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ERB > SEC Filings for ERB > Form 10-K on 14-Apr-2014All Recent SEC Filings

Show all filings for ERBA DIAGNOSTICS, INC.

Form 10-K for ERBA DIAGNOSTICS, INC.


14-Apr-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with the information contained in our Consolidated Financial Statements and the related Notes to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K.

OVERVIEW

We are the parent corporation of the following five subsidiaries:

Delta Biologicals, S.r.l.;

Diamedix Corporation;

Drew Scientific, Inc.;

ImmunoVision, Inc.; and

JAS Diagnostics, Inc.

Through these subsidiaries, we develop, manufacture and market diagnostic test kits, or assays, and automated systems that are used to aid in the detection of disease markers primarily in the areas of autoimmune, infectious diseases, clinical chemistry, hematology and diabetes testing. In addition to diagnostic kits, we also design and manufacture laboratory instruments that perform the tests and provide fast and accurate results, while reducing labor costs. We also develop, manufacture and market raw materials, such as antigens used in the production of diagnostic kits.

Our management reviews financial information, allocates resources and manages the business as two segments defined by geographic region. One segment - the domestic region - contains Diamedix, Drew Scientific, ImmunoVision and JAS Diagnostics, our subsidiaries located in the United States, and corporate operations. Our other segment - the European region - contains Delta Biologicals, our subsidiary located in Italy, and, from October 2012 until March 2013, Drew Scientific Limited Co., our subsidiary which was located in the United Kingdom. For financial information related to these segments, see Note 11, Segment Information, to the Consolidated Financial Statements.

Acquisition of Drew Scientific, Inc.

On October 3, 2012, we acquired all of the issued and outstanding shares of capital stock of Drew Scientific, Inc. for $6,500,000. We funded the purchase price by issuing to ERBA Diagnostics Mannheim GmbH, or ERBA Mannheim, 8,666,667 shares of our common stock at a purchase price of $0.75 per share, for an aggregate purchase price of $6,500,000, pursuant to the Stock Purchase Agreement between us and ERBA Mannheim which is discussed throughout this Annual Report on Form 10-K.

Included in the acquisition were Drew Scientific's wholly-owned subsidiaries - JAS Diagnostics, Inc. in the United States and formerly Drew Scientific Limited Co. in the United Kingdom, which, together with Drew Scientific, Inc., are collectively referred to as Drew Scientific.

We acquired Drew Scientific with the purpose of integrating Drew Scientific's manufacturing and distribution capabilities with our legacy operations to achieve economies of scale and maximize the utilization of our assets and facilities.

Drew Scientific is a diagnostics company specializing in the design, manufacture and distribution of instruments for blood cell counting and blood analysis. Drew Scientific is focused on providing instrumentation and consumables for the physician office and veterinary office laboratories. Drew Scientific also supplies the reagent and other consumable materials needed to operate the instruments. JAS Diagnostics specializes in the manufacture of a broad range of liquid stable, diagnostics chemistry reagents used for in vitro diagnostics testing. Many of these reagents are single vial stable, which we believe offer ease of use, increased speed of results and extended on-board stability. JAS Diagnostics' reagents are sold through distributors and directly to end users customers - physicians, reference laboratories, hospital and veterinary diagnostic testing laboratories.


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Prior to the October 3, 2012 acquisition date, our management decided to cease the operations of Drew Scientific and its subsidiaries at their facilities in Dallas, Texas and the United Kingdom. As a result, we accrued on the opening balance sheet as of October 3, 2012 estimated plant closing costs, including lease buy-out and severance costs, of $160,000 and $118,000, respectively. Regarding the Dallas, Texas facility, in May 2013, our management initially announced that the closing would be effective in late September 2013, but subsequently made a decision to keep the Dallas facility open for the foreseeable future. With respect to the United Kingdom facility, the closing was effective in late March 2013.

Majority Stockholder

ERBA Mannheim, an in vitro diagnostics company headquartered in Germany, the parent company of which is Transasia Bio-Medicals Ltd., or Transasia, is the beneficial owner, directly or indirectly, of approximately 82.4% of the outstanding shares of our common stock.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principals generally accepted in the United States of America, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, allowance for doubtful accounts, inventories, intangible assets, stock compensation, income and other tax accruals, the realization of long-lived assets and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our assumptions and estimates may, however, prove to have been incorrect and our actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies and the judgments and estimates we make concerning their application have significant impact on our consolidated financial statements.

The critical accounting policies discussed below are not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for management's judgment in their application. There are also areas in which management's judgment in selecting any available alternative would not produce a materially different result.

Revenue Recognition

A principal source of revenue is our "reagent rental" program in which customers make reagent kit purchase commitments with us that will usually last for a period of three to five years. In exchange, we typically include an instrument system, which remains our property (or, in the case of a lease financing arrangement, that of the financing company). We also include any required instrument service. The customer, through these reagent kit purchases, pays for both the instrumentation and service over the life of the commitment. We recognize revenue from the reagent kit sales when title passes, which is generally at the time of shipment. If actual reagent kit or instrument failure rates significantly increase, then our future operating results could be negatively impacted by increased warranty obligations and service delivery costs.

We recognize milestone payments when earned, as evidenced by written acknowledgment from the collaborator, provided that the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement, the milestone represents the culmination of an earnings process, the milestone payment is non-refundable and our past research and development services, as well as our ongoing commitment to provide research and development services under the collaboration, are charged at fees that are comparable to the fees that we customarily charge for similar research and development services.

Cost of Sales and Gross Margins

We strive to control our costs of revenue and thereby maintain our gross margins. Significant items impacting cost of sales include component prices and our direct technical and production personnel costs. Our gross margins have remained relatively stable; however, factors such as sales price, product mix, inventory


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obsolescence, returns, component price increases and increases in our direct production personnel costs, significantly impact our gross margins from quarter to quarter and represent indicators we monitor on a regular basis.

Operating Expenses

Operating expenses are substantially driven by personnel and related overhead expenses. Significant operating expenses that we monitor include selling, administrative, and research and development.

Liquidity and Cash Flows

Our financial condition remains strong with significant cash, overall significant working capital, and limited long-term liabilities for severance in Italy and deferred income taxes. The change in our cash position was primarily due to cash used in operating activities and cash used for capital expenditures which were offset by an increase in net borrowings under our revolving line of credit.

Balance Sheet

We view cash, accounts receivable, inventory, accounts payable, and our revolving line of credit as important indicators of our financial health. Utilization of our revolving line of credit has increased due to increased sales in Italy and the extended length of time that it takes to collect on accounts receivable in Italy.

Allowance for Doubtful Accounts

We grant credit without collateral to our customers based on our evaluation of a particular customer's credit worthiness. In addition, allowances for doubtful accounts are maintained, particularly in Italy where payment cycles are longer than in the United States and in some instances may take in excess of a year to collect, for potential credit losses based on the age of the accounts receivable and the results of our periodic credit evaluations of our customers' financial condition. We maintain allowances for doubtful accounts, particularly in Italy for the operations of our European subsidiary, for estimated losses based on historical loss percentages resulting from the inability of our customers to make required payments.

Inventory

We regularly review inventory quantities on hand, which include components for current or future versions of products and instrumentation. If necessary, we record a provision for excess and obsolete inventory based primarily on our estimates of component obsolescence, product demand and production requirements, as well as based upon the status of a product within the regulatory approval process. In accordance with our inventory accounting policy, our inventory balance includes components for current or future versions of products and instrumentation.

Goodwill, Other Intangibles, and Fixed Assets

Goodwill represents the excess purchase price over the estimated fair value of net assets acquired as of the acquisition date. We test goodwill for impairment on an annual basis and between annual tests when impairment indicators are identified, and goodwill is written down when impaired. Goodwill was recognized in connection with the acquisition of ImmunoVision and the more recent acquisition of Drew Scientific. We perform our annual goodwill impairment test during the last quarter of the fiscal year. No impairment charge was recorded for the goodwill at ImmunoVision or Drew Scientific during 2013 or 2012.

As part of our annual goodwill impairment test, we first perform a qualitative assessment to determine whether further impairment testing is necessary. If, as a result of the qualitative assessment, it is more-likely-than-not (i.e. greater than 50% chance) that the fair value of the reporting unit is less than the carrying amount, then the quantitative impairment test will be required. Otherwise, no further testing will be required.

Examples of events and circumstances that might indicate that a reporting unit's fair value is less than its carrying amount include macro-economic conditions such as deterioration in the entity's operating environment or industry or market considerations; entity-specific events such as increasing costs, declining financial performance, or loss of key personnel; or other events such as an expectation that a reporting unit will be sold or a sustained decrease in its stock price on either an absolute basis or relative to peers.


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If it is determined, as a result of the qualitative assessment, that it is more-likely-than-not that the fair value of the reporting unit is less than the carrying amount, then the provisions of authoritative guidance require that we perform a two-step impairment test on goodwill. The first step of the test identifies whether potential impairment may have occurred, while the second step of the test measures the amount of impairment, if any. Impairment is recognized when the carrying amount of goodwill exceeds its fair value.

We review for impairment our long-live assets, including other intangibles and fixed assets that are held and used in our operations, whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If such an event or change in circumstances occurs, then we will estimate the undiscounted future net cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the future undiscounted cash flows is less than the carrying amount of the related assets, then we will recognize an impairment loss.

Stock-Based Compensation

Stock-based compensation expense for all stock-based compensation awards is based on the grant-date fair value estimate calculated in accordance with applicable accounting guidance. We recognize these compensation costs using the straight-line attribution method over the requisite service period of the related award, which is generally the option vesting term of (i) immediately or
(ii) in equal annual amounts over a four-year period. We recorded total compensation expense of $134,000 and $55,000 for the years ended December 31, 2013 and 2012, respectively.

Valuations are based on highly subjective assumptions about the future, including stock price volatility and exercise patterns. The fair value of share-based payment awards has been estimated using the Black-Scholes Option Pricing model. Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate expected term, taking into account option exercise and employee terminations. The expected term of options granted represents the periods of time that the options granted are expected to be outstanding. The risk-free rate for years within the expected life of the option is based on the United States Treasury yield curve in effect at the time of the grant.

Income Taxes

We are required to estimate our income taxes in each of the jurisdictions in which we operate as part of the process of preparing our consolidated financial statements. This process involves estimating our actual current tax exposure, including assessing the risks associated with tax audits, together with assessing temporary differences resulting from the different treatment of items for tax and accounting purposes.

Prior to 2013, we have experienced net losses from our operations. In accordance with GAAP, we are required to record a valuation allowance against the deferred tax asset associated with these losses if it is more-likely-than-not (i.e. greater than 50% chance) that we will not be able to utilize the net operating loss to offset future taxes. Due to the cumulative net losses from the operations of both our domestic and European operations, we have provided a full valuation allowance against our deferred tax assets as of December 31, 2013. Over time we may reach levels of profitability that could cause our management to conclude that it is more likely than not that we will realize all or a portion of our net operating loss carry forwards and other temporary differences. Upon reaching such a conclusion, and upon such time as we reverse the entire amount or a portion of the valuation allowance against the deferred tax asset, we would then provide for income taxes at a rate equal to our effective tax rate.

Under Section 382 of the Internal Revenue Code, our ability to use our net operating loss carry forwards will be limited in the future as a result of the September 1, 2010 acquisition by ERBA Mannheim of the approximately 72.4% of the then outstanding shares of our common stock. As a result of that acquisition, our ability to utilize net operating loss carry forwards to offset future taxable income is currently limited to approximately $827,000 per year, plus both any limitation unused since the acquisition and any unused net operating losses generated after the September 1, 2010 acquisition date. The amount of the annual limitation will be adjusted upwards for any recognized built-in gains on certain assets sold during the five year period commencing with the September 1, 2010 ownership change, but may be further limited in the event of any future change in control or similar transaction. Our results for the years ended December 31, 2013 and 2012 were not impacted by these limitations.


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RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2013 COMPARED TO YEAR ENDED DECEMBER 31, 2012

Net income for the year ended December 31, 2013 was $676,000 compared to a net loss of $1,553,000 for the year ended December 31, 2012. The $2,229,000 increase was composed of the following:

Net revenues increased by $8,906,000 to $28,255,000 in 2013 from $19,349,000 in 2012. This 46% increase was primarily attributed to the inclusion of net revenues of $13,754,000 from Drew Scientific during the full year in 2013, compared to net revenues of $3,391,000 from Drew Scientific during the post-acquisition portion of the year in 2012, offset by other factors from legacy domestic operations resulting in a decrease of $1,457,000. This decrease of $1,457,000 consisted primarily of a decrease in net external revenues from legacy domestic operations of $1,514,000, to $8,783,000 in 2013 from $10,297,000 in 2012.

Cost of sales increased $4,186,000 to $14,443,000 in 2013 from $10,257,000 in 2012. This 41% increase was directly related to the changes in net revenue related to Drew Scientific and legacy domestic operations as mentioned above.

Gross profit increased by $4,721,000 to $13,813,000 in 2013 from $9,092,000 in 2012. This 52% increase was attributed to the inclusion of gross profit of $5,626,0000 from Drew Scientific during the full year in 2013, compared to gross profit of $881,000 from Drew Scientific during the post-acquisition portion of the year in 2012. Gross profit margins increased from 47.0% in 2012 to 48.9% in 2013. This increase was a result of the increase in reagent sales from our acquisition of Drew Scientific, which have a higher gross profit margin than instruments.

Total operating expenses increased by $2,481,000 to $12,776,000 in 2013 from $10,295,000 in 2012. The 24.1% increase was a result of increases in all three operating expense categories: selling expenses increased $692,000, or 15%, to $5,309,000 in 2013 from $4,617,000, in 2012; general and administrative expenses increased $991,000, or 21.8%, to $5,547,000 in 2013 from $4,556,000 in 2012; and research and development expenses increased by $797,000, or 70.9%, to $1,920,000 in 2013 from $1,123,000 in 2012. The increase in total operating expenses is primarily attributable to the inclusion of total operating expenses of $3,864,000 from Drew Scientific during the full year in 2013 compared to total operating expenses of $1,102,000 from Drew Scientific during the post-acquisition portion of the year in 2012.

Operating income was $1,037,000 in 2013 compared to an operating loss of $1,203,000 in 2012. The change from an operating loss in 2012 to an operating profit in 2013 resulted primarily from the inclusion of operating income of $1,762,000 from Drew Scientific during the full year in 2013, compared to operating loss of $221,000 from Drew Scientific during the post-acquisition portion of the year in 2012.

NET REVENUES AND GROSS PROFIT

The following table presents comparative net revenues and gross profit for our
operations, including the operations for Drew Scientific since the October 3,
2012 date of acquisition.

[[Image Removed]]   [[Image Removed]]      [[Image Removed]]      [[Image Removed]]
                            2013                   2012                Increase
Net Revenues:
Domestic            $      23,117,000      $      14,317,000      $       8,800,000
European                    5,138,000              5,032,000                106,000
Total                      28,255,000             19,349,000              8,906,000
Cost of Sales              14,442,000             10,257,000              4,185,000
Gross Profit        $      13,813,000      $       9,092,000      $       4,721,000
% of Total                  48.9      %            47.0      %

The net increase in revenues was primarily attributed to the inclusion of net revenues of $13,754,000 from Drew Scientific during the full year in 2013 compared to net revenues of $3,391,000 from Drew Scientific during the post-acquisition portion of the year in 2012, offset by other factors from legacy domestic operations resulting in a decrease of $1,457,000. This decrease of $1,457,000 consisted primarily of a decrease in net external revenues from legacy domestic operations of $1,514,000, to $8,783,000 in 2013 from $10,297,000 in


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2012. The decrease in net revenues from legacy domestic operations of $1,514,000 was principally due to a decrease in reagent sales in the United States due to revamping of the sales organization and significant reduction in the sales to Europe due to economic conditions in major portions of Europe.

The net increase in gross profit was attributed to the inclusion of gross profit of $5,626,000 from Drew Scientific during the full year in 2013 compared to gross profit of $881,000 from Drew Scientific during the post-acquisition portion of the year in 2012. Gross profit as a percentage of net revenues increased from 47.0% in 2012 to 48.9% in 2013, resulting principally from the an increase in reagent sales in Drew Scientific, which have a higher gross profit margin than instrument sales.

OPERATING EXPENSES

The following table presents comparative operating expenses for us, including
the amounts for Drew Scientific since the October 3, 2012 date of acquisition.
The percentages below are based on the net revenues in the above table.

[[Image Removed]]   [[Image Removed]]      [[Image Removed]]      [[Image Removed]]      [[Image Removed]]      [[Image Removed]]
                            2013               % of Revenue               2012               % of Revenue            Increase
Selling             $        5,309,000               18.8 %       $        4,617,000               23.9 %       $         692,000
General and                  5,547,000               19.7 %                4,555,000               23.5 %                 992,000
Administrative
Research and                 1,920,000                6.8 %                1,123,000                5.8 %                 797,000
Development
Total Operating     $       12,776,000               45.3 %       $       10,295,000               53.2 %       $       2,481,000
Expenses

Total operating expenses increased $2,481,000 from $10,295,000 in 2012 to $12,775,000 in 2013.

The 15.0% increase of $692,000 in selling expenses in 2013 compared to 2012 was due to the inclusion of selling expenses of $2,230,000 from Drew Scientific during the full year in 2013 compared to selling expenses of $522,000 from Drew Scientific during the post-acquisition portion of the year in 2012, offset by the decrease of $1,007,000 from legacy domestic operations which was due principally to open sales positions in the United States and lower commissions from lower sales in various commissionable categories.

The 21.8% increase of $992,000 in general and administrative expenses in 2013 compared to 2012 was primarily due to the inclusion of general and administrative expenses of $1,235,000 from Drew Scientific during the full year in 2013 compared to general and administrative expenses of $320,000 from Drew Scientific during the post-acquisition portion of the year in 2012.

The 71.1% increase of $797,000 in research and development expenses in 2013 compared to 2012 was primarily due to an increase in research and development activities from the research and development efforts in Italy related to the development of the next generation ELISA platform - LISA XL. Additional expenditures of approximately Euro 675,000 (equivalent to approximately $896,000) incurred in 2013 related to the research and development efforts in Italy were billed to ERBA Mannheim.

INCOME (LOSS) FROM OPERATIONS

Income from operations totaled $1,037,000 in 2013 as compared to an operating loss of $1,203,000 in 2012, primarily due to the inclusion of operating income of $1,762,000 from Drew Scientific during the full year in 2013 compared to an operating loss of $221,000 from Drew Scientific during the post-acquisition portion of the year in 2012, as well as an improvement in our European operations of $281,000 from an operating loss of $382,000 in 2012 to an operating loss $101,000 in 2013.

OTHER INCOME (EXPENSE), NET

Other income (expense) totaled a net expense of $242,000 in 2013 as compared to a net expense of $228,000 in 2012. The 2013 balance consists of foreign currency transaction gains of $187,000, interest expense of $122,000, expenses of $211,000 related to the acquisition of Drew Scientific, and net other expenses of $96,000. The 2012 amounts consist of foreign currency transaction losses of $56,000, net interest expense of $40,000, expenses of $211,000 related to the acquisition of Drew Scientific, and net other income of $79,000.


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INCOME TAX PROVISION

We recorded income tax provisions of $119,000 for 2013 and $122,000 for 2012. The current portion of our tax provisions in both years relates to Italian local income taxes based upon applicable statutory rates effective in Italy. In addition, the domestic provision of $69,000 for 2013 and $81,000 for 2012 represent the deferred tax provisions in these years relating to domestic tax-deductible goodwill. No current tax benefit was recorded during the two years on our losses because we had a full valuation allowance against the net deferred income tax assets.

See also Note 7, Income Taxes, to the Consolidated Financial Statements regarding other tax matters.

NET INCOME (LOSS)

Net income for 2013 was $676,000, compared to a net loss of $1,553,000 in 2012. Drew Scientific generated net income of $1,614,000 during the full year in 2013 as compared to net loss of $238,000 during the post-acquisition portion of the year in 2012. Basic and diluted net income per common share was $0.02 and $0.01, . . .

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