a significant risk. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Factors that May
Affect Results-Limited Manufacturing Experience and Capacity; Reliance on
Third-Party Manufacturers".
In addition to manufacturing products for the Company, Diamond manufactures
bovine vaccines and other veterinary biologicals, veterinary pharmaceuticals and
personal healthcare products for marketing and sale by other companies. Diamond
currently has the capacity to manufacture more than 50 million doses of vaccines
each year. Diamond's customers purchase products in both bulk and finished
format, and Diamond performs all phases of manufacturing, including growth of
the active bacterial and viral agents, sterile filling, lyophilization and
packaging. In addition, Diamond offers to support its customers through
research services, regulatory compliance services, validation support and
distribution services.
In addition to manufacturing products for the Company, Center manufactures
allergy immunotherapy products which are distributed in the human market using
an independent and unaffiliated distribution company, Center Pharmaceuticals,
Inc.
Collaborative Agreements
Novartis
In April 1996, the Company entered into several agreements with Novartis.
Such agreements were entered into in connection with a $36.0 million equity
investment by Novartis in the Company. Novartis received, under the marketing
agreements, certain rights to manufacture and market any flea control vaccine or
feline heartworm control vaccine developed by the Company as to which USDA
prelicensing serials are completed on or before December 31, 2005. The Company
and Novartis have co-exclusive rights to market these products under their own
trade names throughout the world (other than in countries in which Eisai Co.,
Ltd. ("Eisai") has such rights) and, if both parties elect to market,
10
the parties will share revenues on their sales. The marketing agreements remain
in force through 2010 or longer, if Novartis is still actively marketing such
products. In addition, the parties entered into a screening and development
agreement under which the parties may undertake joint research and development
activities in certain fields. If the parties fail to agree to perform joint
research activities, then Novartis has the right to use certain materials of the
Company on an exclusive basis to develop food animal pharmaceutical products or
on a co-exclusive basis with the Company to develop pharmaceutical products for
parasite control in companion animals or food animal vaccines. Novartis would
pay royalties on any such products developed by it. Currently, there are no
joint research projects being undertaken under this agreement, although several
are in the proposal stage. The Company and Novartis also entered into a right of
first refusal agreement under which the Company, prior to granting licenses to
any third party to any products or technology developed or acquired by the
Company for either companion animal or food animal applications, must first
notify and offer Novartis such rights. If the parties are unable to come to an
agreement within 150 days of the Company's first notice, Heska may thereafter
license such rights to third parties on terms not materially more favorable than
the terms last offered by the Company to Novartis. The screening and development
agreement and right of first refusal agreement each terminate in 2005.
In October 1998, the Company and Novartis also entered into an exclusive
distribution agreement pursuant to which Novartis has the exclusive right to
distribute selected Heska products in Japan, including Heska's in-clinic feline
and canine heartworm diagnostic products, periodontal disease therapeutic and
feline viral vaccines, upon obtaining regulatory approval in Japan for such
products. Novartis also granted to Heska a right of first refusal to evaluate
for possible development and marketing worldwide certain new product
technologies for the veterinary market as they may become available from
Novartis.
Bayer
In June 1994, the Company entered into research agreements (the "Research
Agreements") with Bayer providing for funding of research (the "Research
Program") by Bayer on a recombinant feline toxoplasmosis vaccine and a canine
heartworm vaccine (the "Vaccines"). Bayer has the option to obtain an
exclusive, royalty-bearing license to sell the Vaccines in all countries except
in those in which Eisai has rights. If Bayer exercises this option, the parties
will negotiate license and distribution agreements. The Company has the first
option to manufacture any products sold pursuant to any such distribution
agreement. The Research Agreements will terminate upon completion of the
Research Program. Bayer may terminate the Research Agreements prior to
completion, but would not have any rights to market the Vaccines (unless it
terminated due to Heska's breach), although it would have non-exclusive access
to technology developed in the Research Program for use other than in Vaccines.
In the event Bayer elects to terminate the Research Agreements (other than due
to Heska's breach), the Company would recover the right to market the Vaccines,
subject to certain royalties to Bayer intended to repay certain amounts Bayer
paid under the Research Agreements.
Eisai
In January 1993, the Company entered into an agreement with Eisai, a
leading Japanese pharmaceutical company, pursuant to which the Company granted
Eisai the exclusive right to market the Company's feline and canine heartworm
vaccines, flea control vaccine and feline toxoplasmosis vaccine in Japan and
most other countries in East Asia. In exchange, the Company received an up-
front license fee and research funding for the development of these products.
Heska will have the right to manufacture any such products pursuant to a supply
agreement to be negotiated between the parties. The agreement will terminate in
January 2008, unless extended or earlier terminated by either party for material
breach of the agreement or by Eisai pursuant to certain early termination
rights.
Ralston Purina Company
In July 1998, Heska entered into a strategic alliance with Ralston Purina
Company ("Ralston Purina"), the world's largest manufacturer of dry dog and dry
and soft-moist cat foods. Ralston Purina acquired exclusive rights to license
the Company's discoveries, know-how and technologies for innovative diets for
dogs and cats. Heska and Ralston Purina are jointly developing therapeutic
diets for both dogs and cats. The Company believes that the combination of
Heska's expertise in companion
11
animal disease physiology with Ralston Purina's expertise in formulation and
diet testing will permit the development of novel nutritional products. Testing
of experimental formulations is ongoing. In the event any products that are the
subject of the collaboration are commercialized by Ralston Purina, Ralston
Purina will pay Heska a royalty on products incorporating Heska's technology. In
connection with this alliance, Ralston Purina made a $15 million equity
investment in the Company.
Quidel
The Company has entered into a development agreement with Quidel under
which the parties are jointly developing certain of the Company's point-of-care
diagnostic tests using Quidel's rapid in-clinic test technology. The parties
also have entered into a supply agreement under which Quidel will perform
manufacturing services with respect to these tests for the Company.
Intellectual Property
Heska believes that patents, trademarks, copyrights and other proprietary
rights are important to its business. Heska also relies upon trade secrets,
know-how, continuing technological innovations and licensing opportunities to
develop and maintain its competitive position.
Heska actively seeks patent protection both in the United States and
abroad. As of February 28, 1999, Heska owned or co-owned 31 issued U.S. patents
and 90 pending U.S. patent applications. Heska's issued U.S. patents primarily
relate to the Company's proprietary flea bite allergy, flea control, heartworm,
vaccine delivery and certain patient monitoring equipment technologies. The
Company's pending patent applications primarily relate to proprietary allergy,
flea control, heartworm, vaccine production and delivery and patient monitoring
equipment technologies. Applications corresponding to pending U.S. applications
have been or will be filed in other countries. As of February 28, 1999, Heska
had 6 issued foreign patents and 99 pending foreign filings, including 21
pending Patent Cooperation Treaty ("PCT") filings.
The Company also has obtained exclusive and non-exclusive licenses for
numerous other patents held by academic institutions and biotechnology and
pharmaceutical companies. The proprietary technologies of Diamond, Center, SDI,
Heska UK and CMG are primarily protected through trade secret protection of, for
example, their manufacturing processes. In general, the intellectual property
of Diamond's customers belongs to such customers.
As patent applications in the United States are maintained in secrecy until
patents issue and as publication of discoveries in the scientific or patent
literature often lags behind the actual discoveries, the Company cannot be
certain that it was the first to make the inventions covered by each of its
pending patent applications or that it was the first to file patent applications
for such inventions. Furthermore, the patent positions of biotechnology and
pharmaceutical companies are highly uncertain and involve complex legal and
factual questions, and, therefore, the breadth of claims allowed in
biotechnology and pharmaceutical patents or their enforceability cannot be
predicted. There can be no assurance that patents will issue from any of the
Company's patent applications or, should patents issue, that the Company will be
provided with adequate protection against potentially competitive products.
Furthermore, there can be no assurance that should patents issue, they will be
of commercial value to the Company, or that the United States Patent and
Trademark Office ("USPTO") or private parties, including competitors, will not
successfully challenge the Company's patents or circumvent the Company's patent
position. In the absence of adequate patent protection, the Company's business
may be adversely affected by competitors who develop comparable technology or
products.
Pursuant to the terms of the Uruguay Round Agreements Act, patents issuing
from applications filed on or after June 8, 1995 have a term of 20 years from
the date of such filing, irrespective of the period of time it may take for such
patent to ultimately issue. This method of patent term calculation can result
in a shorter period of patent protection afforded to the Company's products
compared to the prior method of term calculation (17 years from the date of
issue) as patent applications in the biopharmaceutical sector often take
considerable time to issue. Under the Drug Price Competition and Patent Term
Restoration Act of 1984 and the Generic Animal Drug and Patent Term Restoration
Act, a patent which claims a product, use or method of manufacture covering
drugs and certain other products may be extended for up to five years to
compensate the patent holder for a portion of the time required
12
for FDA review of the product. There can be no assurance that the Company will
be able to take advantage of the patent term extension provisions of this law.
The Company also relies on trade secrets and continuing technological
innovation which it seeks to protect with reasonable business procedures for
maintaining trade secrets, including confidentiality agreements with its
collaborators, employees and consultants. There can be no assurance that these
agreements will not be breached, that the Company will have adequate remedies
for any breach or that the Company's trade secrets and proprietary know-how will
not otherwise become known or be independently discovered by competitors. Under
certain of the Company's research and development agreements, inventions
discovered in certain cases become jointly owned by the Company and the
corporate sponsor or partner and in other cases become the property of the
Company or the corporate sponsor or partner. Disputes may arise with respect to
ownership of any such inventions.
The commercial success of the Company also depends in part on the Company
and its collaborators neither infringing patents or proprietary rights of third
parties nor breaching any licenses that may relate to the Company's technologies
and products. The Company is aware of several third party patents and patent
applications that may relate to the practice of the Company's technologies.
There can be no assurance that the Company or its collaborators do not or will
not infringe any valid patents or proprietary rights of third parties.
Furthermore, to the extent that Heska or its consultants or research
collaborators use intellectual property owned by others in work performed for
the Company, disputes may arise as to the rights in such intellectual property
or in related or resulting know-how and inventions. Any legal action against
the Company or its collaborative partners claiming damages and seeking to enjoin
commercial activities relating to the Company's products and processes affected
by third party rights, in addition to subjecting the Company to potential
liability for damages, may require the Company or its collaborative partner to
obtain a license in order to continue to manufacture or market the affected
products and processes or to stop the manufacture and marketing of the affected
products and processes. There can be no assurance that the Company or its
collaborative partners would prevail in any such action or that any license
(including licenses proposed by third parties) required under any such patent
would be made available on commercially acceptable terms, if at all. There are
a significant number of United States and foreign patents and patent
applications in the practice of the Company's areas of interest and the Company
believes that there may be significant litigation in the industry regarding
patent and other intellectual property rights. If the Company becomes involved
in such litigation, it could consume a substantial portion of the Company's
managerial and financial resources, which could have a material adverse effect
on the Company's business, financial condition and results of operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Factors That May Affect Results-Uncertainty of Patent and
Proprietary Technology Protection; License of Technology of Third-Parties".
Government Regulation
Most of the products being developed by Heska will require licensing by a
governmental agency before marketing. In the United States, governmental
oversight of animal health products is primarily provided by two agencies: the
USDA and the FDA. Vaccines and point-of-care diagnostics for animals are
considered veterinary biologics and are regulated by the Center for Veterinary
Biologics ("CVB") of the USDA under the auspices of the Virus-Serum-Toxin Act.
Alternatively, animal drugs, which generally include all synthetic compounds,
are approved and monitored by the Center for Veterinary Medicine ("CVM") of the
FDA under the auspices of the Federal Food, Drug and Cosmetic Act. A third
agency, the Environmental Protection Agency ("EPA"), has jurisdiction over
certain products applied topically to animals or to premises to control external
parasites. In the United States, governmental oversight of human health
products is provided exclusively by the FDA.
Many of the regulated products presently under development by Heska will be
regulated by the USDA. The purpose of the Virus-Serum-Toxin Act is to ensure
that veterinary biologics sold in the United States are safe and efficacious.
Pre-market testing is performed by the manufacturer and the CVB prior to
approval of the product for sale as well as on each new lot. Although the
procedures for licensing products by the USDA are formalized, the acceptable
standards of performance for any product are agreed upon between the
manufacturer and the CVB. For novel products that are unlike others already
licensed, the agreement on expected performance standards is typically reached
through a dialogue between the CVB and the manufacturer. The formal
demonstration of acceptable efficacy of
13
the product is done in carefully controlled laboratory trials. This is normally
a much more efficient and reliable process than demonstration of efficacy in
clinical trials using client-owned animals.
Recent industry data indicates that it takes approximately four years and
$1.0 million to license a conventional vaccine for animals from basic research
through licensing. In contrast to vaccines, point-of-care diagnostics can
typically be licensed by the USDA in about a year, with considerably less cost.
However, vaccines or diagnostics that use innovative materials such as those
resulting from recombinant DNA technology usually require additional time to
license. The USDA licensing process involves the submission of several data
packages. These packages include information on how the product will be
prepared, information on the performance and safety of the product in laboratory
studies and information on performance of the product in field conditions.
However, the submission and review of these data packages is not staged, so that
one must be completed before beginning the next.
Recent industry data indicate that it takes about 11 years and $5.5 million
to develop a new drug for animals, from commencement of research to market
introduction. Of this time, approximately three years is spent in the clinical
trial and review process. However, unlike human drugs, neither preclinical
studies in model systems nor a sequential phase system of clinical trials are
required. Rather, for animal drugs, clinical trials for safety and efficacy may
be conducted immediately in the species for which the drug is intended. Thus,
there is no required phased evaluation of drug performance, and the CVM will
review data at appropriate and productive times in the drug development process.
In addition, the time and cost for developing companion animal drugs may be
significantly less than for drugs for food producing animals, as food safety
issues relating to tissue residue levels are not present.
A number of animal health products are not regulated. For example, assays
for use in a veterinary diagnostic laboratory and certain pieces of equipment do
not have to be licensed by either the USDA or FDA. Additionally, certain
botanically derived products, certain nutritional products, and grooming and
supportive care products are exempt from significant regulation as long as they
do not bear a therapeutic claim that represents the product as a drug.
The European Union ("EU") is centralizing the regulatory process for
companion animal drugs and biologics for member states. In addition, both the
USDA and the FDA are working with the EU and Japan via the Veterinary
International Cooperation on Harmonization initiative to harmonize the
regulatory requirements for companion animal health products. Thus, in the
future, it is hoped that a single set of requirements will be in place to
streamline the licensing of veterinary products in the major companion animal
markets.
Delays in obtaining or failure to obtain any necessary regulatory approvals
for Heska's products could have a material adverse effect on the Company's
future product sales and operations. Heska has experienced delays in the past
and could incur additional delays in the future. Any acquisitions of new
products and technologies may subject the Company to additional government
regulation. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations-Factors That May Affect Results-Government Regulation;
No Assurance of Obtaining Regulatory Approvals".
Competition
The market in which the Company competes is intensely competitive. Heska's
competitors include companion animal health companies and major pharmaceutical
companies that have animal health divisions. Companies with a significant
presence in the companion animal health market, such as American Home Products,
Bayer, Merial Ltd., Novartis, Pfizer Inc., Schering-Plough Corp., Pharmacia &
Upjohn, Inc. and IDEXX Laboratories, Inc., have developed or are developing
products that do or would compete with the Company's products. These
competitors have substantially greater financial, technical, research and other
resources and larger, more established marketing, sales, distribution and
service organizations than the Company. Moreover, such competitors may offer
broader product lines and have greater name recognition than the Company.
Novartis and Bayer are marketing partners of the Company and their agreements
with the Company do not restrict their ability to develop and market competing
products. See "Collaborative Agreements". The market for companion animal
health care products is highly fragmented, with discount stores and specialty
pet stores accounting for a substantial percentage of such sales. As Heska
intends to distribute its products primarily through veterinarians, a
substantial segment of the potential market may not be reached and the Company
may not be able to
14
offer its products at prices which are competitive with those of companies that
distribute their products through retail channels.
Center's human allergy immunotherapy products compete with similar products
offered by a number of other companies, some of which have substantially greater
financial, technical, research and other resources than Center and more
established marketing, sales, distribution and service organizations than Center
Pharmaceuticals, Inc. The bovine vaccines sold by Diamond to Bayer and AgriLabs
compete with each other and with similar products offered by a number of other
companies, some of which have substantially greater financial, technical,
research and other resources than Diamond and more established marketing, sales,
distribution and service organizations than AgriLabs.
There can be no assurance that the Company's competitors will not develop
or market technologies or products that are more effective or commercially
attractive than the Company's current or future products or that would render
the Company's technologies and products obsolete. Moreover, there can be no
assurance that the Company will have the financial resources, technical
expertise or marketing, distribution or support capabilities to compete
successfully. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations-Factors That May Affect Results-Highly Competitive
Industry".
Employees
As of January 1, 1999, Heska and its subsidiaries employed 533 full-time
persons, of whom 196 are in manufacturing, quality control and materials
management, 105 are in research, development and regulatory affairs, 105 are in
management, finance, administration, legal, information systems, human
resources, purchasing and facilities management; 78 are in sales and marketing
and 49 are in the diagnostic laboratories. There can be no assurance that the
Company will continue to be able to attract and retain qualified technical and
management personnel. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations-Factors That May Affect Results-Dependence
on Key Personnel". None of the Company's employees are covered by a collective
bargaining agreement, and the Company believes its employee relations are good.
Item 2. Properties.
Heska currently leases an aggregate of approximately 75,000 square feet of
administrative and laboratory space in six buildings located mostly in one
business park in Fort Collins, Colorado under leases expiring from 1999 through
2004, with options to extend through 2010 for the larger facilities. Heska is
vacating one of these buildings comprising approximately 19,000 square feet of
space and is seeking a subtenant for that space. Heska believes that its
present Fort Collins facilities are adequate for its current and planned
activities and that suitable additional or replacement facilities in the Fort
Collins area are readily available on commercially reasonable terms should such
facilities be needed in the future. Diamond's principal manufacturing facility
in Des Moines, Iowa, consisting of 166,000 square feet of buildings on 34 acres
of land, is owned by Diamond. Diamond also owns a 160-acre farm used
principally for research purposes located in Carlisle, Iowa. Center owns its
approximately 27,000 square foot facility in Port Washington, New York. SDI
leases approximately 19,500 feet of office and manufacturing space in Waukesha,
Wisconsin. The Company's European subsidiaries lease their facilities.
Item 3. Legal Proceedings.
In November 1998, Synbiotics Corporation filed a lawsuit against the
Company in the United States District Court for the Southern District of
California in which it alleges that the Company infringes a patent owned by
Synbiotics relating to heartworm diagnostic technology. Heska has answered the
complaint and discovery is proceeding. Heska has obtained legal opinions from
its outside patent counsel that Heska's heartworm diagnostic products do not
infringe the Synbiotics patent and that the patent is invalid. The opinions of
non-infringement are consistent with the results of Heska's internal
evaluations. While Heska believes that it has valid defenses to Synbiotics'
allegations and intends to defend the action vigorously, there can be no
assurance that an adverse result or settlement would not have a material adverse
effect on the financial position, the operations or the cash flow of the
Company.
15
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
Executive Officers of the Registrant
The executive officers of the Company and their ages as of March 15, 1999
are as follows:
Name Age Position
- ---- --- --------
Robert B. Grieve 47 Vice Chairman and Chief Executive Officer
James H. Fuller 54 President and Chief Operating Officer
Ronald L. Hendrick 53 Executive Vice President, Chief Financial Officer and Secretary
Paul S. Hudnut 40 Executive Vice President
Guisseppe Miozzari 52 Managing Director, Heska Europe
R. Lee Seward 53 Executive Vice President
Robert B. Grieve, a founder of the Company, currently serves as Chief
Executive Officer and Vice Chairman of the Board of Directors. Dr. Grieve was
named Chief Executive Officer effective January 1, 1999 and Vice Chairman
effective December 1994. Dr. Grieve also served as Chief Scientific Officer
from December 1994 to January 1999 and Vice President, Research and Development,
from March 1992 to December 1994. He has been a member of the Company's Board
of Directors since 1990. Dr. Grieve was a Professor of Parasitology at Colorado
State University from 1987 until joining the Company in January 1994. He holds
a Ph.D. degree from the University of Florida and M.S. and B.S. degrees from the
University of Wyoming.
James H. Fuller is President and Chief Operating Officer of the Company.
He joined the Company in January 1999. Prior to joining the Company, Mr. Fuller
served as Corporate Vice President of Allergan, Inc. ("Allergan"), a leading
specialty pharmaceutical company, from 1994 through 1998. Prior to that, Mr.
Fuller served in a number of sales and marketing positions at Allergan since
1974. He holds M.S. and B.S. degrees from the University of Southern
California.
Ronald L. Hendrick is Executive Vice President, Chief Financial Officer and
Secretary of the Company. He joined the Company in December 1998. Prior to
joining the Company, Mr. Hendrick was Executive Vice President and Chief
Financial Officer of Xenometrix, Inc., a human biotechnology concern, from 1995
until December 1998. Prior to that, Mr. Hendrick served as Vice President and
Corporate Controller at Alexander & Alexander Services, Inc., a NYSE financial
services firm, from 1993 until 1995 and before that he held a number of finance
and accounting positions at Adolph Coors Company. Mr. Hendrick is a Certified
Public Accountant. He is a former director of the University of Colorado
Foundation and the Denver World Trade Center. He holds a M.B.A. from the
University of Colorado and a B.A. degree from Michigan State University.
Paul S. Hudnut is Executive Vice President of the Company. He was elected
Executive Vice President in September 1998, and prior to that was Vice President
of Business Development of the Company since June 1996. Prior to joining the
Company in June 1996, Mr. Hudnut was a General Manager at US WEST Media Group
and held various positions in management and business development at
subsidiaries of US WEST, Inc. from February 1988. Prior to joining US WEST, Mr.
Hudnut was an associate with the Denver, Colorado law firm of Davis, Graham and
Stubbs. He holds a J.D. degree from the University of Virginia and a B.A.
degree from The Colorado College.
Giuseppe Miozzari joined the Company as Managing Director, Heska Europe in
March 1997. From 1980 to March 1997, Dr. Miozzari served in senior research
positions with Novartis, most recently as the Head of Research of the Animal
Health Sector and prior to that, from 1980 to 1983, as Head of the Molecular
Biology Research Unit in the Pharmaceuticals Division. Dr. Miozzari also served
as Novartis' designate on the Board of Directors of the Company from April 1996
to March 1997. Dr. Miozzari holds Ph.D. and Dipl. Sc. Nat. degrees from the
Federal Institute of Technology (ETH) in Zurich, Switzerland.
16
R. Lee Seward is Executive Vice President of the Company. He joined the
Company in October 1994. Before joining the Company, Dr. Seward held successive
positions with Merck & Co., Inc. from May 1981 until September 1994. His most
recent position with Merck was Executive Director, Animal Science Research, a
position in which he headed worldwide animal health product development. Dr.
Seward was in private veterinary practice from March 1980 until he joined Merck
& Co., Inc. He holds D.V.M. and B.S. degrees from Colorado State University.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The Company's Common Stock has been quoted on the Nasdaq National Market
under the symbol "HSKA" since July 1, 1997. The Company's initial public
offering price was $8.50 per share. The following table sets forth the intraday
high and low prices for the Common Stock as reported by the Nasdaq National
Market.
1997 HIGH LOW
---- ------- -------
Third Quarter...................................................... $ 16.00 $7.125
Fourth Quarter..................................................... 15.625 11.25
1998
----
First Quarter.................................................... 14.875 9.25
Second Quarter ................................................. 16.75 8.75
Third Quarter.................................................... 11.938 5.125
Fourth Quarter................................................... 7.625 3.00
As of March 15, 1999, there were approximately 275 stockholders of record
of the Company's Common Stock and approximately 4,050 beneficial stockholders.
The Company has never declared or paid cash dividends on its capital stock and
does not anticipate paying any cash dividends in the foreseeable future. The
Company currently intends to retain future earnings for the development of its
business.
Recent Sales of Unregistered Securities
In April 1998, the Registrant issued 4,912 shares to an equipment lessor
pursuant to the net exercise of a warrant to 6,225 shares of Heska Common Stock.
The Registrant relied upon the exemption provided by Section 4(2) of the Act.
In July 1998 and November 1998, the Registrant issued an aggregate of
22,250 shares to a product development services provider in consideration of the
completion of certain research projects. The Registrant relied upon the
exemption provided by Section 4(2) of the Act.
In September 1998, the Registrant issued 9,773 shares to a consultant in
consideration of the cancellation of an option to purchase 10,000 shares of
Heska Common Stock. The Registrant relied upon the exemption provided by
Section 4(2) of the Act.
17
Item 6. Selected Consolidated Financial Data.
The data set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements and related Notes included as Items 7 and
8 in this Form 10-K.
Year Ended December 31,
-------------------------------------------------------------------
1994 1995 1996 1997 1998
---------- ------------- ------------- ----------- -----------
(in thousands, except per share amounts)
(restated) (restated) (restated) (restated)
Consolidated Statement of Operations Data:
Revenues:
Products, net $ 2,929 $ 4,719 $ 15,570 $ 26,725 $38,451
Research and development 3,858 2,230 1,946 2,578 1,321
-------- -------- -------- --------- -------
Total revenues 6,767 6,949 17,516 29,303 39,772
Costs and operating expenses:
Cost of goods sold 2,004 2,842 12,002 20,077 29,087
Research and development 3,890 6,412 14,513 20,343 25,126
Selling and marketing 349 902 4,168 9,954 13,188
General and administrative 1,248 1,442 5,514 13,192 11,939
Amortization of intangible assets
and deferred compensation 170 278 1,289 2,500 2,745
Purchased research and development -- -- -- 2,399 --
Loss on assets held for sale -- -- -- -- 1,287
Restructuring expense -- -- -- -- 2,356
-------- -------- -------- --------- -------
Total costs and operating expenses 7,661 11,876 37,486 68,465 85,728
-------- -------- --------- --------- -------
Loss from operations (874) (4,927) (19,970) (39,162) 45,956
Other income (expense) (622) 19 721 298 1,682
-------- -------- -------- --------- -------
Net loss (1,496) $ (4,908) $(19,249) $(38,864) $ 44,274
======= ======== ======== ======== =======
Basic net loss per share $(1.79)
=======
Unaudited pro forma basic net loss per share (1) $1.53 $2.42
======= =======
Shares used to compute basic net loss per share
and unaudited pro forma basic net loss per share 12,609 16,042 24,693
December 31,
--------------------------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- --------- ------- ------
(in thousands)
(restated) (restated) (restated) (restated)
Consolidated Balance Sheet
Data:
Cash, cash equivalents and $ 546 $ 6,849 $ 23,721 $ 28,752 $ 51,930
marketable securities.....
Working capital............ 575 6,843 24,224 31,461 51,947
Total assets............... 3,989 11,291 45,651 69,020 98,054
Long-term obligations...... 501 903 5,077 10,754 11,367
Accumulated deficit........ (9,471) (14,379) (33,628) (72,492) (116,766)
Total stockholders' equity. 1,391 7,414 32,671 43,850 67,114
(1) See Note 2 of Notes to Consolidated Financial Statements for information
concerning the computation of pro forma basic net loss per share.
18
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
The following discussion and analysis of the Company's financial condition
and results of operations should be read in conjunction with "Selected
Consolidated Financial Data" and the Consolidated Financial Statements and
related Notes included in Items 6 and 8 of this Form 10-K.
This discussion contains, in addition to historical information, forward-
looking statements that involve risks and uncertainties. The Company's actual
results and the timing of certain events could differ materially from the
results discussed in the forward-looking statements. When used in this
discussion the words "expects," "anticipates," "estimates" and similar
expressions are intended to identify forward-looking statements. Such
statements, which include statements concerning future revenue sources and
concentration, gross margins, research and development expenses, selling and
marketing expenses, general and administrative expenses, capital resources,
additional financings or borrowings and additional losses, are subject to risks
and uncertainties, including those set forth below under "--Factors that May
Affect Results" that could cause actual results to differ materially from those
projected. These forward-looking statements speak only as of the date hereof.
The Company expressly disclaims any obligation or undertaking to release
publicly any updates or revisions to any forward-looking statements contained
herein to reflect any change in the Company's expectations with regard thereto
or any change in events, conditions, or circumstances on which any such
statement is based.
Overview
Heska is primarily focused on the discovery, development and marketing of
companion animal health products. In addition to manufacturing certain of
Heska's companion animal products, the Company's primary manufacturing
subsidiary, Diamond also manufactures bovine vaccine products and pharmaceutical
and personal healthcare products which are marketed and distributed by third
parties. In addition to manufacturing veterinary allergy products for marketing
and sale by Heska, Heska's subsidiaries, Center and CMG, also manufacture and
sell human allergy products.
From the Company's inception in 1988 until early 1996, the Company's
operating activities related primarily to research and development activities,
entering into collaborative agreements, raising capital and recruiting
personnel. Prior to 1996, the Company had not received any revenues from the
sale of products. During 1996, Heska grew from being primarily a research and
development concern to a fully-integrated research, development, manufacturing
and marketing company. The Company accomplished this by acquiring Diamond, a
licensed pharmaceutical and biological manufacturing facility in Des Moines,
Iowa, hiring key employees and support staff, establishing marketing and sales
operations to support Heska products introduced in 1996, and designing and
implementing more sophisticated operating and information systems. The Company
also expanded the scope and level of its scientific and business development
activities, increasing the opportunities for new products. In 1997, the Company
introduced 13 additional products and expanded in the United States through the
acquisition of Center, an FDA and USDA licensed manufacturer of allergy
immunotherapy products located in Port Washington, New York, and internationally
through the acquisitions of Heska UK, a veterinary diagnostic laboratory in
Teignmouth, England and CMG in Fribourg, Switzerland, which manufactures and
markets allergy diagnostic products for use in veterinary and human medicine,
primarily in Europe. Each of the Company's acquisitions during this period was
accounted for under the purchase method of accounting and accordingly, the
Company's financial statements reflect the operations of these businesses only
for the periods subsequent to the acquisitions. In July 1997, the Company
established a new subsidiary, Heska AG, located near Basel, Switzerland, for the
purpose of managing its European operations.
During the first quarter of 1998 the Company acquired SDI, a manufacturer and
marketer of patient monitoring devices used in both animal health and human
applications. The financial results of SDI have been consolidated with those of
the Company under the pooling-of-interests accounting method for all periods
presented.
The Company has incurred net losses since its inception and anticipates
that it will continue to incur additional net losses in the near term as it
introduces new products, expands its sales and marketing capabilities and
continues its research and development activities. Cumulative net losses from
inception of the Company in 1988 through December 31, 1998 have totaled $116.8
million.
19
The Company's ability to achieve profitable operations will depend
primarily upon its ability to successfully market its products, commercialize
products that are currently under development, develop new products and
efficiently integrate acquired businesses. Most of the Company's products are
subject to long development and regulatory approval cycles and there can be no
assurance that the Company will successfully develop, manufacture or market
these products. There can also be no assurance that the Company will attain
profitability or, if achieved, will remain profitable on a quarterly or annual
basis in the future. Until the Company attains positive cash flow, the Company
may continue to finance operations with additional equity and debt financing.
There can be no assurance that such financing will be available when required or
will be obtained under favorable terms. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Factors That May
Affect Results-Loss History and Accumulated Deficit; Uncertainty of Future
Profitability; Quarterly Fluctuations and Customer Concentration".
Results of Operations
Year Ended December 31, 1998
Total revenues, which include product and research and development
revenues, increased 36% to $39.8 million in 1998 compared to $29.3 million in
1997. Product revenues increased 44% to $38.5 million in 1998 compared to $26.7
million in 1997. The growth in revenues during 1998 was primarily due to sales
of new products introduced during 1998, increased sales of the Company's
existing products and from consolidating revenues of Center and CMG subsequent
to their acquisitions in July 1997 and September 1997, respectively. Sales to
one customer, Bayer, represented 15% of total revenues in 1998 and are expected
to decline as a percentage of total revenues in future years. See "Business-
Food Animal Products".
Revenues from sponsored research and development decreased to $1.3 million
in 1998 from $2.6 million in 1997. Fluctuations in revenues from sponsored
research and development are generally the result of changes in the number of
funded research projects as well as the timing and performance of contract
milestones. The Company expects that revenues from sponsored research and
development will decline in future periods, reflecting the expiration of current
funding commitments and the Company's decision to fund its future research
activities primarily from internal sources, although the Company may engage in
additional sponsored research if such projects become available and are
consistent with the Company's research priorities.
Cost of goods sold totaled $29.1 million in 1998 compared to $20.1 million
in 1997, and the resulting gross profit for 1998 increased to $9.4 million from
$6.6 million in 1997. The Company's gross margin percentage was 24% in 1998,
compared to 25% in 1997. Gross profit margins in 1998 were adversely affected
by inventory write-downs of approximately $1.5 million during the year. Without
these inventory write-downs, gross profit margins would have been 28%. The
Company believes that gross margins as a percentage of revenues will improve in
future years, as more of the Company's proprietary diagnostic, vaccine and
pharmaceutical products are approved by the applicable regulatory bodies and
achieve market acceptance.
Research and development expenses increased to $25.1 million in 1998 from
$20.3 million in 1997. The increase in 1998 was primarily due to increases in
the level and scope of the Company's internal research and development
activities, expenses related to new collaborative agreements and licenses to
support research efforts for potential products to be developed by the Company.
The Company expects that research and development expenses will be lower in the
near term as a result of the Company's restructuring in December 1998.
Selling and marketing expenses increased to $13.2 million in 1998 from
$10.0 million in 1997. This increase reflects primarily the expansion of the
Company's sales and marketing organization and costs associated with the
introduction and marketing of new products. Selling and marketing expenses
consist primarily of salaries, commissions and benefits for sales and marketing
personnel, commissions paid to contract sales agents and expenses of product
advertising and promotion. The Company expects selling and marketing expenses
to increase as sales volumes increase and new products are introduced to the
marketplace, but to decrease as a percentage of total revenues in future years.
20
General and administrative expenses decreased to $11.9 million in 1998 from
$13.2 million in 1997. The decrease in 1998 was primarily due to a one-time
charge in 1997 relating to a supply agreement termination fee. General and
administrative expenses are expected to decrease as a percentage of total
revenues in future years.
Amortization of intangible assets and deferred compensation increased to
$2.7 million in 1998 from $2.5 million in 1997. Intangible assets resulted
primarily from the Company's 1997 and 1996 business acquisitions and are being
amortized over lives of 2 to 10 years. The amortization of deferred
compensation resulted in a non-cash charge to operations in 1998 of
approximately $736,000 compared to $645,000 in 1997. In connection with the
grant of certain stock options in 1997 and 1996, the Company recorded deferred
compensation representing the difference between the deemed value of the common
stock for accounting purposes and the exercise price of such options at the date
of grant. In 1998 the Company also granted stock options to non-employees in
exchange for consulting services. Compensation costs, equal to the fair value
of the options on the date of grant, will be recognized over the service period.
The Company will incur a non-cash charge to operations as a result of option
grants outstanding at December 31, 1998 of approximately $658,000, $585,000 and
$34,000 per year for 1999, 2000 and 2001, respectively, for amortization of
deferred compensation.
The loss on assets held for sale recorded in 1998 reflects the write-down
of certain tangible and intangible assets to their expected net realizable
values.
In December 1998 the Company completed a cost reduction and restructuring
plan. The restructuring was based on the Company's determination that, while
revenues had been increasing steadily, management believed that reducing
expenses was necessary in order to accelerate the Company's efforts to reach
profitability. In connection with the restructuring, the Company recognized a
charge to operations in 1998 of approximately $2.4 million. These expenses
primarily related to personnel severance costs and costs associated with excess
facilities and equipment.
Interest income increased to $3.2 million in 1998 from $1.6 million in 1997
as a result of increased cash available for investment arising from the proceeds
from the Company's IPO in July 1997, the follow-on offering completed in March
1998 and the private placement of common stock with Ralston Purina in July 1998.
Interest income is expected to decline in the future as the Company uses cash to
fund its business operations. Interest expense increased to $2.0 million in 1998
from $1.4 million in 1997 due to increases in debt financing for laboratory and
manufacturing equipment and debt related to the Company's 1997 business
acquisitions.
Year Ended December 31, 1997
Total revenues, which include product and research and development
revenues, increased 67% to $29.3 million in 1997 compared to $17.5 million in
1996. Product revenues increased 71% to $26.7 million in 1997 compared to $15.6
million in 1996. The growth in revenues during 1997 was primarily due to new
product introductions, increased sales of the Company's existing products and
from consolidating revenues of Diamond, Center and CMG subsequent to their
acquisitions in April 1996, July 1997 and September 1997, respectively. Sales to
one customer, Bayer, represented 21% of total revenues in 1997.
Revenues from sponsored research and development increased to $2.6 million
in 1997 from $1.9 million in 1996. Fluctuations in revenues from sponsored
research and development are generally the result of changes in the number of
funded research projects as well as the timing and performance of contract
milestones.
Cost of goods sold totaled $20.1 million in 1997 compared to $12.0 million
in 1996, and the resulting gross profit for 1997 increased to $6.6 million from
$3.6 million in 1996. The Company's gross profit margin was 25% in 1997,
compared to 23% in 1996.
Research and development expenses increased to $20.3 million in 1997 from
$14.5 million in 1996. The increase in 1997 was primarily due to increases in
the level and scope of the Company's
21
internal research and development activities, expenses related to new
collaborative agreements and licenses to support research efforts for potential
products to be developed by the Company.
Selling and marketing expenses increased to $10.0 million in 1997 from $4.2
million in 1996. This increase reflects primarily the expansion of the
Company's sales and marketing organization and costs associated with the
introduction and marketing of new products. Selling and marketing expenses
consist primarily of salaries, commissions and benefits for sales and marketing
personnel, commissions paid to contract sales agents and expenses of product
advertising and promotion.
General and administrative expenses increased to $13.2 million in 1997 from
$5.5 million in 1996. The increase in 1997 primarily resulted from the growth
of accounting and finance, human resources, legal, administrative, information
systems and facilities operations to support the Company's increased business,
financing and financial reporting requirements. General and administrative
expenses for 1997 include a one-time charge of $750,000 for the termination of a
supply agreement.
Amortization of intangible assets and deferred compensation increased to
$2.5 million in 1997 from $1.3 million in 1996. Intangible assets resulted
primarily from the Company's 1997 and 1996 business acquisitions and are being
amortized over lives of 2 to 10 years. The amortization of deferred
compensation resulted in a non-cash charge to operations in 1997 of
approximately $645,000 compared to $188,000 in 1996. In connection with the
grant of certain stock options in 1997 and 1996, the Company recorded deferred
compensation representing the difference between the deemed value of the common
stock for accounting purposes and the exercise price of such options at the date
of grant.
Purchased research and development expenses of $2.4 million for 1997
reflect a one-time non-cash charge related to the acquisition in May 1997 of a
development stage company.
Interest income increased to $1.6 million in 1997 from $1.4 million in 1996
as a result of increased cash available for investment resulting from the
proceeds from the Company's IPO. Interest expense increased to $1.4 million in
1997 from $500,000 in 1996 due to increases in debt financing for laboratory and
manufacturing equipment and debt related to the Company's 1996 and 1997 business
acquisitions.
Year Ended December 31, 1996
Total revenues, which include product and research and development
revenues, increased 154% to $17.5 million in 1996 compared to $6.9 million in
1995. Product revenues increased 232% to $15.6 million in 1996 compared to $4.7
million in 1995. The growth in revenues during 1996 was primarily due to
consolidating revenues from Diamond subsequent to its acquisition in April 1996
and increased sales of the Company's products. Sales to one customer, Bayer,
represented 36% of total consolidated revenues in 1996.
Revenues from sponsored research and development decreased to $2.0 million
in 1996 from $2.2 million in 1995. Fluctuations in revenues from sponsored
research and development are generally the result of changes in the number of
funded research projects as well as the timing and performance of contract
milestones.
Cost of goods sold totaled $12.0 million in 1996 compared to $2.8 million
in 1995, and the resulting gross profit for 1996 increased to $3.6 million from
$1.9 million in 1995. The Company's gross profit margin declined to 23% in 1996
from 40% in 1995, primarily as a result of consolidating the results of Diamond
subsequent to its acquisition in April 1996.
Research and development expenses increased to $14.5 million in 1996 from
$6.4 million in 1995. The increase in 1996 was primarily due to increases in
the level and scope of the Company's internal research and development
activities, expenses related to new collaborative agreements and licenses to
support research efforts for potential products to be developed by the Company.
Selling and marketing expenses increased to $4.2 million in 1996 from
$900,000 in 1995. This increase reflects primarily the expansion of the
Company's sales and marketing organization and costs associated with the
introduction and marketing of new products. Selling and marketing expenses
consist
22
primarily of salaries, commissions and benefits for sales and marketing
personnel and expenses of product advertising and promotion.
General and administrative expenses increased to $5.5 million in 1996 from
$1.4 million in 1995. The increase in 1996 resulted from the growth of
accounting and finance, human resources, legal, administrative, information
systems and facilities operations to support the Company's increased business,
financing and financial reporting requirements, and to a lesser extent, as a
result of consolidating the general and administrative expenses from Diamond
subsequent to its acquisition.
Amortization of intangible assets and deferred compensation increased to
$1.3 million in 1996 from $278,000 in 1995. Intangible assets resulted
primarily from the Company's 1996 business acquisitions and are being amortized
over lives of 2 years to 37 months. The amortization of deferred compensation
resulted in a non-cash charge to operations in 1996 of approximately $188,000
compared to $278,000 in 1995. In connection with the grant of certain stock
options in 1996, the Company recorded deferred compensation representing the
difference between the deemed value of the common stock for accounting purposes
and the exercise price of such options at the date of grant.
Interest income increased to $1.4 million in 1996 from $172,000 in 1995 as
a result of increased cash available for investment resulting from the proceeds
from the private placement of preferred stock with Novartis in April 1996.
Interest expense increased to $490,000 in 1996 from $143,000 in 1995 due to
increases in debt financing for laboratory and manufacturing equipment and debt
assumed as part of the Company's 1996 business acquisitions.
Liquidity and Capital Resources
The Company's primary source of liquidity at December 31, 1998 was its
$51.9 million in cash, cash equivalents and marketable securities. The source
of these funds was primarily attributable to the Company's follow-on public
offering of common stock in March 1998 and the July 1998 private placement of
common stock with Ralston Purina, which provided the Company with net proceeds
of approximately $48.6 million and $15.0 million, respectively. As additional
sources of liquidity, the Company and its subsidiaries have secured lines of
credit and other debt facilities totaling approximately $4.5 million, against
which borrowings of approximately $4.0 million were outstanding at December 31,
1998. These financing facilities are secured by assets of Heska and its
respective subsidiaries and by corporate guarantees of Heska. The Company
expects to seek additional asset-based borrowing facilities.
Cash used in operating activities was $38.1 million in 1998, compared to
$35.1 million and $15.4 million in 1997 and 1996, respectively. Inventory
levels increased by $1.4 million in 1998, primarily to support increased sales
of existing products and inventory build-up in anticipation of new product
introductions. The increase of $1.2 million in accounts receivable was mainly
due to increased sales volume. Accounts payable increased by $1.2 million in
1998, primarily as a result of the increase in inventory levels and operating
expenses. Expenses which were recognized as a result of the Company's
restructuring accounted for $1.6 million of the change in accrued liabilities
for 1998.
The Company used $34.6 million in cash for investing activities during
1998, compared to $9.4 million in 1997. Cash used for investing activities was
primarily related to the purchase of marketable securities to invest the
proceeds of the Company's issuance of common stock during 1998. Expenditures
for property and equipment totaled $6.5 million for 1998 compared to $6.2
million in 1997. The Company has historically used, and anticipates that it
will continue, to use capital equipment lease and debt facilities to finance
equipment purchases and, if possible, leasehold improvements. The Company
currently expects to spend approximately $3.5 million in 1999 for capital
equipment, including expenditures for the upgrading of certain manufacturing
operations to improve efficiencies as well as various enhancements to assure
ongoing compliance with certain regulatory requirements. The Company expects to
finance these expenditures through equipment leases and secured debt facilities,
where possible.
The Company's financing activities generated $67.9 million in cash in 1998,
compared to $48.5 million in 1997. The primary sources of funds were the follow-
on public offering of common stock and the private placement of common stock
with Ralston Purina, which provided the Company with net
23
proceeds of approximately $48.6 million and $15.0 million, respectively. The
Company received proceeds from borrowings under capital lease and debt
facilities of $10.2 million in 1998, compared to $5.5 million in 1997. $453,000
of these borrowings were used to refinance debt which had been assumed as part
of the Company's 1996 business acquisitions. Repayments of debt and capital
lease obligations totaled $6.8 million in 1998, $453,000 of which related to the
refinancing of existing debt.
The Company's primary short-term needs for capital, which are subject to
change, are for its continuing research and development efforts, its sales,
marketing and administrative activities, working capital associated with
increased product sales and capital expenditures relating to developing and
expanding the Company's manufacturing operations. The Company's future
liquidity and capital requirements will depend on numerous factors, including
the extent to which the Company's present and future products gain market
acceptance, the extent to which products or technologies under research or
development are successfully developed, the timing of regulatory actions
regarding the Company's products, the costs and timing of expansion of sales,
marketing and manufacturing activities, the cost, timing and business management
of current and potential acquisitions and contingent liabilities associated with
such acquisitions, the procurement and enforcement of patents important to the
Company's business and the results of competition.
The Company believes that its available cash and cash from operations will
be sufficient to satisfy its projected cash requirements for at least the next
12 months, assuming no significant uses of cash in acquisition activities.
Thereafter, if cash generated from operations is insufficient to satisfy the
Company's cash requirements, the Company will need to raise additional capital
to continue its business operations. There can be no assurance that such
additional capital will be available on terms acceptable to the Company, if at
all. Furthermore, any additional equity financing would likely be dilutive to
stockholders and debt financing, if available, may include restrictive covenants
which may limit the Company's operations and strategies.
Net Operating Loss Carryforwards
As of December 31, 1998, the Company had a net operating loss ("NOL")
carryforward of approximately $94.5 million and approximately $2.3 million of
research and development ("R&D") tax credits available to offset future federal
income taxes. The NOL and tax credit carryforwards, which are subject to
alternative minimum tax limitations and to examination by the tax authorities,
expire from 2003 to 2012. The Company's acquisition of Diamond resulted in a
"change of ownership" under the provisions of Section 382 of the Internal
Revenue Code of 1986, as amended. As such, the Company will be limited in the
amount of NOLs incurred prior to the merger that it may utilize to offset future
taxable income. This limitation will total approximately $4.7 million per year
for periods subsequent to the Diamond acquisition. Similar limitations also
apply to utilization of R&D tax credits to offset taxes payable. In addition,
the Company believes that its follow-on public offering of common stock in March
1998 resulted in a further "change of ownership." This limitation will total
approximately $12.5 million per year for periods subsequent to the follow-on
offering. The Company believes that these limitations may affect the eventual
utilization of its total NOL carryforwards.
Recent Accounting Pronouncements
The Company does not expect the adoption of any standards recently issued
by the Financial Accounting Standards Board to have a material impact on the
Company's financial position or results of operations.
Year 2000 Compliance
The Year 2000 ("Y2K") issue is the result of computer programs being
written using two digits, rather than four, to define the applicable year.
Mistaking "00" for the year 1900, rather than 2000, could result in
miscalculations and errors and cause significant business interruptions for the
Company, as well as the government and most other companies. The Company has
initiated procedures to identify, evaluate and implement any necessary changes
to its computer systems, applications and embedded technologies resulting from
the conversion. The Company is coordinating these activities with suppliers,
distributors, financial institutions and others with whom it does business.
Based on the results of its current evaluation, the Company does not believe
that the Y2K conversion will have a material adverse effect on its business.
24
State of Readiness
The Company relies on software in its information systems and manufacturing
and laboratory equipment. Most of this equipment and software was installed and
written within the past three years. The Company has done an initial survey of
the installed control systems, computers, and applications software, and it
appears that these systems are either Y2K compliant, or the vendors claim Y2K
compliance, or the problems can be corrected by purchasing or receiving
relatively small amounts of hardware, software, or software upgrades.
Costs
The Company has a plan to validate each of these systems by the end of the
second quarter of 1999. This plan (40% of total expected hours were completed as
of December 31, 1998) will be accomplished through a combination of written
vendor confirmations, when available, and specific validation testing. This
validation process is expected to be accomplished primarily with internal
corporate staff. This validation phase is expected to cost approximately
$100,000, including consulting and internal resources.
Based on management's evaluations to date, remediation costs are not
expected to be material due to the fact that the Company's information and
embedded systems are new, generally off-the-shelf, and vendor relationships
still exist for most subject equipment and software. These costs are expected
to consist of replacing relatively low-cost personal computers, and
installations of bug-fixes from major manufacturers of equipment, along with
some custom software fixes. These costs, including hardware replacements
accelerated by the Y2K situation, and other contingency plan activities, are not
expected to exceed approximately $200,000.
Risks
The most likely risks to the Company from Y2K issues are external, due to
the difficulty of validating the readiness of key third parties for Y2K. The
Company will seek confirmation of such compliance and seek relationships which
are compliant. However, the risk that a major supplier or customer will become
unreliable due to Y2K problems will still exist. The Company will develop
contingency plans for key relationships as they arise.
Factors That May Affect Results
Dependence on Development and Successful Introduction of New Products
Some of the Company's products have only recently been introduced and many
are still under development. There can be no assurance that current products
will gain market acceptance or that products will be successfully developed or
commercialized on a timely basis, or at all. Several of the Company's current
products as well as a number of products under development, are novel. The
Company must expend substantial efforts in educating and convincing its customer
base in the use of and the need for such products. The Company believes that its
revenue growth and profitability, if any, will substantially depend upon its
ability to improve market acceptance of its current products and complete
development of and successfully introduce and commercialize its new products.
The development and regulatory approval activities necessary to bring new
products to market are time-consuming and costly. The Company has experienced
delays in receiving regulatory approvals. There can be no assurance that the
Company will not experience difficulties that could delay or prevent
successfully developing, obtaining regulatory approvals to market or introducing
these new products, that regulatory clearance or approval of any new products
will be granted by the USDA, the FDA, the EPA or foreign regulatory authorities
on a timely basis, or at all, or that the new products will be successfully
commercialized. The Company's strategy is to develop a broad range of products
addressing different disease indications. The Company has limited resources to
devote to the development of all its products and consequently a delay in the
development of one product or the use of resources for product development
efforts that prove unsuccessful may delay or jeopardize the development of its
other product candidates. Further, for certain of the Company's proposed
products, the Company is dependent on collaborative partners to successfully and
timely perform research and development activities on behalf of the Company. In
order
25
to successfully commercialize any new products, the Company will be required to
establish and maintain a reliable, cost-efficient source of manufacturing for
such products. If the Company is unable, for technological or other reasons, to
complete the development, introduction or scale up of manufacturing of any new
product or if any new product is not approved for marketing or does not achieve
a significant level of market acceptance, the Company could be materially and
adversely affected. Following the introduction of a product, adverse side
effects may be discovered that make the product no longer commercially viable.
Publicity regarding such adverse effects could affect sales of the Company's
other products for an indeterminate time period. The Company is dependent on the
acceptance of its products by both veterinarians and pet owners. The failure of
the Company to engender confidence in its products and services could affect the
Company's ability to attain sustained market acceptance of its products. See
"Business-Manufacturing," "-Government Regulation" and "-Collaborative
Agreements".
Loss History and Accumulated Deficit; Uncertainty of Future Profitability;
Quarterly Fluctuations and Customer Concentration
Heska has incurred net losses since its inception. At December 31, 1998,
the Company's accumulated deficit was $116.8 million. The Company anticipates
that it will continue to incur additional operating losses in the near term.
Such losses have resulted principally from expenses incurred in the Company's
research and development programs and, to a lesser extent, from general and
administrative and sales and marketing expenses. Currently, a substantial
portion of the Company's revenues are from Diamond, which manufactures
veterinary biologicals and pharmaceuticals for other companies in the animal
health industry. Revenues from one Diamond customer comprised approximately 15%
of total revenues in 1998 under the terms of a take-or-pay contract which
terminates in January 2000. If this customer does not continue to purchase from
Diamond and if the lost revenues are not replaced by other customers or
products, the Company's financial condition and results of operations could be
adversely affected.
There can be no assurance that the Company will attain profitability or, if
achieved, will remain profitable on a quarterly or annual basis in the future.
The Company believes that future operating results will be subject to quarterly
fluctuations due to a variety of factors, including whether and when new
products are successfully developed and introduced by the Company or its
competitors, market acceptance of current or new products, regulatory delays,
product recalls, competition and pricing pressures from competitive products,
manufacturing delays, shipment problems, product seasonality and changes in the
mix of products sold. Because the Company has high operating expenses for
personnel, new product development and marketing, the Company's operating
results will be adversely affected if its sales do not correspondingly increase
or if its product development efforts are unsuccessful or subject to delays.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 of Part II of this Form 10-K.
Limited Sales and Marketing Experience; Dependence on Others
To be successful, Heska will have to continue to develop and train its
direct sales force or rely on marketing partners or other arrangements with
third-parties for the marketing, distribution and sale of its products. The
Company is currently marketing its products to veterinarians through a direct
sales force and certain third parties. There can be no assurance that the
Company will be able to successfully maintain marketing, distribution or sales
capabilities or make arrangements with third parties to perform those activities
on terms satisfactory to the Company. See "Business-Sales and Marketing".
In addition, the Company has granted marketing rights to certain products
under development to third parties, including Novartis, Bayer, Eisai and Ralston
Purina. Novartis has the right to manufacture and market throughout the world
(except in countries where Eisai has such rights) under Novartis trade names any
flea control vaccine or feline heartworm vaccine developed by the Company on or
before December 31, 2005. The Company retained the right to co-exclusively
manufacture and market these products throughout the world under its own trade
names. Accordingly, if both elect to market these products, the Company and
Novartis will be direct competitors, with each party sharing revenues on the
other's sales. Heska also granted Novartis a right of first refusal pursuant to
which, prior to granting rights to any third party for any products or
technology developed or acquired by the Company for either companion animal or
food animal applications, Heska must first offer Novartis such rights. In
Japan, Novartis also has the exclusive right upon regulatory approval to
distribute the Company's heartworm
26
diagnostics, periodontal disease therapeutic, trivalent and bivalent feline
vaccines and certain other Heska products. Bayer has exclusive marketing rights
to the Company's canine heartworm vaccine and its feline toxoplasmosis vaccine
(except in countries where Eisai has such rights). Eisai has exclusive rights in
Japan and most countries in East Asia to market the Company's feline and canine
heartworm vaccines, feline and canine flea control vaccines and feline
toxoplasmosis vaccine. The Company's agreements with its corporate marketing
partners generally contain no minimum purchase requirements in order for such
parties to maintain their exclusive or co-exclusive marketing rights. In
addition, the Company recently granted to Ralston Purina the exclusive rights to
develop and commercialize the Company's discoveries, know-how and technologies
in certain pet food products. There can be no assurance that Novartis, Bayer or
Eisai or any other collaborative party will devote sufficient resources to
marketing the Company's products. Furthermore, there is nothing to prevent
Novartis, Bayer or Eisai or any other collaborative party from pursuing
alternative technologies or products that may compete with the Company's
products. See "Business-Collaborative Agreements".
Highly Competitive Industry
The market in which the Company competes is intensely competitive. Heska's
competitors include companion animal health companies and major pharmaceutical
companies that have animal health divisions. Companies with a significant
presence in the animal health market, such as American Home Products, Bayer,
Merial Ltd., Novartis, Pfizer Inc and IDEXX Laboratories, Inc., have developed
or are developing products that do or would compete with the Company's products.
These competitors have substantially greater financial, technical, research and
other resources and larger, more established marketing, sales, distribution and
service organizations than the Company. Moreover, such competitors may offer
broader product lines and have greater name recognition than the Company.
Novartis and Bayer are marketing partners of the Company, and their agreements
with the Company do not restrict their ability to develop and market competing
products. The market for companion animal healthcare products is highly
fragmented, with discount stores and specialty pet stores accounting for a
substantial percentage of such sales. As Heska intends to distribute its
products only through veterinarians, a substantial segment of the potential
market may not be reached, and the Company may not be able to offer its products
at prices which are competitive with those of companies that distribute their
products through retail channels. There can be no assurance that the Company's
competitors will not develop or market technologies or products that are more
effective or commercially attractive than the Company's current or future
products or that would render the Company's technologies and products obsolete.
Moreover, there can be no assurance that the Company will have the financial
resources, technical expertise or marketing, distribution or support
capabilities to compete successfully. Center's human allergy immunotherapy
products compete with similar products offered by a number of other companies,
some of which have substantially greater financial, technical, research and
other resources than Center and more established marketing, sales, distribution
and service organizations than Center Pharmaceuticals, Inc. The bovine vaccines
sold by Diamond to Bayer and AgriLabs compete with each other and with similar
products offered by a number of other companies, some of which have
substantially greater financial, technical, research and other resources than
Diamond and more established marketing, sales, distribution and service
organizations than AgriLabs. See "Business-Competition".
Uncertainty of Patent and Proprietary Technology Protection; License of
Technology of Third-Parties
The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its technology and either
to operate without infringing the proprietary rights of others or to obtain
rights to such technology. Heska has United States and foreign issued patents
and is currently prosecuting patent applications in the United States and with
certain foreign patent offices. There can be no assurance that any of the
Company's pending patent applications will result in the issuance of any patents
or that, if issued, any such patents will offer protection against competitors
with similar technology. There can be no assurance that any patents issued to
the Company will not be challenged, invalidated or circumvented in the future or
that the rights created thereunder will provide a competitive advantage.
The biotechnology and pharmaceutical industries have been characterized by
extensive litigation regarding patents and other intellectual property rights.
In 1998, Synbiotics Corporation filed a lawsuit against Heska alleging
infringement of a Synbiotics patent relating to heartworm diagnostic technology.
27
See Item 3 of this Form 10-K-Legal Proceedings. There can be no assurance that
the Company will not in the future become subject to additional patent
infringement claims and litigation in the United States or other countries or
interference proceedings conducted in the USPTO to determine the priority of
inventions. The defense and prosecution of intellectual property suits, USPTO
interference proceedings, and related legal and administrative proceedings are
costly, time consuming and distracting. Litigation may be necessary to enforce
any patents issued to the Company or its collaborative partners, to protect
trade secrets or know-how owned by the Company or its collaborative partners, or
to determine the enforceability, scope and validity of the proprietary rights of
others. Any litigation or interference proceeding will result in substantial
expense to the Company and significant diversion of effort by the Company's
technical and management personnel. An adverse determination in litigation or
interference proceedings to which the Company may become a party could subject
the Company to significant liabilities to third parties. Further, either as the
result of such litigation or proceedings or otherwise, the Company may be
required to seek licenses from third parties which may not be available on
commercially reasonable terms, if at all.
The Company licenses technology from a number of third-parties. The
majority of such license agreements impose due diligence or milestone
obligations and in some cases impose minimum royalty and/or sales obligations
upon the Company in order for the Company to maintain its rights thereunder.
The Company's products may incorporate technologies that are the subject of
patents issued to, and patent applications filed by, others. As is typical in
its industry, from time to time the Company and its collaborators have received
and may in the future receive notices claiming infringement from third-parties
as well as invitations to take licenses under third-party patents. It is the
Company's policy when it receives such notices to conduct investigations of the
claims asserted. With respect to notices the Company has received to date, the
Company believes, after due investigation, that it has meritorious defenses to
the infringement claims asserted. Any legal action against the Company or its
collaborators may require the Company or its collaborators to obtain a license
in order to market or manufacture affected products or services. However, there
can be no assurance that the Company or its collaborators will be able to obtain
licenses for technology patented by others on commercially reasonable terms,
that they will be able to develop alternative approaches if unable to obtain
licenses, or that the current and future licenses will be adequate for the
operation of their businesses. The failure to obtain necessary licenses or to
identify and implement alternative approaches could prevent the Company and its
collaborators from commercializing certain of their products under development
and could have a material adverse effect on the Company's business, financial
condition or results of operations.
The Company also relies upon trade secrets, technical know-how and
continuing invention to develop and maintain its competitive position. There
can be no assurance that others will not independently develop substantially
equivalent proprietary information and techniques or otherwise gain access to
the Company's trade secrets. See "Business-Intellectual Property".
Limited Manufacturing Experience and Capacity; Reliance on Third-Party
Manufacturers
To be successful, the Company must manufacture, or contract for the
manufacture of, its current and future products in compliance with regulatory
requirements, in sufficient quantities and on a timely basis, while maintaining
product quality and acceptable manufacturing costs. In order to provide for
manufacturing of its products, the Company acquired Diamond in April 1996 and
certain assets of Center in July 1997. Significant work will be required for
the scaling up of manufacturing of many new products and there can be no
assurance that such work can be completed successfully or on a timely basis.
In addition to Diamond and Center, the Company intends to rely on third-
party manufacturers for certain of its products. The Company currently has
supply agreements with Atrix for its canine periodontal disease therapeutic and
a supply agreement with Quidel for certain manufacturing services relating to
its point-of-care diagnostic tests. Patient monitoring equipment and associated
consumable products are also manufactured to the Company's specifications by
third parties. These agreements typically require the manufacturing partner to
supply the Company's requirements within certain parameters. There can be no
assurance that these partners will be able to manufacture products to regulatory
standards and the Company's specifications or in a cost-effective and timely
manner. The Company has experienced some delays in manufacturing scale-up at
Quidel in the production of certain
28
diagnostic products. If a supplier were to be delayed in scaling up commercial
manufacturing, were to be unable to produce a sufficient quantity of products to
meet market demand, or were to request renegotiation of contract prices, the
Company's business could be materially and adversely affected. While the Company
typically retains the right to manufacture products itself or contract with an
alternative supplier in the event of the manufacturer's breach, any transfer of
production would necessarily involve significant delays in production and
additional expense to the Company to scale up production at a new facility and
to apply for regulatory licensure for the production of products at that new
facility. In addition, there can be no assurance that the Company will be able
to locate suitable manufacturing partners for its products under development or
alternative suppliers if present arrangements are not satisfactory. See
"Business-Manufacturing".
Government Regulation; No Assurance of Obtaining Regulatory Approvals
The development, manufacture and marketing of most of the Company's
products are subject to regulation by various governmental authorities,
consisting principally of the USDA and the FDA in the United States and various
regulatory agencies outside the United States. Delays in obtaining, or failure
to obtain any necessary regulatory approvals would have a material adverse
effect on the Company's future product sales and operations. Any acquisitions of
new products and technologies may subject the Company to additional government
regulation.
The Company's manufacturing facilities and those of any third-party
manufacturers the Company may use are subject to the requirements of and subject
to periodic regulatory inspections by the FDA, USDA and other federal, state and
foreign regulatory agencies. There can be no assurance that the Company or its
contractors will continue to satisfy such regulatory requirements, and any
failure to do so would have a material adverse effect on the Company's business,
financial condition or results of operations.
There can be no assurance that the Company will not incur significant costs
to comply with laws and regulations in the future or that laws and regulations
will not have a material adverse effect upon the Company's business, financial
condition or results of operations. See "Business-Government Regulation".
Future Capital Requirements; Uncertainty of Additional Funding
The Company believes that its available cash and cash from operations will
be sufficient to satisfy its projected cash requirements for at least the next
12 months, assuming no significant uses of cash in acquisition activities. The
Company has incurred negative cash flow from operations since inception and does
not expect to generate positive cash flow sufficient to fund its operations for
the next several years. Thus, the Company may need to raise additional capital
to fund its research and development, manufacturing and sales and marketing
activities. The Company's future liquidity and capital requirements will depend
on numerous factors, including the extent to which the Company's present and
future products gain market acceptance, the extent to which products of
technologies under research or development are successfully developed, the
timing of regulatory actions regarding the Company's products, the costs and
timing of expansion of sales, marketing and manufacturing activities, the cost,
timing and business management of recent and potential acquisitions and
contingent liabilities associated with such acquisitions, the procurement and
enforcement of patents important to the Company's business, and the results of
competition. There can be no assurance that such additional capital will be
available on terms acceptable to the Company, if at all. Furthermore, any
additional equity financing would likely be dilutive to stockholders, and debt
financing, if available, may include restrictive covenants which may limit the
Company's currently planned operations and strategies. If adequate funds are
not available, the Company may be required to curtail its operations
significantly or to obtain funds through entering into collaborative agreements
or other arrangements on unfavorable terms. The failure by the Company to raise
capital on acceptable terms when needed would have a material adverse effect on
the Company's business, financial condition or results of operations. See
"Liquidity and Capital Resources".
29
Potential Difficulties in Management of Growth; Identification and Integration
of Acquisitions
The Company anticipates growth in the number of its employees, the scope of
its operating and financial systems and the geographic area of its operations as
new products are developed and commercialized. This growth will result in an
increase in responsibilities for both existing and new management personnel.
The Company's ability to manage growth effectively will require it to continue
to implement and improve its operational, financial and management information
systems and to train, motivate and manage its current employees and hire new
employees. There can be no assurance that the Company will be able to manage
its expansion effectively, and a failure to do so could have a material adverse
effect on the Company's business, financial condition or results of operations.
In 1996, Heska consummated the acquisitions of Diamond and of certain
assets relating to its canine allergy business. The Company's recent
acquisitions include: the February 1997 purchase of Heska UK; the July 1997
purchase of the allergy immunotherapy products business of Center; the September
1997 purchase of CMG which manufactures and markets allergy diagnostic products
for use in veterinary and human medicine, primarily in Europe and the March 1998
acquisition of SDI. The Company may issue additional shares of Common Stock to
effect future acquisitions, and such issuances may be dilutive. Identifying and
pursuing acquisition opportunities, integrating the acquired businesses and
managing growth requires a significant amount of management time and skill.
There can be no assurance that the Company will be effective in identifying and
effecting attractive acquisitions, integrating acquisitions or managing future
growth. The failure to do so may have a material adverse effect on the Company's
business, financial condition or results of operations.
Dependence on Key Personnel
The Company is highly dependent on the efforts of its senior management and
scientific team. The loss of the services of any member of its senior
management or scientific staff may significantly delay or prevent the
achievement of product development and other business objectives. Because of
the specialized scientific nature of the Company's business, the Company is
highly dependent on its ability to attract and retain qualified scientific and
technical personnel. There is intense competition among major pharmaceutical
and chemical companies, specialized biotechnology firms and universities and
other research institutions for qualified personnel in the areas of the
Company's activities. Loss of the services of, or failure to recruit, key
scientific and technical personnel could adversely affect the Company's
business, financial condition or results of operations. See "Business-
Employees" and "Executive Officers of the Registrant".
Potential Product Liability; Limited Insurance Coverage
The testing, manufacturing and marketing of the Company's current products
as well as those currently under development entail an inherent risk of product
liability claims and associated adverse publicity. To date, the Company has not
experienced any material product liability claims, but any such claims arising
in the future could have a material adverse effect on the Company's business,
financial condition or results of operations. Potential product liability
claims may exceed the amount of the Company's insurance coverage or may be
excluded from coverage under the terms of the policy. There can be no assurance
that the Company will be able to continue to obtain adequate insurance at a
reasonable cost, if at all. In the event that the Company is held liable for a
claim against which it is not indemnified or for damages exceeding the limits of
its insurance coverage or which results in significant adverse publicity against
the Company, such claim could have a material adverse effect on the Company's
business, financial condition or results of operations.
Year 2000 Compliance and Risks
The Year 2000 ("Y2K") issue is the result of computer programs being
written using two digits, rather than four, to define the applicable year.
Mistaking "00" for the year 1900, rather than 2000, could result in
miscalculations and errors and cause significant business interruptions for the
Company, as well as the government and most other companies. The Company has
initiated procedures to identify, evaluate and implement any necessary changes
to its computer systems, applications and embedded technologies resulting from
the Y2K conversion. The Company is coordinating these activities with
suppliers, distributors, financial institutions and others with whom its does
business. There can be no assurance that
30
full compliance will be achieved in a timely manner or at all. Based on the
results of its current evaluation, the Company does not believe that the Y2K
conversion will have a material adverse effect on its business, however, there
can be no assurance in this regard.
Risk of Liability from Release of Hazardous Materials
The Company's products and development programs involve the controlled use
of hazardous and biohazardous materials, including chemicals, infectious disease
agents and various radioactive compounds. Although the Company believes that
its safety procedures for handling and disposing of such materials comply with
the standards prescribed by applicable local, state and federal regulations, the
risk of accidental contamination or injury from these materials cannot be
completely eliminated. In the event of such an accident, the Company could be
held liable for any damages or fines that result and any such liability could
exceed the resources of the Company. The Company may incur substantial costs to
comply with environmental regulations as the Company expands its manufacturing
capacity.
Possible Volatility of Stock Price
The securities markets have from time to time experienced significant price
and volume fluctuations that are unrelated to the operating performance of
particular companies. The market prices of securities of many publicly-held
biotechnology companies have in the past been, and can in the future be expected
to be, especially volatile. Announcements of technological innovations or new
products by the Company or its competitors, release of reports by securities
analysts, developments or disputes concerning patents or proprietary rights,
regulatory developments, changes in regulatory policies, economic and other
external factors, as well as quarterly fluctuations in the Company's financial
results, may have a significant impact on the market price of the Common Stock.
Control by Directors, Executive Officers, Principal Stockholders and Affiliated
Entities
The Company's directors, executive officers, principal stockholders and
entities affiliated with them beneficially own approximately 46% of the
Company's outstanding Common Stock. Three major stockholders of the Company,
who together beneficially own approximately 40% of the Company's outstanding
Common Stock, have entered into a voting agreement dated as of April 12, 1996
(the "Voting Agreement") whereby each agreed to collectively vote its shares in
such manner so as to ensure that each major stockholder was represented by one
member on the Company's Board of Directors. The Voting Agreement terminates on
December 31, 2005 unless prior to such date any of the investors ceases to
beneficially hold 2,000,000 shares of the voting stock of the Company, at which
time the Voting Agreement would terminate. The major stockholders, if acting
together, could substantially influence matters requiring approval by the
stockholders of the Company, including the election of directors and the
approval of mergers or other business combination transactions.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Market risk represents the risk of loss that may impact the financial
position, results of operations or cash flows of the Company due to adverse
changes in financial and commodity market prices and rates. The Company is
exposed to market risk in the areas of changes in United States and foreign
interest rates and changes in foreign currency exchange rates as measured
against the United States dollar. These exposures are directly related to its
normal operating and funding activities. Historically and as of December 31,
1998, the Company has not used derivative instruments or engaged in hedging
activities.
Interest Rate Risk
The interest payable on certain of the Company's lines-of-credit is
variable based on the United States prime rate, or LIBOR, and, therefore,
affected by changes in market interest rates. At December 31, 1998,
approximately $4.0 million was outstanding with a weighted average interest rate
of 9.1%. The lines-of-credit mature from February 1999 through November 1999 and
are subject to annual renewal. The Company may pay the balance in full at any
time without penalty. The Company manages interest rate risk by investing
excess funds in cash equivalents or marketable securities which bear interest
rates which reflect current market yields. Additionally, the Company monitors
interest rates and at
31
December 31, 1998 had sufficient cash balances to pay off the lines-of-credit
should interest rates increase significantly. As a result, the Company does not
believe that reasonably possible near-term changes in interest rates will result
in a material effect on future earnings, fair values or cash flows of the
Company.
Foreign Currency Risk
The Company has wholly-owned subsidiaries located in England and
Switzerland. Sales from these operations are denominated in British Pounds and
Swiss Francs or Euros, respectively, thereby creating exposures to changes in
exchange rates. The changes in the British/U.S. exchange rate, Swiss/U.S.
exchange rate or Euro/U.S. exchange rate may positively or negatively affect the
Company's sales, gross margins and retained earnings. The Company does not
believe that reasonably possible near-term changes in exchange rates will result
in a material effect on future earnings, fair values or cash flows of the
Company, and therefore, has chosen not to enter into foreign currency hedging
instruments. There can be no assurance that such an approach will be
successful, especially in the event of a significant and sudden decline in the
value of the British Pound, Swiss Franc or Euro.
32
Item 8. Financial Statements and Supplementary Data.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
------
Report of Independent Public Accountants.............................................................. 34
Consolidated Balance Sheets as of December 31, 1997 and 1998.......................................... 35
Consolidated Statements of Operations and Comprehensive Loss for the years ended December 31, 1996,
1997 and 1998........................................................................................ 36
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1996, 1997 and 1998 37
Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998............ 38
Notes to Consolidated Financial Statements............................................................ 39
33
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Heska Corporation:
We have audited the accompanying consolidated balance sheets of Heska
Corporation (a Delaware corporation) and subsidiaries as of December 31, 1997
and 1998, and the related consolidated statements of operations and
comprehensive loss, stockholders' equity and cash flows for the three years
ended December 31, 1996, 1997 and 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these 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 financial statements referred to above present fairly,
in all material respects, the financial position of Heska Corporation and
subsidiaries as of December 31, 1997 and 1998, and the results of their
operations and their cash flows for the three years ended December 31, 1996,
1997 and 1998, in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Denver, Colorado
January 22, 1999
34
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
ASSETS
December 31,
--------------------------
1997 1998
----------- -------------
(restated)
Current assets:
Cash and cash equivalents.............................................................. $ 10,679 $ 5,921
Marketable securities.................................................................. 18,073 46,009
Accounts receivable, net............................................................... 5,327 6,659
Inventories, net....................................................................... 10,562 12,197
Other current assets................................................................... 1,236 734
-------- ---------
Total current assets................................................................ 45,877 71,520
Property and equipment, net.............................................................. 15,979 21,226
Intangible assets, net................................................................... 6,009 4,311
Restricted marketable securities and other assets........................................ 1,155 997
-------- ---------
Total assets........................................................................ $ 69,020 $ 98,054
======== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable....................................................................... $ 6,425 $ 7,542
Accrued liabilities.................................................................... 2,970 3,871
Deferred revenue....................................................................... 284 656
Current portion of capital lease obligations........................................... 600 562
Current portion of long-term debt...................................................... 4,137 6,942
-------- ---------
Total current liabilities........................................................... 14,416 19,573
Capital lease obligations, less current portion.......................................... 1,620 1,129
Long-term debt, less current portion..................................................... 9,021 10,162
Accrued pension liability................................................................ 113 76
-------- ---------
Total liabilities................................................................... 25,170 30,940
-------- ---------
Commitments and contingencies
Stockholders' equity:
Common stock, $.001 par value, 40,000,000 shares authorized; 19,491,022 and
26,458,424 shares issued and outstanding, respectively............................... 19 26
Additional paid-in capital............................................................. 118,447 185,163
Deferred compensation.................................................................. (1,967) (1,277)
Stock subscription receivable from officers............................................ (158) (120)
Accumulated other comprehensive income................................................. 1 88
Accumulated deficit.................................................................... (72,492) (116,766)
-------- ---------
Total stockholders' equity.......................................................... 43,850 67,114
-------- ---------
Total liabilities and stockholders' equity.......................................... $ 69,020 $ 98,054
======== =========
See accompanying notes to consolidated financial statements
35
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except per share amounts)
Year Ended December 31,
--------------------------------------
1996 1997 1998
------------ ----------- -----------
(restated) (restated)
Revenues:
Products, net $ 15,570 $ 26,725 $ 38,451
Research and development 1,946 2,578 1,321
-------- -------- --------
17,516 29,303 39,772
Costs and operating expenses:
Cost of goods sold 12,002 20,077 29,087
Research and development 14,513 20,343 25,126
Selling and marketing 4,168 9,954 13,188
General and administrative 5,514 13,192 11,939
Amortization of intangible assets and deferred compensation 1,289 2,500 2,745
Purchased research and development -- 2,399 --
Loss on assets held for sale -- -- 1,287
Restructuring expense -- -- 2,356
-------- -------- --------
37,486 68,465 85,728
-------- -------- --------
Loss from operations (19,970) (39,162) (45,956)
Other income (expense):
Interest income 1,356 1,571 3,183
Interest expense (490) (1,364) (2,009)
Other, net (145) 91 508
-------- -------- --------
Net loss (19,249) (38,864) (44,274)
-------- -------- --------
Other comprehensive income:
Foreign currency translation adjustments -- 1 2
Unrealized gain on marketable securities -- -- 85
-------- -------- --------
Other comprehensive income -- 1 87
-------- -------- --------
Comprehensive loss $(19,249) $(38,863) $(44,187)
======== ======== ========
Basic net loss per share $(1.79)
========
Unaudited pro forma basic net loss per share $(1.53) $(2.42)
======== ========
Shares used to compute basic net loss per share
and unaudited pro forma basic net loss per share 12,609 16,042 24,693
See accompanying notes to consolidated financial statements
36
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands, except per share data)
Preferred Stock Common Stock Additional
------------------------ ------------ Paid-in
Shares Amount Shares Amount Capital
---------- ------------ ---------- -------- ----------
Balances, December 31, 1995............................................. 6,618 $ 19,516 919 $ 1 $ 143
Effects of pooling-of-interests resulting from SDI acquisition.......... -- -- 449 -- 2,573
---------- ------------ ------ --- --------
Balances, December 31, 1995 (restated) 6,618 19,516 1,368 1 2,716
Issuance of preferred stock to acquire Diamond......................... 842 7,072 -- -- --
Grant of options to purchase common stock.............................. -- -- -- -- 8
Exercise of options to purchase common stock for cash.................. -- -- 202 -- 1,246
Issuance of preferred stock for cash.................................. 3,000 36,000 -- -- --
Deferred compensation related to stock options......................... -- -- -- -- 933
Amortization of deferred compensation.................................. -- -- -- -- --
Interest on stock subscription receivable.............................. -- -- -- -- --
Net loss............................................................... -- -- -- -- --
---------- ------------ ------ --- --------
Balances, December 31, 1996 (restated).................................. 10,460 62,588 1,570 1 4,904
Issuance of common stock for cash...................................... -- -- 89 - 1,342
Issuance of common stock for stock subscription receivable............. -- -- 25 -- 30
Issuance of preferred stock related to business acquisitions........... 124 1,236 -- -- --
Issuance of common stock related to business acquisitions.............. -- -- 454 -- 2,656
Issuance of common stock upon the Company's initial public offering
("IPO"), net.......................................................... -- -- 5,638 6 43,867
Conversion of preferred stock into common stock upon the IPO........... (10,584) (63,824) 11,289 11 63,813
Issuance of common stock for services.................................. -- -- 1 -- --
Cashless exercise of warrants to purchase common stock................. -- -- 5 -- --
Issuance of common stock related to options and the Employee Stock
Purchase Plan ("ESPP")................................................ -- -- 420 1 299
Interest on stock subscription receivable.............................. -- -- -- -- --
Foreign currency translation adjustments............................... -- -- -- -- --
Deferred compensation related to stock options......................... -- -- -- -- 1,537
Amortization of deferred compensation.................................. -- -- -- -- --
Net loss............................................................... -- -- -- -- --
---------- ------------ ------ --- --------
Balances, December 31, 1997 (restated).................................. -- -- 19,491 19 118,447
Issuance of common stock for cash...................................... -- -- 3 -- 6
Issuance of common stock upon the Company's follow-on public offering,
net................................................................... -- -- 5,250 5 48,595
Issuance of common stock and warrants for cash......................... -- -- 1,165 1 14,999
Issuance of common stock in exchange for assets and in repayment of
debt.................................................................. -- -- 206 -- 2,262
Issuance of common stock for services.................................. -- -- 32 -- 461
Cashless exercise of warrants to purchase common stock................. -- -- 5 -- --
Issuance of common stock related to options, the ESPP and other........ -- -- 306 1 347
Deferred compensation related to stock options......................... -- -- -- -- 46
Amortization of deferred compensation.................................. -- -- -- -- --
Interest on stock subscription receivable.............................. -- -- -- -- --
Payments received on stock subscription receivable..................... -- -- -- -- --
Foreign currency translation adjustments............................... -- -- -- -- --
Unrealized gain on marketable securities............................... -- -- -- -- --
Net loss............................................................... -- -- -- -- --
---------- ------------ ------ --- --------
Balances, December 31, 1998............................................. -- $ -- 26,458 $26 $185,163
========== ============ ====== === ========
Accumulated
Stock Other Total
Deferred Subscription Comprehensive Accumulated Stockholders'
Compensation Receivable Income Deficit Equity
------------ ------------ ------------- ----------- -------------
Balances, December 31, 1995........................................ -- $(110) $-- $ (12,301) $ 7,249
Effects of pooling-of-interests resulting from SDI acquisition..... (330) -- -- (2,078) 165
------------ ------------ ------------- ----------- ------------
Balances, December 31, 1995 (restated) (330) (110) -- (14,379) 7,414
Issuance of preferred stock to acquire Diamond.................... -- -- -- -- 7,072
Grant of options to purchase common stock......................... -- -- -- -- 8
Exercise of options to purchase common stock for cash............. -- -- -- -- 1,246
Issuance of preferred stock for cash............................. -- -- -- -- 36,000
Deferred compensation related to stock options.................... (933) -- -- -- --
Amortization of deferred compensation............................. 188 -- -- -- 188
Interest on stock subscription receivable......................... -- (8) -- -- (8)
Net loss.......................................................... -- -- -- (19,249) (19,249)
------------ ------------ ------------- ----------- ------------
Balances, December 31, 1996 (restated)............................. (1,075) (118) -- (33,628) 32,671
Issuance of common stock for cash................................. -- -- -- -- 1,342
Issuance of common stock for stock subscription receivable........ -- (30) -- -- --
Issuance of preferred stock related to business acquisitions...... -- -- -- -- 1,236
Issuance of common stock related to business acquisitions......... -- -- -- -- 2,656
Issuance of common stock upon the Company's initial public
offering ("IPO"), net............................................ -- -- -- -- 43,873
Conversion of preferred stock into common stock upon the IPO...... -- -- -- -- --
Issuance of common stock for services............................. -- -- -- -- --
Cashless exercise of warrants to purchase common stock............ -- -- -- -- --
Issuance of common stock related to options and the Employee
Stock Purchase Plan ("ESPP").................................... -- -- -- -- 300
Interest on stock subscription receivable......................... -- (10) -- -- (10)
Foreign currency translation adjustments.......................... -- -- 1 -- 1
Deferred compensation related to stock options.................... (1,537) -- -- -- --
Amortization of deferred compensation............................. 645 -- -- -- 645
Net loss.......................................................... -- -- -- (38,864) (38,864)
------------ ------------ ------------- ----------- ------------
Balances, December 31, 1997 (restated)............................. (1,967) (158) 1 (72,492) 43,850
Issuance of common stock for cash................................. -- -- -- -- 6
Issuance of common stock upon the Company's follow-on public
offering, net.................................................... -- -- -- -- 48,600
Issuance of common stock and warrants for cash.................... -- -- -- -- 15,000
Issuance of common stock in exchange for assets and in repayment
of debt.......................................................... -- -- -- -- 2,262
Issuance of common stock for services............................. -- -- -- -- 461
Cashless exercise of warrants to purchase common stock............ -- -- -- -- --
Issuance of common stock related to options, the ESPP and other... -- -- -- -- 348
Deferred compensation related to stock options.................... (46) -- -- -- --
Amortization of deferred compensation............................. 736 -- -- -- 736
Interest on stock subscription receivable......................... -- (13) -- -- (13)
Payments received on stock subscription receivable................ -- 51 -- -- 51
Foreign currency translation adjustments.......................... -- -- 2 -- 2
Unrealized gain on marketable securities.......................... -- -- 85 -- 85
Net loss.......................................................... -- -- -- (44,274) (44,274)
------------ ------------ ------------- ----------- ------------
Balances, December 31, 1998........................................ $(1,277) $(120) $88 $(116,766) $ 67,114
============ ============ ============= =========== ============
See accompanying notes to consolidated financial statements
37
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Year Ended December 31,
----------------------------------------
1996 1997 1998
------------ ----------- -------------
(restated) (restated)
CASH FLOWS USED IN OPERATING ACTIVITIES:
Net loss................................................................... $(19,249) $(38,864) $ (44,274)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization......................................... 1,190 2,391 3,600
Amortization of intangible assets and deferred compensation........... 1,289 2,500 2,745
Purchased research and development.................................... -- 2,399 --
Loss (gain) on disposition of assets.................................. 60 (132) 2
Interest receivable on stock subscription............................. (8) (10) (13)
Increase (decrease) in accrued pension liability...................... 62 (14) (37)
Changes in operating assets and liabilities:
Accounts receivable, net.......................................... (1,028) (3,142) (1,177)
Inventories, net.................................................. (445) (2,951) (1,608)
Other assets...................................................... (87) (950) 406
Contract receivable............................................... 500 -- --
Accounts payable.................................................. 979 3,111 1,189
Accrued liabilities............................................... 235 1,707 896
Deferred revenue.................................................. 987 (1,129) 502
Other............................................................. 141 23 (352)
-------- -------- ---------
Net cash used in operating activities....................... (15,374) (35,061) (38,121)
-------- -------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisitions of businesses, net of cash acquired........................... (478) (2,714) --
Cash deposited in restricted cash account related to Bloxham
acquisition.............................................................. -- (238) --
Additions to intangible assets............................................. (203) (157) (549)
Purchase of marketable securities.......................................... (31,243) (18,718) (123,842)
Purchase of restricted marketable securities............................... (1,219) -- --
Proceeds from sale of marketable securities................................ 14,152 18,342 96,248
Proceeds from disposition of property and equipment........................ -- 343 --
Purchases of property and equipment........................................ (5,289) (6,248) (6,470)
-------- -------- ---------
Net cash used in investing activities....................... (24,280) (9,390) (34,613)
-------- -------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock..................................... 1,246 45,515 64,505
Proceeds from stock subscription receivable................................ -- -- 51
Proceeds from borrowings................................................... 3,718 5,528 10,171
Repayments of debt and capital lease obligations........................... (1,529) (2,537) (6,804)
Proceeds from issuance of preferred stock.................................. 36,000 -- --
-------- -------- ---------
Net cash provided by financing activities................... 39,437 48,506 67,923
-------- -------- ---------
EFFECT OF EXCHANGE RATE CHANGES ON CASH..................................... -- (6) 53
-------- -------- ---------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............................ (219) 4,049 (4,758)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR................................ 6,849 6,630 10,679
-------- -------- ---------
CASH AND CASH EQUIVALENTS, END OF YEAR...................................... $ 6,630 $ 10,679 $ 5,921
======== ======== =========
See accompanying notes to consolidated financial statements
38
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BUSINESS
Heska Corporation ("Heska" or the "Company") is primarily focused on the
discovery, development and marketing of companion animal health products. In
addition to manufacturing certain of Heska's companion animal health products,
the Company's primary manufacturing subsidiary, Diamond Animal Health, Inc.
("Diamond"), also manufactures bovine vaccine products and pharmaceutical and
personal healthcare products which are marketed and distributed by third
parties. In addition to manufacturing veterinary allergy products for marketing
and sale by Heska, Heska's subsidiaries, Center Laboratories, Inc. ("Center")
and CMG-Heska Allergy Products S.A. ("CMG"), a Swiss corporation, also
manufacture and sell human allergy products. The Company also offers diagnostic
services to veterinarians at its Fort Collins, Colorado location and in the
United Kingdom through a wholly-owned subsidiary.
From the Company's inception in 1988 until early 1996, the Company's
operating activities related primarily to research and development activities,
entering into collaborative agreements, raising capital and recruiting
personnel. Prior to 1996, the Company had not received any revenues from the
sale of products. During 1996, Heska grew from being primarily a research and
development concern to a fully-integrated research, development, manufacturing
and marketing company. The Company accomplished this by acquiring Diamond, a
licensed pharmaceutical and biological manufacturing facility in Des Moines,
Iowa, hiring key employees and support staff, establishing marketing and sales
operations to support Heska products introduced in 1996, and designing and
implementing more sophisticated operating and information systems. The Company
also expanded the scope and level of its scientific and business development
activities, increasing the opportunities for new products. In 1997, the Company
introduced 13 additional products and expanded in the United States through the
acquisition of Center, a Food and Drug Administration ("FDA") and United States
Department of Agriculture ("USDA") licensed manufacturer of allergy
immunotherapy products located in Port Washington, New York, and internationally
through the acquisitions of Heska UK Limited ("Heska UK", formerly Bloxham
Laboratories Limited), a veterinary diagnostic laboratory in Teignmouth, England
and CMG (formerly Centre Medical des Grand'Places S.A.) in Fribourg,
Switzerland, which manufactures and markets allergy diagnostic products for use
in veterinary and human medicine, primarily in Europe. Each of the Company's
acquisitions during this period was accounted for under the purchase method of
accounting and accordingly, the Company's financial statements reflect the
operations of these businesses only for the periods subsequent to the
acquisitions. In July 1997, the Company established a new subsidiary, Heska AG,
located near Basel, Switzerland, for the purpose of managing its European
operations.
During the first quarter of 1998 the Company acquired Sensor Devices, Inc.
("SDI"), a manufacturer and marketer of patient monitoring devices used in both
animal health and human applications. The financial results of SDI have been
consolidated with those of the Company under the pooling-of-interests accounting
method for all periods presented.
The Company has incurred net losses since its inception and anticipates
that it will continue to incur additional net losses in the near term as it
introduces new products, expands its sales and marketing capabilities and
continues its research and development activities. Cumulative net losses from
inception of the Company in 1988 through December 31, 1998 have totaled $116.8
million.
The Company's ability to achieve profitable operations will depend
primarily upon its ability to successfully market its products, commercialize
products that are currently under development, develop new products and
efficiently integrate acquired businesses. Most of the Company's products are
subject to long development and regulatory approval cycles and there can be no
guaranty that the Company will successfully develop, manufacture or market these
products. There can also be no guaranty that the Company will attain
profitability or, if achieved, will remain profitable on a quarterly or annual
basis in the future. Until the Company attains positive cash flow, the Company
may continue to finance operations with additional equity and debt financing.
There can be no guaranty that such financing will be available when required or
will be obtained under favorable terms.
39
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying consolidated financial statements include the accounts of
the Company and of its wholly-owned subsidiaries since their respective dates of
acquisitions when accounted for under the purchase method of accounting, and for
all periods presented when accounted for under the pooling-of-interests method
of accounting. All material intercompany transactions and balances have been
eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles 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
reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents are stated at cost, which approximates market, and
include short-term highly liquid investments with original maturities of less
than three months. Cash equivalents consist of United States government
obligations.
Marketable Securities and Restricted Investments
The Company classifies its marketable securities as "available-for-sale"
and, accordingly, carries such securities at aggregate fair value. Unrealized
gains or losses, if material, are included as a component of accumulated other
comprehensive income.
At December 31, 1997 these securities had an aggregate amortized cost of
$18.7 million, which approximated fair market value, a maximum maturity of
approximately three years and consisted entirely of U.S. government obligations.
At December 31, 1998 these securities had an aggregate amortized cost of $46.2
million, a maximum maturity of approximately ten years and consisted entirely of
U.S. government agency obligations. The fair market value of marketable
securities at December 31, 1998 was approximately $46.3 million. The unrealized
gain of approximately $85,000 has been recorded as a component of accumulated
comprehensive income within stockholders' equity. Marketable securities at
December 31, 1997 and 1998 included approximately $645,000 and $281,000 of
restricted investments held as collateral for capital leases (See Note 4) and
$18.1 million and $46.0 million of short-term marketable securities,
respectively.
Inventories, net
Inventories are stated at the lower of cost or market using the first-in,
first-out method. If the cost of inventories exceeds fair market value,
provisions are made for the difference between cost and fair market value.
Inventories, net of provisions, consist of the following (in thousands):
December 31,
-------------------------
1997 1998
------------ -----------
(restated)
Raw materials........................................................... $ 2,652 $ 3,271
Work in process......................................................... 3,567 5,338
Finished goods.......................................................... 4,343 3,588
------- -------
$10,562 $12,197
======= =======
40
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Property, Equipment and Intangible Assets
Property and equipment are recorded at cost and depreciated on a straight-
line or declining balance basis over the estimated useful lives of the related
assets. Amortization of assets acquired under capital leases is included with
depreciation expense on owned assets.
Leasehold improvements are amortized over the applicable lease period or
their estimated useful lives, whichever is shorter. Maintenance and repairs are
charged to expense when incurred, and major renewals and improvements are
capitalized.
Intangible assets primarily consist of various assets arising from business
combinations and are amortized using the straight-line method over the period of
expected benefit.
The Company periodically reviews the appropriateness of the remaining life
of its property, equipment and intangible assets considering whether any events
have occurred or conditions have developed which may indicate that the remaining
life requires adjustment. After reviewing the appropriateness of the remaining
life and the pattern of usage of these assets, the Company then assesses their
overall recoverability by determining if the net book value can be recovered
through undiscounted future operating cash flows. Absent any unfavorable
findings, the Company continues to amortize and depreciate its property,
equipment and intangible assets based on the existing estimated life.
Property and equipment consist of the following (in thousands):
December 31,
Estimated ----------------------------
Useful Life 1997 1998
--------------- ------------- -------------
(restated)
Land....................................................... N/A $ 291 $ 435
Buildings.................................................. 10 to 20 years 1,811 4,091
Machinery and equipment.................................... 3 to 15 years 15,462 20,431
Leasehold improvements..................................... 7 to 15 years 2,472 3,404
------- -------
20,036 28,361
Less accumulated depreciation and amortization............. (4,057) (7,135)
------- -------
$15,979 $21,226
======= =======
Intangible assets consist of the following (in thousands):
Estimated December 31,
---------------------------
Useful Life 1997 1998
--------------- ------------ -------------
(restated)
Take-or-pay contract....................................... 37 months $ 3,873 $ 3,873
Customer lists and market presence......................... 7 years 2,848 2,848
Other intangible assets.................................... 2 to 10 years 2,296 2,594
------- -------
9,017 9,315
Less accumulated amortization.............................. (3,008) (5,004)
------- -------
$ 6,009 $ 4,311
======= =======
The take-or-pay contract resulted from the acquisition of Diamond in April
1996. The customer lists and market presence resulted from the Company's 1997
acquisitions. The remaining intangible assets resulted primarily from the
acquisitions of certain lines of business and assets in 1996, 1997 and 1998.
41
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Revenue Recognition
Product revenues are recognized at the time goods are shipped to the
customer, or at the time services are performed, with an appropriate provision
for returns and allowances.
The Company recognizes revenue from sponsored research and development as
research activities are performed or as development milestones are completed
under the terms of the research and development agreements. Costs incurred in
connection with the performance of sponsored research and development are
expensed as incurred. The Company defers revenue recognition of advance
payments received during the current year until research activities are
performed or development milestones are completed.
Cost of Sales
Royalties payable in connection with certain research, development and
licensing agreements (See Note 10) are reflected in cost of sales as incurred.
Unaudited Pro Forma Basic Net Loss Per Share
The Company has computed net loss per share in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 128, Earnings per Share, which the
Company adopted in 1997. Also, the Company has adopted the guidance of
Securities and Exchange Commission ("SEC") Staff Accounting Bulletin ("SAB") No.
98 and related interpretations. Due to the automatic conversion of all shares
of convertible preferred stock into common stock upon the closing of the
Company's initial public offering in July 1997 (the "IPO"), historical basic net
loss per common share for fiscal 1996 and 1997 is not considered meaningful as
it would differ materially from the pro forma basic net loss per common share
and common stock equivalent shares given the changes in the capital structure of
the Company.
Pro forma basic net loss per common share is computed using the weighted
average number of common shares outstanding during the period. Diluted net loss
per common share is not presented as the effect of common equivalent shares from
stock options and warrants is anti-dilutive. The Company has assumed the
conversion of convertible preferred stock issued into common stock for all
periods presented.
Prior to the current period and pursuant to SEC SAB No. 83 rules, common
stock and common stock equivalent shares issued by the Company during the 12
months immediately preceding the filing of the IPO, plus shares which became
issuable during the same period as a result of the granting of options to
purchase common stock ("SAB 83 Shares"), were included in the calculation of
basic weighted average number of shares of common stock as if they were
outstanding for all periods presented (using the treasury stock method),
regardless of whether they were anti-dilutive. In February 1998 the SEC issued
SAB No. 98 which replaced SAB No. 83 in its entirety. As a result, SAB 83
Shares which were originally included in the previously reported 1996 and 1997
weighted average common shares outstanding have now been excluded in the
restated 1996 and 1997 weighted average common shares outstanding. The effect
of the adoption of SAB No. 98 was as follows (per share amounts for 1996 and
1997 have been restated to include the effects of the SDI acquisition recorded
under the pooling-of-interests accounting method. See Note 3):
Year Ended December 31,
-------------------------
1996 1997
---------- ----------
Pro forma basic net loss per share as reported $(1.40) $(2.34)
(restated)..........................................
Impact of adoption of SAB No. 98.................... ( .13) ( .08)
------ ------
Unaudited pro forma basic net loss per share $(1.53) $(2.42)
(restated).......................................... ====== ======
42
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table shows the reconciliation of the numerators and
denominators of the basic net loss per share and unaudited pro forma basic net
loss per share computations as required under SFAS No. 128 (in thousands, except
per share amounts):
For the Year Ended December 31, 1996
---------------------------------------------
(restated)
Income Shares Per-Share
(Numerator) (Denominator) Amount
-------------- --------------- ------------
Weighted average common shares outstanding (actual)................... N/A 1,426 N/A
Assumed conversion of preferred stock from original date of
issuance.............................................................. N/A 11,183 N/A
------
Unaudited pro forma basic net loss per $(19,249) 12,609 $(1.53)
share................................................................. ============= ====== ===========
For the Year Ended December 31, 1997
---------------------------------------------
(restated)
Income Shares Per-Share
(Numerator) (Denominator) Amount
-------------- --------------- ------------
Weighted average common shares outstanding (actual)............. N/A 10,172 N/A
Assumed conversion of preferred stock from original date of
issuance...................................................... N/A 5,870 N/A
------
Unaudited pro forma basic net loss per share.................... $(38,864) 16,042 $(2.42)
============= ====== ===========
For the Year Ended December 31, 1998
---------------------------------------------
Income Shares Per-Share
(Numerator) (Denominator) Amount
-------------- --------------- ------------
Weighted average common shares outstanding (actual)............... N/A 24,693 N/A
------
Basic net loss per share.......................................... $(44,274) 24,693 $(1.79)
======== ====== ======
__________
N/A = not applicable
Foreign Currency Translation
The functional currencies of the Company's international subsidiaries are
the Pound Sterling ("(Pounds)") for Heska UK and the Swiss Franc ("CHF") for all
others. Assets and liabilities of the Company's international subsidiaries are
translated using the exchange rate in effect at the balance sheet date. Revenue
and expense accounts are translated using an average of exchange rates in effect
during the period. Cumulative translation gains and losses, if material, are
shown in the consolidated balance sheets as a separate component of
stockholders' equity. Exchange gains and losses arising from transactions
denominated in foreign currencies (i.e. transaction gains and losses) are
recognized in current operations. To date, the Company has not entered into any
forward contracts or hedging transactions.
3. BUSINESS ACQUISITION
Acquisition of SDI - In March 1998 the Company completed its acquisition of
all of the outstanding shares of SDI, a manufacturer and marketer of medical
sensor products, in a transaction valued at approximately $8.9 million using the
pooling-of-interests accounting method. The Company issued 639,622 shares of
its common stock and also reserved an additional 147,898 shares of its common
stock for
43
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
issuance in connection with outstanding SDI options that were assumed by the
Company in the merger. Accordingly, the consolidated financial statements of
the Company have been restated to include the accounts of SDI for all periods
presented. There were no adjustments required to the net assets or previously
reported results of operations of the Company or SDI as a result of the adoption
of the same accounting practices by the respective entities. The following
table shows the reconciliation of restating the accounts of the Company
resulting from the pooling-of-interests on previously reported financial
statements (in thousands):
Effect of
As Previously Pooling-of-
Reported Interests Restated
------------- ----------------- -------------
Total assets as of December 31, 1997........................ $ 65,248 $ 3,772 $ 69,020
Total stockholders' equity as of December 31, 1997.......... 43,672 178 43,850
Total revenues:
For the year ended December 31, 1996 ................... 9,959 7,557 17,516
For the year ended December 31, 1997 ................... 20,877 8,426 29,303
Loss from operations:
For the year ended December 31, 1996 ................... (18,861) (1,109) (19,970)
For the year ended December 31, 1997 ................... (37,768) (1,394) (39,162)
Net loss:
For the year ended December 31, 1996 ................... (17,975) (1,274) (19,249)
For the year ended December 31, 1997 ................... (37,292) (1,572) (38,864)
4. CAPITAL LEASE OBLIGATIONS
The Company has entered into certain capital lease agreements for laboratory
equipment, office equipment, machinery and equipment, and computer equipment and
software. For the years ended December 31, 1997 and 1998, the Company had
capitalized machinery and equipment under capital leases with a net book value
of approximately $3.1 million and $1.9 million, respectively. The capitalized
cost of the equipment under capital leases is included in the accompanying
balance sheets under the respective asset classes. Under the terms of the
Company's lease agreements, the Company is required to make monthly payments of
principal and interest through the year 2003, at interest rates ranging from
4.05% to 20.00% per annum. The equipment under the capital leases serves as
security for the leases.
The Company has a capital lease with a commercial bank which requires the
Company to pledge cash or investments as additional collateral for the lease.
The lease agreement, which has a borrowing limit of $2.0 million calls for a
collateral balance equal to 25% of the borrowed amount when the Company's annual
revenues reach $28.0 million. The lease also requires the Company to maintain
minimum levels of cash and cash equivalent balances throughout the term of the
lease. As of December 31, 1997 and 1998, the Company was in compliance with all
covenants of the master lease and held restricted U.S. Treasury Bonds of
approximately $645,000 and $281,000 as additional collateral under the lease,
respectively.
44
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The future annual minimum required payments under capital lease obligations
as of December 31,1998 were as follows (in thousands):
Year Ending
December 31,
- ------------
1999 $ 702
2000................................................................................... 597
2001................................................................................... 543
2002................................................................................... 88
2003................................................................................... 26
------
Total minimum lease payments.........................................................1,956
Less amount representing interest.................................................... (265)
------
Present value of net minimum lease payments..........................................1,691
Less current portion................................................................. (562)
------
Total long-term capital lease obligations.......................................$1,129
======
5. RESTRUCTURING EXPENSES
In December 1998 the Company completed a cost reduction and restructuring
plan. The restructuring was based on the Company's determination that, while
revenues had been increasing steadily, management believed that reducing
expenses was necessary in order to accelerate the Company's efforts to reach
profitability. In connection with the restructuring, the Company recognized a
charge to operations in 1998 of approximately $2.4 million. These expenses
related to personnel severance costs for 69 individuals and costs associated
with excess facilities and equipment, primarily at the Company's Fort Collins,
Colorado location.
Shown below is a reconciliation of restructuring costs for the year ended
December 31, 1998 (in thousands):
Payments/Charges
through Balance at
Original December 31, December 31,
Reserve 1998 1998
--------------- --------------------- -------------
Severance pay, benefits and relocation expenses............... $1,723 $(630) $1,093
Noncancellable leased facility closure costs.................. 430 -- 430
Asset write-offs.............................................. 77 (77) --
Other......................................................... 126 (18) 108
------ ----- ------
Total................................... $2,356 $(725) $1,631
====== ===== ======
The balance of $1.6 million is included in accrued liabilities in the
accompanying balance sheet as of December 31, 1998.
45
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. LONG-TERM DEBT AND NOTES PAYABLE
Long-term debt consists of the following (in thousands):
December 31,
---------------------
1997 1998
--------- ---------
(restated)
Heska, Diamond, Center and SDI obligations:
Equipment financing due in monthly installments through November 2001, and final
payments due March 2000 through January 2002, with stated interest rates between
14.0% and 18.1%, secured by certain equipment and fixtures....................................... $ 5,551 $ 6,957
Center obligations:
Promissory note to former owner of Center due in July 2000, with quarterly interest payments at
a stated interest rate of prime (8.5% and 7.75% at December 1997 and 1998, respectively) plus
0.75%............................................................................................ 3,464 3,464
Diamond obligations:
9.5% real estate mortgage to Hartford-Carlisle Bank, paid in full in September 1998.................. 201 --
9.2% term note to Iowa Business Growth, paid in full in September 1998............................... 152 --
Promissory note to the Iowa Department of Economic Development ("IDED"), due in annual
installments through June 2004, with $125 forgivable in March 1999 based upon levels of
employment at Diamond, with a stated interest rate of 3.0% and a 9.5% imputed interest rate, net 183 175
Promissory note to the City of Des Moines, due in monthly installments through May 2004,
with a stated interest rate of 3% and a 9.5% imputed interest rate, net.......................... 112 97
10.0% promissory notes, paid in full in September 1998............................................... 348 --
Unsecured promissory note to customer, forgiven in July 1998......................................... 407 --
$2,000 commercial bank line of credit, due September 1999, with monthly interest payments at
prime (7.75% at December 1998) plus 1.75%........................................................ 667 1,749
Real estate mortgage to Norwest Business Credit, Inc., due in monthly installments through
September 2003, with a stated interest rate of prime (7.75% at December 1998) plus 1.75%........... -- 1,520
SDI obligations:
$800 commercial bank line of credit, due November 1999, with monthly interest payments at prime
(7.75% at December 1998) plus 1.75%.............................................................. 750 800
Note payable to bank, guaranteed by the Small Business Administration ("SBA"), due in monthly
installments through November 2001, with a stated interest rate of prime (7.75% at December
1998) plus 1.75%................................................................................. 426 350
Note payable to the State of Wisconsin, due in monthly installments through January 2000, with a
stated interest rate of 5%....................................................................... 71 50
Unsecured note payable, due in monthly installments, with no stated interest rate.................... 44 44
Heska obligations:
Promissory notes to former Heska UK shareholders due in semi-annual interest payments
through February 2007, due on demand in whole or in part at any time together with accrued
interest, with a stated interest rate of 4.5%, denominated in pounds sterling.................... 329 262
Heska UK obligations:
Real estate mortgage due in monthly principal payments and quarterly interest payments
through December 2006, with a stated interest rate of a bank's base rate (7.25% and 7.75%
at December 1997 and 1998, respectively) plus 2.75%, denominated in pounds sterling.............. 117 142
(Pounds)725 commercial bank line of credit, due February 1999, with semi-annual interest payments,
with a stated interest rate of LIBOR (5.1% at December 1998) plus 4.0%........................... 165 1,153
CMG obligations:
.................................................................................................
CHF400 commercial bank line of credit, due upon demand, with quarterly interest payments,
with a stated interest rate of 5.5%, plus 0.25% per quarter...................................... 171 341
------ ------
13,158 17,104
Less installments due within one year................................................................... (4,137) (6,942)
------ ------
$ 9,021 $10,162
====== ======
46
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company records long-term debt at fair values based on quoted market
prices for the same or similar issues or on the rates offered to the Company for
debt of the same remaining maturities at the time debt is incurred. Certain
debts assumed as a result of acquisitions were restated to fair values at the
dates of acquisitions.
The IDED and City of Des Moines promissory notes are secured by a first
security interest in essentially all assets of Diamond except assets acquired
through capital leases and are included as cross-collateralized obligations by
the respective lenders. These notes, along with the unsecured note to the
customer, were assumed as a result of the 1996 Diamond acquisition.
The SDI line of credit and SBA and State of Wisconsin loans are secured by
a first security interest in essentially all assets of SDI except assets
acquired through capital leases and are included as cross-collateralized
obligations by the respective lenders. These obligations, along with the
unsecured note payable, were assumed as a result of the acquisition of SDI in
March 1998.
One of the Company's Swiss subsidiaries also has a CHF250,000 line of credit
with a stated interest rate of 5.5%, plus 0.25% per quarter. There were no
borrowings against this credit facility as of December 31, 1998.
The Company's other debt instruments are secured by the assets of the
respective subsidiaries and general corporate guarantees by Heska Corporation.
As of December 31, 1998, the Company was in compliance with all covenants of
the debt agreements.
Maturities of long-term debt and notes payable as of December 31, 1998 were
as follows (in thousands):
Year ending
December 31,
- ------------
1999................................................................................. $ 6,942
2000................................................................................. 6,526
2001................................................................................. 1,685
2002................................................................................. 722
2003................................................................................. 404
Thereafter........................................................................... 825
-------
$17,104
=======
7. ACCRUED PENSION LIABILITY
Diamond has a noncontributory defined benefit pension plan covering all
employees who have met the eligibility requirements. The plan provides monthly
benefits based on years of service which are subject to certain reductions if
the employee retires before reaching age 65. Diamond's funding policy is to
make the minimum annual contribution that is required by applicable regulations.
Effective October 1992, Diamond froze the plan, restricting new participants and
benefits for future service.
47
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table sets forth the plan's funded status and amounts
recognized in the accompanying balance sheets (in thousands):
December 31,
------------------------------
1997 1998
------------ -----------
Change in benefit obligation:
Benefit obligation, beginning........................ $ 1,089 $ 1,117
Service cost......................................... -- --
Interest cost........................................ 75 76
Actuarial loss....................................... 7 2
Benefits paid........................................ (54) (69)
------- -------
Benefit obligation, ending........................... 1,117 1,126
Change in plan assets:
Fair value of plan assets, beginning................. 962 1,004
Actual return on plan assets......................... 96 115
Employer contribution................................ -- --
Benefits paid........................................ (54) (69)
------- -------
Fair value of plan assets, ending.................... 1,004 1,050
Funded status.................................................... (113) (76)
Unrecognized net actuarial loss.................................. 190 150
------- -------
Prepaid benefit cost............................................. 77 74
Additional minimum liability disclosures:
Accrued benefit liability............................ (113) $ (76)
Components of net periodic benefit costs:
Service cost.........................................
Interest cost........................................ 74 76
Expected return on plan assets....................... (72) (75)
Recognized net actuarial loss........................ 4 3
------- -------
Net periodic benefit cost............................ $ 6 $ 4
======= =======
Assumptions used by Diamond in the determination of the pension plan
information consisted of the following:
December 31,
--------------------------
1997 1998
---------- ---------
Discount rate...................................... 7.00% 7.00%
Expected long-term rate of return on plan assets... 7.75% 7.75%
8. INCOME TAXES
The Company accounts for income taxes under the provisions SFAS No. 109,
Accounting for Income Taxes. As of December 31, 1998 the Company had
approximately $94.5 million of net operating loss ("NOL") carryforwards for
income tax purposes and approximately $2.3 million of research and development
tax credits available to offset future federal income tax, subject to
limitations for alternative minimum tax. The NOL and credit carryforwards are
subject to examination by the tax authorities and expire in various years from
2003 through 2011. The Tax Reform Act of 1986 contains provisions that may
limit the NOL and credit carryforwards available for use in any given year upon
the occurrence of certain events, including significant changes in ownership
interest. A change in ownership of a company
48
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
of greater than 50% within a three-year period results in an annual limitation
on the Company's ability to utilize its NOL carryforwards from tax periods prior
to the ownership change. The acquisition of Diamond in April 1996 resulted in
such a change of ownership and the Company estimates that the resulting NOL
carryforward limitation will be approximately $4.7 million per year for periods
subsequent to April 19, 1996. In addition, the Company believes that its follow-
on public offering of common stock in March 1998 resulted in a further "change
of ownership". This limitation will total approximately $12.5 million per year
for periods subsequent to the follow-on offering. The Company believes that
these limitations may affect the eventual utilization of its total NOL
carryforwards.
The acquisition of Diamond was completed on a tax free basis. Accordingly,
the basis of the assets for financial reporting purposes exceeds the basis of
the assets for income tax purposes. The Company has recorded a deferred tax
liability related to this basis difference. As the Company had previously
recorded a valuation allowance against its deferred tax assets, the Company
reduced its valuation allowance in an amount equal to the deferred tax liability
at the date of the merger.
The Company's NOLs represent a previously unrecognized tax benefit.
Recognition of these benefits requires future taxable income, the attainment of
which is uncertain, and therefore, a valuation allowance has been established
for the entire tax benefit and no benefit for income taxes has been recognized
in the accompanying consolidated statements of operations.
Deferred tax assets and liabilities consist of the following (in thousands):
December
December 31, 31,
1997 Changes 1998
----------------------- -------------------------- -----------
(restated)
Deferred tax assets:
Research and development credits $ 1,148 $ 1,170 $ 2,318
Inventory valuation and reserves 222 566 788
Deferred revenue 38 81 119
Pension liability 43 (14) 29
Accrued compensation 128 (7) 121
Amortization of intangible assets 218 97 315
Loss on assets held for sale -- 492 492
Restructuring reserve -- 624 624
Other 53 11 64
Net operating loss carryforwards 23,679 12,475 36,154
-------- -------- --------
25,529 15,495 41,024
Less valuation allowance (24,826) (15,644) (40,470)
-------- -------- --------
703 (149) 554
Deferred tax liability:
Property and equipment (703) 149 (554)
-------- -------- --------
(703) 149 (554)
-------- -------- --------
Net deferred taxes $ -- $ -- $ --
======== ======== ========
9. RESEARCH AND DEVELOPMENT AGREEMENTS
In June 1994, the Company entered into agreements with Bayer AG ("Bayer"), a
pharmaceutical company, pursuant to which Bayer is funding and assisting in the
development of certain technologies. In return, the Company granted Bayer the
option to license the technologies to manufacture certain products for sale, as
well as the right to distribute for all parts of the world, except Japan and
East Asia. To the extent the Company is determined to have manufacturing
capabilities, under the terms of the agreement, Bayer will be required to
purchase its requirements for such products from the Company.
49
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In exchange for the above, Bayer agreed to provide research funding to the
Company, of which $500,000 was received in 1996, $550,000 in 1997 and $1.1
million in 1998. The Company expects to receive periodic research payments
until December 1999 as the related expenses are incurred and specified
milestones are reached. In connection with this contract, the Company
recognized research revenue of $1.3 million, $1.2 million and $850,000 for the
years ended December 31, 1996, 1997 and 1998, respectively.
Additionally, the Company will receive royalties based on a percentage of
any net sales of products developed under the agreements not manufactured by the
Company.
Bayer may terminate the agreement for convenience at any anniversary, with
90 days notice, in which case, the product rights revert to the Company. In the
event of such a termination, the Company would be required to pay Bayer a
royalty at a modest rate on net sales of these products exceeding a specified
threshold. The total amount of this royalty would not exceed the amount of
research funding provided by Bayer.
In January 1993, the Company entered into an agreement with Eisai Co., Ltd.
("Eisai") pursuant to which Eisai obtained the exclusive right to market certain
products in Japan and East Asia. Under the terms of the agreement, the Company
is to receive periodic payments for support of research, one half of which is
only to be received upon completion of certain milestones. No revenue was
recognized for the years ended December 31, 1996, 1997 or 1998. Although the
agreement does not expire until 2008, Eisai may terminate its research support
for any product with 90 days written notice.
In October 1996, the Company and Diamond entered into three related
agreements with a pharmaceutical company concerning the research, development,
licensing, manufacturing and marketing of certain products. Under the research
and development agreement, Diamond granted a non-exclusive, royalty-free, paid-
up right and license to develop, manufacture and market certain of its bovine
products. In return, the pharmaceutical company agreed to fund certain research
costs associated with the development of these products, subject to the
achievement of certain milestones. In connection with this research funding,
the Company recognized research and development revenue of $210,000 during the
fourth quarter of 1996, and $1.1 million and $460,000 for the years ended
December 31, 1997 and 1998, respectively. As additional consideration, the
Company received an exclusive, royalty-free, worldwide license for certain
feline biological vaccines. The Company also has a three-year agreement with
the pharmaceutical company for the manufacture of these feline vaccines.
The Company estimates its future cash flows from its existing research and
development contracts, subject to scheduled completion of specified milestones,
are as follows (in thousands):
Year Ending
December 31,
------------
1999...................................... $ 925
2000...................................... 600
------
$1,525
======
10. COMMITMENTS AND CONTINGENCIES
The Company holds certain rights to market and manufacture all products
developed or created under certain research, development and licensing
agreements with various entities. In connection with such agreements, the
Company has agreed to pay the entities royalties on net product sales. In the
years ended December 31, 1997 and 1998, $15,000 and $52,000 in royalties became
payable under these agreements, respectively.
In connection with an equity investment by a pharmaceutical firm in April
1996 (the "Investor"), the Company granted the Investor the rights, co-exclusive
with the Company's rights, to market two products under development by the
Company, the flea control vaccine and feline heartworm vaccine.
50
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company and the Investor have a revenue sharing arrangement for net sales of
these products through the year 2005.
In addition to the marketing agreements described above, the Company entered
into a pharmaceutical screening cooperation agreement with the Investor,
pursuant to which the two parties may enter into joint development arrangements
to develop pharmaceutical and vaccine products. In addition, to the extent that
the Company decides to grant a license to any third party for any products or
technology for companion or food animal applications, the Investor must be
offered first right to negotiate to acquire such license.
In connection with the acquisition of Center, the Company entered into a
sales and marketing agreement with a domestic distribution company which grants
the right to the distribution company to market and sell Center's allergenic
extracts for human use, with sales commission rates which vary from 20% to 25%.
The agreement expires in December 2002.
The Company contracts with various parties that conduct research and
development on the Company's behalf. In return, the Company generally receives
the right to commercialize any products resulting from these contracts. In the
event the Company licenses any technology developed under these contracts, the
Company will generally be obligated to pay royalties at specified percentages of
future sales of products utilizing the licensed technology.
The Company has entered into operating leases for its office and research
facilities and certain equipment with future minimum payments as of December 31,
1998 as follows (in thousands):
Year Ending
December 31,
------------
1999 ................................................................ $1,490
2000 ................................................................ 1,300
2001 ................................................................ 1,143
2002 ................................................................ 1,100
2003 ................................................................ 869
Thereafter ........................................................... 899
------
$6,801
======
The Company had rent expense of $642,000, $1.4 million and $1.4 million in
1996, 1997 and 1998, respectively.
11. CAPITAL STOCK
Common Stock
In July 1998, the Company issued 1.165 million shares of the Company's
common stock to Ralston Purina Company ("Ralston Purina"), for $14.75 million in
cash, and also issued, for an additional cash payment of $250,000, warrants to
purchase an additional 1.165 million shares of the Company's common stock. The
exercise price of the warrants is $12.67 for the first year of the warrants,
increasing by 20% per year for each of the second and third years of the
warrants. The warrants were exercisable immediately as of July 30, 1998 and
expire in three years with respect to any unexercised shares.
In July 1998, the Company issued 205,619 shares of common stock to Bayer
Corporation ("Bayer") in consideration for the acquisition by Diamond of certain
assets, including land and buildings formerly leased by Diamond from Bayer, and
as repayment in full of certain indebtedness of Diamond to Bayer, in a
transaction valued at approximately $2.3 million.
51
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
In March 1998, the Company completed its follow-on public offering of
5,750,000 shares of common stock (including 500,000 shares offered by a
stockholder of the Company and an underwriters' over-allotment option exercised
for 750,000 shares) at a price of $9.875 per share, providing the Company with
net proceeds of approximately $48.6 million.
In July 1997, the Company completed its IPO of 5,637,850 shares of common
stock (including an underwriters' over-allotment option exercised for 637,850
shares) at a price of $8.50 per share, providing the Company with net proceeds
of approximately $43.9 million. Upon closing of the IPO, all of the outstanding
shares of Series A, B, C, D, E and F preferred stock were automatically
converted into 11,289,388 shares of common stock.
The Company has granted stock purchase rights to acquire 322,000 shares of
common stock to key executives and Directors pursuant to the 1994 Key Executive
Stock Plan. As of December 31, 1998, executives had exercised all of these
stock purchase rights by executing promissory notes payable to the Company. The
fair market value of the underlying common stock equaled the exercise price on
the date of grant and exercise. The notes mature in six years, bear interest at
7.5% and are secured by a pledge of the underlying shares of common stock.
Under the terms of the Key Executive Stock Plan, if the purchaser's relationship
with the Company ceases for any reason within 48 months of the grant date, the
Company may, within 90 days following termination, repurchase at the original
exercise price all of the stock which has not vested. The stock vests ratably
over a 48 month period. During the years ended December 31, 1997 and 1998,
250,834 and 310,520 shares had vested and been released from the purchase
option, respectively.
Stock Option Plans
The Company has a stock option plan which authorizes the grant of stock
options and stock purchase rights to employees, officers, directors and
consultants of the Company to purchase shares of common stock. In 1997, the
board of directors adopted the 1997 Stock Incentive Plan (the "1997 Plan") and
terminated two prior option plans. However, options granted and unexercised
under the prior plans are still outstanding. All shares remaining available for
grant under the terminated plans were rolled into the 1997 Plan. In addition,
all shares which are subsequently cancelled under the prior plans are rolled
into the 1997 Plan on a quarterly basis. The number of shares reserved for
issuance under the 1997 Plan increases automatically on January 1 of each year
by a number equal to the lesser of (a) 1,500,000 shares or (b) 5% of the shares
of common stock outstanding on the immediately preceding December 31. The
number of shares reserved for issuance under all plans as of January 1, 1999 was
5,291,283.
The stock options granted by the board of directors may be either incentive
stock options ("ISOs") or nonstatutory stock options ("NSOs"). The purchase
price for options under all of the plans may be no less than 100% of fair market
value for ISOs or 85% of fair market value for NSOs. Options granted will
expire no later than the tenth anniversary subsequent to the date of grant or 90
days following termination of employment, except in cases of death or
disability, in which case the options will remain exercisable for up to twelve
months. Under the terms of the 1997 Plan, in the event the Company is sold or
merged, options granted will either be assumed by the surviving corporation or
vest immediately.
SFAS No. 123 ("SFAS 123")
SFAS 123, Accounting for Stock-Based Compensation, defines a fair value
based method of accounting for employee stock options, employee stock purchases,
or similar equity instruments. However, SFAS 123 allows the continued
measurement of compensation cost for such plans using the intrinsic value based
method prescribed by APB Opinion No. 25, Accounting for Stock Issued to
Employees ("APB 25"), provided that pro forma disclosures are made of net income
or loss, assuming the fair value based method of SFAS 123 had been applied. The
Company has elected to account for its stock-based compensation plans under APB
25; accordingly, for purposes of the pro forma disclosures presented below, the
Company has computed the fair values of all options granted during 1996, 1997
and 1998, using the Black-Scholes pricing model and the following weighted
average assumptions:
52
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1996 1997 1998
--------------- --------------- ---------------
Risk-free interest rate...................... 6.12% 6.49% 5.28%
Expected lives............................... 3.11 years 4.93 years 3.8 years
Expected volatility.......................... 80% 72% 89%
Expected dividend yield...................... 0% 0% 0%
To estimate expected lives of options for this valuation, it was assumed
options will be exercised at varying schedules after becoming fully vested
dependent upon the income level of the option holder. For measurement purposes,
options have been segregated into three income groups, and estimated exercise
behavior of option recipients varies from six months to one and one half years
from the date of vesting, dependent on income group (less highly compensated
employees are expected to have shorter holding periods). All options are
initially assumed to vest. Cumulative compensation cost recognized in pro forma
basic net income or loss with respect to options that are forfeited prior to
vesting is adjusted as a reduction of pro forma compensation expense in the
period of forfeiture. Because the Company's common stock has only recently been
publicly traded, the expected market volatility was estimated for 1996 using the
estimated average volatility of four publicly held companies which the Company
believes to be similar with respect to the markets in which they compete.
Actual volatility of the Company's stock was used for 1997 and 1998
computations. Fair value computations are highly sensitive to the volatility
factor assumed; the greater the volatility, the higher the computed fair value
of the options granted.
The total fair value of options granted was computed to be approximately
$1.2 million, $5.0 million and $8.8 million for the years ended December 31,
1996, 1997 and 1998, respectively. The amounts are amortized ratably over the
vesting periods of the options. Pro forma stock-based compensation, net of the
effect of forfeitures, was $367,000, $1.8 million and $3.9 million for 1996,
1997 and 1998, respectively.
A summary of the Company's stock option plans is as follows:
Year Ended December 31,
--------------------------------------------------------------
1997 1998
----------------------------- ---------------------------
(restated)
Weighted Weighted
Average Average
Exercise Exercise
Options Price Options Price
------------- ------------- ------------- -------------
Outstanding at beginning of period................. 2,008,942 $0.6814 2,570,533 $ 1.9053
Granted.......................................... 1,060,196 $4.1842 1,304,443 $10.6166
Cancelled........................................ (100,265) $1.7630 (315,543) $ 5.9544
Exercised........................................ (398,340) $0.3579 (350,116) $ 1.2188
--------- ---------
Outstanding at end of period....................... 2,570,533 $1.9053 3,209,317 $ 5.1204
========= =========
Exercisable at end of period....................... 1,077,284 $0.9760 1,531,895 $ 2.9417
========= =========
53
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The weighted average exercise prices and weighted average estimated fair
value of options granted during the years ended December 31, 1997 and 1998 were
as follows:
Year Ended December 31,
------------------------------------------------------------------
1997 1998
------------------------------- -----------------------------
(restated)
Weighted Weighted Weighted Weighted
Average Average Average Average
Number of Estimated Exercise Number of Estimated Exercise
Options Fair Value Price Options Fair Value Price
--------- ---------- -------- --------- ---------- --------
Exercise price equal to estimated fair 167,400 $5.4622 $9.3684 1,304,443 $6.7635 $10.6166
value
Exercise price less than estimated fair value 892,796 $3.8469 $3.2122 -0- -0- -0-
--------- ---------
1,060,196 $4.1019 $4.1842 1,304,443 $6.7635 $10.6166
========= =========
The Company recorded deferred compensation (as calculated under APB 25) of
$933,00 and $1.5 million during the years ended December 31, 1996 and 1997,
respectively, representing the difference between the deemed value of the common
stock for accounting purposes and the exercise price of such options at the date
of grant. In 1998 the Company also granted stock options to non-employees in
exchange for consulting services, recording deferred compensation of $46,000
based on the estimated fair value of the options at the date of grant. Deferred
compensation is being amortized over the applicable vesting periods. The
amortization of deferred compensation resulted in a non-cash charge to
operations of $188,000, $645,000 and $736,000 in the years ended December 31,
1996, 1997 and 1998, respectively.
The following table summarizes information about stock options outstanding
and exercisable at December 31, 1998:
Options Outstanding Options Exercisable
-------------------------------------- --------------------------
Number of Weighted Number of
Options Average Options
Outstanding Remaining Weighted Exercisable Weighted
at December Contractual Average at December Average
31, Life in Exercise 31, Exercise
Exercise Prices 1998 Years Price 1998 Price
----------------- ------------- ----------- --------- ------------- -----------
$ 0.15 - $0.25 176,192 3.59 $ 0.2032 176,192 $ 0.2032
$ 0.35 460,109 6.45 $ 0.3500 376,122 $ 0.3500
$ 1.20 - $1.50 935,995 8.30 $ 1.2259 565,095 $ 1.2429
$ 2.50 - $5.25 491,867 9.20 $ 4.4111 138,895 $ 3.7187
$ 7.62 - $11.75 409,305 9.22 $ 9.9710 87,383 $ 9.8143
$ 11.88 652,747 9.05 $11.8800 162,524 $11.8800
$12.50 - $15.00 83,102 9.17 $13.0348 25,684 $12.9096
--------- ---------
$ 0.15 - $15.00 3,209,317 8.21 $ 5.1204 1,531,895 $ 2.9417
========= =========
Employee Stock Purchase Plan (the "ESPP")
Under the 1997 Employee Stock Purchase Plan, the Company is authorized to
issue up to 250,000 shares of common stock to its employees. Employees of the
Company and its U.S. subsidiaries who are expected to work at least 20 hours per
week and five months per year are eligible to participate. Under the terms of
the plan, employees can choose to have up to 10% of their annual base earnings
withheld to purchase the Company's common stock. The purchase price of the
stock is 85% of the lower of its beginning-of-enrollment period or end-of-
measurement period market price. Each enrollment period is two years, with six
month measurement periods ending July 30 and December 31.
54
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company has computed the fair values of stock purchased under the ESPP
in 1997 and 1998, using the Black-Scholes pricing model and the following
weighted average assumptions:
1997 1998
----------- -----------
Risk-free interest rate 5.69% 5.01%
Expected lives 2 years 2 years
Expected volatility 72% 89%
Expected dividend yield 0% 0%
The total fair value of stock sold under the ESPP was computed to be
approximately $103,000 and $268,000 for the years ended December 31, 1997 and
1998, with a weighted-average fair value of the purchase rights granted of $4.73
and $4.57 per share, respectively. Pro forma stock-based compensation, net of
the effect of forfeitures, was approximately $103,000 and $268,000 in 1997 and
1998, respectively, for the ESPP.
Pro Forma Basic Net Loss per Share under SFAS 123
If the Company had accounted for all of its stock-based compensation plans
in accordance with SFAS 123, the Company's net loss would have been reported as
follows (in thousands, except per share amounts):
Year Ended December 31,
------------------------------------------
1996 1997 1998
------------- ------------- ------------
Net loss: (restated) (restated)
As reported $(19,429) $(38,864) $(44,274)
======== ======== ========
Pro forma (unaudited) $(19,796) $(40,767) $(48,442)
======== ======== ========
Basic net loss per share:
As reported (unaudited pro forma basic net loss per share
for 1996 and 1997) $ (1.53) $ (2.42) $ (1.79)
======== ======== ========
Pro forma (unaudited) $ (1.57) $ (2.54) $ (1.96)
======== ======== ========
Stock Warrants
The Company had issued warrants to purchase 6,400 shares of Series C
preferred stock at an exercise price of $2.50 per share and 6,225 shares, 267
shares and 18,500 shares of Series D preferred stock at an exercise price of
$3.25 per share in connection with certain leases discussed in Note 4. Upon the
closing of the IPO, the rights were converted to warrants to purchase the
Company's common stock at the original exercise prices. In September 1997, the
Company issued 5,323 shares of common stock in exchange for the warrant for
6,400 shares at an exercise price of $2.50 per share in a cashless "net"
exercise. In April 1998, the Company issued 4,912 shares of common stock in
exchange for the warrant for 6,225 shares at an exercise price of $3.25 per
share in a cashless "net" exercise. The remaining warrants expire on December
30, 2002 and October 20, 2003, respectively. In July 1998, the Company issued
warrants to purchase 1.165 million shares of the Company's common stock in
connection with the private placement with Ralston Purina described previously.
The exercise price of the warrants is $12.67 for the first year of the warrants,
increasing by 20% per year for each of the second and third years of the
warrants. The warrants were exercisable immediately as of July 30, 1998 and
expire in three years with respect to any unexercised shares. No warrants other
than those described above had been exercised as of December 31, 1998.
55
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. MAJOR CUSTOMERS
The Company had sales of greater than 10% of total revenue to only one
customer during the years ended December 31, 1996, 1997 and 1998. This
customer, which represented 36%, 21% and 15% of total revenues, respectively,
purchases vaccines from Diamond.
13. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Year Ended December 31,
----------------------------------
1996 1997 1998
---------- ---------- ----------
(restated) (restated)
(in thousands)
Cash paid for interest $ 496 $1,274 $1,999
Non-cash investing and financing activities:
Issuance of debt related to acquisitions 207 3,465 --
Issuance of preferred stock and options to purchase common stock in exchange
for the common stock of Diamond, net of cash acquired 7,058 -- --
Issuance of common and preferred stock related to acquisitions, net of cash
acquired -- 3,892 --
Issuance of common stock in exchange for assets and as repayment of debt -- -- 2,262
Reduction in future payment on debt to customer in exchange for the granting of
certain rights 1,250 -- --
Purchase of assets under direct capital lease financing -- 894 86
14. SEGMENT REPORTING
During 1998, the Company adopted the provisions of SFAS No. 131,
Disclosures About Segments of an Enterprise, which changes the way the Company
reports information about its operating segments. The information for 1997 has
been restated from the prior year's presentation in order to conform to the 1998
presentation.
The Company's divides its operations into two reportable segments, Animal
Health, which includes the operations of Heska, Diamond, SDI, Heska UK and Heska
AG, and Allergy Diagnostics and Treatment, which includes the operations of
Center and CMG.
Summarized financial information concerning the Company's reportable
segments is shown in the following table (in thousands). The "Other" column
includes the elimination of intercompany transactions and other items as noted.
Allergy
Animal Diagnostics and
Health Treatment Other Total
-------------- ------------------ ---------------------- ----------------
1998:
Revenues............................... $ 35,755 $ 8,479 $ (4,462) $ 39,772
Operating loss......................... (38,768) (1,014) (6,174) (a) (45,956)
Total assets........................... 123,965 7,495 (33,406) 98,054
Capital expenditures................... 5,936 868 -- 6,804
Depreciation and amortization.......... 3,215 365 -- 3,600
________
(a) Includes the write-down of certain tangible and intangible assets to their
expected net realizable values, resulting from a loss on assets held for sale
of $1.3 million, restructuring expenses of $2.4 million (See Note 5) and
inventory write-downs of $1.5 million.
56
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Allergy
Animal Diagnostics and
Health Treatment Other Total
---------------- ------------------ ------------------------ ---------------
1997:
Revenues............................. $ 29,465 $3,273 $ (3,435) $ 29,303
Operating loss....................... (38,825) (284) (53) (39,162)
Total assets......................... 82,105 8,670 (21,755) 69,020
Capital expenditures................. 6,158 90 -- 6,248
Depreciation and amortization........ 2,230 161 -- 2,391
1996:
Revenues............................. $ 18,582 $ -- $ (1,066) $ 17,516
Operating loss....................... (19,970) -- -- (19,970)
Total assets......................... 55,335 -- (9,684) 45,651
Capital expenditures................. 5,289 -- -- 5,289
Depreciation and amortization........ 1,190 -- -- 1,190
The Company manufactures and markets its products in two major geographic
areas, North America and Europe. The Company's three primary manufacturing
facilities are located in North America. Revenues earned in North America are
attributable to Heska, Diamond, SDI and Center. Revenues earned in Europe are
primarily attributable to Heska UK, CMG and Heska AG. There have been no
significant exports from North America or Europe.
In 1997 and 1998, European subsidiaries purchased products from North
America for sale to European customers. Transfer prices to international
subsidiaries are intended to allow the North American companies to produce
profit margins commensurate with their sales and marketing efforts. Prior to
1997, the Company had neither international subsidiaries, nor international
revenues. Certain information by geographic area is shown in the following
table (in thousands). The "Other" column includes the elimination of
intercompany transactions.
North America Europe Other Total
----------------- ------------------ ----------------------- -------------
1998:
Revenues............................. $ 40,573 $ 3,661 $ (4,462) $ 39,772
Operating loss....................... (37,386) (2,396) (6,174 (45,956)
Total assets......................... 127,004 4,457 (33,406) 98,054
Capital expenditures................. 6,524 280 -- 6,804
Depreciation and amortization........ 3,009 591 -- 3,600
1997:
Revenues............................. $ 30,513 $ 2,225 $ (3,435) $ 29,303
Operating loss....................... (38,325) (784) (53) (39,162)
Total assets......................... 86,262 4,513 (21,755) 69,020
Capital expenditures................. 6,113 135 -- 6,248
Depreciation and amortization........ 2,254 137 -- 2,391
1996:
Revenues............................. $ 18,582 $ -- $ (1,066) $ 17,516
Operating loss....................... (19,970) -- -- (19,970)
Total assets......................... 55,335 -- (9,684) 45,651
Capital expenditures................. 5,289 -- -- 5,289
Depreciation and amortization........ 1,190 -- -- 1,190
57
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
15. RECENT ACCOUNTING PRONOUNCEMENTS
During 1998, the Company adopted the provisions of a new accounting
standard, American Institute of Certified Public Accountants ("AICPA") Statement
of Position ("SOP") No. 98-5, Reporting on the Costs of Start-up Activities,
which requires that start-up costs, including organization costs, be expensed as
incurred rather than capitalized. The adoption of this Statement has had no
effect on the Company's reported results of operations.
During 1998 , the Company adopted the provisions of SFAS No. 130, Reporting
Comprehensive Income. The Statement establishes standards for reporting
comprehensive income and its components in financial statements. Comprehensive
income, as defined, includes all changes in equity (net assets) during a period
from non-owner sources. The Company has reported comprehensive income (loss) in
the accompanying consolidated statements of stockholders' equity, and statements
of operations and comprehensive loss.
During 1998, the Company adopted the provisions SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities. The Statement establishes
accounting and reporting standards requiring that every derivative instrument
(including certain derivative instruments embedded in other contracts) be
recorded in the balance sheet as either an asset or liability measured at fair
value. The Statement requires that changes in the derivative's fair value be
recognized currently in earnings unless specific hedging criteria are met. The
adoption of this Statement has had no effect on the Company's reported earnings
or comprehensive income.
The AICPA has also issued SOP No. 98-1, Software for Internal Use, which
provides guidance on accounting for the cost of computer software developed or
obtained for internal use. SOP No. 98-1 is effective for financial statements
for fiscal years beginning after December 15, 1998. The Company does not expect
that that the adoption of SOP No. 98-1 will have a material impact on its
financial statements.
58
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
Not applicable.
PART III
Certain information required by Part III is incorporated by reference to
the Company's definitive Proxy Statement to be filed with the Securities and
Exchange Commission in connection with the solicitation of proxies for the
Company's 1999 Annual Meeting of Stockholders (the "Proxy Statement").
Item 10. Directors and Executive Officers of the Registrant.
The information required by this section is incorporated by reference to
the information in the sections entitled "Election of Directors--Directors and
Nominees for Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Proxy Statement. The required information concerning
executive officers of the Company is contained in the section entitled
"Executive Officers of the Registrant" in Part I of this Form 10-K.
Item 11. Executive Compensation.
The information required by this section is incorporated by reference to
the information in the sections entitled "Election of Directors--Directors'
Compensation" and "Executive Compensation" in the Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by this section is incorporated by reference to
the information in the section entitled "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement.
Item 13. Certain Relationships and Related Transactions.
The information required by this section is incorporated by reference to
the information in the section entitled "Certain Transactions and Relationships"
in the Proxy Statement.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) The following documents are filed as a part of this Form 10-K.
(1) Financial Statements:
Reference is made to the Index to Consolidated Financial Statements
under Item 8 in Part II of this Form 10-K.
(2) Financial Statement Schedules:
All schedules are omitted because they are not applicable or the
required information is shown in the financial statements or notes thereto.
59
(3) Exhibits:
The exhibits listed below are required by Item 601 of Regulation S-K.
Each management contract or compensatory plan or arrangement required to be
filed as an exhibit to this Form 10-K has been identified.
Exhibit
Number Notes Description of Document
- ------- ------ -----------------------
4.2 (1) First Amended Investors' Rights Agreement by and among Registrant and certain stockholders of
Registrant dated as of April 12, 1996.
4.2(a) (6) Waiver and Amendment to first Amended Investors' Rights Agreement among the Company and
certain other parties.
4.2(b) (6) Second Waiver and Amendment to first Amended Investors' Rights Agreement among the Company and
certain other parties.
4.2(c) (6) Third Waiver and Amendment to first Amended Investors' Rights Agreement among the Company and
certain other parties.
4.3 (1) Form of warrant to purchase Series C Preferred Stock.
4.4 (1) Form of warrant to purchase Series D Preferred Stock.
4.5 (5) Company Stock Warrant Purchase Agreement dated as of July 29, 1998 between the Company and
Ralston Purina Company.
9.1 (1) Voting Agreement by and among Registrant and certain stockholders of Registrant, dated as of
April 12, 1996.
10.1H (1) Collaborative Agreement between Registrant and Eisai Co., Ltd. dated January 25, 1993.
10.2H (1) Canine Heartworm Cooperation Agreement between Registrant and Bayer AG dated as of June 10,
1994.
10.3H (1) Feline Toxoplasmosis Cooperation Agreement between Registrant and Bayer AG dated as of June
10, 1994.
10.4H (1) Product Supply and License Agreement between Registrant and Atrix Laboratories, Inc. dated May
1, 1995, as amended June 23, 1995.
10.5H (1) Screening and Development Agreement between Ciba-Geigy Limited and Registrant, dated as of
April 12, 1996.
10.6 (1) Right of First Refusal Agreement between Ciba-Geigy Limited and Registrant, dated as of April
12, 1996.
10.7 (1) Marketing Agreement between Registrant and Ciba-Geigy Limited dated as of April 12, 1996.
10.8H (1) Marketing Agreement between Registrant and Ciba-Geigy Corporation dated as of April 12, 1996.
10.9H (1) Manufacturing and Supply Agreement between and among Diamond Animal Health, Inc., Agrion
Corporation, Diamond Scientific Co. and Miles Inc. dated December 31, 1993 and Amendment and
Extension thereto dated September 1, 1995.
10.9(a)H (5) Second Amendment to Manufacturing and Supply Agreement between Diamond Animal Health, Inc. and
Bayer Corporation dated February 26, 1998.
10.10* (1) Employment Agreement between Registrant and Robert B. Grieve dated January 1, 1994, as amended
March 4, 1997.
10.11* (1) Employment Agreement between Registrant and Fred M. Schwarzer dated November 1, 1994, as
amended March 4, 1997.
10.12* (1) Employment Agreement between Registrant and R. Lee Seward dated October 17, 1994.
10.13* (1) Employment Agreement between Registrant and Louis G. Van Daele dated April 14, 1996.
10.14H (2) Supply Agreement between Registrant and Quidel Corporation dated July 3, 1997.
10.15* (1) Restricted Stock Purchase Agreement dated February 28, 1995 by and between Registrant and Fred
M. Schwarzer.
60
10.16* (1) Restricted Stock Purchase Agreement dated February 28, 1995 by and between Registrant and R.
Lee Seward.
10.17* (1) Restricted Stock Purchase Agreement dated January 11, 1997 by and between Registrant and Denis
H. Pomroy.
10.18* (1) Form of Indemnification Agreement entered into between Registrant and its directors and
certain officers.
10.19* (1) 1997 Incentive Stock Plan of Registrant.
10.20* (1) Forms of Option Agreement.
10.21* (1) 1997 Employee Stock Purchase Plan of Registrant.
10.22 (1) Lease Agreement dated March 8, 1994 between Sharp Point Properties, LLC and Registrant.
10.23 (1) Lease Agreement dated as of June 27, 1996 between GB Ventures and Registrant.
10.24 (1) Lease Agreement dated as of July 11, 1996 between GB Ventures and Registrant.
10.25 (1) Lease Agreement dated as of December 31, 1993 between Miles, Inc. and Diamond Animal Health,
Inc., as amended September 1, 1995.
10.26* (3) Employment Agreement between Registrant and Giuseppe Miozzari dated July 1, 1997.
10.27* (4) Employment Agreement between Registrant and John A. Shadduck dated January 27, 1997.
10.28* Employment Agreement between Registrant and Ronald L. Hendrick dated December 1, 1998.
10.29* Employment Agreement between Registrant and James H.
Fuller dated January 18, 1999.
10.30* Separation Agreement between Registrant and Fred M.
Schwarzer dated December 14, 1998.
10.31* Consulting Services and Confidentiality Agreement
between Registrant and Fred M. Schwarzer dated December
14, 1998.
10.32* Separation Agreement between Registrant and John A.
Shadduck dated December 14, 1998.
10.33* Consulting Services and Confidentiality Agreement
between Registrant and John A. Shadduck dated December
14, 1998.
10.34H Exclusive Distribution Agreement dated as of August 18,
1998 between the Company and Novartis Agro K.K.
10.35 Right of First Refusal Agreement dated as of August 18,
1998 between the Company and Novartis Animal Health,
Inc.
21.1 Subsidiaries of the Company.
23.1 Consent of Arthur Andersen LLP.
24.1 Power of Attorney (See page 62 of this Form 10-K).
27.1 (3) Financial Data Schedule.
Notes
-----
* Indicates management contract or compensatory plan or arrangement.
H Confidential treatment has been granted with respect to certain
portions of these agreements.
(1) Filed with Registrant's Registration Statement on Form S-1 (File
No. 333-25767).
(2) Filed with the Registrant's Form 10-Q for the quarter ended
September 30, 1997.
(3) Filed with Registrant's Registration Statement on Form S-1 (File
No. 333-44835).
(4) Filed with the Registrant's Form 10-K for the year ended
December 31, 1998.
(5) Filed with the Registrant's Form 10-Q for the quarter ended
31, 1998.
(6) Filed with the Registrant's Form 10-Q for the quarter ended
September 30, 1998.
(b) Reports on Form 8-K:
There were no Reports on Form 8-K filed by the Company during the quarter
ended December 31, 1998.
61
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 26, 1999.
HESKA CORPORATION
By /s/ ROBERT B. GRIEVE
--------------------------
Robert B. Grieve
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Robert B. Grieve, Ronald L. Hendrick,
Paul Hudnut and A. Lynn DeGeorge, and each of them, his or her true and lawful
attorneys-in-fact, each with full power of substitution, for him or her in any
and all capacities, to sign any amendments to this report on Form 10-K and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact or their substitute or
substitutes may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date indicated:
Name Title Date
---- ----- ----
/s/ ROBERT B. GRIEVE Chief Executive Officer (Principal March 26, 1999
- -------------------------- Executive Officer) and Director
Robert B. Grieve
/s/ RONALD L. HENDRICK Chief Financial Officer (Principal March 26, 1999
- -------------------------- Financial and Accounting Officer)
Ronald L. Hendrick
/s/ JAMES H. FULLER President and Chief Operating Officer March 26, 1999
- --------------------------
James H. Fuller
/s/ FRED M. SCHWARZER Chairman of the Board March 26, 1999
- --------------------------
Fred M. Schwarzer
/s/ A. BARR DOLAN Director March 26, 1999
- --------------------------
A. Barr Dolan
/s/ LYLE A. HOHNKE Director March 26, 1999
- --------------------------
Lyle A. Hohnke
/s/ DENIS H. POMROY Director March 26, 1999
- --------------------------
Denis H. Pomroy
/s/ LYNNOR B. STEVENSON Director March 26, 1999
- --------------------------
Lynnor B. Stevenson
/s/ GUY L. TEBBIT Director March 26, 1999
- --------------------------
Guy L. Tebbit
/s/ JOHN F. SASEN, Sr. Director March 26, 1999
- --------------------------
John F. Sasen, Sr.
62