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| HSKA > SEC Filings for HSKA > Form 10-Q on 11-May-2009 | All Recent SEC Filings |
11-May-2009
Quarterly Report
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 May 11, 2009, 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, which represented 86% of our revenue for the twelve months ended March 31, 2009 and Other Vaccines, Pharmaceuticals and Products, which represented 14% of our revenue for the twelve months ended March 31, 2009.
The Core Companion Animal Health ("CCA") segment includes diagnostic instruments and supplies as well as single use diagnostic and other tests, pharmaceuticals and vaccines, primarily for canine and feline use.
Diagnostic instruments and supplies represented approximately 48% of our revenue for the twelve months ended March 31, 2009. 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 35% of our revenue for the twelve months ended March 31, 2009 resulted from the sale of such consumables to an installed base of instruments and approximately 13% of our 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 blood analysis instruments, our chemistry instruments and our hematology instruments and their affiliated operating consumables. Revenue from products in these three areas, including revenues from consumables, represented approximately 43% of our revenue for the twelve months ended March 31, 2009.
Other CCA revenue, including single use diagnostic and other tests, pharmaceuticals and vaccines as well as research and development, licensing and royalty revenue, represented approximately 38% of our revenue for the twelve months ended March 31, 2009. 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 in this area include our heartworm diagnostic tests, our heartworm preventive, our allergy test kits, our allergy immunotherapy and our allergy diagnostic tests. Combined revenue from heartworm-related products and allergy-related products represented approximately 33% of our revenue for the twelve months ended March 31, 2009.
All our CCA products are ultimately sold 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 by us as well as through independent third-party distributors and other relationships, such as corporate agreements. Revenue from direct sales, independent third-party distributors and other relationships represented approximately 50%, 28% and 22%, respectively, of CCA revenue for the twelve months ended March 31, 2009.
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 competitive 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 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. Revenue in this segment grew 2% for the twelve months ended March 31, 2009 as compared to the twelve months ended March 31, 2008. We believe poor economic conditions over the past year have impacted our revenue growth as, for example, veterinarians have delayed or deferred capital expenditures on new diagnostic instrumentation.
The Other Vaccines, Pharmaceuticals and Products segment ("OVP") includes our 168,000 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 such as small mammals. 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 and Mexico until December 2009. Our OVP segment also produces vaccines and pharmaceuticals for other third parties.
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.
We generate our revenue through the sale 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
• Collectibility 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 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.
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
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.
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.
Deferred Tax Assets - Valuation Allowance
Our deferred tax assets, such as an 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 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 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 decreased 8% to $20.1 million for the three months ended March 31, 2009 as compared to $21.9 million for the corresponding period in 2008.
Revenue from our CCA segment was $18.1 million for the three months ended March 31, 2009, an increase of 3% as compared to $17.6 million for the corresponding period in 2008. The largest factor in the increase was greater sales of our heartworm diagnostic tests. Other key factors in the increase were higher sales of our instrument consumables, primarily from increased chemistry testing, and greater sales of our heartworm preventive. Gains in these areas were somewhat offset by decreased instrument hardware sales, primarily for our chemistry instruments and hematology instruments.
Revenue from our Other Vaccines, Pharmaceuticals and Products segment ("OVP") decreased by $2.3 million to $2.0 million for the three months ended March 31, 2009 as compared to $4.3 million in the corresponding period in 2008. The largest factor in this decline was loss of fish vaccine revenue from AquaHealth, a unit of Novartis, who had previously informed us that they would be taking their production in-house, so they ordered no product from us in the first quarter of 2009. Lower revenue under our contract with AgriLabs also contributed to the year-over-year revenue decline in this segment.
We expect 2009 total revenue to decline slightly as compared with 2008.
Cost of Revenue
Cost of revenue totaled $12.8 million for the first three months of 2009, a 10% decrease as compared to $14.2 million for the corresponding period in 2008. Gross profit decreased by $362 thousand to $7.4 million for the three months ended March 31, 2009 as compared to $7.7 million in the prior year corresponding period.
We expect Gross Margin to be flat or down slightly for 2009 as compared to 2008.
Operating Expenses
Total operating expenses decreased 20% to $6.4 million in the three months ended March 31, 2009 as compared to $8.0 million in the prior year period.
Selling and marketing expenses decreased 24% to $3.8 million in the three months ended March 31, 2009 as compared to $4.9 million in the corresponding period in 2008. Key factors in the decline were lower spending related to product launches and lower commissions.
Research and development expenses were $446 thousand for the three months ended March 31, 2009, a decline of approximately $93 thousand as compared to $539 thousand in the corresponding period in 2008. A key factor in the decline was lower spending on research and development resources, such as laboratory supplies.
General and administrative expenses were $2.2 million in the three months ended March 31, 2009, down 14% from $2.5 million in the prior year period. A factor in the change was savings resulting from our year-end restructuring.
We expect 2009 operating expenses will be lower than in 2008.
Interest and Other Expense, Net
Interest and other expense, net was $165 thousand in the three months ended March 31, 2009, a slight decrease as compared to $166 thousand in the prior year period. Interest and other expense, net can be broken into two components: net interest expense and net foreign currency gain (or loss). Net interest expense was $139 thousand in the three months ended March 31, 2009, a decrease of $49 thousand from $188 thousand in the prior year period. Lower loan balances and lower interest rates, somewhat offset by an increased interest rate spread negotiated with our bank in December, were responsible for the decline. In the three months ended March 31, 2009, net foreign currency loss was $26 thousand, a change of $48 thousand from a net foreign currency gain of $22 thousand in the prior year period.
We expect interest and other expense, net to decrease in 2009 as compared to 2008 based on lower market interest rates and lower average borrowings, somewhat offset by an increase in our interest rate spread.
Income Tax Expense (Benefit)
Income tax expense was $392 thousand in the three months ended March 31, 2009, a $555 thousand increase as compared to a tax benefit of $163 thousand in the prior year period. In both periods, the tax entry was primarily non-cash and offsetting either an increase or decrease in our deferred tax assets. The tax benefit recorded in the prior year period was due to an anticipated future tax benefit from the loss occurring in that period and increased our deferred tax assets.
In 2009, we expect current income tax expense as compared to an income tax benefit in 2008 as we expect to generate income before income taxes as opposed to the loss before income taxes we experienced in 2008.
Net income was $460 thousand in the three months ended March 31, 2009, an increase of approximately $686 thousand compared to net loss of $226 thousand in the prior year period. As discussed above, the increase was primarily due to lower operating expenses.
In 2009, we expect to generate net income as opposed to the net loss we reported in 2008, primarily as a result of lower operating expenses.
Liquidity and Capital Resources
We have incurred net cumulative negative cash flow from operations since our inception in 1988. For the three months ended March 31 2009, we had a net income of $460 thousand. During the three months ended March 31, 2009, our operations provided cash of approximately $981 thousand. At March 31, 2009, we had $4.4 million of cash and cash equivalents, $10.1 million of working capital, $10.0 million of outstanding borrowings under our revolving line of credit, discussed below, and $957 thousand of other debt.
Net cash provided by operating activities was approximately $981 thousand for the three months ended March 31, 2009 as compared to $597 thousand of cash used in operating activities in the prior year period, an improvement of approximately $1.6 million. Major factors in the change were a $1.7 million increase in cash provided by inventory as we reduced our overall inventory levels, an increase of $1.5 million in cash provided by accounts payable which was somewhat offset by $595 thousand in cash used for accrued liabilities, an increase in net income of $686 thousand, a reduction in cash used for deferred revenue and other liabilities of $673 thousand and a $563 thousand increase in cash provided related to deferred tax expense. These factors were somewhat offset by a $2.6 million increase in cash used for accounts receivable as we recognized a relatively large portion of revenue late in the three months ended March 31, 2009.
Net cash flows from investing activities used cash of $22 thousand in the three months ended March 31, 2009, a decline of nearly $500 thousand compared to $518 thousand during the corresponding period in 2008. All expenditures were for the purchase of property and equipment in both cases.
Net cash flows used in financing activities was $1.2 million during the three months ended March 31, 2009, a $2.4 million change as compared to providing $1.2 million during the corresponding period in 2008. The primary reason for the change is a $2.3 million change related to our revolving line of credit with Wells Fargo, where we borrowed an additional $1.3 million in the three months ended March 31, 2008 and repaid nearly $1 million in the three months ended March 31, 2009. In addition, proceeds from the issuance of common stock declined by $68 thousand as a result of option exercises which occurred in the three months ended March 31, 2008, but not 2009.
At March 31, 2009, we had a $15.0 million asset-based revolving line of credit with Wells Fargo which has a maturity date of June 30, 2011 as part of our credit and security agreement with Wells Fargo. At March 31, 2009, $10.0 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 March 31, 2009, interest was charged at a stated rate of prime plus 2.50% 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 March 31, 2009. At March 31, 2009, we had $2.2 million borrowing capacity based upon eligible accounts receivable and eligible inventory under our revolving line of credit.
At March 31, 2009, we had deferred revenue and other long-term liabilities, net . . .
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