UNITED STATES

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 September 30, 2004

 

Commission File Number 0-18044

 

PROCYTE CORPORATION

(Exact name of the registrant as specified in its charter)

 

 

 

 

 

 

 

 

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 ý

No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes o

No ý

 

As of November 5, 2004, there were issued and outstanding 15,816,762 shares of common stock, par value $.01 per share.

 

 

 

ProCyte Corporation

 

Index

 

 

Part I - Financial Information	3
Item 1. Condensed Consolidated Financial Statements (unaudited)	3
Balance Sheets - as of September 30, 2004 and December 31, 2003 (unaudited)	3
Statements of Operations - Three and Nine Months Ended September 30, 2004 and 2003 (unaudited)	4
Statements of Cash Flows — Nine Months Ended September 30, 2004 and 2003 (unaudited)	5
Statements of Stockholders’ Equity — Nine Months Ended September 30, 2004 (unaudited)	6
Notes to Condensed Consolidated Financial Statements (unaudited)	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3. Quantitative and Qualitative Disclosures About Market Risk	25
Item 4. Controls and Procedures	25
Part II - Other Information	27
Item 6. Exhibits	27
Signatures	27

 

2

 

Part I—Financial Information

 

Item 1. Condensed Consolidated Financial Statements (unaudited)

 

Balance Sheets - as of September 30, 2004 and December 31, 2003 (unaudited)

(in thousands)

		September 30, 2004			December 31, 2003
Assets
Current Assets
Cash and cash equivalents		$	5,321		$	3,796
Accounts receivable, net of allowance for doubtful accounts		1,317			1,336
Inventory		2,977			2,942
Assets held for sale		814			—
Prepaid and other		295			289
Total current assets		10,724			8,363
Property and equipment
Equipment		325			315
Leasehold improvements		3,141			3,520
Less accumulated depreciation and amortization		(3,392		)	(3,294		)
Property and equipment, net		74			541
Intangible assets		3,198			3,212
Note due from related party, net		—			781
Deferred tax asset		6,938			7,068
Other assets		38			38
Total Assets		$	20,972		$	20,003
Liabilities and Stockholders’ Equity
Current Liabilities
Accounts payable, trade		$	542		$	147
Accrued salaries and benefits		293			246
Other accrued liabilities		200			239
Deferred revenue		381			60
Total current liabilities		1,416			692
Other liabilities		75			93
Total Liabilities		1,491			785
Stockholders’ Equity
Common stock and additional paid-in-capital		85,443			85,419
Deferred compensation		(42		)	(59		)
Accumulated deficit		(65,920		)	(66,142		)
Stockholders’ Equity		19,481			19,218
Total Liabilities and Stockholders’ Equity		$	20,972		$	20,003

 

See notes to condensed consolidated financial statements

 

3

 

Statements of Operations—Three and Nine Months Ended September 30, 2004 and 2003
(unaudited)

(in thousands, except per share amounts)

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
Revenues
Product sales		$	2,883		$	2,286		$	9,198		$	7,481
Licenses and royalties		353			437			942			1,220
Total revenues		3,236			2,723			10,140			8,701
Cost of product sales		756			675			2,774			2,477
Gross profit		2,480			2,048			7,366			6,224
Operating Expenses
Marketing and selling		1,091			1,024			3,549			3,237
Research, general, and administrative		1,055			797			3,203			2,731
Loss on asset impairment		25			—			319			—
Total operating expenses		2,171			1,821			7,071			5,968
Operating income		309			227			295			256
Interest and other income		14			34			64			159
Net income before tax		323			261			359			415
Provision (benefit) for income tax		122			—			137			(18		)
Net income		$	201		$	261		$	222		$	397
Net earnings per share
Basic		$	0.01		$	0.02		$	0.01		$	0.03
Diluted		$	0.01		$	0.02		$	0.01		$	0.02
Shares used in per share computation
Basic		15,807			15,774			15,799			15,761
Diluted		15,954			15,974			16,000			15,973

 

See notes to condensed consolidated financial statements

 

4

 

Statements of Cash Flows—Nine Months Ended September 30, 2004 and 2003
(unaudited)

(in thousands)

 

		Nine months ended September 30,
		2004			2003
Operating Activities
Net income		$	222		$	397
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		119			244
Amortization of deferred proceeds		—			(201		)
Non-cash expense related to stock-based compensation		41			40
Amortization of promissory note discount		—			(23		)
Change in deferred tax asset, net of change in valuation allowance		130			—
Loss on asset impairment		319			—
Change in operating assets and liabilities:
Accounts receivable		19			206
Inventory		(15		)	(882		)
Prepaid and other		(6		)	132
Accounts payable, trade		395			13
Accrued salaries and benefits		47			(144		)
Other accrued liabilities		(39		)	(69		)
Deferred revenue		321			228
Other liabilities		(18		)	2
Net cash provided by (used in) operating activities		1,535			(57		)
Financing Activities
Proceeds from issuance of common stock		—			10
Investing Activities
Purchase of property and equipment		(10		)	(53		)
Net increase (decrease) in cash and cash equivalents		1,525			(100		)
Cash and Cash Equivalents
At beginning of period		3,796			4,556
At end of period		$	5,321		$	4,456
Supplemental Non-Cash Financing Activities
Assets received in settlement of note receivable		841			—

See notes to condensed consolidated financial statements

 

5

 

Statements of Stockholders’ Equity—Nine Months Ended September 30, 2004
(unaudited)

(in thousands)

 

		Common Stock
		Shares		Par Value			Additional Paid-in Capital			Deferred Compen- sation			Accumulated Deficit			Total
Balance, December 31, 2003		15,783		$	158		$	85,261		$	(59	)	$	(66,142	)	$	19,218
Shares issued under non-employee director stock plan		24		(*		)	27			—			—			27
Re-measurement of stock options granted to non-employees		—		—			(3		)	3			—			—
Amortization of deferred compensation		—		—			—			14			—			14
Net income		—		—			—			—			222			222
Balance, September 30, 2004		15,807		$	158		$	85,285		$	(42	)	$	(65,920	)	$	19,481

 

 

                This statement contains rounding, and (*) is placed where the number rounds to less than $1,000.

 

See notes to condensed consolidated financial statements

 

 

6

 

 

 

ProCyte Corporation

Notes to Condensed Consolidated Financial Statements (unaudited)

 

 

1.              Basis of Presentation

 

The accompanying condensed consolidated financial statements include the accounts of ProCyte Corporation and its wholly-owned subsidiaries, NextDerm, Inc. (a Delaware corporation) and NextDerm, Inc. (a Washington corporation) (collectively “ProCyte” or the “Company”), for the three and nine month periods ended September 30, 2004 and 2003, and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.  Pursuant to such rules and regulations, the condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for audited financial statements.  Accordingly, this financial information should be read in conjunction with the complete audited financial statements, including the notes thereto, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.  In the opinion of management, all material adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial statements have been included.  Interim results are not necessarily indicative of the results that may be expected for the year.

 

Use of Estimates in Financial Statements

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the reporting period and the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, particularly with respect to the valuation of inventory, assets held for sale, goodwill, leasehold improvements and deferred tax assets.  Actual results could differ from those estimates.

 

Stock Based Compensation

The Company follows the intrinsic value based accounting method for stock options contained in APB Opinion No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation.  Under this method, no compensation expense has been recognized for employee incentive stock options, as the exercise price of options granted equaled the fair value on the date of grant.

 

The following table represents what the Company’s pro forma amounts of net income and net income per share would have been for the three and nine months ended September 30, 2004 and 2003, had compensation expense for the Company’s stock options granted under the incentive compensation plan been recognized based upon the fair value of the awards granted.

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
		(in thousands, except per share amounts)
Net income, as reported		$	201		$	261		$	222		$	397
Stock option-based compensation expense determined under fair value-based method		(58		)	(97		)	(47		)	(224		)
Pro forma net income		$	143		$	164		$	175		$	173

 

 

7

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
		(in thousands, except per share amounts)
Earnings per share:
As reported basic		$	0.01		$	0.02		$	0.01		$	0.03
As reported diluted		$	0.01		$	0.02		$	0.01		$	0.02
Pro forma basic		$	0.01		$	0.01		$	0.01		$	0.01
Pro forma diluted		$	0.01		$	0.01		$	0.01		$	0.01

 

The Company determined the fair value of stock options granted during the three and nine months ended September 30, 2004 and 2003 using the Black-Scholes option pricing model and the following assumptions:

 

		Three months ended September 30,				Nine months ended September 30,
		2004		2003		2004		2003
Options Granted
Risk-free interest rate		3.26	%	2.35	%	2.44-3.26	%	2.35-2.81	%
Expected option life (years)		6.00		6.00		6.00		6.00
Dividend yield		0.00		0.00		0.00		0.00
Expected volatility		59	%	60	%	59-63	%	59-62	%

 

2.              Accounts Receivable

 

Three customers represented greater than 10% of the net accounts receivable balance at September 30, 2004 and two of such customers represented greater than 10% of the net accounts receivable balance at December 31, 2003 as follows:

 

		September 30, 2004		December 31, 2003
Customer A		27	%	46	%
Customer B		17	%	5	%
Customer C		12	%	12	%

 

The Company provided an allowance for uncollectible receivables in the amount of $18,000 and $102,000 at September 30, 2004 and December 31, 2003, respective1y.  The bad debt expense, net of recoveries of $38,000 in 2004 and $1,000 in 2003, was a benefit of $29,000 and an expense of $15,000 for the three months ended September 30, 2004 and 2003, respectively.  The bad debt expense, net of recoveries of $172,000 in 2004 and $6,000 in 2003, was a benefit of $240,000 and an expense of $44,000 for the nine months ended September 30, 2004 and 2003, respectively.  Accounts written off to the allowance amounted to $2,000 and $1,000 for the three-month periods ended September 30, 2004 and 2003, respectively.  Accounts written off to the allowance account amounted to $16,000 and $14,000 for the nine-month periods ended September 30, 2004 and 2003, respectively.

 

 

8

 

 

3.              Inventory

 

Inventory consisted of the following:

 

		September 30, 2004			December 31, 2003
		(in thousands)
Finished Goods		$	2,153		$	2,235
Work in process		416			406
Raw materials		408			301
Total		$	2,977		$	2,942

 

4.              Intangible Assets

 

Intangible assets consisted of the following:

 

		September 30, 2004			December 31, 2003
		(in thousands)
Patents, net of amortization		$	57		$	70
Other intangibles, net of amortization		27			36
Goodwill		3,114			3,106
Intangible Assets, net		$	3,198		$	3,212

 

Patents are shown net of accumulated amortization of $233,000 and $221,000, at September 30, 2004 and December 31, 2003, respectively.  Patents are amortized over the term of the patent and the amortization expense related thereto was $4,000 for each of the three-month periods ended September 30, 2004 and 2003, respectively and $12,000 for each of the nine-month periods ended September 30, 2004 and 2003, respectively.  Patent amortization expense is expected to be $16,000 for each of the years ending December 31, 2004 through 2007 and $6,000 for the year ending December 31, 2008.

 

Other intangible assets are shown net of accumulated amortization of $9,000 at September 30, 2004.  The assets consist of trademarks and a customer list acquired from Annette Hanson, Inc. on December 30, 2003.  The trademarks and customer list are being amortized over their expected lives and the amortization expense related thereto was $3,000 and $9,000 for the three and nine months periods ended September 30, 2004, respectively. The amortization expense is expected to be $12,000 for each of the years ending December 31, 2004 through 2006.

 

Intangible assets also include goodwill of $3.1 million at September 30, 2004 and December 31, 2003.  The Company determined that it has one reporting unit, therefore, all of the goodwill is deemed to be associated with ProCyte’s overall business operations.

 

5.              Federal and State Income Taxes

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. As of September 30, 2004 and December 31, 2003, a partial valuation reserve for tax benefits of net operating losses and a full valuation reserve for research and development tax credit carry forwards remains in place due to the uncertainty of realizing the full tax benefits of the net operating losses and tax credits as a result of their expiration.  The net changes in the valuation allowance during the nine months

 

 

9

 

 

 

ended September 30, 2004, and the year ended December 31, 2003, were a reduction of $33,000 and $7.1 million, respectively.

 

As of September 30, 2004, the Company’s U.S. federal net operating loss and general business credit carry forward for income tax purposes were approximately $67.4 million and $1.6 million, respectively.  If not utilized, the federal net operating loss carry forward and tax credit carry forwards will expire between 2005 and 2021 as follows:

 

		Net operating loss			General business credits
		(in thousands)
2005		$	2,002		$	178
2006		3,928			133
2007		5,173			158
2008		7,912			242
Thereafter		48,422			865
Total		$	67,437		$	1,576

 

Future changes in ownership, as defined by Section 382 of the IRC, may limit the amount of net operating loss carry forward used in any one year.

 

6.              Earnings per share

 

Basic and diluted per share results for all periods presented were computed based on the net earnings for the respective periods.  The weighted average number of common shares outstanding during the period was used in the calculation of basic earnings per share.  In accordance with FAS 128, “Earnings Per Share,” the weighted average number of common shares used in the calculation of diluted per share amounts is adjusted for the dilutive effects of stock options based on the treasury stock method only if an entity records earnings from operations, as such adjustments would otherwise be anti-dilutive to earnings per share from operations.  For the three months ended September 30, 2004 and 2003, 146,830 and 200,823 dilutive stock options were included in the calculation of the average number of common shares outstanding for diluted computations, respectively.  For the three month periods ended September 30, 2004 and 2003, options and warrants to purchase 1,924,180 shares and 1,043,007 shares of common stock, respectively, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive because the exercise prices were greater than the average fair market value of the Company’s common stock for the period of $0.98 and $1.16, respectively.  For the nine months ended September 30, 2004 and 2003, 201,176 and 211,601 dilutive stock options, respectively, were included in the calculation of the average number of common shares outstanding for diluted computations. For the nine months ended September 30, 2004 and 2003, options to purchase 1,826,580 shares and 981,342 shares, respectively, of common stock with exercise prices greater than the average fair market value of the Company’s common stock for the period of $1.08 and $1.19, respectively, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive.

 

7.              Stock Options

 

The Company has stock option plans for directors, officers, employees and consultants that provide for grants of nonqualified and incentive stock options.  Options generally are granted at fair market value, expire between five and ten years from grant date and vest over one to three years.

 

 

10

 

The following table summarizes information about stock option activity in nine-month periods ended September 30, 2004 and 2003:

 

		2004					2003
Items		Number of Options		Wtd. Avg. Exercise Price			Number of Options		Wtd. Avg. Exercise Price
Outstanding, beginning of year		2,570,167		$	1.41		2,185,335		$	1.57
Granted		162,000		1.10			169,500		1.29
Exercised		—		—			(12,000	)	0.86
Canceled or expired		(136,167	)	1.57			(149,835	)	2.74
Outstanding, September 30,		2,596,000		$	1.38		2,193,000		$	1.47
Exercisable, September 30,		1,861,348		$	1.47		1,633,179		$	1.51

 

The options outstanding at September 30, 2004 consisted of the following:

 

Range of exercise prices		Number of Options Outstanding		Wtd. Avg. Remaining Life		Wtd. Avg. Exercise Price			Number of Options Exercisable		Wtd. Avg. Exercise Price
$ 0.49 - $0.77		564,000		5.32		$	0.74		564,000		$	0.74
$ 0.77 - $1.09		536,000		8.09		1.02			135,667		0.94
$ 1.11 - $1.30		576,000		7.14		1.23			360,171		1.25
$ 1.31 - $1.83		536,500		6.55		1.57			418,010		1.59
$ 2.16 - $3.44		383,500		1.39		2.78			383,500		2.78
$ 0.49 - $3.44		2,596,000		5.97		$	1.38		1,861,348		$	1.47

 

The weighted average fair value of options granted during the three-month periods ended September 30, 2004 and 2003 was approximately $0.43 and $0.51, respectively.  The weighted average fair value of options granted during the nine months ended September 30, 2004 and 2003 were approximately $0.49 and $0.76, respectively.

 

On April 12, 2004, the Board of Directors adopted the ProCyte Corporation 2004 Stock Option Plan subject to stockholder approval, which approval was obtained on May 19, 2004.  2,000,000 shares of common stock have been reserved for the plan, which provides for the grant of nonqualified and incentive stock options.  At September 30, 2004 there were 41,662 shares reserved for issuance under the Company’s 1996 Stock Option Plan.

 

8.              Related Party Disclosures

 

In July 2001 the Company sold its contract manufacturing operations to Emerald Pharmaceutical L.P. (“Emerald”) and received a promissory note in the principal amount of $2 million as part of the consideration.  The note was secured by a security agreement covering substantially all of the assets of Emerald and requires Emerald to make monthly interest-only payments equal to the effective yield on the 10 Year US Treasury Note, adjusted quarterly.  As part of the agreement, ProCyte subleased a portion of its leased facility, including existing leasehold improvements, to Emerald.  The Company also received a minority limited partnership interest in Emerald as part of the consideration received in the sale.

 

Emerald suspended operations in February 2004 and until that time ProCyte had engaged Emerald to manufacture copper peptide compounds, and to perform incoming quality testing and other analytical

 

 

11

 

 

 

services.  Emerald billed ProCyte a total of $415,000 for the three-month period ended September 30, 2003, and $19,000 and $1.6 million for the nine months ended September 30, 2004 and 2003, respectively, for such products and services.  Emerald provided no products or services during the three months ended September 30, 2004. ProCyte has other sources for these products and services at prices that do not materially differ from those charged by Emerald.  ProCyte had no trade payables to Emerald at September 30, 2004 and December 31, 2003.

 

One of the Company’s Directors also serves as Chairman and Chief Executive Officer of one of ProCyte’s customers.  ProCyte’s sales to the customer were $235,000 and $248,000 for the three month periods ended September 30, 2004 and 2003, respectively and $632,000 and $593,000 for the nine month periods ended September 30, 2004 and 2003, respectively.  The customer’s trade receivable balances were $158,000 and $165,000 on September 30, 2004 and December 31, 2003, respectively.

 

9.              Loss on Asset Impairment ; Assets Held For Sale

 

In February 2004, the General Partner of Emerald informed the Company that Emerald had suspended operations and terminated all employees in an effort to conserve remaining capital while it sought other entities to operate or purchase the facility.  Emerald was ultimately not successful in returning to operations and, therefore, ProCyte terminated the facility sublease effective June 25, 2004.  In addition, effective July 16, 2004, ProCyte, as a secured party, completed a strict foreclosure process of accepting substantially all of Emerald’s assets in satisfaction of Emerald’s obligations under the $2 million promissory note.  Based upon the information known at the time, ProCyte recorded a $294,000 impairment charge in the period ended June 30, 2004. The fair value of assets received upon completion of the strict foreclosure in July 2004 was estimated to be $841,000.  Assets received that related to the contract manufacturing operation were made available for immediate sale and the estimated fair value of such assets was recorded as assets held for sale.  As a result of the sale of the assets described in note 10, management concluded that the carrying value of the assets should be reduced an additional $25,000, which was recorded as a loss on asset impairment in the third quarter ended September 30, 2004.

 

10.       Subsequent Event

 

On October 22, 2004, ProCyte entered into a definitive agreement to sell substantially all of the assets described in footnote 9 and simultaneously closed the sale transaction contemplated by the agreement.  The sale agreement contained customary representations, warranties and covenants, including a covenant from ProCyte to defend, indemnify and hold harmless the buyer and its affiliates, successors and assigns from and against any loss, liability, claim, damage or expense arising out of our related to any breach by ProCyte of its representations, warranties or covenants under the agreement, including a warranty of good and valid title to the assets transferred by the agreement.  Net proceeds, after deducting costs related to the sale incurred in October, were $814,000, which was equal to the net carrying value of the assets sold recorded on the balance sheet at September 30, 2004.

 

In connection with the agreement, ProCyte also entered into an amendment to its current facilities lease dated October 1, 1993, as amended (the “Lease”).  The amendment removes 20,600 square feet from ProCyte’s existing facility lease, reducing ProCyte’s future operating lease obligation immediately after the sale by approximately $16,000 per month.  The total reduction in the future lease obligation as a result of this amendment is approximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of its contingent obligation to reimburse the landlord for certain facility restoration work provided for in the lease.  Other principle terms of the lease, including the expiration dates (December 2005 for 1,727 square feet and June 2007 for the remaining 12,182 square feet), were not modified by the amendment.

 

12

 

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

 

This Quarterly Report on Form 10-Q contains forward-looking statements. These statements relate to future events or future financial performance.  In some cases you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “propose” or “continue,” the negative of these terms, or other terminology.  These statements are only predictions.  Actual events or results may differ materially.  In evaluating these statements, you should specifically consider various factors described below in the section entitled “Additional Information About the Company’s Business; Risk Factors.” These factors may cause our actual results to differ materially from any forward-looking statement.

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, product demand, performance or achievements.  You should not place undue reliance on our forward-looking statements, which speak only as of the date of this report. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Recent Events

 

On July 16, 2004, the Company, as a secured party, completed the strict foreclosure process of accepting substantially all of Emerald’s assets in satisfaction of Emerald’s obligations under the $2 million promissory note.  Based upon the information known at the time, including management’s assessment of the estimated fair value of the assets received, ProCyte recorded an impairment charge of $294,000 at June 30, 2004.  Assets received that related to the contract manufacturing operation were made available for immediate sale and the estimated fair value of such assets was recorded as assets held for sale.  At September 30, 2004, management reviewed the cost estimates related to the selling activity for these assets and concluded that the carrying value of the assets should be reduced an additional $25,000, which was recorded as a loss on asset impairment in the third quarter ended September 30, 2004.

 

On October 22, 2004, ProCyte entered into a definitive agreement to sell the above described assets and simultaneously closed the sale transaction contemplated by the agreement.  The sale agreement contained customary representations, warranties and covenants, including a covenant from ProCyte to defend, indemnify and hold harmless the buyer and its affiliates, successors and assigns from and against any loss, liability, claim, damage or expense arising out of our related to any breach by ProCyte of its representations, warranties or covenants under the agreement, including a warranty of good and valid title to the assets transferred by the agreement.  Net proceeds, after deducting costs incurred in October related to the sale were $814,000, the net carrying value on the balance sheet of the assets sold.

 

In connection with the agreement, ProCyte also entered into an amendment to its current facilities lease dated October 1, 1993, as amended (the “Lease”).  The amendment removes 20,600 square feet from ProCyte’s existing facility lease, reducing ProCyte’s future operating lease obligation immediately after the sale by approximately $16,000 per month, a benefit that increases in June 2005 when there is a scheduled rate increase.  The total reduction in the future lease obligation as a result of this amendment is approximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of its contingent obligation to reimburse the landlord for certain facility restoration work provided for in the lease.  Other principle terms of the lease, including the expiration dates (December 2005 for 1,727 square feet and June 2007 for the remaining 12,182 square feet), were not modified by the amendment.

 

13

 

 

Critical Accounting Policies and Estimates

 

The “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures included elsewhere in this Form 10-Q, are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingencies.  On an ongoing basis, we evaluate the estimates used, including those related to impairment and useful lives of intangible assets, allowances for accounts receivable and assets held for sale, and for excess and obsolete inventory.  We base our estimates on historical experience, current conditions and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identifying and assessing our accounting treatment with respect to commitments and contingencies.  Actual results may differ from these estimates under different assumptions or conditions.  We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of the consolidated financial statements.

 

Under the guidance of SFAS 109, “Accounting for Income Taxes,” we review our net deferred tax assets to determine which amounts, if any, are “more likely than not” to be utilized in future periods.  Our analysis of whether these tax assets will be utilized involved a substantial amount of judgment related to our ability to generate taxable net income in future periods, including revenue trends, product mix, and estimated margins, the amount and timing of which impacts the amount of net operating tax losses that could be utilized prior to their expiration.

 

Product revenues are recognized when products are shipped, license fees are recognized over the term of the license agreement, and royalties are recognized when earned.  On occasion, we will receive advance deposits with customer purchase orders.  These deposits are reported as a deferred revenue liability, until the product is shipped to the customer.

 

Under the guidance of SFAS 142, “Goodwill and Other Intangible Assets,” we analyze whether the fair value of recorded goodwill is impaired on an annual basis.  Application of the goodwill impairment test requires judgment, including the identification of reporting units and determining the fair value of each reporting unit.  Significant judgments required to estimate the fair value of the reporting unit include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value.

 

We maintain an allowance for doubtful accounts for estimated losses resulting from the potential inability of our customers or other debtors to make required payments.  The allowance is based upon historical experience and a review of individual customer balances.  If the financial condition of our customers or other debtors were to deteriorate, resulting in an impairment of their ability to make payments to us, additional allowances may be required.

 

Inventories are stated at the lower of cost or market value.  Cost is principally determined by the first-in, first-out method.  We record adjustments to the value of inventory based upon forecasted plans to sell our inventories.  The physical condition (e.g., age and quality) of the inventories is also considered in establishing its valuation.  These adjustments are estimates, which could vary significantly, either favorably or unfavorably, from the amounts that we may ultimately realize upon the disposition of inventories, if future economic conditions, customer inventory levels, product discontinuances or competitive conditions differ from our estimates and expectations.

 

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We record impairment losses on long-lived assets used in operations when events and circumstances indicate that assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets.  Estimation of future values for the long-lived assets requires a significant amount of judgment related to assessing the possible outcomes and the timing related to each outcome.  The adjustments are estimates, which could vary significantly, either favorably or unfavorably, from the amounts that we may ultimately realize for these assets if the actual events differ significantly from our estimates and expectations.

 

Assets acquired in settlement of debt and held for sale are valued at their estimated fair value as of the date of foreclosure.  Management evaluates the value of foreclosed assets held for sale periodically and decreases the carrying value of the assets for any subsequent declines in fair value.  Changes in the valuation of and gains/losses on sales of foreclosed assets are included in loss on asset impairment.

 

Results of Operations

 

Three Months Ended September 30, 2004 and 2003

 

Revenue

 

		Three Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Products		$	2,683		$	1,918		40	%
Copper peptide compound		200			368			(46	)%
Royalties		353			437			(19	)%
		$	3,236		$	2,723		19	%

 

Product revenues for the third quarter of 2004 increased $765,000, or 40 percent over the third quarter of 2003.  The increase was primarily due to a $339,000, or 247 percent increase in sales to international distributors, a $187,000 or 12 percent increase in sales to physicians and the additional sales related to the spa distribution business included in the 2004 third quarter.  During 2004, we directed specific efforts at growing our international business, including the addition of a new international sales director in November 2003.  During the third quarter of 2004, we completed the negotiations for a new distribution agreement with our current Korean distributor and entered into distribution agreements with four new distributors located in Taiwan, Hong Kong, Malaysia and Australia.  Due to the number of new agreements occurring in a single quarter and the buying patterns of our international distributors, the results of the 2004 third quarter are not necessarily an indication of future quarterly international sales results for a single quarter.  Sales to physicians have been improving each quarter, on a comparable quarter basis, since the third quarter of 2003 driven in part by the introduction of new products in the first and second quarter of 2004 and the implementation of new sales and training programs.

 

Copper peptide compound shipments are driven by the purchasing patterns of our largest licensee, Neutrogena, which can vary based upon production cycles, adjustments in safety stock and other factors beyond our control.  As a result of these factors, 46% less copper peptide compound was shipped in the third quarter of 2004 as compared to the comparable 2003 quarter.

 

Royalty revenue is based upon sales generated by our licensees, principally Neutrogena.  Royalty revenues may fluctuate from quarter to quarter, due to the licensees’ timing of new market launches,

 

 

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special promotions and other factors beyond the Company’s control.  Royalties received from Neutrogena in the third quarter of 2004 were 19 percent lower than the comparable 2003 quarter.  Royalty revenue varies from quarter to quarter due to differences in the timing of our licensees’ promotions and expansions into new territories and therefore quarterly comparisons are expected to vary as a result.

 

Gross Profit

 

Gross profit for the 2004 third quarter increased by $432,000, or 21 percent, over the third quarter of 2003 to $2.5 million.  Gross margin for the 2004 third quarter was 77 percent as compared to 76 percent in the 2003 third quarter.  The increase in gross profit is primarily from the 40% increase in product revenues for the 2004 third quarter, which was partially offset by the decrease in royalty revenue for that quarter.

 

Operating Expenses

 

		Three Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Marketing and selling		$	1,092		$	1,024		7	%
Research, general and administrative		1,055			797			32	%
Loss on asset impairment		25			—			—
Total operating expenses		$	2,171		$	1,821		19	%

 

Marketing and selling expenses for the third quarter of 2004 increased primarily due to expenses related to the spa distribution business in the 2004 quarter.  This is partially offset by $83,000 in costs related to the development and testing of an infomercial included in the third quarter of 2003 and not repeated in 2004.

 

Research, general and administrative expenses for the 2004 third quarter increased $258,000 over the comparable 2003 period.  This was primarily due to approximately $111,000 in expenses related to Emerald not making rental and other payments under its sublease and other agreements and costs related to supporting the manufacturing facility.  Such payments partially offset the Company’s rent expense in the 2003 quarter.  The remaining increase for the 2004 third quarter over the comparable 2003 period was from general market increases in compensation and employee benefit expenses, a provision for estimated bonuses included in the 2004 third quarter but not in the 2003 third quarter due to lower performance in 2003, legal expense increases due to the timing of contract and general corporate work, and additional expenses from the inclusion of spa operations in the 2004 third quarter period.  These increased expenses were partially offset by a $38,000 decrease in bad debt expense due to the receipt of payments in the 2004 third quarter from accounts previously written off in prior periods.

 

Loss on asset impairment relates to the assets held for sale.  The Company sold these assets on October 22, 2004.  Considering the proceeds received in October and the remaining cost incurred to sell, ProCyte took a loss on asset impairment charge of $25,000 at September 30, 2004.

 

 

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Interest and Other Income

 

Interest and other income earned during the third quarter of 2004 decreased primarily due to interest income not received on the Emerald note during the 2004 quarter.

 

Net Income

 

Net income before income taxes was $323,000 for the third quarter of 2004, an increase of 24% as compared to $261,000 for the 2003 period.  As a result of the partial reversal of our deferred tax asset valuation allowance in the fourth quarter of 2003, ProCyte’s 2004 third quarter reflects a provision for income tax expense while in the comparable 2003 period no income tax expense was recorded.  Accordingly, third quarter 2004 net income, after a $122,000 provision for income tax expense was $201,000 or $0.01 per diluted share as compared to net income of $261,000 or $0.02 per diluted share in the 2003 third quarter.

 

Nine Months Ended September 30, 2004 and 2003

 

Revenue

 

		Nine Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Products		$	7,834		$	5898		33	%
Copper peptide compound		1,364			1,583			(14	)%
Royalties		942			1,220			(23	)%
		$	10,140		$	8,701		17	%

 

Product revenues for the first nine months of 2004 increased $1.9 million, or 33 percent, over the first nine months of 2003. The increase was primarily due to a $1.1 million or 23 percent increase in sales to physicians, a $330,000 or 68 percent increase in sales to international distributors, and $594,000 in sales related to the spa distribution business included in the comparable 2004 period.  Sales to physicians have been improving each quarter, on a comparable quarter basis, since the third quarter of 2003 driven in part by the introduction of new products in the first and second quarter of 2004 and the implementation of new sales and training programs.

 

Copper peptide compound shipments are driven by the purchasing patterns of our largest licensee, Neutrogena, which can vary based upon production cycles, adjustments in safety stock and other factors beyond our control.  Accordingly, the quarterly comparisons can be volatile and inconsistent and they have been so in 2004 as compared to comparable quarters of 2003.  For the first nine months of 2004 Copper peptide compound revenues were 14 percent lower than the comparable 2003 period.

 

Royalty revenue is based upon sales generated by our licensees.  Royalty revenues may fluctuate from quarter to quarter, due to the licensees’ timing of new market launches, special promotions and other factors beyond the Company’s control.  Royalties earned in the first nine months of 2004 decreased 23 percent as compared to the corresponding 2003 period, principally due to lower reported sales of licensed products by Neutrogena.  In addition, upon the expiration of the underlying ProCyte patent in February 2005, the license agreement specifies that lower royalty percentages be used for the remaining term, the impact of which will be a reduction in the average effective royalty rate of approximately 34 percent. The actual dollar amount of royalty income recognized in future periods is dependent upon both the royalty

 

 

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percentages in effect during the period and the actual applicable sales reported by Neutrogena, which can vary from quarter to quarter.  Therefore, historic royalty revenue is not an indication of future results.

 

 

Gross Profit

 

Gross profit for the first nine months of 2004 increased by $1.1 million, or 18 percent, to $7.4 million.  Gross margin for the first nine months of 2004 was 73 percent as compared to 72 percent in the corresponding 2003 period.  The increase in gross profit during the first nine months of 2004 was primarily due to the 33% increase in product sales, which was partially offset by the decrease in royalty revenue when compared to the first nine months of 2003. The increase in gross margin percentage is due to a slightly different revenue mix in the two periods being compared.

 

Operating Expenses

 

		Nine Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Marketing and selling		$	3,549		$	3,237		10	%
Research, general and administrative		3,203			2,731			17	%
Loss on asset impairment		319			—			—
Total operating expenses		$	7,071		$	5,968		19	%

 

Marketing and selling expenses for the first nine months of 2004 increased $312,000 primarily due to increased selling activity during the period.  Of the net increase, approximately $407,000 was related to higher salary, benefit and travel costs from increased headcount supporting selling efforts in the 2004 period, higher commission expense related to the 33% increase in current period product sales and increased legal expenses related to the establishment and defense of the Company’s trademarks.  In addition, the first nine months of 2004 includes expenses related to the spa distribution business not included in the 2003 period.  These increases are partially offset by $770,000 in costs related to the development and testing of an infomercial included in the 2003 period and not repeated in 2004.

 

Research, general and administrative expenses for the first nine months of 2004 increased $472,000 over the comparable 2003 period.  This was primarily due to approximately $343,000 in expenses related to Emerald not making rental and other payments under its sublease and other agreements and costs related to supporting the manufacturing facility.  Such payments from Emerald partially offset the Company’s rent expense in the 2003 period.  The remaining increase for the nine months of 2004 over the comparable 2003 period was from general market increases in compensation and employee benefit expenses, legal expenses increasing due to the timing of contract and general corporate work, and expenses from the addition of spa operations in the 2004 period.  These increased expenses were partially offset by a $285,000 decrease in bad debt expense due to the receipt of payments in 2004 from accounts previously written off in prior periods and a lower accrual for estimated bonuses in the first nine months of 2004 as compared to the comparable 2003 period.

 

Interest and Other Income

 

Interest and other income earned during the first nine months of 2004 decreased $95,000 to $64,000 primarily due to a decrease of $79,000 in interest income not recognized on the Emerald note in the 2004

 

 

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period due to Emerald’s suspension of operations in February 2004 and a termination settlement of $50,000 received from Merck KGaA in the first quarter of 2003.  This decrease was partially offset by interest income of $34,000 recognized during the second quarter of 2004 upon the final settlement of accounts receivable from a former licensee and written off in 2002.

 

Net Income

 

Net income before income taxes was $359,000 for the first nine months of 2004, a decrease of 13% as compared to $414,000 for the comparable 2003 period.  Net income for the first nine months of 2004, after a $137,000 provision for income tax expense was $222,000, or $0.01 per diluted share, compared to net income of $397,000 or $0.02 per diluted share for the same period of 2003, which included no comparable provision for income tax expense. The decrease in net income is due to the effect of including the provision for income tax expenses in the 2004 period and the expenses and impairment charge related to the manufacturing facility incurred during the nine month period ended September 30, 2004.

 

Liquidity and Capital Resources

 

The Company relies primarily on cash flow from operations to fund its operations and capital expenditures.  At September 30, 2004, the Company had approximately $5.3 million in cash and cash equivalents, compared to $3.8 million at December 31, 2003.  The net change in cash and cash equivalents during the first nine months of 2004 reflects a net increase in cash of $1.5 million.  The significant components of this positive cash increase are an increase in trade payables, the receipt of payment on a note due from an officer and the receipt of a customer deposit under a supply contract.  Positive cash generated was partially offset by the reduction in cash flow from Emerald as discussed below, the payment of the 2003 management bonuses in March 2004, an increase in prepaid insurance premiums for several annual policies that renewed in August or were extended until August of 2005, and net cash used in support of the spa products distribution business.

 

As of February 2004, Emerald Pharmaceuticals, L.P. suspended operations and in fiscal 2003 ProCyte recorded an impairment related to its $2.0 million note receivable due to the uncertainty that the full amount would be collected.  Emerald also leased its facility from ProCyte under an operating sublease.  During the first nine months of 2004, except for January rent, ProCyte did not receive the interest and rental payments due under its agreements with Emerald.  Therefore, cash flow from operations was reduced by $40,000 per month, from the comparable 2003 period.  ProCyte terminated the sublease on June 25, 2004 in order to take back the facility and protect the Company’s collateral and other interests.  Effective that date, ProCyte become responsible for facility related operating expenses such as utilities, insurance and security of approximately $11,000 per month.  In October 2004, ProCyte completed the asset sale described in Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Events,” and received net proceeds, after deducting costs incurred in October related to the sale of $814,000.  As part of the asset sale, the Company amended its primary facility lease reducing the monthly rent expense by $16,000 per month, or a total of $668,000 over the remaining term of the lease.

 

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Spa sales have developed more slowly than initially anticipated at the time we acquired the spa business at the end of 2003, and for the nine months ended September 30, 2004 spa sales activity had required net cash to support operations of $300,000.  Based upon recent experience and current plans, ProCyte believes that additional cash of up to $150,000 could be required over the next two quarters before spa operations provide positive cash flow from operations.

 

We may see fluctuations in operating cash flows in future periods as they depend in large part on the timing of deposits received from our licensees, of new product introductions and the timing of shipments to and payments received from our customers.  Additionally, ProCyte received $900,000 in cash from the completion of the asset sale on October 22, 2004 increasing available cash in the fourth quarter of 2004.

 

The Company believes that its existing cash and cash equivalents and interest thereon, will be sufficient to meet its working capital requirements for at least the next two years.  However, there can be no assurance that the underlying forecasts of revenue and expense will prove to have been accurate.  The Company’s actual cash requirements will depend upon numerous factors, including the levels of resources that the Company devotes to taking advantage of strategic acquisitions and/or establishing and maintaining marketing, sales and distribution capabilities, the emergence of competitive products and other adverse market developments, the timing and amount of revenues and expense reimbursements resulting from relationships with third parties, the Company’s degree of success in commercializing new products and the cost of preparing, filing, prosecuting, maintaining and enforcing patent claims and intellectual property rights, and actions by regulatory authorities.  The Company will depend on product revenues, royalties and license fees, interest income, equity financing, and funding from corporate alliances to meet its future capital needs.  See “Additional Information About the Company’s Business; Risk Factors.”

 

Additional Information About the Company’s Business; Risk Factors

 

Loss of or Reduction in Orders by Significant Customers Could Adversely Affect Our Net Revenues and Results of Operations

Although the Company’s customer base is made up of a large number of customers, Neutrogena accounted for approximately 23 percent of the Company’s net revenue during the first nine months of 2004 and our top 10 customers comprised approximately 37 percent of such net revenues.  Any decrease in or loss of revenues from these customers could have an adverse effect on our net revenues and results of operations or impair our ability to increase net revenues.  The Neutrogena technology license agreement expires in April 2010, however the royalty payments related to each territory continue for a period not less than five years from the date products were first sold in each territory, which may extend the royalty period beyond 2010 for certain territories.  Royalty revenue from the Neutrogena license agreement accounted for 9 percent and 14 percent of the Company’s net revenues in the first nine months of 2004 and 2003, respectively.  The patent related to the Neutrogena license agreement expires February 5, 2005, the effect of which will be a reduction in the percentage paid as royalty during the remaining royalty period as set forth in the agreement.  Revenues from sale of copper peptide compound to Neutrogena pursuant to a related supply agreement, accounted for 14 percent and 18 percent of net revenues in the first nine months of 2004 and 2003, respectively. The supply agreement expires in April 2005, with extensions for additional two-year terms by mutual consent of the parties up to April 2010.  There can be no assurance that this agreement will be extended beyond April 2005, or if extended, that it will be extended to April 2010.  Also, the timing of copper peptide compound shipments are driven by Neutrogena’s purchasing patterns, which can vary based upon production cycles, adjustments in safety

 

 

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stock and other factors beyond our control, causing the revenue from copper peptide compound sales to fluctuate from quarter to quarter.

 

We expect that we will continue to depend on revenue from larger customers, generally under multi-year license or supply agreements.  Such agreements can be terminated under certain circumstances, including our inability to supply product within required time frames.  Any downturn in the business from these customers or the inability to renew or replace agreements with new customers as they expire could significantly decrease sales to such customers, which could adversely affect our net revenues and results of operations.

 

Furthermore, we ship most orders when received.  Virtually all orders are shipped within 48 hours and therefore we do not have a substantial non-cancelable backlog of orders.  Variations in the timing of orders can cause significant fluctuations in our quarterly operating results, and the cancellation or deferral of product orders or overproduction due to the failure of anticipated orders to materialize could result in us holding excess or obsolete inventory, which has resulted and could again in the future result in write-downs of inventory that would have a material adverse effect on our operating results.

 

Dependence on and Management of Existing and Future Corporate Alliances

The successful commercialization of the Company’s existing and future products in the mass retail, prestige, specialty retail, and home shopping categories and wound care markets will depend upon ProCyte’s ability to enter into and effectively manage corporate alliances.  There can be no assurance that the Company will be successful in establishing corporate alliances in the future, or that it will be successful in performing and maintaining existing or any future corporate alliances.  Moreover, there can be no assurance that the interests and motivations of any distributor, licensee or other alliance party would be or remain consistent with those of the Company, or that the Company and such distributors,  licensees or alliance party will successfully perform the necessary technology transfer, clinical development, regulatory compliance, manufacturing, marketing, commercialization and other obligations under their agreements. Any of these failures could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

Recent Profitability; Profitability May Fluctuate in Future Periods

The Company has been marketing products based on its proprietary copper peptide technology since 1996.  In addition to sales of products based on its proprietary copper peptide technology, the Company’s revenues have historically included sales of non-proprietary products, license fees and royalties, revenue from contract manufacturing and interest income.  The contract manufacturing operation was sold in July 2001.  During fiscal 2002, the Company reported net profits and positive cash flow from operations for the first time in its operating history.  During 2003, the Company reported net income before tax benefit and break even cash flow from operations.  During the first nine months of 2004, the company reported a net profit and positive cash flow from operations.  Attaining consistent profitability is dependent upon a wide variety of factors, including successfully manufacturing and marketing of the Company’s products, entering into and maintaining agreements with third parties for commercialization of the Company’s products, successfully licensing the Company’s products and technology and general economic conditions, including those which affect demand for the services of our dermatologist, plastic and cosmetic surgery customers.  Payments under corporate alliances and licensing arrangements may be subject to fluctuations in both timing and amounts and therefore the level of profitability may vary significantly from quarter to quarter.

 

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We Rely On Third Party Manufacturers for Our Products

We use third party manufacturers to make products. In many cases, third party manufacturers are not obligated under contracts that fix the term of their commitments and they may discontinue production upon little or no advance notice.  Manufacturers also may experience problems with product quality or timeliness of product delivery.  We rely on these manufacturers to comply with applicable current quality system regulations (“QSR”).  The loss of a contract manufacturer may force us to shift production to in-house facilities and possibly cause manufacturing delays, disrupt our ability to fill orders, or require us to suspend production until we find another third party manufacturer.  We are not able to control the manufacturing efforts of these third party manufacturers as closely as we control our business.  Should any of these manufacturers fail to meet the applicable standards, we or our third-party manufacturer could face various enforcement actions, which would have an adverse effect on our net revenues and results of operations.

 

Need for Additional Capital

The Company generated positive cash from operations in the first nine months ended September 30, 2004 and break even cash flow from operations in 2003.  The Company currently expects that it will generate positive cash flow from operations in 2004.  As of September 30, 2004, the Company had cash and cash equivalents of $5.3 million.  The Company estimates that, at its planned rate of spending, its existing cash and cash equivalents and the interest income thereon will be sufficient to meet its operating and capital requirements for at least the next two years.  There can be no assurance, however, that our underlying assumed levels of revenue and expense will prove accurate.  Whether or not these assumptions prove to be accurate, the Company may need to raise additional capital as the Company may require additional funds to expand or enhance its sales and marketing activities, to accelerate product development, or to acquire a product line or company.  The Company may be required to seek this additional funding through public or private financing, including equity financing, or through collaborative arrangements.  Adequate funds for these purposes, whether obtained through financial markets or from collaborative or other arrangements, may not be available when needed or may not be available on terms favorable to the Company.  If we issue equity securities to raise additional funds, dilution to existing shareholders will result.  If funding is insufficient at any time in the future, the Company may be required to: delay, scale back or eliminate some or all of its marketing and research and development programs; or license to third parties the rights to commercialize products or technologies that the Company would otherwise seek to develop on its own.  Furthermore, the terms of any such license agreements or asset sales might be less favorable than if the Company were negotiating from a stronger position.

 

Uncertainty of Patent Position and Proprietary Rights

The patent positions of biotechnology, medical device and healthcare products companies are often uncertain and involve complex legal and factual questions, and the breadth of claims allowed in such patents cannot be predicted.  The Company’s success will depend on its ability to obtain patents and licenses to patent rights, to maintain trade secrets, and to operate without infringing on the proprietary rights of others, both in the United States and in other countries.  The failure of the Company or its licensors to obtain, maintain and enforce patent protection for the Company’s technology could have a material adverse effect on the Company.

 

ProCyte’s success depends, in part, upon its ability to protect its products, technology and trademarks under intellectual property laws in the United States and abroad.  The Company receives a significant amount of its revenue from technology licensing agreements, which are dependent upon patents, and expects to continue licensing its technology for certain markets.  Royalty revenue from the Neutrogena

 

 

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license agreement accounted for 9 percent and 14 percent of the Company’s net revenues in the first nine months of 2004 and 2003, respectively and is based upon Neutrogena’s applicable sales, as set forth in the agreement, multiplied by specified royalty percentages.  The patent related to the Neutrogena license agreement expires February 5, 2005.  Upon expiration of this patent, the agreement specifies that lower royalty percentages be used for the remaining term, the impact of which is a reduction in the average effective royalty rate of approximately 34 percent.  The actual amount of royalty income recognized in future periods is dependent upon the royalty percentages in effect during the period and the actual applicable sales reported by Neutrogena, which can vary from quarter to quarter.  The expiration of the patent would also allow others, including Neutrogena, to manufacture the compound.  The supply agreement expires in April 2005, with extensions for additional two-year terms by mutual consent of the parties up to April 2010.  There can be no assurance that this agreement will be extended beyond April 2005, or if extended, that it will be extended to April 2010.

 

As of October 22, 2004, the Company had 19 issued US patents expiring between 2005 and 2017 and numerous issued foreign patents and patent registrations.  In addition, the Company has 12 patents applied for of which 9 have been published and are pending action by the United States Patent & Trademark Office.  The patents relate to use of the Company’s copper peptide-based technology for a variety of healthcare applications, and to the composition of certain biologically active, synthesized compounds.  The Company’s strategy has been to apply for patent protection for certain compounds and their discovered uses that are believed to have potential commercial value in countries that offer significant market potential.  There can be no assurance that patent applications relating to the technology used by the Company will result in patents being issued.  Nor can there be any assurance that any patent issued to the Company will not be subject to further proceedings limiting the scope of the rights under the patent or that such patent will provide a competitive advantage, will afford protection against competitors with similar technology, or will not be successfully challenged, invalidated or circumvented by competitors.

 

The Company’s processes and potential products may conflict with patents that have been or may be granted to competitors and others.  As the biotechnology, medical device and healthcare industries expand and more patents are issued, the risk increases that the Company’s processes and potential products may give rise to claims that they infringe the patents of others.  Such other persons could bring legal actions against the Company claiming damages and seeking to enjoin clinical testing, manufacturing and marketing of the affected product or use of the affected process.  Litigation may be necessary to enforce patents issued to the Company, to protect trade secrets or know-how owned by the Company or to determine the enforceability, scope and validity of proprietary rights of others.  If the Company becomes involved in such litigation, it could result in substantial expense to the Company and significant diversion of effort by the Company’s technical and management personnel.  In addition to any potential liability for significant damages, the Company could be required to obtain a license to continue to manufacture or market the affected product or use the affected process.  Costs associated with any licensing arrangement may be substantial and could include ongoing royalties.  There can be no assurance that any license required under any such patent would be made available to the Company on acceptable terms, if at all.  If such licenses could not be obtained on acceptable terms, the Company could be prevented from manufacturing and marketing existing or potential products.  Accordingly, an adverse determination in such litigation could have a material adverse effect on the Company’s business, financial condition and results of operations.  The Company is not aware of any conflicts at this time.

 

The Company also relies upon non-patented proprietary technology.  There can be no assurance that the Company can meaningfully protect its rights to such non-patented technology, that any obligation to maintain the confidentiality of such proprietary technology will not be breached by employees, consultants, collaborators or others or that others will not independently develop or acquire substantially

 

 

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equivalent technology.  To the extent that licensees or consultants apply Company technological information independently developed by them or by others to Company projects or apply Company technology or know-how to other projects, disputes may arise as to the ownership of proprietary rights to such information.  Any failure to protect non-patented proprietary technology or any breach of obligations designed to protect such technology or development of equivalent technology may have a material adverse effect on the Company’s business, financial condition and results of operations.

 

Uncertainty of Government Regulatory Requirements

The Federal Food, Drug and Cosmetic Act, and the regulations promulgated thereunder, and other federal and state statutes govern, among other things, the testing, manufacture, safety, labeling, storage, record-keeping, advertising and promotion of cosmetic products and medical devices.  The Company’s products and product candidates may be regulated by any of a number of divisions of the FDA and in other countries by similar health and regulatory authorities.  The process of obtaining and maintaining regulatory approvals for the manufacturing or marketing of the Company’s existing and potential products is costly and time-consuming and is subject to unanticipated delays.  Regulatory requirements ultimately imposed could also adversely affect the ability of the Company to clinically test, manufacture or market products.

 

In the United States, products that do not seek to make effectiveness claims based on human clinical evaluation may be subject to review and regulation under the FDA’s cosmetic, drug or 510(k) medical device guidelines.  Similar guidelines exist for such products in other countries.  Such 510(k) products, which include wound care dressings and certain ointments and gels, must show safety and substantial equivalency with predicate products already cleared by the FDA to be marketed.  There can be no assurance that product applications submitted to the FDA or similar agencies in other countries will receive clearance to be marketed, or that the labeling claims sought will be approved, or that, if cleared, such products will be commercially successful or free from third party claims relating to the effectiveness or safety of such products.

 

The Company also is or may become subject to various other federal, state, local and foreign laws, regulations and policies relating to, among other things, safe working conditions, good laboratory practices, and the use and disposal of hazardous or potentially hazardous substances used in connection with research and development.

 

Failure to obtain regulatory approvals where appropriate for its product candidates or to attain or maintain compliance with QSR or other manufacturing requirements would have a material adverse effect on the Company’s business, financial condition and results of operations.

 

Intense Competition

Competition in the wound care, skin health and hair care markets is intense.  The Company’s competitors include well-established pharmaceutical, cosmetic and healthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia, Declore and Murad.  These competitors have substantially more financial and other resources, larger research and development staffs, and more experience and capabilities in researching, developing and testing products in clinical trials, in obtaining FDA and other regulatory approvals and in manufacturing, marketing and distribution than the Company.  In addition, a number of smaller companies are developing or marketing competitive products.  The Company’s competitors may succeed in developing and commercializing products or obtaining patent protection or other regulatory approvals for products more rapidly than the Company.  In addition, competitive products may be manufactured and marketed more successfully than the Company’s potential products.  Such developments could render the Company’s existing or potential products less competitive or obsolete and

 

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could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

Product Liability Claims

The testing, manufacturing, marketing and sale of our products may subject the Company to product liability claims.  ProCyte maintains insurance coverage against product liability risks up to an aggregate annual limit of $10 million.  However, continuing insurance coverage may not be available at an acceptable cost, if at all.  The Company may not be able to obtain insurance coverage that will be adequate to satisfy any liability that may arise.  Regardless of merit or eventual outcome, product liability claims may result in decreased demand for a product, injury to its reputation, withdrawal of clinical trial volunteers and loss of revenues.  As a result, regardless of whether the Company is insured, a product liability claim or product recall may result in losses that could be material to ProCyte.

 

Potential Volatility of Stock Price; Bulletin Board Listing

The market prices for securities of healthcare, pharmaceutical and biotechnology companies are subject to volatility, and the market has from time to time experienced significant fluctuations that are unrelated to the operations of the Company.  ProCyte’s market price has fluctuated over a wide range since the Company’s initial public offering in 1989, and since March 25, 1999, the Company’s common stock has traded on the NASD OTC bulletin board.  Because real-time price information may not be easily available for bulletin board securities, an investor is likely to find it more difficult to dispose of, or to obtain accurate quotations on the market value of, the Company’s securities than if they were listed on a the Nasdaq or a national exchange.  In addition, purchases and sales of the Company’s securities may become subject to Rule 15g-9 of the Securities Exchange Act of 1934, which imposes various sales practice requirements on broker-dealers, or to the “penny stock” rules, either of which would likely reduce the level of trading activity in the secondary market for the Company’s securities and make selling the securities more difficult for an investor.

 

Announcements concerning the Company or its competitors, including fluctuations in operating results, research and development program direction, results of clinical trials, addition or termination of corporate alliances, technology licenses, clearance or approval to market products, announcements of technological innovations or new products by the Company or its competitors, changes in government regulations, healthcare reform, developments in patent or other proprietary rights of the Company or its competitors, litigation concerning business operations or intellectual property, or public concern as to safety of products, as well as changes in general market conditions and mergers and acquisitions, may have a significant effect on the market price of ProCyte’s common stock.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

For a discussion of our market risks, refer to the Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the year ended December 31, 2003. There have been no material changes to the information provided that would require additional information with respect to the nine months ended September 30, 2004.

 

Item 4.  Controls and Procedures

 

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness and design of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation,

 

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the principal executive officer and principal financial officer concluded that these disclosure controls and procedures were effective as of September 30, 2004, in ensuring that the information required to be disclosed by the Company in reports it files or submits under the Exchange Act within the time periods specified in the SEC rules and forms.

 

There were no changes in the Company’s internal controls over financial reporting during the third quarter of 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Limitations on the Effectiveness of Controls

 

The Company’s management, including our principal executive officer and principal financial officer, does not expect that the Company’s disclosure controls or its internal controls will prevent all error and all fraud.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of that control system are met.  Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of control must be considered relative to their costs. Because of the inherent limitation in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the reality that judgments in decision-making can be faulty, and breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more persons, or by management override of the control.  The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time controls may become inadequate because of changes in conditions, of the degree of compliance with the policies and procedures may deteriorate.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

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Part II - Other Information

 

 

Item 6.  Exhibits

 

(a) Exhibits

 

See Exhibit Index below.

 

 

 

 

Signatures

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

	ProCyte Corporation
Date: November 12, 2004	By:	/s/ John F. Clifford
		John F. Clifford, Chairman and CEO
Date: November 12, 2004	By:	/s/ Robert W. Benson
		Robert W. Benson, Chief Financial Officer

 

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Exhibit Index

 

Exhibit		Description		Note
3.1		Restated Articles of Incorporation of the Registrant		A
3.2		Restated Bylaws of the Registrant		A
4.1		Rights Agreement between the Registrant and American Securities Transfer and Trust as of December 7, 1994		G
10.1*		1987 Stock Benefit Plan of ProCyte Corporation		A
10.2*		ProCyte Corporation 1989 Restated Stock Option Plan		B
10.3*		ProCyte Corporation 1991 Restated Stock Option Plan for Non-employee Directors and amendments thereto		D
10.4†		Teachers Insurance & Annuity Association Lease dated as of October 1, 1993 and second amendment thereto dated February 28, 1997		D
10.5*		1996 Stock Option Plan		D
10.6*		ProCyte Corporation 1998 Non-employee Director Stock Plan		F
10.7*		Change of Control Agreement for Ms. Robin Carmichael		K
10.8*		Change of Control Agreement for Mr. John Clifford		K
10.9*		Change of Control Agreement for Mr. Robert Benson		K
10.10*		Form of Indemnity Agreement dated February 23, 1995 between the Registrant and each of Dr. Blake, Mr. Patterson and Mr. Clifford.		C
10.11*		Form of Indemnity Agreement between ProCyte Corporation and each of various of its Officers and Directors		F
10.12*		Severance Agreement for Mr. John Clifford		K
10.13†		License Agreement dated April 19, 2000 between ProCyte Corporation and Neutrogena Corporation		I
10.14*		Indemnity Agreement between ProCyte Corporation and Robert L. Benson dated June 3, 2004		H
10.15*		ProCyte Corporation 2004 Stock Option Plan		K
10.16		Asset Purchase Agreement dated as of October 22, 2004, by and between ProCyte Corporation and ICOS Corporation		J
10.17		Fifth Lease Amendment dated October 20, 2004, between ProCyte Corporation and TIAA Realty, Inc.		J
31.1		Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer		L
31.2		Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer		L
32.1		Section 1350 Certification of Chief Executive Officer		L
32.2		Section 1350 Certification of Chief Financial Officer		L

*		Management contract or compensatory plan or arrangement.
†		Confidential treatment has been granted or requested with respect to portions of this exhibit.
A		Incorporated by reference to the Registrant’s Registration Statement of Form S-1 (No. 33-31353).
B		Incorporated by reference to the Registrant’s Registration Statement of Form S-1 (No. 33-46364).
C		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 1994.
D		Incorporated by reference to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 1996.
F		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended June 30, 1998.
G		Incorporated by reference to the Registrant’s Amended Annual Report on Form 10-K/A dated December 31, 1997.
H		Incorporated by reference to the Registrant’s Amended Quarterly Report on Form 10-Q/A (Amendment No.1) for the quarter ended June 30, 2004, filed on August 20, 2004 .
I		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended March 31, 2000.
J		Incorporated by reference to the Registrant’s Current Report on Form 8-K filed October 22, 2004
K		Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended June 30, 2004.
L		Filed herewith.

 

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