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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
               EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2005

[ ]           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—000-14961

LXU HEALTHCARE, INC.
(Formerly PrimeSource Healthcare, Inc.)
(Exact name of registrant as specified in its charter)

Massachusetts
  
04-2741310
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. Employer
Identification No.)

3708 E. Columbia Street, Tucson, AZ 85714
(Address of principal executive offices) (Zip code)

(520) 512-1100
(Registrant’s telephone number, including area code)

PrimeSource Healthcare, Inc.
(Former name)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes _X    No ___

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

Yes ___   No _X  . 

On April 12, 2005, there were 22,375,144 shares of the Registrant’s common stock outstanding.
 


LXU HEALTHCARE, INC. (FORMERLY PRIMESOURCE HEALTHCARE, INC.)
TABLE OF CONTENTS
 

Part I
Financial Information
Page
       
 
Item 1.
Unaudited Condensed Financial Statements
 
       
   
Condensed Consolidated Balance Sheets as of March 31, 2005
  
   
and June 30, 2004
3
       
   
Condensed Consolidated Statements of Income for the three and
  
   
nine months ended March 31, 2005 and 2004 (As restated, see Note 12)
5
       
   
Condensed Consolidated Statements of Cash Flows for the nine months
 
    ended March 31, 2005 and 2004 (As restated, see Note 12) 
 6
   
 
   
Notes to Condensed Consolidated Financial Statements
8
       
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and
  
   
Results of Operations
20
       
 
Item 3.
Quantitative and Qualitative Disclosure about Market Risk
27
       
 
Item 4.
Controls and Procedures
27
       
Part II
Other Information
  
       
 
Item 1.
Legal Proceedings
28
       
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
28
       
 
Item 6.
Exhibits
28
       
Signatures
  
29



2 
 
PART I—FINANCIAL INFORMATION
 
ITEM 1.     FINANCIAL STATEMENTS
 
LXU HEALTHCARE, INC. AND SUBSIDIARIES
    
(Formerly Primesource Healthcare, Inc.)
    
     
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
     
 
           
   
March 31, 
    
June 30,
  
     
2005
    
2004
  
ASSETS
          
 
               
CURRENT ASSETS:
              
Cash and cash equivalents
  
$
47,636
 
$
98,903
 
Accounts receivable—net of allowance for doubtful accounts
             
of approximately $49,000 and $132,000, respectively
    
6,672,708
   
5,718,346
 
Inventories—net
    
7,948,328
   
6,732,542
 
Income taxes receivable
    
157,781
   
129,913
 
Prepaid expenses and other current assets
    
147,877
   
224,865
 
               
Total current assets
    
14,974,330
   
12,904,569
 
               
PROPERTY AND EQUIPMENT—Net
    
772,328
   
887,325
 
               
INTANGIBLE ASSETS—Net of accumulated amortization of
              
approximately $251,000 and $245,000, respectively
    
53,658
   
60,273
 
               
GOODWILL—Net
   
15,956,883
   
15,956,883
 
               
OTHER ASSETS
    
77,713
   
90,196
 
               
TOTAL
  
$
31,834,912
 
$
29,899,246
 
               
         
(Continued) 
  
 
 

3 


LXU HEALTHCARE, INC. AND SUBSIDIARIES
    
(Formerly Primesource Healthcare, Inc.)
    
     
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY    
March 31, 
June 30, 
2005 
2004
  
               
CURRENT LIABILITIES:
              
Accounts payable
  
$
4,306,511
 
$
4,253,295
 
Accrued expenses
    
1,596,852
   
1,509,432
 
Accrued restructuring costs
    
   
43,726
 
Customer deposits
    
177,138
   
166,873
 
Lines of credit
    
4,485,828
   
5,204,139
 
Current portion of notes payable
    
17,942
   
16,713
 
Current portion of capital lease obligations
    
30,403
   
21,568
 
               
Total current liabilities
    
10,614,674
   
11,215,746
 
               
CAPITAL LEASE OBLIGATIONS—Net of current portion
    
23,131
   
22,149
 
               
NOTES PAYABLE—Net of current portion
    
75,369
   
88,983
 
               
Total liabilities
    
10,713,174
   
11,326,878
 
               
COMMITMENTS AND CONTINGENCIES (Notes 5, 9, 10 and 11)
              
               
SERIES G CONVERTIBLE, REDEEMABLE PREFERRED STOCK—
              
No par value—authorized 230,000 shares; issued and outstanding,
              
222,501 shares; aggregate liquidation value of $15,772,722 and
              
$15,294,342, respectively
    
15,084,681
   
12,534,619
 
               
STOCKHOLDERS' EQUITY:
              
Common stock, $0.01 par value—authorized 75,000,000 shares; issued and
              
outstanding, 22,375,144 shares
    
223,751
   
223,751
 
Additional paid-in capital
    
31,372,665
   
31,372,665
 
Accumulated deficit
    
(25,559,359
)
  
(25,558,667
)
 
              
Net stockholders' equity
    
6,037,057
   
6,037,749
 
               
TOTAL
  
$
31,834,912
 
$
29,899,246
 
               
 
          
(Concluded) 
  
See notes to unaudited condensed consolidated financial statements.
              
 

4

 
LXU HEALTHCARE, INC. AND SUBSIDIARIES
    
(Formerly Primesource Healthcare, Inc.)
    
     
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS    
THREE AND NINE MONTHS ENDED MARCH 31, 2005 and 2004
 
 
     
 
 
Nine Months Ended
March 31,  
Three Months Ended
March 31,
   
 2005
 2004
 2005
 2004
 (As restated, 
 (As restated,
 see Note 12) 
 see Note 12)
REVENUES:
          
 
              
Net product sales
  
$
13,473,173
 
$
11,641,953
 
$
38,537,396
 
$
34,652,941
 
Commissions and service revenues
    
603,117
   
611,462
   
1,867,264
   
2,303,535
 
                           
Net revenues
    
14,076,290
   
12,253,415
   
40,404,660
   
36,956,476
 
           
         
 
COST OF PRODUCT SOLD
    
8,998,049
   
7,956,448
   
25,773,355
   
23,475,343
 
                           
GROSS PROFIT
    
5,078,241
   
4,296,967
   
14,631,305
   
13,481,133
 
                           
OPERATING EXPENSES:
                          
Selling expenses
    
2,212,648
   
1,994,911
   
6,138,043
   
6,039,609
 
General and administrative expenses
    
1,770,181
   
1,641,348
   
5,098,763
   
5,052,873
 
Depreciation and amortization expenses
    
82,854
   
81,487
   
244,021
   
411,738
 
                           
Total operating expenses
    
4,065,683
   
3,717,746
   
11,480,827
   
11,504,220
 
                           
OPERATING INCOME
    
1,012,558
   
579,221
   
3,150,478
   
1,976,913
 
                           
INTEREST EXPENSE
    
(118,058
)
  
(164,926
)
  
(362,164
)
  
(609,818
)
                           
OTHER EXPENSE
    
(1,019
)
  
109
   
(223,094
)
  
(126,685
)
                           
INCOME FROM OPERATIONS
    
893,481
   
414,404
   
2,565,220
   
1,240,410
 
                           
INCOME TAX PROVISION
    
(600
)
  
(13,600
)
  
(15,850
)
  
(64,600
)
                           
NET INCOME
    
892,881
   
400,804
   
2,549,370
   
1,175,810
 
                           
DIVIDENDS AND ACCRETION ON
                         
PREFERRED STOCK
    
(799,400
)
  
(838,275
)
  
(2,550,062
)
  
(2,529,941
)
                           
INCOME AVAILABLE (LOSS ATTRIBUTABLE)
                         
TO COMMON STOCKHOLDERS
  
$
93,481
 
$
(437,471
)
$
(692
)
$
(1,354,131
)
                           
LOSS PER SHARE:
                          
Basic
  
$
0.00
 
$
(0.02
)
$
0.00
 
$
(0.06
)
Diluted
  
$
0.00
 
$
(0.02
)
$
0.00
 
$
(0.06
)
                           
WEIGHTED AVERAGE SHARES USED IN COMPUTATION OF LOSS PER SHARE:
            
Basic
    
22,375,144
   
22,375,144
   
22,375,144
   
22,375,125
 
Diluted
    
22,375,144
   
22,375,144
   
22,375,144
   
22,375,125
 
                           
See notes to unaudited condensed consolidated financial statements.
                  


 5

LXU HEALTHCARE, INC. AND SUBSIDIARIES
    
(Formerly Primesource Healthcare, Inc.)
    
     
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS    
NINE MONTHS ENDED MARCH 31, 2005 and 2004
 
 
     
   
 Nine months ended
 March 31,
 2005
 2004
 (As restated,
 see Note 12)
  
CASH FLOWS FROM OPERATING ACTIVITIES:
          
           
Net income
  
$
2,549,370
 
$
1,175,810
 
Adjustments to reconcile net income to net cash provided by
             
(used in) operating activities:
              
Depreciation and amortization
    
244,021
   
411,738
 
Loss on disposal of property and equipment and intangibles
    
5,986
   
39,669
 
Issuance of compensatory stock options
          
10,000
 
Debt forgiveness
          
(150,000
)
Change in operating assets and liabilities:
              
Accounts receivable
    
(954,362
)
  
36,776
 
Inventories
    
(1,215,786
)
  
241,728
 
Income taxes receivable
    
(27,868
)
  
(65,173
)
Prepaid expenses and other current assets
    
76,988
   
13,822
 
Other assets
    
12,483
   
(91,650
)
Accounts payable
    
53,216
   
(724,873
)
Accrued expenses
    
87,420
   
(520,109
)
Accrued restructuring costs
    
(43,726
)
  
(508,525
)
Customer deposits
    
10,265
   
100,014
 
               
Net cash provided by (used in) operating activities
    
798,007
   
(30,773
)
               
CASH FLOWS FROM INVESTING ACTIVITIES:
              
Purchases of property and equipment
    
(101,191
)
  
(82,854
)
Proceeds from the sale of property and equipment
    
635
   
5,233
 
               
Net cash used in investing activities
    
(100,556
)
  
(77,621
)
               
 
           (Continued)   
 

6 



LXU HEALTHCARE, INC. AND SUBSIDIARIES
    
(Formerly Primesource Healthcare, Inc.)
    
     
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
    
NINE MONTHS ENDED MARCH 31, 2005 AND 2004
 
 
     
 
 
Nine months ended
 
March 31,
 
2005
2004
   
(As restated,
   
see Note 12)
CASH FLOWS FROM FINANCING ACTIVITIES:
          
 Borrowings under lines of credit
     38,313,625     27,538,405  
 Repayments on lines of credit
     (39,031,936 )   (27,351,722 )
 Repayments on notes payable
     (12,385 )   (358,767 )
 Repayments on capital leases
     (18,022 )   (22,960 )
 Proceeds from issuance of stock
         32  
           
 Net cash used in financing activities
     (748,718 )   (195,012 )
           
 NET DECREASE IN CASH AND CASH EQUIVALENTS     (51,267 )   (303,406 )
 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD     98,903     489,911  
 CASH AND CASH EQUIVALENTS, END OF PERIOD   $ 47,636   $ 186,505  
           
 SUPPLEMENTAL DISCLOSURES OF CASH FLOW          
 INFORMATION -Cash paid during the period for:
          
 Interest
   $ 362,164   $ 412,527  
 Taxes
   $ 20,530   $ 78,080  
 SUPPLEMENTAL DISCLOSURES OF NONCASH          
 TRANSACTIONS -
          
 Discount on issuance of note payable for legal services
       $ 12,232  
Equipment acquired under capital leases
   $ 27,839   $ 25,304  
           
 
         (Concluded)   
 
See notes to unaudited condensed consolidated financial statements.
              

 

7 

LXU HEALTHCARE, INC. AND SUBSIDIARIES
(Formerly Primesource Healthcare, Inc.)
 
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005 and 2004 
 
1. BASIS OF PRESENTATION 
 
On October 20, 2004, the Board of Directors recommended that the Company’s Articles of Organization be amended and restated to change the Company’s name from PrimeSource Healthcare, Inc. to LXU Healthcare, Inc. The Board recommended the adoption of the Amendment of the Articles after a claim was asserted against the Company by PrimeSource Healthcare Systems, Inc., an Illinois corporation, for, among other things, trademark infringement and unfair competition. The Company was not served with the complaint and as a result of settlement discussions, the parties agreed that the dispute could be resolved by changing the Company’s name. On December 10, 2004 at the annual stockholders meeting the stockholders approved the proposed name change.

The unaudited condensed consolidated financial statements include the accounts of LXU Healthcare, Inc. (“LXU Healthcare”) and its subsidiaries (collectively, “LXU” or the “Company”). The Company’s wholly owned operating subsidiaries include LXU Healthcare, Inc. - Medical Specialty Products, formerly PrimeSource Surgical, Inc., (“LXU-Medical Specialty Products”) and Bimeco, Inc. (“Bimeco”). All intercompany balances and transactions are eliminated in consolidation.

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (hereafter referred to as “generally accepted accounting principles”) for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statement presentation. In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation have been included and are of a normal recurring nature. Operating results for the three and nine months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the entire year.
 
LXU Healthcare, Inc., a Massachusetts corporation formerly known as Primesource Healthcare, Inc., is a specialty medical products sales, marketing and manufacturing company. The Company sells a broad portfolio of specialty medical products, some of which it manufactures, to hospitals and surgery centers nationwide through a dedicated organization of sales and marketing professionals.
 
2. NEW ACCOUNTING PRONOUNCEMENTS
 
 
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R) ("SFAS No. 123(R)"), Share-Based Payment. SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. SFAS No. 123(R) focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as expense in the historical financial statements as services are performed. Prior to SFAS No. 123(R), only certain pro forma disclosures of fair value were required. SFAS No. 123(R) is effective for the Company as of July 1, 2005. The Company has not yet determined the impact of adoption of SFAS No. 123(R).
 

 8
 
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an Amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for amounts of idle facility expenses, freight, handling costs and waste material (spoilage). This statement is effective for the Company for the fiscal year beginning July 1, 2006. The adoption of SFAS No. 151 is not expected to have a material effect on the Company’s consolidated financial statements.
 
3.      INVENTORIES

At March 31, 2005 and June 30, 2004, inventories consisted of the following:


 
    
March 31, 
    
June 30,
  
     
2005
    
2004
  
               
    Raw materials
  
$
1,305,131
 
$
708,949
 
    Work-in-process
    
146,639
   
-
 
    Finished goods
    
7,203,666
   
6,693,999
 
    Reserve for obsolescence
    
(707,108
)
  
(670,406
)
               
    Inventories—net
  
$
7,948,328
 
$
6,732,542
 
 
 
4. GOODWILL, INTANGIBLE AND OTHER ASSETS
 
At both March 31, 2005 and June 30, 2004, the Company had $15,956,883 of recorded goodwill. In accordance with FASB Statement No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), the Company’s goodwill is not subject to amortization.
 
In accordance with SFAS No. 142, the Company performed its annual impairment test in July 2004 and found no impairment in its existing goodwill balances.
 
At March 31, 2005 and June 30, 2004, the Company had intangible assets subject to amortization with useful lives of 4 to 20 years, primarily consisting of trademarks and patents with a total cost of $304,838 and accumulated amortization of $251,180 and $244,565, respectively.
 
The Company also had other intangible assets included in other assets on the balance sheet at March 31, 2005 and June 30, 2004 consisting primarily of security deposits with a total cost of $77,713 and $90,196, respectively.

 9

 
Intangible and other asset amortization expense for the nine months ended March 31, 2005 and 2004 was approximately $6,600 and $175,000, respectively. Estimated amortization expense remaining for the five succeeding fiscal years ending June 30 and thereafter is as follows:
 

    2005
  
$
2,205
 
    2006
    
8,820
 
    2007
    
8,416
 
    2008
    
8,380
 
    2009
    
8,380
 
    Thereafter
    
17,457
 
         
     Total    $ 53,658   

5. LINES OF CREDIT AND NOTES PAYABLE

The Company’s senior debt financing is provided under a $7,500,000 revolving demand note (the “PrimeSource Healthcare Line of Credit”) from Wells Fargo Business Credit, Inc. (“Wells Fargo”) under the PrimeSource Healthcare Credit and Security Agreement, dated as of December 10, 2003, by and among the Company, LXU - - Medical Specialty Products, Bimeco and Wells Fargo (the “Credit and Security Agreement”). The Credit and Security Agreement has no stated maturity date, but remains in effect until the borrower terminates the credit facility or the lender demands payment. Although there is no stated maturity, if the Line of Credit is terminated before certain dates, termination fees will be due Wells Fargo, as follows: on or before December 10, 2005, 2% of the maximum line, or $150,000; on or before December 10, 2006, 1% of the maximum line, or $75,000. Pursuant to the Credit and Security Agreement, the maximum amount available to borrow under the PrimeSource Healthcare Line of Credit is limited to the lesser of $7,500,000 or a certain percentage of accounts receivable and inventory, as defined by the Credit and Security Agreement ($7,500,000 at March 31, 2005). As of March 31, 2005, borrowings bore interest at Wells Fargo’s prime rate plus 2.50% (8.25% at March 31, 2005). Borrowings are secured by substantially all assets held by LXU Healthcare and its subsidiaries. At March 31, 2005 and June 30, 2004, there were outstanding borrowings of $4,485,828 and $5,204,139, respectively. At March 31, 2005, there was $3,014,172 of availability under the PrimeSource Healthcare Line of Credit.

The Credit and Security Agreement contains certain covenants, including covenants that require the maintenance of defined income levels and maximum capital expenditures. The Company was in compliance with these covenants as of March 31, 2005.

Notes payable include the Luxtec tenant note payable for tenant improvements issued to the lessor of Luxtec’s leased premises in West Boylston, Massachusetts. The note bears interest at 9.5% and is due September 19, 2007. Payments were interest only for the first 12 months, with remaining payments calculated on a 7-year amortization table with a balloon payment due on September 19, 2007. At March 31, 2005 and June 30, 2004, Luxtec had outstanding borrowings of $50,061 and $62,446, respectively, under the tenant note payable. In addition, notes payable include a long-term note with an outstanding balance of $43,250 at both March 31, 2005 and June 30, 2004.
 
6. INCOME TAXES
 
At March 31, 2005 and June 30, 2004, the Company had deferred tax assets primarily resulting from federal net operating loss carryforwards of approximately $4,233,600 and $5,254,600, respectively. A full valuation allowance has been provided against these deferred tax assets as of March 31, 2005 as it is more likely than not that sufficient taxable income will not be generated to realize these carryforwards. In addition, the Company’s federal net operating loss carryforwards may be subject to limitations relating to ownership changes.
 

10 

The Company generated pre-tax income of $893,481 and $2,565,220 for the three and nine-month period ended March 31, 2005. However, this amount is expected to be offset by federal net operating losses in the Company’s income tax return for the year ending June 30, 2005. The Company recognized income tax expense totaling $600 and $15,850 for the three and nine-month periods ended March 31, 2005 relating to state income taxes in states with no offsetting net operating loss carryforwards.
 
The Company generated pre-tax net income of $414,404 and $1,240,410 for the three and nine-month periods ended March 31, 2004. This amount was offset by net operating losses in the Company’s income tax return for the year ended June 30, 2004. The Company recognized income tax expense totaling $13,600 and $64,600, respectively, for the three and nine-month periods ended March 31, 2004 relating to income taxes due in states with no offsetting net operating loss carryforwards.
 
7. SEGMENT REPORTING
 
The Company is organized into three operating segments based on management’s operating criteria. These segments are Specialty Medical Products Manufacturing, Specialty Distribution Services—Surgical, and Specialty Distribution Services—Critical Care. A description of each segment and principal products and operations is as follows:
 
Specialty Medical Products Manufacturing—This segment includes the Massachusetts division acquired in March 2001, referred to as Luxtec (“Luxtec”), which designs and manufactures fiber optic headlight and video camera systems, light sources, cables, retractors, and custom-made and other surgical equipment for the medical and dental industries.
 
Specialty Distribution Services—Surgical—The surgical segment is a regional sales and marketing organization that markets and sells surgical products primarily to hospitals and surgery centers. The primary specialty areas include gynecology, cardiovascular, endoscopy, and general surgery. These products are primarily used in hospital operating rooms and in outpatient surgery centers. This segment does business as LXU Healthcare, Inc. - Medical Specialty Products.
 
Specialty Distribution Services—Critical Care—The critical care segment is a regional sales and marketing organization that sells products primarily to hospitals and surgery centers in the southeastern and northeastern United States. Within this segment, the primary specialties include maternal/child care, and neonatal intensive care. This segment does business as Bimeco.
 

11 

Operations that are not included in any of the segments are included in the category “Corporate/Other” and consist primarily of corporate staff operations, including unallocated corporate general and administrative expenses. The sales between segments are made at market prices and are eliminated in consolidation.
 
The total assets of each segment consist primarily of net property and equipment, inventories, accounts receivable, and other assets directly associated with the segments’ operations. Included in the total assets of the corporate operations are property and equipment, intangibles and other assets.
 
Sales between the manufacturing and surgical segments totaled $1,826,816 and $5,239,532 for the three and nine-month periods ended March 31, 2005, and $1,132,165 and $4,106,813 for the same periods in 2004.
 
The Company charges a management fee allocation to each segment based on estimates of each segment’s corporate resource usage and reclassifies a portion of the corporate expense to the operating segments.
 
Disclosures regarding the Company’s reportable segments with reconciliations to consolidated totals are presented below for the three months ended March 31 and total assets as of the end of each period:
 
 
    
    
Distribution
Surgical
    
Distribution
Critical Care
    
Manufacturing
    
Corporate/
Other
    
Elimination
    
Total
  
        Net revenues
                                      
        2005
  
$
8,597,593
 
$
3,212,426
 
$
4,093,087
       
$
(1,826,816
)
$
14,076,290
 
        2004
    
6,718,898
   
3,429,844
   
3,236,838
         
(1,132,165
)
  
12,253,415
 
                                   
 
        Net income
                               
 
        2005
    
413,479
   
(176,897
)
  
657,911
 
$
(1,612
)
        
892,881
 
        2004
    
185,735
   
(17,930
)
  
256,730
   
(23,731
)
        
400,804
 
                               
 
        Depreciation and amortization
                                
 
        2005
    
28,511
   
426
   
51,712
   
2,205
         
82,854
 
        2004
    
33,783
   
294
   
45,205
   
2,205
         
81,487
 
                               
 
        Interest expense
                                
 
        2005
    
44,933
   
38,841
   
32,834
   
1,450
         
118,058
 
        2004
    
48,479
   
57,942
   
37,141
   
21,364
         
164,926
 
                               
 
        Total assets
                                
 
        March 31, 2005
    
24,428,947
   
2,918,491
   
4,348,199
   
139,275
         
31,834,912
 
        June 30, 2004
    
23,524,547
   
3,290,404
   
2,899,675
   
184,620
         
29,899,246
 
                                   
        Net goodwill
                                    
        March 31, 2005
    
12,660,950
   
607,981
   
2,687,952
             
15,956,883
 
        June 30, 2004
    
12,660,950
   
607,981
   
2,687,952
               
15,956,883
 
 

12 
Disclosures regarding the Company’s reportable segments with reconciliations to consolidated totals are presented below for the nine months ended March 31 and total assets as of the end of each period:
 

   
 
  
 
      
 
  
 
      
   
Distribution
Surgical
  
Distribution
Critical Care
  
Manufacturing
  
Corporate/
Other
  
Elimination
  
Total
  
                                       
        Net revenues
                                      
        2005
  
$
24,348,503
 
$
9,566,772
 
$
11,728,917
       
$
(5,239,532
)
$
40,404,660
 
        2004
    
21,433,580
   
9,604,373
   
10,025,336
         
(4,106,813
)
$
36,956,476
 
                                     
        Net income
                                   
        2005
    
1,166,303
   
68,345
   
1,308,718
 
$
6,004
         
2,549,370
 
        2004
    
680,357
   
122,518
   
910,678
   
(537,743
)
        
1,175,810
 
                                   
        Depreciation and amortization
                                    
        2005
    
85,417
   
1,190
   
150,799
   
6,615
       
244,021
 
        2004
    
99,622
   
764
   
136,215
   
175,137
         
411,738
 
                                   
        Interest expense
                                    
        2005
    
129,414
   
126,470
   
103,032
   
3,248
         
362,164
 
        2004
    
174,323
   
111,698
   
88,600
   
235,197
         
609,818
 
                                   
        Total assets
                                    
        March 31, 2005
    
24,428,947
   
2,918,491
   
4,348,199
   
139,275
         
31,834,912
 
        June 30, 2004
    
23,524,547
   
3,290,404
   
2,899,675
   
184,620
         
29,899,246
 
                                   
        Net Goodwill
                                    
        March 31, 2005
    
12,660,950
   
607,981
   
2,687,952
               
15,956,883
 
        June 30, 2004
    
12,660,950
   
607,981
   
2,687,952
               
15,956,883
 
 
 
8. INCOME (LOSS) PER SHARE
 
Loss per share amounts are calculated using income available (loss attributable) to common stockholders and weighted average common shares outstanding, which consisted of the following for the three and nine months ended March 31:


 
  
 Three months ended 
  
 Nine months ended
  
 
    
March 31, 
    
March 31,
  
     
2005
    
2004
    
2005
    
2004
  
Numerator:
                          
Income available (loss attributable) to common
                         
stockholders
  
$
93,481
 
$
(437,471
)
$
(692
)
$
(1,354,131
)
                           
Weighted average common shares for the purpose
                          
of calculating basic and diluted income (loss)
                         
per share
    
22,375,144
   
22,375,144
   
22,375,144
   
22,375,125
 

For the three and nine months ended March 31, 2005, options and warrants to purchase common stock totaling 26,510,982 were not included in weighted average common shares outstanding for the purpose of calculating diluted earnings per share since the result would be antidilutive. For the three and nine
 

 13

months ended March 31, 2004, options and warrants to purchase common stock totaling 26,619,321 were not included in weighted average common shares outstanding for the purpose of calculating diluted earnings per share since the result would be antidilutive. No effect was included in the calculation of diluted earnings per share for the conversion of the Series G Convertible Redeemable Preferred Stock as the effect would be antidilutive.

9. PREFERRED STOCK
 
On August 6, 2002, the Company created a new series of preferred stock, Series G Convertible Redeemable Preferred Stock, no par value (the “Series G Stock”). The Series G Stock has 230,000 authorized shares. At both March 31, 2005 and June 30, 2004, 222,501 shares of Series G Stock were issued and outstanding. Each share of Series G Stock is convertible into 100 shares of common stock, subject to adjustment, at the option of the holder. Each share of Series G Stock has one vote for each share of common stock into which it would be convertible. In addition, Series G Stock ranks senior to all other outstanding stock of the Company. Series G Stock accrues dividends at the rate of 8% per year of the original issuance price of $32.00 per share, compounded annually, and has a liquidation value equal to $64.00 per share plus an amount equal to all accrued but unpaid dividends. The Series G Stock is redeemable at the election of not less than 60% of the Series G stockholders any time after June 30, 2005, and is redeemable at $64.00 per share plus accrued but unpaid dividends. The Series G Stock also has special consent rights to certain of the Company’s activities, including, but not limited to, amendment of the Company’s articles or bylaws and merger or consolidation of the Company. As of March 31, 2005 and June 30, 2004, cumulative unpaid dividends on the Series G Stock totaled $1,532,658 and $1,054,278, respectively, and were included in the carrying amount of Series G Stock in the consolidated balance sheet.
 
The Company’s Series G Stock was initially issued August 6, 2002, in connection with a recapitalization of the Company’s equity structure (the “Recapitalization”). Certain other classes of outstanding preferred stock, including Series C Redeemable, Convertible Preferred Stock and Series F Redeemable, Convertible Preferred Stock, were converted to common stock. Another class of outstanding preferred stock, Series F Redeemable, Convertible Preferred Stock, was exchanged for Series G Stock, and additional shares of Series G Stock were issued for cash consideration. Warrants to purchase common stock were issued to the Series C, F, E and G Stockholders, and previously issued warrants to purchase common stock held by these stockholders were repriced.

The Series G Stock was originally recorded at the original issue price of $32.00 per share which approximated fair value. The Series G Stock is being increased to its redemption value of $64.00 per share in periodic accretions from the date of original issuance through the first possible redemption date of June 30, 2005. At March 31, 2005 and June 20, 2004, cumulative accretion of costs and redemption value totaled $6,935,302 and $4,863,620, respectively.

During the year ended June 30, 2003, the Company granted options to purchase 7,500 shares of Series G Stock for $16 per share to an executive of the Company. Options vested one year from August 6, 2002, the date of grant, and have a 10 year life. For the nine months ended March 31, 2004, the Company recorded compensation expense related to these options of $10,000. In October 15, 2003, this executive exercised an option for the purchase of one share of Series G Stock for $16. At March 31, 2005, the remaining 7,499 options were vested and exercisable.


14 

10. STOCK OPTIONS AND WARRANTS
 
 
Options - At March 31, 2005, the Company had three stock-based employee compensation plans. The Company accounts for those plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.
 
Warrants - - At March 31, 2005, the Company had outstanding warrants for the purchase of 16,774,768 shares of common stock, with exercise prices between $0.01 and $2.35 per share, and original lives of 10 years.
 
Changes in shares under options and warrants for the period ended March 31, 2005 are as follows:
 


   
Options
  
Warrants
  
   
Shares 
    
Weighted
Average
Exercise
Price
    
Shares
    
Weighted
Average
Exercise
Price
  
                           
Balance, July 1, 2004
    
9,787,930
 
$
0.49
   
16,774,768
 
$
0.02
 
     
                   
Forfeited
    
(51,716
)
  
2.48
   
0
    
 
                           
Balance, March 31, 2005
    
9,736,214
 
$
0.48
   
16,774,768
 
$
0.02
 
                           
Vested and exercisable, June 30, 2004
    
6,544,957
         
16,774,768
       
                           
Vested and exercisable, March 31, 2005
    
7,815,685
         
16,774,768
       
 
SFAS No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost based on the fair value of employee stock option and warrant grants. The Company has chosen to continue to account for employee option and warrant grants using intrinsic value under APB Opinion No. 25. However, compensation expense in the amount of $10,000 for the three and nine-month periods ended March 31, 2004, has been recognized for certain employee stock options granted below market value. No compensation expense has been recognized for the remaining employee stock option and warrant grants.
 
 

 15

 
Had compensation expense for these employee stock option grants been determined based on the fair value at the grant dates, consistent with SFAS No. 123, the Company’s income available (loss attributable) to common stockholders and per share amounts for the three and nine months ended March 31, 2005 and 2004 would have been the pro forma amounts indicated below:
 
   
 
  
 
  
   
Three Months Ended
March 31,
 
Nine Months Ended
March 31,
 
     
2005
    
2004
    
2005
    
2004
  
                           
Net income, as reported
  
$
892,881
 
$
400,804
 
$
2,549,370
 
$
1,175,810
 
 
                          
Stock-based employee compensation expense
determined under fair-value method
    
(18,602
)
  
(36,888
)
  
(70,466
)
  
(112,290
)
                           
Proforma net income
    
874,279
   
363,916
   
2,478,904
   
1,063,520
 
                           
Dividends and accretion on preferred stock
    
(799,400
)
  
(838,275
)
  
(2,550,062
)
  
(2,529,941
)
                           
Pro forma income available (loss
                          
attributable) to common stockholders
  
$
74,879
 
$
(474,359
)
$
(71,158
)
$
(1,466,421
)
                           
Loss per share:
    
   
   
   
 
Basic- as reported
  
$
0.00
 
$
(0.02
)
$
0.00
 
$
(0.06
)
Basic- pro forma
    
0.00
   
(0.02
)
  
0.00
   
(0.07
)
                           
Diluted- as reported
    
0.00
   
(0.02
)
  
0.00
   
(0.06
)
Diluted- pro forma
    
0.00
   
(0.02
)
  
0.00
   
(0.07
)

 
For purposes of applying SFAS No. 123, the estimated fair value of stock options granted during the nine months ended March 31, 2004 was $0.01 per share. The fair value of the stock option grant was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: risk free interest rate of 2.32%, expected volatility of 50%, expected life of 3 years and expected dividend yield of 0%. There were no stock options granted during the nine months ended March 31, 2005.
 
11.
COMMITMENTS AND CONTINGENCIES
 
During the quarter ended December 31, 2004, the Company agreed in principle to resolve a legal matter with a former employee. As a result, the Company has accrued certain amounts in other expense and relating to the matter.
 
The Company is involved in litigation incidental to its business. Management does not believe the ultimate disposition of this litigation will have a material adverse effect on the Company’s financial position, results of operations or liquidity.
 
12. RESTATEMENT OF FINANCIAL STATEMENTS
 
 
Subsequent to the issuance of the Company’s financial statements for the quarter ended March 31, 2004, the Company determined that the Company’s Series G Stock should not have been classified as a liability under SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS No. 150”). In addition, the Company determined that the accounting treatment originally afforded to certain aspects of the recapitalization of the Company’s equity at the time of the original issuance of the Series G Preferred Stock in August 2002 (the “Recapitalization”), including the issuance of warrants to purchase common stock, the repricing of previously issued warrants to purchase common stock and related accretion of these amounts was incorrect, as discussed below. The Company also determined that certain amounts included in net sales for the years ended June 30, 2002, 2003 and 2004 should have been recorded as commissions and service revenues in the statements of operations.

 

16 

Effective July 1, 2003 the Company implemented SFAS No. 150, and at that time it changed the classification of its Series G Preferred Stock to a liability. However the Company subsequently determined that the Series G Preferred Stock did not meet the criteria of a mandatorily redeemable preferred stock that should be classified as a liability because redemption is at the option of the holders and requires the approval of not less than 60% of the Series G Stockholders at any time after June 30, 2005. Accordingly, the Company determined that it should have continued to classify the Series G Stock as mezzanine equity in the Company’s balance sheet, and should not have included the dividends that accrue on the Company’s Series G Stock in interest expense in the statements of income, but should have reflected them in dividends and accretion on preferred stock for all reporting periods after July 1, 2003.

The Company also determined that the historical accounting treatment afforded to the Series G Stock warrants that were issued and repriced in connection with the Recapitalization, the conversion and redemption features of the Series G Stock, and the fair values assigned to the Company’s Series G Stock and common stock at the date of the Recapitalization was incorrect.

The Company originally accounted for the warrants issued and repriced in the Recapitalization using an estimate of the fair value of its common stock of $.32 per share. In connection with its reconsideration of the accounting for the Series G Stock, the Company also determined that the estimated fair value of its common stock that was used in determining the fair value of the warrants issued and repriced in connection with the Recapitalization should have been less than $.01 per share.

The Company originally recorded a beneficial conversion feature relating to the Series G Stock based on its intrinsic value in accordance with EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments (“EITF No. 00-27”), and did not separately account for the conversion feature as an embedded derivative for the conversion and redemption features in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”). The Company has now determined that the conversion feature represents an embedded derivative that should have been separated from the preferred stock based on its relative fair value and that it should not have recognized a beneficial conversion feature under EITF No. 00-27. The Company has valued the embedded derivative using the Black Scholes model with the following assumptions: weighted average risk-free discount rate 1.68%; 0% expected dividend; 50% volatility; and an expected life of 3 years, and determined that it had no value at the date of issuance, because the fair value of the common stock was less than $.01 per share. Accordingly, the value originally assigned to the beneficial conversion feature has been adjusted to zero from date of issuance. Future changes in the fair value of the derivative will result in a charge or credit to income during the period of change.
 
The Company originally accounted for the Recapitalization in accordance with EITF No. 00-27, and the excess of consideration given up by the preferred stockholders over what they received was recorded as a credit to accumulated deficit, resulting in an increase in income available to (decrease in loss attributable to) common stockholders for purposes of calculating income (loss) per share. The Company has now determined that certain conversions of the preferred stock in the Recapitalization were induced conversions that should have been accounted for in accordance with EITF No. D-42, The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock, which results in the excess of the consideration transferred by the preferred stockholders over what they received being credited to additional paid-in capital instead of accumulated deficit.
 

17 

Finally, the carrying value of the Series G Stock was originally recorded at the original issue price of $32 per share, net of issuance costs, the fair value of the warrants and the intrinsic value of the beneficial conversion feature discussed above. The Series G Stock was being accreted up to the $32 per share original issue price through the earliest redemption date of June 30, 2005, consistent with guidance in EITF D-98, Classification and Measurement of Redeemable Securities; however, the Company has now determined that, based on the redemption value of the Series G Stock of $64 per share, the Company should have recorded additional accretion of $32 per share.

In addition, subsequent to filing its March 31, 2004 Form 10Q, the Company reevaluated the nature of its revenues, and corrected classification of commissions and service revenues to present them separate from net product sales in accordance with EITF 99-19.

As a result, the Company’s financial statements have been restated from the amounts previously reported to correct the accounting for these transactions. A summary of the significant effects of the restatement is as follows:
 

   
 
    
 
  
 
    
Three Months Ended
March 31, 2004 
    
Nine Months Ended
March 31, 2004
  
   
As previously reported 
    
As restated
    
As previously reported
    
As restated
  
                           
    Net product sales
    $
-      
      $
11,641,953
    $
-       
   $
34,652,941
  
    Commissions and service revenues
    
-      
   
611,462
     -         
2,303,535
  
    Net sales
    
12,253,415
    
12,253,415
    
36,956,476
    
36,956,476
  
                           
    Interest expense
    
(306,937
 )   
(164,926
 )   
(1,038,969
 )   
(609,818
 ) 
    Income from operations before income taxes
    
272,393
    
414,404
    
811,259
    
1,240,410
  
    Net income
   
258,793
    
400,804
    
746,659
    
1,175,810
  
    Dividends and accretion on preferred stock
    
-     
     
(838,275
 )   
-       
   
(2,529,941
 ) 
    Income available (loss attributable) to
                          
       common stockholders
    
258,793
    
(437,471
 )   
746,659
    
(1,354,131
 ) 
                           
    Income (loss) per share:
                          
       Basic
    
0.01
    
(0.02
 )   
0.03
    
(0.06
 ) 
       Diluted
    
0.01
    
(0.02
 )   
0.03
    
(0.06
 ) 
                           
    Net cash used in operating activities
    
-     
   
-     
   
(459,925
 )   
(30,773
 ) 
    Net cash provided by (used in) financing activities
    
-     
   
-     
   
234,140
    
(195,012
 ) 
 

 18

 

 
 
13. SUBSEQUENT EVENT
 
The Company's common stock is not listed on any stock exchange. The Company values it common stock through obtaining periodic valuations performed by independent valuation consultants. The Company's Board of Directors reviewed and approved a current valuation of $.04 per common share at their May 12, 2005, Board of Director's meeting. This amount will be used for determining market value for future stock option grants and for reporting purposes.
 

 
* * * * *
 


19 

 
LXU HEALTHCARE, INC. AND SUBSIDIARIES
(Formerly Primesource Healthcare, Inc.)
 
 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
       THREE AND NINE MONTHS ENDED MARCH 31, 2005
 
All statements contained herein that are not historical facts, including but not limited to, statements regarding our expectations concerning future operations, margins, profitability, liquidity, capital expenditures and capital resources, are based on current expectations. These statements are forward-looking in nature and involve a number of risks and uncertainties. Generally, the words “anticipates,” “believes,” “estimates,” “expects” and similar expressions as they relate to us and our manage-ment are intended to identify forward-looking statements. Although we believe that the expectations in such forward-looking statements are reasonable, we cannot assure that any forward-looking statements will prove to be correct. We wish to caution readers not to place undue reliance on any forward-looking statements, which statements are made pursuant to the Private Litigation Reform Act of 1995. The forward-looking statements contained in this quarterly report on Form 10-Q speak only as of the date that we have filed the report. We expressly disclaim any obliga-tion or undertaking to update or revise any forward-looking statement contained in this report, including to reflect any change in our expectations with regard to that forward-looking statement or any change in events, conditions or circumstances on which that forward-looking statement is based.
 
As discussed in Note 12 to the condensed consolidated financial statements, the Company’s March 31, 2004 financial statements have been restated. The accompanying management’s discussion and analysis gives effect to that restatement.
 
Business Overview
 
General
 
We are a specialty medical products sales, marketing and manufacturing company. We sell a broad portfolio of high quality, differentiated specialty medical products, some of which we manufacture, to hospitals and surgery centers nationwide through a dedicated organization of sales and marketing professionals. We believe that we are continuing to build a valuable niche franchise in the estimated $5 billion specialty medical marketplace, selling technologically innovative products that command premium pricing. Today, we have three primary businesses, which are separately managed and present separate financial results: Specialty Medical Distribution- Surgical, Specialty Medical Distribution- Critical Care and Manufactured Products. As of March 31, 2005, we had 140 employees and generated total revenue of $14.1 million and $40.4 million for the three and nine months ended March 31, 2005, respectively.
 

20 

 
Business Strategy
 
Our goal is to be one of the nation’s leading suppliers of specialty medical products to hospitals and surgery centers. We intend to continue to grow by:
 
  · hiring experienced territory sales representatives;
 
  · securing additional specialty product lines to our product offerings; and
 
  · selectively acquiring specialty medical products manufacturers. We expect to benefit from the acquisition of select specialty medical products manufacturers by increasing sales of acquired product lines through use of our direct specialty medical products sales force.
 
We believe our Manufactured Products business continues to lead the surgical headlamp business and focuses its research and development efforts on new and innovative products which can be sold through our distribution segment.

Products and Services

Specialty Medical Distribution

Within Specialty Medical Distribution, we have a Surgical business and a Critical Care business. The Surgical business is a regional sales and marketing organization that markets and sells a large number of surgical products primarily to hospitals and surgery centers in the midwestern, mid-atlantic and southeastern United States. The Critical Care business is a regional sales and marketing organization that sells a large number of products primarily to hospitals and surgery centers in the southeastern and northeastern United States.

Within the Surgical business, the primary specialties are Cardio Vascular, Endoscopy, General Surgery and Gynecology.

Within the Critical Care business, the primary specialties are Neonatal Intensive Care and Maternal and Child Care.

The sale of specialty disposable products and capital equipment account for the majority of our revenues. Our capital equipment products are typically complex and require significant consultative selling to medical staff personnel, which is provided as part of our marketing and customer service efforts. Our specialty disposable products are often sold to support the capital equipment products and offer a recurring and stable source of revenue.

The Manufactured Products Division

We operate the Manufactured Products business through our Luxtec division (“Luxtec”), which designs, manufactures and markets fiber optic headlight and video camera systems, light sources, cables, retractors and surgical and other custom-made equipment for the medical and dental industries. Luxtec has developed a proprietary, fiber optic drawing system designed to manufacture optical glass to a specified diameter. The fibers are utilized in fiber optic cables, which are incorporated with Luxtec's surgical headlight systems and video camera systems, as well as into an array of fiber optic transilluminators utilized with Luxtec’s surgical instruments. Luxtec also markets replacement fiber optic cables, bulbs, and light sources for use with other manufacturers' products, including various endoscopic systems used in minimally invasive surgical procedures.


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Fiber optics allow for the transmission of a light or image from one place to another through a flexible conduit of optical glass rods and tubes. The flexible conduit provides for an improved ability to bend and transmit light and images to and from places with limited or difficult access.

The technology used by Luxtec to provide illumination directly to the surgical site is facilitated by fiber optic cables transmitting light to an adjustable headlight composed of a series of lenses and mirrors mounted on a headband. These lenses then focus the light directly on the surgical site when worn by the surgeon. This provides a lightweight, low temperature illumination source to enhance visualization for microsurgical and deep cavity illumination.

Results of Operations
 
Net Revenues—Net revenues increased $1,822,875, or 14.9%, and $3,448,184, or 9.3%, in the three and nine-month periods ended March 31, 2005, relative to the comparable periods in 2004 primarily due to higher product sales volume from existing product lines and the addition of a new selling territory for our proprietary products provided by the Luxtec division. Sales of the Luxtec product increased approximately $910,000 and $1,669,000 in the three and nine months ended March 31, 2005, respectively, compared to the same periods in 2004. Revenues from our agency business for the three and nine-month period ended March 31, 2005 decreased approximately $8,000 and $436,000, respectively, over the same periods in 2004.
 
Cost of Products Sold—Cost of products sold decreased to 63.9% of net product sales for the three months ended March 31, 2005, compared to 64.9% for the same period in 2004. Cost of products sold increased to 63.8% of net product sales for the nine months ended March 31, 2005, compared to 63.5% for the same period in 2004. The increase of $1,041,601, or 13.1%, and $2,298,012, or 9.8%, in the three and nine-month periods ended March 31, 2005, respectively, relative to the comparable periods in 2004 was primarily the result of the corresponding increase in net product sales, as discussed above. The decrease in cost of products sold as a percentage of net product sales in the three-month period ended March 31, 2005 and the increase in cost of products sold as a percentage of net product sales in the nine-month period ended March 31, 2005 compared to the same periods in 2004 is due primarily to the difference in product mix sold between Luxtec and Specialty Medical Distribution products.
 
Gross Profit—Gross profit was 36.1% and 36.2% of net product sales for the three and nine months ended March 31, 2005, respectively, and 35.1% and 36.5% of net product sales for the same periods in 2004, respectively. The increase of $781,274, or 18.2%, and $1,150,172, or 8.5%, in the three and nine-month periods ended March 31, 2005, respectively, relative to the comparable periods in 2004 is primarily due to higher sales volume from existing product lines and the addition of a new selling territory for our proprietary products provided by the Luxtec division. Gross profit on the Luxtec product increased approximately $271,000 and $368,000 in the three and nine months ended March 31, 2005 compared to the same period in 2004. The decrease in cost of products sold as a percentage of net product sales in the three-month period ended March 31, 2005 and the increase in cost of products sold as a percentage of net product sales in the nine-month period ended March 31, 2005 compared to the same periods in 2004 is due primarily to the difference in product mix sold as discussed above.
 
 

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Selling Expenses—Selling expenses increased $217,737 and $98,434 for the three and nine months ended March 31, 2005, respectively, compared to the same periods in 2004. The increase was primarily the result of increased selling commissions due to higher sales volume as discussed above. Selling commissions are paid on agency sales at approximately the same percentage as stocking sales, and as a result, sales commissions as a percent of net revenues do not generally fluctuate when the product mix of agency and stocking sales varies.
 
General and Administrative Expenses—General and administrative expenses were 12.6% and 12.6% of net revenues, for the three and nine months ended March 31, 2005, respectively, compared to 13.4% and 13.7% for the same periods in 2004. The increase of $128,833, or 7.8%, and $45,890, or 0.9%, for the three and nine-month periods ended March 31, 2005 is primarily the result of increased employee benefit and commercial insurance premium expenses offset by decreased legal fees for the Company.
 
Depreciation and Amortization Expenses—Depreciation and amortization expenses decreased to 0.6% of net revenues for the three and nine months ended March 31, 2005, compared to 0.7% and 1.1% of net revenues, for the same periods in 2004, respectively. The decrease of $167,717, or 40.7%, in depreciation and amortization expenses for the nine months ended March 31, 2005, respectively, is primarily the result of certain assets and intangible assets becoming fully depreciated prior to the quarter ended March 31, 2005.
 
Interest Expense—The decrease in interest expense of $46,868, or 28.4%, and $247,654, or 40.6%, for the three and nine months ended March 31, 2005, respectively, is the result of non-recurring fees on the Company’s senior debt in the quarter ended December 31, 2003. Interest expense on the Company’s senior debt decreased by $50,267 during the nine-month period ended March 31, 2005 over the same period in 2004.
 
Income Tax Provision—The Company recorded $600 and $15,850 of income tax expense for the three and nine-month periods ended March 31, 2005, respectively, compared to $13,600 and $64,600 of income tax expense for the same periods in 2004. Although the majority of the Company’s current year taxable income for federal and certain states can be eliminated due to the use of net operating loss carryforwards to offset federal and state income tax liabilities, the Company is still be subject to income taxes in certain state jurisdictions which have limitations on the use of its net operating loss carryforwards.
 
Liquidity and Capital Resources
 
Year to date sales performance through March 2005 continues to allow us to maintain our cash and retain our credit availability at its higher benchmark since we refinanced our senior debt in December 2003. Our cash and availability remains relatively stable, due to working capital management. We expect our cash position to remain stable as we experience sales growth over prior quarters, and effect reductions in non-operating cash outflows and operating expenses.  
 
For the nine months ended March 31, 2005, our cash provided by operating activities was $798,007, driven primarily by our increased net income, which was primarily reduced by our increased investment in inventory to support sales volumes and accounts receivable increases related to expanded territories for Luxtec’s product lines and certain new product lines.
 
 

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At March 31, 2005, we had working capital of $4,359,656, compared to $1,688,823 at June 30, 2004. The increase in our working capital was primarily the result of increases in accounts receivable and inventory balances related to increased sales and a decrease in the borrowings under the line of credit.
 
In December 2003, we consolidated our previously outstanding senior debt facilities. Our senior debt financing is now provided under a $7,500,000 revolving demand note (the “PrimeSource Healthcare Line of Credit”) from Wells Fargo Business Credit, Inc. (“Wells Fargo”) under the PrimeSource Healthcare Credit and Security Agreement, dated as of December 10, 2003, by and among the Company, LXU Healthcare- Medical Specialty Products, Bimeco and Wells Fargo (the “Credit and Security Agreement”). Pursuant to the Credit and Security Agreement, the maximum amount available to borrow under the PrimeSource Healthcare Line of Credit is limited to the lesser of $7,500,000 or a certain percentage of accounts receivable and inventory, as defined by the Credit and Security Agreement ($7,500,000 at March 31, 2005). As of March 31, 2005, borrowings bore interest at Wells Fargo’s prime rate plus 2.50% (8.25% at March 31, 2005). Borrowings are secured by substantially all assets held by LXU Healthcare and its subsidiaries. At March 31, 2005 and June 30, 2004, there were outstanding borrowings of $4,485,828 and $5,204,139, respectively. At March 31, 2005, there was $3,014,172 of availability under the PrimeSource Healthcare Line of Credit.
 
The Credit and Security Agreement contains certain covenants, including covenants that require the maintenance of defined income levels and maximum capital expenditures. We were in compliance with these covenants as of March 31, 2005.
 
Notes payable include the Luxtec tenant note payable for tenant improvements to the lessor of Luxtec’s leased premises in West Boylston, Massachusetts. The note bears interest at 9.5% and is due September 19, 2007. Payments were interest only for the first 12 months, with remaining payments calculated on a 7-year amortization table with a balloon payment due on September 19, 2007. At March 31, 2005 and June 30, 2004, Luxtec had outstanding borrowings of $50,061 and $62,446, respectively, under the tenant note payable. In addition, notes payable include a long-term note with an outstanding balance of $43,250 at March 31, 2005 and June 30, 2004.
 
As of March 31, 2005, we had $47,636 of cash. In addition, the principal source of our short-term borrowing is the PrimeSource Healthcare Line of Credit. As discussed above, at March 31, 2005, we had $3,014,172 of available credit under the PrimeSource Healthcare Line of Credit.
 
Application of Critical Accounting Policies
 
Our discussion and analysis of financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. During preparation of these financial statements, we make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, inventories, goodwill and other intangible assets and income taxes. We base our estimates on historical experience and various other assumptions that we believe are reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 

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The following critical accounting policies require us to make significant judgments and estimates used in the preparation of our financial statements.
 
Inventory Reserves for Obsolescence
 
We write down our inventory for estimated obsolescence or unmarketable inventory in an amount equal to the lower of the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions prove to be less favorable than those projected by management, additional inventory write-downs may be required. 
 
Goodwill and Other Intangible Assets
 
We evaluate goodwill and other intangible assets for impairment at least annually, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”). For goodwill, we first compare the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds the fair value of a reporting unit, additional tests would be used to measure the amount of impairment loss, if any. We use a present value technique to measure reporting unit fair value. If the carrying amount of any other intangible asset exceeds its fair value, we would recognize an impairment loss for the difference between fair value and the carrying amount. If events occur and circumstances change, causing the fair value of a reporting unit to fall below its carrying amount, impairment losses may be recognized in the future. In accordance with SFAS No. 142, the Company performed its annual impairment test in July 2004 and found no impairment in its existing goodwill balances.
 
Deferred Tax Assets
 
We estimate our actual current tax exposure obligations together with the temporary differences that have resulted from the differing treatment of items dictated by accounting principles generally accepted in the United States of America versus U.S. tax laws. These temporary differences result in deferred tax assets and liabilities. On an on-going basis, we then assess the likelihood that our deferred tax assets will be recovered from future taxable income. If we believe the recovery to be less than likely, we establish a valuation allowance against the deferred tax asset and charge the amount as an income tax expense in the period in which such a determination is made. 
 
Sales Recognition Policy
 
The Company’s policy is to recognize revenues from product sales when earned, as defined by accounting principles generally accepted in the United States of America. Specifically, product and commissions revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred (or services have been rendered), the price is fixed or determinable, and collectibility is reasonably assured.

Product sales are recognized as revenue when the title transfers, generally when shipped.

Revenues earned under agency agreements are recognized when the customer has received the product, and amounts are recorded as commissions in net revenues, at the net amount retained by the Company.


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Provisions for vendor discounts and product returns are provided for at the time the related sales are recorded, and are reflected as a reduction of product sales. The Company estimates customer discounts and product returns at the time of sale based on historical experience. These estimates are reviewed periodically and, if necessary, revised, with any revisions recognized immediately as adjustments to product sales.
 
The Company periodically and systematically evaluates the collectibility of accounts receivable and determines the appropriate allowance for doubtful accounts. In determining the amount of the allowance, management considers historical credit losses, the past due status of receivables, payment history and other customer-specific information, and any other relevant factors or considerations.
 
 


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LXU HEALTHCARE, INC. AND SUBSIDIARIES
 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
The Company’s market risk exposure relates to outstanding debt. The outstanding balance of the Company’s credit facilities at March 31, 2005 is $4,485,828 all of which is subject to interest rate fluctuations. The Company’s credit facilities are indexed to the Prime Rate. As a result, we have exposure relating to the fair value of our outstanding debt, which is a function of market interest rate changes, and investor perception of the quality of the Company’s debt.
 
 ITEM 4. CONTROLS AND PROCEDURES
 
As of March 31, 2005, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. The errors identified and discussed in Note 12 of the consolidated condensed financial statements were principally the result of the misapplication of the accounting guidance of  SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity to the Company's Series G Redeemable Convertible Preferred Stock ("Series G Stock"), and also the misapplication of EITF 00-27 Application of Issue No. 98-5 to Certain Convertible Instruments and EITF D-42, The Effect on the Calculation of Earnings Per Share for the Redemption or Induced Conversion of Preferred Stock to the original accounting for the same Series G Stock as of August 6, 2002. The errors were identified during January 2005. In light of the facts and circumstances relating to the restatement, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the restatement is a material weakness (as defined under standards established by the Public Company Accounting Oversight Board) in the Company’s internal controls. The material weakness was caused by an inadequate control over the review process of the implementation of new accounting guidance, and the application of accounting guidance to new transactions. The Company has engaged outside consultants to assist in enhancing the internal controls over new accounting guidance and new transactions. In addition, the Company has created a new position of Internal Auditor to help document, maintain and test the Companies internal control processes.

Attached as exhibits to this quarterly report are certifications of the Chief Executive Officer and the Chief Financial Officer required in accordance with Rule 13a-14 of the Exchange Act. This portion of the Company’s quarterly report includes the information concerning the controls evaluation referred to in the certifications and should be read in conjunction with the certifications for a more complete understanding of the topics presented.


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PART II. OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
 
 
During the quarter ended December 31, 2004, the Company agreed in principle to resolve a legal matter with a former employee. As a result, the Company has accrued certain amounts in other expense and relating to the matter.

We are also subject to claims and suits arising in the ordinary course of our business. We believe that such legal proceedings will not have a material adverse effect on our financial position, results of operations or liquidity.
 
 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
None.
 

 
 ITEM 6. EXHIBITS
 
(a)  Exhibits
 
See Exhibit Index




 
 
 
 
 

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LXU HEALTHCARE, INC. and Subsidiaries
 
 SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 

 

 
 
LXU HEALTHCARE, INC.
                                                                                      (Registrant)
 

 


 
May 16, 2005
/s/ Shaun D. McMeans
Date:
Shaun D. McMeans
 
Chief Financial Officer
 
(Principal Accounting Officer and Duly
 
Authorized Executive Officer)



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 INDEX TO EXHIBITS
 
 3(i)
Amended and Restated Articles of Organization.
   
  3(ii)
Amended and Restated By-Laws.
   
 4.1
Specimen of Common Stock Certificate. (Incorporated by reference to Form S-18, File No. 33-5514B, declared effective on July 7, 1986).
   
 4.2
Registration Rights Agreement made as of June 3, 1996, between the Company and the Purchasers identified therein. (Incorporated by reference to Form 10-Q, File No. 0-14961, filed September 13, 1996).
   
 4.3
Second Amended and Restated Registration Rights, dated as of August 6, 2002, by and among PrimeSource Healthcare, Inc. and the persons listed as Stockholders therein. (Incorporated by reference to Form 8-K, File No. 0-14961, filed August 8, 2002).
   
 4.4
Amended and Restated Co-Sale Agreement, dated June 28, 2001, by and among PrimeSource Healthcare, Inc. and the persons listed as Stockholders therein. (Incorporated by reference to Form 10-K, File No. 0-14961, filed October 15, 2001).
   
 4.5
Co-Sale Agreement, dated August 6, 2002, by and among PrimeSource Healthcare, Inc. and the persons listed as Stockholders on the signature pages thereto. (Incorporated by reference to Form 8-K, File No. 0-14961, filed August 8, 2002).
   
10.1
Employment Agreement, entered into between PrimeSource Healthcare, Inc. and Bradford C. Walker, effective upon the Initial Closing as defined in the Purchase Agreement dated as of August 6, 2002. (Incorporated by reference to Form 10-K, File No. 0-14961, filed September 30, 2002).
   
 

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10.2
Luxtec Corporation 1992 Stock Plan, as amended. (Incorporated by reference to Form 10-K, File No. 0-14961, filed January 28, 1994).
 
10.3
Luxtec Corporation 1995 Stock Option Plan for Non-Employee Directors. (Incorporated by reference to Form 10-K, File No. 0-14961, filed January 27, 1996).
   
10.4
Tucson Medical Corporation 1997 Stock Option / Stock Issuance Plan, as amended. (Incorporated by reference to Schedule 14A, File No. 0-14961, filed June 1, 2001).
   
10.5
Unit Purchase Agreement among PrimeSource Healthcare, Inc. and the Purchasers named in Schedule I thereto, dated as of June 28, 2001. (Incorporated by reference to Form 8-K, File No. 0-14961, filed July 11, 2001).
   
10.6
Form of Warrant. (Incorporated by reference to Form 8-K, File No. 0-14961, filed July 11, 2001).
   
10.7
Conversion and Exchange Agreement, dated as of August 6, 2002, by and among PrimeSource Healthcare, Inc. and the persons listed in the signature pages thereto. (Incorporated by reference to Form 8-K, File No 0-14961, filed August 8, 2002).
   
10.8
Purchase Agreement, dated as of August 6, 2002, among PrimeSource Healthcare, Inc. and the Initial Purchasers named in Schedule I thereto. (Incorporated by reference to Form 8-K, File No 0-14961, filed August 8, 2002).
   
 

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10.9
Lease Agreement, dated as of March 1, 2000, by and between Holualoa Butterfield Industrial, L.L.C. and PrimeSource Surgical, Inc. (Incorporated by reference to Form 10-K, File No. 0-14961, filed on October 15, 2001).
   
10.10
Credit and Security Agreement, dated as of December 10, 2003, by and among PrimeSource Healthcare, Inc., PrimeSource Surgical, Inc., Bimeco, Inc. and Wells Fargo Business Credit, Inc. (Incorporated by reference to Form 8-K, File No. 0-14961, filed December 17, 2003).
   
10.11
Waiver Agreement, dated June 30, 2003, by and among PrimeSource Healthcare, Inc. and the Purchasers named therein. (Incorporated by reference to Form 8-K, File No. 0-14961, filed July 2, 2003).
   
10.12
Severance Agreement, dated September 5, 2003, by and between PrimeSource Healthcare, Inc. and Bradford C. Walker. (Incorporated by reference to Form 8-K, File No. 0-14961, filed September 8, 2003).
   
 21.1
Subsidiaries of the Registrant.
   
 31.1
Certification of the President Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
 31.2
Certification of CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
 32.1
Certification of the President and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 

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