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
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, additional
financings or borrowings and additional losses, are subject to risks and uncertainties,
including, but not limited to, those discussed below and elsewhere in this Form 10-Q,
particularly in 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 November 13, 2007, and we do not intend to update this forward-looking
information.
Overview
We discover, develop, manufacture, market, sell, distribute and support
veterinary products. Our business is comprised of two reportable segments, Core Companion
Animal Health, which represented 81% of our product revenue for the twelve months ended
September 30, 2007 and Other Vaccines, Pharmaceuticals and Products, which represented 19%
of our product revenue for the twelve months ended September 30, 2007.
The Core Companion Animal Health ("CCA") segment includes diagnostic and
other instruments and supplies as well as single use diagnostic and other tests, vaccines
and pharmaceuticals, primarily for canine and feline use.
Diagnostic and monitoring instruments and supplies represented approximately
44% of our product revenue for the twelve months ended September 30, 2007. 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 32% of our product revenue for the twelve months ended September 30, 2007
resulted from the sale of such consumables to an installed base of instruments and
approximately 12% of our product revenue was from new hardware sales. A loss of or
disruption in supply of consumables we are selling to an installed base of instruments
could substantially harm our business. All products in this area 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
handheld diagnostic instrument, our chemistry instrument and our hematology instrument and
their affiliated operating consumables. Revenue from products in these three areas,
including revenues from consumables, represented approximately 39% of our product revenue
for the twelve months ended September 30, 2007.
Single use diagnostic and other tests, vaccines and pharmaceuticals
represented approximately 37% of our product revenue for the twelve months ended September
30, 2007. Since items in this area are single use by their nature, our 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 in this area include our
heartworm preventives, our heartworm diagnostic tests, our allergy diagnostic kits, our
allergy immunotherapy and our allergy diagnostic tests. Combined revenue from
heartworm-related products and allergy-related products represented approximately 33% of
our product revenue for the twelve months ended September 30, 2007.
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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. We strive to provide high value products
and advance the state of veterinary medicine.
All our CCA products are ultimately sold to or through veterinarians. In
many cases, veterinarians will markup their costs to the end user. The acceptance of our
products by veterinarians is critical to our success. CCA products are sold directly by us
as well as through independent third party distributors and other distribution
relationships, such as corporate agreements. Revenue from direct sales, independent
third-party distributors and other distribution relationships represented approximately
50%, 27% and 23%, respectively, of CCA product revenue for the twelve months ended
September 30, 2007.
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. 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 distributor's
time and focus given other products the distributor may be carrying, potentially including
those of our competitors. We believe that one of our largest competitors, IDEXX
Laboratories, Inc. ("IDEXX"), in effect prohibits its distributors from selling
competitors' products, including our diagnostic instruments and heartworm diagnostic tests.
We believe the IDEXX restrictions limit our ability to engage national distributors to sell
our full distribution line of products.
We intend to sustain profitability through a combination of revenue growth,
gross margin improvement and expense control. Accordingly, we closely monitor product
revenue growth trends in our CCA segment. Product revenue in this segment grew 12% for the
twelve months ended September 30, 2007 as compared to the twelve months ended September 30,
2006 and has grown at a compounded annual growth rate of 18% since 1998, our first full
year as a public company.
The Other Vaccines, Pharmaceuticals and Products segment ("OVP") includes
our 168 thousand square foot USDA- and FDA-licensed production facility in Des Moines,
Iowa. We view this facility as a strategic asset which will allow us to control our cost of
goods on any vaccines and pharmaceuticals that we may commercialize in the future. We are
increasingly integrating this facility with our operations elsewhere. For example,
virtually all our U.S. inventory is now stored at this facility and 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 including small mammals and
fish. All OVP products are sold by third parties under third party labels.
We have developed our own line of bovine vaccines that are licensed by the
USDA. We have a long-term agreement with a distributor, Agri Laboratories, Ltd.,
("AgriLabs"), for the marketing and sale of certain of these vaccines which are sold
primarily under the Titanium® and MasterGuard® brands which are registered
trademarks of AgriLabs. This agreement generates a significant portion of our OVP
segment's revenue. Subject to certain purchase minimums, under our long-term agreement
AgriLabs has the exclusive right to sell the aforementioned bovine vaccines in the United
States, Africa, China, Mexico and Taiwan until at least December 2009. This exclusivity may
be extended under certain conditions. Our OVP segment also produces vaccines and
pharmaceuticals for other third parties.
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Additionally, we generate non-product revenues from licensing agreements,
royalties and research and development projects for third parties. We perform these
research and development projects for both companion animal and livestock product
purposes.
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 of products, 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:
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Persuasive evidence of an arrangement exists;
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Delivery has occurred or services rendered;
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Price is fixed or determinable; and
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Collectibility is reasonably assured.
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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 product 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 do
utilize past payment history, and, to the extent available for new customers, public credit
information in making our assessment, the determination of whether collectibility 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.
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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. Revenue from licensing technology and product rights
is reported in our Research, development and other revenue line item in certain
circumstances. An example of the former, i.e., licensing technology, would be a patent we
own under which we have granted a third party exclusive rights to the human healthcare
market for the life of the patent in exchange for an upfront payment and royalty payments
on sales of any product based on the patent. The upfront payment will be amortized over the
life of the patent and reported along with any affiliated royalty payments in our Research,
development and other revenue line item. An example of the latter, i.e., product rights, is
our July 2002 agreement to license Intervet Inc. certain rights to patents, trademarks and
know-how for our Flu AVERT I.N. equine influenza vaccine, the world's first intranasal
influenza vaccine for horses. As we have no further rights to manufacture, market or sell
this vaccine without Intervet Inc.'s permission, we are reporting the amortization of the
upfront payment we received in this agreement along with any affiliated royalty payments in
our Research, development and other revenue line item. The upfront payment is being
amortized over the estimated life of the product.
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.
Occasionally we enter into arrangements that include multiple elements. Such
arrangements may include the licensing of technology and manufacturing of product. 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 collectibility risk
based on such factors, among others, as: (i) the aging of the accounts receivable balance;
(ii) the client's past payment experience; (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 uncollectible 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.
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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 obsolescence. 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.
Capitalized Patent Costs
In the nine months ended September 30, 2006, we deferred and capitalized
certain costs, including payments to third-party law firms for patent prosecution to expand
the scope of our patents, related to the technology or patents underlying a variety of
long-term licensing agreements. We owned a portfolio of patents not then utilized in our
product development or manufacture. Several entities paid upfront licensing fees to utilize
the technology supported by these patents in their own product development and
commercialization efforts. Because we believed that we had an obligation to protect the
underlying patents, we deferred the revenue associated with these long-term agreements and
the direct and incremental costs of prosecuting the patents that supported the agreements.
We use the term "patent prosecution" in this context in the narrow sense often used by
intellectual property professionals – to describe activities where we seek to expand
the scope of existing patents such as geographically, where we may look to expand patent
protection into new countries, or for broader applications, such as for newly contemplated
uses or expanded claim breadth coverage of the technology defined by those licensing our
technology within existing geographies. A situation where a third party has violated our
intellectual property rights by using our patented technology without permission and we
have filed a corresponding lawsuit would not meet this definition of "patent prosecution"
and we would therefore expense the corresponding legal expenses as incurred. In accordance
with SFAS No. 95, paragraph 17(c), we have classified patent prosecution expenditures which
are capitalized as cash used for investing activities since, like a capital expenditure to
improve a building or add a piece of equipment, the cost is a necessary investment into a
productive asset to maintain our future revenue process. No internal costs are
capitalized. These capitalized costs were amortized over the same period as the
licensing revenue related to those patents was recognized. Costs in excess of the
amount of remaining related deferred licensing revenue were not capitalized, but expensed
as incurred. The Company capitalized approximately $124 thousand and
$292 thousand, respectively, for the three and nine months ended September 30,
2006 and amortized approximately $43 thousand and $299 thousand, respectively, for the
same periods. In December 2006, we sold all patents for which we had capitalized patent
costs and, accordingly, we have no capitalized patent costs on our balance sheet as of
September 30, 2007. We do not expect to capitalize any patent costs in the
future.
Deferred Tax Assets – Valuation Allowance
Our deferred tax assets, such as a net operating loss carryforward ("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 an NOL, 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 our NOL in the future. The first time
this occurs in a given jurisdiction, it will result in a net deferred tax asset on our
balance sheet 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 our NOL. The corresponding journal entry will be a reduction of our deferred
tax asset. If there is a change
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regarding our tax position in the future, we will make a corresponding
adjustment to the related valuation allowance. As an example, in 2005 we reduced our
valuation allowance related to the NOL for our Swiss operating subsidiary which resulted in
a net deferred tax asset on our balance sheet and we increased this valuation allowance
based on agreements subsequently obtained from tax authorities in Switzerland in 2006. Our
domestic NOL represents a deferred tax asset, which has been completely offset by a
valuation allowance. Based on our domestic cumulative operating losses in recent years, as
well as other factors including uncertainties regarding our future operations, we have been
unable to conclude that it was more likely than not that we will realize a future benefit
from our domestic NOL. Accordingly, a valuation allowance has been established for the
entire domestic deferred tax asset at September 30, 2007. Should we conclude it is
more likely than not that we will realize a future benefit from our domestic NOL, we likely
would recognize a very large income tax benefit and a corresponding deferred tax asset on
our balance sheet at that time and we would expect a significant increase in our income tax
expense as compared to historical levels in future periods.
Results of Operations
Revenue
Total revenue consists of two components: 1) product revenue and 2)
research, development and other revenue. Total revenue increased 14% to $62.3 million for
the nine months ended September 30, 2007 as compared to $54.6 million for the
corresponding period in 2006. Product revenue increased 15% to $61.1 million for the
nine months ended September 30, 2007 as compared to $53.3 million for the corresponding
period in 2006. Total revenue increased 5% to $19.5 million for the three months ended
September 30, 2007 as compared to the corresponding period in 2006. Product revenue
increased 5% to $19.0 million for the three months ended September 30, 2007 as
compared to the corresponding period in 2006.
Product revenue from our CCA segment was $48.8 million for the nine months
ended September 30, 2007, an increase of 10% as compared to $44.5 million for the
corresponding period in 2006. Key factors in the increase were greater sales of our
instrument consumables, our IV pumps, our allergy diagnostic kits, our handheld diagnostic
instruments and sales of our heartworm preventives internationally, somewhat offset by
lower revenue from our chemistry instruments. Product revenue from our CCA segment was
$15.6 million for the three months ended September 30, 2007, down slightly compared to the
corresponding period in 2006. The largest factor in the decline was lower sales of our
heartworm preventives domestically. This was somewhat offset by greater sales of our
heartworm diagnostic tests and our instrument consumables. At September 30, 2007, we had
approximately $756 thousand in customer orders for a new hematology instrument we launched
in July 2007 for which we did not have the inventory to fulfill and therefore did not
recognize the corresponding revenue. We shipped instruments under those customer orders
after September 30, 2007.
Product revenue from our Other Vaccines, Pharmaceuticals and Products
segment ("OVP") increased by $3.5 million to $12.3 million for the nine months ended
September 30, 2007 as compared to $8.8 million in the corresponding period in 2006. A key
factor in the increase was greater sales of our fish vaccines. Another key factor in the
increase was approximately $1.6 million in revenue recognized (the "United Revenue") upon
receipt of a payment for product previously shipped and "take or pay" minimums for 2005 and
2006 which previously had not been paid as part of a now settled dispute with United
Vaccines, Inc. ("UV"), a former customer. As UV has ceased operations, we do not expect to
generate any future revenue from UV. Product revenue from our Other Vaccines,
Pharmaceuticals and Products segment was $3.4 million for the three months ended September
30, 2007, a 33% increase as compared to the corresponding period in 2006. The largest
factor in the increase was greater sales of our fish vaccines, which was somewhat offset by
lower sales of our equine influenza vaccine and Canadian bovine vaccine sales.
Research, development and other revenue was $1.2 million in the nine months
ended September 30, 2007, down from $1.3 million in the corresponding period in 2006. A key
factor in the decrease was certain
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deferred
licensing fees which were recognized as revenue in the period ended in 2006, but not the
corresponding period in 2007 as a result of the acceleration of revenue recognition for
related deferred licensing fees upon completion of the sale of a worldwide patent portfolio
covering a number of major allergens and the genes that encode them (the "Allergopharma
Portfolio") in December 2006. This was somewhat offset by revenue from a now completed
service contract we had with the buyer of the Allergopharma Portfolio under which we
received our final payment in the three months ended September 30, 2007. Research,
development and other revenue was $491 thousand for the three months ended September 30,
2007, up from $432 thousand for the corresponding period in 2006. A key factor in the
increase was revenue from a now completed service contract we had with the buyer of the
Allergopharma Portfolio under which we received our final payment in the three months ended
September 30, 2007, somewhat offset by certain deferred licensing fees which were
recognized as revenue in the period ended in 2006, but not the corresponding period in 2007
as a result of the acceleration of revenue recognition for related deferred licensing fees
upon completion of the sale of the Allergopharma Portfolio.
In 2007, we expect continued growth in our Core Companion Animal Health
segment. We anticipate 2007 OVP revenue of around $15 million, an increase as compared to
2006. We expect research, development and other revenue to be approximately $1.5 million in
2007, a significant decline when compared to 2006.
Cost of Revenue
Cost of revenue consists of two components: 1) cost of products sold and 2)
cost of research, development and other revenue, both of which correspond to their
respective revenue categories. Cost of revenue totaled $36.0 million for the first
nine months of 2007, a 12% increase as compared to $32.2 million for the corresponding
period in 2006. Gross profit increased by $3.9 million to $26.3 million for the nine months
ended September 30, 2007 as compared to $22.4 million in the prior year corresponding
period. Gross Margin, i.e. gross profit divided by total revenue, increased to 42.2% for
the nine months ended September 30, 2007 as compared to 41.0% in the corresponding period
in 2006. Cost of revenue totaled $11.9 million for the three months ended September
30, 2007, an increase compared to $10.7 million for the corresponding period in 2006. Gross
profit decreased by $328 thousand to $7.6 million for the three months ended September 30,
2007. Gross Margin was 39.0% for the three months ended September 30, 2007, down from 42.7%
in the corresponding period in 2006.
Cost of products sold increased by $4.4 million to $35.8 million in the nine
months ended September 30, 2007 from $31.4 million in the prior year period. Gross
profit on product revenue increased by $3.3 million to $25.3 million for the nine
months ended September 30, 2007 as compared to $22.0 million in the prior year
period. Product Gross Margin, i.e. gross profit on product revenue divided by product
revenue, was 41.4% for the nine months ended September 30, 2007, a slight increase from
41.2% in the corresponding period in 2006. The largest factor in the increase was
recognition of the United Revenue for which the affiliated Cost of products sold had been
recognized in prior periods. This was somewhat offset by lower margins resulting from
aggressive sales and marketing programs related to our diagnostic instruments which were to
be supplanted by newer instruments from major product launches. Cost of products sold was
$11.8 million in the three months ended September 30, 2007, a $1.5 million increase from
the prior year period. Gross profit on product revenue was $7.2 million for the three
months ended September 30, 2007, a decrease of approximately $650 thousand dollars from the
prior year period. Product Gross Margin was 37.8% in the three months ended September 30,
2007, a decrease from 43.1% in the corresponding period in 2006. Lower sales of our
heartworm preventives, aggressive sales and marketing programs related to our diagnostic
instruments which were to be supplanted by newer instruments from major product launches
and higher sales in our OVP segment were key factors in the decline. Our heartworm
preventives represent a relatively high margin product area and our OVP segment is a
relatively low margin product area.
Cost of research, development and other revenue was $234 thousand in the
nine months ended September 30, 2007, a decrease of $635 thousand as compared to $869
thousand in the prior year period. Gross profit on research, development and other revenue
was $969 thousand for the nine months ended September 30, 2007, a $509 thousand increase as
compared to $460 thousand in the prior year period. Other Gross Margin, i.e.
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gross
profit on research, development and other revenue divided by research, development and
other revenue, was 80.5% for the nine months ended September 30, 2007, up from 34.6% in the
prior year period. Cost of research, development and other revenue decreased
to $58 thousand in the three months ended September 30, 2007, a decrease of $263
thousand from the prior year period. Gross profit on research, development and other
revenue was $433 thousand for the three months ended September 30, 2007, an increase of
$322 thousand compared to the prior year period. Other Gross Margin was 88.2% for the three
months ended September 30, 2007, an increase from 25.7% in the prior year period. In
both cases, a key factor in the increase was the amortization of previously capitalized
patent costs affiliated with the Allergopharma Portfolio and related to deferred licensing
fees affiliated with the Allergopharma Portfolio discussed above in the period ended in
2006, but not the corresponding period in 2007.
We expect our gross margin on product sales will increase in 2007 as
compared to 2006 as we expect to sell a greater proportion of total sales in relatively
higher margin products.
Operating Expenses
Total operating expenses increased 3% to $21.3 million in the nine months
ended September 30, 2007 as compared to $20.6 million in the prior year period. Total
operating expenses decreased 5% to $6.5 million in the three months ended September 30,
2007 as compared to $6.8 million in the prior year period.
Selling and marketing expenses increased 13% to $12.2 million in the nine
months ended September 30, 2007 as compared to $10.8 million in the corresponding period in
2006. A key factor in the increase was expense recognized related to the launch of our new
handheld diagnostic instrument and the launch of our new hematology instrument. Selling and
marketing expenses increased 9% to $3.8 million in the three months ended September 30,
2007 as compared to the corresponding period in 2006. A key factor in the increase was
expense recognized related to the launch of our new hematology instrument.
Research and development expenses were $2.1 million for the nine months
ended September 30, 2007, a decline of approximately $554 thousand compared to $2.7 million
in the corresponding period in 2006. Lower spending on lab supplies was a factor in the
decline. Research and development expenses were approximately $663 thousand in the three
months ended September 30, 2007, a $151 thousand decline from the corresponding period in
2006. A factor in the decline was a decrease in accrual expense related to our Management
Incentive Program ("MIP") recognized in the period ended in 2007 as compared to the period
ended in 2006.
General and administrative expenses were $7.0 million in the nine months
ended September 30, 2007, down 2% from $7.2 million in the prior year period. General and
administrative expenses were $2.0 million in the three months ended September 30,
2007, down 19% from the prior year period. In both cases, a key factor in the decline was
lower legal fees, primarily related to litigation with UV in 2006.
In 2007, we expect total operating expenses to increase as compared to 2006.
We expect operating expenses generally will increase more slowly than increases in revenue
from existing operations.
Interest and Other Expense, Net
Interest and other expense, net was $433 thousand in the nine months ended
September 30, 2007, a decrease of $376 thousand as compared to $809 thousand in the
prior year period. Interest and other expense, net can be broken into two components: net
interest expense and net foreign currency gains (or losses). Net interest expense was
$475 thousand in the nine months ended September 30, 2007, a decrease of
$368 thousand from $843 thousand in the prior year period. In the nine months ended
September 30, 2007, net foreign currency gains increased slightly to $42 thousand, up $8
thousand from $34 thousand in the prior year period. The largest factor in the
decrease in net interest expense was lower borrowings under our credit and security
agreement with Wells Fargo Bank, National Association ("Wells Fargo") along with the fact
that we repaid $500 thousand in subordinated debt in May 2007. Another factor was lower
interest rate spreads to Prime on our borrowings with
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Wells
Fargo resulting from our achievement of negotiated milestones. This was somewhat offset by
higher levels in the Prime rate of interest in the first six months of 2007 compared to the
corresponding period in 2006. Interest and other expense, net was $94 thousand in the
three months ended September 30, 2007, a decrease of $169 thousand as compared to
the prior year period. Net interest expense was $114 thousand in the three months
ended September 30, 2007, a decrease of $159 thousand from the prior year period. In
the three months ended September 30, 2007, net foreign currency gains were
$20 thousand, up from $10 thousand in the prior year period. The largest factor
in the decrease in net interest expense was lower borrowings under our credit and security
agreement with Wells Fargo. Another factor in the decrease was the lower interest rate
spreads on our borrowings with Wells Fargo resulting from our achievement of negotiated
milestones.
We expect net interest expense to decrease in 2007 due to anticipated lower
use of our revolving credit facility and lower interest rate spreads under our agreement
with Wells Fargo.
Income Tax Expense (Benefit)
Income tax expense was $121 thousand in the nine months ended September 30,
2007, a $43 thousand increase as compared to $78 thousand in the prior year period. The
increase was due to the accrual of domestic Federal alternative minimum tax and the
recognition of certain state income taxes, both of which did not occur in the corresponding
2006 period, somewhat offset by the lower recognition of income tax in Switzerland after we
reduced the valuation allowance corresponding to our NOL in Switzerland as a result of
agreements obtained from the tax authorities in the canton of Fribourg. Income tax expense
was $27 thousand in the three months ended September 30, 2007, an increase of $4 thousand
as compared to the prior year period. The increase was due to the accrual of domestic
Federal alternative minimum tax, which did not occur in the corresponding 2006 period,
largely offset by the lower recognition of income tax in Switzerland after we reduced the
valuation allowance corresponding to our NOL in Switzerland as a result of agreements
obtained from the tax authorities in the canton of Fribourg.
We expect income tax expense to be less in 2007 than it was in 2006,
primarily due to lower estimated taxable income in Switzerland and an increase in the
valuation allowance related to the NOL for our Swiss operating subsidiary recognized in the
fourth quarter of 2006, both of which are a result of agreements from the tax authorities
in the canton of Fribourg.
Net Income (Loss)
Our net income was $4.4 million in the nine months ended September 30, 2007,
an increase of approximately $3.5 million compared to $927 thousand in the prior year
period. As discussed above, the improvement was primarily due to higher product revenue,
somewhat offset by higher operating expenses. Our net income was $1.0 million in the three
months ended September 30, 2007, a 17% increase from the prior year period. As discussed
above, the improvement was primarily due to lower operating expenses and higher product
revenue, somewhat offset by lower Product Gross Margin.
In 2007, we expect to increase our net income primarily due to increased
revenue, somewhat offset by increased operating expenses.
Liquidity and Capital Resources
We have incurred net cumulative negative cash flow from operations since our
inception in 1988. For the nine months ended September 30, 2007, we had net income of $4.4
million. During the nine months ended September 30, 2007, our operations provided cash of
approximately $2.0 million. At September 30, 2007, we had $5.3 million of cash and
cash equivalents, $9.8 million of working capital, $7.9 million of outstanding borrowings
under our revolving line of credit, discussed below, and $2.1 million of other debt and
capital leases.
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Net cash provided by operating activities was $2.0 million for the nine
months ended September 30, 2007 as compared to $1.8 million in the prior year period. Major
factors in the improvement was an increase in net income of approximately $3.5 million and
approximately $809 thousand more cash provided from accounts receivable in the 2007 period.
This was somewhat offset by a $2.2 million increase in cash used to reduce accrued
liabilities in the 2007 period, primarily related to payments made in early 2007 for our
2006 MIP; there were no corresponding payments in early 2006 as our 2005 MIP did not
generate any payout. Other factors that somewhat offset our improvement in cash provided by
operating activities was approximately $1.0 million related to deferred revenue and other
long-term liabilities, primarily due to a customer of our OVP segment utilizing a year end
prepaid balance to a greater degree in the 2007 period, and greater cash used of
approximately $876 thousand related to inventory, primarily related to instruments used by
our customers on a rental basis which were accounted for as a non-cash transfer from
inventory to property and equipment at the time of placement.
Net cash flows from investing activities used cash of $1.6 million in the
nine months ended September 30, 2007, compared to $979 thousand during the
corresponding period in 2006. The greater usage of cash was primarily due to an
approximately $1.0 million increase in capital expenditures in 2007, somewhat offset by the
recognition of capitalized patent costs in 2006 and the gain on the sale of assets related
to the sale of certain patents in 2007.
Net cash flows from financing activities used cash of approximately $480
thousand during the nine months ended September 30, 2007 as compared to using cash of
$796 thousand during the corresponding period in 2006. Approximately $523 thousand
less cash used to pay down our revolving line of credit was largely offset by an
approximately $512 thousand increase in scheduled repayments of other debts, including $500
thousand in repayment of a subordinated note in May 2007. The balance of the approximately
$316 thousand lower usage of cash in the 2006 period was due to approximately $305 thousand
greater proceeds from the issuance of common stock, primarily related to stock option
exercises.
At September 30, 2007, we had a $12.0 million asset-based revolving
line of credit with Wells Fargo which has a maturity date of June 30, 2009 as part of our
credit and security agreement with Wells Fargo. At September 30, 2007, $7.9 million
was outstanding 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, 2007, interest was charged at a stated rate of prime plus 0% and was
payable monthly. We are required to comply with various financial and non-financial
covenants, and we have made various representations and warranties. Among the financial
covenants is a requirement to maintain a minimum liquidity (cash plus excess borrowing
base) of $1.5 million. Additional requirements include covenants for minimum capital
monthly and minimum net income quarterly. 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. Any default under the Wells Fargo
agreement could also accelerate the repayment of our other borrowings. We were in
compliance with all financial covenants as of September 30, 2007. At
September 30, 2007, our remaining available borrowing capacity based upon eligible
accounts receivable and eligible inventory under our revolving line of credit was
approximately $4.1 million.
At September 30, 2007, we also had outstanding obligations for long-term
debt and capital leases totaling approximately $2.1 million primarily related to three
term loans with Wells Fargo. One term loan is secured by real estate in Iowa and had an
outstanding balance at September 30, 2007 of approximately $534 thousand due in monthly
installments of $17,658 plus interest, with a balloon payment of approximately $163
thousand due upon maturity of the credit facility agreement on June 30, 2009. The term loan
had a stated interest rate of prime plus 0% on September 30, 2007. The other two term loans
are secured by machinery and equipment at our Des Moines, Iowa and Loveland, Colorado
locations, respectively (the "Equipment Notes"). The Equipment Notes had a stated interest
rate of prime plus 0% as of September 30, 2007. The Equipment Notes had an outstanding
balance at September 30, 2007 of approximately $1.6 million with principal payments on the
Equipment Notes of $46,296 plus interest due in monthly installments and with a balloon
payment of approximately $602 thousand
20
due upon
maturity of the credit facility agreement on June 30, 2009. Our capital lease obligations
totaled approximately $13 thousand at September 30, 2007.
At September 30, 2007, we had property and equipment, net, of approximately
$9.5 million, an increase of approximately $2.5 million as compared to the level on
December 31, 2006. This increase was primarily related to instruments used by our customers
on a rental basis which were accounted for as a non-cash transfer from inventory to
property and equipment at the time of placement.
At September 30, 2007, we had deferred revenue and other long-term
liabilities, net of current portion, of approximately $6.7 million. Included in this
total is approximately $5.8 million of deferred revenue related to up-front fees that have
been received for certain product rights and technology rights out-licensed prior to
September 30, 2007. These deferred amounts are being recognized on a straight-line
basis over the remaining lives of the agreements, products, patents or
technology.
Our primary short-term need for capital, which is subject to change, is to
fund our operations, which consist of continued sales and marketing, general and
administrative and research and development efforts, working capital associated with
increased product sales and capital expenditures relating to maintaining and developing our
manufacturing operations. Our future liquidity and capital requirements will depend on
numerous factors, including the extent to which our marketing, selling and distribution
efforts, as well as those of third parties who market, sell and distribute our products,
are successful in increasing revenue, the extent to which currently planned products and/or
technologies under research and development are successfully developed, launched and
sold, changes required by us or by regulatory bodies to maintain our operations and
other factors.
Our financial plan for 2007 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 2007
and into 2008. Our financial plan for 2007 expects that we will have positive cash flow
from operations, primarily through increased revenue and limiting any increase in operating
expenses to a modest degree. 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
sale of equity or debt securities or refinancing loans currently outstanding on assets with
historical appraised values significantly in excess of related debt. 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. If we cannot
raise the additional funds through these options on acceptable terms or with the necessary
timing, management could also reduce discretionary spending to decrease our cash burn rate
through actions such as delaying or canceling budgeted research activities or marketing
plans. These actions would likely extend the then available cash and cash equivalents, and
then available borrowings.
Net Operating Loss Carryforwards
As of December 31, 2006, we had a net domestic operating loss carryforward,
or NOL, of approximately $167.5 million, a domestic alternative minimum tax credit of
approximately $83 thousand and a domestic research and development tax credit carryforward
of approximately $307 thousand. The NOL and tax credit carryforwards are subject to
alternative minimum tax limitations and to examination by the tax authorities. In addition,
we had a "change of ownership" as defined under the provisions of Section 382 of the
Internal Revenue Code of 1986, as amended (an "Ownership Change"). We believe the latest,
and most restrictive, Ownership Change occurred at the time of our initial public offering
in July 1997. We do not believe this Ownership Change will place a significant restriction
on our ability to utilize our NOLs in the future. As of December 31, 2006, we also had net
operating loss carryforwards in Switzerland of approximately $1.9 million related to losses
previously recorded by Heska AG, our Swiss operating subsidiary. Heska AG also had a "tax
holiday" from canton, municipal and church income taxes in the canton of Fribourg through
August 31, 2007.
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Recent Accounting Pronouncements
None.
Item
3.