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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003.
[ ] 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: 0-16159
LECTEC CORPORATION
-------------------
(Exact name of registrant as specified in its charter)
Minnesota 41-1301878
- --------------------------------- --------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10701 Red Circle Drive, Minnetonka, Minnesota 55343
- ------------------------------------------------- ----------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (952) 933-2291
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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [ X ]
The number of shares outstanding of the registrant's common stock as of November
18, 2003 was 3,966,395 shares.
LECTEC CORPORATION
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION
Item 1. Condensed Financial Statements and Notes to Condensed Financial Statements
(unaudited) .............................................................. I-1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations ............................................................... I-10
Item 3. Quantitative and Qualitative Disclosures About Market Risk ............... I-14
Item 4. Controls and Procedures .................................................. I-14
PART II - OTHER INFORMATION
Item 1. Legal Proceedings ....................................................... II-1
Item 2. Changes in Securities and Use of Proceeds ................................ II-1
Item 3. Defaults Upon Senior Securities .......................................... II-1
Item 4. Submission of Matters to a Vote of Security Holders ...................... II-1
Item 5. Other Information ........................................................ II-1
Item 6. Exhibits and Reports on Form 8-K ......................................... II-1
Signature Page ........................................................... II-2
PART I - FINANCIAL INFORMATION
ITEM 1- CONDENSED FINANCIAL STATEMENTS AND NOTES TO CONDENSED
FINANCIAL STATEMENTS
LECTEC CORPORATION
CONDENSED BALANCE SHEETS
September 30, December 31,
2003 2002
------------ ------------
(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 366,161 $ 671,588
Trade receivables and other, net of allowances of $69,000
and $80,655 at September 30, 2003 and December 31, 2002 73,129 318,896
Inventories
Raw materials 1,040,584 716,957
Work-in-process 8,953 24,294
Finished goods 278,078 269,538
---------- ----------
1,327,615 1,010,789
Prepaid expenses and other 197,736 112,831
---------- ----------
Total current assets 1,964,641 2,114,104
PROPERTY, PLANT AND EQUIPMENT - AT COST, NET 562,170 1,750,241
OTHER ASSETS
Patents and trademarks, less accumulated amortization of $1,401,357
and $1,319,840 at September 30, 2003 and December 31, 2002 234,813 285,862
---------- ----------
$2,761,624 $4,150,207
========== ==========
The accompanying notes are an integral part of these condensed
financial statements.
I-I
LECTEC CORPORATION
CONDENSED BALANCE SHEETS - CONTINUED
September 30, December 31,
2003 2002
------------- -------------
(UNAUDITED)
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Current maturities of long-term obligations 257,259 1,154,404
Accounts payable 708,599 587,650
Accrued expenses 143,957 286,149
Accrued payroll 179,813 181,984
Reserve for sales returns and credits 210,605 312,378
Customer deposits 1,207,598 650,073
------------ ------------
Total current liabilities 2,707,831 3,172,638
LONG-TERM OBLIGATIONS, LESS CURRENT MATURITIES 65,825 10,770
COMMITMENTS AND CONTINGENCIES - -
SHAREHOLDERS' EQUITY (DEFICIT)
Common stock, $.01 par value: 15,000,000 shares authorized;
3,966,395 shares issued and outstanding 39,664 39,664
Additional paid-in capital 11,547,678 11,389,678
Accumulated deficit (11,599,374) (10,462,543)
------------ ------------
(12,032) 966,799
------------ ------------
$ 2,761,624 $ 4,150,207
============ ============
The accompanying notes are an integral part of these condensed
financial statements.
I-2
LECTEC CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three months ended Nine months ended
September 30, September 30,
------------------------------- -------------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net sales $ 1,978,007 $ 2,013,949 $ 5,248,113 $ 5,111,451
Cost of goods sold 1,638,530 1,430,488 4,026,330 3,606,883
----------- ----------- ----------- -----------
Gross profit 339,477 583,461 1,221,783 1,504,568
Operating expenses
Sales and marketing 131,205 300,463 494,880 1,230,323
General and administrative 434,009 509,794 1,471,804 1,714,777
Research and development 111,035 109,126 309,816 393,649
Loss on sale of building - - 52,375 -
----------- ----------- ----------- -----------
676,249 919,383 2,328,875 3,338,749
----------- ----------- ----------- -----------
Loss from operations (336,772) (335,922) (1,107,092) (1,834,181)
Other income (expenses)
Interest expense (6,683) (37,855) (31,336) (114,686)
Other, net (342) 3,316 1,597 3,822
----------- ----------- ----------- -----------
Loss before income taxes (343,797) (370,461) (1,136,831) (1,945,045)
Income taxes - - - -
----------- ----------- ----------- -----------
Net loss $ (343,797) $ (370,461) $(1,136,831) $(1,945,045)
=========== =========== =========== ===========
Net loss per share - basic and diluted $ (0.09) $ (0.09) $ (0.29) $ (0.49)
=========== =========== =========== ===========
Weighted average shares outstanding - basic and diluted 3,966,395 3,957,982 3,966,395 3,954,429
=========== =========== =========== ===========
The accompanying notes are an integral part of these condensed
financial statements.
I-3
LECTEC CORPORATION
STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended September 30,
--------------------------------
2003 2002
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(1,136,831) $(1,945,045)
Adjustments to reconcile net loss to net cash
used in operating activities:
Loss on sale of building 52,375 -
Loss on write down of impaired assets 19,437
Depreciation and amortization 395,504 464,085
Common stock issued for consulting services - 19,009
Changes in operating assets and liabilities:
Trade and other receivables 245,767 486,806
Inventories (316,826) 4,009
Prepaid expenses and other 143,607 163,158
Accounts payable 120,949 59,502
Accrued expenses (251,379) (242,751)
Restructuring charge - (105,232)
Customer deposits 557,525 363,942
----------- -----------
Net cash used in operating activities (169,872) (732,517)
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of equipment 1,677 -
Purchase of property, plant and equipment (23,677) (13,334)
Investment in patents and trademarks (49,905) (64,505)
----------- -----------
Net cash used in investing activities (71,905) (77,839)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock - 10,372
Proceeds from sale of building 845,000 -
Payoff of building mortgage loan (820,000) -
Repayment of long-term obligations (88,650) (88,238)
----------- -----------
Net cash used in financing activities (63,650) (77,866)
----------- -----------
Net decrease in cash and cash equivalents (305,427) (888,222)
Cash and cash equivalents at beginning of period 671,588 1,425,205
----------- -----------
Cash and cash equivalents at end of period $ 366,161 $ 536,983
=========== ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest expense $ 22,926 $ 113,139
Income taxes $ 1,500 $ -
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES:
Leasehold improvement in exchange for lease obligation payable $ 66,560
Sales credit obligation exchanged for a long-term note payable $ - $ 220,000
Fair value of warrants issued in connection with the sale of the building $ 158,000 $ -
Value of free rent received in connection with the sale of the building $ 228,512 $ -
The accompanying notes are an integral part of these condensed
financial statements.
I-4
LECTEC CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)
(1) GENERAL
The accompanying condensed financial statements include the accounts of
LecTec Corporation (the "Company") as of and for the three and nine-month
periods ended September 30, 2003 and 2002. The Company's condensed financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America and should be read in conjunction with
the Company's Annual Report on Form 10-K for the year ended December 31, 2002.
The interim condensed financial statements are unaudited and in the opinion of
management, reflect all adjustments necessary for a fair presentation of results
for the periods presented. Results for interim periods are not necessarily
indicative of results for the year.
Certain reclassifications have been made to the statements of
operations for the three and nine-month periods ended September 30, 2002, to
conform to the presentation used in 2003. Such reclassifications had no effect
on the previously reported net loss or stockholders' equity.
(2) LIQUIDITY AND GOING CONCERN
The accompanying financial statements have been prepared in conformity
with generally accepted accounting principles, which contemplate continuation of
the Company as a going concern. The Company has experienced recurring negative
cash flows from operations and net losses resulting in an accumulated deficit of
$11,599,374 as of September 30, 2003 and, as of that date, the Company's current
liabilities exceeded its current assets by $743,190.
In view of the matters described in the preceding paragraph,
recoverability of a major portion of the recorded asset amounts shown in the
accompanying balance sheet is dependent upon profitable operations of the
Company and adequate working capital to fund continuing operations. The
financial statements do not include any adjustments relating to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence. Management expects to continue to operate at a
net loss and experience negative cash flow from operating activities through the
foreseeable future.
In May 2002, the Company renegotiated its Supply Agreement with
Novartis Corporation (the Company's largest customer) and since that time has
been receiving advance payments from Novartis against open orders 60 days prior
to shipment. At September 30, 2003, the amount owed to Novartis under product
prepayment advances was $832,914. In exchange for this product prepayment
program, the Company agreed to pledge substantially all of its assets to secure
its obligations under the program as well as a $220,000 note payable to
Novartis. In addition, the Company granted Novartis a nonexclusive license to
produce hydrogel patches in the event that the Company defaults in its
obligation to supply patches to Novartis. The Company has also been receiving
advance product payments from other customers. Maintaining adequate levels of
working capital to support the Company's manufacturing operations has been and
will be dependent upon the continuation of these advance product payments.
In September 2003, management learned that, as a result of a change in
its internal supplier selection criteria, Novartis intends to stop using LecTec
as a contract manufacturer for its topical patches during 2004. In addition,
Johnson & Johnson Consumer Products Company has indicated that it intends to
stop using the Company as a contract manufacturer in 2004. Novartis and Johnson
& Johnson accounted for 56.8% and 17.9% of the Company's net sales for the nine
months ended September 30, 2003. Based on these anticipated changes, the Board
of Directors has determined that the Company will cease manufacturing operations
prior to the end of the second quarter of 2004. The Company anticipates that it
will enter into a licensing agreement with Novartis and possibly other contract
manufacturing customers to enable them to use the Company's proprietary patch
technology in producing topical patch products in the future. However, there can
be no assurance that the Company will be successful in entering into these
licensing agreements. The Company currently believes that it will be able to
wind down and exit its manufacturing operations and facility lease obligations
without defaulting in its contractual obligations to any contract manufacturing
customer. However, there can be no assurance that
I-5
the Company will be able to exit manufacturing or its facility lease without
defaulting on contractual obligations or other debts which become due and
payable.
The Company expects to continue to operate at a net loss and experience
negative cash flows from operating activities for the foreseeable future. These
factors raise substantial doubt about its ability to continue as a going
concern.
In connection with the pending cessation of manufacturing operations,
the Company is planning to implement employee reduction and retention programs
to reduce the number of employees to that needed to support the wind down of
manufacturing operations while retaining those employees who are critical to
that process and to managing the Company's ongoing licensing agreements and
intellectual property portfolio. The Company is exploring its alternatives with
respect to the sale of its manufacturing assets, the renegotiation or
termination of its leases and other contractual obligations, and other
adjustments resulting directly from its exit from manufacturing. In addition,
the Company will be considering other possible fundamental changes in future
periods which could include, among other things, a sale of its remaining assets
or of the business as a whole.
It is management's intent to wind down its manufacturing operations,
sell off manufacturing assets, renegotiate its manufacturing facility lease and
fund continuing operations with royalty income from licensing agreements and /or
from other income derived from protection of rights pertaining to the Company's
intellectual property. However, there can be no assurance that the Company will
be successful in the wind down of manufacturing, selling off the manufacturing
assets, renegotiating its manufacturing facility lease, negotiation of license
agreements, or in the protection of its rights related to intellectual property.
If the Company continues in operation, funding of the Company's
operations in future years may require additional capital or other funding;
however, there can be no assurance that sources of additional capital or other
funding will be available on terms acceptable to the Company. If the Company is
not successful in winding down its manufacturing operations without defaulting
on its existing obligations, or if any additional funds required for its ongoing
operations are not available, the Company may be forced to cease operations
entirely in the near future.
(3) NET LOSS PER SHARE
The Company's basic net loss per share amounts have been computed by
dividing net loss by the weighted average number of outstanding common shares.
The Company's diluted net loss per share amounts have been computed by dividing
net loss by the weighted average number of outstanding common shares and common
share equivalents, when dilutive. Options and warrants to purchase 1,300,057 and
1,268,472 shares of common stock with a weighted average exercise price of $1.88
and $1.92 were outstanding during the three and nine-month periods ended
September 30, 2003, but were excluded from the calculation because they were
antidilutive. Options and warrants to purchase 1,199,885 and 1,194,557 shares of
common stock with a weighted average exercise price of $2.11 and $3.85 were
outstanding during the three and nine-month periods ended September 30, 2002,
but were excluded from the calculation because they were antidilutive.
I-6
(4) SEGMENTS
The Company operates its business in one reportable segment - the
manufacture and sale of products based on advanced skin interface technologies.
Each of the Company's major product lines has similar economic characteristics,
technology, manufacturing processes, and regulatory environments. Customers and
distribution and marketing strategies vary within major product lines as well as
overlap between major product lines. The Company's executive decision makers
evaluate sales performance based on the total sales of each major product line
and profitability on a total company basis, due to shared infrastructures, to
make operating and strategic decisions. The Company's initial sales of skin care
products occurred during the three months ended March 31, 2002. The Company sold
the conductive and medical tape product lines during the fiscal year ended
September 30, 2001. The Company had negative sales during the third quarter
ended September 30, 2002 due to return sales of skin care products. Net sales by
major product line for the three and nine-month periods ended September 30, 2003
and September 30, 2002 were as follows:
Three months ended Nine months ended
September 30, September 30,
------------- -------------
2003 2002 2003 2002
---- ---- ---- ----
Therapeutic consumer products $ 1,963,056 $ 1,964,940 $ 5,230,010 $ 4,112,856
Skin care products 14,951 (77,947) 18,103 280,316
Conductive products - 126,956 - 718,279
----------- ----------- ----------- -----------
$ 1,978,007 $ 2,013,949 $ 5,248,113 $ 5,111,451
=========== =========== =========== ===========
(5) LONG-TERM OBLIGATIONS
In May 2002, the Company entered into a $220,000 promissory note with a
major customer related to the costs incurred by the customer associated with
resolving a packaging issue that previously had been recorded as a sales credit
by the Company. The principal balance of the note is due in December 2003.
Monthly payments of interest are computed at the prime rate plus 2.0% (effective
rate of 6% at September 30, 2003). The promissory note is collateralized by
substantially all of the Company's assets.
The Company entered into a lease obligation with its landlord, relating
to improvements made to its leased corporate facility (roof repair and cooling
tower). The costs of the improvements were $66,560 with monthly payments of $879
beginning in July, 2003. Stated interest rate is 10% with payments for 10 years.
The Company has other capital lease obligations primarily related to leased
computer equipment and leases related to production equipment. At September 30,
2003, the principal balance remaining on the lease obligations was $103,084.
(6) CUSTOMER DEPOSITS
The Company receives advance payments from customers for future product
orders and records these amounts as liabilities. At September 30, 2003, the
Company had recorded customer deposits of $1,207,598.
(7) SALE OF CORPORATE FACILITY
On February 25, 2003, the Company sold its corporate facility in
Minnetonka, Minnesota for an aggregate purchase price of $910,270, repaid the
balance of the mortgage note payable of $820,000, and recorded a loss on sale of
$52,375 during the quarter ended March 31, 2003. In connection with the sale,
the Company entered into a lease of its corporate facility which grants the
Company free rent for the 12 months following the sale/leaseback transaction and
thereafter extends the lease at costs based on current market conditions. Also
in connection with the sale, the purchaser received a warrant to purchase
200,000 shares of common stock at $0.90 per share.
I-7
(8) SALE OF CONDUCTIVE BUSINESS ASSETS
In April 2001, the Company sold its diagnostic electrode and
electrically conductive adhesive hydrogel business assets that were used to
produce the Company's conductive products. The conductive products included
diagnostic electrodes and electrically conductive adhesive hydrogels. Under a
manufacturing and supply agreement between the Company and the buyer, the
Company continued to manufacture, and supply to the buyer, certain conductive
products through January 2002. The Company supplied the products at its cost of
production through October 2001, and at its cost of production plus ten percent
from November 2001 through January 2002. The Company continued to manufacture
and supply the buyer electrically conductive adhesive hydrogels, at margins of
approximately 30%, through September 2002. The Company anticipates no additional
sales to the buyer in 2003.
(9) STOCK BASED COMPENSATION
The Company utilizes the intrinsic value method of accounting for stock
based employee compensation plans. All options granted had an exercise price
equal to the market value of the underlying common stock on the date of grant
and no compensation cost is reflected in net loss, for the three and nine months
ended September 30, 2003 and 2002. The following table illustrates the effect on
net loss if the Company had applied the fair value recognition provisions of
FASB Statement No. 123, Accounting for Stock-based Compensation:
Three months ended Nine months ended
September 30, September 30,
------------- -------------
2003 2002 2003 2002
---- ---- ---- ----
Net loss, as reported $ (343,797) $ (370,461) $(1,136,831) $(1,945,045)
Less: compensation expense
determined under the fair value
method (32,467) (64,773) (133,124) (194,317)
----------- ----------- ----------- -----------
Pro-forma net loss $ (376,264) $ (435,234) $(1,269,955) $(2,139,362)
=========== =========== =========== ===========
Net loss per share:
Basic and diluted, as reported $ (0.09) $ (0.09) $ (0.29) $ (0.49)
Basic and diluted, pro-forma $ (0.09) $ (0.11) $ (0.32) $ (0.54)
The pro-forma information above should be read in conjunction with the
related historical information.
The weighted average fair value of options granted during the three
months ended September 30, 2003 and 2002 was $0.47 and $0.52. The weighted
average fair value of options granted during the nine months ended September 30,
2003 and 2002 was $0.46 and $1.10. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option valuation model
with the following weighted-average assumptions used for all grants during the
nine months ended September 30, 2003 and 2002, zero dividend yield, expected
volatility of 153% and 121%, risk-free interest rates of 2.85% and 3.13% and
expected lives of 4.0 years.
Management believes the Black-Scholes option valuation model currently
provides the best estimate of fair value. However, the Black-Scholes option
valuation model was developed for use in estimating the fair value of traded
options, which have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of several subjective
assumptions. The Company's employee and director stock options have
characteristics different from those of traded options, and changes in the
subjective input assumptions can materially affect the fair value estimate.
I-8
(10) INCOME TAXES
The provision for income tax benefits for the three and nine-month
periods ended September 30, 2003 and 2002 has been offset by a valuation
allowance for deferred taxes.
(11) RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board (FASB) issued
Financial Interpretations No. 46 (FIN 46), "Consolidation of Variable Interest
Entities." FIN 46 is an interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements," and addresses consolidation by business
enterprises of variable interest entities. FIN 46 applies immediately to
variable interest entities created or obtained after January 31, 2003 and
applies in the first fiscal year or interim period beginning after September 15,
2003, to variable interest entities in which an enterprise holds a variable
interest that it acquired before February 1, 2003. This interpretation is not
anticipated to have an impact on the Company's financial position or results of
operations.
In April 2003, the FASB issued Statement 149, Amendment of Statement
133 on Derivative Instruments and Hedging Activities. Statement 149 clarifies
implementation issues and amends Statement 133, to include the conclusions
reached by the FASB on certain FASB Staff Implementation Issues that, while
inconsistent with Statement 133's conclusions, were considered by the Board to
be preferable, amends discussion of financial guarantee contracts and the
application of the shortcut method to an interest-rate swap agreement that
includes an embedded option, and amends other pronouncements. Statement 149 is
effective to contracts entered into or modified, and hedging arrangements
designated after June 30, 2003, with various exceptions as outlined in the
statement. Adoption of Statement 149 is not anticipated to have an impact on the
Company's consolidated financial position or results of operations.
In May 2003, the FASB issued Statement 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity.
Statement 150 changes the classification in the statement of financial position
of certain common financial instruments from either equity or mezzanine
presentation to liabilities and requires an issuer of those financial statements
to recognize changes in fair value or redemption amount, as applicable, in
earnings. SFAS 150 is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003. Adoption of Statement 150 is
not anticipated to have an impact on the Company's financial position or results
of operations.
I-9
PART I - FINANCIAL INFORMATION
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
RESULTS OF OPERATIONS
Net sales for the third quarter ended September 30, 2003 were
$1,978,007 compared to net sales of $2,013,949 for the comparable quarter of
2002, a decrease of 1.8%. The decrease is attributable to a decrease in
TheraPatch branded product sales and Hydrogel products, partially offset by
increased sales of therapeutic consumer contract manufacturing sales and
increased sales of discontinued products sold through discount wholesalers.
Contract manufacturing net sales increased 26.0% to $1,810,630 for the third
quarter of 2003 from $1,437,198 for the same period in the prior year due to
increased sales volume from the Company's largest customer. Therapeutic retail
consumer product sales declined 71.1% in the third quarter of 2003 to $152,426
from $527,742 for the same period in the prior year. The retail consumer product
sales decrease was primarily the result of a planned reduction in the number of
products offered and the discontinued active promotion of the NeoSkin(R) line of
skin care products due to the inability to fund national advertising programs.
The NeoSkin product line was launched in the second quarter of 2002 and included
pre-formed face masks and under eye gel patches. Net sales of discontinued skin
care products, Hydrogel products and other sales totaled $14,951 in the third
quarter of 2003 compared to net sales of $49,009 for the third quarter of 2002.
Also offsetting the contract manufacturing net sales increase in the third
quarter of 2003 was the absence of conductive product sales. The Company
supplied conductive products to the purchaser under the terms of the asset sale
agreement through September 2002. The Company expects no future sales of
conductive products.
Net sales for the first nine months of 2003 were $5,248,113 compared to
net sales of $5,111,451 for the first nine months of 2002, an increase of 2.7%.
The increase was primarily due to an increase in sales of consumer contract
therapeutic patch products. Contract manufacturing net sales increased 67.8% to
$4,636,169 from $2,762,615 for the first nine months of 2003 compared to the
same period of 2002 due to increased sales volume from the Company's largest
customer. Offsetting the contract manufacturing net sales increase was a decline
in therapeutic retail consumer brand product sales, which decreased 56.0% to
$593,841 for the nine month period ended September 30, 2003, from $1,349,307 for
the comparable nine month period of the prior year. The decline was attributable
to a planned reduction in the number of products the Company offers to the
retail market and the discontinued active promotion of the NeoSkin(R) line of
skin care products due to the inability to fund national advertising programs.
Net sales of discontinued skin care products, Hydrogel products and other sales
totaled $18,103 for the nine months ended September 30, 2003, compared to net
sales of $999,529 for the same period in 2002. There were no sales of conductive
products during the nine months ended September 30, 2003, compared to net sales
of $671,461 for the nine months ended September 30, 2002. The decline was due to
the reasons stated above.
Gross profit for the third quarter of 2003 was $339,477, compared to
$583,461 for the third quarter of 2002, a decrease of 41.8%. Gross profit as a
percentage of net sales for the third quarter of 2003 was 17.2% compared to
29.0% for the third quarter of the prior year. The decrease in gross profit
dollars and gross profit as a percentage of net sales for the third quarter of
2003 compared to the same quarter of 2002 resulted primarily from a shift in
sales mix to lower margin consumer contract manufacturing products coupled with
higher sales returns of retail products during the quarter of $276,231 or 14.0%
of net sales.
Gross profit for the first nine months of 2003 was $1,221,783 compared
to $1,504,568 for the first nine months of 2002, a decrease of 18.8%. Gross
profit as a percentage of net sales for the first nine months of 2003 was 23.3%
compared to 29.4% for the first nine months of 2002. The decrease in gross
profit dollars and gross profit margin as a percentage of net sales for the
first nine months of 2003 compared to the same period of 2002 resulted from a
shift in sales mix to lower margin consumer contract manufacturing products,
higher inventory obsolescence costs related to the product discontinuations
discussed above of approximately $200,000, or 3.8% of net sales and
approximately $400,000 in sales returns, or 7.6% of net sales.
I-10
Sales and marketing expenses were $131,205 and $300,463 during the
third quarters ended September 30, 2003 and 2002, a decrease of 56.3%. As a
percentage of net sales, sales and marketing expenses were 6.6% and 14.9%,
respectively. The decrease in sales and marketing expenses for the third quarter
of 2003 was primarily due to a decrease of $55,669 in product promotional
expenses and a decrease of $109,378 in compensation related expenses. These
decreases resulted from aggressive cost control/reduction programs implemented
by management.
Sales and marketing expenses were $494,880 and $1,230,323 during the
first nine months of 2003 and 2002, and as a percentage of net sales, were 9.4%
and 24.1%, respectively. The decrease in sales and marketing expenses for the
first nine months of 2003 as compared with the same period of 2002 was primarily
due to a decrease of $247,549 in product promotional expenses and a decrease of
$383,564 in compensation related expenses. The Company anticipates that sales
and marketing expenses as a percentage of net sales will continue to decrease in
2003 due to the implementation of additional cost control/reduction programs by
management.
General and administrative expenses were $434,009 and $509,794 during
the third quarters of 2003 and 2002, and as a percentage of net sales, were
21.9% and 25.3%, respectively. The decrease in general and administrative
expenses was primarily due to decreases in headcount and compensation related
expenses of $55,478 and a reduction in professional fees and services of
$78,270. These reductions were offset by an increase in rent expense of $57,128
due to the sale and leaseback of the Company's Minnetonka, Minnesota corporate
facility.
General and administrative expenses were $1,471,804 and $1,714,777
during the first nine months of 2003 and 2002, and as a percentage of net sales,
were 28.0% and 33.6% respectively. The decrease in general and administrative
expenses for the nine months ended September 30, 2003 from the nine months ended
September 30, 2002 was primarily due to a decrease of $241,614 in compensation
related expenses and a decrease of $119,807 in professional fees and services.
These reductions were offset by an increase in rent expense of $133,299 due to
the sale and leaseback of the Company's Minnetonka's Corporate facility. The
Company anticipates that general and administrative expenses as a percent of net
sales for the remainder of 2003 will continue to decrease.
Research and development expenses for the third quarters of 2003 and
2002 were $111,035 and $109,126, respectively, and as a percentage of net sales,
were 5.6% and 5.4%, respectively. The increase in research and development
expenses was primarily due to the write-off of $19,437 in net capitalized
patents with a cost of $138,832 and related accumulated amortization of $119,395
during the third quarter ended September 30, 2003 after determining that these
patents would be of no future value to the Company. The patent write-off was
partially offset with decreases in headcount and compensation related expenses
of $15,236 net of increases in other research and development expenses.
Research and development expenses were $309,816 and $393,649 during the
first nine months of 2003 and 2002, and as a percentage of net sales, was 5.9%
and 7.7% respectively. The decrease in research and development expenses for the
nine months ended September 30, 2003 from the nine months ended September 30.
2002 was primarily due to the patent right-off discussed above offset by a
decrease of $61,523 in compensation related expenses. The Company anticipates
that research and development expenses as a percent of net sales for the
remainder of 2003 will continue to decrease.
Interest expense declined in the third quarter of 2003 to $6,683 from
$37,855 in the third quarter of 2002. The decline resulted primarily from the
sale of the Minnetonka, Minnesota corporate facility and related payoff of debt
that occurred in February 2003.
Interest expense decreased in the first nine months of 2003 to $31,336
from $114,686 in the first nine months of 2002. The decline resulted primarily
from the sale of the Minnetonka, Minnesota corporate facility and related payoff
of debt that occurred in February 2003. The decrease also resulted from the
absence of a line of credit in existence during a portion of 2002.
The Company recorded a net loss of $343,797, or $0.09 per basic and
fully diluted share, compared to a net loss of $370,461 or $0.09 per basic and
fully diluted share for the third quarters ended September 30, 2003 and 2002,
respectively. For the nine months ended September 30, 2003 and 2002 the Company
recorded a net loss of $1,136,831, or $0.29 per basic and fully diluted share,
compared to a
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net loss of $1,945,045, or $0.49 per basic and fully diluted share. The
improvement in the net loss and the net loss per share for the three and nine
months ended September 30, 2003 from the comparable periods in 2002 is due
primarily to the reasons stated above including headcount reductions, a shift in
strategic focus from retail consumer products to contract manufacturing and
aggressive reductions of operating expenses.
The provision for income tax benefits for the third quarter of fiscal
2003 and 2002 and the nine months ended September 30, 2003 and 2002 has been
offset by a valuation allowance for deferred taxes.
Inflation has not had a significant impact on the Company's operations
or cash flow.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased by $305,427 to $366,161 during the
nine-month period ended September 30, 2003 from December 31, 2002. The decrease
in cash and cash equivalents during the nine month period was primarily due to
cash used in operating activities of $169,872. Trade and other receivables
decreased $245,767 during the nine month period ended September 30, 2003 to
$73,129 from $318,896 at December 31, 2002, primarily due to increased
collections from retail sales customers. Inventories increased during the nine
month period ended September 30, 2003 from December 31, 2002 by $316,826, due
primarily to increases in raw material purchases to meet future consumer
contract manufacturing customer requirements. Accounts payable increased
$120,949 during the nine month period ended September 30, 2003 to $708,599 from
$587,650 at December 31, 2002, primarily due to increased payables related to
inventory purchases to meet ramped up customer requirements and higher sales
return exposure. Capital spending for manufacturing equipment and plant
improvements totaled $23,677 and investments in patents and trademarks totaled
$49,905 for the nine-month period ended September 30, 2003. There were no
material commitments for capital expenditures at September 30, 2003. Net cash
used in financing activities totaled $63,650 for the nine-month period ended
September 30, 2003, resulting primarily from the repayment of long-term capital
lease obligations.
The Company had a working capital deficit of $743,190 and a current
ratio of 0.73 at September 30, 2003 compared to a working capital deficit of
$1,058,534 and a current ratio of 0.67 at December 31, 2002. The improvement in
current ratio and working capital deficit during the nine month period ended
September 30, 2003 is attributable to the payoff of the $820,000 mortgage
payable related to the sale and leaseback of the Company's Minnetonka, Minnesota
corporate facility in the first quarter of 2003, offset in part by the decline
in cash and cash equivalents and trade receivables. See Note 7 of Notes to
Condensed Financial Statements on page I-7 of this report for additional
information on the corporate facility sale.
In August 2002, the Company and its bank mutually agreed to terminate a
two-year, $2,000,000 asset-based line of credit financing arrangement due to the
Company's default of covenants relating to the minimum net worth and the maximum
loss before income taxes.
In May 2002, the Company renegotiated its Supply Agreement with
Novartis Corporation (the Company's largest customer) and since that time has
been receiving advance payments from Novartis against open orders 60 days prior
to shipment. At September 30, 2003, the amount owed to Novartis under product
prepayment advances was $832,914. In exchange for this product prepayment
program, the Company agreed to pledge substantially all of its assets to secure
its obligations under the program as well as a $220,000 note payable to
Novartis. In addition, the Company granted Novartis a nonexclusive license to
produce hydrogel patches in the event that the Company defaults in its
obligation to supply patches to Novartis. The Company has also been receiving
advance product payments from other customers. Maintaining adequate levels of
working capital to support the Company's manufacturing operations has been and
will be dependent upon the continuation of these advance product payments.
In September 2003, management learned that, as a result of a change in
its internal supplier selection criteria, Novartis intends to stop using LecTec
as a contract manufacturer for its topical patches during 2004. In addition,
Johnson & Johnson Consumer Products Company has indicated that it intends to
stop using the Company as a contract manufacturer in 2004. Novartis and Johnson
& Johnson accounted for 56.8% and 17.9% of the Company's net sales for the nine
months ended September 30, 2003. Based on these anticipated changes, the Board
of Directors has determined that the Company will
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cease manufacturing operations prior to the end of the second quarter of 2004.
The Company anticipates that it will enter into a licensing agreement with
Novartis and possibly other contract manufacturing customers to enable them to
use the Company's proprietary patch technology in producing topical patch
products in the future. However, there can be no assurance that the Company will
be successful in entering into these licensing agreements. The Company currently
believes that it will be able to wind down and exit its manufacturing operations
and facility lease obligations without defaulting in its contractual obligations
to any contract manufacturing customer. However, there can be no assurance that
the Company will be able to exit manufacturing or its facility lease without
defaulting on contractual obligations or other debts which become due and
payable.
The Company expects to continue to operate at a net loss and experience
negative cash flows from operating activities for the foreseeable future. These
factors raise substantial doubt about its ability to continue as a going
concern.
In connection with the pending cessation of manufacturing operations,
the Company is planning to implement employee reduction and retention programs
to reduce the number of employees to that needed to support the wind down of
manufacturing operations while retaining those employees who are critical to
that process and to managing the Company's ongoing licensing agreements and
intellectual property portfolio. The Company is exploring its alternatives with
respect to the sale of its manufacturing assets, the renegotiation or
termination of its leases and other contractual obligations, and other
adjustments resulting directly from its exit from manufacturing. In addition,
the Company will be considering other possible fundamental changes in future
periods which could include, among other things, a sale of its remaining assets
or of the business as a whole.
It is management's intent to wind down its manufacturing operations,
sell off manufacturing assets, renegotiate its manufacturing facility lease and
fund continuing operations with royalty income from licensing agreements and /or
from other income derived from protection of rights pertaining to the Company's
intellectual property. However, there can be no assurance that the Company will
be successful in the wind down of manufacturing, selling off the manufacturing
assets, renegotiating its manufacturing facility lease, negotiation of license
agreements, or in the protection of its rights related to intellectual property.
If the Company continues in operation, funding of the Company's
operations in future years may require additional capital or other funding;
however, there can be no assurance that sources of additional capital or other
funding will be available on terms acceptable to the Company. If the Company is
not successful in winding down its manufacturing operations without defaulting
on its existing obligations, or if any additional funds required for its ongoing
operations are not available, the Company may be forced to cease operations
entirely in the near future.
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FORWARD-LOOKING STATEMENTS
From time to time, in reports filed with the Securities and Exchange
Commission (including this Form 10-Q), in press releases, and in other
communications to shareholders or the investment community, the Company may
provide forward-looking statements concerning possible or anticipated future
results of operations or business developments which are typically preceded by
the words "believes", "expects", "anticipates", "intends", "will", "may",
"should" or similar expressions. Such forward-looking statements are subject to
risks and uncertainties that could cause results or developments to differ
materially from those indicated in the forward-looking statements. Such risks
and uncertainties include, but are not limited to, the buying patterns of major
customers; competitive forces including new products or pricing pressures; costs
associated with and acceptance of the Company's TheraPatch brand strategy;
impact of interruptions to production; dependence on key personnel; need for
regulatory approvals; changes in governmental regulatory requirements or
accounting pronouncements; ability to satisfy funding requirements for operating
needs, expansion or capital expenditures; and the matters discussed on our
"Cautionary Statements" filed as Exhibit 99.1 to Form 10-K for the year ended
December 31, 2002.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has no history of, and does not anticipate in the future,
investing in derivative financial instruments, derivative commodity instruments
or other such financial instruments. Transactions with international customers
are entered into in U.S. dollars with the exception of TheraPatch sales to
Canadian customers, precluding the need for foreign currency hedges. Canadian
sales have not been material, and the Company is anticipating exiting this
market during 2003. Additionally, the Company invests in money market funds that
experience minimal volatility. Therefore, the exposure to market risk is not
material.
ITEM 4 - CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management,
including our principal executive and financial officer, we have evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13a-15 under the Securities Exchange Act of 1934)
as of the last day of the period covered by this quarterly report. Based upon
this evaluation, the principal executive and financial officer has concluded
that, as of such date, our disclosure controls and procedures were effective in
making him aware on a timely basis of the material information relating to the
Company required to be included in our periodic filings with the Securities and
Exchange Commission.
There were no significant changes made in our internal controls over
financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange
Act of 1934) during the period covered by this report that materially affected
or are reasonable likely to materially affect our internal control over
financial reporting.
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PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
None.
ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5 - OTHER INFORMATION
None.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Item No. Item
-------- ---------------------------------------------------
3.1 Articles of Incorporation of Registrant, as amended
(incorporated by reference to Exhibit 3.1 to the
Registrant's Form S-18 (File No. 33-9774C) filed on
October 31, 1986)
3.2 Bylaws of Registrant (incorporated by reference to
Exhibit 3.2 to the Registrant's Form S-18 (File No.
33-9774C) filed on October 31, 1986)
31.1 Certification of Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Acting Chief Financial Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Chief Executive Officer Certification Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002.
99.1 Cautionary Statements, incorporated herein by reference
to Exhibit 99.1 to the Company's Form 10-K for the
fiscal year ended December 31, 2002.
(b) REPORTS ON FORM 8-K
None.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LECTEC CORPORATION
Date November 18, 2003 By /s/ Timothy P. Fitzgerald
----------------- -----------------------------
Timothy P. Fitzgerald
Chief Executive Officer & President
(principal financial officer)
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