Back to GetFilings.com
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
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
HESKA CORPORATION
-----------------------------------------------------
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0192527
-------------------------------------- --------------------------------------
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OR ORGANIZATION)
1613 PROSPECT PARKWAY
FORT COLLINS, COLORADO 80525
---------------------------------------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (970) 493-7272
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
The number of shares of the Registrant's Common Stock, $.001 par value,
outstanding at August 13, 2002 was 47,650,010
================================================================================
HESKA CORPORATION
FORM 10-Q
QUARTERLY REPORT
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets (Unaudited) as of
December 31, 2001 and June 30, 2002 2
Consolidated Statements of Operations (Unaudited)
for the three months and six months ended June
30, 2001 and 2002 3
Consolidated Statements of Cash Flows (Unaudited)
for the six months ended June 30, 2001 and 2002 4
Notes to Consolidated Financial Statements (Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 27
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 28
Item 2. Changes in Securities and Use of Proceeds 28
Item 3. Defaults Upon Senior Securities Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information Not Applicable
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(dollars in thousands except per share amounts)
(unaudited)
ASSETS
DECEMBER 31, June 30,
2001 2002
-------------------- --------------------
Current assets:
Cash and cash equivalents $ 5,710 $ 3,746
Accounts receivable, net of allowance for doubtful accounts of
$501 and $230, respectively 10,313 7,501
Inventories 8,589 9,200
Other current assets 1,063 646
------------------- -------------------
Total current assets 25,675 23,549
Property and equipment, net 10,118 9,113
Goodwill and intangible assets, net 1,400 1,341
Other assets 564 433
------------------- -------------------
Total assets $ 37,757 $ 31,980
=================== ===================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 4,263 $ 5,109
Accrued liabilities 6,302 4,868
Deferred revenue 343 1,226
Line of credit 5,737 5,467
Current portion of capital lease obligations 104 62
Current portion of long-term debt 711 2,600
------------------- -------------------
Total current liabilities 17,460 19,332
Capital lease obligations, net of current portion 57 24
Long-term debt, net of current portion 2,052 686
Deferred revenue and other long-term liabilities 1,022 1,049
------------------- -------------------
Total liabilities 20,591 21,091
------------------- -------------------
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value, 25,000,000 shares authorized; none issued
or outstanding - -
Common stock, $.001 par value, 75,000,000 shares authorized; 47,842,198 and
47,647,948 shares issued and outstanding, respectively 48 48
Additional paid-in capital 211,589 211,620
Deferred compensation (681) (577)
Accumulated other comprehensive loss (627) (374)
Accumulated deficit (193,163) (199,828)
------------------- -------------------
Total stockholders' equity 17,166 10,889
------------------- -------------------
Total liabilities and stockholders' equity $ 37,757 $ 31,980
=================== ===================
See accompanying notes to consolidated financial statements
2
HESKA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ ------------------------
2001 2002 2001 2002
--------- --------- ---------- ---------
Revenue:
Products, net of sales returns and allowance $ 10,700 $ 11,963 $ 21,014 $ 21,884
Research, development and other 238 261 850 505
---------- ----------- ---------- ----------
Total revenue 10,938 12,224 21,864 22,389
Cost of products sold 6,990 7,157 13,204 13,056
---------- ----------- ---------- ----------
3,948 5,067 8,660 9,333
---------- ----------- ---------- ----------
Operating expenses:
Selling and marketing 3,584 3,155 7,142 6,332
Research and development 3,118 2,209 6,573 5,125
General and administrative 1,859 1,813 4,023 3,548
Restructuring and other expenses - 621 - 857
---------- ----------- ---------- ----------
Total operating expenses 8,561 7,798 17,738 15,862
---------- ----------- ---------- ----------
-
Loss from operations (4,613) (2,731) (9,078) (6,529)
Other income (expense), net (51) (43) (158) (136)
Net loss $ (4,664) $ (2,774) $ (9,236) $ (6,665)
========== =========== ========== ===========
Basic and diluted net loss per share $ (0.12) $ (0.06) $ (0.24) $ (0.14)
========== =========== ========== ===========
Shares used to compute basic and diluted net loss per share 38,673 47,804 37,855 47,820
========== =========== =========== ===========
See accompanying notes to consolidated financial statements
3
HESKA CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
SIX MONTHS ENDED
JUNE 30,
-------------------------------
2001 2002
----------- ------------
CASH FLOWS USED IN OPERATING ACTIVITIES:
Net loss $ (9,236) $ (6,665)
Adjustments to reconcile net loss to cash used in operating activities:
Depreciation and amortization 1,891 1,243
Amortization of intangible assets and deferred compensation 133 139
Changes in operating assets and liabilities:
Accounts receivable, net 1,185 2,812
Inventories (866) (611)
Other current assets 412 417
Other long-term assets 191 190
Accounts payable 328 846
Accrued liabilities (1,339) (1,434)
Deferred revenue and other long-term liabilities (89) 910
Other (157) -
----------- -----------
Net cash used in operating activities $ (7,547) $ (2,153)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sale of marketable securities 2,500 -
Proceeds from disposition of property and equipment 67 -
Purchase of property and equipment (440) (242)
----------- -----------
Net cash provided by (used in) investing activities 2,127 (242)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 5,435 31
Proceeds from borrowings 2,658 1,000
Repayments of debt and capital lease obligations (1,091) (822)
----------- -----------
Net cash provided by financing activities 7,002 209
----------- -----------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS (156) 222
----------- -----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,426 (1,964)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,176 5,710
----------- -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 4,602 $ 3,746
=========== ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 271 $ 190
=========== ===========
See accompanying notes to consolidated financial statements
4
HESKA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2002
(UNAUDITED)
1. ORGANIZATION AND BUSINESS
Heska Corporation ("Heska" or the "Company") is primarily focused on the
discovery, development, manufacturing and marketing of companion animal health
products and delivery of diagnostic services to veterinarians. The Company
currently conducts its operations through two reportable segments. Through its
Companion Animal Health segment, the Company sells diagnostic, vaccine and
pharmaceutical products and veterinary diagnostic and patient monitoring
instruments, offers diagnostic services, and performs a variety of research and
development activities. The operations of this segment are carried out through
the Company's facilities in Fort Collins, Colorado, and its wholly owned Swiss
subsidiary, Heska AG. Through its Food Animal Health segment, the Company
manufactures food animal vaccine and pharmaceutical products that are marketed
and distributed by third parties. The operations of this segment are carried
out through the Company's wholly owned subsidiary Diamond Animal Health, Inc.
("Diamond"), located in Des Moines, Iowa.
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 revenue 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, hiring key
employees and support staff, establishing marketing and sales operations to
support new Heska products, 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 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 Heska AG (formerly Centre
Medical des Grand'Places S.A.) in Fribourg, Switzerland, which manufactures and
markets allergy diagnostic products primarily in Europe.
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 June 30, 2002 have totaled $199.8
million. During the six months ended June 30, 2002, the Company incurred a loss
of approximately $6.7 million and used cash of approximately $2.2 million for
operations.
The Company's primary short-term needs for capital are its continuing
research and development efforts, its sales, marketing and administrative
activities, working capital associated with increased product sales and capital
expenditures relating to maintaining and developing its manufacturing
operations. 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 and develop new products. Many of
the Company's products are subject to long development and regulatory approval
cycles and there can be no guarantee that the Company will successfully develop,
manufacture or market these products. There can also be no guarantee that
5
the Company will attain profitability or, if achieved, will remain profitable
on a quarterly or annual basis in the future.
The Company believes that its available cash and cash equivalents, together
with cash from operations, borrowings expected to be available under its
revolving line of credit facility, cash from the license of the rights to its
Flu AVERT I.N. product (see Note 10) and other sources discussed below, should
be sufficient to satisfy its projected cash requirements through June 30, 2003.
Other potential sources to raise additional funds include one or more of the
following: (1) obtaining new loans secured by unencumbered assets; (2) sale of
various products or marketing rights; (3) licensing of technology; (4) sale of
various assets; and (5) sale of additional equity or debt securities.
Under the Company's revolving line of credit agreement with Wells Fargo
Business Credit, it is required to comply with various financial and non-
financial covenants, and the Company has made various representations and
warranties. Among the financial covenants is a requirement to maintain $2.5
million of minimum liquidity (cash plus excess borrowing base). Additional
requirements include covenants for minimum capital monthly and minimum
net income quarterly. The Company currently believes it is not likely to be
able to meet its existing covenants for minimum net income and minimum book
capital in future periods. The Company intends to negotiate modifications or
a waiver of these covenants. The Company has obtained modifications and a
waiver of covenants in the past, although there can be no assurance it can
obtain similar modifications or waivers in the future.
Failure to comply with any of the covenants, representations or warranties
could result in the Company being in default under the loan and could cause all
outstanding amounts to become immediately due and payable or impact the
Company's ability to borrow under the agreement. All amounts due under the
credit facility mature on May 31, 2003. The Company intends to rely on
available borrowings under the credit agreement to fund its operations through
2002 and into 2003. If the Company is unable to borrow funds under this
agreement, it will need to raise additional capital to fund its cash needs and
continue its operations. If the Company is unable to extend or refinance the
borrowings under the credit facility as of, or before, May 31, 2003, or complete
other options to meet its cash needs created by maturing debt, it may be unable
to continue as a going concern.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. The balance sheet as of June 30, 2002, the statements of
operations for the three months and six months ended June 30, 2002 and 2001 and
the statements of cash flows for the six months ended June 30, 2002 and 2001 are
unaudited but include, in the opinion of management, all adjustments (consisting
of normal recurring adjustments) which the Company considers necessary for a
fair presentation of its financial position, operating results and cash flows
for the periods presented. All material intercompany transactions and balances
have been eliminated in consolidation. Although the Company believes that the
disclosures in these financial statements are adequate to make the information
presented not misleading, certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to the rules and
regulations of the Securities and Exchange Commission.
Results for any interim period are not necessarily indicative of results
for any future interim period or for the entire year. The accompanying
financial statements and related disclosures have been prepared with the
presumption that users of the interim financial information have read or have
access to the audited financial statements for the preceding fiscal year.
Accordingly, these financial statements should be read in conjunction with the
audited financial statements and the related notes thereto for the year ended
December 31, 2001,
6
included in the Company's Annual Report on Form 10-K filed with the Securities
and Exchange Commission on April 1, 2002.
Basic and Diluted Net Loss Per Share
Basic net loss per common share is computed using the weighted average
number of common shares outstanding during the period. Diluted net loss per
share is computed using the sum of the weighted average number of shares of
common stock outstanding and, if not anti-dilutive, the effect of outstanding
common stock equivalents (such as stock options and warrants) determined using
the treasury stock method. Since inception, due to the Company's net losses,
all potentially dilative dilutive securities are anti-dilutive and as a result,
basic and net loss per share is the same as diluted net loss per share for all
periods presented. At June 30, 2001 and 2002, outstanding options and warrants
to purchase 6,162,416 and 6,553,530 shares, respectively, of the Company's
common stock have been excluded from diluted net loss per share because they are
anti-dilutive.
3. MAJOR CUSTOMERS
One customer accounted for approximately 11% and 12% of total revenues for
the Company for the three months ended June 30, 2001 and 2002, respectively.
This same customer accounted for approximately 11% and 11% of total revenues for
the six months ended June 30, 2001 and 2002, respectively. At June 30, 2002,
this customer accounted for approximately 17% of total accounts receivable. No
single customer accounted for 10% or more of total accounts receivable at June
30, 2001. This customer purchased vaccines from Diamond.
4. RESTRUCTURING AND OTHER EXPENSES
The Company recorded a one time charge to other operating expenses during
the second quarter of 2002 totaling approximately $621,000 related to personnel
severance costs.
The Company recorded a restructuring charge in the first quarter of 2002.
The charge to operations of approximately $566,000 related primarily to
personnel severance costs for 32 individuals and the costs associated with
disposal of leased vehicles and other costs for certain of the employees.
In the fourth quarter of 2001, the Company recorded a $1.5 million
restructuring charge related to a strategic change in its distribution model and
the consolidation of its European operations into one facility. This expense
related to personnel severance costs, costs to adjust the Company's products to
align with the new distribution model and the cost to close a leased facility in
Europe. During the first quarter of 2002, the Company revised its cost
estimates related to the restructuring charge recorded in the fourth quarter of
2001 as certain liabilities were favorably settled. This change in estimate was
approximately $330,000 and was offset against the restructuring charge recorded
in the first quarter of 2002 as described above.
Shown below is a reconciliation of restructuring costs for the six months
ended June 30, 2002 (in thousands):
PAYMENTS FOR THE
BALANCE AT ADDITIONS FOR THE SIX BALANCE AT
DECEMBER 31, SIX MONTHS ENDED MONTHS ENDED JUNE 30,
2001 JUNE 30, 2002 JUNE 30, 2002 OTHER 2002
------------------ ------------------ ------------------ ------------------ ------------------
Severance pay and benefits $ 378 $ 466 $ (543) $ (6) $ 295
Leased facility closure costs 50 - (50) - -
Products and other 1,100 100 (583) (324) 293
-------------- -------------- ------------- ------------- --------------
Total $ 1,528 $ 566 $ (1,176) $ (330) $ 588
============== ============== ============= ============= ==============
7
5. GOODWILL AND INTANGIBLES
The Company adopted SFAS No. 141, "Business Combinations" and SFAS No. 142,
"Goodwill and Other Intangible Assets" effective as of January 1, 2002. SFAS
No. 141 requires that all business combinations initiated after June 30, 2001 be
accounted for using the purchase accounting method. SFAS No. 142 states that
goodwill is no longer subject to amortization over its useful life. Rather,
goodwill will be subject to an annual assessment for impairment and be written
down to its fair value only if the carrying amount is greater than the fair
value. In addition, intangible assets will be separately recognized if the
benefit of the intangible asset is obtained through contractual or other legal
rights, or if the intangible asset can be sold, transferred, licensed, rented or
exchanged, regardless of the acquirer's intent to do so. The amount and timing
of non-cash charges related to intangibles acquired in business combinations
will change significantly from prior practice.
The Company's recorded goodwill relates to the acquisition in 1997 of Heska
AG, and beginning in fiscal 2002 it is no longer amortized on a periodic basis.
The balance at June 30, 2002 is approximately $643,000. No impairment was
recognized and there were no other changes to the goodwill balance during the
six months ended June 30, 2002. This goodwill is included in the assets of the
Companion Animal Health segment.
The Company has net intangible assets related to capitalized patent costs
totaling approximately $698,000 as of June 30, 2002. These costs are being
amortized over an average life of 15 years. Amortization expense for the six
months ended June 30, 2002, was approximately $34,000. There are no
additional intangible assets not being amortized on a periodic basis. These
intangible assets are included in the assets of the Companion Animal Health
segment.
The following reflects the impact on the Company's financial results of
amortization expense for goodwill and other intangible assets during the prior
three fiscal years. There was no material impact for the six months ended June
30, 2002. (In thousands except per share amounts):
FOR THE YEAR ENDED DECEMBER 31,
---------------------------------------------------------------
1999 2000 2001
----------------- ----------------- -----------------
Reported net loss $ (35,836) $ (21,870) $ (18,691)
Add back: Goodwill amortization 241 209 210
------------- -------------- -------------
Adjusted net loss $ (35,595) $ (21,661) $ (18,481)
============= ============= =============
Basic and diluted earnings per share:
Reported net loss $ (1.31) $ (0.65) $ (0.48)
Goodwill amortization 0.01 0.01 0.01
------------- ------------- -------------
Adjusted net loss $ (1.30) $ (0.64) $ (0.47)
============= ============= =============
6. SEGMENT REPORTING
The Company's business is comprised of two reportable segments, Companion
Animal Health and Food Animal Health. Within the Companion Animal Health
segment products include pharmaceuticals, vaccines and diagnostics and
veterinary diagnostic and patient monitoring instruments. These products are
sold through operations in Fort Collins, Colorado and Europe. Within the Food
Animal Health segment, products include food animal vaccines and
pharmaceuticals. Food Animal Health products are manufactured at, and sold by,
the Company's Diamond Animal Health subsidiary in Des Moines, Iowa.
Non-product revenues are generated from sponsored research and development
projects for third parties, licensing of technology and royalties. These
sponsored research and development projects are performed for both companion
animal and food animal purposes.
8
Summarized financial information concerning the Company's reportable
segments is shown in the following table (in thousands).
COMPANION FOOD
ANIMAL ANIMAL
HEALTH HEALTH INTERCOMPANY TOTAL
------------- -------------- -------------- --------------
THREE MONTHS ENDED
JUNE 30, 2002:
Revenue $ 9,300 $ 3,149 $ (225) $ 12,224
Operating income (loss) (3,315) 584 - (2,731)
Total assets 46,270 24,347 (38,637) 31,980
Capital expenditures - 170 (25) 145
Depreciation and amortization 319 297 - 616
THREE MONTHS ENDED
JUNE 30, 2001:
Revenue $ 8,351 $ 3,193 $ (606) $ 10,938
Operating income (loss) (4,710) 97 - (4,613)
Total assets 49,106 18,091 (31,533) 35,664
Capital expenditures 101 39 - 140
Depreciation and amortization 564 365 - 929
COMPANION FOOD
ANIMAL ANIMAL
HEALTH HEALTH INTERCOMPANY TOTAL
------------- -------------- ------------- --------------
SIX MONTHS ENDED
JUNE 30, 2002:
Revenue $ 17,132 $ 6,070 $ (813) $ 22,389
Operating income (loss) (7,347) 818 - (6,529)
Total assets 46,270 24,347 (38,637) 31,980
Capital expenditures 97 170 (25) 242
Depreciation and amortization 635 608 - 1,243
SIX MONTHS ENDED
JUNE 30, 2001:
Revenue $ 16,463 $ 6,555 $ (1,154) $ 21,864
Operating income (loss) (9,266) 188 - (9,078)
Total assets 49,106 18,091 (31,533) 35,664
Capital expenditures 204 236 - 440
Depreciation and amortization 1,128 763 - 1,891
The Company manufactures and markets its products in two major geographic
areas, North America and Europe. The Company's primary manufacturing facilities
are located in North America. Revenues earned in North America are attributable
to Heska and Diamond. Revenues earned in Europe are primarily attributable to
Heska AG. There have been no significant exports from North America or Europe.
During each of the years presented, 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.
Certain information by geographic area is shown in the following table (in
thousands).
9
NORTH AMERICA EUROPE INTERCOMPANY TOTAL
--------------- --------------- ----------------- ----------------
THREE MONTHS ENDED
JUNE 30, 2002:
Revenue $ 11,832 $ 617 $ (225) $ 12,224
Operating income (loss) (2,728) (3) - (2,731)
Total assets 68,509 2,108 (318,637) 31,980
Capital expenditures 99 71 (25) 145
Depreciation and amortization 528 88 - 616
THREE MONTHS ENDED
JUNE 30, 2001:
Revenue $ 11,089 $ 455 $ (606) $ 10,938
Operating income (loss) (4,471) (142) - (4,613)
Total assets 65,152 2,045 (31,533) 35,664
Capital expenditures 140 - - 140
Depreciation and amortization 913 16 - 929
NORTH AMERICA EUROPE INTERCOMPANY TOTAL
--------------- --------------- ----------------- -----------------
SIX MONTHS ENDED
JUNE 30, 2002:
Revenue $ 21,978 $ 1,224 $ (813) $ 22,389
Operating income (loss) (6,558) 29 - (6,529)
Total assets 68,509 2,108 (38,637) 31,980
Capital expenditures 195 72 (25) 242
Depreciation and amortization 1,110 133 - 1,243
SIX MONTHS ENDED
JUNE 30, 2001:
Revenue $ 21,974 $ 1,045 $ (1,155) $ 21,864
Operating income (loss) (8,870) (208) - (9,078)
Total assets 65,152 2,045 (31,533) 35,664
Capital expenditures 440 - - 440
Depreciation and amortization 1,868 23 - 1,891
7. CREDIT FACILITY
In March 2002, the Company entered into an amendment to its revolving line
of credit facility. The Company's ability to borrow under this agreement varies
based upon available cash, eligible accounts receivable and eligible inventory.
The minimum liquidity (cash plus excess borrowing base) required to be
maintained has been reduced to $2.5 million during 2002. The Company had
borrowed approximately $5.5 million under its revolving line of credit as of
June 30, 2002. As of June 30, 2002, the Company's remaining available borrowing
capacity was approximately $500,000. The credit facility expires on May 31,
2003.
8. COMPREHENSIVE INCOME
Comprehensive income includes net income (loss) plus the results of certain
stockholders' equity changes not reflected in the Consolidated Statements of
Operations. Such changes include foreign currency items, unrealized gains and
losses on certain investments in marketable securities and unrealized gains and
losses on derivative instruments. Total comprehensive income and the components
of comprehensive income follow (in thousands):
10
THREE MONTHS ENDED
JUNE 30,
----------------------------------------------
2001 2002
-------------------- --------------------
Net loss per Consolidated Statements of Operations $ (4,664) $ (2,774)
Foreign currency translation adjustments 14 95
Changes in unrealized gains (losses) on forward contracts, net of realized
gains (losses) (68) 14
Comprehensive loss $ (4,718) $ (2,665)
=============== ================
SIX MONTHS ENDED
JUNE 30,
----------------------------------------------
2001 2002
-------------------- --------------------
Net loss per Consolidated Statements of Operations $ (9,236) $ (6,665)
Foreign currency translation adjustments (143) 229
Changes in unrealized gains (losses) on forward contracts, net of realized
gains (losses) (68) 24
Changes in unrealized loss on marketable securities 44 -
---------------- ----------------
Comprehensive loss $ (9,403) $ (6,412)
================ ================
Accumulated gains and losses from derivative contracts are as follows:
2001 2002
----------------- -----------------
Accumulated derivative gains (losses), December 31 $ - $ (24)
Unrealized losses on forward contracts (68) -
Realized losses on forward contracts reclassified to current earnings - 24
------------ -----------
Accumulated derivative gains (losses), June 30 $ (68) $ -
============ ===========
9. RELATED PARTY TRANSACTIONS
In December 1999, the Company approved a personal loan to Dr. Grieve, its
Chairman and Chief Executive Officer, for $100,000. This loan is evidenced by a
promissory note that was originally due and payable on December 23, 2002. The
terms of this loan were modified in May 2002 to permit the payment of all
interest due on December 23, 2002 and to extend the term of the loan for an
additional three years or until December 23, 2005. Interest on the outstanding
principal balance accrues at the rate of 5.74% per annum. Payment of any unpaid
principal balance together with all accrued and unpaid interest can be
accelerated and become payable within ninety days after Dr. Grieve's
relationship with us is terminated for any reason other than Dr. Grieve's death
or permanent disability.
10. SUBSEQUENT EVENT
On July 30, 2002, the Company agreed to license rights to certain patents,
trademarks and know-how for its Flu AVERT I.N. vaccine to Intervet. For these
rights, the Company received an undisclosed upfront cash payment and may be
entitled to future milestone and royalty payments.
11
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion contains forward-looking statements that involve risks and
uncertainties. 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, but not limited to, those
discussed below and elsewhere in this Form 10-Q, particularly in "Factors that
May Affect Results," that could cause actual results to differ materially from
those projected. The forward-looking statements set forth in this Form 10-Q are
as of the date of this filing, and we undertake no duty to update this
information.
CORPORATE OVERVIEW
We discover, develop, manufacture and market companion animal health
products, principally for dogs and, cats and horses. We employ approximately 60
scientists, of whom over one quarter hold doctoral degrees, with expertise in
several disciplines including microbiology, immunology, genetics, biochemistry,
molecular biology, parasitology and veterinary medicine. This scientific
expertise is focused on the development of a broad range of diagnostic, vaccine
and pharmaceutical products for companion animals. We also sell veterinary
diagnostic and patient monitoring instruments and offer diagnostic services to
veterinarians in the United States and Europe, principally for companion
animals. In addition to manufacturing companion animal health products for
marketing and sale by Heska, our Diamond Animal Health subsidiary manufactures
food animal vaccines and other food animal products that are marketed and
distributed by other animal health companies.
OUR BUSINESS
We currently market our products in the United States to veterinarians
through approximately 20 independent third-party distributors and through a
direct sales force. Nearly one-half of these domestic distributors purchase the
full line of our diagnostic, vaccine, pharmaceutical and instrumentation
products. We have recently begun to rely on distributors for a greater portion
of our sales.
Our business is comprised of two reportable segments, Companion Animal
Health and Food Animal Health. Within the Companion Animal Health segment, our
products include diagnostics, vaccines and pharmaceuticals and veterinary
diagnostic and patient monitoring instruments. These products are sold through
our operations in Fort Collins, Colorado and Europe. Within the Food Animal
Health segment, we sell food animal vaccine and pharmaceutical products. We
manufacture these food animal products at our Diamond Animal Health subsidiary,
located in Des Moines, Iowa.
Additionally, we generate non-product revenues from sponsored research and
development projects for third parties, licensing of technology and royalties.
We perform these sponsored research and development projects for both companion
animal and food animal purposes.
CRITICAL ACCOUNTING POLICIES
The Company's discussion and analysis of its financial condition and
results of operations is based upon the consolidated financial statements, which
have been prepared in accordance with U.S. generally accepted accounting
principles ("GAAP"). The preparation of financial statements in conformity with
GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the
12
disclosure of contingent assets and liabilities as of the date of the financial
statements, and the reported amounts of revenue and expenses during the periods.
These estimates are based on historical experience and various other assumptions
that we believe to be reasonable under the circumstances. Actual results may
differ materially from these estimates under different assumptions or
conditions. Our critical accounting policies include:
* We generate our revenue through sale of products, licensing of technology
and sponsored research and development. Revenue is accounted for in
accordance with the guidelines provided by Staff Accounting Bulletin 101
"Revenue Recognition in Financial Statements" (SAB 101). Our policy is
to recognize revenue when the applicable revenue recognition criteria
have been met, which generally include the following:
- Persuasive evidence of an arrangement exists;
- Delivery has occurred or services rendered;
- Price is fixed or determinable; and
- Collectibility is reasonably assured.
Revenue from the sale of products is generally recognized after both the
goods are shipped to the customer and acceptance has been received with
an appropriate provision for returns and allowances. The terms of the
customer arrangements generally pass title and risk of ownership to the
customer at the time of shipment. Certain customer arrangements provide
for acceptance provisions. Revenue for these arrangements is not
recognized until the acceptance has been received or the acceptance
period has lapsed.
In addition to its direct sales force, we utilize third-party
distributors to sell our products. Distributors purchase goods from us,
take title to those goods and resell them to their customers in the
distributors' territory.
License revenues under arrangements to sell product rights or technology
rights are recognized upon the sale and completion by us of all
obligations under the agreement. Royalties are recognized as products
are sold to customers.
We recognize revenue from sponsored research and development over the
life of the contract as research activities are performed. The revenue
recognized is the lesser of revenue earned under a percentage of
completion method based on total expected revenues or actual non-
refundable cash received to date under the agreement.
* Inventories are stated at the lower of cost or market, cost being
determined on the first-in, first-out method. Inventories are written
down if the estimated net realizable value is less than the recorded
value.
RESULTS OF OPERATIONS
Revenue
Total revenue, which includes product revenue as well as research,
development and other revenue increased 12% to $12.2 million in the second
quarter of 2002 compared to $10.9 million for the second quarter of 2001. Year-
to-date, total revenue increased 2% to $22.4 million from $21.9 million for the
six-month period ended June 30, 2001.
Product revenue for the three months ended June 30, 2002, increased by 12%
to $12.0 million compared to $10.7 million in the same period of 2001. Product
revenue in our Companion Animal Health segment grew by over 12% to $9.2 million
from $8.2 million in same period of 2001. Product revenue from this segment of
our
13
business includes diagnostics, vaccines, pharmaceuticals and medical
instrumentation. This growth was driven by increased sales of our medical
instrument reagents and consumables, sales of our most recent product
introduction the E.R.D.-Screen (TM) urine test for early renal disease in dogs,
increased export sales of our canine heartworm diagnostic for Japanese
distribution and increased sales of our SpotChem EZ clinical chemistry system,
offset somewhat by declines in sales of our heartworm diagnostic products in the
United States.
Product revenue increased 4% to $21.9 million for the first half of 2002
compared to $21.0 million for the first half of 2001. Product revenue for the
first six months of 2002 in our Companion Animal Health segment grew by nearly
7% to $16.8 million from $15.7 million in same period of 2001. This growth was
driven by increased sales of our medical instrument reagents and consumables,
increased sales of our SpotChem (TM) EZ clinical chemistry system, sales of our
most recent product introduction the E.R.D.-Screen (TM) urine test for early
renal disease in dogs and increased export sales of our canine heartworm
diagnostic for Japanese distribution, offset somewhat by declines in sales of
our heartworm diagnostic products in the United States.
Product revenue in our Food Animal Health segment for the three months
ended June 30, 2002, grew by nearly 10% to $2.8 million compared to $2.5 million
in the second quarter of 2001. This increase was due to special orders for
pharmaceuticals from an existing customer. Product revenue in the first half of
2002 from the Food Animal Health segment of the business decreased 4% to $5.1
million from $5.3 million in the first half of last year.
Revenue from research, development and other sources were up slightly in
the second quarter of 2002 as compared to the second quarter of 2001. This same
revenue for the first half of 2002 was down $345,000 compared to the first half
of 2001 due primarily to non-recurring revenue from a sponsored product
development project in last year's first quarter.
Cost of Products Sold
Cost of products sold totaled $7.2 million in the second quarter of 2002
compared to $7.0 million in the second quarter of 2001. Gross profit as a
percentage of product sales increased to 40.2% in the second quarter of 2002
compared to 34.7% in the same quarter last year. Cost of products sold totaled
$13.1 million for the first half of 2002 compared to $13.2 million for the first
half of 2001. Gross profit as a percentage of product sales increased to 40.3%
for the six months ended June 30, 2002, compared to 37.2% for the same period
last year. These improvements in gross profit reflect the increase in sales of
our proprietary PVD products, increased sales of instrument reagents and
consumables and improved margins at Diamond. We expect gross profit as a
percentage of product sales to continue to improve as we increase the sales of
our higher margin proprietary PVD products and the increased sales of instrument
reagents and consumables.
Operating Expenses
Selling and marketing expenses decreased 12% to $3.2 million in the second
quarter of 2002 compared to $3.6 million in the second quarter of 2001. Selling
and marketing expenses decreased 11% to $6.3 million for the first half of 2002
compared to $7.1 million for the same period in 2001. Both decreases are due
primarily to lower personnel and related costs. We expect selling and marketing
expense as a percentage of total sales to decrease in the future as we continue
to increase sales from our business.
Research and development expenses decreased 29% to $2.2 million in the
second quarter of 2002 from $3.1 million in the second quarter of 2001.
Research and development expenses decreased 22% to $5.1 million for the first
half of 2002 compared to $6.6 million for the first half of 2001. These
decreases are due primarily to lower personnel costs. We expect research and
development expense as a percentage of total sales to decrease in the future as
we continue to increase sales from our business.
14
General and administrative expenses decreased 2% to $1.8 million in the
second quarter of both 2002 and from $1.9 million in the second quarter of 2001
due to lower depreciation costs. General and administrative expenses decreased
12% to $3.5 million for the first half of 2002 compared to $3.94.0 million for
the same period in 2001 due to lower personnel and depreciation costs. We
expect general and administrative expense as a percentage of total sales to
decrease in the future as we continue to increase sales from our business and
continue our disciplined management of operating expenses.
Restructuring Expenses and Other
During the second quarter of 2002, we recorded a one time charge to other
operating expenses of $621,000 related to personnel severance costs and other
related expenses. In the first quarter of 2002, we recorded a restructuring
charge $566,000 for personnel severance costs and other related expenses
related to 32 individuals. We also reversed approximately $330,000 of the
restructuring charge recorded in the fourth quarter of 2001 due to the
favorable settlement of certain liabilities. For the six months ended June
30, 2002, we recorded net restructuring and other expenses totaling $857,000.
Net Loss
For the quarter ended June 30, 2002, our net loss declined to $2.8 million
from $4.7 million in the second quarter of the prior year. The net loss per
common share in the second quarter of 2002 was $0.06, compared with a net loss
per common share of $0.12 in the second quarter of the prior year. Our net loss
for the first half of 2002 decreased to $6.7 million compared to $9.2 million in
the same period of 2001. The net loss per common share decreased to $0.14 for
the first half of this year compared to $0.24 for the first half of 2001.
LIQUIDITY AND CAPITAL RESOURCES
We have incurred negative cash flow from operations since inception in
1988. Our negative operating cash flows have been funded primarily through the
sale of common stock and borrowings. At June 30, 2002, we had cash and cash
equivalents of $3.7 million.
We amended our credit agreement with our lender in March 2002 to set the
financial covenants for 2002 and extend the maturity date of the loans an
additional year to May 31, 2003. If our lender imposes additional loan
covenants or other credit requirements that would prevent us from accessing the
full amount of our line of credit, we would need to raise additional capital to
fund any shortfall from our borrowings expected to be available under the
revolving line of credit. We anticipate that any additional capital would be
raised through one or more of the following:
* obtaining new loans secured by unencumbered assets;
* sale of various products or marketing rights;
* licensing of technology;
* sale of various assets; and
* sale of additional equity or debt securities.
At June 30, 2002, we had outstanding obligations for long-term debt and
capital leases totaling $3.4 million primarily related to two term loans with
Wells Fargo Business Credit and a promissory note from one of Diamond's
customers. One of these two term loans is secured by real estate at Diamond and
had an outstanding balance at June 30, 2002 of $1.7 million due in monthly
installments of $17,658 plus interest, with a balloon payment of approximately
$1.5 million due on May 31, 2003. The other term loan is secured by machinery
and equipment at Diamond and had an outstanding balance at June 30, 2002 of
approximately $576,000 payable in monthly installments of $18,667 plus interest,
with a balloon payment of approximately $370,000 due on May 31, 2003. Both
loans have a stated interest rate of prime plus 1.25%. The promissory note with
Diamond's customer is payable in three annual installments beginning April 15,
2003 and bears interest at prime plus 0.25%. In addition, Diamond has
promissory notes to the Iowa Department of Economic
15
Development and the City of Des Moines with outstanding balances at June 30,
2002 of $28,000 and $43,000, respectively, due in annual and monthly
installments through June 2004 and May 2004, respectively. Both promissory
notes have a stated interest rate of 3.0% and an imputed interest rate of 9.5%.
The notes are secured by first security interests in essentially all of
Diamond's assets and both lenders have subordinated their first security
interest to Wells Fargo. We also had $240,000 of equipment financing which was
paid in full in January 2002. Our capital lease obligations totaled $86,000 at
June 30, 2002.
We also have a $10.0 million asset-based revolving line of credit with
Wells Fargo Business Credit. Available borrowings under this line of credit are
based upon percentages of our eligible domestic accounts receivable and domestic
inventories. Interest is charged at a stated rate of prime plus 1% and is
payable monthly. Our ability to borrow under this facility varies based upon
available cash, eligible accounts receivable and eligible inventory. The line
of credit has a maturity date of May 31, 2003. At June 30, 2002, our
outstanding borrowings under the line of credit were $5.5 million and we had
remaining available borrowing capacity of $500,000.
Net cash used in operating activities was $2.2 million for the first six
months of 2002, compared to $7.5 million for the same period in 2001. The
improvement was primarily due to the lower net loss, increases in accounts
receivable collections and higher accounts payable balances.
Net cash flows from investing activities used $242,000 during the first
half of 2002, compared to providing $2.1 million in the same period of 2001.
The higher cash provided in 2001 resulted from the sale of our marketable
securities.
Net cash flows from financing activities provided $209,000 during the first
six months of 2002 compared to providing $7.0 million for the same period last
year. The cash provided in 2001 was the result of approximately $5.3 million of
net proceeds from a private placement of our common stock plus $2.7 million of
borrowings against our line of credit, offset by debt repayments.
Our primary short-term needs for capital are our continuing research
and development efforts, our sales, marketing and administrative activities,
working capital associated with increased product sales and capital expenditures
relating to maintaining and developing our manufacturing operations. Our future
liquidity and capital requirements will depend on numerous factors, including
the extent to which our 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 our 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 our business and the results
of competition.
We believe that our available cash and cash equivalents, together with cash
from operations, borrowings expected to be available under our revolving line of
credit facility, cash from the license of the rights to our Flu AVERT I.N.
product (see Note 10) and other sources discussed below, should be sufficient to
satisfy our projected cash requirements through June 30, 2003. Other potential
sources to raise additional funds include one or more of the following: (1)
obtaining new loans secured by unencumbered assets; (2) sale of various products
or marketing rights; (3) licensing of technology; (4) sale of various assets;
and (5) sale of additional equity or debt securities.
Under our revolving line of credit agreement with Wells Fargo Business
Credit, we are required to comply with various financial and non-financial
covenants, and we have made various representations and warranties. Among the
financial covenants is a requirement to maintain $2.5 million of minimum
liquidity (cash plus excess borrowing base). Additional requirements include
covenants for minimum capital monthly and minimum net income quarterly.
We currently believe we are not likely to be able to meet our existing
covenants for minimum net income and minimum book capital in future periods.
We intend to negotiate modifications or a
16
waiver of these covenants. We have obtained modifications and a waiver of
covenants in the past, although there can be no assurance we can obtain
similar modifications or waivers in the future.
Failure to comply with any of the covenants, representations or warranties
could result in our being in default under the loan and could cause all
outstanding amounts to become immediately due and payable or impact our ability
to borrow under the agreement. All amounts due under the credit facility mature
on May 31, 2003. We intend to rely on available borrowings under the credit
agreement to fund our operations through 2002 and into 2003. If we are unable
to borrow funds under this agreement, we will need to raise additional capital
to fund our cash needs and continue our operations. If we are unable to extend
or refinance the borrowings under the credit facility as of, or before, May 31,
2003, or complete other options to meet our cash needs created by maturing debt,
we may be unable to continue as a going concern. See "Factors that May Affect
Results."
A summary of our contractual obligations at June 30, 2002 is shown below
(amounts in thousands).
PAYMENTS DUE BY PERIOD
---------------------------------------------------------------------------------------
LESS THAN 1-3 4-5 AFTER
TOTAL 1 YEAR YEARS YEARS 5 YEARS
--------------- -------------- -------------- -------------- --------------
CONTRACTUAL OBLIGATIONS
Long-Term Debt $ 3,286 $ 2,600 $ 686 $ - $ -
Capital Lease Obligations 86 62 24 - -
Line of Credit 5,467 5,467 - - -
Operating Leases 2,298 460 1,707 131 -
Unconditional Purchase Obligations 2,909 102 2,007 800 -
Other Long-Term Obligations 149 - - - 149
Total Contractual Cash Obligations $ 14,195 $ 8,691 $ 4,424 $ 931 $ 149
RECENT ACCOUNTING PRONOUNCEMENTS
The Company adopted SFAS No. 141, "Business Combinations" and SFAS No. 142,
"Goodwill and Other Intangible Assets" effective as of January 1, 2002. SFAS
No. 141 requires that all business combinations initiated after June 30, 2001 be
accounted for using the purchase accounting method. SFAS No. 142 states that
goodwill is no longer subject to amortization over its useful life. Rather,
goodwill will be subject to an annual assessment for impairment and be written
down to its fair value only if the carrying amount is greater than the fair
value. In addition, intangible assets will be separately recognized if the
benefit of the intangible asset is obtained through contractual or other legal
rights, or if the intangible asset can be sold, transferred, licensed, rented or
exchanged, regardless of the acquirer's intent to do so. The amount and timing
of non-cash charges related to intangibles acquired in business combinations
will change significantly from prior practice.
On January 1, 2002, the Company adopted SFAS No. 144, "Accounting for the
Impairment or disposal of Long-Lived Assets" ("SFAS 144"). SFAS 144 supersedes
SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of" ("SFAS 121"). The primary objectives of SFAS 144 were
to develop one accounting model based on the framework established in SFAS 121
for long-lived assets to be disposed of by sale, and to address significant
implementation issues. The adoption of SFAS 144 did not have a material impact
on the Company's financial position or results of operations.
In June 2002, the Financial Accounting Standards Board issued SFAS 146,
"Accounting for Costs Associated with Exit or Disposal Activities" (SFAS 146).
This statement addresses financial accounting and reporting for costs associated
with exit or disposal activities and nullifies Emerging Issues Task Force Issue
No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)." The Company will adopt the provisions of this statement during
the first quarter of 2003. The adoption of this statement will have an impact
on the accounting for future exit or disposal activities, if any.
17
FACTORS THAT MAY AFFECT RESULTS
Our future operating results may vary substantially from period to period
due to a number of factors, many of which are beyond our control. The following
discussion highlights these factors and the possible impact of these factors on
future results of operations. If any of the following factors actually occur,
our business, financial condition or results of operations could be harmed. In
that case, the price of our common stock could decline, and you could experience
losses on your investment.
WE ANTICIPATE FUTURE LOSSES AND MAY NOT BE ABLE TO ACHIEVE PROFITABILITY.
We have incurred net losses since our inception in 1988 and, as of June 30,
2002, we had an accumulated deficit of $199.8 million. We anticipate that we
will continue to incur additional operating losses in the near term. These
losses have resulted principally from expenses incurred in our research and
development programs and from sales and marketing and general and administrative
expenses. Even if we achieve profitability, we may not be able to sustain or
increase profitability on a quarterly or annual basis. If we cannot achieve or
sustain profitability, we may not be able to fund our expected cash needs or
continue our operations.
WE ARE NOT GENERATING POSITIVE CASH FLOW AND MAY NEED ADDITIONAL CAPITAL AND
ANY REQUIRED CAPITAL MAY NOT BE AVAILABLE ON ACCEPTABLE TERMS OR AT ALL.
We have incurred negative cash flow from operations since inception in
1988. Our financial plan for 2002 indicates that our cash on hand, together
with borrowings expected to be available under our revolving line of credit and
other sources, should be sufficient to fund our operations through 2002 and into
2003. However, should our actual results achieved this year fall below those
reflected in our forecast, or if we are unable to borrow the funds we expect to
be available, we may need to raise additional capital.
We amended our credit agreement with our lender in March 2002 to set the
financial covenants for 2002 and extend the maturity date of the loans an
additional year to May 31, 2003. If our lender imposes additional loan
covenants or other credit requirements that would prevent us from accessing the
full amount of our line of credit, we would need to raise additional capital to
fund any shortfall from our borrowings expected to be available under the
revolving line of credit. We anticipate that any additional capital would be
raised through one or more of the following:
* obtaining new loans secured by unencumbered assets;
* sale of various products or marketing rights;
* licensing of technology;
* sale of various assets; and
* sale of additional equity or debt securities.
Additional capital may not be available on acceptable terms, if at all.
The public markets may remain unreceptive to equity financings, and we may not
be able to obtain additional private equity financing. Furthermore, amounts we
expect to be available under our existing revolving credit facility may not be
available, and other lenders could refuse to provide us with additional debt
financing. Furthermore, any additional equity financing would likely be
dilutive to stockholders, and additional debt financing, if available, may
include restrictive covenants which may limit our currently planned operations
and strategies. If adequate funds are not available, we may be required to
curtail our operations significantly and reduce discretionary spending to extend
the currently available cash resources, or to obtain funds by entering into
collaborative agreements or other arrangements on unfavorable terms, all of
which would likely have a material adverse effect on our business, financial
condition and our ability to continue as a going concern.
18
WE MUST MAINTAIN VARIOUS FINANCIAL AND OTHER COVENANTS UNDER OUR REVOLVING
LINE OF CREDIT AGREEMENT.
Under our revolving line of credit agreement with Wells Fargo Business
Credit, we are required to comply with various financial and non-financial
covenants, and we have made various representations and warranties. Among the
financial covenants is a requirement to maintain $2.5 million of minimum
liquidity (cash plus excess borrowing base). Additional requirements include
covenants for minimum capital monthly and minimum net income quarterly.
We currently believe we are not likely to be able to meet our existing covenants
for minimum net income and minimum book capital in future periods. We intend to
negotiate modifications or a waiver of these covenants. We have obtained
modifications and a waiver of covenants in the past, although there can be no
assurance we can obtain similar modifications or waivers in the future.
Failure to comply with any of the covenants, representations or warranties
could result in our being in default under the loan and could cause all
outstanding amounts to become immediately due and payable or impact our ability
to borrow under the agreement. All amounts due under the credit facility mature
on May 31, 2003. We intend to rely on available borrowings under the credit
agreement to fund our operations through 2002 and into 2003. If we are unable
to borrow funds under this agreement, we will need to raise additional capital
to fund our cash needs and continue our operations. If we are unable to extend
or refinance the borrowings under the credit facility as of, or before, May 31,
2003, or complete other options to meet our cash needs created by maturing debt,
we may be unable to continue as a going concern.
OUR COMMON STOCK COULD BE DELISTED FROM THE NASDAQ STOCK MARKET, WHICH MAY
MAKE IT MORE DIFFICULT FOR YOU TO SELL YOUR SHARES.
Our common stock is currently listed on the Nasdaq National Market. We are
in the process of applying to transfer our listing to the Nasdaq SmallCap
Market. Both the Nasdaq National Market and the Nasdaq SmallCap Market have
requirements we must meet in order to remain listed, including a minimum bid
price requirement of $1.00. We are currently not in compliance with the minimum
bid price requirement and have received notification from Nasdaq to that effect.
If the transfer of our listing to the Nasdaq SmallCap Market is approved, we
will have until November 18, 2002 to comply with the minimum $1.00 bid price
requirement which requires that our common stock close at $1.00 per share or
more for a minimum of 10 consecutive trading days. We may also be eligible for
an additional 180-day grace period, or until May 16, 2003, provided that we have
stockholders' equity of $5 million or meet certain other initial listing
criteria required by Nasdaq. We cannot assure you that our application to
transfer to the Nasdaq SmallCap Market will be approved, nor can we assure you
that we will be able to maintain such listing. If we are delisted from the
Nasdaq stock market, our common stock will be considered a penny stock under the
regulations of the Securities and Exchange Commission and would therefore be
subject to rules that impose additional sales practice requirements on broker-
dealers who sell our securities. The additional burdens imposed upon broker-
dealers discourage broker-dealers from effecting transactions in our common
stock, which could severely limit market liquidity of the common stock and your
ability to sell our securities in the secondary market. This lack of liquidity
would also make it more difficult to raise capital in the future.
WE MAY FACE COSTLY INTELLECTUAL PROPERTY DISPUTES.
Our ability to compete effectively will depend in part on our ability to
develop and maintain proprietary aspects of our technology and either to operate
without infringing the proprietary rights of others or to obtain rights to
technology owned by third parties. We have United States and foreign-issued
patents and are currently prosecuting patent applications in the United States
and with various foreign countries. Our pending patent applications may not
result in the issuance of any patents or any issued patents that will offer
protection against competitors with similar technology. Patents we receive may
be challenged, invalidated or circumvented in the future or the rights created
by those patents may not provide a competitive advantage. We also rely on trade
secrets, technical know-how and continuing invention to develop and maintain our
competitive position. Others
19
may independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to our trade secrets.
The biotechnology and pharmaceutical industries have been characterized by
extensive litigation relating to patents and other intellectual property rights.
In 1998, Synbiotics Corporation filed a lawsuit against us alleging infringement
of a Synbiotics patent relating to heartworm diagnostic technology, and this
litigation remains ongoing. The sole remaining claim in the lawsuit is expected
to be scheduled for trial in 2003.
We may become subject to additional patent infringement claims and
litigation in the United States or other countries or interference proceedings
conducted in the United States Patent and Trademark Office, or 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. We
may also need to pursue litigation to enforce any patents issued to us or our
collaborative partners, to protect trade secrets or know-how owned by us or our
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 us and significant diversion of the
efforts of our technical and management personnel. Any adverse determination in
litigation or interference proceedings could subject us to significant
liabilities to third parties. Further, as a result of litigation or other
proceedings, we may be required to seek licenses from third parties which may
not be available on commercially reasonable terms, if at all.
WE HAVE LIMITED RESOURCES TO DEVOTE TO PRODUCT DEVELOPMENT AND
COMMERCIALIZATION. IF WE ARE NOT ABLE TO DEVOTE ADEQUATE RESOURCES TO PRODUCT
DEVELOPMENT AND COMMERCIALIZATION, WE MAY NOT BE ABLE TO DEVELOP OUR PRODUCTS.
Our strategy is to develop a broad range of products addressing companion
animal healthcare. We believe that our revenue growth and profitability, if
any, will substantially depend upon our ability to:
* improve market acceptance of our current products;
* complete development of new products; and
* successfully introduce and commercialize new products.
We have introduced some of our products only recently and many of our
products are still under development. Among our recently introduced products
E.R.D.-SCREEN Urine Test for detecting albumin in canine urine, ALLERCEPT E-
SCREEN Test for assessing allergies in dogs, and SPOTCHEM (TM) EZ, a compact
system for measuring animal blood chemistry. We currently have under
development or in preliminary clinical trials a number of products, including a
gene based therapy for canine cancer. Because we have limited resources to
devote to product development and commercialization, any delay in the
development of one product or reallocation of resources to product development
efforts that prove unsuccessful may delay or jeopardize the development of our
other product candidates. If we fail to develop new products and bring them to
market, our ability to generate revenues will decrease.
In addition, our products may not achieve satisfactory market acceptance,
and we may not successfully commercialize them on a timely basis, or at all. If
our products do not achieve a significant level of market acceptance, demand for
our products will not develop as expected and it is unlikely that we ever will
become profitable.
WE MAY BE UNABLE TO SUCCESSFULLY MARKET AND DISTRIBUTE OUR PRODUCTS AND HAVE
RECENTLY MODIFIED OUR DISTRIBUTION STRATEGY.
The market for companion animal healthcare products is highly fragmented.
Because our proprietary products are available only by prescription and our
medical instruments require technical training, we sell our companion animal
health products only to veterinarians. Therefore, we may fail to reach a
substantial segment of the potential market.
20
We currently market our products in the United States to veterinarians
through approximately 20 independent third-party distributors and through a
direct sales force. Nearly one-half of these domestic distributors carry the
full line of our pharmaceutical, vaccine, diagnostic and instrumentation
products. We have recently begun to rely on distributors for a greater portion
of our sales and therefore need to increase our training efforts directed at the
sales personnel of our distributors. To be successful, we will have to continue
to develop and train our direct sales force as well as sales personnel of our
distributors and rely on other arrangements with third parties to market,
distribute and sell our products. In addition, most of our distributor
agreements can be terminated on 60 days' notice and we believe IDEXX, our
largest competitor, prohibits its distributors from selling competitors'
products, including ours. For example, one of our largest distributors recently
informed us that they would no longer carry our heartworm diagnostic products or
our chemistry or hematology instruments because they wish to carry products from
one of our competitors, IDEXX, who required exclusivity of its comparable
products.
We may not successfully develop and maintain marketing, distribution or
sales capabilities, and we may not be able to make arrangements with third
parties to perform these activities on satisfactory terms. If our marketing and
distribution strategy is unsuccessful, our ability to sell our products will be
negatively impacted and our revenues will decrease. Furthermore, the recent
change in our distribution strategy and our expected increase in sales from
distributors and decrease in direct sales may have a negative impact on our
gross margins.
WE MUST OBTAIN AND MAINTAIN COSTLY REGULATORY APPROVALS IN ORDER TO MARKET
OUR PRODUCTS.
Many of the products we develop and market are subject to extensive
regulation by one or more of the USDA, the FDA, the EPA and foreign regulatory
authorities. These regulations govern, among other things, the development,
testing, manufacturing, labeling, storage, pre-market approval, advertising,
promotion, sale and distribution of our products. Satisfaction of these
requirements can take several years and time needed to satisfy them may vary
substantially, based on the type, complexity and novelty of the product.
Our Flu AVERT I.N. Vaccine, SOLO STEP CH, SOLO STEP FH, and SOLO STEP Batch
Test Strips and Trivalent Intranasal/Intraocular Vaccine each have received
regulatory approval in the United States by the USDA. In addition, the Flu
AVERT I.N. Vaccine has been approved in Canada by the CFIA. SOLO STEP CH and
SOLO STEP Batch Test Strips are pending approval by the CFIA. SOLO STEP CH has
also been approved by the Japanese Ministry of Agriculture, Forestry and
Fisheries. U.S. regulatory approval by the USDA is currently pending for our
Feline ImmuCheck Assay, Canine Cancer Gene Therapy and Feline Mucosal Vaccine.
The effect of government regulation may be to delay or to prevent marketing
of our products for a considerable period of time and to impose costly
procedures upon our activities. We have experienced in the past, and may
experience in the future, difficulties that could delay or prevent us from
obtaining the regulatory approval or license necessary to introduce or market
our products. For example, the Flu AVERT I.N. vaccine for equine influenza was
not approved until six months after the date on which we expected approval.
This delay caused us to miss the initial primary selling season for equine
influenza vaccines, and we believe it delayed the initial market acceptance of
this product. Regulatory approval of our products may also impose limitations
on the indicated or intended uses for which our products may be marketed.
Among the conditions for certain regulatory approvals is the requirement
that the facilities of our third party manufacturers conform to current Good
Manufacturing Practices. Our manufacturing facilities and those of our third
party manufacturers must also conform to or certain other manufacturing
regulations, which include requirements relating to quality control and
quality assurance as well as maintenance of records and documentation. The
USDA, FDA and foreign regulatory authorities strictly enforce manufacturing
regulatory requirements through periodic inspections. If any regulatory
authority determines that our manufacturing facilities or those of our third
party manufacturers do not conform to appropriate manufacturing requirements,
we or the manufacturers of our products may be subject to sanctions,
including warning letters, product recalls or seizures, injunctions, refusal
to permit products to be imported into or exported out of the United States,
refusals
21
of regulatory authorities to grant approval or to allow us to enter into
government supply contracts, withdrawals of previously approved marketing
applications, civil fines and criminal prosecutions.
FACTORS BEYOND OUR CONTROL MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE, AND
SINCE MANY OF OUR EXPENSES ARE FIXED, THIS FLUCTUATION COULD CAUSE OUR STOCK
PRICE TO DECLINE.
We believe that our future operating results will fluctuate on a quarterly
basis due to a variety of factors, including:
* results from Diamond;
* the introduction of new products by us or by our competitors;
* our recent change in distribution strategy;
* market acceptance of our current or new products;
* regulatory and other delays in product development;
* product recalls;
* competition and pricing pressures from competitive products;
* manufacturing delays;
* shipment problems;
* product seasonality; and
* changes in the mix of products sold.
We have high operating expenses for personnel, new product development and
marketing. Many of these expenses are fixed in the short term. If any of the
factors listed above cause our revenues to decline, our operating results could
be substantially harmed.
Our operating results in some quarters may not meet the expectations of
stock market analysts and investors. In that case, our stock price probably
would decline.
OUR LARGEST CUSTOMER ACCOUNTED FOR OVER 15% OF OUR REVENUES FOR THE PREVIOUS
TWO YEARS, AND THE LOSS OF THAT CUSTOMER OR OTHER CUSTOMERS COULD HARM OUR
OPERATING RESULTS.
We currently derive a substantial portion of our revenues from sales by our
subsidiary, Diamond, which manufactures several of our products and products for
other companies in the animal health industry. Revenues from one contract
between Diamond and Agri Laboratories, Ltd., comprised approximately 11% and 11%
of our total revenues for the six months ended June 30, 2001 and 2002,
respectively. In May 2002, Diamond signed a seven-year contract extension with
Agri Laboratories. However, if Agri Laboratories does not continue to purchase
from Diamond and if we fail to replace the lost revenue with revenues from other
customers, our business could be substantially harmed. In addition, sales from
our next three largest customers accounted for an aggregate of approximately 12%
of our revenues in 2001. If we are unable to maintain our relationships with
one or more of these customers, our sales may decline.
WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY, WHICH COULD RENDER OUR PRODUCTS
OBSOLETE OR SUBSTANTIALLY LIMIT THE VOLUME OF PRODUCTS THAT WE SELL. THIS WOULD
LIMIT OUR ABILITY TO COMPETE AND ACHIEVE PROFITABILITY.
We compete with independent animal health companies and major
pharmaceutical companies that have animal health divisions. Companies with a
significant presence in the animal health market, such as Wyeth, Bayer, IDEXX,
Intervet, Merial, Novartis, Pfizer, Pharmacia and Schering Plough, have
developed or are developing products that compete with our products or would
compete with them if developed. These competitors may have substantially
greater financial, technical, research and other resources and larger, better-
established marketing, sales, distribution and service organizations than us.
In addition, we believe that IDEXX prohibits its distributors from selling
competitors' products, including our SOLO STEP heartworm diagnostic products and
medical diagnostic instruments. Our competitors frequently offer broader
product lines and have greater name recognition than we do. Our competitors may
develop or market technologies or products that are
22
more effective or commercially attractive than our current or future products or
that would render our technologies and products obsolete. Further, additional
competition could come from new entrants to the animal healthcare market.
Moreover, we may not have the financial resources, technical expertise or
marketing, distribution or support capabilities to compete successfully. If we
fail to compete successfully, our ability to achieve profitability will be
limited.
OUR TECHNOLOGY AND THAT OF OUR COLLABORATORS MAY BECOME THE SUBJECT OF LEGAL
ACTION.
We license technology from a number of third parties, including Quidel
Corporation, Genzyme Corporation, Diagnostic Chemicals, Ltd., Valentis, Inc.,
Corixa Corporation, Roche, New England Biolabs, Inc. and Hybritech Inc., as well
as a number of research institutions and universities. The majority of these
license agreements impose due diligence or milestone obligations on us, and in
some cases impose minimum royalty and/or sales obligations on us, in order for
us to maintain our rights under these agreements. Our products may incorporate
technologies that are the subject of patents issued to, and patent applications
filed by, others. As is typical in our industry, from time to time we and our
collaborators have received, and may in the future receive, notices from third
parties claiming infringement and invitations to take licenses under third party
patents. It is our policy that when we receive such notices, we conduct
investigations of the claims they assert. With respect to the notices we have
received to date, we believe, after due investigation, that we have meritorious
defenses to the infringement claims asserted. Any legal action against us or
our collaborators may require us or our collaborators to obtain one or more
licenses in order to market or manufacture affected products or services.
However, we or our collaborators may not be able to obtain licenses for
technology patented by others on commercially reasonable terms, we may not be
able to develop alternative approaches if unable to obtain licenses, or current
and future licenses may not be adequate for the operation of our businesses.
Failure to obtain necessary licenses or to identify and implement alternative
approaches could prevent us and our collaborators from commercializing our
products under development and could substantially harm our business.
WE RELY SUBSTANTIALLY ON THIRD-PARTY MANUFACTURERS. THE LOSS OF ANY THIRD-
PARTY MANUFACTURERS COULD LIMIT OUR ABILITY TO LAUNCH OUR PRODUCTS IN A TIMELY
MANNER, OR AT ALL.
To be successful, we must manufacture, or contract for the manufacture of,
our 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 increase our manufacturing
capacity, we acquired Diamond in April 1996.
We currently rely on third parties to manufacture those products we do not
manufacture at our Diamond facility. We currently have supply agreements with
Quidel Corporation for various manufacturing services relating to our point-of-
care diagnostic tests, with Centaq, Inc. for the manufacture of our own allergy
immunotherapy treatment products and with various manufacturers for the supply
of our veterinary diagnostic and patient monitoring instruments. Our
manufacturing strategy presents the following risks:
* Delays in the scale-up to quantities needed for product development could
delay regulatory submissions and commercialization of our products in
development;
* Our manufacturing facilities and those of some of our third party
manufacturers are subject to ongoing periodic unannounced inspection by
regulatory authorities, including the FDA, USDA and other federal and
state agencies for compliance with strictly enforced Good Manufacturing
Practices regulations and similar foreign standards, and we do not have
control over our third party manufacturers' compliance with these
regulations and standards;
* If we need to change to other commercial manufacturing contractors for
certain of our products, additional regulatory licenses or approvals must
be obtained for these contractors prior to our use. This would require
new testing and compliance inspections. Any new manufacturer would have
to
23
be educated in, or develop substantially equivalent processes necessary
for the production of our products;
* If market demand for our products increases suddenly, our current
manufacturers might not be able to fulfill our commercial needs, which
would require us to seek new manufacturing arrangements and may result in
substantial delays in meeting market demand; and
* We may not have intellectual property rights, or may have to share
intellectual property rights, to any improvements in the manufacturing
processes or new manufacturing processes for our products.
Any of these factors could delay commercialization of our products under
development, interfere with current sales, entail higher costs and result in our
being unable to effectively sell our products.
Our agreements with various suppliers of the veterinary medical instruments
require us to meet minimum annual sales levels to maintain our position as the
exclusive distributor of these instruments. We may not meet these minimum sales
levels in the future, and maintain exclusivity over the distribution and sale of
these products. If we are not the exclusive distributor of these products,
competition may increase.
WE HAVE GRANTED THIRD PARTIES SUBSTANTIAL MARKETING RIGHTS TO CERTAIN OF OUR
EXISTING PRODUCTS AS WELL AS PRODUCTS UNDER DEVELOPMENT. IF THE THIRD PARTIES
ARE NOT SUCCESSFUL IN MARKETING OUR PRODUCTS OUR SALES MAY NOT INCREASE.
Our agreements with our corporate marketing partners generally contain no
minimum purchase requirements in order for them to maintain their exclusive or
co-exclusive marketing rights. Currently, Novartis Agro K.K. markets and
distributes SOLO STEP CH in Japan, and Novartis Animal Health Canada, Inc.
distributes our FLU AVERT I.N. vaccine in Canada. In addition, we have entered
into agreements with Novartis and Eisai Inc. to market or co-market certain of
the products that we are currently developing. Also, Nestle Purina Petcare has
exclusive rights to license our technology for nutritional applications for dogs
and cats. One or more of these marketing partners may not devote sufficient
resources to marketing our products. Furthermore, there is nothing to prevent
these partners from pursuing alternative technologies or products that may
compete with our products. In the future, third-party marketing assistance may
not be available on reasonable terms, if at all. If any of these events occur,
we may not be able to commercialize our products and our sales will decline.
WE DEPEND ON PARTNERS IN OUR RESEARCH AND DEVELOPMENT ACTIVITIES. IF OUR
CURRENT PARTNERSHIPS AND COLLABORATIONS ARE NOT SUCCESSFUL, WE MAY NOT BE ABLE
TO DEVELOP OUR TECHNOLOGIES OR PRODUCTS.
For several of our proposed products, we are dependent on collaborative
partners to successfully and timely perform research and development activities
on our behalf. For example, we jointly developed several point-of-care
diagnostic products with Quidel Corporation, and Quidel manufactures these
products. We license DNA delivery and manufacturing technology from Valentis
Inc. and distribute chemistry analyzers for Arkray, Inc. We also have worked
with i-STAT Corporation to develop portable clinical analyzers for dogs and
Diagnostic Chemicals, Ltd. to develop the E.R.D.-SCREEN Urine Test. One or more
of our collaborative partners may not complete research and development
activities on our behalf in a timely fashion, or at all. If our collaborative
partners fail to complete research and development activities, or fail to
complete them in a timely fashion, our ability to develop technologies and
products will be impacted negatively and our revenues will decline.
IF RECENT CHANGES IN OUR SENIOR MANAGEMENT ARE NOT SUCCESSFUL, WE WILL NOT BE
ABLE TO ACHIEVE OUR GOALS.
Our President and Chief Operating Officer and Chief Financial Officer
retired in May 2002. We have appointed a new Chief Financial Officer and Dr.
Grieve, our Chief Executive Officer, assumed the duties of the President and
Chief Operating Officer. These changes may place a strain on our resources and
planning and management processes during this transition period. If these
changes are not successful, we will not be able to
24
implement our business strategy. In addition, we will not be able to increase
revenues or control costs unless we continue to improve our operational,
financial and managerial controls and reporting systems and procedures.
WE DEPEND ON KEY PERSONNEL FOR OUR FUTURE SUCCESS. IF WE LOSE OUR KEY
PERSONNEL OR ARE UNABLE TO ATTRACT AND RETAIN ADDITIONAL PERSONNEL, WE MAY BE
UNABLE TO ACHIEVE OUR GOALS.
Our future success is substantially dependent on the efforts of our senior
management and scientific team, particularly Dr. Robert B. Grieve, our Chairman
and Chief Executive Officer. The loss of the services of members of our 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 our business, we depend substantially on
our 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 our activities. Although we have an
employment agreement with Dr. Grieve, he is an at-will employee, which means
that either party may terminate his employment at any time without prior notice.
If we lose the services of, or fail to recruit, key scientific and technical
personnel, the growth of our business could be substantially impaired. We do
not maintain key person life insurance for any of our key personnel.
WE MAY FACE PRODUCT RETURNS AND PRODUCT LIABILITY LITIGATION AND THE EXTENT
OF OUR INSURANCE COVERAGE IS LIMITED. IF WE BECOME SUBJECT TO PRODUCT LIABILITY
CLAIMS RESULTING FROM DEFECTS IN OUR PRODUCTS, WE MAY FAIL TO ACHIEVE MARKET
ACCEPTANCE OF OUR PRODUCTS AND OUR SALES COULD DECLINE.
The testing, manufacturing and marketing of our current products as well as
those currently under development entail an inherent risk of product liability
claims and associated adverse publicity. Following the introduction of a
product, adverse side effects may be discovered. Adverse publicity regarding
such effects could affect sales of our other products for an indeterminate time
period. To date, we have not experienced any material product liability claims,
but any claim arising in the future could substantially harm our business.
Potential product liability claims may exceed the amount of our insurance
coverage or may be excluded from coverage under the terms of the policy. We may
not be able to continue to obtain adequate insurance at a reasonable cost, if at
all. In the event that we are held liable for a claim against which we are not
indemnified or for damages exceeding the $10 million limit of our insurance
coverage or which results in significant adverse publicity against us, we may
lose revenue and fail to achieve market acceptance.
WE MAY BE HELD LIABLE FOR THE RELEASE OF HAZARDOUS MATERIALS, WHICH COULD
RESULT IN EXTENSIVE CLEAN UP COSTS OR OTHERWISE HARM OUR BUSINESS.
Our products and development programs involve the controlled use of
hazardous and biohazardous materials, including chemicals, infectious disease
agents and various radioactive compounds. Although we believe that our safety
procedures for handling and disposing of such materials comply with the
standards prescribed by applicable local, state and federal regulations, we
cannot eliminate the risk of accidental contamination or injury from these
materials. In the event of such an accident, we could be held liable for any
fines, penalties, remediation costs or other damages that result. Our liability
for the release of hazardous materials could exceed our resources, which could
lead to a shutdown of our operations. In addition, we may incur substantial
costs to comply with environmental regulations as we expand our manufacturing
capacity.
WE EXPECT TO EXPERIENCE VOLATILITY IN OUR STOCK PRICE, WHICH MAY AFFECT OUR
ABILITY TO RAISE CAPITAL IN THE FUTURE OR MAKE IT DIFFICULT FOR INVESTORS TO
SELL THEIR SHARES.
The securities markets have experienced significant price and volume
fluctuations and the market prices of securities of many public biotechnology
companies have in the past been, and can in the future be expected to be,
especially volatile. For example, in the last twelve months our closing stock
price has ranged from a low of $0.27 to a high of $1.47. Fluctuations in the
trading price or liquidity of our common stock may adversely affect
25
our ability to raise capital through future equity financings. Factors that may
have a significant impact on the market price and marketability of our common
stock include:
* announcements of technological innovations or new products by us or by
our competitors;
* our quarterly operating results;
* releases of reports by securities analysts;
* developments or disputes concerning patents or proprietary rights;
* regulatory developments;
* developments in our relationships with collaborative partners;
* changes in regulatory policies;
* litigation;
* economic and other external factors; and
* general market conditions.
In the past, following periods of volatility in the market price of a
company's securities, securities class action litigation has often been
instituted. If a securities class action suit is filed against us, we would
incur substantial legal fees and our management's attention and resources would
be diverted from operating our business in order to respond to the litigation.
26
ITEM 3.
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 due to adverse changes in
financial and commodity market prices and rates. We are 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 our normal operating and funding
activities. During 2002, we sold products to a Japanese distributor and the
yen-based consideration we received is being held for the purchase of inventory
during fiscal 2002. As of December 31, 2001, all of these forward contracts
had been settled.
INTEREST RATE RISK
The interest payable on certain of our lines of credit and other borrowings
is variable based on the United States prime rate and, therefore, is affected by
changes in market interest rates. At June 30, 2002, approximately $8.7 million
was outstanding on these lines of credit and other borrowings with a weighted
average interest rate of 5.73%. We manage interest rate risk by investing
excess funds principally in cash equivalents or marketable securities, which
bear interest rates that reflect current market yields. We completed an
interest rate risk sensitivity analysis of these borrowings based on an assumed
one percentage point increase in interest rates. Based on our outstanding
balances as of June 30, 2002, a one percentage point increase in market interest
rates would cause an annual increase in our interest expense of approximately
$87,000. We also had approximately $3.7 million of cash and cash equivalents at
June 30, 2002, the majority of which is invested in liquid interest bearing
accounts. Based on our outstanding balances, a one percentage point increase
in market interest rates would cause an annual increase in our interest income
of approximately $37,000.
FOREIGN CURRENCY RISK
We have a wholly owned subsidiary located in Switzerland. Sales from this
operation are denominated in Swiss Francs or Euros, thereby creating exposures
to changes in exchange rates. The changes in the Swiss/U.S. exchange rate or
Euro/U.S. exchange rate may positively or negatively affect our sales, gross
margins and retained earnings. We completed a foreign currency exchange risk
sensitivity analysis on an assumed 1% increase in foreign currency exchange
rates. If foreign currency exchange rates increase/decrease by 1% during the
three months ended September 30, 2002, we would experience an increase/decrease
in our foreign currency gain/loss of approximately $100,000 based on the
investment in foreign subsidiaries as of June 30, 2002. We purchase inventory
for sale from one foreign vendor and sell our products to two foreign customers
in transactions which are denominated in non-U.S. currency, primarily Japanese
yen and Canadian dollars. If the exchange rate of the U.S. dollar
increases/decreases by 1%, the net impact on our operating results would be
approximately $14,000 based upon our purchases and sales in these foreign
currencies over the past 12 months.
27
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In November 1998, Synbiotics Corporation filed a lawsuit against us in the
United States District Court for the Southern District of California in which it
alleges that we infringe a patent owned by Synbiotics relating to heartworm
diagnostic technology. We have obtained legal opinions from our outside patent
counsel that our 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 our internal evaluations related to the one
remaining claim. In September 2000, the U.S. District Court hearing the case
granted our request for a partial summary judgment, holding two of the
Synbiotics patent claims to be invalid, leaving only the one remaining claim in
the lawsuit. The one remaining claim is currently scheduled for trial in 2003.
While we believe that we have valid defenses to Synbiotics' allegations and
intend to defend the action vigorously, there can be no assurance that an
adverse result or settlement would not have a material adverse effect on our
financial position, results of operations or cash flow.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's 2002 annual meeting of stockholders (the "2002 Annual
Meeting") was held on May 16, 2002 in Fort Collins, Colorado. Three proposals,
as described in the Company's Proxy Statement dated April 11, 2002, were voted
on at the meeting. Following is a brief description of the matters voted upon
and the results of the voting:
1. Election of Directors:
Nominee Number of Shares
------------------ ----------------------
A. Barr Dolan For 35,611,498
Withheld 349,346
Robert B. Grieve For 35,611,498
Withheld 349,346
John F. Sasen, Sr. For 35,611,548
Withheld 349,296
2. To approve an amendment to the Company's 1997 Employee Stock Purchase
Plan to increase the number of shares reserved for issuance under the
plan by 1,000,000 shares.
For Against Abstain
35,461,559 423,974 75,311
28
3. To ratify and approve an amendment to Article 8 of the Company's bylaws.
For Against Abstain Not Voted
28,730,767 483,979 176,749 6,569,349
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
3(ii) Bylaws of the Registrant.
10.3(a)H Amendment No. 4 to Bovine Vaccine Distribution Agreement
between Diamond Animal Health, Inc. and AGRI Laboratories,
Ltd., dated as of April 15, 2002.
10.28(a)* Resignation Agreement and General Release between Registrant
and Ronald L. Hendrick, effective as of June 6, 2002.
10.29(a)* Resignation Agreement and General Release between Registrant
and James H. Fuller effective as of June 20, 2002.
99.1 Certification Under Section 906 of Sarbanes-Oxley Act
Notes
-----
H Confidential treatment has been requested with respect to
certain portions of this agreement.
* Indicates management contract or compensatory plan or
arrangement.
(b) Reports on Form 8-K
The Company filed a report on Form 8-K dated May 7, 2002, related to
the retirement of its President and Chief Operating Officer, the
retirement of its Chief Financial Officer and the appointment of a new
Chief Financial Officer.
29
HESKA CORPORATION
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HESKA CORPORATION
Date: August 14, 2002 By /s/ Robert B. Grieve
------------------------------
ROBERT B. GRIEVE
Chief Executive Officer and
Chairman of the Board
(on behalf of the Registrant and
as the Registrant's Principal
Executive Officer)
August 14, 2002 By /s/ Jason A. Napolitano
------------------------------
JASON A. NAPOLITANO
Executive Vice President and Chief
Financial Officer
(on behalf of the Registrant and
as the Registrant's Chief
Financial Officer)
30