10-Q 1 cli04q1.txt FORM 10Q QUARTERLY PERIOD ENDED MARCH 31, 2004 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q (Mark One) ( x ) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2004 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 0-11997 CARRINGTON LABORATORIES, INC. (Exact name of registrant as specified in its charter) Texas 75-1435663 ------------------------------- --------------------------------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 2001 Walnut Hill Lane, Irving, Texas 75038 ----------------------------------------------------- (Address of principal executive offices and Zip Code) 972-518-1300 ----------------------------------------------------- (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days Yes [ X ] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ] The number of shares of the registrant's common stock outstanding as of March 4, 2004 was 10,555,142. INDEX Page ---- Part I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at March 31, 2004 (unaudited) and December 31, 2003 3 Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003 (unaudited) 4 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (unaudited) 5 Notes to Condensed Consolidated Financial Statements (unaudited) 6 Item 2. Management's Discussion and Analysis of 10 Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures 14 About Market Risk Item 4. Controls and Procedures. 15 Part II. OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes in Securities and Use of Proceeds 16 Item 6. Exhibits and Reports on Form 8-K 17 PART I - FINANCIAL INFORMATION Item 1. Financial Statements Carrington Laboratories, Inc. Condensed Consolidated Balance Sheets (Amounts in thousands) March 31, December 31, 2004 2003 ------ ------ (unaudited) ASSETS: Current Assets: Cash and cash equivalents $ 1,997 $ 1,920 Accounts receivable, net 2,823 3,098 Inventories, net 5,561 5,960 Prepaid expenses 466 253 ------ ------ Total current assets 10,847 11,231 Property, plant and equipment, net 10,419 10,538 Customer relationships, net 728 777 Other assets, net 232 238 ------ ------ Total assets $22,226 $22,784 ====== ====== LIABILITIES AND SHAREHOLDERS' EQUITY: Current Liabilities: Line of credit $ 1,587 $ 1,587 Accounts payable 2,261 2,037 Accrued liabilities 1,144 1,604 Current portion of long-term debt and capital lease obligations 1,118 1,104 Deferred revenue 1,800 1,880 ------ ------ Total current liabilities 7,910 8,212 Long-term debt and capital lease obligations 1,675 1,953 SHAREHOLDERS' EQUITY: Common stock 105 104 Capital in excess of par value 53,266 53,000 Accumulated deficit (40,727) (40,482) Treasury stock at cost (3) (3) ------ ------ Total shareholders' equity 12,641 12,619 ------ ------ Total liabilities and shareholders' equity $22,226 $22,784 ====== ====== The accompanying notes are an integral part of these statements. Carrington Laboratories, Inc. Condensed Consolidated Statements of Operations (unaudited) (Dollar amounts and shares in thousands, except per share amounts) Three Months Ended March 31, 2004 2003 ------ ------ Revenue: Net product sales $ 6,693 $ 6,287 Royalty income 617 617 Grant income, DelSite 30 - ------ ------ Total revenue 7,340 6,904 Cost of sales 4,573 4,337 ------ ------ Gross margin 2,767 2,567 Expenses: Selling, general and administrative 1,864 1,876 Research and development 241 207 Research and development-DelSite 883 711 Other income (27) - Interest expense, net 51 71 ------ ------ Net income (loss) before income taxes (245) (298) Provision for income taxes - - ------ ------ Net income (loss) $ (245) $ (298) ====== ====== Basic and diluted earnings (loss) per share $ (0.02) $ (0.03) Basic and diluted average shares outstanding 10,433 9,993 The accompanying notes are an integral part of these statements. Carrington Laboratories, Inc. Condensed Consolidated Statements of Cash Flows (unaudited) (Dollar amounts in thousands) Three Months Ended March 31, 2004 2003 ------ ------ Cash flows used in operating activities Net loss $ (245) $ (298) Adjustments to reconcile net income (loss) to net cash used in operating activities: Provision for bad debts - 15 Provision for inventory obsolescence 42 45 Depreciation and amortization 333 317 Changes in assets and liabilities: Receivables 275 (850) Inventories 357 124 Prepaid expenses (213) (333) Other assets 6 94 Accounts payable and accrued liabilities (236) (128) Deferred revenue (80) 11 ------ ------ Net cash provided by (used in) operating activities 239 (1,003) ------ ------ Investing activities: Purchases of property, plant and equipment (165) (615) ------ ------ Net cash used in investing activities (165) (615) Financing activities: Proceeds from debt issuance - 500 Principal payments on debt and capital lease obligations (264) (196) Issuances of common stock 267 32 ------ ------ Net cash provided by financing activities 3 336 ------ ------ Net (decrease) increase in cash and cash equivalents 77 (1,282) Cash and cash equivalents, beginning of period 1,920 3,636 ------ ------ Cash and cash equivalents, end of period $ 1,997 $ 2,354 ====== ====== Cash paid during the period for interest $ 59 $ 75 Assets acquired under capital leases - 182 The accompanying notes are an integral part of these statements. Notes to Condensed Consolidated Financial Statements (unaudited) (1) Condensed Consolidated Financial Statements: The condensed consolidated balance sheet as of March 31, 2004, the condensed consolidated statements of operations for the three month periods ended March 31, 2004 and 2003 and the condensed consolidated statements of cash flows for the three month periods ended March 31, 2004 and 2003 of Carrington Laboratories, Inc., (the "Company") have been prepared by the Company without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (which include all normal recurring adjustments) necessary to present fairly the consolidated financial position, results of operations and cash flows for all periods presented have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company's annual report to shareholders on Form 10-K for the year ended December 31, 2003. Certain prior year amounts have been reclassified to conform with the 2004 presentation. (2) New Accounting Pronouncements: The FASB has issued Interpretation No. 46, "Consolidation of Variable Interest Entities". FIN 46 addresses the consolidation by business enterprises of variable interest entities whose equity holders have not provided sufficient equity to allow the entity to finance its own activities or whose equity holders lack the essential characteristics of a controlling financial interest. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the entity's activities or entitled to receive a majority of the entity's residual returns, or both. The provisions of FIN 46 were effective March 31, 2004 for entities formed before February 2003. Adoption of FIN 46 had no material effect to the Company. (3) Stock-Based Compensation: The Company accounts for employee stock options in accordance with Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25. Under APB 25, the Company recognizes no compensation expense related to employee or director stock options when options are granted with exercise prices at the quoted market price of the stock on the date of grant. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (FAS 123), Accounting for Stock-Based Compensation and Statement of Financial Accounting Standards No. 148 (FAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123. Under the provisions of FAS 123, pro forma compensation expense related to options issued to employees is disclosed based on the fair value of options on the grant date. The following table (in thousands) illustrates the effect on net income (loss) if the Company had applied the fair value recognition provision of FAS 123 to stock based compensation: ---------------------------------------------------------------------------- Three Months Ended March 31, 2004 2003 ---------------------------------------------------------------------------- Net loss (in thousands): As reported $ (245) $ (298) Less: Stock-based compensation expense determined under fair value-based method (833) (85) ------ ------ Pro forma net loss $(1,078) $ (383) Net loss per share: As reported $ (0.02) $ (0.03) Pro forma $ (0.10) $ (0.04) ---------------------------------------------------------------------------- Because options vest over a period of several years and additional awards are generally made each year, the pro forma information presented above is not necessarily indicative of the effects on reported or pro forma net earnings or losses for future years. (4) Net Income (Loss) Per Share: Basic income (loss) per common share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. When the effects are not anti-dilutive, diluted net income (loss) per common share is computed by dividing net income by the weighted average number of shares outstanding and the impact of all dilutive potential common shares, primarily stock options. The dilutive impact of stock options is determined by applying the "treasury stock" method. In calculating the diluted loss per share for the three-month periods ended March 31, 2004 and 2003, no effect was given to options or warrants, because the effect of including these securities would have been anti-dilutive. Total options and warrants outstanding as of March 31, 2004 and 2003 were 1,618,224, and 1,219,551 respectively. (5) Concentration of Credit Risk: Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of trade accounts receivable. The Company's customers are not concentrated in any specific geographic region but are concentrated in the health care industry. Significant sales, defined as amounts in excess of ten percent (10%) of revenue, were made to two customers. Sales to Natural Alternatives International, Inc., ("Natural Alternatives") a customer in the Consumer Services Division, accounted for 37% and 33% of the company's total revenue during the quarter ended March 31, 2004 and 2003, respectively. Sales to Medline Industries, Inc., ("Medline") a customer in the Medical Services Division, accounted for 33% and 30% of the company's total revenue during the quarter ended March 31, 2004 and 2003, respectively. Customers with significant receivable balances as of March 31, 2004, defined as amounts in excess of ten percent (10%) of gross receivables included Natural Alternatives, ($1,051,000) and Medline ($855,000). Of these amounts, $1,299,640 has been collected as of May 4, 2004. (6) Inventories: The following summarizes the components of inventory (in thousands): March 31, December 31, 2004 2003 ------ ------ Raw materials and supplies $ 2,581 $ 3,009 Work-in-process 880 638 Finished goods 2,877 3,048 Less obsolescence reserve (777) (735) ------ ------ Total $ 5,561 $ 5,960 ====== ====== (7) Debt: In March 2003, the Company received a loan of $500,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate plus 2.0%. The loan is secured by a mortgage on an unused, 164- acre parcel of land owned by the Company in Costa Rica plus a lien on specified oral patch production equipment. The proceeds of the loan were used in the Company's operations. As of March 31, 2004, there was $449,000 outstanding on the loan. In July 2003, the Company received a loan of $1,000,000 from Comerica Bank- Texas ("Comerica") under a variable rate installment note with interest and principal to be repaid in monthly installments over five years. The interest rate on the loan is the U.S. Prime Rate plus 0.5%. The loan is collateralized by the Company's accounts receivable and inventory and by a lien on the Company's production facility in Irving, Texas. The proceeds of the loan are being used in the Company's operations. As of March 31, 2004, there was $867,000 outstanding on the loan. The Company also has a $3,000,000 line of credit with Comerica structured as a demand note without a stated maturity date and with an interest rate equal to the Comerica prime rate plus 0.5%. The line of credit is collateralized by the Company's accounts receivable and inventory and by a first lien on the Company's production facility and is used for operating needs, as required. As of March 31, 2004, there was $1,587,000 outstanding on the credit line with $713,000 credit available for operations, net of outstanding letters of credit of $700,000. The credit facility with Comerica includes covenants that require the Company to maintain certain financial ratios. The Company was not in compliance with two of the covenant ratios as of March 31, 2004. Comerica has waived the events of noncompliance for the period ended March 31, 2004. Pursuant to the 2000 Distributor and License Agreement with Medline, the Company is to receive $12,500,000 in base royalties over a five-year period ending November 30, 2005. In December 2002, the Company received an advance on future royalty payments due from Medline of $2.0 million, which was recorded in the Company's financial statements as a loan to be repaid in quarterly installments through September 2005. The interest rate on the loan is 6.0%. As of March 31, 2004, there was $1,136,000 outstanding on the advance. (8) Income Taxes: The tax effects of temporary differences including net operating loss carryforwards have given rise to net deferred tax assets. At March 31, 2004 and December 31, 2003, the Company provided a valuation allowance against the entire balance of deferred tax asset due to the uncertainty as to the realization of the asset. At December 31, 2003, the Company had net operating loss carryforwards of approximately $43,600,000 for federal income tax purposes, which began expiring in 2003, and research and development tax credit carryforwards of approximately $386,000, which began expiring in 2003, all of which are available to offset federal income taxes due in current and future periods. For the three months ended March 31, 2004 and 2003, the Company recognized no benefit for income taxes. (9) Contingencies: From time to time in the normal course of business, the Company is party to various matters involving claims or possible litigation. Management believes the ultimate resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations. (10) Commitments: In December 2002, the Company purchased certain assets of the Custom Division of Creative Beauty Innovations, Inc. ("CBI"), including specialized manufacturing customer information, intellectual property, equipment and selected inventories. CBI is a privately held manufacturer of skin and cosmetic products with operations in Carrollton, Texas. Under the Agreement the Company paid CBI approximately $1.6 million, including approximately $0.6 million for inventory. In addition, for the five-year period ending in December 2007, the Company agreed to pay CBI an amount equal to 9.0909% of the Company's net sales up to $6.6 million per year and 8.5% of the Company's net sales over $6.6 million per year of CBI products to CBI's transferring customers. The acquired assets include equipment and other physical property previously used by CBI's Custom Division to compound and package cosmetic formulations of liquids, creams, gels and lotions into bottles, tubes or cosmetic jars. Carrington uses these assets in a substantially similar manner. The Company provides services to these customers through its Consumer Services Division. The Company recorded royalty expense of approximately $60,000 related to the sale of CBI products to CBI's former customers in the quarter ended March 31, 2004. (11) Reportable Segments: The Company operates in three reportable segments: 1) Medical Services Division, which sells human and veterinary medical products through distributors and provides manufacturing services to customers in medical products markets; 2) Consumer Services Division, which provides bulk raw materials, finished products and manufacturing services to customers in the cosmetic and nutraceutical markets and 3) DelSite Biotechnologies, Inc., a research and development subsidiary responsible for the development of the Company's proprietary GelSiteJ technology for controlled release and delivery of bioactive pharmaceutical ingredients. The Company previously reported its results in two segments: Medical Services Division and Caraloe, Inc. The Caraloe activities have been renamed the Consumer Services Division. In addition, due to the growing significance of DelSite's operations, the Company has decided to report DelSite as a separate segment. DelSite was previously reported as part of the Corporate operations category. The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes. Assets which are used in more than one segment are reported in the segment where the predominant use occurs. Total cash for the Company is included in the Corporate Assets figure. Reportable Segments (in thousands) Medical Consumer Services Services DelSite Corporate Total ---------------------------------------------------------------------------- Quarter ended March 31, 2004 Revenues to unaffiliated customers $ 2,890 $4,420 $ 30 $ - $ 7,340 Income (loss) before income taxes (365) 973 (853) - (245) Identifiable assets 6,199 12,891 520 2,616 22,226 Capital expenditures - 88 77 - 165 Depreciation and amortization 96 212 25 - 333 Quarter ended March 31, 2003 Revenues to unaffiliated customers $ 2,861 $ 4,043 $ - $ - $ 6,904 Income (loss) before income taxes (381) 794 (711) - (298) Identifiable assets 7,862 11,793 322 2,310 22,287 Capital expenditures - 433 182 - 615 Depreciation and amortization 153 143 21 - 317 (12) Subsequent Events: Effective April 9, 2004, the Company entered into an Amendment to the Distributor and License Agreement and Supply Agreement (the "Amendment") with Medline. The Amendment modified certain provisions contained in that certain Distributor and License Agreement, dated as of November 3, 2000, between the Company and Medline (the "Distributor Agreement") and that certain Supply Agreement dated as of November 3, 2000, between the Company and Medline (the "Supply Agreement"). Among other things, the Amendment extends the term of the Distributor Agreement and the term of the Supply Agreement through November 30, 2008 and, subject to certain refund rights more specifically described in the Amendment, provides that the Company will receive a $1.25 million advance payment of royalties in consideration of the extended term of the Distributor Agreement. The Company received the funds on April 21, 2004. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. BACKGROUND The Company is a research-based biopharmaceutical, medical device, raw materials and nutraceutical company engaged in the development, manufacturing and marketing of naturally-derived complex carbohydrates and other natural product therapeutics for the treatment of major illnesses, the dressing and management of wounds and nutritional supplements. The Company operates in three reportable segments: 1) Medical Services Division, which sells human and veterinary medical products through distributors and provides manufacturing services to customers in medical products markets; 2) Consumer Services Division, which provides bulk raw materials, finished products and manufacturing services to customers in the cosmetic and nutraceutical markets and 3) DelSite Biotechnologies, Inc., a research and development subsidiary responsible for the development of the Company's proprietary GelSiteJ technology for controlled release and delivery of bioactive pharmaceutical ingredients. The Company previously reported its results in two segments: Medical Services Division and Caraloe, Inc. The Caraloe activities have been renamed the Consumer Services Division. In addition, due to the growing significance of DelSite's operations, the Company has decided to report DelSite as a separate segment. DelSite was previously reported as part of the Corporate operations category. Products sold through the Medical Services Division include hydrogels, wound cleansers, hydrocolloids, advanced wound covering products, incontinence- care products and two lines of condition-specific products. Many products sold through this division contain the Company's proprietary, medical-grade raw material, Acemannan Hydrogel[TM]. The Company regularly engages in development projects to create line extensions and other new products for this category. Products sold through the Consumer Services Division include Manapol[R] and other proprietary and non-proprietary raw materials sold to nutraceutical and cosmetic customers; nutritional products sold under the AloeCeuticals[R] brand; skin care products sold under the Snow and Sun[TM] brand and private-labeled products manufactured to customer specifications, including powders, creams, liquids, gels, lotions, drinks, tablets and capsules for various customers. Prior to 1996, the Company generated most of its revenues from product sales in its Medical Services Division. In 1996, the Company launched its line of raw materials, including Manapol[R] powder, through its Consumer Services Division. In 2001, the Company created its specialty manufacturing group to provide services to cosmetic, nutraceutical and medical markets. In December 2002, the Company acquired the assets of the custom division of CBI, which substantially increased revenues for the Consumer Services Division. In 2003 approximately 29% of the Company's revenues were generated through product sales and royalties in its Medical Services Division and 71% through sales of products and services in its Consumer Services Division. The Company's wholly-owned subsidiary, DelSite, operates independently from the Company's research and development program and is responsible for the research, development and marketing of the Company's proprietary GelSite[TM] technology for controlled release and delivery of bioactive pharmaceutical ingredients. Additional revenues to the Company arise from time to time through research grants awarded to DelSite. LIQUIDITY AND CAPITAL RESOURCES Cash at March 31, 2004 was $1,997,000 versus $1,920,000 at December 31, 2003. The increase in cash was primarily due to decreases in accounts receivable balances and inventory levels. In addition, the Company invested $165,000 in capital expenditures to provide additional infrastructure for its operations and reduced debt and capital lease obligations of $264,000. These cash uses were partially offset by proceeds from stock option exercises of $267,000. The Company has a line of credit with Comerica Bank-Texas ("Comerica") that provides for borrowings of up to $3,000,000 based on the level of qualified accounts receivable and inventory. The line of credit is collateralized by accounts receivable and inventory. Borrowings under the line of credit bear interest at Comerica's prime rate plus 0.5%. The credit facility with Comerica includes covenants that require the Company to maintain certain financial ratios. The Company was not in compliance with two of the covenant ratios as of March 31, 2004. Comerica has waived the events of non- compliance for the period ended March 31, 2004. The Company and Comerica may amend the covenants in the future. As of March 31, 2004, there was $1,587,000 outstanding on the credit line with $713,000 credit available for operations, net of outstanding letters of credit of $700,000. In July 2003, the Company received a loan of $1,000,000 from Comerica under a variable rate installment note with interest and principal to be repaid in monthly installments over five years. The interest rate on the loan is the U.S. Prime Rate plus 0.5%. The loan is collateralized by the Company's accounts receivable and inventory and by a first lien on the Company's production facility in Irving, TX. The proceeds of the loan are being used in the Company's operations. As of March 31, 2004, there was $867,000 outstanding on the loan. In March 2003, the Company received a loan of $500,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate plus 2.0%. The loan is secured by a mortgage on an unused, 164- acre parcel of land owned by the Company in Costa Rica plus a lien on specified oral patch production equipment. The proceeds of the loan were used in the Company's operations. As of March 31, 2004, there was $449,000 outstanding on the loan. Pursuant to the Distributor Agreement with Medline, the Company is to receive $12,500,000 in base royalties over a five-year period ending November 30, 2005. As discussed in Note 12 to the unaudited Condensed Consolidated Financial Statements herein, effective April 9, 2004, the Company entered into an Amendment to the Distributor Agreement. The Amendment modified certain provisions contained in the Distributor Agreement and the Supply Agreement. Among other things, the Amendment extends the term of the Distributor Agreement and the term of the Supply Agreement through November 30, 2008, and subject to certain refund rights more specifically described in the Amendment, provides that the Company will receive an additional $1.25 million of royalties, to be paid upon the signing of the Amendment, in consideration of the extended term of the Distributor Agreement. The Company received the funds on April 21, 2004. The Company continues to recognize royalty income under this agreement, as amended, on a straight-line basis. At March 31, 2004, the Company had received $1,667,000 more in royalties than it had recognized in income, which is recorded as deferred revenue on the balance sheet. Royalties to be received subsequent to March 31, 2004 total $2,500,000. In December 2002, the Company received an advance on future royalty payments due from Medline of $2.0 million which was recorded in the Company's financial statements as a loan to be repaid in quarterly installments through September 2005. The advance bears interest at 6.5% and is being repaid by reducing each quarterly royalty payment due from Medline by approximately $200,000. As of March 31, 2004, there was $1,136,000 outstanding on the advance. The Company anticipates capital expenditures in 2004 of approximately $1.8 million. The expenditures will primarily be comprised of production and laboratory equipment and facility modifications. Presently, the Company's debt/equity ratio is 0.76 to 1. Based on its current estimates, management believes that the Company has the capacity to incur additional debt, and, in 2004, the Company intends to seek additional financing to be used as working capital. The Company anticipates that such borrowings, together with the expected cash flows from operations and licensing agreements and expected revenues from government grant programs, will provide the funds necessary to finance its current operations, including expected levels of research and development for at least the next twelve months. However, the Company does not expect that its current cash resources will be sufficient to finance future major clinical studies and costs of filing new drug applications necessary to develop its products to their full commercial potential. Additional funds, therefore, may need to be raised through equity offerings, borrowings, licensing arrangements or other means. Management believes that each of the enumerated financing avenues is presently available to the Company. However, there is no assurance that the Company will be able to obtain such funds on satisfactory terms when they are needed. As a result of the current level of sales of raw materials produced at the Company's processing facility in Costa Rica, the Company's demand for Aloe vera L. leaves has exceeded and continues to exceed both the current and the normal production capacity of its farm. It has therefore been necessary for the Company to purchase Aloe vera L. leaves from other sources. Since March 1998, the Company has been a minority investor in Aloe and Herbs International, Inc., a Panamanian corporation ("Aloe & Herbs"), the owner of Rancho Aloe (C.R.), S.A., a Costa Rican corporation, which produces Aloe vera L. leaves and sells them to the Company at competitive, local market rates. RESULTS OF OPERATIONS Quarter ended March 31, 2004 compared to quarter ended March 31, 2003 Revenue for the quarter ended March 31, 2004, increased 6.3%, or $436,000, to $7,340,000 as compared to $6,904,000 during the quarter ended March 31, 2003. Consumer Services revenue during the first quarter of 2004 increased 9.3%, or $377,000, to $4,420,000 versus $4,043,000 for the same quarter last year. The increase in Consumer Services revenue is attributable to increased raw material sales of $319,000, decreased specialty manufacturing sales of $281,000 and increased sales of cosmetic products of $339,000 resulting from the acquisition of certain assets of the custom division of CBI in December 2002. Medical services revenue during the quarter ended March 31, 2004, increased slightly to $2,890,000 as compared to $2,861,000 during the quarter ended March 31, 2003. The relatively flat sales are attributable to soft wound care product sales to Medline. Grant revenue in the amount of $30,000 has been generated from a Small Business Innovation Research (SBIR) biodefense grant to DelSite. This is the first quarter for grant revenue to be reported. The total amount of the grant awarded is up to $888,000 over a two-year period, depending on actual expenses for approved research. The grant will fund additional development of GelVac[TM], DelSite's intranasal vaccine delivery platform technology. Gross margin was $2,767,000 during the quarter ended March 31, 2004, as compared to $2,567,000 during the quarter ended March 31, 2003, an increase of 7.8%. Gross margin as a percentage of revenue grew to 37.7% during the first quarter of 2004 from 37.2% during the same quarter last year. The increase in gross margin is attributable to a decrease in unfavorable manufacturing variances of $193,000 which was the result of higher production volumes, thus creating more efficient operations. Selling, general and administrative expenses during the quarter ended March 31, 2004, decreased $12,000 to $1,864,000 as compared to $1,876,000 during the quarter ended March 31, 2003. Product-support research and development during the quarter ended March 31, 2004, increased to $241,000 as compared to $207,000 during the quarter ended March 31, 2003, primarily due to new product development costs. The Company continues to focus the efforts of this group on product development in support of its manufacturing business. Research and development for DelSite during the quarter ended March 31, 2004, increased $172,000 or 24.2% to $883,000 as compared to $711,000 during the quarter ended March 31, 2003, as product development efforts for injectible and intranasal delivery platforms continued and business development efforts increased. Other income of $27,000 for the quarter ended March 31, 2004, resulted from collections on a note receivable which had previously been reserved. Net interest expense during the quarter ended March 31, 2004, decreased $20,000 from the quarter ended March 31, 2003, to $51,000 for the quarter ended March 31, 2004, as a result of lower interest rates on existing debt. Net loss for the first quarter of 2004 was $245,000 as compared to a net loss of $298,000 for the same quarter last year, a decrease of $53,000 primarily due to volume-related increases in sales and gross margins. Loss per share for the first quarter 2004 was $0.02 compared to loss per share of $0.03 for the first quarter of 2003. OTHER ITEMS Governmental Regulation The Company is subject to regulation by numerous governmental authorities in the United States and other countries. Certain of the Company's proposed products will require governmental approval prior to commercial use. The approval process applicable to pharmaceutical products and therapeutic agents usually takes several years and typically requires substantial expenditures. The Company and any licensees may encounter significant delays or excessive costs in their respective efforts to secure necessary approvals. Future United States or foreign legislative or administrative acts could also prevent or delay regulatory approval of the Company's or any licensees' products. Failure to obtain requisite governmental approvals or failure to obtain approvals of the scope requested could delay or preclude the Company or any licensees from marketing their products, or could limit the commercial use of the products, and thereby have a material adverse effect on the Company's liquidity and financial condition. Cautionary Statements for the Purposes of the "Safe Harbor" Provisions for "Forward-Looking Statements" Certain statements contained in this report are "forward-looking statements" within the meaning of Section 27A of the Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are subject to risks, uncertainties and other factors, which could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Potential risks and uncertainties include, but are not limited to, the ability of the Company and/or DelSite to obtain sufficient funds to finance DelSite's proposed activities; the ability of DelSite to successfully exploit the Company's new drug delivery technology; the adequacy of the Company's cash resources and cash flow from operations to finance its current operations; the Company's intention, plan or ability to repurchase shares of its outstanding Common Stock; the Company's ability to obtain the quantity or quality of raw materials it needs; and the impact of governmental regulations. For further information about the risks, uncertainties and other factors that could cause the Company's results to differ materially from the results indicated by such forward-looking statements refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Fluctuations in interest rates on any variable rate debt instruments, which are tied to the prime rate, would affect our earnings and cash flows but would not affect the fair market value of the variable rate debt. The Company's exposure to market risk from changes in foreign currency exchange rates and the supply and prices of Aloe vera L. leaves has not changed materially from its exposure at December 31, 2003, as described in the Company's Annual Report on Form 10-K for the year then ended. See also, "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Item 4. Controls and Procedures The Company's management under the supervision and with the participation of its principal executive officer and principal financial officer, evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, its principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. We believe that a controls system, no matter how well designed and operated, can not provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. There have been no significant changes in the Company's internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. Part II OTHER INFORMATION Item 1. Legal Proceedings. On April 3, 2001, Arthur Singer, a former employee of the Company (the "Plaintiff"), filed a lawsuit entitled Arthur Singer vs. Carrington Laboratories, Inc. and Carlton Turner, CV-01-2084 in the United States District Court for the Eastern District of New York, Long Island Division, alleging multiple causes of action against the Company and its chief executive officer (the "Defendants") and seeking damages in excess of $4.0 million, plus legal fees and expenses. The Plaintiff, who was formerly employed by the Company as a sales representative, alleged in substance that the Company failed to pay the full amount of commissions owed to him; that the Defendants breached an alleged contract of employment with him; that the Company deprived him of the opportunity to exercise some vested stock options, prevented some of his unvested stock options from vesting and caused all of his options to expire earlier than they otherwise would have; and that the Defendants misrepresented that the Company intended to retain him as an employee, fraudulently induced him to remain in its employ and breached alleged covenants of fair dealing. On May 31, 2001, the Defendants filed a motion seeking to have the complaint dismissed or to have the case transferred to Texas. On August 28, 2001, the Defendants' motion to transfer was granted, and the case was transferred to the United States District Court for the Northern District of Texas, Dallas Division, as Case No. 01-CV-1776. The Defendants and Plaintiff then both filed motions for summary judgment. On October 3, 2003, the court denied the Plaintiffs motion for summary judgment and granted Defendants motion for summary judgment for all complaints except three, the alleged damages for which total approximately $56,000. On January 5, 2004, a jury trial was held to settle the remaining claims, with the jury finding for the Plaintiff on one claim, awarding $28,162, plus interest, for unpaid commissions, and finding for the Defendants on a second claim. The judge dismissed the third claim at the end of testimony, citing lack of sufficient evidence to support the Plaintiff's claim. The court awarded no legal fees or expenses to the Plaintiff. Total judgment was for approximately $35,000, which was recorded as of the period ended December 31, 2003. The Company has received notice of Plaintiff's intention to appeal the court's ruling on legal fees. On June 22, 2001, a lawsuit styled Swiss-American Products, Inc. v. G. Scott Vogel and Carrington Laboratories Inc., Cause No. 01-5163-A, was filed in the 193rd Judicial District Court of Dallas County, Texas. On June 25, 2001, the Company was served with this lawsuit, an Ex Parte Temporary Restraining Order, and an Order Appointing Independent Third Party Expert Pursuant to Temporary Restraining Order. The suit alleges, among other things, that Mr. Vogel (the Company's former Vice President, Operations) improperly obtained proprietary information of Swiss-American Products, Inc. ("Plaintiff") from a former employer that manufactured products under contract for Plaintiff, and used that information on behalf of the Company, in breach of certain common law duties and a confidentiality agreement between his former employer and Plaintiff. The suit further alleges that Mr. Vogel and the Company ("Defendants") conspired to unlawfully disclose, convert and misappropriate Plaintiff's trade secrets. The suit seeks permanent injunctive relief, including a permanent injunction prohibiting Defendants from disclosing or using to Plaintiff's disadvantage any confidential proprietary information belonging to Plaintiff which Mr. Vogel allegedly obtained from his former employer, or from developing or marketing products based on Plaintiff's formulas or other information allegedly taken from Mr. Vogel's former employer. The suit also seeks to recover damages in an unspecified amount from Defendants. Following a hearing on July 30, 2001, the trial court entered an order setting the case for trial on July 30, 2002 and granted a temporary injunction that prohibits Defendants from (i) disclosing or using any of Plaintiff's confidential, proprietary or trade secret information; (ii) developing or marketing a wound cleanser product that is the same or substantially the same as reflected in a formula that is at issue in the lawsuit (although this prohibition expressly does not apply to products actively manufactured and sold by the Company before January 1, 2001 using the exact same formula then in effect); and (iii) destroying, concealing, altering, removing or disposing of any documents, files, computer data or other things relating to Plaintiff or Mr. Vogel's former employer, or containing or referring to trade secrets or confidential or proprietary information of Plaintiff or Mr. Vogel's former employer. A trial was held on October 7, 2003. Three days into the proceeding a mistrial was declared due to juror misconduct. The trial judge ordered the two parties to mediate the suit and such mediation is scheduled to occur on May 17, 2004. In the event mediation efforts are not successful, the court has set a new trial date of June 1, 2004. The Company believes that Plaintiff's claims are without merit and intends to vigorously defend against those claims. Item 2. Changes in Securities and Use of Proceeds. EQUITY SECURITIES REPURCHASE PROGRAM In March 2001, the Board of Directors authorized the Company to repurchase up to one million shares of its outstanding Common Stock. The Company believes it has the financial resources necessary to repurchase shares from time to time pursuant to the Board's repurchase authorization. The Company did not repurchase any shares of its outstanding Common Stock during the quarter ended March 31, 2004. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.1 Amendment to Distributor and License Agreement and Supply Agreement with Medline Industries, Inc. dated April 9, 2004 (filed as Exhibit 10.1 to the Company's Form 8-K filed April 22, 2004, and incorporated herein by reference). 32.1 Rule 13a-14(a)/15d-14(a) Certification. 32.2 Rule 13a-14(a)/15d-14(a) Certification. 32.3 Section 1350 Certification. 32.4 Section 1350 Certification. (b) Reports on Form 8-K The Company did not file any reports on Form 8-K for the quarter ended March 31, 2004. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CARRINGTON LABORATORIES, INC. (Registrant) Date: May 12, 2004 By: /s/ Carlton E. Turner ----------------------------- Carlton E. Turner, President and Chief Executive Officer (principal executive officer) Date: May 12, 2004 By: /s/ Robert W. Schnitzius ----------------------------- Robert W. Schnitzius, Vice President and Chief Financial Officer (principal financial and accounting officer) INDEX TO EXHIBITS Item Description No. 10.1 Amendment to Distributor and License Agreement and Supply Agreement with Medline Industries, Inc. dated April 9, 2004 (filed as Exhibit 10.1 to the Company's Form 8-K filed April 22, 2004, and incorporated herein by reference). 31.1 CEO Certification of SEC Reports Pursuant to Rule 13a-14(a)/15d- 14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 CFO Certification of SEC Reports Pursuant to Rule 13a-14(a)/15d- 14(a), as adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 CEO Certification of SEC Reports Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 CFO Certification of SEC Reports Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.