10-Q 1 cli04q3.txt FORM 10Q QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 September 30, 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 November 5, 2004 was 10,667,350. INDEX Page ---- Part I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets at September 30, 2004 (unaudited) and December 31, 2003 3 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003 (unaudited) 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited) 6 Notes to Condensed Consolidated Financial Statements (unaudited) 7 Item 2. Management's Discussion and Analysis of 12 Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures 18 About Market Risk Item 4. Controls and Procedures 19 Part II. OTHER INFORMATION Item 1. Legal Proceedings 19 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 21 Item 6. Exhibits 21 PART I - FINANCIAL INFORMATION Item 1. Financial Statements Carrington Laboratories, Inc. Condensed Consolidated Balance Sheets (Amounts in thousands) September 30, December 31, 2004 2003 ------ ------ (unaudited) ASSETS: Current Assets: Cash and cash equivalents $ 3,165 $ 1,920 Accounts receivable, net 2,110 3,098 Inventories, net 4,769 5,960 Prepaid expenses 449 253 ------ ------ Total current assets 10,493 11,231 Property, plant and equipment, net 11,154 10,538 Customer relationships, net 632 777 Other assets, net 197 238 ------ ------ Total assets $22,476 $22,784 ====== ====== LIABILITIES AND SHAREHOLDERS' EQUITY: Current Liabilities: Line of credit $ 1,587 $ 1,587 Accounts payable 1,237 2,037 Accrued liabilities 1,306 1,604 Current portion of long-term debt and capital lease obligations 1,180 1,104 Deferred revenue 2,690 1,880 ------ ------ Total current liabilities 8,000 8,212 Long-term debt and capital lease obligations 1,420 1,953 SHAREHOLDERS' EQUITY: Common stock 107 104 Capital in excess of par value 53,611 53,000 Accumulated deficit (40,659) (40,482) Treasury stock at cost (3) (3) ------ ------ Total shareholders' equity 13,056 12,619 ------ ------ Total liabilities and shareholders' equity $22,476 $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 September 30, 2004 2003 ------ ------ Revenue: Net product sales $ 6,991 $ 6,915 Royalty income 617 617 Grant income, DelSite 121 - ------ ------ Total revenue 7,729 7,532 Cost of sales 4,391 5,035 ------ ------ Gross margin 3,338 2,497 Expenses: Selling, general and administrative 1,929 2,046 Research and development 256 288 Research and development-DelSite 997 623 Other income - (56) Interest expense, net 52 62 ------ ------ Income (loss) before income taxes 104 (466) Provision for income taxes - - ------ ------ Net income (loss) $ 104 $ (466) ====== ====== Basic and diluted earnings (loss) per share $ 0.01 $ (0.05) Basic average shares outstanding 10,656 10,141 Diluted average shares outstanding 11,507 10,141 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) Nine Months Ended September 30, 2004 2003 ------ ------ Revenue: Net product sales $ 20,898 $20,545 Royalty income 1,852 1,853 Grant income, DelSite 310 - ------ ------ Total revenue 23,060 22,398 Cost of sales 13,778 14,256 ------ ------ Gross margin 9,282 8,142 Expenses: Selling, general and administrative 5,867 5,891 Research and development 710 665 Research and development-DelSite 2,762 1,962 Other income (37) (124) Interest expense, net 157 174 ------ ------ Income (loss) before income taxes (177) (426) Provision for income taxes - - ------ ------ Net income (loss) $ (177) $ (426) ====== ====== Basic and diluted earnings (loss) per share $ (0.02) $ (0.04) Basic and diluted average shares outstanding 10,559 10,054 The accompanying notes are an integral part of these statements. Carrington Laboratories, Inc. Condensed Consolidated Statements of Cash Flows (unaudited) (Dollar amounts in thousands) Nine Months Ended September 30, 2004 2003 ------ ------ Cash flows used in operating activities Net income (loss) $ (177) $ (426) Adjustments to reconcile net income (loss) to net cash used in operating activities: Provision for bad debts 22 75 Provision for inventory obsolescence 135 200 Depreciation and amortization 1,009 991 Changes in assets and liabilities: Receivables 966 (1,865) Inventories 1,056 (1,863) Prepaid expenses (196) 119 Other assets 41 48 Accounts payable and accrued liabilities (1,099) 673 Deferred revenue 810 88 ------ ------ Net cash provided by (used in) operating activities 2,567 (1,960) ------ ------ Investing activities: Purchases of property, plant and equipment (1,479) (1,392) ------ ------ Net cash used in investing activities (1,479) (1,392) Financing activities: Proceeds from debt issuance 350 1,500 Principal payments on debt and capital lease obligations (807) (442) Issuances of common stock 614 322 ------ ------ Net cash provided by financing activities 157 1,380 ------ ------ Net increase (decrease) in cash and cash equivalents 1,245 (1,972) Cash and cash equivalents, beginning of period 1,920 3,636 ------ ------ Cash and cash equivalents, end of period $ 3,165 $ 1,664 ====== ====== Cash paid during the period for interest $ 157 $ 174 Cash paid during the period for federal, state and local income taxes 8 32 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 September 30, 2004, the condensed consolidated statements of operations for the three and nine month periods ended September 30, 2004 and 2003 and the condensed consolidated statements of cash flows for the nine month periods ended September 30, 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) 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 except per share data) 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 Nine Months Ended September 30, September 30, 2004 2003 2004 2003 ---------------------------------------------------------------------------- Net income (loss) (in thousands): As reported $ 104 $ (466) $ (177) $ (426) Less: Stock-based compensation expense determined under fair value-based method (100) (110) (1,050) (330) ------ ------ ------ ------ Pro forma net income (loss) $ 4 $ (576) $(1,227) $ (756) ====== ====== ====== ====== Net income (loss) per share: As reported $ 0.01 $ (0.05) $ (0.02) $ (0.04) Pro forma $ - $ (0.05) $ (0.12) $ (0.08) 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. (3) Net Income (Loss) Per Share: Basic Earnings Per Share ("EPS") calculations are based on the weighted- average number of common shares outstanding during the period, while diluted EPS calculations are calculated using the weighted-average number of common shares and dilutive common share equivalents outstanding during each period. The Company's average closing price for the period is used to calculate the dilution of stock options in its EPS calculation. The following data shows the amounts used in computing EPS and their effect on the weighted-average number of common shares and dilutive common share equivalents for the three months ended September 30, 2004 and 2003. At September 30, 2004, 775,475 common stock options were excluded from the diluted EPS calculation, as their effect was antidilutive. At September 30, 2003, 1,494,312 common stock options and 50,000 warrants were excluded from the diluted EPS calculation, as their effect was antidilutive. The amounts are rounded to the nearest thousand, except per share amounts. For the three months ended For the three months ended September 30, 2004 September 30, 2003 ------------------------------------ ------------------------------------ Income Shares Per share Income Shares Per share (Numerator) (Denominator) amount (Numerator) (Denominator) amount Basic EPS: ---------- Net income (loss) available to common shareholders $ 104 10,656 $ 0.01 $ (466) 10,141 $ (0.05) Effect of dilutive securities: Stock Options 0 851 0.00 0 0 0.00 ----- ------ ------ ------ ------ ------ Diluted EPS: ------------ Net income (loss) available to common shareholders plus assumed conversions $ 104 11,507 $ 0.01 $ (466) 10,141 $ (0.05) ===== ====== ====== ====== ====== ====== The following data shows the amounts used in computing EPS and their effect on the weighted-average number of common shares and dilutive common share equivalents for the nine months ended September 30, 2004 and 2003. At September 30, 2004, 1,626,664 common stock options were excluded from the diluted EPS calculation as their effect was antidilutive. At September 30, 2003, 1,494,312 common stock options and 50,000 warrants were excluded from the diluted EPS calculation, as their effect was antidilutive. The amounts are rounded to the nearest thousand, except per share amounts. Total options and warrants outstanding as of September 30, 2004 and 2003 were 1,626,664, and 1,544,312, respectively. For the nine months ended For the nine months ended September 30, 2004 September 30, 2003 ------------------------------------ ------------------------------------ Income Shares Per share Income Shares Per share (Numerator) (Denominator) amount (Numerator) (Denominator) amount Basic EPS: ---------- Net income (loss) available to common shareholders $ (177) 10,559 $ (0.02) $ (426) 10,054 $ (0.04) Effect of dilutive securities: Stock Options 0 0 0.00 0 0 0.00 ----- ------ ------ ------ ------ ------ Diluted EPS: ------------ Net income (loss) available to common shareholders plus assumed conversions $ (177) 10,559 $ (0.02) $ (426) 10,054 $ (0.04) ===== ====== ====== ====== ====== ======
(4) 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 and personal 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 42% and 45% of the Company's total revenue during the quarter ended September 30, 2004 and 2003, respectively. Sales to Medline Industries, Inc., ("Medline") a customer in the Medical Services Division, accounted for 31% and 32% of the Company's total revenue during the quarter ended September 30, 2004 and 2003, respectively. Customers with significant receivable balances as of September 30, 2004, defined as amounts in excess of ten percent (10%) of gross receivables included Natural Alternatives, ($660,000) and Medline ($887,000). Of these amounts, $1,238,000 has been collected as of November 5, 2004. (5) Inventories: The following summarizes the components of inventory (in thousands): September 30, December 31, 2004 2003 ------ ------ Raw materials and supplies $ 2,512 $ 3,009 Work-in-process 676 638 Finished goods 2,413 3,048 Less obsolescence reserve (832) (735) ------ ------ Total $ 4,769 $ 5,960 ====== ====== (6) 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 (4.75%) 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 September 30, 2004, there was $432,000 outstanding on the loan. In July 2003, the Company received a loan of $1.0 million 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 (4.75%) 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 September 30, 2004, there was $767,000 outstanding on the loan. The Company also has a $3.0 million 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 (4.75%) 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 September 30, 2004, there was $1,587,000 outstanding on the credit line with $813,000 credit available for operations, net of outstanding letters of credit of $600,000. Effective July 1, 2004, the Company and Comerica negotiated an amendment to the Company's credit facilities, which, among other things, redefined the covenants that require the Company to maintain certain financial ratios. As a result of the amendment, the Company is now, and as of September 30, 2004 was, in compliance with all of the covenant provisions. The new covenants and the Company's position at September 30, 2004 are as follows: Covenant Covenant Requirement Company's Position -------- -------------------- ------------------ Total Net Worth $11,300,000 $12,380,000 Current Ratio 1.60 1.89 Liquidity Ratio 1.75 2.24 The Total Net Worth covenant amount will escalate up to $12,200,000 by December 31, 2004 and maintain at that level until maturity. The Current Ratio and the Liquidity Ratio covenant amount will remain at the same fixed amount until maturity of the loan. Both of the credit facilities with Comerica are cross-collateralized and cross-defaulted. In September 2004, the Company received a loan of $350,000 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 (4.75%) plus 2.5%. The loan is secured by certain of the Company's equipment. The proceeds of the loan are being used in the Company's operations. As of September 30, 2004, there was $347,000 outstanding on the loan. Pursuant to the 2000 Distributor and License Agreement with Medline, the Company is to receive $12.5 million 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 6.5%. As of September 30, 2004, there was $769,000 outstanding on the advance. (7) Income Taxes: The tax effects of temporary differences including net operating loss carryforwards have given rise to net deferred tax assets. At September 30, 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 $43.6 million 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-month and nine-month periods ended September 30, 2004 and 2003, the Company recognized no benefit for income taxes. (8) Contingencies: From time to time in the normal course of business, the Company is a 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. (9) Commitments: In December 2002, the Company purchased certain assets of the Custom Division of Creative Beauty Innovations, Inc. ("CBI"). As part of the purchase price for the acquired assets, 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 transferred customers. The Company recorded royalty expense of approximately $71,000 related to the sale of CBI products to CBI's transferred customers in the quarter ended September 30, 2004. On May 3, 2004, the Company retained Redington, Inc. to provide certain investor relations services. In addition to cash payments for their consulting services, Redington was also granted a non-qualified stock option to purchase 150,000 shares of the Company's Common Stock at a price of $4.15 per share, the closing price on that date. The options are exercisable based upon the attainment of certain sustained share price levels during a defined period of time. (10) 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. ("DelSite"), a research and development subsidiary responsible for the development of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. Prior to January 1, 2004, the Company 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, in 2004 the Company began reporting 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 September 30, 2004 Revenues from unaffiliated customers $ 2,542 $ 5,066 $ 121 $ - $ 7,729 Income (loss) before income taxes (584) 1,564 (876) - 104 Identifiable assets 7,279 10,364 1,021 3,812 22,476 Capital expenditures - 50 617 - 667 Depreciation and amortization 89 209 51 - 349 Quarter ended September 30, 2003 Revenues from unaffiliated customers $ 2,852 $ 4,680 $ - $ - $ 7,532 Income (loss) before income taxes (787) 943 (622) - (466) Identifiable assets 9,575 11,942 279 2,121 23,917 Capital expenditures - 301 - - 301 Depreciation and amortization 105 225 47 - 377 Nine months ended September 30, 2004 Revenues from unaffiliated customers $ 7,942 $14,808 $ 310 $ - $23,060 Income (loss) before income taxes (1,621) 3,896 (2,452) - (177) Capital expenditures - 170 1,309 - 1,479 Depreciation and amortization 259 648 102 - 1,009 Nine months ended September 30, 2003 Revenues from unaffiliated customers $ 8,163 $14,235 $ - $ - $22,398 Income (loss) before income taxes (1,351) 2,887 (1,962) - (426) Capital expenditures 291 919 182 - 1,392 Depreciation and amortization 263 638 90 - 991 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, a research and development subsidiary responsible for the development of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. Prior to January 1, 2004, the Company 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 2000, the Company entered into a Distributor and License Agreement with Medline granting Medline exclusive rights to distribute the Company's wound care products in the US. 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. Since 2001, significant sales, defined as amounts in excess of ten percent (10%) of revenue, were made to two customers: Natural Alternatives and Medline. Sales to Natural Alternatives, a customer in the Consumer Services Division, accounted for 42% and 45% of the Company's total revenue during the quarter ended September 30, 2004 and 2003, respectively. Sales to Natural Alternatives are governed by a joint supply agreement with Natural Alternatives and Mannatech, Inc. ("Mannatech"). Due to the nature of the product and the Company's relationship with Natural Alternatives and Mannatech, the Company expects this supply agreement will be renewed prior to its expiration at the end of November 2004. Sales to Medline, a customer in the Medical Services Division, accounted for 31% and 32% of the Company's total revenue during the quarter ended September 30, 2004 and 2003, respectively. Effective April 9, 2004, the Company entered into an amendment to the Distributor and License Agreement which, among other things, extended the term of the Distributor and License Agreement and the accompanying Supply Agreement through November 30, 2008. 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[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. The Company's Gelsite[R] polymer technology is the basis for the GelVac[TM] Nasal Powder vaccine delivery system, a novel polysaccharide that turns from a powder to a gel upon contact with the nasal fluids, resulting in controlled release and increased nasal residence time of vaccine antigens. Additional revenues to the Company arise from time to time through research grants awarded to DelSite. In March 2004 DelSite received a Small Business Innovation Research (SBIR) grant award of up to $888,000 over a two-year period. The grant will fund additional development of GelVac[TM], DelSite's intranasal vaccine delivery platform technology. In October 2004 DelSite received notification of a $6 million grant over a three-year period from the National Institute of Allergy and Infectious Diseases. The $6 million grant is to fund the development of an inactivated influenza nasal powder vaccine against the H5N1 strain, commonly known as bird flu, utilizing the Company's proprietary GelVac[TM] delivery system. The grant was awarded under a biodefense and SARS product development initiative and will fund a three-year preclinical program. LIQUIDITY AND CAPITAL RESOURCES Cash at September 30, 2004 was $3,165,000 versus $1,920,000 at December 31, 2003. The increase in cash was primarily due to a $1,056,000 reduction in inventory levels, a $966,000 reduction in accounts receivable, the receipt of $350,000 in loan proceeds, the receipt of $1,250,000 from Medline as an advance payment of royalties in consideration of the extended term of the Distributor and License Agreement and proceeds from stock option exercises and employee purchases of shares of $614,000. These cash receipts were partially offset by the Company's investment of $1,479,000 in capital expenditures to acquire operating assets, reduced debt and capital lease obligations of $807,000 and reduced accounts payable and accrued liabilities of $1,099,000. In July 2003, the Company received a loan of $1.0 million 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 (4.75%) 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 September 30, 2004, there was $767,000 outstanding on the loan. The Company also has a line of credit with Comerica that provides for borrowings of up to $3.0 million 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 (4.75%) plus 0.5%. Effective July 1, 2004, the Company and Comerica negotiated an amendment to the Company's credit facilities, which, among other things, redefined the covenants that require the Company to maintain certain financial ratios. As a result of the amendment, the Company is now, and as of September 30, 2004 was, in compliance with all of the covenant provisions. The new covenants and the Company's position at September 30, 2004 are as follows: Covenant Covenant Requirement Company's Position -------- -------------------- ------------------ Total Net Worth $11,300,000 $12,380,000 Current Ratio 1.60 1.89 Liquidity Ratio 1.75 2.24 The Total Net Worth covenant amount will escalate up to $12,200,000 by December 31, 2004 and maintain at that level until maturity. The Current Ratio and the Liquidity Ratio covenant amount will remain at the same fixed amount until maturity of the loan. Both of the credit facilities with Comerica are cross-collateralized and cross-defaulted. As of September 30, 2004, there was $1,587,000 outstanding on the credit line with $813,000 credit available for operations, net of outstanding letters of credit of $600,000. 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 (4.75%) 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 September 30, 2004, there was $432,000 outstanding on the loan. In September 2004, the Company received a loan of $350,000 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 (4.75%) plus 2.5%. The loan is secured by certain of the Company's equipment. The proceeds of the loan are being used in the Company's operations. As of September 30, 2004, there was $347,000 outstanding on the loan. Pursuant to the Distributor and License Agreement with Medline, the Company is to receive $12.5 million in base royalties over a five-year period ending November 30, 2005. Effective April 9, 2004, the Company entered into an Amendment (the "Amendment") to the Distributor and License Agreement. The Amendment modified certain provisions contained in the Distributor and License Agreement and the Supply Agreement. Among other things, the Amendment extends the term of the Distributor and License 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 and License 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 September 30, 2004, the Company had received $2.6 million 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 September 30, 2004 total $1.5 million. 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 September 30, 2004, there was $769,000 outstanding on the advance. The Company anticipates capital expenditures in 2004 of approximately $1.9 million. The Company has spent $1,479,000 in the first nine months of 2004 and anticipates spending $421,000 in the remaining three months of the year. The expenditures will primarily be comprised of production and laboratory equipment and facility modifications. Presently, the Company's debt/equity ratio is 0.72 to 1. Debt includes all current liabilities and long-term debt. Based on its current estimates, management believes that the Company has the capacity to incur additional debt, and, in 2005, the Company may 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 the Company's existing government grant programs related to DelSite, 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 in Costa Rica at prices comparable to the cost of acquiring leaves from the Company's farm. From time to time the Company also imports leaves from other Latin American countries at prices comparable to those in the local market. The Company anticipates that the suppliers it currently uses will be able to meet all of its requirements for leaves for the foreseeable future. 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 September 30, 2004 compared to quarter ended September 30, 2003 Revenue for the quarter ended September 30, 2004 increased 2.6%, or $197,000, to $7,729,000 as compared to $7,532,000 during the quarter ended September 30, 2003. Consumer Services revenue during the third quarter of 2004 increased 8.2%, or $386,000, to $5,066,000 versus $4,680,000 for the same quarter last year. The increase in Consumer Services revenue is primarily attributable to increased raw material sales of $655,000, which resulted from increased demand from Natural Alternatives. This increase was partially offset by decreased sales of cosmetic products of $219,000, which was primarily attributable to lower cosmetic product demand. Medical Services revenue during the quarter ended September 30, 2004 decreased 10.9%, or $310,000, to $2,542,000 as compared to $2,852,000 during the quarter ended September 30, 2003. The decrease in Medical Services revenue was attributable to decreased demand from Medline. Grant revenue in the amount of $121,000 was generated from a Small Business Innovation Research biodefense grant to DelSite. The total amount of the grant awarded was up to $888,000 over a two-year period beginning in March of 2004, 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 $3,338,000 during the quarter ended September 30, 2004 as compared to $2,497,000 during the quarter ended September 30, 2003, an increase of 33.7%. Gross margin as a percentage of revenue grew to 43.2% during the third quarter of 2004 from 33.1% during the same quarter last year. The increase in gross margin was primarily attributable to a favorable shift in the mix of products sold and lower manufacturing variances of $381,000, primarily due to higher production volumes in the United States. Selling, general and administrative expenses during the quarter ended September 30, 2004 decreased $117,000 to $1,929,000 as compared to $2,046,000 during the quarter ended September 30, 2003. This decrease was primarily due to lower legal expenses associated with defending the Company against claims made by Swiss American Products, Inc. and Arthur Singer. Product-support research and development during the quarter ended September 30, 2004 decreased to $256,000 as compared to $288,000 during the quarter ended September 30, 2003. The Company continues to focus the efforts of this group on product development in support of its manufacturing business. DelSite expenses during the quarter ended September 30, 2004 increased $374,000 or 60.0% to $997,000 as compared to $623,000 during the quarter ended September 30, 2003, as product development efforts for injectible and intranasal delivery platforms continued and business development efforts increased. Net interest expense during the quarter ended September 30, 2004 decreased $10,000 from the quarter ended September 30, 2003 to $52,000, as a result of lower debt balances. Net income for the third quarter of 2004 was $104,000 as compared to net loss of $466,000 for the same quarter last year, an increase of $570,000 based on the factors described above. Earnings per share for the third quarter 2004 were $0.01 compared to a loss per share of $0.05 for the third quarter of 2003. Nine months ended September 30, 2004 compared to nine months ended September 30, 2003 Revenue for the nine months ended September 30, 2004 increased $662,000, or 3.0%, to $23,060,000 as compared to $22,398,000 for the nine months ended September 30, 2003. Consumer Services revenue for the nine months ended September 30, 2004 increased $573,000, or 4.0%, to $14,808,000 as compared to $14,235,000 for the nine months ended September 30, 2003. The increase in Consumer Services revenue was primarily due to increased raw material sales of $2,032,000 to Natural Alternatives. This was partially offset by decreased sales of cosmetic products of $507,000, attributable to lower cosmetic product demand, and decreased specialty manufacturing sales of $952,000, which was primarily attributable to decreased sales to a major customer. Medical Services revenue during the nine months ended September 30, 2004 decreased $221,000, or 2.7%, to $7,942,000 as compared to $8,163,000 for the nine months ended September 30, 2003. The decrease in Medical Services revenue was attributable to decreased demand from Medline. Gross margin for the nine months ended September 30, 2004 increased $1,140,000, or 14.0%, to $9,282,000 as compared to $8,142,000 for the nine months ended September 30, 2003. Gross margin as a percentage of revenue increased to 40.3% for the nine months ended September 30, 2004 from 36.3% for the nine months ended September 30, 2003. The increase in gross margin was attributable to a shift in the mix of products toward higher margin product sales and lower manufacturing variances of $258,000 that was primarily attributable to higher production volumes in the United States. Selling, general and administrative expenses for the nine months ended September 30, 2004 decreased $24,000, or 0.4%, to $5,867,000 as compared to $5,891,000 for the nine months ended September 30, 2003. Product-support research and development for the nine months ended September 30, 2004 increased to $710,000 as compared to $665,000 for the nine months ended September 30, 2003 primarily due to additional formulation development activities as the Company pursues new customers. The Company continues to focus the efforts of this group on product development in support of its manufacturing business. DelSite expenses for the nine months ended September 30, 2004 increased $800,000, or 40.8%, to $2,762,000 as compared to $1,962,000 for the nine months ended September 30, 2003 as product development efforts for injectible and intranasal delivery platforms continued and business development efforts increased. Net interest expense for the nine months ended September 30, 2004 decreased $17,000 to $157,000 as compared to $174,000 for the nine months ended September 30, 2003, primarily due to lower debt balances. Net loss for the nine months ended September 30, 2004 decreased $249,000 to $177,000 from a net loss of $426,000 for the nine months ended September 30, 2003. The decrease is primarily due to the factors described above. Loss per share for the nine months ended September 30, 2004 was $0.02 as compared to a loss per share of $0.04 for the nine months ended September 30, 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 the Company's 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, cannot 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 changes in the Company's internal control over financial reporting during its 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. On June 23, 2004, the United States District Court denied the Plaintiff's appeal for reasonable legal fees. On July 7, 2004, the Plaintiff filed a motion of appeal with the Fifth Circuit Court regarding all judgments entered by the District Court. 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 subsequently ordered the two parties to mediate the suit and such mediation was held on May 17, 2004. Despite the efforts of the mediator, the parties were unable to reach a settlement. Although a trial date had been set for June 1, 2004, the court later moved the trial start date to September 21, 2004. Due to the Court's striking of the economic damage model provided by the Plaintiff's expert witness, a motion for continuance was filed and accepted by the Court postponing the trial start date until June 21, 2005. The Company believes that Plaintiff's claims are without merit and intends to vigorously defend against those claims. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds (c) 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 September 30, 2004. Item 6. Exhibits 10.1 Certificate of Pledge between Sabila Industrial, S.A., a Costa Rica Corporation and wholly-owned subsidiary of Carrington Laboratories, Inc. and Banco Credito Agricola de Cartago dated August 6, 2004. (portions of this exhibit have been omitted pursuant to a request for confidential treatment) 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. 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: November 11, 2004 By: /s/ Carlton E. Turner ----------------------------- Carlton E. Turner, President and Chief Executive Officer (principal executive officer) Date: November 11, 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 Certificate of Pledge between Sabila Industrial, S.A., a Costa Rica Corporation and wholly-owned subsidiary of Carrington Laboratories, Inc. and Banco Credito Agricola de Cartago dated August 6, 2004. (portions of this exhibit have been omitted pursuant to a request for confidential treatment) 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.