-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, JxwPzsCOTjBDZMT0Q+A46nK6uj+ny1UUY7HQZ8vFPwF+QvPtxbvnPWTe1nRcggqE CCUkLUYFkeVc+y1NdtK0cg== 0001038133-01-500028.txt : 20020410 0001038133-01-500028.hdr.sgml : 20020410 ACCESSION NUMBER: 0001038133-01-500028 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011113 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HESKA CORP CENTRAL INDEX KEY: 0001038133 STANDARD INDUSTRIAL CLASSIFICATION: BIOLOGICAL PRODUCTS (NO DIAGNOSTIC SUBSTANCES) [2836] IRS NUMBER: 770192527 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 333-72155 FILM NUMBER: 1784581 BUSINESS ADDRESS: STREET 1: 1613 PROSPECT PARKWAY CITY: FORT COLLINS STATE: CO ZIP: 80525 BUSINESS PHONE: 9704937272 MAIL ADDRESS: STREET 1: 1825 SHARP POINT DR CITY: FORT COLLINS STATE: CO ZIP: 80525 10-Q 1 final.txt HESKA THIRD QUARTER 2001 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to ____________ Commission file number 000-22427 HESKA CORPORATION (Exact name of Registrant as specified in its charter) Delaware 77-0192527 [State or other jurisdiction of [I.R.S. Employer incorporation or organization] Identification No.] 1613 PROSPECT PARKWAY FORT COLLINS, COLORADO 80525 (Address of principal executive offices) (970) 493-7272 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [ X ] Yes [ ] No The number of shares of the Registrant's Common Stock, $.001 par value, outstanding at November 9, 2001 was 39,895,601 HESKA CORPORATION FORM 10-Q QUARTERLY REPORT TABLE OF CONTENTS
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Balance Sheets (Unaudited) as of September 30, 2001 and December 31, 2000 3 Consolidated Statements of Operations (Unaudited) for the three and nine months ended September 30, 2001 and 2000 4 Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2001 and 2000 5 Notes to Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 28 PART II. OTHER INFORMATION Item 1. Legal Proceedings Not Applicable Item 2. Changes in Securities and Use of Proceeds 29 Item 3. Defaults Upon Senior Securities Not Applicable Item 4. Submission of Matters to a Vote of Security Holders Not Applicable Item 5. Other Information Not Applicable Item 6. Exhibits and Reports on Form 8-K 29 Exhibit Index 29 Signatures 30
HESKA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (dollars in thousands except per share amounts) (unaudited)
ASSETS SEPTEMBER 30, DECEMBER 31, 2001 2000 -------------- --------------- Current assets: Cash and cash equivalents $ 2,906 $ 3,176 Marketable securities - 2,482 Accounts receivable, net of allowance of $279 and $431, respectively 8,597 8,433 Inventories, net of reserve of $578 and $606, respectively 9,593 8,716 Other current assets 1,440 742 -------------- -------------- Total current assets 22,536 23,549 Property and equipment, net of accumulated depreciation of $16,066 and $13,645, respectively 10,594 12,901 Intangible assets, net of accumulated amortization of $1,296 and $1,041, respectively 1,482 1,457 Restricted marketable securities and other assets 634 1,253 -------------- -------------- Total assets $ 35,246 $ 39,160 ============== ============== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 4,851 $ 3,370 Accrued liabilities 3,339 4,258 Deferred revenue and other 1,261 467 Line of credit 4,345 912 Current portion of capital lease obligations 137 584 Current portion of long-term debt 762 650 -------------- -------------- Total current liabilities 14,695 10,241 Capital lease obligations, net of current portion 69 138 Long-term debt, net of current portion 2,258 2,670 Other long-term liabilities 924 1,011 -------------- -------------- Total liabilities 17,946 14,060 -------------- -------------- Commitments and contingencies Stockholders' equity: Preferred stock, $.001 par value, 25,000,000 shares authorized; none outstanding - - Common stock, $.001 par value, 75,000,000 shares authorized; 38,838,214 and 34,072,640 shares issued and outstanding, respectively 39 34 Additional paid-in capital 205,228 199,789 Accumulated other comprehensive loss (364) (251) Accumulated deficit (187,603) (174,472) -------------- -------------- Total stockholders' equity 17,300 25,100 -------------- -------------- Total liabilities and stockholders' equity $ 35,246 $ 39,160 ============== ==============
See accompanying notes to consolidated financial statements
HESKA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited) THREE MONTHS NINE MONTHS ENDED ENDED SEPTEMBER 30, SEPTEMBER 30, ------------- ------------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenues: Products, net $ 11,035 $ 12,396 $ 32,048 $ 38,533 Research, development and other 720 312 1,571 2,781 -------- -------- -------- -------- Total revenues 11,755 12,708 33,619 41,314 Cost of products sold 6,920 8,452 20,124 26,338 -------- -------- -------- -------- 4,835 4,256 13,495 14,976 -------- -------- -------- -------- Operating expenses: Selling and marketing 3,349 3,275 10,491 11,486 Research and development 3,236 3,605 9,809 11,406 General and administrative 1,883 1,888 5,773 7,217 Amortization of intangible assets and deferred compensation 67 207 200 623 Gain on sale of assets - - - (151) Restructuring expense - - - 435 -------- -------- -------- -------- Total operating expenses 8,535 8,975 26,273 31,016 -------- -------- -------- -------- Loss from operations (3,700) (4,719) (12,778) (16,040) Other (expense), net (194) (12) (352) (322) -------- -------- -------- -------- Net loss $ (3,894) $ (4,731) $(13,130) $(16,362) ======== ======== ======== ======== Basic and diluted net loss per share $ (0.10) $ (0.14) $ (0.34) $ (0.49) ======== ======== ======== ======== Shares used to compute basic and diluted net loss per share 38,838 33,872 38,187 33,735 ======== ======== ======== ========
See accompanying notes to consolidated financial statements HESKA CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
NINE MONTHS ENDED SEPTEMBER 30, ------------- 2001 2000 ---- ---- CASH FLOWS USED IN OPERATING ACTIVITIES: Net cash used in operating activities $ (10,300) $ (14,244) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of marketable securities 2,500 15,546 Proceeds from sale of subsidiary - 6,000 Proceeds from disposition of property and equipment 317 406 Purchase of property and equipment (790) (889) --------- --------- Net cash provided by investing activities 2,027 21,063 --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock 5,444 495 Proceeds from borrowings 4,345 136 Repayments of debt and capital lease obligations (1,733) (6,758) --------- --------- Net cash provided by (used in) financing activities 8,056 (6,127) --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH (53) (148) --------- --------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (270) 544 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,176 1,499 --------- --------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 2,906 $ 2,043 ========= ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 447 $ 1,006 ========= =========
See accompanying notes to consolidated financial statements HESKA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2001 (UNAUDITED) 1. ORGANIZATION AND BUSINESS Heska Corporation ("Heska" or the "Company") is primarily focused on the discovery, development, manufacturing and marketing of companion animal health products. In addition to manufacturing some of Heska's companion animal health products, the Company's primary manufacturing subsidiary, Diamond Animal Health, Inc. ("Diamond"), manufactures food animal vaccines and pharmaceutical products that are marketed and distributed by third parties. The Company also offers diagnostic services to veterinarians at its Fort Collins, Colorado location and through its subsidiary, CMG-Heska Allergy Products S.A. ("CMG"), a Swiss corporation. From the Company's inception in 1988 until early 1996, the Company's operations related primarily to research and development activities, entering into collaborative agreements, raising capital and recruiting personnel. Prior to 1996, the Company had not received any revenues from the sale of products. During 1996, Heska grew from being primarily a research and development concern to a fully-integrated research, development, manufacturing and marketing company. The Company accomplished this by acquiring Diamond, a licensed pharmaceutical and biological manufacturing facility in Des Moines, Iowa, hiring key employees and support staff, establishing marketing and sales operations to support new Heska products, and designing and implementing more sophisticated operating and information systems. The Company also expanded the scope and level of its scientific and business development activities, increasing the opportunities for new products. In 1997, the Company introduced additional products and expanded (1) in the United States through the acquisition of Center, a Food and Drug Administration ("FDA") and United States Department of Agriculture ("USDA") licensed manufacturer of allergy immunotherapy products located in Port Washington, New York, and (2) internationally through the acquisitions of Heska UK Limited ("Heska UK", formerly Bloxham Laboratories Limited), a veterinary diagnostic laboratory in Teignmouth, England and CMG (formerly Centre Medical des Grand'Places S.A.) in Fribourg, Switzerland, which manufactures and markets allergy diagnostic products for use in veterinary and human medicine, primarily in Europe. Each of the Company's acquisitions during this period was accounted for under the purchase method of accounting and accordingly, the Company's financial statements reflect the operations of these businesses only for the periods subsequent to the respective acquisitions. In July 1997, the Company established a new subsidiary, Heska AG, located near Basel, Switzerland, for the purpose of managing its European operations. In 1998 the Company acquired Heska Waukesha (formerly Sensor Devices, Inc.), a manufacturer and marketer of patient monitoring devices used in both animal health and human applications. The financial results of Heska Waukesha have been consolidated with those of the Company under the pooling-of-interests accounting method for all periods presented. During 1999 and 2000, the Company restructured and refocused its business. The operations of Heska Waukesha were combined with existing operations in Fort Collins, Colorado and Des Moines, Iowa during the fourth quarter of 1999. The Heska Waukesha facility was closed in December 1999. In the first quarter of 2000, the Company sold Heska UK. The Company recorded a loss on disposition of approximately $1.0 million during 1999 for this sale. In June 2000, the Company sold Center. The Company recognized a gain on the sale of approximately $151,000. The Company has incurred net losses since its inception and anticipates that it will continue to incur additional net losses in the near term as it introduces new products, expands its sales and marketing capabilities and continues its research and development activities. Cumulative net losses from inception of the Company in 1988 through September 30, 2001 have totaled $187.6 million. The Company's primary short-term needs for capital, which are subject to change, are for its continuing research and development efforts, its sales, marketing and administrative activities, working capital associated with increased product sales and capital expenditures relating to our manufacturing operations. The Company's ability to achieve profitable operations will depend primarily upon its ability to successfully market its products, commercialize products that are currently under development and develop new products. Most of the Company's products are subject to long development and regulatory approval cycles and there can be no guarantee that the Company will successfully develop, manufacture or market these products. There can also be no guarantee that the Company will attain profitability or, if achieved, will remain profitable on a quarterly or annual basis in the future. Until the Company attains positive cash flow, the Company will continue to finance operations with additional equity and debt financing. There can be no guarantee that such financing will be available when required or will be obtained under favorable terms. The Company's primary sources of liquidity at September 30, 2001 were the $2.9 million in cash and cash equivalents and the asset-based revolving line of credit. At September 30, 2001, the Company had borrowed $4.3 million under its revolving line of credit facility and had available additional borrowing capacity of approximately $2.5 million. The Company believes that its available cash and cash equivalents, together with cash from operations, available borrowings and borrowings expected to be available under its revolving line of credit facility will be sufficient to satisfy projected cash requirements through the end of 2001. The Company will need to raise additional capital to continue its business operations in 2002. The Company expects to raise these additional funds through one or more of the following: (1) sale of additional equity or debt securities; (2) sale of various assets; (3) licensing of technology; and (4) sale of various products or marketing rights. If the Company cannot raise the additional funds through these options on acceptable terms or with the necessary timing, management will need to take actions to conserve its cash balances, including reducing capital expenditures, reducing operating expenses, eliminating personnel and curtailing certain operations, all of which would likely have a material adverse affect on the Company's business, financial condition and results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. The balance sheet as of September 30, 2001, the statements of operations for the three and nine months ended September 30, 2001 and 2000 and the statements of cash flows for the nine months ended September 30, 2001 and 2000 are unaudited but include, in the opinion of management, all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of its financial position, operating results and cash flows for the periods presented. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries since the dates of their respective acquisitions when accounted for under the purchase method of accounting, and for all periods presented when accounted for under the pooling-of-interests method of accounting. All material intercompany transactions and balances have been eliminated in consolidation. Although the Company believes that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 31, 2000, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 29, 2001. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents The Company had $2.9 million of cash and cash equivalents as of September 30, 2001. Included in these amounts were Japanese yen with a value in U.S. dollars of approximately $504,000 which were held in an interest-bearing multi- currency account of a non-U.S. bank. The Company values its Japanese yen at the spot market rate as of the balance sheet date. These yen resulted from settlement of forward contracts entered into for purchases of inventory throughout fiscal 2001 (See Note 8). Changes in the fair value of the yen are recorded in current earnings. The Company recognized a loss from devaluation of the yen of approximately $6,000 during the three months ended September 30, 2001. The Company had no Japanese yen at December 31, 2000. Inventories, net Inventories are stated at the lower of cost or market using the first-in, first-out method. If the cost of inventories exceeds fair market value, provisions are made for the difference between cost and fair market value. Inventories consist of the following (in thousands):
SEPTEMBER 30, DECEMBER 31, 2001 2000 ------------ ----------- Raw materials $ 2,699 $ 2,596 Work in process 3,529 2,904 Finished goods 3,943 3,822 Less reserves for losses (578) (606) --------- --------- $ 9,593 $ 8,716 ========= =========
Derivative Financial Instruments The Company utilizes derivative financial instruments to reduce financial market risks. These instruments may be used to hedge foreign currency, interest rate and certain equity market exposures of underlying assets, liabilities and other obligations. The Company does not use derivative financial instruments for speculative or trading purposes. The Company accounts for its derivative instruments in accordance with the Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 138. This standard requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company's accounting policies for these instruments are based on whether they meet the Company's criteria for designation as hedging transactions. The criteria the Company uses for designating an instrument as a hedge includes the instrument's effectiveness in risk reduction and one-to-one matching of derivative instruments to underlying transactions. Gains and losses on currency forward contracts, and options that are designated and effective as hedges of anticipated transactions, for which a firm commitment has been attained, are deferred and recognized in income in the same period that the underlying transactions are settled. Gains and losses on currency forward contracts, options and swaps that are designated and effective as hedges of existing transactions are recognized in income in the same period as losses and gains on the underlying transactions are recognized and generally offset. Gains and losses on any instruments not meeting the above criteria are recognized in income in the current period. If an underlying hedged transaction is terminated earlier than initially anticipated, the offsetting gain or loss on the related derivative instrument would be recognized in each period until the instrument matures, is terminated or is sold. Revenue Recognition Product revenues are recognized at the time goods are shipped to the customer with an appropriate provision for returns and allowances. License revenues under arrangements to sell product rights or technology rights are recognized upon the sale and completion by the Company of all obligations under the agreement. Royalties are recognized as products are sold to customers. The Company recognizes revenue from sponsored research and development over the life of the contract as research activities are performed. The revenue recognized is the lesser of revenue earned under a percentage of completion method based on total expected revenues or actual non-refundable cash received to date under the agreement. In addition to its direct sales force, the Company utilizes both distributors and a limited number of sales agency organizations to sell its products. Distributors purchase goods from the Company, take title to those goods and resell them to their customers in the distributors' territory. Sales agents maintain inventories of goods on consignment from the Company and sell these goods on behalf of the Company to customers in the sales agents' territory. The Company recognizes revenue at the time goods are sold to the customers by the sales agents. Sales agents are paid a fee for their services, which include maintaining product inventories, sales activities, billing and collections. Fees earned by sales agents are netted against revenues generated by these entities. Basic and Diluted Net Loss Per Share Basic net loss per common share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed using the sum of the weighted average number of shares of common stock outstanding and, if not anti-dilutive, the effect of outstanding stock options and warrants determined using the treasury stock method. At December 31, 2000 and September 30, 2001, outstanding options to purchase 3,964,668 and 3,934,076 shares, respectively, of the Company's common stock and warrants to purchase 1,165,592 and zero shares of the Company's common stock as of each date, have been excluded from diluted net loss per share because they would be anti-dilutive. Foreign Currency Translation The functional currency of the Company's international subsidiaries is the Swiss Franc. Assets and liabilities of the Company's international subsidiaries are translated using the exchange rate in effect at the balance sheet date. Revenue and expense accounts are translated using an average of exchange rates in effect during the period. Cumulative translation gains and losses are included in accumulated other comprehensive income in the consolidated balance sheets. Exchange gains and losses arising from transactions denominated in foreign currencies (i.e., transaction gains and losses) are recognized in current operations. Reclassifications Certain prior period results have been reclassified to conform to the current year's presentation. Recently Issued Accounting Pronouncements During June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 143 "Accounting for Asset Retirement Obligations". This statement establishes accounting standards for recognition and measurement of a liability for an asset retirement obligation and the associated asset retirement cost. It requires an entity to recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate can be made. The Company is required to adopt this statement in its fiscal year 2003. The Company does not believe that this statement will materially impact its results of operations. During August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to Be Disposed of" and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for segments to be disposed of. This statement applies to recognized long-lived assets of an entity to be held and used or to be disposed of. This statement does not apply to goodwill, intangible assets not being amortized, financial instruments, and deferred tax assets. This statement requires an impairment loss to be recorded for assets to be held and used when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. An asset that is classified as held for sale shall be recorded at the lower of its carrying amount or fair value less cost to sell. The Company is required to adopt this statement for the first quarter of 2002. The Company does not believe that this statement will materially impact its results of operations. 3. MAJOR CUSTOMERS One customer in 2001 and two customers in 2000 accounted for approximately 15% and 41% of total revenue during the three months ended September 30, 2001 and 2000, respectively. These same customers accounted for 12% and 28% of total revenue for the nine months ended September 30, 2001 and 2000, respectively. At September 30, 2001, one customer accounted for approximately 19% of accounts receivable. These customers purchased vaccines from Diamond. 4. SEGMENT REPORTING The Company divides its operations into three reportable segments. Companion Animal Health includes the operations of Heska, CMG and Heska AG. Food Animal Health includes the operations of Diamond Animal Health. Allergy Treatment includes the operations of Center, which was sold in June 2000. Summarized financial information concerning the Company's reportable segments is shown in the following table (in thousands). The "Other" column includes the elimination of intercompany transactions and other items as noted.
COMPANION FOOD ANIMAL ANIMAL ALLERGY HEALTH HEALTH TREATMENT OTHER TOTAL --------- ------ --------- ----- ----- THREE MONTHS ENDED SEPTEMBER 30, 2001: Revenues $ 7,869 $ 4,278 $ - $ (392) $ 11,755 Operating income (loss) (4,240) 540 - - (3,700) Total assets 48,258 20,435 - (33,447) 35,246 Capital expenditures 169 181 - - 350 Depreciation and amortization 495 394 - - 889 THREE MONTHS ENDED SEPTEMBER 30, 2000: Revenues $ 6,332 $ 6,807 $ - $ (431) $ 12,708 Operating income (loss) (5,761) 1,042 - - (4,719) Total assets 56,036 20,415 - (31,913) 44,538 Capital expenditures 67 83 - - 150 Depreciation and amortization 556 649 - - 1,205
COMPANION FOOD ANIMAL ANIMAL ALLERGY HEALTH HEALTH TREATMENT OTHER TOTAL --------- ------ --------- ----- ----- NINE MONTHS ENDED SEPTEMBER 30, 2001: Revenues $ 24,333 $ 10,833 $ - $ (1,547) $ 33,619 Operating income (loss) (13,505) 727 - - (12,778) Total assets 48,258 20,435 - (33,447) 35,246 Capital expenditures 373 417 - - 790 Depreciation and amortization 1,623 1,157 - - 2,780 NINE MONTHS ENDED SEPTEMBER 30, 2000: Revenues $ 23,483 $ 16,382 $ 3,353 $ (1,904) $ 41,314 Operating income (loss) (17,219) 1,637 (23) (435)(a) (16,040) Total assets 56,036 20,415 - (31,913) 44,538 Capital expenditures 597 292 - - 889 Depreciation and amortization 1,686 1,423 212 - 3,321
-------------- (a) Includes restructuring expenses of $435,000 (See Note 3). The Company manufactures and markets its products in two major geographic areas, North America and Europe. The Company's primary manufacturing facilities are located in North America. Revenues earned in North America are attributable to Heska, Diamond and Center (through June 2000). Revenues earned in Europe are primarily attributable to Heska UK (through January 2000), CMG and Heska AG. There have been no significant exports from North America or Europe. During the three and nine months ended September 30, 2001 and 2000, European subsidiaries purchased products from the Company's North American facilities for sale to European customers. Transfer prices to international subsidiaries are intended to allow the North American companies to earn profit margins commensurate with their sales and marketing efforts. Certain information by geographic area is shown in the following table (in thousands). The "Other" column includes the elimination of intercompany transactions.
NORTH AMERICA EUROPE OTHER TOTAL -------- ------ ----- ----- THREE MONTHS ENDED SEPTEMBER 30, 2001: Revenues $ 11,861 $ 286 $ (392) $ 11,755 Operating income (loss) (3,597) (103) - (3,700) Total assets 66,668 2,025 (33,447 35,246 Capital expenditures 285 65 - 350 Depreciation and amortization 824 65 - 889 THREE MONTHS ENDED SEPTEMBER 30, 2000: Revenues $ 12,720 $ 419 $ (431) $ 12,708 Operating income (loss) (4,384) (335) - (4,719) Total assets 73,712 2,739 (31,913) 44,538 Capital expenditures 153 (3) - 150 Depreciation and amortization 1,192 13 - 1,205
NORTH AMERICA EUROPE OTHER TOTAL ------- ------ ----- ----- NINE MONTHS ENDED SEPTEMBER 30, 2001: Revenues $ 33,835 $ 1,331 $ (1,547) $ 33,619 Operating income (loss) (12,467) (311) - (12,778) Total assets 66,668 2,025 (33,447) 35,246 Capital expenditures 755 35 - 790 Depreciation and amortization 2,692 88 - 2,780 NINE MONTHS ENDED SEPTEMBER 30, 2000: Revenues $ 41,312 $ 1,906 $ (1,904) $ 41,314 Operating income (loss) (14,831) (774) (435)(a) (16,040) Total assets 73,712 2,739 (31,913) 44,538 Capital expenditures 838 51 - 889 Depreciation and amortization 3,260 61 - 3,321
-------------- (a) Includes restructuring expenses of $435,000 (See Note 3). 5. SALE OF COMMON STOCK In February 2001, the Company sold 4,573,000 shares of common stock through a private placement with net proceeds of approximately $5.3 million, and filed a registration statement covering resales of these shares. The Company intends to keep the registration statement effective until April 5, 2003, or such earlier date of the disposition of these shares, subject to the Company's right to suspend the use of the registration statement. 6. CREDIT FACILITY In March 2001, the Company entered into an amendment to its revolving line of credit facility. The Company's ability to borrow under this agreement varies based upon available cash, eligible accounts receivable and eligible inventory. The minimum liquidity (cash plus excess borrowing base) required to be maintained has been reduced to $3.0 million during 2001. The Company had borrowed approximately $4.3 million under its revolving line of credit at September 30, 2001. As of September 30, 2001, the Company's remaining available borrowing capacity was approximately $2.5 million. During the three months ended September 30, 2001, the Company borrowed $1.6 million against this facility. 7. HEDGING ACTIVITIES In April 2001, the Company entered into a series of forward contracts to purchase Japanese yen at various dates throughout the remainder of the year. The yen will be used to purchase inventory from a Japanese manufacturer throughout fiscal 2001. These derivative instruments have been designated and qualify as cash flow hedging instruments under the definition provided by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". The forward contracts were entered into with settlement dates, and for amounts, that approximately correspond with the Company's projected needs to purchase inventory with the hedged currency. All of these forward contracts will be settled and the associated inventory purchased by December 31, 2001. These derivative instruments were consistent with the Company's risk management policy, which allows for the hedging of risk associated with fluctuations in foreign currency for anticipated future transactions. These instruments have been determined to be fully effective as a hedge in reducing the risk of the underlying transaction. An unrealized loss of approximately $24,000 has been recorded in Other Comprehensive Income during the nine months ended September 30, 2001 (See Note 9). These unrealized gains or losses will be reclassified to cost of products sold and recognized as the purchased inventory is sold to customers. The Company has recognized a loss of approximately $21,000 and $22,000 in cost of products sold during the three months and nine months ended September 30, 2001, respectively. 8. COMPREHENSIVE INCOME Comprehensive income includes net income (loss) plus the results of certain stockholders' equity changes not reflected in the Consolidated Statements of Operations. Such changes include foreign currency items, unrealized gains and losses on certain investments in marketable securities and unrealized gains and losses on derivative instruments. During the nine months ended September 30, 2001, the Company realized a loss of approximately $22,000 on the sale of marketable securities. Total comprehensive income and the components of comprehensive income follow (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, --------------------- 2001 2000 --------- --------- Net loss per Consolidated Statements of Operations $ (3,894) $ (4,731) Foreign currency translation adjustments 9 (131) Changes in unrealized gains (losses) on forward contracts, net of realized gains (losses) 44 - Changes in unrealized loss on marketable securities - 71 -------- -------- Comprehensive loss $ (3,841) $ (4,791) ======== ========
NINE MONTHS ENDED SEPTEMBER 30, 2001 2000 --------- --------- Net loss per Consolidated Statements of Operations $(13,130) $(16,362) Foreign currency translation adjustments (134) (229) Changes in unrealized gains (losses) on forward contracts, net of realized gains (losses) (24) - Changes in unrealized loss on marketable securities 44 75 -------- -------- Comprehensive loss $(13,244) $(16,516) ======== ========
Accumulated gains and losses from derivative contracts is as follows:
2001 ------ Accumulated derivative gains (losses), December 31, 2000 $ - Unrealized losses on forward contracts (46) Realized losses on forward contracts reclassified to current earnings 22 ----- Accumulated derivative gains (losses), September 30, 2001 $ (24) =====
9. SUBSEQUENT EVENT In September 2001, the Company offered its current employees the opportunity to exchange all options outstanding with exercise prices greater than $3.90 per share under the 1997 Stock Incentive Plan for shares of restricted stock. The tender offer closed on September 28, 2001 with options to purchase 1,044,900 shares of common stock exchanged for 1,044,900 shares of restricted stock. The restricted stock vests over 48 months from its issuance on October 1, 2001. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. Our actual results and the timing of certain events could differ materially from the results discussed in the forward-looking statements. When used in this discussion the words "expects," "anticipates," "believes," "continue," "could," "may," "will" and similar expressions are intended to identify forward-looking statements. Such statements, which include statements concerning future revenue sources and concentration, gross margins, research and development expenses, selling and marketing expenses, general and administrative expenses, capital resources, additional financings or borrowings and additional losses, are subject to risks and uncertainties, including those set forth below under "Factors that May Affect Results" that could cause actual results to differ materially from those projected. These forward-looking statements speak only as of the date hereof. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions, or circumstances on which any such statement is based. OVERVIEW We discover, develop, manufacture and market companion animal health products. We have a sophisticated scientific effort devoted to applying biotechnology to create a broad range of pharmaceutical, vaccine and diagnostic products for the companion animal health market. In addition to our pharmaceutical, vaccine and diagnostic products, we also sell veterinary diagnostic and patient monitoring instruments and offer diagnostic services in the United States and Europe to veterinarians. Our primary manufacturing subsidiary, Diamond Animal Health, Inc., or Diamond, manufactures some of our companion animal products and food animal vaccine and pharmaceutical products, which are marketed and distributed by third parties. From our inception in 1988 until early 1996, our operating activities related primarily to research and development activities, entering into collaborative agreements, raising capital and recruiting personnel. Prior to 1996, we had not received any revenues from the sale of products. During 1996, we grew from being primarily a research and development concern to a fully- integrated research, development, manufacturing and marketing company. We accomplished this by acquiring Diamond, a licensed pharmaceutical and biological manufacturing facility in Des Moines, Iowa, hiring key employees and support staff, establishing marketing and sales operations to support our products introduced in 1996, and designing and implementing more sophisticated operating and information systems. We also expanded the scope and level of our scientific and business development activities, increasing the opportunities for new products. In 1997, we introduced 13 additional products and expanded in the United States through the acquisition of Center, an FDA and USDA licensed manufacturer of allergy immunotherapy products located in New York, and internationally through the acquisitions of Heska UK, a veterinary diagnostic laboratory in England, and CMG in Switzerland, which manufactures and markets allergy diagnostic products for use in veterinary and human medicine, primarily in Europe. Each of our acquisitions during this period was accounted for under the purchase method of accounting and accordingly, our financial statements reflect the operations of these businesses only for the periods subsequent to the acquisitions. In July 1997, we established a new subsidiary, Heska AG, located near Basel, Switzerland, for the purpose of managing our European operations. In 1998 we acquired a manufacturer and marketer of patient monitoring devices. The financial results of this entity have been consolidated with ours under the pooling-of-interests accounting method for all periods presented. These operations were consolidated with our existing operations in Fort Collins, Colorado and Des Moines, Iowa as of December 31, 1999, and our facility in Waukesha, Wisconsin was closed. We sold our subsidiary in the United Kingdom, Heska UK, in the first quarter of 2000. In June 2000, we completed the sale of Center. We have incurred net losses since our inception and anticipate that we will continue to incur additional net losses in the near term as we introduce new products, expand our sales and marketing capabilities and continue our research and development activities. Cumulative net losses from inception in 1988 through September 30, 2001 have totaled $187.6 million. Our ability to achieve profitable operations will depend primarily upon our ability to successfully market our existing products, commercialize products that are currently under development and develop new products. Most of our products are subject to long development and regulatory approval cycles, and we may not successfully develop, manufacture or market these products. We also may not attain profitability or, if achieved, may not remain profitable on a quarterly or annual basis in the future. Until we attain positive cash flow, we will continue to finance operations with additional equity and debt financing. Such financing may not be available when required or may not be obtained under favorable terms. See the discussions later in this section titled "Liquidity and Capital Resources" and "Factors That May Affect Results" for a more in-depth explanation of risks faced by us. RESULTS OF OPERATIONS Three Months Ended September 30, 2001 and 2000 Total revenues, which include product, research and development and other revenues, decreased 7% to $11.8 million in the third quarter of 2001 compared to $12.7 million for the third quarter of 2000. Product revenues decreased 11% to $11.0 million in the third quarter of 2001 compared to $12.4 million for the same period in 2000, primarily as a result of a $2.6 million decrease in sales at Diamond. Gross profit margins on products sold improved 5.5 percentage points over the third quarter of the prior year, as the sales mix contained a larger percentage of high margin Heska proprietary products. In addition, total operating expenses for the 2001 third quarter declined by $440,000 from third quarter 2000 levels. Our net loss was reduced by over $800,000, or 18%, for the third quarter of 2001 as compared to the same quarter in 2000. Total reported product revenues during the quarter were derived from the three components of our continuing core business. These revenue components are as follows: PHARMACEUTICALS, VACCINES AND DIAGNOSTIC PRODUCTS (PVD). This group of products includes our heartworm diagnostic products, equine influenza vaccine, allergy products, feline vaccines and other such products for the companion animal health market. During the third quarter of 2001, PVD product revenue increased approximately 15% over the comparable quarter of 2000, to $3.2 million, primarily relating to strong sales of our Flu Avert (TM) I.N. vaccine for equine influenza and of our feline trivalent vaccine, which increased by 135% and 112%, respectively, from prior year levels. In addition, our new E-Screen allergy test introduced in the third quarter also contributed to the increase in our PVD product revenue. VETERINARY MEDICAL INSTRUMENTATION PRODUCTS. This group of products includes all of our veterinary medical instrumentation, as well as the reagents, consumables, parts and accessories for these instruments, which are for the companion animal health market. During the third quarter of 2001, medical instrumentation product revenue increased by approximately 25% from the comparable quarter of 2000, to $4.0 million, primarily attributable to our SPOTCHEM (TM) clinical chemistry system that we introduced earlier this year and our i-STAT (R) portable clinical analyzer and associated reagents. DIAMOND ANIMAL HEALTH PRODUCTS. This group of products is comprised principally of vaccines and other biological products for cattle and other non- companion animals. In addition, Diamond also manufactures some of our PVD products and serves as our primary product distribution center. During the third quarter of 2001, Diamond's product revenue declined by approximately 40% from the comparable quarter of 2000, to $3.8 million. The decline in third quarter revenue at Diamond was principally due to cancelled and delayed orders from customers. Cost of products sold totaled $6.9 million in the third quarter of 2001 compared to $8.5 million in the third quarter of 2000. Gross profit as a percentage of product sales increased to 37.3% in the third quarter of 2001 compared to 31.8% in the same quarter last year. The improvement in gross profit as a percentage of product sales in the third quarter of 2001 compared to 2000 reflects the increase in sales of our proprietary PVD products. We expect gross profit as a percentage of product sales to continue to improve as we increase the sales of our higher margin proprietary PVD products and the increased sales of instrument reagents and consumables. Selling and marketing expenses were unchanged at $3.3 million in the third quarter of 2001 compared to $3.3 million in the third quarter of 2000. We expect selling and marketing expense as a percentage of total sales to decrease in the future as we continue to increase sales from our business. Research and development expenses decreased to $3.2 million in the third quarter of 2001 from $3.6 million in the third quarter of 2000. Fluctuations in research and development expenses are generally the result of the number of research projects in progress. We expect research and development expense as a percentage of total sales to decrease in the future as we continue to increase sales from our business. General and administrative expenses were unchanged at $1.9 million in the third quarter of 2001 compared to $1.9 million in the third quarter of 2000. We expect general and administrative expense as a percentage of total sales to decrease in the future as we continue to increase sales from our business. For the quarter ended September 30, 2001, our net loss declined to $3.9 million from $4.7 million in the third quarter of the prior year. This represents an 18% improvement over results reported in the prior year. The net loss per common share in the third quarter of 2001 was $0.10, compared with a net loss per common share of $0.14 in the third quarter of the prior year. Nine Months Ended September 30, 2001 and 2000 Total revenues, which include product, research and development and other revenues, decreased 19% to $33.6 million in the first nine months of 2001 compared to $41.3 million for the same period of 2000. Product revenues decreased 17% to $32.0 million this period in 2001 compared to $38.5 million in 2000 primarily as a result of lower sales at Diamond, which fell $5.9 million, or 39% from the comparable period in 2000. The total reported revenue for the nine months ended September 30, 2000 included approximately $3.2 million from businesses sold in fiscal 2000 and approximately $1.25 million attributable to the sale of worldwide rights to our PERIOceutic (TM) Gel product. Product revenue from our continuing core business (excluding sold businesses and discontinued product lines) declined by 9% in the first nine months of 2001 compared to the same period of the prior year. Gross profit margins on products sold improved by 5.5 percentage points over the first nine months of the prior year, as the sales mix contained a larger percentage of high margin Heska proprietary products. In addition, total operating expenses declined by $4.7 million from 2000 levels. Our net loss was reduced by $3.3 million for the first nine months of 2001 as compared to the same period in 2000. Total reported product revenues are derived from the three components of our continuing core business, plus revenues from sold businesses and discontinued products. These revenue components are as follows: PHARMACEUTICALS, VACCINES AND DIAGNOSTIC PRODUCTS (PVD). This group of products includes our heartworm diagnostic products, equine influenza vaccine, allergy products, feline vaccines and other such products for the companion animal health market. During the first nine months of 2001, PVD product revenue increased approximately 19% over the comparable period of 2000, to $11.6 million, primarily due to an increase in heartworm diagnostic product line sales of 11% and an increase in equine influenza vaccine sales of over 91% year-to-date. VETERINARY MEDICAL INSTRUMENTATION PRODUCTS. This group of products includes all of our veterinary medical instrumentation, as well as the reagents, consumables, parts and accessories for these instruments, which are for the companion animal health market. During the first nine months of 2001, medical instrumentation product revenue increased by approximately 7% from the comparable period of 2000, to $11.3 million, primarily attributable to our SPOTCHEM (TM) clinical chemistry system that we introduced earlier this year and our i-STAT (R) portable clinical analyzer and associated reagents. DIAMOND ANIMAL HEALTH PRODUCTS. Revenue reported from this group of products is comprised principally of vaccines and other biological products for cattle and other non-companion animals. In addition, Diamond also manufactures some of our PVD products and serves as our primary product distribution center. During the first nine months of 2001, Diamond's product revenue declined by approximately 39% from the comparable period of 2000, to $9.1 million. The decline in revenue at Diamond was principally due to cancelled and delayed orders from customers. SOLD BUSINESSES AND DISCONTINUED PRODUCTS. During 2000, we engaged in a number of activities to restructure our business, including the sale of Heska UK, effective January 31, 2000 and the sale of Center, effective June 23, 2000. Our total reported product revenue in 2000 includes the revenue from these sold businesses prior to the dates of sale. The revenue attributable to these sold businesses in the first nine months of 2000 was approximately $3.2 million. Cost of products sold totaled $20.1 million in the first nine months of 2001 compared to $26.3 million in the same period of 2000. Gross profit as a percentage of product sales increased to 37.2% in the first nine months of 2001 compared to 31.7% for the same period last year. The improvement in gross profit as a percentage of product sales in 2001 compared to 2000 reflects the increase in sales of our proprietary PVD products and the increased sales of instrument reagents and consumables. We expect gross profit as a percentage of product sales to continue to improve as we increase the sales of our higher margin proprietary PVD products. Selling and marketing expenses decreased to $10.5 million in the first nine months of 2001 from $11.5 million in the same period of 2000. This decrease reflects primarily the costs associated with the introduction and marketing of new products in the first half of 2000, as well as the sale of Center and Heska UK in 2000. We expect selling and marketing expense as a percentage of total sales to decrease in the future as we continue to increase sales from our continuing core business. Research and development expenses decreased to $9.8 million in the first nine months of 2001 from $11.4 million in the same period of 2000. Fluctuations in research and development expenses are generally the result of the number of research projects in progress. We expect research and development expense as a percentage of total sales to decrease in the future as we continue to increase sales from our continuing core business. General and administrative expenses decreased to $5.8 million in the first nine months of 2001 from $7.2 million in the same period of 2000. This decrease is due to tighter expense control at all locations and the sale of Center and Heska UK in 2000. We expect general and administrative expense as a percentage of total sales to decrease in the future as we continue to increase sales from our continuing core business. During the first quarter of fiscal 2000, we initiated a cost reduction and restructuring plan at Diamond. The restructuring resulted from the rationalization of Diamond's business including a reduction in the size of its workforce and our decision to vacate a leased warehouse and distribution facility no longer needed after our decision to discontinue contract manufacturing of certain low margin human health care products. The charge to operations of approximately $435,000 related primarily to personnel severance costs for 12 individuals and the costs associated with closing the leased facility, terminating the lease and abandoning certain leasehold improvements. The facility was closed in April 2000. For the nine months ended September 30, 2001, our net loss declined to $13.1 million from $16.4 million in the same period of the prior year. This represents a 20% improvement over results reported in the prior year. The net loss per common share in the first nine months of 2001 was $0.34, compared with a net loss per common share of $0.49 in the same period of the prior year. LIQUIDITY AND CAPITAL RESOURCES Our primary source of liquidity at September 30, 2001 was our $2.9 million in cash and cash equivalents and, our asset-based revolving line of credit. At September 30, 2001, we had borrowed $4.3 million under the revolving line of credit facility and had an additional $2.5 million of borrowing capacity available. Our credit facility requires us to maintain various financial covenants including monthly minimum book net worth, minimum quarterly net income and minimum cash balances or liquidity levels. In March 2001, we negotiated new covenants under this line of credit which lowered our minimum liquidity requirements. In February 2001, we sold 4,573,000 shares of our common stock through a private placement offering and received net proceeds of $5.3 million. Cash used in operating activities was $10.3 million in the first nine months of 2001, compared to $14.2 million in the same period of 2000. The decrease in cash used in operating activities is attributable primarily to the decrease of $3.2 million in our net loss for the first nine months of 2001 compared to the prior year. Our investing activities provided cash of $2.0 million in the first nine months of 2001, compared to $21.1 million during the same period of 2000. Cash provided by investing activities was primarily related to the sale of marketable securities to fund our business operations. Expenditures for property and equipment were approximately $790,000 for the first nine months of 2001 compared to approximately $889,000 in the first nine months of 2000. We have historically used capital equipment lease and debt facilities to finance equipment purchases and, if possible, leasehold improvements. We currently expect to spend approximately $900,000 in 2001 for capital equipment, including expenditures for the upgrading of manufacturing operations to improve efficiencies as well as various enhancements to assure ongoing compliance with regulatory requirements. Our financing activities provided $8.1 million in the first nine months of 2001 compared to $6.1 million used in the first nine months of 2000. This 2001 cash was provided principally by our sale of 4,573,000 shares of our common stock in a private placement in February 2001 with net proceeds to us of approximately $5.3 million and net borrowings from our revolving credit facility of $3.4 million. Our primary short-term needs for capital, which are subject to change, are for our continuing research and development efforts, our sales, marketing and administrative activities, working capital associated with increased product sales and capital expenditures relating to our manufacturing operations. Our future liquidity and capital requirements will depend on numerous factors, including the extent to which our present and future products gain market acceptance, the extent to which products or technologies under research or development are successfully developed, the timing of regulatory actions regarding our products, the costs and timing of expansion of sales, marketing and manufacturing activities, the cost, timing and business management of current and potential acquisitions and contingent liabilities associated with such acquisitions, the procurement and enforcement of patents important to our business and the results of competition. We believe available cash and cash equivalents, together with cash from operations, available borrowings and borrowings expected to be available under our revolving line of credit facility will be sufficient to satisfy projected cash requirements through the end of 2001. We will need to raise additional capital to continue our business operations in 2002. If necessary, we expect to raise these additional funds through one or more of the following: (1) sale of additional equity or debt securities; (2) sale of various assets; (3) licensing of technology; and (4) sale of various products or marketing rights. If we cannot raise the additional funds through these options on acceptable terms or with the necessary timing, management will need to take actions to conserve its cash balances, including reducing capital expenditures, reducing operating expenses, eliminating personnel and curtailing certain operations, all of which would likely have a material adverse affect on our business, financial condition and results of operations. Consequently, any projections of future cash needs and cash flows are subject to substantial uncertainty. NET OPERATING LOSS CARRYFORWARDS As of December 31, 2000, we had a net operating loss carryforward, or NOL, of approximately $154.6 million and approximately $3.1 million of research and development tax credits available to offset future federal income taxes. The NOL and tax credit carryforwards, which are subject to alternative minimum tax limitations and to examination by the tax authorities, expire on various dates from 2003 to 2020. Our acquisition of Diamond resulted in a "change of ownership" under the provisions of Section 382 of the Internal Revenue Code of 1986, as amended. As such, we will be limited in the amount of NOL's incurred prior to the merger that we may utilize to offset future taxable income. Approximately $4.7 million of NOLs per year will be available to offset future taxable income for periods subsequent to the Diamond acquisition. Similar limitations also apply to utilization of research and development tax credits to offset taxes payable. We believe that this limitation may affect the eventual utilization of our total NOL carryforwards. RECENT ACCOUNTING PRONOUNCEMENTS During June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 143 "Accounting for Asset Retirement Obligations". This statement establishes accounting standards for recognition and measurement of a liability for an asset retirement obligation and the associated asset retirement cost. It requires an entity to recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate can be made. The Company is required to adopt this statement in its fiscal year 2003. The Company does not believe that this statement will materially impact its results of operations. During August 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to Be Disposed of" and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for segments to be disposed of. This statement applies to recognized long-lived assets of an entity to be held and used or to be disposed of. This statement does not apply to goodwill, intangible assets not being amortized, financial instruments, and deferred tax assets. This statement requires an impairment loss to be recorded for assets to be held and used when the carrying amount of a long-lived asset is not recoverable and exceeds its fair value. An asset that is classified as held for sale shall be recorded at the lower of its carrying amount or fair value less cost to sell. The Company is required to adopt this statement for the first quarter of 2002. The Company does not believe that this statement will materially impact its results of operations. FACTORS THAT MAY AFFECT RESULTS We will need additional capital to fund continued business operations in 2002 and we cannot be sure that additional financing will be available. We have incurred negative cash flow from operations since inception in 1988. We do not expect to generate positive cash flow sufficient to fund our operations in 2002. Moreover, based on our current projections, we will need to raise additional capital in the near future. We expect to raise this additional capital through one or more of the following:
* sale of additional equity or debt securities; * sale of various assets; * licensing of technology; and * sale of various products or marketing rights.
Additional capital may not be available on acceptable terms, if at all. Furthermore, any additional equity financing would likely be dilutive to stockholders, and additional debt financing, if available, may include restrictive covenants which may limit our currently planned operations and strategies. If adequate funds are not available, we will have to curtail our operations significantly and reduce discretionary spending to extend the currently available cash resources, or to obtain funds by entering into collaborative agreements or other arrangements on unfavorable terms, all of which would likely have a material adverse effect on our business, financial condition and our ability to reduce losses or generate profits. We anticipate future losses and negative cash flow. We have incurred net losses since our inception in 1988 and, as of September 30, 2001, we had an accumulated deficit of $187.6 million. We anticipate that we may continue to incur additional operating losses in the near term. These losses have resulted principally from expenses incurred in our research and development programs and from general and administrative and sales and marketing expenses. Even if we achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we cannot achieve or sustain profitability, we may not be able to meet our working capital expenditures, which would have a material adverse effect on our business. We have limited resources to devote to product development and commercialization. If we are not able to devote resources to product development and commercialization, we may not be able to develop our products. Our strategy is to develop a broad range of products addressing companion animal healthcare. We believe that our revenue growth and profitability, if any, will substantially depend upon our ability to:
* improve market acceptance of our current products; * complete development of new products; and * successfully introduce and commercialize new products.
We have introduced some of our products only recently and many of our products are still under development. Because we have limited resources to devote to product development and commercialization, any delay in the development of one product or reallocation of resources to product development efforts that prove unsuccessful may delay or jeopardize the development of our other product candidates. If we fail to develop new products and bring them to market, our ability to generate revenues will decrease. In addition, our products may not achieve satisfactory market acceptance, and we may not successfully commercialize them on a timely basis, or at all. If our products do not achieve a significant level of market acceptance, demand for our products will not develop as expected and it is unlikely that we ever will become profitable. We must obtain and maintain costly regulatory approvals in order to market our products. Many of the products we develop and market are subject to extensive regulation by one or more of the United States Department of Agriculture, or USDA, the Food and Drug Administration, or FDA, the Environmental Protection Agency, or EPA, and foreign regulatory authorities. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, premarket approval, advertising, promotion, sale and distribution of our products. Satisfaction of these requirements can take several years and time needed to satisfy them may vary substantially, based on the type, complexity and novelty of the product. The effect of government regulation may be to delay or to prevent marketing of our products for a considerable period of time and to impose costly procedures upon our activities. We have experienced in the past, and may experience in the future, difficulties that could delay or prevent us from obtaining the regulatory approval or license necessary to introduce or market our products. Regulatory approval of our products may also impose limitations on the indicated or intended uses for which our products may be marketed. Among the conditions for regulatory approval is the requirement that our manufacturing facilities or those of our third party manufacturers conform to current Good Manufacturing Practices. The FDA and foreign regulatory authorities strictly enforce Good Manufacturing Practices requirements through periodic inspections. We can provide no assurance that any regulatory authority will determine that our manufacturing facilities or those of our third party manufacturers will conform to Good Manufacturing Practices requirements. Failure to comply with applicable regulatory requirements can result in sanctions being imposed on us or the manufacturers of our products, including warning letters, product recalls or seizures, injunctions, refusal to permit products to be imported into or exported out of the United States, refusals of regulatory authorities to grant approval or to allow us to enter into government supply contracts, withdrawals of previously approved marketing applications, civil fines and criminal prosecutions. Factors beyond our control may cause our operating results to fluctuate, and since many of our expenses are fixed, this fluctuation could cause our stock price to decline. We believe that our future operating results will fluctuate on a quarterly basis due to a variety of factors, including:
* results from our Diamond Animal Health subsidiary; * the introduction of new products by us or by our competitors; * market acceptance of our current or new products; * regulatory and other delays in product development; * product recalls; * competition and pricing pressures from competitive products; * manufacturing delays; * shipment problems; * product seasonality; and * changes in the mix of products sold.
We have high operating expenses for personnel, new product development and marketing. Many of these expenses are fixed in the short term. If any of the factors listed above cause our revenues to decline, our operating results could be substantially harmed. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price probably would decline. We must maintain various financial and other covenants under our revolving line of credit agreement. Under our revolving line of credit agreement with Wells Fargo Business Credit, Inc., we are required to comply with various financial and non-financial covenants, and we have made various representations and warranties. Among the financial covenants are requirements for monthly minimum book net worth, minimum quarterly net income and minimum cash balances or liquidity levels. Failure to comply with any of the covenants, representations or warranties would negatively impact our ability to borrow under the agreement. Our inability to borrow to fund our operations could materially harm our business. A small number of large customers account for a large percentage of our revenues, and the loss of any of them could harm our operating results. We currently derive a substantial portion of our revenues from sales by our subsidiary Diamond, which manufactures various of our products and products for other companies in the animal health industry. Revenues from one Diamond customer in 2001, AgriLabs, and two Diamond customers in 2000, AgriLabs and Alpharma, comprised approximately 15% and 41% of our total revenues for the three months ended September 30, 2001 and 2000, respectively, and 12% and 28% of our total revenues for the nine months ended September 30, 2001 and 2000, respectively. If we are not successful in maintaining our relationships with our customers and obtaining new customers, our business and results of operations will suffer. We operate in a highly competitive industry, which could render our products obsolete or substantially limit the volume of products that we sell. This would limit our ability to compete and achieve profitability. We compete with independent animal health companies and major pharmaceutical companies that have animal health divisions. Companies with a significant presence in the animal health market, such as American Home Products, Bayer, IDEXX Laboratories, Inc., Intervet International B.V., Merial Ltd., Novartis, Pfizer Inc., Pharmacia Animal Health and Schering Plough Corporation, have developed or are developing products that compete with our products or would compete with them if developed. These competitors may have substantially greater financial, technical, research and other resources and larger, better-established marketing, sales, distribution and service organizations than us. In addition, IDEXX, which has products that compete with our heartworm diagnostic products, prohibits its distributors from selling competitors' products, including ours. Our competitors frequently offer broader product lines and have greater name recognition than we do. Our competitors may develop or market technologies or products that are more effective or commercially attractive than our current or future products or that would render our technologies and products obsolete. Further, additional competition could come from new entrants to the animal healthcare market. Moreover, we may not have the financial resources, technical expertise or marketing, distribution or support capabilities to compete successfully. If we fail to compete successfully, our ability to achieve profitability will be limited. We have limited experience in marketing our products, and may be unable to commercialize our products. The market for companion animal healthcare products is highly fragmented, with discount stores and specialty pet stores accounting for a substantial percentage of sales. Because we sell our companion animal health products only to veterinarians, we may fail to reach a substantial segment of the potential market, and we may not be able to offer our products at prices which are competitive with those of companies that distribute their products through retail channels. We currently market our products to veterinarians through a direct sales force and through third parties. To be successful, we will have to continue to develop and train our direct sales force or rely on marketing partnerships or other arrangements with third parties to market, distribute and sell our products. We may not successfully develop and maintain marketing, distribution or sales capabilities, and we may not be able to make arrangements with third parties to perform these activities on satisfactory terms. If we fail to develop a successful marketing strategy, our ability to commercialize our products and generate revenues will decrease. We have granted third parties substantial marketing rights to our products under development. If our current third party marketing agreements are not successful, or if we are unable to develop our own marketing capabilities or enter into additional marketing agreements in the future, we may not be able to develop and commercialize our products. Our agreements with our corporate marketing partners generally contain no minimum purchase requirements in order for them to maintain their exclusive or co-exclusive marketing rights. Novartis, Eisai or Ralston Purina or any other collaborative party may not devote sufficient resources to marketing our products. Furthermore, there is nothing to prevent Novartis, Eisai or Ralston Purina or any other collaborative party from pursuing alternative technologies or products that may compete with our products. If we fail to develop and maintain our own marketing capabilities, we may find it necessary to continue to rely on potential or actual competitors for third party marketing assistance. Third party marketing assistance may not be available in the future on reasonable terms, if at all. If any of these events occur, we may not be able to develop and commercialize our products and our revenues will decline. We may face costly intellectual property disputes. Our ability to compete effectively will depend in part on our ability to develop and maintain proprietary aspects of our technology and either to operate without infringing the proprietary rights of others or to obtain rights to technology owned by third parties. We have United States and foreign-issued patents and are currently prosecuting patent applications in the United States and with various foreign countries. Our pending patent applications may not result in the issuance of any patents or that any issued patents will offer protection against competitors with similar technology. Patents we receive may be challenged, invalidated or circumvented in the future or the rights created by those patents may not provide a competitive advantage. We also rely on trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. Others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. The biotechnology and pharmaceutical industries have been characterized by extensive litigation relating to patents and other intellectual property rights. In 1998, Synbiotics Corporation filed a lawsuit against us alleging infringement of a Synbiotics patent relating to heartworm diagnostic technology, and this litigation remains ongoing. We may become subject to additional patent infringement claims and litigation in the United States or other countries or interference proceedings conducted in the United States Patent and Trademark Office to determine the priority of inventions. The defense and prosecution of intellectual property suits, USPTO interference proceedings, and related legal and administrative proceedings are costly, time-consuming and distracting. We may also need to pursue litigation to enforce any patents issued to us or our collaborative partners, to protect trade secrets or know-how owned by us or our collaborative partners, or to determine the enforceability, scope and validity of the proprietary rights of others. Any litigation or interference proceeding will result in substantial expense to us and significant diversion of the efforts of our technical and management personnel. Any adverse determination in litigation or interference proceedings could subject us to significant liabilities to third parties. Further, as a result of litigation or other proceedings, we may be required to seek licenses from third parties which may not be available on commercially reasonable terms, if at all. We license technology from a number of third parties. The majority of these license agreements impose due diligence or milestone obligations on us, and in some cases impose minimum royalty and/or sales obligations on us, in order for us to maintain our rights under these agreements. Our products may incorporate technologies that are the subject of patents issued to, and patent applications filed by, others. As is typical in our industry, from time to time we and our collaborators have received, and may in the future receive, notices from third parties claiming infringement and invitations to take licenses under third party patents. It is our policy that when we receive such notices, we conduct investigations of the claims they assert. With respect to the notices we have received to date, we believe, after due investigation, that we have meritorious defenses to the infringement claims asserted. Any legal action against us or our collaborators may require us or our collaborators to obtain one or more licenses in order to market or manufacture affected products or services. However, we or our collaborators may not be able to obtain licenses for technology patented by others on commercially reasonable terms, we may not be able to develop alternative approaches if unable to obtain licenses, or current and future licenses may not be adequate for the operation of our businesses. Failure to obtain necessary licenses or to identify and implement alternative approaches could prevent us and our collaborators from commercializing our products under development and could substantially harm our business. We have limited manufacturing experience and capacity and rely substantially on third party manufacturers. The loss of any third party manufacturers could limit our ability to launch our products in a timely manner, or at all. To be successful, we must manufacture, or contract for the manufacture of, our current and future products in compliance with regulatory requirements, in sufficient quantities and on a timely basis, while maintaining product quality and acceptable manufacturing costs. In order to increase our manufacturing capacity, we acquired Diamond in April 1996. We currently rely on third parties to manufacture those products we do not manufacture at our Diamond facility. We currently have supply agreements with Quidel Corporation for various manufacturing services relating to our point-of- care diagnostic tests, with Centaq, Inc. for the manufacture of our own allergy immunotherapy treatment products and with various manufacturers for the supply of our veterinary diagnostic and patient monitoring instruments. Our manufacturing strategy presents the following risks:
* Delays in the scale-up to quantities needed for product development could delay regulatory submissions and commercialization of our products in development; * Our manufacturing facilities and those of some of our third party manufacturers are subject to ongoing periodic unannounced inspection by regulatory authorities, including the FDA, USDA and other federal and state agency's for compliance with strictly enforced Good Manufacturing Practices regulations and similar foreign standards, and we do not have control over our third party manufacturers' compliance with these regulations and standards; * If we need to change to other commercial manufacturing contractors for certain of our products, additional regulatory licenses or approvals must be obtained for these contractors prior to our use. This would require new testing and compliance inspections. Any new manufacturer would have to be educated in, or develop substantially equivalent processes necessary for the production of our products; * If market demand for our products increases suddenly, our current manufacturers might not be able to fulfill our commercial needs, which would require us to seek new manufacturing arrangements and may result in substantial delays in meeting market demand; and * We may not have intellectual property rights, or may have to share intellectual property rights, to any improvements in the manufacturing processes or new manufacturing processes for our products.
Any of these factors could delay commercialization of our products under development, interfere with current sales, entail higher costs and result in our being unable to effectively sell our products. Our agreements with various suppliers of the veterinary medical instruments require us to meet minimum annual sales levels to maintain our position as the exclusive distributor of these instruments. We may not meet these minimum sales levels in the future, and maintain exclusivity over the distribution and sale of these products. If we are not the exclusive distributor of these products, competition may increase. We depend on partners in our research and development activities. If our current partnerships and collaborations are not successful, we may not be able to develop our technologies or products. For various of our proposed products, we are dependent on collaborative partners to successfully and timely perform research and development activities on our behalf. These collaborative partners may not complete research and development activities on our behalf in a timely fashion, or at all. If our collaborative partners fail to complete research and development activities, or fail to complete them in a timely fashion, our ability to develop technologies and products will be impacted negatively and our revenues will decline. We depend on key personnel for our future success. If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals. Our future success is substantially dependent on the efforts of our senior management and scientific team. The loss of the services of members of our senior management or scientific staff may significantly delay or prevent the achievement of product development and other business objectives. Because of the specialized scientific nature of our business, we depend substantially on our ability to attract and retain qualified scientific and technical personnel. There is intense competition among major pharmaceutical and chemical companies, specialized biotechnology firms and universities and other research institutions for qualified personnel in the areas of our activities. If we lose the services of, or fail to recruit, key scientific and technical personnel, the growth of our business could be substantially impaired. We may face product returns and product liability litigation and the extent of our insurance coverage is limited. If we become subject to product liability claims resulting from defects in our products, we may fail to achieve market acceptance of our products and our business could be harmed. The testing, manufacturing and marketing of our current products as well as those currently under development entail an inherent risk of product liability claims and associated adverse publicity. Following the introduction of a product, adverse side effects may be discovered. Adverse publicity regarding such effects could affect sales of our other products for an indeterminate time period. To date, we have not experienced any material product liability claims, but any claim arising in the future could substantially harm our business. Potential product liability claims may exceed the amount of our insurance coverage or may be excluded from coverage under the terms of the policy. We may not be able to continue to obtain adequate insurance at a reasonable cost, if at all. In the event that we are held liable for a claim against which we are not indemnified or for damages exceeding the $10 million limit of our insurance coverage or which results in significant adverse publicity against us, we may lose revenue and fail to achieve market acceptance. We may be held liable for the release of hazardous materials, which could result in extensive costs which would harm our business. Our products and development programs involve the controlled use of hazardous and biohazardous materials, including chemicals, infectious disease agents and various radioactive compounds. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by applicable local, state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any fines, penalties, remediation costs or other damages that result. Our liability for the release of hazardous materials could exceed our resources, which could lead to a shutdown of our operations. In addition, we may incur substantial costs to comply with environmental regulations as we expand our manufacturing capacity. We expect to experience volatility in our stock price, which may affect our ability to raise capital in the future or make it difficult for investors to sell their shares. The securities markets have experienced significant price and volume fluctuations and the market prices of securities of many publicly-held biotechnology companies have in the past been, and can in the future be expected to be, especially volatile. For example, in the last twelve months our closing stock price has ranged from a low of $0.50 to a high of $2.938. Fluctuations in the trading price or liquidity of our common stock may adversely affect our ability to raise capital through future equity financings. Factors that may have a significant impact on the market price and marketability of our common stock include:
* announcements of technological innovations or new products by us or by our competitors; * our quarterly operating results; * releases of reports by securities analysts; * developments or disputes concerning patents or proprietary rights; * regulatory developments; * developments in our relationships with collaborative partners; * changes in regulatory policies; * litigation; * economic and other external factors; and * general market conditions.
In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted. If a securities class action suit is filed against us, we would incur substantial legal fees and our management's attention and resources would be diverted from operating our business in order to respond to the litigation. If we fail to meet Nasdaq National Market listing requirements, our common stock will be delisted and become illiquid. Our common stock is currently listed on the Nasdaq National Market. Nasdaq has requirements we must meet in order to remain listed on the Nasdaq National Market. If we continue to experience losses from our operations or we are unable to raise additional funds, we might not be able to maintain the standards for continued quotation on the Nasdaq National Market, including a minimum bid price requirement of $1.00. If the minimum bid price of our common stock were to remain below $1.00 for 30 consecutive trading days, or if we were unable to continue to meet Nasdaq's standards for any other reason, our common stock could be delisted from the Nasdaq National Market. Nasdaq has suspended these requirements until January 2, 2002. If as a result of the application of these listing requirements, our common stock were delisted from the Nasdaq National Market, our stock would become harder to buy and sell. Further, our stock could be subject to what are known as the "penny stock" rules. The penny stock rules place additional requirements on broker-dealers who sell or make a market in such securities. Consequently, if we were removed from the Nasdaq National Market, the ability or willingness of broker-dealers to sell or make a market in our common stock might decline. As a result, the ability for investors to resell shares of our common stock could be adversely affected. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk represents the risk of loss that may impact the financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States and foreign interest rates and changes in foreign currency exchange rates as measured against the United States dollar. These exposures are directly related to our normal operating and funding activities. In April 2001, we entered into a series of forward contracts for the purchase of Japanese yen to be used for the purchase of inventory. Interest Rate Risk The interest payable on certain of our lines of credit and other borrowings is variable based on the United States prime rate and, therefore, affected by changes in market interest rates. At September 30, 2001, approximately $6.9 million was outstanding on these borrowings with a weighted average interest rate of 7.09%. We manage interest rate risk by investing excess funds principally in cash equivalents or marketable securities which bear interest rates that reflect current market yields. We completed an interest rate risk sensitivity analysis of these borrowings based on an assumed 1% increase in interest rates. If market rates increase by 1% during the three months ended December 31, 2001, we would experience an increase in interest expense of approximately $17,000 based on the outstanding borrowing balances at September 30, 2001. Foreign Currency Risk At September 30, 2001, we had wholly-owned subsidiaries located in Switzerland. Sales from these operations are denominated in Swiss Francs or Euros, thereby creating exposures to changes in exchange rates. The changes in the Swiss/U.S. exchange rate or Euro/U.S. exchange rate may positively or negatively affect our sales, gross margins and retained earnings. We completed a foreign currency exchange rate risk sensitivity analysis on an assumed 1% change in foreign currency exchange rates. If the foreign currency exchange rates change by 1% during the three months ended December 31, 2001, we would experience an increase/decrease in our foreign currency gain/loss of approximately $100,000 based on the investment in foreign subsidiaries as of and for the three months ended September 30, 2001. PART II. OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) Exhibits None. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the quarter ended September 30, 2001. HESKA CORPORATION SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HESKA CORPORATION
Date: November 13, 2001 By /s/ Ronald L. Hendrick ------------------------- RONALD L. HENDRICK Executive Vice President and Chief Financial Officer (on behalf of the Registrant and as the Registrant's Principal Financial and Accounting Officer)
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