UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549

 

FORM 10-Q

 

[X]	QUARTERLY REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2015
	OR
[_]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from _________________ to ______________________

  

Commission file number: 000-22427
HESKA CORPORATION
(Exact name of registrant as specified in its charter)
Delaware (state or other jurisdiction of incorporation or organization)	77-0192527 (I.R.S. Employer Identification Number)
3760 Rocky Mountain Avenue Loveland, Colorado (Address of principal executive offices)	80538 (Zip Code)
Registrant's telephone number, including area code:
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [X]     No [_]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company as defined in Rule 12b-2 of the Exchange Act.  See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer   [_]	Accelerated filer   [_]
Non-accelerated filer [_] (Do not check if a small reporting company)	Smaller reporting company   [X]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes [X]     No [_]
The number of shares of the Registrant's Public Common Stock outstanding at November 13, 2015 was 6,589,096.

 

 

TABLE OF CONTENTS

				Page
PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets as of December 31, 2014 and September 30, 2015 (Unaudited)			2
	Condensed Consolidated Statements of Income (Unaudited) for the three months and nine months ended September 30, 2014 and 2015			3
	Condensed Consolidated Statements of Comprehensive Income (Unaudited) for the three months and nine months ended September 30, 2014 and 2015			4
	Condensed Consolidated Statements of Cash Flows (Unaudited) for the three months and nine months ended September 30, 2014 and 2015			5
	Notes to Condensed Consolidated Financial Statements (Unaudited)			6
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations			16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk			25
Item 4.	Controls and Procedures			26
PART II -  OTHER INFORMATION
Item 1.	Legal Proceedings			26
Item 1A.	Risk Factors			26
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds			40
Item 3.	Defaults Upon Senior Securities			40
Item 4.	Mine Safety Disclosures			40
Item 5.	Other Information			40
Item 6.	Exhibits			41
Signatures				42
Exhibit Index				43

HESKA, SOLO STEP and VITALPATH are registered trademarks of Heska Corporation. TRI-HEART is a registered trademark of Intervet Inc., d/b/a Merck Animal Health, formerly known as Schering-Plough Animal Health Corporation ("Merck Animal Health"), which is a unit of Merck & Co., Inc. ("Merck"), in the United States and is a registered trademark of Heska Corporation in other countries. This Form 10-Q also refers to trademarks and trade names of other organizations.

HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(amounts in thousands except shares and per share amounts)

 

			December 31, 2014			(unaudited) September 30, 2015
ASSETS
Current assets:
	Cash and cash equivalents		$	5,855		$	5,931
	Accounts receivable, net of allowance for doubtful accounts of $216 and $261, respectively			11,919			13,972
	Due from – related parties			892			503
	Inventories, net			12,658			17,702
	Deferred tax asset, current			1,489			1,448
	Other current assets			1,587			1,719
		Total current assets		34,400			41,275
Property and equipment, net				13,410			15,727
Note receivable – related party				1,466			1,504
Goodwill and other intangibles				21,205			21,027
Deferred tax asset, net of current portion				25,721			24,252
Other long-term assets				642			2,247
		Total assets	$	96,844		$	106,032
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable		$	4,897		$	7,240
	Due to – related party			252			64
	Accrued liabilities			5,130			6,313
	Current portion of deferred revenue and other			4,584			3,943
	Line of credit			48			1,674
	Other short-term borrowings, including current portion of long-term note payable			141			159
		Total current liabilities		15,052			19,393
Long-term note payable, net of current portion				227			104
Deferred revenue and other, net of current portion				12,754			11,521
		Total liabilities		28,033			31,018
Commitments and contingencies
Non-Controlling Interest				15,679			15,855
Stockholders' equity:
	Preferred stock, $.01 par value, 2,500,000 shares authorized; none issued or outstanding			—			—
	Common stock, $.01 par value, 7,500,000 shares authorized, none issued or outstanding			—			—
	Public common stock, $.01 par value, 7,500,000 shares authorized, 6,342,205 and 6,585,628 shares issued and outstanding, respectively			63			66
	Additional paid-in capital			222,297			225,123
	Accumulated other comprehensive income			283			338
	Accumulated deficit			(169,511	)		(166,368	)
		Total stockholders' equity		53,132			59,159
Total liability and stockholders' equity			$	96,844		$	106,032

See accompanying notes to condensed consolidated financial statements.

 

 

HESKA CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share amounts)

(unaudited)

 

 

 

	Three Months Ended September 30,									Nine Months Ended September 30,
	2014					2015				2014		2015
Revenue, net:
Core companion animal health	$	16,371			$		20,983		$	51,223		$	61,312
Other vaccines, pharmaceuticals and products		5,434					7,051			14,291			13,526
Total revenue, net		21,805					28,034			65,514			74,838
Cost of revenue		13,488					16,437			39,841			42,860
Gross profit		8,317					11,597			25,673			31,978
Operating expenses:
Selling and marketing		4,716					5,173			14,413			15,872
Research and development		322					493			1,084			1,304
General and administrative		2,938					3,789			9,019			9,810
Total operating expenses		7,976					9,455			24,516			26,986
Operating income		341					2,142			1,157			4,992
Interest and other (income) expense, net		(40	)				(69	)		(31	)		105
Income before income taxes		381					2,211			1,188			4,887
Income tax expense:
Current tax expense		60					106			113			232
Deferred tax expense		306					722			555			1,511
Total income tax expense		366					828			668			1,743
Net income	$	15			$		1,383		$	520		$	3,144
Net income (loss) attributable to non-controlling interest		(498	)				(32	)		(1,254	)		(66	)
Net income attributable to Heska Corporation	$	513			$		1,415		$	1,774		$	3,210
Basic net income per share attributable to Heska Corporation	$	0.09			$		0.22		$	0.30		$	0.51
Diluted net income per share attributable to Heska Corporation	$	0.08			$		0.20		$	0.28		$	0.46
Weighted average outstanding shares used to compute basic net income per share attributable to Heska Corporation		5,989					6,344			5,929			6,270
Weighted average outstanding shares used to compute diluted    net income per share attributable to Heska Corporation		6,554					7,139			6,314			7,041

 

 

  

 

 

See accompanying notes to condensed consolidated financial statements.

HESKA CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in thousands)

(unaudited)

 

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2014			2015			2014			2015
Net income		$	15		$	1,383		$	520		$	3,144
Other comprehensive income (loss):
	Minimum pension liability		6			—			—			—
	Foreign currency translation		(258	)		(114	)		(188	)		49
	Unrealized gain (loss) on available for sale investments		—			—			(2	)		6
Comprehensive income (loss)		$	(237	)	$	1,269		$	330		$	3,199
Comprehensive income (loss) attributable to non-controlling interest		$	(498	)	$	(32	)	$	(1,254	)	$	(66	)
Comprehensive income attributable to Heska Corporation		$	261		$	1,301		$	1,584		$	3,265

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes to condensed consolidated financial statements.

HESKA CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

(unaudited)

 

	Nine Months Ended September 30,
	2014					2015
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	520			$	3,144
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization		2,594				3,240
Deferred tax expense		555				1,511
Stock-based compensation		1,147				1,540
Unrealized loss (gain) on foreign currency translation		(52	)			34
Changes in operating assets and liabilities:
Accounts receivable		(1,408	)			(2,053	)
Inventories		(4,305	)			(8,439	)
Other current assets		345				(159	)
Accounts payable		1,118				2,154
Accrued liabilities and other		377				1,446
Other non-current assets		(87	)			(1,599	)
Deferred revenue and other		2,801				(1,751	)
Net cash provided by (used in) operating activities		3,605				(932	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment		(1,775	)			(1,976	)
Proceeds from disposition of property and equipment		6				—
Net cash used in investing activities		(1,769	)			(1,976	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock		1,069				1,465
Proceeds from (repayments of) line of credit borrowings, net		(2,954	)			1,627
Repayments of other debt		(144	)			(105	)
Net cash provided by (used in) financing activities		(2,029	)			2,987
EFFECT OF EXCHANGE RATE CHANGES ON CASH		(70	)			(3	)
INCREASE (DECREASE)  IN CASH AND CASH EQUIVALENTS		(263	)			76
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		6,016				5,855
CASH AND CASH EQUIVALENTS, END OF PERIOD	$	5,753			$	5,931

 

 

 

See accompanying notes to condensed consolidated financial statements.

HESKA CORPORATION AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2015

(UNAUDITED)

 

 

1.        ORGANIZATION AND BUSINESS

Heska Corporation ("Heska" or the "Company") develops, manufactures, markets, sells and supports veterinary products. Heska's core focus is on the canine and feline companion animal health markets.

 

2.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements are the responsibility of the Company's management and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and rules and regulations of the Securities and Exchange Commission (the "SEC"). The condensed consolidated balance sheet as of September 30, 2015, the condensed consolidated statements of income for the three months and nine months ended September 30, 2014 and 2015, the condensed consolidated statements of comprehensive income for the three months and nine months ended September 30, 2014 and 2015 and the condensed consolidated statements of cash flows for the nine months ended September 30, 2014 and 2015 are unaudited, but include, in the opinion of management, all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of its financial position, operating results and cash flows for the periods presented. All material intercompany transactions and balances have been eliminated in consolidation. Although the Company believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the SEC.

 

Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2014, included in the Company's Annual Report on Form 10-K filed with the SEC on March 25, 2015.

 

Use of Estimates

 

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 assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenue and expense during the reported period. Actual results could differ from those estimates. Significant estimates are required when establishing the allowance for doubtful accounts and the provision for excess/obsolete inventory, in determining the period over which the Company's obligations are fulfilled under agreements to license product rights and/or technology rights, in determining the need for, and the amount of, a valuation allowance on certain deferred tax assets and in determining the need for, and the amount of, an accrued liability for future payments related to minimum purchase obligations the Company may make in order to maintain certain product rights.

 

  

 Inventories

 

Inventories are stated at the lower of cost or market using the first-in, first-out method. Inventory manufactured by the Company includes the cost of material, labor and overhead. If the cost of inventories exceeds estimated fair value, provisions are made to reduce the carrying value to estimated fair value.

 

Inventories, net consist of the following (in thousands):

 

		December 31, 2014			September 30, 2015
	Raw materials	$	6,298		$	9,180
	Work in process		2,966			4,381
	Finished goods		4,949			5,587
	Allowance for excess or obsolete inventory		(1,555	)		(1,446	)
	Total inventories, net	$	12,658		$	17,702

 

Property and Equipment

The Company has utilized marketing programs whereby its instruments in inventory may be placed in a customer's location on a rental basis. The cost of these instruments is transferred to machinery and equipment or other long-term assets and depreciated or amortized, typically over a five to seven year period depending on the circumstance under which the instrument is placed with the customer. For the nine months ended September 30, 2014 and the nine months ended September 30, 2015, total costs transferred from inventory, including related to instrument rentals, were approximately $3.9 million and $3.4 million, respectively.

The Company has sold certain customer rental contracts and underlying assets to a third party under the agreement that once the customer has met the customer obligations under the contract, ownership of the assets underlying the contract would be returned to the Company. The Company enters a debit to cash and a corresponding credit to deferred revenue at the time of these sales. These sales provided $1.6 million and $59 thousand of cash which was reported in the "deferred revenue and other" line item of the Company's consolidated statements of cash flows as of September 30, 2014 and September 30, 2015, respectively, all related to the Company's 54.6%-owned subsidiary, Heska Imaging US, LLC. As the Company anticipates it will regain ownership of the assets underlying these sales, it reports these assets as part of property and equipment and depreciates these assets per its depreciation policies. The Company had $3.0 million of net property and equipment and $2.4 million of net property and equipment related to these transactions as of December 31, 2014 and September 30, 2015, respectively, all related to the Company's 54.6%-owned subsidiary, Heska Imaging US, LLC.

 

Capitalized Software

 

The Company capitalizes third-party software costs, where appropriate, and reports such capitalized costs, net of accumulated amortization, on the "property and equipment, net" line of its consolidated balance sheets. The Company had $587 thousand and $464 thousand of such capitalized costs, net of accumulated amortization, on the "property and equipment, net" line of its consolidated balance sheets as of December 31, 2014 and September 30, 2015, respectively. Capitalized software costs in a given year are reported on the "purchases of property and equipment" line item of the Company's consolidated statements of cash flows. The Company had $31 thousand and $51 thousand of capitalized software costs reported on the "purchases of property and equipment" line item of its consolidated statements of cash flows for the nine months ended September 30, 2014 and September 30, 2015, respectively.

 

Cash Interest

 

Cash paid for interest for the nine months ended September 30, 2014 and September 30, 2015 was $68 thousand and $63 thousand, respectively.

 

Basic and Diluted Net Income Per Share

 

Basic net income per common share is computed using the weighted average number of common shares outstanding during the period. The weighted average number of common shares outstanding used to calculate basic net income per common share for the three and nine months ended September 30, 2015 excluded unvested shares of restricted common stock, which totaled 209,177 shares at September 30, 2015. Diluted net income (loss) per share is computed using the sum of the weighted average number of shares of common stock outstanding, and, if not anti-dilutive, the effect of outstanding common stock equivalents (such as stock options and warrants) determined using the treasury stock method.

 

For the three and nine months ended September 30, 2014 and September 30, 2015, the Company reported net income attributable to Heska Corporation and therefore, unvested shares of restricted common stock and other dilutive common stock equivalent securities, as computed using the treasury method (but excluding options to purchase fractional shares resulting from the Company's December 2010 1-for-10 reverse stock split), were added to basic weighted average shares outstanding for the period to derive the weighted average shares for diluted earnings per share calculation. Common stock equivalent securities, other than options to purchase fractional shares, that were anti-dilutive for the three and nine months ended September 30, 2014, and therefore excluded were outstanding options to purchase 140,758 and 273,572 shares of common stock, respectively. Common stock equivalent securities, other than options to purchase fractional shares, that were anti-dilutive for the three and nine months ended September 30, 2015, and therefore excluded, were outstanding options to purchase 31,800 and 31,800 shares of common stock, respectively. These securities are anti-dilutive primarily due to exercise prices greater than the average trading price of the Company's common stock during the three and nine months ended September 30, 2014 and September 30, 2015.

 

3.       NON-CONTROLLING INTEREST AND RELATED PARTY ITEMS

 

On February 24, 2013, the Company acquired a 54.6% interest in Cuattro Veterinary USA, LLC, an entity which was subsequently renamed Heska Imaging US, LLC ("Heska Imaging"). The remaining minority position (45.4%) in Heska Imaging is subject to purchase by Heska under performance-based puts and calls following calendar year 2015, 2016 and 2017. Should Heska undergo a change in control, as defined, prior to the end of 2017, Heska Imaging minority unit holders will be entitled to sell their Heska Imaging units to Heska at the highest call value they could have otherwise obtained if Heska Imaging meets certain minimum performance criteria.

 

Heska Imaging markets, sells and supports digital radiography and ultrasound products along with embedded software and support, data hosting and other services.

 

Shawna M. Wilson, Clint Roth, DVM, Steven M. Asakowicz, Rodney A. Lippincott, Kevin S. Wilson and Cuattro, LLC own approximately 29.75%, 8.39%, 4.09%, 3.07%, 0.05% and 0.05% of Heska Imaging, respectively. Kevin S. Wilson is the Chief Executive Officer and President of the Company, a member of the Company's Board of Directors and the spouse of Shawna M. Wilson. Steven M. Asakowicz serves as Executive Vice President, Companion Animal Health Sales for the Company. Rodney A. Lippincott serves as Executive Vice President, Companion Animal Health Sales for the Company. Mr. Wilson, Mrs. Wilson and trusts for their children and family own a 100% interest in Cuattro, LLC. Cuattro, LLC owns a 100% interest in Cuattro Software, LLC and a majority interest in Cuattro Veterinary, LLC. Mr. Wilson, Mrs. Wilson and trusts for their children and family own a majority interest in Cuattro Medical, LLC.

 

Since January 1, 2015, Cuattro, LLC charged Heska Imaging $5.8 million, primarily related to digital imaging products, for which there is an underlying supply contract with minimum purchase obligations, software and services as well as other operating expenses; Heska Corporation charged Heska Imaging $3.4 million, primarily related to sales expenses; Heska Corporation charged Cuattro, LLC $125 thousand, primarily related to facility usage and other services.

 

At September 30, 2015, Heska Imaging has a $1.5 million note receivable, including accrued interest, from Cuattro Veterinary, LLC, which is due on March 15, 2016 and which is listed as "Note receivable – related party" on the Company's consolidated balance sheets; Heska Imaging had accounts receivable from Cuattro Software, LLC of $488 thousand, which is included in "Due from – related parties" on the Company's consolidated balance sheets; Heska Corporation had net accounts receivable from Cuattro, LLC of $15 thousand which is included in "Due from – related parties" on the Company's consolidated balance sheets; Heska Imaging had net accounts payable to Cuattro, LLC of $64 thousand which is included in "Due to – related party" on the Company's consolidated balance sheets; Heska Corporation had accounts receivable from Heska Imaging of $5.8 million, including accrued interest, which eliminated in consolidation of the Company's financial statements; all monies owed accrue interest at the same rate Heska Corporation pays under its credit and security agreement with Wells Fargo Bank, National Association ("Wells Fargo") once past due with the exception of the note receivable, which accrues at this rate to its maturity date.

 

The aggregate position in Heska Imaging of the unit holders who hold the 45.4% of Heska Imaging that Heska Corporation does not own (the "Put Value") is being accreted to its estimated redemption value in accordance with Heska Imaging's Amended and Restated Operating Agreement (the "Operating Agreement"). Since the Operating Agreement contains certain put rights that are out of the control of the Company, authoritative guidance requires the non-controlling interest, which includes the estimated values of such put rights, to be displayed outside of the equity section of the consolidated balance sheets. The adjustment to increase or decrease the Put Value to its expected redemption value and to estimate any distributions required under Heska Imaging's Operating Agreement to the unit holders who hold the 45.4% of Heska Imaging that Heska Corporation does not own (the "Imaging Minority") each reporting period is recorded to stockholders' equity in accordance with United States Generally Accepted Accounting Principles.

 

The following is a reconciliation of the non-controlling interest balance (in thousands):

 

	Beginning at December 31, 2014		$	15,679
		Accretion of Put Value		176
	Balance at September 30, 2015		$	15,855

 

 

4.    CAPITAL STOCK

 

Stock Option Plans

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted average assumptions for options granted in the three and nine months ended September 30, 2014 and 2015.

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2014		2015		2014		2015
	Risk-free interest rate	1.24%		1.15%		1.07%		1.16%
	Expected lives	3.4 years		3.4 years		3.3 years		3.4 years
	Expected volatility	44%		40%		46%		42%
	Expected dividend yield	0%		0%		0%		0%

 

 

 

A summary of the Company's stock option plans, excluding options to purchase fractional shares resulting from the Company's December 2010 1-for-10 reverse stock split is as follows:

 

			Year Ended December 31, 2014						Nine Months Ended September 30, 2015
			Options			Weighted Average Exercise Price			Options			Weighted Average Exercise Price
	Outstanding at beginning of period			1,321,232		$	10.386			1,074,251		$	10.111
		Granted at market		134,800		$	16.398			34,346		$	28.353
		Cancelled		(218,926	)	$	17.786			(27,715	)	$	10.053
		Exercised		(162,855	)	$	7.234			(181,983	)	$	9.984
	Outstanding at end of period			1,074,251		$	10.110			898,899		$	10.835
	Exercisable at end of period			729,175		$	9.800			660,176		$	10.471

 

The estimated fair value of stock options granted during the nine months ended September 30, 2014 and 2015 was computed to be approximately $117 thousand and $309 thousand, respectively. The amount is amortized ratably over the vesting period of the options. The per share weighted average estimated fair value of options granted during the nine months ended September 30, 2014 and 2015 was computed to be approximately $3.68 and $9.00, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2014 and 2015 was approximately $516 thousand and $3.1 million, respectively. The cash proceeds from options exercised during the nine months ended September 30, 2014 and 2015 were approximately $889 thousand and $1.4 million, respectively.

 

The following table summarizes information about stock options outstanding and exercisable at September 30, 2015, excluding outstanding options to purchase an aggregate of 8.6 fractional shares resulting from the Company's December 2010 1-for-10 reverse stock split with a weighted average remaining contractual life of 0.8 years, a weighted average exercise price of $15.27 and exercise prices ranging from $9.50 to $22.50. The Company intends to issue whole shares only from option exercises.

 

		Options Outstanding									Options Exercisable
	Exercise Prices	Number of Options Outstanding at September 30, 2015			Weighted Average Remaining Contractual Life in Years			Weighted Average Exercise Price			Number of Options Exercisable at September 30, 2015				Weighted Average Exercise Price
	$  4.40 - $  6.90		226,552			5.15		$	5.596				218,699			$	5.558
	$  6.91 - $  7.36		183,294			8.14		$	7.360				82,483			$	7.360
	$  7.37 - $12.34		181,242			7.04		$	9.069				138,633			$	9.205
	$12.35 -$17.17		119,261			1.67		$	14.038				115,489			$	14.007
	$17.18 - $32.21		188,550			7.03		$	20.181				104,872			$	26.015
	$  4.40 - $32.21		898,899			6.07		$	10.835				660,176			$	10.471

 

As of September 30, 2015, there was approximately $1.0 million of total unrecognized compensation cost related to outstanding stock options. That cost is expected to be recognized over a weighted average period of 1.6 years, with approximately $163 thousand to be recognized in the three months ending December 31, 2015 and all the cost to be recognized as of September 2019, assuming all options vest according to the vesting schedules in place at September 30, 2015. As of September 30, 2015, the aggregate intrinsic value of outstanding options was approximately $17.7 million and the aggregate intrinsic value of exercisable options was approximately $13.2 million.

 

 

Employee Stock Purchase Plan (the "ESPP")

 

On May 5, 2015, the Company's shareholders approved the amendment and restatement of the ESPP, including a 75,000 share increase to 450,000 total shares authorized under the ESPP as well as the following changes as compared to the ESPP prior to the amendment and restatement. Beginning April 1, 2015, employees may elect to withhold a positive fixed amount from each compensation payment in addition to the previous approach of withholding a whole percentage of such compensation payment, with all withholding for a given employee subject to a maximum monthly amount of $2,500 following the amendment and restatement as opposed to a $25,000 maximum annual amount prior to the amendment and restatement. For offering periods beginning on or after April 1, 2015, the purchase price of stock on March 31, June 30, September 30 and December 31 is to be the lesser of (1) 85% of the fair market value at the time of purchase and (2) the greater of (i) 85% of the fair market value at the beginning of the applicable offering period, (ii) the fair market value at the beginning of the applicable offering period less 1 cent and (iii) 65% of the fair market value at the time of purchase. In addition, participating employees may elect to purchase shares under the ESPP at the beginning of an applicable offering period for a purchase price of stock equal to the greater of (1) 85% of the fair market value at the beginning of the applicable offering period and (2) the fair market value at the beginning of the applicable offering period less 1 cent or at 5 pm on a day other than March 31, June 30, September 30 and December 31 during the applicable offering period for a purchase price of stock equal to the greater of (1) 85% of the fair market value at the time of purchase and (2) the fair market value at the time of purchase less 1 cent.

 

In the nine months ended September 30, 2014, the Company issued 23,418 shares under the ESPP. In the nine months ended September 30, 2015, the Company issued 11,475 shares under the ESPP.

 

For the three and nine months ending September 30 of the following years, the Company estimated the fair values of stock purchase rights granted under the ESPP using the Black-Scholes pricing model and the following weighted average assumptions:

 

		Three Months Ended September 30,				Nine Months Ended September 30,
		2014		2015		2014		2015
	Risk-free interest rate	0.22%		0.26%		0.23%		0.25%
	Expected lives	1.3 years		1.2 years		1.3 years		1.2 years
	Expected volatility	34%		36%		34%		36%
	Expected dividend yield	0%		0%		0%		0%

 

For the nine months ended September 30, 2014, the weighted-average fair value of the purchase rights granted was $2.37 per share. For the nine months ended September 30, 2015, the weighted-average fair value of the purchase rights granted was $5.77 per share.

 

Restricted Stock Vesting and Issuance

 

In the nine months ended September 30, 2015, Mr. Wilson vested 39,000 shares, which were shares originally issued on May 6, 2014 following a vote of approval by the Company's stockholders pursuant to an employment agreement between Mr. Wilson and the Company effective as of March 26, 2014 (the "Wilson Employment Agreement"), upon the Company's achievement of certain stock price targets as defined and further described in the Wilson Employment Agreement as well as 55,000 shares subject to time-based vesting issued on March 26, 2014 pursuant to the Wilson Employment Agreement.

 

On March 17, 2015, the Company issued unvested shares to certain Executive Officers related to performance-based restricted stock grants (the "Performance Grants") and performance-based restricted stock grants related to the Company's 2015 Management Incentive Plan (the "MIP Grants"). The Performance Grants are to cliff vest three years following issuance, subject to the Company's achieving $7 million in Operating Cash Flow, as defined in the underlying restricted stock grant agreement, in at least one of 2015, 2016 or 2017, and other vesting provisions in the underlying restricted stock grant agreement. The MIP Grants are to vest on the date MIP Payouts are to be made under the 2015 Management Incentive Plan and are subject to the Company's achievement of certain financial goals and other vesting provisions in the underlying restricted stock grant agreement. The Company issued 52,956 shares under Performance Grants and 24,649 shares under MIP Grants on March 17, 2015.

 

Restrictions on the transfer of Company stock

 

The Company's Restated Certificate of Incorporation, as amended (the "Certificate of Incorporation"), places restrictions (the "Transfer Restrictions") on the transfer of the Company's stock that could adversely effect the Company's ability to utilize its domestic Federal Net Operating Loss Position. In particular, the Transfer Restrictions prevent the transfer of shares without the approval of the Company's Board of Directors if, as a consequence of such transfer, an individual, entity or groups of individuals or entities would become a 5-percent holder under Section 382 of the Internal Revenue Code of 1986, as amended, and the related Treasury regulations, and also prevents any existing 5-percent holder from increasing his or her ownership position in the Company without the approval of the Company's Board of Directors. Any transfer of shares in violation of the Transfer Restrictions (a "Transfer Violation") shall be void ab initio under the Certificate of Incorporation, and the Company's Board of Directors has procedures under the Certificate of Incorporation to remedy a Transfer Violation including requiring the shares causing such Transfer Violation to be sold and any profit resulting from such sale to be transferred to a charitable entity chosen by the Company's Board of Directors in specified circumstances.

 

 

5.        SEGMENT REPORTING

 

The Company is comprised of two reportable segments, Core Companion Animal Health ("CCA") and Other Vaccines, Pharmaceuticals and Products ("OVP"). The Core Companion Animal Health segment includes diagnostic instruments and supplies, as well as single use diagnostic and other tests and pharmaceuticals. The CCA segment also includes digital radiography and ultrasound products along with embedded software and support, data hosting and other services from Heska Imaging. These products are sold directly by the Company as well as through independent third-party distributors and through other distribution relationships. CCA segment products manufactured at the Des Moines, Iowa production facility included in the OVP segment's assets are transferred at cost and are not recorded as revenue for the OVP segment. The Other Vaccines, Pharmaceuticals and Products segment includes private label vaccine and pharmaceutical production, primarily for cattle, but also for other animals including small mammals. All OVP products are sold by third parties under third-party labels.

 

Summarized financial information concerning the Company's reportable segments is shown in the following table (in thousands):

 

 

			Core Companion Animal Health					Other Vaccines, Pharmaceuticals and Products			Total
	Nine Months Ended September 30, 2014:
		Total revenue	$	51,223			$	14,291			$	65,514
		Operating income (loss)		(545	)			1,702				1,157
		Income (loss) before income taxes		(473	)			1,661				1,188
		Total assets		82,294				14,790				97,084
		Net assets		40,948				10,383				51,331
		Capital expenditures		1,523				252				1,775
		Depreciation and amortization		2,021				573				2,594
	Nine Months Ended September 30, 2015:
		Total revenue	$	61,312			$	13,526			$	74,838
		Operating income		2,768				2,224				4,992
		Income before income taxes		2,703				2,184				4,887
		Total assets		88,228				17,804				106,032
		Net assets		46,696				12,463				59,159
		Capital expenditures		677				1,299				1,976
		Depreciation and amortization		2,712				528				3,240

 

			Core Companion Animal Health					Other Vaccines, Pharmaceuticals and Products			Total
	Three Months Ended September 30, 2014:
		Total revenue	$	16,371			$	5,434			$	21,805
		Operating income (loss)		(280	)			621				341
		Income (loss) before income taxes		(227	)			608				381
		Total assets		82,294				14,790				97,084
		Net assets		40,948				10,383				51,331
		Capital expenditures		189				48				237
		Depreciation and amortization		790				187				977
	Three Months Ended September 30, 2015:
		Total revenue	$	20,983			$	7,051			$	28,034
		Operating income		697				1,445				2,142
		Income before income taxes		782				1,429				2,211
		Total assets		88,228				17,804				106,032
		Net assets		46,696				12,463				59,159
		Capital expenditures		228				812				1,040
		Depreciation and amortization		988				178				1,166

 

 

6.        SUBSEQUENT EVENTS

 

Effective on October 1, 2015, the Employment Agreement (Executive Chair) between the Company and Robert B. Grieve, Ph.D. dated effective as of March 26, 2014 (the "Grieve Agreement") was terminated and, in connection therewith, the Company entered into a Separation and Release Agreement dated as of October 1, 2015 (the "Release Agreement") with Dr. Grieve. Pursuant to the Release Agreement, Dr. Grieve provided to the Company a full and unconditional general release of any and all claims or causes of action, known or unknown, that Dr. Grieve may have against the Company and resigned from the Company's Board of Directors, and the Company agreed to treat the termination of the Grieve Employment Agreement as a termination without cause entitling Dr. Grieve to the accelerated payments and other benefits associated therewith, including the immediate vesting of 41,342 shares, net of shares withheld for tax. As a result of the termination of the Grieve Agreement, and as acknowledged in the Release Agreement, effective October 1, 2015, Dr. Grieve began serving as a consultant to the Company pursuant to the Consulting Agreement (Founder Emeritus) dated as of March 26, 2014.

 

On November 11, 2015, the Company entered into a Unit Purchase Agreement (the "Acquisition Agreement") with Cuattro Veterinary, LLC ("Cuattro International"). Cuattro International sells the same digital radiography solutions outside the United States that Heska Imaging sells in the United States. Under the terms of the Acquisition Agreement, the Company agreed to deliver $6.0 million in stock, subject to a minimum of 175,000 shares and a maximum of 200,000 shares, in exchange for 100% ownership of Cuattro International. Additionally, the Company will assume approximately $2.1 million in debt as part of the Acquisition Agreement. The acquisition is expected to close on or about January 1, 2016 subject to certain closing conditions, including the affirmative vote of the Company's stockholders to increase by 1,000,000 shares each the authorized shares of both classes of the Company's Common Stock Securities, as defined in the Company's Restated Certificate of Incorporation, as amended.

 

 

Item 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with "Selected Consolidated Financial Data" and the Unaudited Condensed Consolidated Financial Statements and related Notes included in Part I Item 1 of this Form 10-Q.

This discussion contains forward-looking statements that involve risks and uncertainties. Such statements, which include statements concerning future revenue sources and concentration, gross profit margins, selling and marketing expenses, general and administrative expenses, research and development expenses, capital resources, capital expenditures and additional financings or borrowings, are subject to risks and uncertainties, including, but not limited to, those discussed below and elsewhere in this Form 10-Q, particularly in Part II Item 1A. "Risk Factors," that could cause actual results to differ materially from those projected. The forward-looking statements set forth in this Form 10-Q are as of the close of business on November 13, 2015,and we do not intend to update this forward-looking information.

Overview

We develop, manufacture, market, sell and support veterinary products. Our business is comprised of two reportable segments, Core Companion Animal Health ("CCA"), which represented 83% of our revenue for the twelve months ended September 30, 2015 (which we define as "LTM") and Other Vaccines, Pharmaceuticals and Products ("OVP"), which represented 17% of LTM revenue.

 

The CCA segment includes, primarily for canine and feline use, blood testing instruments and supplies, digital imaging products, software and services, and single use products and services such as heartworm diagnostic tests, heartworm preventive products, allergy immunotherapy products and allergy testing.

 

Blood testing and other non-imaging instruments and supplies represented approximately 38% of our LTM revenue. Many products in this area involve placing an instrument in the field and generating future revenue from consumables, including items such as supplies and service, as that instrument is used. Approximately 31% of our LTM revenue resulted from the sale of such consumables to an installed base of instruments and approximately 7% of our LTM revenue was from hardware revenue. A loss of or disruption in supply of consumables we are selling to an installed base of instruments could substantially harm our business. All of our blood testing and other non-imaging instruments and supplies are supplied by third parties, who typically own the product rights and supply the product to us under marketing and/or distribution agreements. In many cases, we have collaborated with a third party to adapt a human instrument for veterinary use. Major products in this area include our chemistry instruments, our hematology instruments and our blood gas instruments and their affiliated operating consumables. Revenue from products in these three areas, including revenues from consumables, represented approximately 34% of our LTM revenue.

 

Imaging hardware, software and services represented approximately 19% of LTM revenue. Digital radiography is the largest product offering in this area, which also includes ultrasound instruments. Digital radiography solutions typically consist of a combination of hardware and software placed with a customer, often combined with an ongoing service and support contract. It has been our experience that most of the economic benefit is generated at the time of sale in this area, in contrast to the blood testing category discussed above where ongoing consumable revenue is often a larger component of economic value.

Other CCA revenue, including single use diagnostic and other tests, pharmaceuticals and biologicals as well as research and development, licensing and royalty revenue, represented approximately 26% of our LTM revenue. Since items in this area are often single use by their nature, our typical aim is to build customer satisfaction and loyalty for each product, generate repeat annual sales from existing customers and expand our customer base in the future. Products in this area are both supplied by third parties and provided by us. Major products and services in this area include our heartworm preventives, our heartworm diagnostic tests, our allergy immunotherapy, our allergy testing and our allergy test kits. Combined revenue from heartworm-related products and allergy-related products represented 25% of our LTM revenue.

 

We consider the CCA segment to be our core business and devote most of our management time and other resources to improving the prospects for this segment. Maintaining a continuing, reliable and economic supply of products we currently obtain from third parties is critical to our success in this area. Virtually all of our sales and marketing expenses occur in the CCA segment. The majority of our research and development spending is dedicated to this segment as well.

 

All our CCA products are ultimately sold primarily to or through veterinarians. In many cases, veterinarians will mark up their costs to the end user. The acceptance of our products by veterinarians is critical to our success. CCA products are sold directly to end users by us as well as through distribution relationships, such as our corporate agreement with Merck Animal Health, the sale of kits to conduct blood testing to third-party veterinary diagnostic laboratories and independent third-party distributors. Revenue from direct sales and distribution relationships represented approximately 69% and 31%, respectively, of CCA LTM revenue.

 

We intend to sustain profitability over the long term through a combination of revenue growth, gross margin improvement and expense control. Accordingly, we closely monitor revenue growth trends in our CCA segment. LTM revenue in this segment increased 15% as compared to revenue in this segment for the twelve months ended September 30, 2014.

 

The OVP segment includes our 168,000 square foot USDA- and FDA-licensed production facility in Des Moines, Iowa. We view this facility as an asset which could allow us to control our cost of goods on any pharmaceuticals and vaccines that we may commercialize in the future. We have increased integration of this facility with our operations elsewhere. For example, virtually all our U.S. inventory, excluding Heska Imaging, is now stored at this facility and related fulfillment logistics are managed there. CCA segment products manufactured at this facility are transferred at cost and are not recorded as revenue for our OVP segment. We view OVP reported revenue as revenue primarily to cover the overhead costs of the facility and to generate incremental cash flow to fund our CCA segment.

 

Our OVP segment includes private label vaccine and pharmaceutical production, primarily for cattle but also for other animals such as small mammals. All OVP products are sold by third parties under third-party labels.

Historically, a significant portion of our OVP segment's revenue has been generated from the sale of certain bovine vaccines, which have been sold primarily under the Titanium® and MasterGuard® brands. We have a supply agreement with Eli Lilly and Company ("Eli Lilly") and its Affiliates operating through its Elanco Animal Health division ("Elanco") for the production of these vaccines. Our OVP segment also produces vaccines and pharmaceuticals for other third parties.

 

 

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon the consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expense during the periods. These estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. We have identified those critical accounting policies used in reporting our financial position and results of operations based upon a consideration of those accounting policies that involve the most complex or subjective decisions or assessment. We consider the following to be our critical policies.

 

Revenue Recognition

 

We generate our revenue through the sale and rental of products, as well as through licensing of technology product rights, royalties and sponsored research and development. Our policy is to recognize revenue when the applicable revenue recognition criteria have been met, which generally include the following:

 

·

Persuasive evidence of an arrangement exists;

·

Delivery has occurred or services rendered;

·

Price is fixed or determinable; and

·

Collectability is reasonably assured.

 

Revenue from the sale of products is recognized after both the goods are shipped to the customer and acceptance has been received, if required, with an appropriate provision for estimated returns and allowances. We do not permit general returns of products sold. Certain of our products have expiration dates. Our policy is to exchange certain outdated, expired product with the same product. We record an accrual for the estimated cost of replacing the expired product expected to be returned in the future, based on our historical experience, adjusted for any known factors that reasonably could be expected to change historical patterns, such as regulatory actions which allow us to extend the shelf lives of our products. Revenue from both direct sales to veterinarians and sales to independent third-party distributors are generally recognized when goods are shipped. Our products are shipped complete and ready to use by the customer. The terms of the customer arrangements generally pass title and risk of ownership to the customer at the time of shipment. Certain customer arrangements provide for acceptance provisions. Revenue for these arrangements is not recognized until the acceptance has been received or the acceptance period has lapsed. We reduce our revenue by the estimated cost of any rebates, allowances or similar programs, which are used as promotional programs.

 

Recording revenue from the sale of products involves the use of estimates and management judgment. We must make a determination at the time of sale whether the customer has the ability to make payments in accordance with arrangements. While we may utilize past payment history and public credit information in making our assessment, the determination of whether collectability is reasonably assured is ultimately a judgment decision that must be made by management. We must also make estimates regarding our future obligation relating to returns, rebates, allowances and similar other programs.

 

License revenue under arrangements to sell or license product rights or technology rights is recognized as obligations under the agreement are satisfied, which generally occurs over a period of time. Generally, licensing revenue is deferred and recognized over the estimated life of the related agreements, products, patents or technology. Nonrefundable licensing fees, marketing rights and milestone payments received under contractual arrangements are deferred and recognized over the remaining contractual term using the straight-line method.

Recording revenue from license arrangements involves the use of estimates. The primary estimate made by management is determining the useful life of the related agreement, product, patent or technology. We evaluate all of our licensing arrangements by estimating the useful life of either the product or the technology, the length of the agreement or the legal patent life and defer the revenue for recognition over the appropriate period.

 

We may enter into arrangements that include multiple elements. Such arrangements may include the licensing of technology and manufacturing of product or an agreement allowing for usage of an instrument and a given level of consumables for one monthly payment. In these situations we must determine whether the various elements meet the criteria to be accounted for as separate elements. If the elements cannot be separated, revenue is recognized once revenue recognition criteria for the entire arrangement have been met or over the period that the Company's obligations to the customer are fulfilled, as appropriate. If the elements are determined to be separable, the revenue is allocated to the separate elements based on relative fair value and recognized separately for each element when the applicable revenue recognition criteria have been met. In accounting for these multiple element arrangements, we must make determinations about whether elements can be accounted for separately and make estimates regarding their relative fair values.

 

Allowance for Doubtful Accounts

 

We maintain an allowance for doubtful accounts receivable based on client-specific allowances, as well as a general allowance. Specific allowances are maintained for clients which are determined to have a high degree of collectability risk based on such factors, among others, as: (i) the aging of the accounts receivable balance; (ii) the client's past payment history; (iii) a deterioration in the client's financial condition, evidenced by weak financial condition and/or continued poor operating results, reduced credit ratings, and/or a bankruptcy filing. In addition to the specific allowance, the Company maintains a general allowance for credit risk in its accounts receivable which is not covered by a specific allowance. The general allowance is established based on such factors, among others, as: (i) the total balance of the outstanding accounts receivable, including considerations of the aging categories of those accounts receivable; (ii) past history of uncollectable accounts receivable write-offs; and (iii) the overall creditworthiness of the client base. A considerable amount of judgment is required in assessing the realizability of accounts receivable. Should any of the factors considered in determining the adequacy of the overall allowance change, an adjustment to the provision for doubtful accounts receivable may be necessary.

 

Inventories

 

Inventories are stated at the lower of cost or market, cost being determined on the first-in, first-out method. Inventories are written down if the estimated net realizable value of an inventory item is less than its recorded value. We review the carrying cost of our inventories by product each quarter to determine the adequacy of our reserves for excess/obsolescence inventory. In accounting for inventories we must make estimates regarding the estimated net realizable value of our inventory. This estimate is based, in part, on our forecasts of future sales and shelf life of product.

 

Deferred Tax Assets – Valuation Allowance

 

Our deferred tax assets, such as a domestic Net Operating Loss ("NOL"), are reduced by an offsetting valuation allowance based on judgmental assessment of available evidence if we are unable to conclude that it is more likely than not that some or all of the related deferred tax assets will be realized. If we are able to conclude it is more likely than not that we will realize a future benefit from a deferred tax asset, we will reduce the related valuation allowance by an amount equal to the estimated quantity of income taxes we would pay in cash if we were not to utilize the deferred tax asset in the future. The first time this occurs in a given jurisdiction, it will result in a net deferred tax asset on our consolidated balance sheets and an income tax benefit of equal magnitude in our

statement of operations in the period we make the determination. In future periods, we will then recognize as income tax expense the estimated quantity of income taxes we would have paid in cash had we not utilized the related deferred tax asset. The corresponding journal entry will be a reduction of our deferred tax asset. If there is a change regarding our tax position in the future, we will make a corresponding adjustment to the related valuation allowance.

 

Results of Operations

 

Revenue

 

Total revenue was $74.8 million for the nine months ended September 30, 2015, an increase of 14% as compared to $65.5 million in the corresponding period in 2014. Total revenue was $28.0 million for the three months ended September 30, 2015, a 29% increase from $21.8 million in the corresponding period in 2014.

 

Revenue from our CCA segment was $61.3 million, including $12.9 million recognized from Heska Imaging, for the nine months ended September 30, 2015, an increase of 20% as compared to $51.2 million, including $7.6 million recognized from Heska Imaging, for the corresponding period in 2014. Increased revenue from Heska Imaging, our instrument consumables, our chemistry instruments, our hematology instruments and our allergy drops were key factors in the increase. Revenue from our CCA segment was $21.0 million, including $4.3 million recognized from Heska Imaging, for the three months ended September 30, 2015, an increase of 28% as compared to $16.4 million, including $2.3 million recognized from Heska Imaging, for the corresponding period in 2014. Increased revenue from Heska Imaging, our heartworm preventive and our instrument consumables were key factors in the increase.

 

Revenue from our OVP segment was $13.5 million for the nine months ended September 30, 2015, a decrease of 5% as compared to $14.3 million in the corresponding period in 2014. Lower revenue from our vaccine supply agreement with Elanco, somewhat offset by revenue from a new product for another customer, was a factor in the change. Revenue from our OVP segment was $7.1 million for the three months ended September 30, 2015, an increase of 30% as compared to $5.4 million in the corresponding period in 2014. Revenue from a new product for one of our customers was a key factor in the change.

 

Cost of Revenue

Cost of revenue totaled $42.9 million for the nine months ended September 30, 2015, a 7% increase compared to the corresponding period in 2014. Gross profit was $32.0 million, including $4.8 million recognized from Heska Imaging, for the nine months ended September 30, 2015 a 25% increase as compared to $25.7 million, including $1.5 million recognized from Heska Imaging, in the prior year period. Gross Margin, i.e. gross profit divided by total revenue, increased to 42.7% for the nine months ended September 30, 2015 from 39.2% in the prior year period. A Gross Margin improvement due to product mix from our OVP segment as well as a lower relative contribution of revenue from this segment, which tends to operate at lower Gross Margin than our consolidated Gross Margin and improved Gross Margin from Heska Imaging were factors in the improvement.

 

Cost of revenue totaled $16.4 million for the three months ended September 30, 2015, an increase of 22% as compared to $13.5 million for the corresponding period in 2014. Gross profit was $11.6 million, including $1.6 million recognized from Heska Imaging, for the three months ended September 30, 2015, a 39% increase as compared to $8.3 million, including $381 thousand recognized from Heska Imaging, in the prior year period. Gross Margin increased to 41.4% for the three months ended September 30, 2015 from 38.1% in the prior year period. Product mix and improved Gross Margin from Heska Imaging were factors in the improvement.

 Operating Expenses

 

Total operating expenses were $27.0 million, including $4.8 million recognized from Heska Imaging, in the nine months ended September 30, 2015, an increase of 10% from $24.5 million, including $4.2 million recognized from Heska Imaging, in the prior year period. Total operating expenses were $9.5 million, including $1.6 million recognized from Heska Imaging, in the three months ended September 30, 2015, an increase of 19% from $8.0 million, including $1.4 million recognized from Heska Imaging, in the prior year period.

 

Selling and marketing expenses were $15.9 million in the nine months ended September 30, 2015, as compared to $14.4 million in the nine months ended September 30, 2014, a year-over-year increase of 10%. Selling and marketing expenses were $5.2 million, in the three months ended September 30, 2015, an increase of 10% as compared to $4.7 million in the three months ended September 30, 2014. Increased commissions and distributor incentives were key factors in the change in both cases.

 

Research and development expenses were $1.3 million in the nine months ended September 30, 2015, a 20% increase as compared to $1.1 million in the corresponding period in 2014. Increased development project spending was a factor in the change. Research and development expenses were $493 thousand in the three months ended September 30, 2015, a 53% increase as compared to $322 thousand in the corresponding period in 2014. Increased development project spending and research and development expenses related to Heska Imaging was a factor in the change.

General and administrative expenses were $9.8 million in the nine months ended September 30, 2015, a 9% increase from $9.0 million in the prior year period. General and administrative expenses were $3.8 million in the three months ended September 30, 2015, an increase of 29% from $2.9 million in the prior year period. In both cases, a key factor in the change is a $0.9 million charge for certain accelerated stock vesting and post-termination payments related to the October 1, 2015 termination of our Executive Chair's previously negotiated employment agreement.

 

Interest and Other (Income) Expense, Net

 

In the nine months ended September 30, 2015, this line item was a $105 thousand expense as opposed to a $31 thousand income in the prior year period. In the three months ended September 30, 2015, this line item was a $69 thousand in income as opposed to $40 thousand in income in the prior year period. In both cases, the largest factor in the change related to changes in currency gains or losses in the respective periods. In the nine months ended September 30, we recognized $87 thousand in net currency losses in the 2015 period as opposed to $41 thousand in net currency gains in the 2014 period. In the three months ended September 30, we recognized $84 thousand in net currency gains in the 2015 period as opposed to $47 thousand in net currency gains in the 2014 period.

 

Income Tax Expense

 

We recognized $1.7 million net income tax expense in the nine months ended September 30, 2015, as compared to $668 thousand in the prior year period. We recognized $828 thousand net income tax expense in the three months ended September 30, 2015, as compared to $366 thousand in the prior year period.

 

Current tax expense was $232 thousand in the nine months ended September 30, 2015, an increase of $119 thousand as compared to $113 thousand in the prior year period. Current tax expense was $106 thousand in the three months ended September 30, 2015, an increase of $46 thousand as compared to $60 thousand in the prior year period.

 

For the nine months ended September 30, 2015, deferred tax expense was $1.5 million, a $956 thousand change from $555 thousand in deferred tax expense in the prior year period. For the three months ended September 30, 2015, deferred tax expense was $722 thousand, a $416 thousand change from $306 thousand in deferred tax expense in the prior year period.

 

Greater income before income taxes was a key factor in the increase in both current tax expense and deferred tax expense in the 2015 periods presented as compared to the 2014 periods presented.

 

Net Income

 

Net income was $3.1 million in the nine months ended September 30, 2015, an increase of approximately $2.6 million compared to $520 thousand in the prior year period. Net income was $1.4 million in the three months ended September 30, 2015, an increase of approximately $1.4 million compared to $15 thousand in the prior year period. Greater revenue and higher Gross Margin, somewhat offset by increased operating expenses, were key factors in the change in both cases.

 

Net Income attributable to Heska Corporation

 

Net income attributable to Heska Corporation was $3.2 million in the nine months ended September 30, 2015, an increase of approximately $1.4 million compared to $1.8 million net income in the prior year period. Net income attributable to Heska Corporation was $1.4 million in the three months ended September 30, 2015, an increase of approximately $903 thousand compared to $513 thousand net income in the prior year period. The difference between this line item and "Net Income" above is the net income or loss attributable to the minority interest in Heska Imaging, which was a net loss of $66 thousand in the nine months ended September 30, 2015 and a net loss of $32 thousand in the three months ended September 30, 2015 compared to a net loss of $1.3 million in the nine months ended September 30, 2014 and a net loss of $498 in the three months ended September 30, 2014, respectively. Greater revenue and higher Gross Margin, somewhat offset by increased operating expenses, were key factors in the change in net income attributable to Heska Corporation in both cases.

 

Liquidity and Capital Resources

 

For the nine months ended September 30, 2015, we had net income of $3.1 million. During the nine months ended September 30, 2015, our operations used cash of approximately $0.9 million. At September 30, 2015, we had $5.9 million of cash and cash equivalents, $21.9 million of working capital, and $1.7 million of outstanding borrowings under our revolving line of credit, discussed below.

 

Net cash used by operating activities was $0.9 million for the nine months ended September 30, 2015 as compared to $3.6 million of cash provided by operating activities in the nine months ended September 30, 2014, a change of $4.5 million. Key factors in this change were a $4.6 million increase in cash used for deferred revenue and other long term liabilities, which included a $3.0 million milestone payment received in the 2014 period but not the 2015 period and lower deferred revenue credits resulting from the sale of certain customer contracts and the underlying assets in the 2015 period as compared to the 2014 period, a $4.1 million increase in cash used for inventory and a $1.5 million increase in cash used in other non-current assets, which included the impact of increased capital lease activity under new marketing programs. These factors were somewhat offset by 3.6 million greater cash provided by net income and deferred tax expense and $2.1 million greater cash provided by accounts payable and accrued and other short term liabilities.

 

Net cash flows used in investing activities were $2.0 million in the nine months ended September 30, 2015, an increase of $207 thousand as compared to $1.8 million used in the nine months ended September 30, 2014. Increased investment in our Des Moines production facility including to fulfill certain customers needs, somewhat offset by lower purchases of demonstration and loaner equipment by Heska Imaging in the 2015 period as compared to the 2014 period, was a factor in the change.

 

Net cash flows provided in financing activities were $3.0 million during the nine months ended September 30, 2015, a $5.0 million change as compared to $2.0 million used by financing activities in the nine months ended September 30, 2014. The largest factor in the change was usage of our line of credit where we net borrowed $1.6 million in the 2015 period and net repaid $3.0 million in the 2014 period.

 

 

At September 30, 2015, Heska Corporation had accounts receivable from Heska Imaging of $5.8 million, including accrued interest, which eliminates upon consolidation of our financial statements. These monies accrue interest at the same interest rate as Heska Corporation pays under its asset-based revolving line of credit with Wells Fargo once past due.

At September 30, 2015, we, including the consolidated balance sheets of our subsidiaries, had an account receivable from Cuattro Software, LLC of $488 thousand, net accounts receivable from Cuattro, LLC of $15 thousand and net accounts payable to Cuattro, LLC of $64 thousand. These items are included on our consolidated balance sheets in "Due from – related parties" and "Due to – related parties" as Kevin S. Wilson, our Chief Executive Officer and President, Mrs. Wilson and trusts for their children and family hold a 100% interest in Cuattro, LLC and Cuattro, LLC owns a 100% interest in Cuattro Software, LLC. All monies owed are to accrue interest at the same interest rate the Company pays under its credit and security agreement with Wells Fargo once past due.

 

At September 30, 2015, we had a $1.5 million note receivable, including accrued interest, from Cuattro Veterinary, LLC. The note is to pay interest at the same interest rate as Heska Corporation pays under its asset-based revolving line of credit with Wells Fargo and is due on March 15, 2016. Cuattro Veterinary, LLC sells the same digital radiography solutions outside the United States that Heska Imaging sells in the United States. The note is listed on our balance sheet as a "Note receivable – related party" as Cuattro, LLC holds a majority interest in Cuattro Veterinary, LLC. This note was held by Heska Imaging at the time of our acquisition of Heska Imaging (the "Acquisition") on February 24, 2013.

 

At September 30, 2015, we had a $15.0 million asset-based revolving line of credit with Wells Fargo which had a maturity date of December 31, 2015 as part of our credit and security agreement with Wells Fargo. At September 30, 2015, we had $1.7 million in outstanding borrowings under this line of credit. Our ability to borrow under this facility varies based upon available cash, eligible accounts receivable and eligible inventory. On September 30, 2015, interest on borrowings due was to be charged at a stated rate of three month LIBOR plus 2.75% and payable monthly. We are required to comply with various financial and non-financial covenants, and we have made various representations and warranties under our agreement with Wells Fargo. A key financial covenant is based on a fixed charge coverage ratio under this agreement. Failure to comply with any of the covenants, representations or warranties could result in our being in default on the loan and could cause all outstanding amounts payable to Wells Fargo to become immediately due and payable or impact our ability to borrow under the agreement. We were in compliance with all financial covenants as of September 30, 2015. At September 30, 2015, our available borrowing capacity based upon eligible accounts receivable and eligible inventory under our revolving line of credit was approximately $10.3 million.

 

At September 30, 2015, we had other borrowings outstanding totaling $263 thousand, all of which were obligations of a Heska Imaging loan from De Lage Landen Financial Services, Inc. ("DLL"). The note bears an interest rate of 6% and is due in equal monthly payments, including principal and interest, of $13 thousand through June 2017. The note may be prepaid prior to maturity, but is subject to a surcharge in such a circumstance. $159 thousand of principal associated with this note is listed as short term on our balance sheet as it is due within a year.

 

At September 30, 2015, our consolidated balance sheets included $15.9 million in non-controlling interest. This represents the value of the aggregate position in Heska Imaging of the Imaging Minority. We evaluate the value of this position every reporting period and make adjustments using a weighted average based on various potential outcomes and our estimate of the likelihood of such outcomes. For the nine months ended September 30, 2015, this resulted in approximately $176 thousand in net accretion which was recorded as a credit to this line item, with the corresponding debit to directly reduce additional paid-in-capital as we have an accumulated deficit.

 

Our financial plan for 2015 indicates that our available cash and cash equivalents, together with cash from operations and borrowings expected to be available under our revolving line of credit, will be sufficient to fund our operations through the remainder of 2015 and into 2016. However, our actual results may differ from this plan, and we may be required to consider alternative strategies. We may be required to raise additional capital in the future. If necessary, we expect to raise these additional funds through the increased sale of customer leases, the sale of equity securities or the issuance of new term debt secured by the same category of assets as the term loans which were fully repaid in 2010. There is no guarantee that additional capital will be available from these sources on acceptable terms, if at all, and certain of these sources may require approval by existing lenders.

Under the Operating Agreement, should Heska Imaging meet certain performance criteria, the Imaging Minority has been granted a put option to sell us some or all of the Imaging Minority's remaining 45.4% position in Heska Imaging following the audit of our financial statements in 2015, 2016 and 2017. Furthermore, should Heska Imaging meet certain performance criteria, and the Imaging Minority fail to exercise an applicable put to sell us all of the Imaging Minority's position in Heska Imaging following the audit of our financial statements in 2015, 2016 and 2017, we would have a call option to purchase all, but not less than all, of the Imaging Minority's position in Heska Imaging. While we intend to meet any related cash payment obligations with funds provided by our ongoing operations and assets, likely supplemented by debt financing and potentially with equity financing, there can be no assurance our results will unfold according to our expectations. These potential cash payment obligations are an important consideration for us in our cash management decisions.

We believe it is likely that Heska Imaging will meet the required performance criteria for its 2015 lowest strike put, but not its 2015 highest strike put, in 2015. In this case, the Imaging Minority would be granted a put following our 2015 audit which could require us to deliver up to $13.6 million, as well as 25% of Heska Imaging's cash, to purchase the 45.4% of Heska Imaging we do not own. In such a case, while we have the right to deliver up to 55% of the consideration in our Public Common Stock under certain circumstances, such stock is to be valued based on 90% of market value (the "Delivery Stock Value") and is limited to approximately 650 thousand shares in any case. If the Delivery Stock Value per share is less than the market value per share of our Public Common Stock at the time of the Acquisition, we do not have the right to deliver any Public Common Stock as consideration. Assuming we deliver the full 55% of the consideration in our Public Common Stock, we could still have an obligation to pay as much as approximately $6.1 million in cash as well as 25% of Heska Imaging's cash to the Imaging Minority in this circumstance.

We would consider acquisitions if we felt they were consistent with our strategic direction. We paid $1.6 million in dividends in 2012, and while we may consider paying dividends again in the long term, we do not anticipate the payment of any further dividends for the foreseeable future. We conducted an odd lot tender offer in 2012 which could have led to the repurchase of approximately $400 thousand of our stock if all eligible holders had chosen to participate, and while we may consider stock repurchase alternatives in an opportunistic manner or in the long term, we do not anticipate the implementation of any stock repurchase programs for the foreseeable future.

 

 

Item 3.

 

Quantitative and Qualitative Disclosures about Market Risk

Market risk represents the risk of loss that may impact the financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States and foreign interest rates and changes in foreign currency exchange rates as measured against the United States dollar and against other foreign currencies. These exposures are directly related to our normal operating and funding activities.

Interest Rate Risk

 

At September 30, 2015, there was $1.7 million in debt outstanding on our line of credit with Wells Fargo. We also had approximately $5.9 million of cash and cash equivalents at September 30, 2015, the majority of which was invested in liquid accounts. We had no interest rate hedge transactions in place on September 30, 2015. We completed an interest rate risk sensitivity analysis based on the above and an assumed one percentage point increase/decrease in interest rates. If market rates increase/decrease by one percentage point and such changes were reflected in all our investments, we would experience a decrease/increase in annual net interest expense of approximately $43 thousand based on our outstanding balances as of September 30, 2015.

 

Foreign Currency Risk

Our investment in foreign assets consists primarily of our investment in our Swiss subsidiary. Foreign currency risk may impact our results of operations. In cases where we purchase inventory in one currency and sell corresponding products in another, our gross margin percentage is typically at risk based on foreign currency exchange rates. In addition, in cases where we may be generating operating income in foreign currencies, the magnitude of such operating income when translated into U.S. Dollars will be at risk based on foreign currency exchange rates. Our agreements with suppliers and customers vary significantly in regard to the existence and extent of currency adjustment and other currency risk sharing provisions. We had no foreign currency hedge transactions in place on September 30, 2015.

We have a wholly-owned subsidiary in Switzerland which uses the Swiss Franc as its functional currency. We purchase inventory with exposure to foreign currencies, primarily Euros and Chinese Yuan, and sell corresponding products in U.S. Dollars. We also sell products in foreign currencies, primarily Euros and Japanese Yen, where our inventory costs are largely in U.S. Dollars. Based on our results of operations for the twelve months ending September 30, 2015, currency holdings and currency-related prepaid accounts, accounts receivable and accounts payable (all of which, including currency holdings, we will refer to as "Currency Accounts") as of September 30, 2015 and the functional currency of the accounting entity where such Currency Accounts are held, the expected impact on our consolidated statements of operations, if foreign currency exchange rates were to strengthen/weaken by 25% against the Dollar, would be a resulting gain/loss in operating income of approximately $159 thousand and a currency loss/gain of $66 thousand, if all other currencies were to strengthen/weaken by 25% against the Swiss Franc, would be a resulting loss/gain in operating income of approximately $151 thousand and a currency gain/loss of $386 thousand, and if all other currencies were to strengthen/weaken by 25% against the Euro, would be a resulting loss/gain in operating income of approximately $277 thousand and a currency loss/gain of $445 thousand.

 Item 4.

CONTROLS AND PROCEDURES

 

(a) Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our chief executive officer and our chief financial officer, evaluated the effectiveness of our disclosure controls and procedures, as defined by Rule 13a-15 of the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

 

(b) Changes in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

From time to time, we may be involved in litigation relating to claims arising out of our operations. On March 12, 2015, a complaint was filed against us by Shaun Fauley in the United States District Court Northern District of Illinois alleging our transmittal of unauthorized faxes in violation of the federal Telephone Consumer Protection Act of 1991, as amended by the Junk Fax Prevention Act of 2005, as a class action seeking stated damages of the greater of actual monetary loss or five hundred dollars per violation. We intend to defend the Company vigorously in this matter. As of September 30, 2015 we were not a party to any other legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on our business, financial condition or operating results.

 

Item 1A. Risk Factors

 

Our future operating results may vary substantially from period to period due to a number of factors, many of which are beyond our control. The following discussion highlights some of these factors and the possible impact of these factors on future results of operations. The risks and uncertainties described below are not the only ones we face. Additional risks or uncertainties not presently known to us or that we deem to be currently immaterial also may impair our business operations. If any of the following factors actually occur, our business, financial condition or results of operations could be harmed. In that case, the price of our Public Common Stock could decline and you could experience losses on your investment.

 

Our February 2013 acquisition of a 54.6% majority interest in Cuattro Veterinary USA, LLC, which has been renamed Heska Imaging US, LLC, could be detrimental to the interests of our shareholders due to related puts, calls or other provisions, or for other reasons including related to conflicts of interest.

 

Under the Amended and Restated Operating Agreement of Heska Imaging (the "Operating Agreement"), should Heska Imaging meet certain performance criteria, the Imaging Minority has been granted a put option to sell us some or all of the Imaging Minority's position in Heska Imaging following the audit of our financial statements for 2015, 2016 and 2017. Based on Heska Imaging's current ownership position, this put option could require us to deliver either up to $17.0 million following calendar year 2015, $17.0 million following calendar year 2016 or $36.9 million following calendar year 2017 - as well as 25% of Heska Imaging's cash (any applicable payment in aggregate to be defined as the "Put Payment") to acquire the outstanding minority interest in Heska Imaging. While we have the right to deliver up to 55% of the consideration in our Public Common Stock under certain circumstances, such stock is to be valued based on 90% of market value (the "Delivery Stock

Value") and is limited to approximately 650 thousand shares in any case. If the Delivery Stock Value per share is less than the market value per share of our Public Common Stock at the time of the Acquisition, we do not have the right to deliver any Public Common Stock as consideration. Cash required under any Put Payment could put a significant strain on our financial position or require us to raise additional capital. There is no guarantee that additional capital will be available in such a circumstance on reasonable terms, if at all. We may be unable to obtain debt financing, the public markets may be unreceptive to equity financing and we may not be able to obtain financing from other alternative sources, such as private equity. Any debt financing, if available, may include restrictive covenants and high interest rates and any equity financing would likely be dilutive to stockholders in this scenario. If additional funds are required and are not available, it would likely have a material adverse effect on our business, financial condition and our ability to continue as a going concern.

 

Under the Operating Agreement, should Heska Imaging meet certain performance criteria, and the Imaging Minority fail to exercise an applicable put to sell us all of the Imaging Minority's position in Heska Imaging following the audit of our financial statements for 2015, 2016 and 2017, we would have a call option to purchase all, but not less than all, of the Imaging Minority's position in Heska Imaging. Based on Heska Imaging's current ownership position, exercising this call option could require us to deliver up to $19.6 million following calendar year 2015, $19.6 million following calendar year 2016 or $42.4 million following calendar year 2017 - as well as 25% of Heska Imaging's cash (any applicable payment in aggregate to be defined as the "Call Payment") to acquire the outstanding minority interest in Heska Imaging. While we have the right to deliver up to 55% of the consideration in our Public Common Stock under certain circumstances, such stock is to be valued based on 90% of market value (the "Delivery Stock Value") and is limited to approximately 650 thousand shares in any case. If the Delivery Stock Value per share is less than the market value per share of our Public Common Stock at the time of the Acquisition, we do not have the right to deliver any Public Common Stock as consideration. If we believe it is desirable to exercise any one of these calls, cash required under the Call Payment could put a significant strain on our financial position or require us to raise additional capital. There is no guarantee that additional capital will be available in such a circumstance on reasonable terms, if at all. If we believe it is desirable to exercise any such call, determine we are unable to economically finance the Call Payment and do not exercise the call as a result, we could be subject to a more expensive Put Payment less than a year in the future. In this circumstance, unless there is a significant change in our financial position or market conditions, such a Put Payment could have a material adverse effect on our business, financial condition and our ability to continue as a going concern.

 

Under and as defined in and subject to the terms of the Operating Agreement, should we undergo a change in control prior to the end of 2017, the Imaging Minority will be entitled to sell their Heska Imaging units to us for cash at the highest call value they otherwise could have obtained (the "Change in Control Payment"). This will be $42.4 million until at least the end of 2015 and could be as high as $42.4 million beyond 2015 if Heska Imaging meets certain minimum performance criteria. The Change in Control Payment may materially decrease the interest of third parties in acquiring the Company or a majority of the Company's shares, which could otherwise have occurred at a significant premium to the Company's then current market price for the benefit of some or all of our shareholders. This could make some investors less likely to buy and hold our stock.

 

Under the terms of the Operating Agreement, Heska Imaging is to be managed by a three-person board of managers, two of which are to be appointed by Heska Corporation and one of which is to be appointed by Kevin S. Wilson, a founder of Heska Imaging who has also been Heska Corporation's Chief Executive Officer and President since March 31, 2014. The current board of managers consists of Mr. Wilson, Jason A. Napolitano, Heska Corporation's Executive Vice President, Chief Operating Officer, Chief Financial Officer and Secretary and a vacancy resulting from the resignation of Robert B. Grieve, Ph.D., Heska Corporation's former Executive Chair effective on October 1, 2015. Until the earlier of (1) our acquiring 100% of the units of Heska Imaging pursuant to the puts and/or calls discussed above or (2) the sixth anniversary of the Acquisition, Heska Imaging may only take the following actions, among others, by unanimous consent of the board of managers: (i) issue securities, (ii) incur, guarantee, prepay, refinance, renew, modify or extend debt, (iii) enter into material contracts, (iv) hire or terminate an officer or amend the terms of their employment, (v) make a distribution other than a tax or liquidation distribution, (vi) enter into a material acquisition or disposition arrangement or a merger, (vii) lease or acquire an interest in real property, (viii) convert or reorganize Heska Imaging, or (ix) amend its

certificate of formation or the Heska Imaging Agreement. This unanimous consent provision may hinder our ability to optimize the value of its investment in Heska Imaging in certain circumstances.

 

Mr. Wilson's employment agreement with us acknowledges that Mr. Wilson has business interests in Cuattro, LLC, Cuattro Software, LLC, Cuattro Medical, LLC and Cuattro Veterinary, LLC which may require a portion of his time, resources and attention in his working hours. If Mr. Wilson is distracted by these or other business interests, he may not contribute as much as he otherwise would have to enhancing our business, to the detriment of our shareholder value. Mr. Wilson is the spouse of Shawna M. Wilson ("Mrs. Wilson"). Mr. Wilson, Mrs. Wilson and trusts for their children and family own a majority interest in Cuattro Medical, LLC. In addition, including shares held by Mrs. Wilson and by trusts for the benefit of Mr. and Mrs. Wilson's children and family, Mr. Wilson also owns a 100% interest in Cuattro, LLC, the largest supplier to Heska Imaging. Cuattro, LLC owns a 100% interest in Cuattro Software, LLC and a majority interest in Cuattro Veterinary, LLC. On November 11, 2015, we announced an agreement under which we are to purchase 100% ownership of Cuattro Veterinary, LLC. While the terms of both the Amended and Restated Master License Agreement and the Supply Agreement between Heska Imaging and Cuattro, LLC were negotiated at arm's length as part of the Acquisition, Mr. Wilson has an interest in these agreements and any time and resources devoted to monitoring and overseeing this relationship may prevent us from deploying such time and resources on more productive matters.

 

Since January 1, 2015, Cuattro, LLC charged Heska Imaging $5.8 million, primarily related to digital imaging products, for which there is an underlying supply contract with minimum purchase obligations, software and services as well as other operating expenses provided for under a license agreement and a supply agreement, respectively; Heska Corporation charged Heska Imaging $3.4 million, primarily related to sales and other administrative expenses; Heska Corporation net charged Cuattro, LLC $125 thousand, primarily related to facility usage and other services.

 

At September 30, 2015, Heska Imaging had a $1.5 million note receivable, including accrued interest, from Cuattro Veterinary, LLC, which is due on March 15, 2016; Heska Imaging had accounts receivable from Cuattro Software, LLC of $488 thousand, including accrued interest; Heska Corporation had accounts receivable from Heska Imaging of $5.8 million, including accrued interest; Heska Corporation had net accounts receivable from Cuattro, LLC of $15 thousand; Heska Imaging had net accounts payable to Cuattro, LLC of $64 thousand. All monies owed accrue interest at the same interest rate Heska Corporation pays under its credit and security agreement with Wells Fargo once past due with the exception of the note receivable, which accrues at this rate to its maturity date.

 

Mrs. Wilson, Clint Roth, DVM, Mr. Asakowicz, Mr. Lippincott, Mr. Wilson and Cuattro, LLC own approximately 29.75%, 8.39%, 4.09%, 3.07%, 0.05% and 0.05% of Heska Imaging, respectively, each are a member of Heska Imaging, and each have an interest in the puts and calls discussed above. If Mr. Wilson, Mr. Asakowicz or Mr. Lippincott is distracted by these holdings or interests, they may not contribute as much as they otherwise would have to enhancing our business, to the detriment of our shareholder value. While the Operating Agreement was negotiated at arm's length as part of the Acquisition, and requires that none of the members shall cause Heska Imaging to operate its business in any manner other than the ordinary course of business, any time and resources devoted to monitoring and overseeing this relationship may prevent us from deploying such time and resources on more productive matters.

 

In addition, like any acquisition, if Heska Imaging significantly underperforms our financial expectations, it may serve to diminish rather than enhance shareholder value. Heska Imaging generated an operating loss of approximately $2.1 million in the year ended December 31, 2014.

 

We may face costly legal disputes, including related to our intellectual property or technology or that of our suppliers or collaborators.

 

We may face legal disputes related to our business. For example, on March 12, 2015, a complaint was filed against us by Shaun Fauley in the United States District Court Northern District of Illinois alleging our transmittal of unauthorized faxes in violation of the federal Telephone Consumer Protection Act of 1991, as

amended by the Junk Fax Prevention Act of 2005, as a class action seeking stated damages of the greater of actual monetary loss or five hundred dollars per violation. Even if meritless, these disputes may require significant expenditures on our part and could entail a significant distraction to members of our management team or other key employees. We may have to use legal means and incur affiliated costs to secure the benefits to which we are entitled, such as to collect payment for goods shipped to third parties. Insurance coverage may not cover any costs required to litigate a legal dispute or an unfavorable ruling or settlement. A legal dispute leading to an unfavorable ruling or settlement, whether or not insurance coverage may be available for any portion thereof, could have significant material adverse consequences on our business.

 

We may become subject to patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office, or USPTO, to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings and related legal and administrative proceedings are likely to be costly, time-consuming and distracting. As is typical in our industry, from time to time we and our collaborators and suppliers have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third-party patents. Any legal action against us or our collaborators or suppliers may require us or our collaborators or suppliers to obtain one or more licenses in order to market or manufacture effected products or services. However, we or our collaborators or suppliers may not be able to obtain licenses for technology patented by others on commercially reasonable terms, or at all, may not be able to develop alternative approaches if unable to obtain licenses or current and future licenses may not be adequate, any of which could substantially harm our business.

 

We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceedings will likely result in substantial expense to us and significant diversion of the efforts of our technical and management personnel. Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties. Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, if at all.

 

If the third parties who have substantial marketing rights for certain of our historical products, existing products or future products under development are not successful in marketing those products, then our sales and financial position may suffer.

 

Our agreements with our corporate marketing partners may contain no or small minimum purchase requirements in order for them to maintain their exclusive marketing rights. We are party to an agreement with Merck Animal Health, which grants Merck Animal Health exclusive distribution and marketing rights for our canine heartworm preventive product, TRI-HEART Plus Chewable Tablets, ultimately sold to or through veterinarians in the United States and Canada. Historically, a significant portion of our OVP segment's revenue has been generated from the sale of certain bovine vaccines, which have been sold primarily under the Titanium® and MasterGuard® brands. We have a supply agreement with Eli Lilly and its Affiliates operating through Elanco for the production of these vaccines. Either of these marketing partners may not devote sufficient resources to marketing our products and our sales and financial position could suffer significantly as a result. Revenue from Merck entities, including Merck Animal Health, represented 10% of our LTM revenue. Revenue from Eli Lilly entities, including Elanco and pro forma for an acquisition made by Eli Lilly in the LTM period, represented 10% of our LTM revenue. If Merck Animal Health personnel fail to market, sell and support our heartworm preventive sufficiently or if Elanco personnel fail to market, sell and support the bovine vaccines we produce and sell to Elanco sufficiently, our sales could decline significantly. Furthermore, there may be nothing to prevent these partners from pursuing alternative technologies, products or supply arrangements, including as part of mergers, acquisitions or divestitures. For example, we believe a unit of Merck has obtained FDA approval for a canine heartworm preventive product with additional claims compared with our TRI-HEART Plus Chewable Tablets, which we believe is not currently being marketed actively. Should Merck decide to emphasize sales and marketing efforts of this product rather than our TRI-HEART Plus Chewable Tablets or cancel our agreement regarding canine heartworm preventive distribution and marketing, our sales could decline significantly. In another example, if Elanco were to emphasize sales and marketing efforts for

bovine vaccines other than those we produce or cancel our supply agreement and produce the vaccines we supply to them by themselves, our sales could decline significantly. In the future, third-party marketing assistance may not be available on reasonable terms, if at all. If any of these events occur, we may not be able to maintain our current market share or commercialize certain of our products and our sales will decline accordingly.

 

We operate in a highly competitive industry, which could render our products obsolete or substantially limit the volume of products that we sell. This would limit our ability to compete and maintain sustained profitability.

 

The market in which we compete is intensely competitive. Our competitors include independent animal health companies and major pharmaceutical companies that have animal health divisions. We also compete with independent, third-party distributors, including distributors who sell products under their own private labels. In the point-of-care diagnostic testing market, our major competitors include IDEXX Laboratories, Inc., Abaxis, Inc. ("Abaxis"), and Synbiotics Corporation, a unit of Zoetis Inc. ("Zoetis"). The products manufactured by our OVP segment for sale by third parties compete with similar products offered by a number of other companies, some of which have substantially greater financial, technical, research and other resources than us and may have more established marketing, sales, distribution and service organizations than those of our OVP segment's customers. Competitors may have facilities with similar capabilities to our OVP segment, which they may operate and sell at a lower unit price to customers than our OVP segment does, which could cause us to lose customers. Companies with a significant presence in the companion animal health market, such as Bayer AG, CEVA Santé Animale, Eli Lilly, Merck, Sanofi, Vétoquinol S.A., Virbac S.A. and Zoetis may be marketing or developing products that compete with our products or would compete with them if developed. These and other competitors and potential competitors may have substantially greater financial, technical, research and other resources and larger, more established marketing, sales and service organizations than we do. Our competitors may offer broader product lines and have greater name recognition than we do. For example, if Zoetis devotes its significant commercial and financial resources to growing Synbiotics' market share, our sales could suffer significantly. Our competitors may also develop or market technologies or products that are more effective or commercially attractive than our current or future products or that would render our technologies and products obsolete. Further, additional competition could come from new entrants to the animal health care market. Moreover, we may not have the financial resources, technical expertise or marketing, sales or support capabilities to compete successfully. One of our competitors, Abaxis, recently announced agreements with units of VCA Inc. ("VCA") for the long-term supply of blood chemistry testing products to VCA-owned veterinary clinics and for the co-marketing of Abaxis' blood chemistry testing products with VCA's veterinary diagnostic laboratory offering, which may serve to intensify competition and lower our margins as well as limit our prospects to sell blood chemistry testing products to VCA-owned veterinary clinics.

 

If we fail to compete successfully, our ability to achieve sustained profitability will be limited and sustained profitability, or profitability at all, may not be possible.

 

The loss of significant customers who, for example, are historically large purchasers or who are considered leaders in their field could damage our business and financial results.

 

Revenue from Eli Lilly entities, including Elanco, represented approximately 10% and 13% of our consolidated revenue for the nine months and three months ended September 30, 2015, respectively, as well as 12% and 16% of our consolidated revenue for the nine months and three months ended September 30, 2014, respectively. Merck entities, including Merck Animal Health, represented approximately 10% of our consolidated revenue both for the nine months and the three months ended September 30, 2015, as well as 13% for the nine months and three months ended September 30, 2014. No other single customer accounted for more than 10% of our consolidated revenue for the nine months and three months ending September 30, 2015 or the nine months and three months ending September 30, 2014. Eli Lilly entities, including Elanco, accounted for approximately 23% of our consolidated accounts receivable at September 30, 2015 and 24% of our consolidated accounts receivable at September 30, 2014. Merck entities accounted for approximately 13% of our consolidated accounts receivable at September 30, 2015. No other single customer accounted for more than 10% of our consolidated accounts receivable at September 30, 2015 or September 30, 2014.

 

The loss of significant customers who, for example, are historically large purchasers or who are considered leaders in their field could damage our business, including via reputational damage, and financial results.

 

We rely substantially on third-party suppliers. The loss of products or delays in product availability from one or more third-party suppliers could substantially harm our business.

 

To be successful, we must contract for the supply of, or manufacture ourselves, current and future products of appropriate quantity, quality and cost. Such products must be available on a timely basis and be in compliance with any regulatory requirements. Similarly, we must provide ourselves, or contract for the supply of certain services. Such services must be provided in a timely and appropriate manner. Failure to do any of the above could substantially harm our business.

 

We rely on third-party suppliers to manufacture those products we do not manufacture ourselves and to provide services we do not provide ourselves. Proprietary products provided by these suppliers represent a majority of our revenue. We currently rely on these suppliers for our blood testing instruments and consumable supplies for these instruments, for our imaging products and related software and services, for key components of our point-of-care diagnostic tests as well as for the manufacture of other products.

 

The loss of access to products from one or more suppliers could have a significant, negative impact on our business. Major suppliers who sell us proprietary products who are responsible for more than 5% of our 2015 revenue for the twelve months ended September 30, 2015 are Boule Medical AB, Cuattro, LLC, and FUJIFILM Corporation. None of these suppliers sold us products which were responsible for more than 25% of our 2015 revenue, although products purchased from one of these suppliers was responsible for more than 20% of our 2015 revenue and products purchased from another was responsible for more than 10% of our 2015 revenue. We often purchase products from our suppliers under agreements that are of limited duration or potentially can be terminated on an annual basis. In the case of our blood testing instruments and our digital radiography solutions we are typically entitled to non-exclusive access to consumable supplies, or ongoing non-exclusive access to products and services to meet the needs of an existing customer base, respectively, for a defined period upon expiration of exclusive rights, which could subject us to competitive pressures in the period of non-exclusive access. Although we believe we will be able to maintain supply of our major product and service offerings in the near future, there can be no assurance that our suppliers will meet their obligations under any agreements we may have in place with them or that we will be able to compel them to do so. Risks of relying on suppliers include:

·

Inability to meet minimum obligations. Current agreements, or agreements we may negotiate in the future, may commit us to certain minimum purchase or other spending obligations. It is possible we will not be able to create the market demand to meet such obligations, which could create a drain on our financial resources and liquidity. Some such agreements may require minimum purchases and/or sales to maintain product rights and we may be significantly harmed if we are unable to meet such requirements and lose product rights.

·

Loss of exclusivity. In the case of our blood testing instruments, if we are entitled to non-exclusive access to consumable supplies for a defined period upon expiration of exclusive rights, we may face increased competition from a third party with similar non-exclusive access or our former supplier, which could cause us to lose customers and/or significantly decrease our margins and could significantly affect our financial results. In addition, current agreements, or agreements we may negotiate in the future, with suppliers may require us to meet minimum annual sales levels to maintain our position as the exclusive distributor of these products. We may not meet these minimum sales levels and maintain exclusivity over the distribution and sale of these products. If we are not the exclusive distributor of these products, competition may increase significantly, reducing our revenues and/or decreasing our margins.

·

Changes in economics. An underlying change in the economics with a supplier, such as a large price increase or new requirement of large minimum purchase amounts, could have a significant, adverse effect on our business, particularly if we are unable to identify and implement an alternative source of supply in a timely manner.

 

 

·

The loss of product rights upon expiration or termination of an existing agreement. Unless we are able to find an alternate supply of a similar product, we would not be able to continue to offer our customers the same breadth of products and our sales and operating results would likely suffer. In the case of an instrument supplier, we could also potentially suffer the loss of sales of consumable supplies, which would be significant in cases where we have built a significant installed base, further harming our sales prospects and opportunities. Even if we were able to find an alternate supply for a product to which we lost rights, we would likely face increased competition from the product whose rights we lost being marketed by a third party or the former supplier and it may take us additional time and expense to gain the necessary approvals and launch an alternative product.

·

High switching costs. In our blood testing instrument products we could face significant competition and lose all or some of the consumable revenues from the installed base of those instruments if we were to switch to a competitive instrument. If we need to change to other commercial manufacturing contractors for certain of our regulated products, additional regulatory licenses or approvals generally must be obtained for these contractors prior to our use. This would require new testing and compliance inspections prior to sale, thus resulting in potential delays. Any new manufacturer would have to be educated in, or develop, substantially equivalent processes necessary for the production of our products. We likely would have to train our sales force, distribution network employees and customer support organization on the new product and spend significant funds marketing the new product to our customer base.

·

The involuntary or voluntary discontinuation of a product line. Unless we are able to find an alternate supply of a similar product in this or similar circumstances with any product, we would not be able to continue to offer our customers the same breadth of products and our sales would likely suffer. Even if we are able to identify an alternate supply, it may take us additional time and expense to gain the necessary approvals and launch an alternative product, especially if the product is discontinued unexpectedly.

·

Inconsistent or inadequate quality control. We may not be able to control or adequately monitor the quality of products we receive from our suppliers. Poor quality items could damage our reputation with our customers.

·

Limited capacity or ability to scale capacity. If market demand for our products increases suddenly, our current suppliers might not be able to fulfill our commercial needs, which would require us to seek new manufacturing arrangements and may result in substantial delays in meeting market demand. If we consistently generate more demand for a product than a given supplier is capable of handling, it could lead to large backorders and potentially lost sales to competitive products that are readily available. This could require us to seek or fund new sources of supply, which may be difficult to find or may require terms that are less advantageous if available at all.

·

Regulatory risk. Our manufacturing facility and those of some of our third-party suppliers are subject to ongoing periodic unannounced inspection by regulatory authorities, including the FDA, USDA and other federal, state and foreign agencies for compliance with strictly enforced Good Manufacturing Practices, regulations and similar foreign standards. We do not have control over our suppliers' compliance with these regulations and standards. Regulatory violations could potentially lead to interruptions in supply that could cause us to lose sales to readily available competitive products.

·

Developmental delays. We may experience delays in the scale-up quantities needed for product development that could delay regulatory submissions and commercialization of our products in development, causing us to miss key opportunities.

·

Limited intellectual property rights. We typically do not have intellectual property rights, or may have to share intellectual property rights, to the products supplied by third parties and any improvements to the manufacturing processes or new manufacturing processes for these products.

Potential problems with suppliers such as those discussed above could substantially decrease sales, lead to higher costs and/or damage our reputation with our customers due to factors such as poor quality goods or delays in order fulfillment, resulting in our being unable to sell our products effectively and substantially harming our business.

 

We may be unable to market and sell our products successfully.

 

We may not develop and maintain marketing and/or sales capabilities successfully, and we may not be able to make arrangements with third parties to perform these activities on satisfactory terms. If our marketing and sales strategy is unsuccessful, our ability to sell our products will be negatively impacted and our revenues will decrease. This could result in the loss of distribution rights for products or failure to gain access to new products and could cause damage to our reputation and adversely affect our business and future prospects.

 

The market for companion animal healthcare products is highly fragmented. Because our CCA proprietary products are generally available only to veterinarians or by prescription and our medical instruments require technical training to operate, we ultimately sell all our CCA products primarily to or through veterinarians. The acceptance of our products by veterinarians is critical to our success. Changes in our ability to obtain or maintain such acceptance or changes in veterinary medical practice could significantly decrease our anticipated sales. As the vast majority of cash flow to veterinarians ultimately is funded by pet owners without private insurance or government support, our business may be more susceptible to severe economic downturns than other health care businesses which rely less on individual consumers.

 

We recently have entered into agreements with independent third party distributors, including Butler Animal Health Supply, LLC d/b/a Henry Schein Animal Health ("Henry Schein"), which we expect to market and sell our products to a greater degree than in the recent past. Our agreement with Henry Schein prohibits us from selling our chemistry blood testing products and our hematology blood testing products to an independent third party distributor other than Henry Schein. Independent third-party distributors may be effective in increasing sales of our products to veterinarians, although we would expect a corresponding lower gross margin as such distributors typically buy products from us at a discount to end user prices.  It is possible new or existing independent third-party distributors could cannibalize our direct sales efforts and lower our total gross margin.  For us to be effective when working with an independent third-party distributor, the distributor must agree to market and/or sell our products and we must provide proper economic incentives to the distributor as well as contend effectively for the time, energy and focus of the employees of such distributor given other products the distributor may be carrying, potentially including those of our competitors.  If we fail to be effective with new or existing independent third-party distributors, our financial performance may suffer.

 

Obtaining and maintaining regulatory approvals in order to market our products may be costly and delay the marketing and sales of our products. Failure to meet all regulatory requirements could cause significant losses from affected inventory and the loss of market share.

 

Many of the products we develop, market or manufacture may subject us to extensive regulation by one or more of the USDA, the FDA, the EPA and foreign and other regulatory authorities. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, advertising, promotion and sale of some of our products. Satisfaction of these requirements can take several years and time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product. The decision by a regulatory authority to regulate a currently non-regulated product or product area could significantly impact our revenue and have a corresponding adverse impact on our financial performance and position while we attempt to comply with the new regulation, if such compliance is possible at all.

 

The effect of government regulation may be to delay or to prevent marketing of our products for a considerable period of time and to impose costly procedures upon our activities. We may not be able to estimate he time to obtain required regulatory approvals accurately and such approvals may require significantly more time than we anticipate. We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approval or license necessary to introduce or market our products. Such delays in approval may cause us to forego a significant portion of a new product's sales in its first

year due to seasonality and advanced booking periods associated with certain products. Regulatory approval of our products may also impose limitations on the indicated or intended uses for which our products may be marketed.

 

Difficulties in making established products to all regulatory specifications may lead to significant losses related to affected inventory as well as market share. Among the conditions for certain regulatory approvals is the requirement that our facilities and/or the facilities of our third-party manufacturers conform to current Good Manufacturing Practices and other requirements. If any regulatory authority determines that our manufacturing facilities or those of our third-party manufacturers do not conform to appropriate manufacturing requirements, we or the manufacturers of our products may be subject to sanctions, including, but not limited to, warning letters, manufacturing suspensions, product recalls or seizures, injunctions, refusal to permit products to be imported into or exported out of the United States, refusals of regulatory authorities to grant approval or to allow us to enter into government supply contracts, withdrawals of previously approved marketing applications, civil fines and criminal prosecutions. Furthermore, third parties may perceive procedures required to obtain regulatory approval objectionable and may attempt to disrupt or otherwise damage our business as a result. In addition, certain of our agreements may require us to pay penalties if we are unable to supply products, including for failure to maintain regulatory approvals.

 

Any of these events, alone or in unison, could damage our business.

 

Interpretation of existing legislation, regulations and rules, including financial accounting standards, or implementation of future legislation, regulations and rules could cause our costs to increase or could harm us in other ways.

 

We prepare our financial statements in conformance with United States generally accepted accounting principles, or GAAP. These accounting principles are established by and are subject to interpretation by the SEC, the Financial Accounting Standards Board ("FASB") and others who interpret and create accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is made effective. Such changes may adversely affect our reported financial results, the way we conduct our business or have a negative impact on us if we fail to track such changes. For example, we have found FASB's recent decision to codify the accounting standards has made it more difficult to research complex accounting matters, increasing the risk we will fail to account consistent with FASB rules in the future.

 

If our regulators and/or auditors adopt or interpret more stringent standards than we anticipate, we could experience unanticipated changes in our reported financial statements, including but not limited to restatements, which could adversely affect our business due to litigation and investor confidence in our financial statements. In addition, changes in the underlying circumstances to which we apply given accounting standards and principles may affect our results of operations and have a negative impact on us. For example, we review goodwill recognized on our consolidated balance sheets at least annually and if we were to conclude there was an impairment of goodwill, we would reduce the corresponding goodwill to its estimated fair value and recognize a corresponding expense in our statement of operations. This impairment and corresponding expense could be as large as the total amount of goodwill recognized on our consolidated balance sheets, which was $20.9 million at September 30, 2015. There can be no assurance that future goodwill impairments will not occur if projected financial results are not met, or otherwise.

 

The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") has increased our required administrative actions and expenses as a public company since its enactment. The general and administrative costs of complying with Sarbanes-Oxley will depend on how it is interpreted over time. Of particular concern are the level of standards for internal control evaluation and reporting adopted under Section 404 of Sarbanes-Oxley. If our regulators and/or auditors adopt or interpret more stringent standards than we anticipate, we and/or our auditors may be nable to conclude that our internal controls over financial reporting are designed and operating effectively, which could adversely affect investor confidence in our financial statements and cause our stock price to decline. Even if we and our auditors are able to conclude that our internal controls over financial reporting are designed and operating effectively in such a circumstance, our general and administrative costs are likely to increase. For

the first time since the audit for the year ended December 31, 2008, we will be required to have our independent registered public accountant conduct an audit of our internal controls as on June 30, 2015 our stock market value was above a certain level prescribed by regulation. This is expected to increase our general and administrative costs in 2015 from what they otherwise would have been, at a minimum.

 

Similarly, we are required to comply with the SEC's mandate to provide interactive data using the eXtensible Business Reporting Language as an exhibit to certain SEC filings. Compliance with this mandate has required a significant time investment, which has and may in the future preclude some of our employees from spending time on more productive matters. In addition, actions by other entities, such as enhanced rules to maintain our listing on the Nasdaq Capital Market, could also increase our general and administrative costs or have other adverse effects on us, as could further legislative, regulatory or rule-making action or more stringent interpretations of existing legislation, regulations and rules.

 

We often depend on third parties for products we intend to introduce in the future. If our current relationships and collaborations are not successful, we may not be able to introduce the products we intend to introduce in the future.

 

We are often dependent on third parties and collaborative partners to successfully and timely perform research and development activities to successfully develop new products. For example, we jointly developed point-of-care diagnostic products with Quidel Corporation. In other cases, we have discussed Heska marketing in the veterinary market an instrument being developed by a third party for use in the human health care market. In the future, one or more of these third parties or collaborative partners may not complete research and development activities in a timely fashion, or at all. Even if these third parties are successful in their research and development activities, we may not be able to come to an economic agreement with them. If these third parties or collaborative partners fail to complete research and development activities, fail to complete them in a timely fashion, or if we are unable to negotiate economic agreements with such third parties or collaborative partners, our ability to introduce new products will be impacted negatively and our revenues may decline. For example, we have experienced significant delays compared to our expectations in our development of products in collaboration with Rapid Diagnostek, Inc.

 

We depend on key personnel for our future success. If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals.

 

Our future success is substantially dependent on the efforts of our senior management and other key personnel, including our Chief Executive Officer and President, Kevin Wilson. The loss of the services of members of our senior management or other key personnel may significantly delay or prevent the achievement of our business objectives. Although we have an employment agreement with many of these individuals, all are at-will employees, which means that either the employee or Heska may terminate employment at any time without prior notice. If we lose the services of, or fail to recruit, key personnel, the growth of our business could be substantially impaired. We do not maintain key person life insurance for any of our senior management or key personnel.

 

Our future revenues depend on successful product development, commercialization and/or market acceptance, any of which can be slower than we expect or may not occur.

 

The product development and regulatory approval process for many of our potential products is extensive and may take substantially longer than we anticipate. Research projects may fail. New products that we may be developing for the veterinary marketplace may not perform consistently within our expectations. Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of other product candidates. If we fail to successfully develop new products and bring them to market in a timely manner, our ability to generate additional revenue will decrease.

 

Even if we are successful in the development of a product or obtain rights to a product from a third-party supplier, we may experience delays or shortfalls in commercialization and/or market acceptance of the product. For example, veterinarians may be slow to adopt a product, a product may not achieve the anticipated technical performance in field use or there may be delays in producing large volumes of a product. The former is particularly likely where there is no comparable product available or historical precedent for such a product. The ultimate adoption of a new product by veterinarians, the rate of such adoption and the extent veterinarians choose to integrate such a product into their practice are all important factors in the economic success of one of our new products and are factors that we do not control to a large extent. If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and our revenues will be lower than we anticipate. For example, our VitalPath Blood Gas and Electrolyte Analyzer generated significantly less revenue than we anticipated following its launch in May 2010 as placements of this product with customers did not occur as we expected.

 

Our stock price has historically experienced high volatility, and could do so in the future, including experiencing a material price decline resulting from a large sale in a short period of time. In addition, our Public Common Stock has certain transfer restrictions which could reduce trading liquidity from what it otherwise would have been and have other undesired effects.

 

Should a relatively large shareholder decide to sell a large number of shares in a short period of time, it could lead to an excess supply of our shares available for sale and correspondingly result in a significant decline in our stock price.

 

The securities markets have experienced significant price and volume fluctuations and the market prices of securities of many microcap and small cap companies have in the past been, and can in the future be expected to be, especially volatile. During the twelve months ended September 30, 2015, our closing stock price has ranged from a low of $12.00 to a high of $35.24. Fluctuations in the trading price or liquidity of our Public Common Stock may adversely affect our ability to raise capital through future equity financings. Factors that may have a significant impact on the market price and marketability of our Public Common Stock include:

 

·

stock sales by large stockholders or by insiders;

·

changes in the outlook for our business;

·

our quarterly operating results, including as compared to expected revenue or earnings and in comparison to historical results;

·

termination, cancellation or expiration of our third-party supplier relationships;

·

announcements of technological innovations or new products by our competitors or by us;

·

litigation;

·

regulatory developments, including delays in product introductions;

·

developments or disputes concerning patents or proprietary rights;

·

availability of our revolving line of credit and compliance with debt covenants;

·

releases of reports by securities analysts;

·

economic and other external factors; and

·

general market conditions.

 

In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted. If a securities class action suit is filed against us, it is likely we would incur substantial legal fees and our management's attention and resources would be diverted from operating our business in order to respond to the litigation.

 

On May 4, 2010, our shareholders approved an amendment (the "Amendment") to our Restated Certificate of Incorporation. The Amendment places restrictions on the transfer of our stock that could adversely affect our ability to use our domestic Federal Net Operating Loss carryforward ("NOL"). In particular, the Amendment prevents the transfer of shares without the approval of our Board of Directors if, as a consequence, an individual, entity or groups of individuals or entities would become a 5-percent holder under Section 382 of the Internal Revenue Code of 1986, as amended, and the related Treasury regulations, and also prevents any existing 5-percent holder from increasing his or her ownership position in the Company without the approval of our Board

of Directors. Any transfer of shares in violation of the Amendment (a "Transfer Violation") shall be void ab initio under the our Restated Certificate of Incorporation, as amended (our "Certificate of Incorporation") and our Board of Directors has procedures under our Certificate of Incorporation to remedy a Transfer Violation including requiring the shares causing such Transfer Violation to be sold and any profit resulting from such sale to be transferred to a charitable entity chosen by the Company's Board of Directors in specified circumstances. The Amendment could have an adverse impact on the value and trading liquidity of our stock if certain buyers who would otherwise have bid on or purchased our stock, including buyers who may not be comfortable owning stock with transfer restrictions, do not bid on or purchase our stock as a result of the Amendment. In addition, because some corporate takeovers occur through the acquirer's purchase, in the public market or otherwise, of sufficient shares to give it control of a company, any provision that restricts the transfer of shares can have the effect of preventing a takeover. The Amendment could discourage or otherwise prevent accumulations of substantial blocks of shares in which our stockholders might receive a substantial premium above market value and might tend to insulate management and the Board of Directors against the possibility of removal to a greater degree than had the Amendment not passed.

 

We have historically not consistently generated positive cash flow from operations, may need additional capital and any required capital may not be available on reasonable terms or at all.

 

We may be required to raise additional capital in the future. If necessary, we expect to raise these additional funds by borrowing under our revolving line of credit, the increased sale of customer leases, the sale of equity securities or the issuance of new term debt secured by the same category of assets as the term loans which we fully repaid in 2010. There is no guarantee that additional capital will be available from these sources on reasonable terms, if at all, and certain of these sources may require approval by existing lenders. Funds we expect to be available under our existing revolving line of credit may not be available and other lenders could refuse to provide us with additional debt financing. Financial institutions and other potentially interested parties may not be interested in purchasing our customer leases on economic terms, or at all. The public markets may be unreceptive to equity financings and we may not be able to obtain additional private equity or debt financing. Any equity financing would likely be dilutive to stockholders and additional debt financing, if available, may include restrictive covenants and increased interest rates that would limit our currently planned operations and strategies. Furthermore, even if additional capital is available, it may not be of the magnitude required to meet our needs under these or other scenarios. If additional funds are required and are not available, it would likely have a material adverse effect on our business, financial condition and our ability to continue as a going concern.

 

Our Public Common Stock is listed on the Nasdaq Capital Market and we may not be able to maintain that listing, which may make it more difficult for you to sell your shares. In addition, we have less than 300 record holders, which would allow us to terminate voluntarily the registration of our common stock with the SEC and after which we would no longer be eligible to maintain the listing of our Public Common Stock on the Nasdaq Capital Market.

 

Our Public Common Stock is listed on the Nasdaq Capital Market. The Nasdaq has several quantitative and qualitative requirements companies must comply with to maintain this listing, including a $1.00 minimum bid price. We completed a 1-for-10 reverse stock split effective December 30, 2010 in order to resolve an ongoing minimum bid price deficiency. While we believe we are currently in compliance with all Nasdaq requirements, there can be no assurance we will continue to meet Nasdaq listing requirements including the minimum bid price, that Nasdaq will interpret these requirements in the same manner we do if we believe we meet the requirements, or that Nasdaq will not change such requirements or add new requirements to include requirements we do not meet in the future. If we are delisted from the Nasdaq Capital Market, our Public Common Stock may be considered a penny stock under the regulations of the SEC and would therefore be subject to rules that impose additional sales practice requirements on broker-dealers who sell our securities. The additional burdens imposed upon broker-dealers may discourage broker-dealers from effecting transactions in our Public Common Stock, which could severely limit market liquidity of the Public Common Stock and any stockholder's ability to sell our securities in the secondary market. This lack of liquidity would also likely make it more difficult for us to raise capital in the future.

 

We have less than 300 record holders as of our latest information, a fact which would make us eligible to terminate voluntarily the registration of our common stock with the SEC and therefore suspend our reporting obligations with the SEC under the Exchange Act and become a non-reporting company. If we were to cease reporting with the SEC, we would no longer be eligible to maintain the listing of our common stock on the Nasdaq Capital Market, which we would expect to materially adversely affect the liquidity and market price for our common stock.

 

We may not be able to continue to achieve sustained profitability or increase profitability on a quarterly or annual basis.

 

Prior to 2005, we incurred net losses on an annual basis since our inception in 1988 and, as of September 30, 2015, we had an accumulated deficit of $166.4 million. Relatively small differences in our performance metrics may cause us to generate an operating or net loss in future periods. Our ability to continue to be profitable in future periods will depend, in part, on our ability to increase sales in our CCA segment, including maintaining and growing our installed base of instruments and related consumables, to maintain or increase gross margins and to limit the increase in our operating expenses to a reasonable level as well as avoid or effectively manage any unanticipated issues. We may not be able to generate, sustain or increase profitability on a quarterly or annual basis. If we cannot achieve or sustain profitability for an extended period, we may not be able to fund our expected cash needs, including the repayment of debt as it comes due, or continue our operations.

 

Many of our expenses are fixed and if factors beyond our control cause our revenue to fluctuate, this fluctuation could cause greater than expected losses, cash flow and liquidity shortfalls.

 

We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors which are generally beyond our control, including:

 

·

supply of products from third-party suppliers or termination, cancelation or expiration of such relationships;

·

competition and pricing pressures from competitive products;

·

the introduction of new products or services by our competitors or by us;

·

large customers failing to purchase at historical levels;

·

fundamental shifts in market demand;

·

manufacturing delays;

·

shipment problems;

·

information technology problems, which may prevent us from conducting our business effectively, or at all, and may also raise our costs;

·

regulatory and other delays in product development;

·

product recalls or other issues which may raise our costs;

·

changes in our reputation and/or market acceptance of our current or new products; and

·

changes in the mix of products sold.

 

We have high operating expenses, including those related to personnel. Many of these expenses are fixed in the short term and may increase over the course of the coming year. If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed.

 

 

If we are unable to maintain various financial and other covenants required by our credit facility agreement we will be unable to borrow any funds under the agreement and fund our operations.

 

Under our credit and security agreement with Wells Fargo, we are required to comply with various covenants, both financial and non-financial, in order to borrow under the agreement.  The availability of borrowings under this agreement is expected to be important to continue to fund our operations.  Beginning January 1, 2015 a key financial covenant is based on a fixed charge coverage ratio, as defined in the credit and security agreement with Wells Fargo. Although we believe we will be able to maintain compliance with all these covenants and any covenants we may negotiate in the future, there can be no assurance thereof.  We have not always been able to maintain compliance with all covenants under our credit and security agreement with Wells Fargo.  Although Wells Fargo has granted us a waiver of non-compliance in each case, there can be no assurance we will be able to obtain similar waivers or other modifications if needed in the future on economic terms, if at all. Failure to comply with any of the covenants, representations or warranties, or failure to modify them to allow future compliance, could result in our being in default and could cause all outstanding borrowings under our credit and security agreement to become immediately due and payable, or impact our ability to borrow under the agreement.  In addition, Wells Fargo has discretion in setting the advance rates which we may borrow against eligible assets. We may need to rely on available borrowings under the credit and security agreement to fund our operations in the future.  If we are unable to borrow funds under this agreement, we will need to raise additional capital from other sources to continue our operations, which capital may not be available on acceptable terms, or at all.

 

We may face product returns and product liability litigation in excess of, or not covered by, our insurance coverage or indemnities and/or warranties from our suppliers. If we become subject to product liability claims resulting from defects in our products, we may fail to achieve market acceptance of our products and our sales could substantially decline.

 

The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity. Following the introduction of a product, adverse side effects may be discovered. Adverse publicity regarding such effects could affect sales of our other products for an indeterminate time period. To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. We may not be able to continue to obtain adequate insurance at a reasonable cost, if at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the $10 million limit of our insurance coverage or which results in significant adverse publicity against us, we may lose revenue, be required to make substantial payments which could exceed our financial capacity and/or lose or fail to achieve market acceptance.

 

We may be held liable for the release of hazardous materials, which could result in extensive remediation costs or otherwise harm our business.

 

Certain of our products and development programs produced at our Des Moines, Iowa facility involve the controlled use of hazardous and bio hazardous materials, including chemicals and infectious disease agents. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by applicable local, state and federal regulations, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any fines, penalties, remediation costs or other damages that result. Our liability for the release of hazardous materials could exceed our resources, which could lead to a shutdown of our operations, significant remediation costs and potential legal liability. In addition, we may incur substantial costs to comply with environmental regulations if we choose to expand our manufacturing capacity.

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3. Defaults upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

None.

 

Item 5. Other Information

 

None.

 

 

 

Item 6. Exhibits

 

(a)

Exhibits

 

Number		Description
	10.1	First Amendment to Supply Agreement between Heska Imaging US, LLC and Cuattro, LLC, effective as of August 10, 2015.

10.2

Separation and Release Agreement between Registrant and Robert B. Grieve, effective as of October 1, 2015.

31.1

Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

31.2

Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

32.1**

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

XBRL Instance Document.

101.SCH

XBRL Taxonomy Extension Schema Document.

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document.

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document.

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document.

101.LAB

XBRL Taxonomy Extension Label Linkbase Document.

 

 

** Furnished with this report.

 

HESKA CORPORATION

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.

 

HESKA CORPORATION

Date:	November 16, 2015	By:	/s/ Kevin S. Wilson
			KEVIN S. WILSON
			Chief Executive Officer and President (on behalf of the Registrant and as the Registrant's Principal Executive Officer)
Date:	November 16, 2015	By:	/s/ Jason A. Napolitano
			JASON A. NAPOLITANO
			Executive Vice President, Chief Operating Officer, Chief Financial Officer and Secretary (on behalf of the Registrant and as the Registrant's Principal Financial Officer)

 

 

 

 

Exhibit Index

Number		Description
	10.1	First Amendment to Supply Agreement between Heska Imaging US, LLC and Cuattro, LLC, effective as of August 10, 2015.

10.2

Separation and Release Agreement between Registrant and Robert B. Grieve, effective as of October 1, 2015.

31.1

Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

31.2

Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

32.1**

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101.INS

XBRL Instance Document.

101.SCH

XBRL Taxonomy Extension Schema Document.

101.CAL

XBRL Taxonomy Extension Calculation Linkbase Document.

101.DEF

XBRL Taxonomy Extension Definition Linkbase Document.

101.PRE

XBRL Taxonomy Extension Presentation Linkbase Document.

101.LAB

XBRL Taxonomy Extension Label Linkbase Document.

 

** Furnished with this report.

 

 

 

 

 

 

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