-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OrDiMHyK2uB88fRAw4H3EJDgzzwp4hMSRWyu9maQKl/6H2rrGQgjSKkwxpXD/0Zx ww9BxPPDcsz5SR7HEKKDyw== 0000950137-04-007671.txt : 20040913 0000950137-04-007671.hdr.sgml : 20040913 20040913154517 ACCESSION NUMBER: 0000950137-04-007671 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 20040630 FILED AS OF DATE: 20040913 DATE AS OF CHANGE: 20040913 FILER: COMPANY DATA: COMPANY CONFORMED NAME: D & K HEALTHCARE RESOURCES INC CENTRAL INDEX KEY: 0000888914 STANDARD INDUSTRIAL CLASSIFICATION: WHOLESALE-DRUGS PROPRIETARIES & DRUGGISTS' SUNDRIES [5122] IRS NUMBER: 431465483 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-20348 FILM NUMBER: 041027569 BUSINESS ADDRESS: STREET 1: 8235 FORSYTH BLVD STREET 2: . CITY: ST. LOUIS STATE: MO ZIP: 63105 BUSINESS PHONE: 3147273485 MAIL ADDRESS: STREET 1: 8235 FORSYTH BLVD STREET 2: . CITY: ST. LOUIS STATE: MO ZIP: 63105 FORMER COMPANY: FORMER CONFORMED NAME: D & K WHOLESALE DRUG INC/DE/ DATE OF NAME CHANGE: 19930328 10-K 1 c88104e10vk.txt ANNUAL REPORT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended June 30, 2004 Commission File Number 0-20348 D & K HEALTHCARE RESOURCES, INC. (Exact name of registrant as specified in its charter) Delaware 43-1465483 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 8235 Forsyth Boulevard, St. Louis, Missouri (Address of principal executive offices) 63105 (Zip Code) (314) 727-3485 Registrant's telephone number, including area code Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 Series B Junior Participating Preferred Stock Purchase Rights (Title of Class) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] State the aggregate market value of the voting stock held by non-affiliates of the registrant: approximately $135,319,457 as of September 7, 2004. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date: As of September 07, 2004, 14,057,449 shares of Common Stock, par value $.01, were outstanding. Indicate by check mark whether the registrant is an accelerated filer. Yes [X] No [ ] DOCUMENTS INCORPORATED BY REFERENCE Portions of the following documents are incorporated by reference in the Part of this report indicated below: Part II - Registrant's 2004 Annual Report to Stockholders Part III - Registrant's Proxy Statement for its 2004 Annual Meeting of Stockholders 1 PART I Item 1. Business GENERAL D&K Healthcare Resources, Inc. is a full-service wholesale distributor of branded and generic pharmaceuticals and over-the-counter healthcare and beauty aid products. We serve three classes of customers: - INDEPENDENT AND REGIONAL PHARMACIES: Located in 27 states primarily in the Midwest, Upper Midwest and South, these D&K customers generally operate single or multisite locations in one or more states. - NATIONAL ACCOUNTS: D&K national account customers generally operate a large number of locations in multiple regions of the United States. - OTHER HEALTHCARE PROVIDERS: These D&K customers include hospitals, alternate-site care providers and pharmacy benefit management companies located in our 27-state primary distribution territory. We serve our customers by distributing a broad range of products through eight distribution facilities located in Missouri, Kentucky, Minnesota, Arkansas, South Dakota and Texas. We also offer a number of proprietary information systems, marketing programs and other business management solutions to assist customers in operating and growing their businesses. In addition, D&K owns a 70 % equity stake in Pharmaceutical Buyers, Inc. ("PBI"), an industry leader in alternate site group purchasing services located in Broomfield, CO. In June 2004, the Company reached agreement to acquire the remaining 30% interest in PBI, and is expected to close this transaction by September 30, 2004. Sales to independent and regional pharmacies consist of branded pharmaceuticals (approximately 89% of net sales in fiscal 2004), generic pharmaceuticals (approximately 8% of net sales in fiscal 2004) and over-the-counter health and beauty aid products (approximately 3% of net sales in fiscal 2004). Our national accounts trade class sales are predominantly branded pharmaceuticals. On December 5, 2003, the Company acquired 100 % of the outstanding common stock of Walsh HealthCare Solutions, Inc. ("Walsh") of Texarkana, Texas. Walsh is a full-service pharmaceutical distributor with distribution centers located in San Antonio, Texas and Paragould, Arkansas. On March 13, 2002, we declared a two-for-one stock split in the form of a stock dividend effective April 12, 2002. We have adjusted all share and per share amounts in this report and in the consolidated financial statements to retroactively reflect this stock split. On July 5, 2001, we completed a secondary stock offering of approximately 4.8 million shares of our common stock. We used the net proceeds of approximately $77 million to repay debt. In July 2001, as part of the secondary stock offering, we increased our ownership percentage in PBI to 68%, and in August 2001 we increased our ownership another 2%. We increased our ownership by exchanging PBI stock for shares of D&K common stock as provided for in the acquisition agreement for our initial 50% ownership interest. We describe these transactions more fully in Note 2 to our consolidated financial statements. On June 15, 2001, we acquired 100% of the outstanding stock of Diversified Healthcare, LLC, a pharmaceutical distribution company based in Owensboro, Kentucky that provides comprehensive pharmaceutical distribution services to customers in the Midwest region. On June 1, 1999, we acquired 100% of the outstanding stock of Jewett Drug Co., a pharmaceutical distribution company based in Aberdeen, South Dakota that provides comprehensive pharmaceutical distribution services to customers in the Upper Midwest and Great Plains regions. We believe that our size, decentralized operating structure and high level of customer service provide us with competitive advantages and position us to benefit from trends impacting our industry. The national wholesale distributors are growing in size and scale as they pursue a strategy to become primary distributors to national pharmacies and other large healthcare providers. We believe their approach creates opportunities for us to effectively compete with them based on our business focus and differentiated service offering. 2 INDUSTRY OVERVIEW Wholesale pharmaceutical distributors serve pharmacies and healthcare providers as a single source for pharmaceutical and over-the-counter health and beauty aid products from hundreds of different manufacturers. Wholesale pharmaceutical distributors lower customer inventory costs, provide efficient and timely product delivery, and provide valuable inventory and purchasing information. Also, value-added programs developed by wholesale pharmaceutical distributors, including packaging, stockless inventory and pharmacy computer systems, help customers reduce costs and improve operating efficiencies. Wholesale pharmaceutical distributors are an important distribution channel for pharmaceutical manufacturers, accounting for approximately 73% of the $212.7 billion of prescription drug sales to retailers and institutions during 2003. Wholesale pharmaceutical distribution industry sales increased from $2.4 billion in 1970 to an estimated $155.2 billion in 2003, growth we expect to continue. Several principal factors contribute to this historical and anticipated growth: - AGING POPULATION: The number of individuals in the United States over age 65 grew from approximately 12.3 million in 1950 to approximately 35 million in 2000; the U.S. Census Bureau projects it will increase to more than 70 million by the year 2030. This demographic group represents the largest percentage of new prescriptions filled and obtains more prescriptions per capita annually than any other age group. - INCREASED PHARMACEUTICAL USE: In recent years, a number of factors have contributed to the growth in drug-based therapies to prevent and treat disease. These include increased research and development spending by manufacturers leading to new pharmaceutical introductions, the lower costs of drug-based therapy relative to surgery, and increased direct-to-consumer advertising by manufacturers. - IMPORTANCE OF WHOLESALE DISTRIBUTION CHANNEL: In response to the rising costs and complexity of inventory management and product distribution, pharmaceutical manufacturers are relying increasingly on wholesale distributors to fill these functions more efficiently. Over the past decade, as the cost and complexity of maintaining inventories and arranging for delivery of pharmaceutical products have risen, manufacturers of pharmaceuticals have significantly increased the distribution of their products through wholesalers. Drug wholesalers are generally able to offer their customers and suppliers more efficient distribution and inventory management than pharmaceutical manufacturers. As a result, from 1990 to 2003, the percentage of total pharmaceutical sales through wholesale distributors increased from approximately 57% to approximately 73%. - RISING PHARMACEUTICAL PRICES. For more than a decade, the manufacturers' price increases for branded pharmaceuticals have met or exceeded the overall increases in the Consumer Price Index. We believe this trend will continue largely because the relatively inelastic demand for branded pharmaceuticals supports the higher prices charged for patented drugs as manufacturers attempt to recoup costs associated with developing, testing, and seeking U.S. Food and Drug Administration approval of new products. From 1990 to 2003, the average retail price of a prescription increased from $22.06 to $57.48. CUSTOMERS AND PRODUCTS Our customer base consists of independent and regional pharmacies, national pharmacy chains (national accounts), and other healthcare providers. Independent pharmacies are generally community-based and, we believe, benefit the most from our customized sales, information systems, and other value-added services. Regional pharmacies generally focus on serving people from multiple sites in one or more states. National accounts generally have stores located in more than one region in the United States; they include supermarket and mass merchandiser pharmacies. Other healthcare providers consist of hospitals, other alternate-site care providers (including nursing homes, clinics, home health services and managed care organizations), and pharmacy benefit management companies. We are committed to serving the unique needs of independent and regional pharmacies and have structured our business and operating model to do this efficiently and profitably. We operate on a fiscal year-end of June 30. Unless otherwise indicated, all further references to "2004," "2003," and "2002" in this document will mean our fiscal years ended June 30, 2004, June 30, 2003, and June 30, 2002, respectively. 3 NET SALES
2004 2003 2002 --------------------- --------------------- --------------------- (Dollars In Thousands) AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT ----------- ------- ----------- ------- ----------- ------- Independent and regional pharmacies $ 1,820,312 71.6% $ 1,156,460 52.0% $ 1,089,326 44.4% National accounts 593,733 23.4% 929,582 41.8% 1,246,654 50.8% Other healthcare providers 113,697 4.5% 126,333 5.7% 107,517 4.4% PBI / Software sales 13,448 0.5% 11,013 0.5% 10,251 0.4% ----------- ------ ----------- ------ ----------- ------ Total $ 2,541,190 100.0% $ 2,223,388 100.0% $ 2,453,748 100.0% =========== ====== =========== ====== =========== ======
During 2004, 2003 and 2002, our 10 largest customers accounted for approximately 28.4%, 43.1%, and 56.4%, respectively, of our net sales. Our largest customer during 2004 accounted for approximately 7% of our net sales. Our largest customer in 2003 and 2002 accounted for approximately 9% and 24% of our net sales, respectively. Independent and Regional Pharmacies Since our inception, one of our primary strategies has been to focus on serving the specialized needs of independent and regional pharmacies. While our larger national competitors increasingly organize their businesses around serving the primary needs of national pharmacy chains and national contracts with group purchasing organizations and pharmacy benefit managers, we are organized to profitably and efficiently provide all of our services to our independent and regional pharmacy customers in 27 states, primarily in the Midwest, Upper Midwest, and South from our seven full-service distribution centers in six states. Our independent and regional pharmacy business grew from $1,089.3 million in net sales in 2002 to $1,820.3 million in 2004. Our product offerings to independent and regional pharmacies consist of more than 40,000 SKUs, including branded and generic pharmaceuticals and over-the-counter health and beauty aid products. We deliver these products directly to the stores of our independent pharmacy customers and deliver both to the stores and warehouses of our regional pharmacy customers if they maintain centralized inventory. Our decentralized organization allows our distribution centers to form strong, attentive and responsive business relationships with our independent and regional pharmacy customers. Each center has the personnel and capabilities to autonomously provide customized distribution, information systems, inventory management and other services to our local independent and regional pharmacy customers. We fulfill our customers' orders with a high degree of speed and accuracy and we believe that they value our flexibility and willingness to meet and accommodate their special requests and needs. We believe that the large national wholesale distributors, which are organized to serve primarily large national pharmacies and national contracts, do not have the operating flexibility to service independent and regional pharmacies as we do. National Accounts We have a significant business serving as a secondary supplier of high-volume branded pharmaceuticals to national pharmacies and other national accounts that is built on our strong independent and regional pharmacy business and our competitive position and solid relationships with pharmaceutical manufacturers. We provide our national account customers with more than 2,800 branded and generic bulk pharmaceuticals that we purchase from pharmaceutical manufacturers on favorable terms. Our net revenues from these sales have fallen from $1,246.7 million in 2002 to $593.7 million in 2004, primarily due to changes in pharmaceutical manufacturers' inventory management practices that reduced the availability of attractively priced purchase opportunities. As a percentage of our total net sales, national accounts has fallen from 42% in 2003 to 23% in 2004. We anticipate that in future periods this percentage will be in the 10-15% range of total net sales as independent and regional pharmacy sales continue to grow. We provide our national accounts customers bulk pharmaceuticals that we purchase, if available, on favorable terms from the manufacturers. If we are unable to obtain bulk inventory on favorable terms, our sales in this area will continue to decline. Our industry is subject to regulations that require organizations that distribute or sell pharmaceuticals to trace the detailed history of products back to the manufacturer or an authorized distributor. We purchase the vast majority of our pharmaceuticals directly from manufacturers; the balance comes directly from authorized distributors or otherwise 4 is obtained in accordance with applicable law. We believe our reputation and conservative business practices make us a desirable business partner for pharmaceutical manufacturers and national pharmacy chains. We use our longstanding manufacturer and national account relationships to provide services that benefit both our customers and our suppliers. We have developed and maintain the reputation and contacts that enable us to identify opportunities to purchase branded pharmaceuticals from manufacturers at attractive prices. In addition to our experience and expertise, we also employ sophisticated information and inventory management systems to project the demand for products in advance of purchasing them for distribution. Additional Services Consistent with our strategy to offer a high level of customer service to our customers, we offer a number of proprietary information systems, marketing, and other business management solutions to help customers operate and grow their businesses profitably. Through our Tykon, Inc. subsidiary, we have developed and market a proprietary order entry and confirmation system to the drug distribution industry. We offer and fully support these services from our distribution centers. Although we make these services available to all customers, our independent pharmacy customers profit most from these services and are the heaviest users. Our services and support provide independent and regional pharmacies with resources normally available only to larger businesses. In providing these resources, we believe that we enable them to operate more efficiently and competitively and that we increase our value to them. Principal elements of our service offering to our customers include: - Order entry and confirmation systems: These include DirectKonnect(SM), a proprietary order entry/order confirmation system, that completely automates all order creation, transmission and confirmation operations, and PARTNERS(SM), a fully automated and customizable replenishment software system which helps pharmacies more efficiently coordinate product supply and demand. These proprietary order entry and confirmation systems help customers improve their margins and significantly reduce their working capital needs through effective inventory management. - Dispensing management systems: SCRIPTMASTER(R) gives customers computerized order entry, point-of-sale capabilities, inventory control, patient histories, drug interactions and pharmacy reimbursement. This service provides pharmacies with cost savings and enhanced efficiencies as well as manufacturers with valuable prescription histories. - Merchandising and marketing services: Under our MedPlus(R) identity program, we plan and coordinate cooperative advertising programs for our customers and provide various promotional products, including single-source generics from leading pharmaceutical manufacturers at highly competitive prices. MedPlus(R) also offers new product introduction programs, point-of-sale materials, calendars, blood pressure testing units, automatic new product distribution, rack jobbing, store fixtures and retail employee training programs. Other services offered under MedPlus(R) include: retail merchandising, inventory management systems, electronic order entry, shelf labels and price stickers, private label products, monthly feature promotions, home healthcare marketing programs, store layout assistance, business management reports, pharmacy computer systems and monthly catalogs. OPERATIONS We are an organization of locally managed pharmaceutical wholesale distribution centers. Each distribution center has its own executive, sales and operations staff. These operations use our corporate staff for procurement, marketing, financial, legal, information systems and executive management resources; the corporate staff also manages assets and working capital. Our decentralized sales and distribution network, combined with our centralized procurement and corporate support, enable us to provide high levels of specialized customer service while minimizing administrative expenses and maximizing volume discounts for product purchases. Our distribution centers include computer systems and sophisticated materials handling equipment for receiving, storing and distributing large quantities and varieties of products. We continuously seek to improve our warehouse automation technologies to maximize operational efficiencies on a cost-effective basis. Our distribution centers receive virtually all orders electronically and, upon receipt, the warehouse-management system produces "picking documents" that contain product selection, loading and truck routing information. The system also provides customized price information (geared to the customers' local markets) or individual price stickers that accompany 5 each shipment to facilitate the customers' item pricing. Our distribution centers can ship virtually all orders in less than 24 hours after customers place them. We deliver orders using our fleet of trucks and vans or contract carriers. During the fourth quarter of fiscal 2004, we completed the expansion of our Cape Girardeau, Missouri distribution center. We added 60,000 square feet to the existing building to nearly double the size of the facility. In addition to expanding the facility size, we installed new automated machinery and equipment including sophisticated materials handling equipment for receiving, storing and distributing large quantities and varieties of products. SALES AND MARKETING We employ sales and customer service representatives at each of our distribution centers. Our sales representatives receive regular training to continuously improve customer service and to provide them with the skills and resources for increasing business with existing customers and establishing new customer relationships. Each distribution center also maintains a telephone-based customer service department staffed with trained representatives who answer customer questions and solve problems. We focus our marketing efforts on developing and maintaining primary relationships with customers. Our sales force emphasizes frequent personal interaction with customers, who come to rely on our dependability and responsiveness, order accuracy and the breadth of our product line. Our customers also rely on our sales force for assistance with advertising, merchandising, stocking and inventory management. We believe that our distribution center-based service differentiates us from our national competitors; it is a key element in our marketing program. Our decentralized customer service staffs focus on developing relationships with customers, responding quickly to customer inquiries, and placing orders accurately and efficiently. In July 2003, we entered into an agreement with Parata Systems, LLC to become the exclusive distributor of their robotic dispensing system (RDS) for independent and regional pharmacies in a 23-state region and Puerto Rico. The Parata RDS is specifically designed to meet the needs of retail pharmacies by automating up to 150 prescriptions per hour. The RDS uses a bar-coded maintenance system to ensure accuracy and eliminate potential for operator error. Faced with shortages of qualified pharmacists and pharmacy technicians, the Parata RDS can be a significant tool to increase efficiency, effectiveness and accuracy, and provide pharmacists with more time for interactions with patients. PURCHASING AND INVENTORY CONTROL We use sophisticated inventory control and purchasing software to track inventory, analyze demand history, and project future demand. Our system is designed to enhance profit margins by eliminating the manual ordering process, allowing for automatic inventory replenishment, and identifying inventory buying opportunities. We purchase products from approximately 1,200 suppliers. During 2004 and 2003, our 10 largest suppliers accounted for approximately 54% and 57%, respectively, of our purchases by dollar volume. Our largest supplier accounted for approximately 16% (by dollar volume) of our purchases during 2004 and approximately 8% (by dollar volume) of our purchases during 2003. The increase in percentage purchases from our largest single supplier between 2004 and 2003 was primarily the result of an industry merger. The majority of our supply contracts are terminable by either party upon short notice and without penalty, a common industry practice. We believe that our relationships with our suppliers are strong. MANAGEMENT INFORMATION SYSTEMS Each of our distribution centers operates as a distinct business with complete system functionality including sales order, inventory, and transportation management; customer service; accounts payable and receivable; general ledger; and financial reporting. We use the PeopleSoft EnterpriseOne, formerly JD Edwards OneWorld(TM), product as our Enterprise Resource Planning (ERP) software package to integrate all these functions, which were previously maintained separately by each distribution center. Completed in July 2003, the new system consolidates operations in St. Louis and Cape Girardeau, Missouri, and provides us with significantly improved operations management and financial reporting systems. We are in process of converting the Walsh distribution centers to our system. The Paragould location was converted in July 2004 and the San Antonio location is scheduled to be converted in the second quarter of fiscal 2005. 6 BUYING GROUP In November 1995, we purchased 50% of Pharmaceutical Buyers, Inc. (PBI), a Colorado-based group purchasing organization. PBI, with over 3,600 member organizations, is one of the largest pharmaceutical group purchasing organizations in the United States. PBI's members include long-term care providers, home infusion providers and medical equipment distributors. In connection with our secondary stock offering in July 2001, we increased our ownership in PBI to 68%, and acquired an additional 2% in a subsequent transaction in August 2001. The resulting consolidation of PBI's operations increased our gross profit and gross margin percentage but had no effect on earnings per share. PBI represented 0.3% of our net sales in both 2004 and 2003 and 8.5% and 8.6% of our gross profit in 2004 and 2003, respectively. In June 2004, the Company reached agreement to acquire the remaining 30% interest in PBI for $12.4 million. This transaction is subject to certain financing contingencies, but is expected to close by September 30, 2004. COMPETITION The wholesale distribution of branded and generic pharmaceuticals and over-the-counter health and beauty aid products, is highly competitive. National and regional distributors compete primarily on the basis of service and price. Other competitive factors include delivery service, credit terms, breadth of product line, customer support, merchandising and marketing programs. We compete with national, regional, and other wholesale distributors, pharmaceutical manufacturers, generic pharmaceutical telemarketers and specialty distributors for product purchases and financial support in the form of trade credit from manufacturers. Certain of our competitors, including McKesson Corporation, AmerisourceBergen Corporation, and Cardinal Health, Inc., have significantly greater financial and marketing resources. EMPLOYEES As of August 31, 2004, we employed 784 persons; 737 were full-time employees. Approximately 31 employees at our Minneapolis distribution center are covered by a collective bargaining agreement with the Miscellaneous Drivers, Helpers and Warehousemen's Union, Local 638, which expires in March 2008. Approximately 14 employees at our Jewett Drug Co. subsidiary are covered by a collective bargaining agreement with the General Drivers and Helpers Union Local 749, affiliated with the International Brotherhood of Teamsters, which expires February 29, 2008. We believe we have good employee relations. FORWARD-LOOKING STATEMENTS Certain statements in this document regarding future events, prospects, projections or financial performance are forward looking statements. Such forward looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and may be identified by words such as "anticipates," "believes," "estimates," "expects," "intends" and similar expressions. Such forward-looking statements are inherently subject to risks and uncertainties such as those listed below and elsewhere in this report, which among others, should be considered in evaluation our future financial performance. The reader should not place undue reliance on forward-looking statements, which speak only as of the date they are made. D&K Healthcare undertakes no obligation to publicly update or revise any forward-looking statements. FACTORS THAT MAY IMPACT FUTURE RESULTS The risks and uncertainties described below are those that we currently believe may materially affect our company. Other risks and uncertainties that we do not presently consider to be material or of which we are not presently aware may become important factors that affect our Company in the future. If any of the risks discussed below actually occur, our business, financial condition, operating results, cash flows or prospects could be materially adversely affected. INTENSE COMPETITION IN THE WHOLESALE PHARMACEUTICAL DISTRIBUTION INDUSTRY COULD CAUSE OUR SALES AND MARGINS TO DECLINE. The wholesale distribution of pharmaceuticals is highly competitive, with national and regional distributors competing primarily on the basis of service and price. Other competitive factors include delivery service, credit terms, breadth of product line, customer support and merchandising, information system services and marketing programs. We compete with: 7 - large, national distributors; - local and regional wholesalers; - manufacturers; - generic pharmaceutical telemarketers; and - specialty distributors. Our national competitors have significantly greater financial, distribution and marketing resources than we do. Moreover, our industry has experienced significant consolidation in recent years and, as a result, some of our competitors have significantly increased their advantage in such resources. Additionally, the products we distribute are generally available to our customers from multiple sources and many of our customers also utilize other wholesale distributors. Our competitors could obtain exclusive rights from manufacturers to market particular products that currently are not subject to exclusive distribution arrangements or which are currently distributed by us, which could cause us to lose sales or customers and our margins could decline. In addition, manufacturers could elect to sell a higher proportion of their products directly to customers, which would decrease the demand for such products from wholesale distributors and increase competition. We cannot assure you that we will not encounter increased competition in the future or that we will be able to keep our market share because of the high level of competition in our industry. OUR BUSINESS COULD BE ADVERSELY AFFECTED IF RELATIONS WITH ANY OF OUR SIGNIFICANT SUPPLIERS ARE TERMINATED. Our ability to purchase pharmaceuticals, or to expand the scope of pharmaceuticals purchased, from a particular supplier is largely dependent upon such supplier's assessment of our creditworthiness and our ability to resell the products we purchase. We are also dependent upon our suppliers' continuing need for, and willingness to utilize, our services. If we cease to be able to purchase pharmaceuticals from any of our significant suppliers, such occurrence could have a material adverse effect on our business, results of operations and financial condition because many suppliers own exclusive patent rights and are the sole manufacturers of certain pharmaceuticals. If we were to become unable to purchase patented products from any such supplier, we would be required to purchase such products from other distributors on less favorable terms, and our profit margin on the sale of such products could be eliminated. Substantially all of our agreements with suppliers are terminable by either party upon short notice and without penalty. OUR INDUSTRY HAS EXPERIENCED DECLINING MARGIN PERCENTAGES IN RECENT YEARS AND, IF THIS TREND CONTINUES, OUR BUSINESS COULD BE ADVERSELY AFFECTED. Over the past decade, participants in the wholesale pharmaceutical distribution industry have experienced declining gross and operating margin percentages. Industry sources estimate that the average gross margin percentage of companies in the industry has decreased from approximately 7.35% in calendar year 1990 to approximately 4.33% in calendar year 2002. Our gross margin percentage decreased from approximately 6.74% in fiscal year 1992 to approximately 4.07% in fiscal year 2004, primarily as a result of pricing pressures reducing margins. Currently, profitability of wholesale distributors, including us, is largely dependent upon earning volume incentives, cash discounts and rebates from pharmaceutical manufacturers. Our profitability is also partially dependent on our ability to purchase inventory in advance of anticipated or known manufacturer price increases. Although investment buying opportunities may enable us to increase our gross margin percentage when manufacturers increase prices, such buying requires subjective assessments of future price changes as well as significant working capital. If our gross margin percentages decline significantly, or if our assessments of future price changes are incorrect, or if we do not have the necessary working capital to take advantage of buying opportunities, our profitability could be materially adversely affected. CHANGES IN VENDOR SUPPLY CHAIN MANAGEMENT POLICIES AND THE USE OF INVENTORY MANAGEMENT AGREEMENTS IN THE PHARMACEUTICAL DISTRIBUTION INDUSTRY COULD ADVERSELY IMPACT OUR RESULTS OF OPERATIONS. Our business is dependent on our ability to purchase pharmaceutical products. We historically invested capital in pharmaceutical inventory to take advantage of relevant market dynamics, including anticipated manufacturer price increases. We have recently seen changes in vendor supply chain management policies related to product availability, including the use of inventory management agreements. Inventory management agreements generally provide for the distributor to be compensated on a negotiated basis to help manufacturers better match their shipments to meet market demand, thereby resulting in less surplus inventory available to the distributor. Continued changes in vendor policies related to product availability may limit our ability to leverage our resources and could adversely impact our business and results of operations. THE LOSS OF ONE OR MORE OF OUR LARGEST CUSTOMERS OR A SIGNIFICANT DECLINE IN THE LEVEL OF PURCHASES MADE BY ONE OR MORE OF OUR LARGEST CUSTOMERS COULD HURT OUR BUSINESS BY REDUCING OUR REVENUES AND EARNINGS. Our 10 largest customers accounted for approximately 28% (by dollar volume) of our revenues during fiscal 2004 and approximately 43% (by dollar volume) of our revenues during fiscal 2003. Our largest customer accounted for 8 approximately 7% (by dollar volume) of our revenues during fiscal 2004 and approximately 9% of our revenues during fiscal 2003. As is customary in our industry, our customers are generally permitted to terminate our relationship or reduce purchasing levels on relatively short notice and without penalty. Termination of a relationship by a significant customer or a significant decline in the level of purchases made by a significant customer could have a material adverse effect on our business, results of operations and financial condition. Additionally, an adverse change in the financial condition of a significant customer, including an adverse change as a result of a change in governmental or private reimbursement programs, could have a material adverse effect on our ability to collect our receivables from the customer and the volume of our sales to the customer. OUR SALES COULD DECLINE IF WE WERE TO LOSE OUR PRIME VENDOR STATUS WITH A COOPERATIVE PURCHASING GROUP. We have contracted with several cooperative purchasing groups to be their primary vendor. While we continue to contract directly with the members of these purchasing groups, members are entitled to the pricing we have negotiated with the groups. The majority of our independent and regional customers are members of these cooperative purchasing groups. If a cooperative purchasing group elected not to renew its contract with us, we cannot assure you that all or any of our individual customers that are members of that purchasing group would continue to purchase products from us. If a significant number of customers were to elect not to continue to purchase products from us, our sales would decline. OUR BUSINESS COULD BE ADVERSELY AFFECTED IF WE LOSE ANY MEMBERS OF OUR KEY PERSONNEL. We are dependent on the services of our senior management and on the relationships between our key personnel and our significant customers and suppliers. We have entered into employment agreements or non-competition agreements with four key members of our management team. The loss of certain members of our senior management, particularly our Chief Executive Officer, Chief Operating Officer or Chief Financial Officer, could have a material adverse effect on our business, results of operations and financial condition. We generally do not carry life insurance policies on the lives of our key senior managers or key purchasing or sales personnel. As is generally true in the industry, if any of our senior management or key personnel with an established reputation within the industry were to leave our employ, we cannot assure you that our customers or suppliers who have relationships with such person would not purchase products from such person's new employer, rather than from us, or would continue to sell products or inventory to us on terms at least as favorable as before such person's departure. OUR BUSINESS COULD SUFFER IF WE ARE UNABLE TO COMPLETE AND INTEGRATE ACQUISITIONS SUCCESSFULLY. One aspect of our growth and operating strategy is to pursue strategic acquisitions of other pharmaceutical wholesalers and companies that expand or complement our business. We cannot assure you that suitable acquisition candidates will be identified, that acquisitions can be consummated on acceptable terms, that any acquired companies can be integrated successfully into our operations or that we will be able to retain an acquired company's significant customer and supplier relationships or otherwise realize the intended benefits of any acquisition. Any such expansion could require significant capital resources and divert management's attention from our existing business. Such acquisitions could also result in liabilities being incurred that were not known at the time of acquisition or the creation of tax and accounting issues. Failure to accomplish future acquisitions could limit our revenues and earnings potential. CHANGES IN THE HEALTHCARE INDUSTRY COULD ADVERSELY AFFECT US. The healthcare industry has undergone significant change in recent years as a result of various efforts to reduce costs, including proposed national healthcare reform, trends toward managed care, spending cuts in Medicare, consolidation of pharmaceutical and medical/surgery supply distributors, the development of large, sophisticated purchasing groups and efforts by third party payors to contain or reduce healthcare costs. Group purchasing organizations' contracting practices, especially those of larger entities serving hospital clients, have been subjected to government scrutiny and lawsuits in recent years, primarily from an antitrust perspective. We cannot predict whether these trends will continue or whether any other healthcare reform efforts will be enacted and what effect any such reforms may have on our practices and products or our customers and suppliers. Any future changes in the healthcare industry, including a reduction in governmental financial support of healthcare services, adverse changes in legislation or regulations governing the delivery or pricing of prescription drugs, healthcare services or mandated benefits may cause healthcare industry participants to significantly reduce the amount of our products and services they purchase or the price they are willing to pay for our products and services. Changes in pharmaceutical manufacturers' pricing or distribution policies could also significantly and adversely affect our revenues, margins and profitability. FEDERAL AND STATE LAWS THAT PROTECT PATIENT HEALTH INFORMATION MAY INCREASE OUR COSTS AND LIMIT OUR ABILITY TO COLLECT AND USE THAT INFORMATION. Our activities subject us to numerous federal and state laws and regulations governing the collection, dissemination, use, security and confidentiality of patient-identifiable health information, including the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA, and related rules and regulations. The issuance of these regulations and of future judicial or regulatory guidance regarding the interpretation 9 of regulations, the states' ability to promulgate stricter rules, and continuing uncertainty regarding many aspects of the regulations' implementation may make compliance with the relatively new regulatory landscape difficult. For example, our existing programs and systems may not enable us to comply in all respects with the new security regulations. In order to comply with the regulatory requirements, we will be required to employ additional or different programs and systems. Further, compliance with these regulations would require changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. The new regulations and the related compliance costs could have a material adverse effect on our business. WE COULD BE ADVERSELY AFFECTED IF THERE ARE CHANGES IN THE REGULATIONS AFFECTING THE HEALTHCARE INDUSTRY OR IF WE FAIL TO COMPLY WITH CURRENT REGULATIONS APPLICABLE TO OUR BUSINESS. The healthcare industry is more heavily regulated than many other industries. As a distributor of certain controlled substances and prescription pharmaceuticals, we are required to register with and obtain licenses and permits from certain federal and state agencies and must comply with operating and security measures prescribed by those agencies. We are also subject to various regulations including the 1987 Prescription Drug Marketing Act, an amendment to the federal Food, Drug and Cosmetic Act, which regulates the purchase, storage, security and distribution of prescription pharmaceuticals. Our compliance with these regulations is monitored through periodic site inspections conducted by various governmental agencies. Any failure to comply with these regulations or to respond to changes in these regulations could result in penalties on us such as fines, restrictions on our operations or a temporary or permanent closure of our facilities. These penalties could harm our operating results. We cannot assure you that future changes in applicable laws or regulations will not materially increase the costs of conducting business or otherwise have a material adverse effect on our business, results of operations and financial condition. OUR OPERATIONS AND QUARTERLY RESULTS ARE SUBJECT TO SEASONALITY AND VARIABILITY. Historically, our operations have experienced certain seasonal patterns. Generally, our net sales are highest in the third and fourth quarters and lowest in the first quarter of our fiscal year. As a result, we have historically achieved approximately 60% of our earnings in our third and fourth fiscal quarters. These fluctuations are attributable, in part, to the timing of product price increases enacted by manufacturers and to the winter cold and flu season. Our earnings may continue to vary materially from quarter to quarter due to these and other factors. Item 2. Properties We conduct our business from a total of twelve office and warehouse facilities:
LOCATION DESCRIPTION SQUARE FOOTAGE - ---------------------------- ------------------------------- -------------- Cape Girardeau, Missouri (1) Distribution and administration 126,000 Lexington, Kentucky (1) Distribution and administration 61,900 Minneapolis, Minnesota (2) Distribution and administration 63,000 Aberdeen, South Dakota (1) Distribution and administration 40,000 Flower Mound, Texas (1) Distribution and administration 70,100 Owensboro, Kentucky (2) Distribution and administration 34,000 Texarkana, Texas (1) Walsh headquarters 40,600 San Antonio, Texas (1) Distribution and administration 147,000 Paragould, Arkansas (2) Distribution and administration 78,000 Caguas, Puerto Rico (1) Distribution and administration 5,000 Boulder, Colorado (1) PBI headquarters 5,500 St. Louis, Missouri (1) Corporate offices 31,765
- ------------- 1) Leased. 2) Owned. During fiscal 2004 we completed the expansion of our Cape Girardeau facility adding approximately 60,000 square feet to the current facility. In addition, in August 2004, we entered into a lease for a 180,000 square foot facility in McCalla, Alabama, which is near Birmingham. This facility is scheduled to become fully operational in the first calendar quarter of 2005. We believe our facilities are adequate to support our present business plans. 10 Item 3. Legal Proceedings On February 5, 2004, an individual named Gary Dutton filed a complaint in the United States District Court for the Eastern District of Missouri against the Company and its Chief Executive, Operating and Financial Officers ("Defendants") asserting a class action for alleged breach of fiduciary duties and violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that the Company's press releases and reports filed with the Securities and Exchange Commission between April 23, 2001 and September 16, 2002 were materially false and misleading in that they failed to disclose that the Company's results were based, in material part, on arrangements with a single supplier which the Company allegedly knew could not be sustained. The complaint also claims that as a result of the alleged omissions, the market prices of the Company's common shares during the period were artificially inflated. The complaint seeks unspecified compensatory damages. The Company believes that the complaint describes types of transactions in which the Company has not engaged, contains a number of inaccurate statements, does not state any valid cause of action and that the Company will have substantial meritorious defenses to the complaint. The Court has not selected lead class counsel and the Company has not yet had an opportunity to assert its defenses to the complaint. The Defendants intend to vigorously defend the claims. Item 4. Submission of Matters to a Vote of Security Holders We did not submit any matters to a vote of our security holders during the quarter ended June 30, 2004. Item 4A. Executive Officers of the Registrant The name, age and position of each of our executive officers are set forth below. J. Hord Armstrong, III, 63, has served as Chairman of the Board, Chief Executive Officer and Treasurer, and a director since December 1987. Prior to joining us, Mr. Armstrong served as Vice President and Chief Financial Officer of Arch Mineral Corporation, a coal mining and sales corporation, from 1981 to 1987, and as its Treasurer from 1978 to 1981. Martin D. Wilson, 43, has served as President and Chief Operating Officer since January 1996, as Secretary from August 1993 to April 1999 and as a director since 1997. Mr. Wilson served as Executive Vice President, Finance and Administration from May 1995 to January 1996, as Vice President, Finance and Administration from April 1991 to May 1995, and as Controller from March 1988 to April 1991. Prior to joining us, Mr. Wilson was associated with KPMG Peat Marwick, a public accounting firm. Mr. Wilson serves as a Trustee of the St. Louis College of Pharmacy. Thomas S. Hilton, 52, has served as Senior Vice President and Chief Financial Officer since January 1999. Between May 1980 and June 1998, Mr. Hilton was employed by the Peabody Group, a coal mining and sales corporation in a variety of management positions including Vice President and Treasurer from March 1993 to May 1995, and Vice President and Chief Financial Officer from May 1995 to June 1998. Brian G. Landry, 48, has served as Senior Vice President of Operations and Chief Information Officer since January 2004. . Mr. Landry previously served as Vice President and Chief Information Officer from April 2000, Vice President, information systems product management from April 1999 to April 2000 and as Vice President and General Manager of our Minneapolis distribution center from November 1996 to April 1999. From October 1992 to October 1996, Mr. Landry was employed by Cardinal Health as a general manager of a distribution center. 11 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The information set forth under the caption "Price Range Per Common Share" on the inside back cover of the registrant's 2004 Annual Report to Stockholders is incorporated herein by this reference. The following table contains certain information concerning shares of common stock of the company subject to options issued under our 1992 Long-term Incentive Plan (as amended), 1993 Stock Option Plan (as amended) and 2001 Long-term Incentive Plan. Our stockholders approved the 1992 Long-term Incentive Plan and the 2001 Long-term Incentive Plan. The 1993 Stock Option Plan (the 1993 Plan) is for employees and certain others (not company directors or executive officers) who perform services for us and did not require shareholder approval. Under the 1993 Plan, we can grant options that do not qualify as incentive stock options at a price not less than fair market value of the company's common stock at the time of grant. The term of the options cannot exceed 10 years from the date of grant. There were 700,000 shares authorized under the 1993 Plan.
EQUITY COMPENSATION PLAN INFORMATION - --------------------------------------------------------------------------------------------------------------- NUMBER OF SECURITIES REMAINING AVAILABLE FOR FUTURE NUMBER OF SECURITIES TO BE WEIGHTED-AVERAGE EXERCISE ISSUANCE UNDER EQUITY ISSUED UPON EXERCISE OF PRICE OF OUTSTANDING COMPENSATION PLANS OUTSTANDING OPTIONS, OPTIONS, (EXCLUDING SECURITIES WARRANTS AND RIGHTS WARRANTS AND RIGHTS REFLECTED IN COLUMN (a)) PLAN CATEGORY (a) (b) (C) - ------------------------------ -------------------------- ------------------------- ------------------------ Equity compensation plans approved by stockholders 1,376,466 $15.06 329,433 Equity compensation plans not approved by stockholders 126,250 $11.64 -- --------- ------ ------- TOTAL 1,502,716 $14.78 329,433 ========= ====== =======
ISSUER PURCHASES OF EQUITY SECURITIES
(d) MAXIMUM (c) TOTAL NUMBER OF NUMBER OF SHARES SHARES (a) TOTAL NUMBER PURCHASED AS PART THAT MAY YET BE OF (b) AVERAGE OF PURCHASED UNDER SHARES PRICE PAID PUBLICLY ANNOUNCED THE PLANS OR PERIOD PURCHASED PER SHARE PLANS OR PROGRAMS PROGRAMS - -------------------------- ---------------- ----------- ------------------- ---------------- August 2003 56,500 $14.45 656,500 0 ------ ------ ------- --- Total 56,500 $14.45 656,500 0 ====== ====== ======= ===
In September 2002, the board of directors authorized the repurchase of up to 1.0 million shares, which expired in September 2003. During fiscal 2004, an additional 56,500 shares were repurchased under this authorization bring the total number of shares repurchased to 656,500. Item 6. Selected Financial Data The information set forth under the caption "Financial Highlights" on the inside front cover of the registrant's 2004 Annual Report to Stockholders is incorporated herein by this reference. 12 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RECENT TRENDS Sales in the national accounts trade class are continuing to fall below expectations in the first two months of 2005, as fewer than anticipated product price increases enacted by pharmaceutical manufacturers have resulted in lower activity in this trade class. Changes in manufacturers' inventory management practices resulting in reduced availability of product have also impacted revenues in this trade class. Fewer than anticipated product price increases also resulted in lower gross profit margin in the independent and regional pharmacies trade class during the first two months of 2005. However, during this period sales trends in the trade class show continued growth which partially offset the effect of lower gross profit margins. We believe this sales growth reflects improved regional and independent retail pharmacy industry sales trends in the our service territory and the impact of new business. Changing behavior on the part of pharmaceutical manufacturers is impacting and will continue to impact how distributors generate earnings. Three important changes we have noted include changes in the timing of product price increases, tightening of control over inventory in the distribution channel resulting in fewer opportunities to purchase inventory from sources other than the original manufacturer, and a transition to "fee for service" compensation models which generally reduce the ability to accumulate inventory positions ahead of price increases. With these changes, and with others likely over time, we expect that our business model and earnings growth will evolve to reflect that of our core business. We refer to our "core" operations as the combination of our "independent and regional pharmacies" trade class and the "other healthcare providers" trade class. Customers in both of these classes of trade rely on us as their primary pharmaceutical and over-the-counter products supplier. We are servicing these customers on a daily basis from one of our seven full-service distribution centers. We have taken several important steps to position D&K for the change in pharmaceutical manufacturers' behavior. We have strengthened and broadened our core business through the acquisition of Walsh HealthCare Solutions. As a result of the Walsh acquisition, we expect our net sales and profits to increase. Walsh generated net sales of approximately $900 million in its fiscal year ended April 30, 2003 and pre-tax income of approximately $4.8 million, excluding non-recurring items. The Walsh acquisition provided modest earnings accretion in fiscal 2004 and we feel that there will be significant accretion in fiscal 2005. We have positioned our national accounts business with a flexible cost structure with minimal fixed costs, so that we can maintain a presence and take advantage of opportunities if and when they exist. We also anticipate continued industry consolidation, which may provide additional acquisition opportunities. The current environment makes it difficult to forecast the timing of sales from national accounts. Factors such as higher scrutiny of the healthcare industry in an election year, changes in manufacturers' inventory management practices, changes in product pricing practices, the transition from a `buy and hold' industry model to a `fee for service' model, are all making the current environment difficult to predict. We believe that 2005 earnings results will likely be `back-end' loaded, similar to 2004. During the fiscal 2004 fourth quarter we expanded sales and distribution activities in the Southeast United States. In August 2004, we leased an 180,000 square foot facility near Birmingham, Alabama to support customers in Alabama, Georgia, South Carolina, Mississippi and the Florida panhandle. The Birmingham distribution center is scheduled to become operational in the first calendar quarter of 2005, with current deliveries to customers being accomplished by our other distribution centers. On April 26, 2004, we filed a Form S-3 shelf registration statement that will allow us to sell, from time to time in one or more offerings, up to $200 million of any combination of debt and equity securities described in the registration statement. At this time, we do not have any plans to sell any of these securities. This disclosure does not constitute an offer to sell or the solicitation of an offer to buy any securities. RESULTS OF OPERATIONS The table below sets forth certain statement of income data for the last three fiscal years expressed as a percentage of net sales and in comparison with the prior fiscal year. Unless otherwise indicated, for purposes of this discussion, all references to "2004," "2003," and "2002" shall mean the Company's fiscal years ended June 30, 2004, June 30, 2003, and June 30, 2002, respectively. 13 The table below contains certain operations data for the last three years expressed as a percentage of net sales and in comparison with the prior year:
PERCENTAGE CHANGE FROM PERCENTAGE OF NET SALES PRIOR YEAR ----------------------------------------- --------------------------- 2004 2003 2002 2003-2004 2002-2003 ------ ------ ------ --------- --------- Net sales 100.00% 100.00% 100.00% 14.3% (9.4%) Gross profit 4.07% 4.08% 4.19% 14.0% (11.8%) Total operating expenses (2.82%) (2.44%) (2.30%) 31.9% (3.9%) ------ ------ ------ Income from operations 1.25% 1.64% 1.89% (12.8%) (21.5%) Interest expense, net (0.55%) (0.48%) (0.40%) 30.5% 9.7% Securitization termination costs -- (0.09%) -- NM NM Other, net (0.00%) (0.00%) (0.03%) NM NM Income tax provision (0.27%) (0.41%) (0.58%) (23.2%) (35.8%) Minority interest (0.03%) (0.03%) (0.03%) 10.0% (3.4%) ------ ------ ------ Net income before cumulative effect of accounting change 0.40% 0.63% 0.86% (26.7%) (33.8%) Cumulative effect of accounting change, net -- (0.19%) -- NM NM ------ ------ ------ Net income 0.40% 0.44% 0.86% 5.5% (54.0%) ====== ====== ======
FISCAL YEAR ENDED JUNE 30, 2004 COMPARED WITH THE FISCAL YEAR ENDED JUNE 30, 2003 NET SALES Net sales increased $317.8 million to $2.541 billion, or 14.3%, in 2004 compared to the corresponding period of the prior year. Sales to independent and regional pharmacies increased $663.9 million to $1.820 billion, or 57.4%. Approximately 69% of the increase related to Walsh sales included in our results since the acquisition in December 2003. Approximately 25% of the increase relates to new business with the balance driven by same store growth. National accounts sales decreased $335.8 million to $593.7 million, or 36.1%, compared to last year primarily as a result of changes in pharmaceutical manufacturers' inventory management practices that reduced the availability of attractively priced purchase opportunities. We provide our national accounts customers bulk pharmaceuticals that we purchase, if available, on favorable terms from the manufacturers. If we are unable to obtain bulk inventory on favorable terms, our sales in this area will continue to decline. During 2004 and 2003 we made no dock-to-dock sales, which historically were not included in net sales due to our accounting policy of recording only the commission on such transactions as a reduction to cost of sales in our consolidated statements of operations. Dock-to-dock sales represent bulk sales of pharmaceuticals to self-warehousing chain pharmacies for which we act only as an intermediary in the order and subsequent delivery of products to the customers' warehouses. The commission on dock-to-dock sales is typically lower than the gross profit realized on sales of products from inventory. GROSS PROFIT Gross profit increased $12.7 million to $103.4 million, or 14.0%, compared to the corresponding period of the prior year. As a percentage of net sales, gross margin decreased from 4.08% to 4.07% compared to the corresponding period of the prior year. The increase in gross profit was in our wholesale drug distribution segment due to the addition of Walsh sales and additional sales related to new business and same store growth. The increase also included gains from two class action legal settlements received during the year totaling $3.1 million that reduced cost of sales. Without these settlements, gross margin would have been 3.95%. The decrease in gross margin relates to lower national accounts sales that typically had higher gross margin realization than independent and regional pharmacy sales and continued pricing pressure on new and existing business. OPERATING EXPENSES Operating expenses (including depreciation and amortization) increased $17.3 million to $71.7 million, or 31.9%, compared to the corresponding period of the prior year. The ratio of operating expenses to net sales was 2.82%, a 38 basis point increase from the comparable period of the prior year. The increase in operating expenses resulted primarily from the inclusion of Walsh-related operating expenses since the acquisition in December 2003. The ratio of operating expense to net sales increased due to the decrease in national accounts sales. 14 INTEREST EXPENSE, NET Net interest expense increased $3.2 million to $13.9 million, or 30.5%, compared to the corresponding period of the prior year. As a percentage of net sales, net interest expense increased to 0.55% from 0.48%, compared to the corresponding period of the prior year. The increase in net interest expense was primarily the result of higher average borrowing levels driven by financing the purchase of Walsh in combination with higher average investment in inventory. INCOME TAX PROVISION Our effective income tax rate was 38.7% for 2004 compared to 38.2% for the corresponding period of the prior year. These rates were different from the statutory blended federal and state rates primarily because of the impact of state income taxes. Our effective rate is slightly higher than the corresponding period of last year due to the impact of the sales mix on the blended state income tax rate. MINORITY INTEREST Minority interest increased to $0.8 million for 2004 compared to $0.7 million in 2003. This represents our minority interest in PBI with the slight increase related to PBI's performance during 2004. FISCAL YEAR ENDED JUNE 30, 2003 COMPARED WITH THE FISCAL YEAR ENDED JUNE 30, 2002 NET SALES Net sales decreased $230.4 million to $2.223 billion, or 9.4%, in 2003, compared to the corresponding period of the prior year. The sales decline was in the national accounts trade class and related to fewer attractively priced purchase opportunities. Sales to independent and regional pharmacies increased $67.1 million to $1.156 billion, or 6.2%, primarily as a result of the net increase in sales to existing customers. National accounts sales decreased $317.1 million to $929.6 million, or 25.4%, compared to 2002 related to fewer attractively priced purchase opportunities of approximately $554 million partially offset by sales to new customers of approximately $235 million. Sales to other healthcare providers increased $18.8 million to $126.3 million, or 17.5% as a result of new customers. During 2003 we made no dock-to-dock sales, which historically were not included in net sales due to our accounting policy of recording only the commission on such transactions as a reduction to cost of sales in our consolidated statements of operations. Dock-to-dock sales represent bulk sales of pharmaceuticals to self-warehousing chain pharmacies for which we act only as an intermediary in the order and subsequent delivery of products to the customers' warehouses. The commission on dock-to-dock sales is typically lower than the gross profit realized on sales of products from inventory. Dock-to-dock sales were $70.5 million during 2002. GROSS PROFIT Gross profit decreased $12.1 million to $90.7 million, or 11.8%, for 2003, compared to the corresponding period of the prior year. As a percentage of net sales, gross margin decreased from 4.19% to 4.08% for 2003, compared to the corresponding period of the prior year. The decrease in gross margin percentage was due to the impact on our prices of the competitive forces in the business. OPERATING EXPENSES Operating expenses (including depreciation and amortization) decreased $2.2 million to $54.3 million, or 3.9%, for 2003 compared to the corresponding period of the prior year. The ratio of operating expenses to net sales for 2003 was 2.44%, a 14 basis point increase from the comparable period of the prior year. The decrease in operating expenses resulted from the elimination of approximately $2.5 million of goodwill amortization related to our adoption of SFAS 142, offset by higher depreciation expense of approximately $0.4 million related to the new ERP computer system that was fully implemented during 2003. The ratio of operating expense to net sales increased due to the decrease in national accounts sales. INTEREST EXPENSE, NET Net interest expense increased $0.9 million to $10.7 million, or 9.7%, for 2003, compared to the corresponding period of the prior year. As a percentage of net sales, net interest expense increased to 0.48% from 0.40% for 2003, compared to the corresponding period of the prior year. The increase in net interest expense was primarily the result of higher average borrowing levels driven by higher average investment in inventory. SECURITIZATION TERMINATION COSTS In March 2003, we entered into a new credit facility that resulted in the termination of the existing accounts receivable securitization agreement. As a result, a one-time charge of $2.0 million was incurred during the third quarter of 2003. These costs were associated with eliminating a $50 million fixed rate component of the accounts receivable securitization program. INCOME TAX PROVISION Our effective income tax rate was 38.2% for 2003 compared to 39.3% for the corresponding period of the prior year. These rates were different from the statutory blended federal and state rates primarily because of the impact of state income taxes. Our effective rate is lower than the corresponding period of last year due to the impact of the sales mix on the blended state income tax rate. 15 MINORITY INTEREST Minority interest remained at $0.7 million for 2003. We began recording minority interest during 2002 as a result of our additional investment in PBI in July 2001. CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET As a result of the adoption of Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets", we recognized an impairment loss of approximately $7.0 million ($4.2 million net of tax) during the first quarter of 2003. This impairment results from an appraisal valuation and relates to goodwill originally established for the acquisition of Jewett Drug Co. LIQUIDITY AND CAPITAL RESOURCES On March 31, 2003, we entered into a new $600 million credit facility. The credit facility, an asset-based senior secured revolving credit facility, increased our available credit from $430 million to $600 million. The new single credit facility replaced a $230 million revolving bank line of credit and a $200 million accounts receivable securitization program. Under the credit facility, the total amount of loans and letters of credit outstanding at any time cannot exceed the lesser of an amount based on percentages of eligible receivables and inventories (the borrowing base formula). Total credit available at June 30, 2004 was approximately $390 million of which approximately $83 million was unused. The interest rate on the new credit facility is based on the 30-day London Interbank Offering Rate (LIBOR) plus a factor based on certain financial criteria. The interest rate was 3.59% at June 30, 2004. The agreement expires in March 2007, and, therefore, the related debt has been classified as long-term. We are required to pay an annual facility fee, which was $100,000 in 2004. In addition, we are charged a monthly fee of 0.375% of the unused balance of the facility. We are required under the terms of our debt agreements to comply with certain financial covenants, including those related to fixed charge coverage ratio and tangible net worth. We are required to reduce borrowings by cash received. We also are limited in our ability to make loans and investments, enter into leases, or incur additional debt, among other things, without the consent of our lenders. We are in compliance with our debt covenants as of June 30, 2004. The new credit facility resulted in the termination of the existing accounts receivable securitization agreement. As a result, a one-time charge of $2.0 million was incurred during the third fiscal quarter of 2003. These costs were associated with eliminating a $50 million fixed rate component of the accounts receivable securitization program that had an interest rate of 4.85%. Under the provisions of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," (as amended by SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities") the accounts receivable sold under the agreement were removed from the consolidated balance sheet. We generally meet our working capital requirements through a combination of internally generated funds, borrowings under the revolving line of credit and trade credit from our suppliers. We use the following ratios as key indicators of our liquidity and working capital management:
JUNE 30, JUNE 30, 2004 2003 ---------- ----------- Working capital (000s) $ 382,900 $ 215,639 Current ratio 2.52 to 1 2.14 to 1
Working capital is total current assets less total current liabilities on our balance sheet. The current ratio is calculated by dividing total current assets by total current liabilities. As cash is collected on accounts receivable, it is used to immediately reduce long term debt. Working capital and current ratio at June 30, 2004 are higher than June 30, 2003 levels. The change was due mainly to increases in inventory levels and the additional working capital provided by Walsh that amounted to $97.3 million at June 30, 2004. We invested $5.4 million in capital assets in 2004 compared with $2.4 million in 2003. The 2004 expenditures were primarily related to the expansion at our Cape Girardeau distribution center. The 2003 expenditures were primarily related to leasehold improvements associated with our new corporate offices. We believe that continuing investment in capital assets is necessary to achieve our goal of improving operational efficiency, thereby enhancing our productivity and profitability. 16 Net cash inflows from financing activities totaled $193.3 million for 2004 with net cash outflows of $58.7 million in 2003. Borrowings under our revolving line of credit related to the purchase of Walsh and to support our inventory levels produced this result. During 2003, repayments under our revolving line of credit related to the decrease in inventory levels combined with our purchase of treasury stock produced this result. Stockholders' equity increased to $179.3 million at June 30, 2004 from $170.1 million at June 30, 2003, primarily due to the net earnings during the period. We believe that funds available under the new credit facility, together with internally generated funds, will be sufficient to meet our capital requirements for the foreseeable future. CONTRACTUAL OBLIGATIONS The following table summarizes our outstanding contractual obligations as of June 30, 2004:
PAYMENTS DUE BY PERIOD FY 2006-FY FY 2009 - FY 2012 AND CONTRACTUAL OBLIGATIONS TOTAL FY 2005 2008 FY 2011 THEREAFTER - ------------------------------- ------- ------- ---------- --------- ----------- Long-Term Debt Obligations (1) $308.4 $ 0.7 $307.7 -- -- Capital Lease Obligations $ 0.4 $ 0.3 $ 0.1 -- -- Operating Lease Obligations (2) $ 30.9 $ 6.0 $ 14.3 $7.3 $3.3 Purchase Obligations (3) $ 31.8 $10.5 $ 21.3 -- -- Other Long-Term Liabilities $ 2.7 $ 0.3 $ 0.7 $0.2 $1.5 Total $374.2 $17.8 $344.1 $7.5 $4.8
(1) Includes repayment of revolving credit facility in March 2007 (2) Our future minimum rental commitments under noncancellable leases comprise the category. (3) Represents required purchases under our agreement with Parata Systems, LLC INFLATION We prepare our consolidated financial statements on the basis of historical costs and they do not reflect changes in the relative purchasing power of the dollar. Because we take advantage of purchasing opportunities in anticipation of price increases (forward purchasing), we believe that our gross profits generally increase when manufacturers increase the prices of products we distribute. Our gross profits may decline if manufacturers increase prices more slowly. Generally, we pass price increases through to customers, therefore reducing the negative effect of inflation. During the past three years, we have offset other non-inventory cost increases such as payroll, supplies and services by increasing volume and improving productivity. CRITICAL ACCOUNTING POLICIES The methods, estimates and judgments we use in applying the accounting policies most critical to our financial statements have a significant impact on our reported results. The U.S. Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results, and require us to make our most difficult and subjective judgments. Based on this definition, our most critical policies include the following: (1) inventory valuation; (2) accounts receivable; (3) valuation of goodwill and other intangible assets (4) accounting for stock options; and (5) income taxes. We also have other key accounting policies including policies for revenue recognition. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective as the others listed above, or are less likely to have a significant impact on our reported results of operations for a given period. For additional information, see Note 1 "Summary of Significant Accounting Policies" in Item 8 of Part II, "Financial Statements and Supplementary Data," 17 of this report. Although we believe that our estimates and assumptions are reasonable, they are based upon information available at the time the estimates and assumptions were made. Actual results may differ significantly from our estimates and our estimates could be different using different assumptions or conditions. Revenue Recognition Revenue is recognized when products are shipped or services are provided to customers and we have no further obligation with respect to such products or services. Revenues as reflected in the accompanying consolidated statements of operations are net of sales returns and allowances. We recognize sales returns as a reduction of revenue and cost of sales for the sales price and cost, respectively. Our customer return policy generally allows customers to return products only if the products have the ability to be added back to inventory and resold at full value or can be returned to suppliers for credit. Rebates received from suppliers are recognized as a reduction in cost of sales at the time the product is sold. Shipping and handling costs associated with the shipment of goods are recorded as operating expenses in the consolidated statements of operations. Inventory Valuation Inventories consist of pharmaceutical drugs and related over-the-counter items, which are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. We establish reserves that permanently reduce the cost basis of our inventory to reflect situations in which the cost of the inventory is not expected to be recovered. We record provisions for inventory reserves as part of cost of sales. During 2004, approximately $75,000 was charged to cost of sales relating to inventory reserve adjustments. A change in our inventory reserves of $250,000 would impact our diluted earnings per share by approximately $0.01 based on shares outstanding at June 30, 2004. Accounts Receivable We perform ongoing credit evaluations of our customers, including reviews of their current credit information, and we adjust credit limits based upon their payment histories and current credit worthiness. We continuously monitor collections and payments from customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues we have identified. However, our ultimate ability to collect receivables depends on the individual customer's financial condition, which can change rapidly and without warning. Valuation of Goodwill and Intangible Assets We review goodwill and certain identifiable intangible assets when events or circumstances indicate that the net book value may not be recoverable. Effective with our adoption of SFAS No. 142,"Goodwill and Other Intangible Assets" in July 2002, we are no longer amortizing goodwill and intangible assets that have indefinite lives but will test them annually for impairment, or more frequently if circumstances indicate potential impairment. We will continue to amortize other intangible assets over their estimated useful lives. As a result of this adoption and assessment, we recognized an impairment loss of approximately $7.0 million ($4.2 million net of tax) during the first quarter of fiscal 2003. This was recognized as the cumulative effect of a change in accounting principle. This impairment results from an appraisal valuation and relates to goodwill originally established for the acquisition of Jewett Drug Co., which is included in our wholesale drug distribution segment. Stock Options We account for employee-based stock compensation in accordance with Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under APB No. 25, we record compensation expense based on a stock option's intrinsic value, which is the difference between a stock's market value and the exercise price at the date of grant. As we generally grant stock options at market value at the date of the grant, our compensation expense as a result of option grants has been nominal. An alternative to APB No. 25 used by many companies in accounting for stock options is SFAS No.123, "Stock-Based Compensation." SFAS No. 123 uses the fair value method in valuing stock options and requires expensing of such values. Companies determine fair value based on an option-pricing model, with the Black-Scholes model used most commonly. These pricing models require using several estimates including the expected life of the option, volatility of common stock, dividend yields (including estimates of future dividends and market values of common stock), risk-free interest rates and employee turnover. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, An Amendment of FASB Statement No. 123" ("SFAS 148"). This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In 18 addition, SFAS 148 amends the disclosure requirements of Statement No. 123 to require more prominent disclosures, in both interim and annual financial statements, about the method of accounting for stock-based employee compensation and the effect the method used has on reported results. The provisions of SFAS 148 are effective for fiscal years ending after December 15, 2002 and the interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. We will continue to account for stock-based compensation using the intrinsic value method and have adopted the disclosure requirements prescribed by SFAS 148. The additional required disclosures have been provided in Note 1 to the consolidated financial statements. Income taxes Deferred tax assets and liabilities are determined by the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. Please reference Note 11 entitled Income Taxes of "Notes to Consolidated Financial Statements" for the types of items that give rise to significant deferred income tax assets and liabilities. Deferred income taxes are classified as assets or liabilities based on the classification of the related asset or liability for financial reporting purposes. Deferred income taxes that are not related to an asset or liability for financial reporting are classified according to the expected reversal date. The recoverability of deferred tax assets is dependent upon our assessment of whether it is more-likely- than-not that sufficient future taxable income will be generated in the relevant tax jurisdiction to utilize the deferred tax asset. A valuation allowance is provided for the portion of deferred tax assets, which are "more-likely-than-not" to be unrealized. We regularly review deferred tax assets for recoverability based upon projected future taxable income and the expected timing of the reversals of existing temporary differences. As a result of this review, we have not established a valuation allowance against the deferred tax assets. We are periodically reviewed by domestic and foreign tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, we record reserves for probable exposures. Based on our evaluation of current tax positions, we believe we have appropriately accrued for probable exposures. NEW ACCOUNTING STANDARDS In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No. 133 for decisions made as part of the FASB's Derivatives Implementation Group process, other FASB projects dealing with financial instruments, and in connection with implementation issues raised in relation to the application of the definition of a derivative. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 modifies the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position and affects an issuer's accounting for (1) mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets, (2) instruments, other than outstanding shares, that do or may require the issuer to buy back some of its shares in exchange for cash or other assets, or (3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuer's shares. In addition to its requirements for the classification and measurement of financial instruments within its scope, SFAS 150 also requires disclosures about alternative ways of settling those instruments and the capital structure of entities, all of whose shares are mandatorily redeemable. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our consolidated financial statements. 19 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Our primary exposure to market risk consists of changes in interest rates on borrowings. An increase in interest rates would adversely affect the operating results and the cash flow available to fund operations and expansion. Based on the average anticipated borrowings during 2005, a change of 25 basis points in the average variable borrowing rate would result in a change of approximately $0.7 million in annual interest expense. We continually monitor this risk and review the potential benefits of entering into hedging transactions, such as interest rate swap agreements, to mitigate the exposure to interest rate fluctuations. Our hedging arrangements at June 30, 2004 are described more fully in the footnotes to our consolidated financial statements. Item 8. Financial Statements and Supplementary Data
PAGE ------- Report of Independent Registered Public Accounting Firm Page 21 Consolidated Balance Sheets at June 30, 2004 and June 30, 2003 Page 22 Consolidated Statements of Operations for the years ended June 30, 2004, June 30, 2003, and June 30, 2002 Page 23 Consolidated Statements of Stockholders' Equity for the years Ended June 30, 2004, June 30, 2003, and June 30, 2002 Page 24 Consolidated Statements of Cash Flows for the years ended June 30, 2004, June 30, 2003, and June 30, 2002 Page 25 Notes to Consolidated Financial Statements Page 26
20 Report of Independent Registered Public Accounting Firm The Board of Directors D&K Healthcare Resources, Inc.: We have audited the accompanying consolidated balance sheets of D&K Healthcare Resources, Inc. and subsidiaries (the Company) as of June 30, 2004 and 2003, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended June 30, 2004. In connection with our audits of the consolidated financial statements, we also have audited the related financial statement schedule. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of D&K Healthcare Resources, Inc. and subsidiaries as of June 30, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2004 in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As described in Notes 1 and 3 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets" effective July 1, 2002. KPMG LLP August 6, 2004 21 D&K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of June 30, (in thousands, except share and per share data)
2004 2003 ---------- ---------- ASSETS Current Assets Cash (including restricted cash of $12,499 and $14,301 respectively) $ 12,499 $ 14,301 Receivables, net of allowance for doubtful accounts of $5,444 and $1,604, respectively 130,770 122,982 Inventories 461,295 257,984 Deferred income taxes 7,874 2,322 Prepaid expenses and other current assets 21,862 6,540 ---------- ---------- Total current assets 634,300 404,129 Property and Equipment, net of accumulated depreciation and amortization of $12,274 and $10,673, respectively 24,494 11,140 Other Assets 14,298 11,511 Goodwill, net of accumulated amortization 64,233 44,105 Other Intangible Assets, net of accumulated amortization 6,546 1,810 ---------- ---------- Total assets $ 743,871 $ 472,695 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Current maturities of long-term debt $ 676 $ 1,677 Accounts payable 219,580 173,342 Accrued expenses 31,144 13,471 ---------- ---------- Total current liabilities 251,400 188,490 Long-term Liabilities 2,663 3,703 Deferred Income Taxes 2,785 -- Long-term Debt 307,693 110,423 ---------- ---------- Total liabilities 564,541 302,616 Stockholders' Equity Preferred stock -- -- Common stock 152 152 Paid-in capital 125,552 124,704 Accumulated other comprehensive loss (1,208) (1,371) Deferred compensation - restricted stock (730) (411) Retained earnings 67,790 58,415 Less treasury stock (12,226) (11,410) ---------- ---------- Total stockholders' equity 179,330 170,079 ---------- ---------- Total liabilities and stockholders' equity $ 743,871 $ 472,695 ========== ==========
Preferred stock has no par value; 1 million shares are authorized. In 2004 and 2003, no shares were issued or outstanding. Common stock has a par value of $.01 per share; 25 million shares are authorized; 15,306,749 and 15,177,100 shares were issued at June 30,2004 and 2003, respectively. At June 30, 2004, 14,057,449 shares were outstanding and 1,249,300 shares were held in treasury. At June 30 2003, 13,984,300 shares were outstanding and 1,192,800 shares were held in treasury. The accompanying notes are an integral part of these statements. 22 D&K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the year ended June 30, (in thousands, except per share data)
2004 2003 2002 ----------- ----------- ----------- Net Sales $ 2,541,190 $ 2,223,388 $ 2,453,748 Cost of Sales 2,437,795 2,132,689 2,350,917 ----------- ----------- ----------- Gross profit 103,395 90,699 102,831 Depreciation and Amortization 3,782 2,492 4,453 Operating Expenses 67,874 51,820 52,039 ----------- ----------- ----------- Income from operations 31,739 36,387 46,339 ----------- ----------- ----------- Other Income (Expense): Interest expense (14,531) (11,070) (10,386) Interest income 622 410 667 Securitization termination costs -- (2,008) -- Other, net 124 (13) (710) ----------- ----------- ----------- (13,785) (12,681) (10,429) ----------- ----------- ----------- Income before income tax provision and minority interest 17,954 23,706 35,910 Income Tax Provision (6,956) (9,058) (14,113) Minority Interest (784) (713) (738) ----------- ----------- ----------- Net income before cumulative effect of accounting change 10,214 13,935 21,059 ----------- ----------- ----------- Cumulative effect of accounting change, net -- (4,249) -- ----------- ----------- ----------- Net income $ 10,214 $ 9,686 $ 21,059 =========== =========== =========== Earnings Per Share - Basic Net income before cumulative effect of accounting change $ 0.73 $ 0.98 $ 1.48 Cumulative effect of accounting change -- (0.30) -- ----------- ----------- ----------- Net income $ 0.73 $ 0.68 $ 1.48 =========== =========== =========== Earnings Per Share - Diluted Net income before cumulative effect of accounting change $ 0.71 $ 0.95 $ 1.42 Cumulative effect of accounting change -- (0.30) -- ----------- ----------- ----------- Net income $ 0.71 $ 0.65 $ 1.42 =========== =========== ===========
The accompanying notes are an integral part of these statements. 23 D&K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
ACCUMULATED DEFERRED OTHER COMPENSATION- COMMON PAID-IN COMPREHENSIVE RESTRICTED RETAINED TREASURY (in thousands) STOCK CAPITAL LOSS STOCK EARNINGS STOCK TOTAL ------ -------- ------------- ------------- -------- -------- -------- BALANCE AT JUNE 30, 2001 $ 47 $ 34,006 $ (356) $ -- $ 29,359 $ (5,546) $ 57,510 Comprehensive income: Net income -- -- -- -- 21,059 -- 21,059 Change in value of cash flow hedge, net of $347 tax benefit -- -- (531) -- -- -- (531) -------- Total comprehensive income 20,528 Secondary stock offering 24 76,838 -- -- -- -- 76,862 Shares issued upon acquisition of PBI 2 6,905 -- -- -- -- 6,907 Stock options exercised, including tax benefit 3 6,340 -- -- -- -- 6,343 Stock split in the form of a stock dividend 75 -- -- -- (75) -- -- Dividends paid ($0.0525/share) -- -- -- -- (753) -- (753) ------ -------- ------------- ------------- -------- -------- -------- BALANCE AT JUNE 30, 2002 $ 151 $124,089 $ (887) $ -- $ 49,590 $ (5,546) $167,397 Comprehensive income: Net income -- -- -- -- 9,686 -- 9,686 Change in value of cash flow hedge, net of $318 tax benefit -- -- (484) -- -- -- (484) -------- Total comprehensive income 9,202 Issuance of restricted stock 1 615 -- (616) -- -- -- Deferred compensation amortization - restricted stock -- -- -- 205 -- -- 205 Treasury stock purchases -- -- -- -- -- (5,864) (5,864) Dividends paid ($0.06/share) -- -- -- -- (861) -- (861) ------ -------- ------------- ------------- -------- -------- -------- BALANCE AT JUNE 30, 2003 $ 152 $124,704 $ (1,371) $ (411) $ 58,415 $(11,410) $170,079 Comprehensive income: Net income -- -- -- -- 10,214 -- 10,214 Change in value of cash flow hedge, net of $104 tax benefit -- -- 163 -- -- -- 163 -------- Total comprehensive income 10,377 Issuance of restricted stock -- 699 -- (699) -- -- -- Deferred compensation amortization - restricted stock -- -- -- 380 -- -- 380 Stock options exercised, including tax benefit -- 149 -- -- -- -- 149 Treasury stock purchases -- -- -- -- -- (816) (816) Dividends paid ($0.06/share) -- -- -- -- (839) -- (839) ------ -------- ------------- ------------- -------- -------- -------- BALANCE AT JUNE 30, 2004 $ 152 $125,552 $ (1,208) $ (730) $ 67,790 $(12,226) $179,330 ====== ======== ============= ============= ======== ======== ========
The accompanying notes are an integral part of these statements. 24 D&K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
For the year ended June 30, (in thousands) 2004 2003 2002 ------------ ------------ ---------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 10,214 $ 9,686 $ 21,059 Adjustments to reconcile net income to net cash flows from operating activities -- Depreciation and amortization 3,788 2,492 4,453 Amortization of debt issuance costs 1,632 1,425 1,096 Loss / (gain) from sale of assets 73 (3) 333 Deferred income taxes 1,673 (3,463) (1,796) Cumulative effect of accounting change, net -- 4,249 -- Decrease (increase) in receivables, net 42,341 (11,765) 15,478 (Increase) decrease in inventories (115,088) 106,260 (149,204) Increase in prepaid expenses and other current assets (8,897) (1,816) (5,576) Increase (decrease) in accounts payable (29,020) (42,435) 56,626 Increase in accrued expenses 11,221 3,006 4,419 Other, net (4,557) (3,839) (1,500) ------------ ------------ ---------- Net cash flows from operating activities (86,620) 63,797 (54,612) ------------ ------------ ---------- CASH FLOWS FROM INVESTING ACTIVITIES Payments for acquisitions, net of cash acquired (102,868) -- 961 Investment in other assets (200) (200) (200) Purchases of property and equipment (5,392) (2,371) (3,445) Proceeds from sale of assets 4 3 543 ------------ ------------ ---------- Net cash flows from investing activities (108,456) (2,568) (2,141) ------------ ------------ ---------- CASH FLOWS FROM FINANCING ACTIVITIES Borrowings under revolving line of credit 2,807,387 1,158,172 896,667 Repayments under revolving line of credit (2,609,861) (1,128,602) (912,752) Repurchase of receivables under securitization agreement -- (80,000) -- Proceeds from secondary stock offering -- -- 76,862 Payments of long-term debt (985) (948) (757) Payments of capital lease obligations (271) (249) (236) Proceeds from exercise of stock options 96 -- 2,260 Payment for termination of derivative instrument (1,047) -- -- Payment of dividends (839) (861) (753) Dividends paid by affiliate (390) (330) (300) Purchase of treasury stock (816) (5,864) -- ------------ ------------ ---------- Net cash flows from financing activities 193,274 (58,682) 60,991 ------------ ------------ ---------- (Decrease) increase in cash (1,802) 2,547 4,238 Cash, beginning of period 14,301 11,754 7,516 ------------ ------------ ---------- Cash, end of period $ 12,499 $ 14,301 $ 11,754 ------------ ------------ ---------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for -- Interest $ 12,119 $ 9,605 $ 9,258 Income taxes, net $ 3,156 $ 7,241 $ 11,076
The accompanying notes are an integral part of these statements. 25 D&K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The consolidated financial statements include the accounts of all divisions and wholly owned and majority-owned subsidiaries of D&K Healthcare Resources, Inc. (the Company). All significant intercompany accounts and transactions are eliminated. Fiscal Year The Company's fiscal year end is June 30. References to years relate to fiscal years rather than calendar years unless otherwise stated. Concentration of Credit Risk The Company is a full-service, regional wholesale pharmaceutical drug distributor. From facilities in Missouri, Kentucky, Minnesota, Arkansas, South Dakota and Texas, the Company distributes a broad range of branded and generic pharmaceuticals and over-the-counter health and beauty aid products to its customers in more than 27 states. The Company is focused on serving the unique needs of independent and regional pharmacies. In 2004, sales to one customer represented approximately 7% of total net sales. In 2003, sales to one customer represented approximately 9% of total net sales. In 2002, sales to one customer represented approximately 24% of total net sales. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition Revenue is recognized when products are shipped or services are provided to customers and the Company has no further obligation with respect to such products or services. Revenues as reflected in the accompanying consolidated statements of operations are net of sales returns and allowances. The Company recognizes sales returns as a reduction of revenue and cost of sales for the sales price and cost, respectively. Our customer return policy generally allows customers to return products only if the products have the ability to be added back to inventory and resold at full value or can be returned to suppliers for credit. Rebates received from suppliers are recognized as a reduction in cost of sales at the time the product is sold. Shipping and handling costs associated with the shipment of goods are recorded as operating expenses in the consolidated statements of operations, which amounted to $7.3 million, $4.6 million and $4.5 million in 2004, 2003, and 2002, respectively. During 2002, the Company had $70.5 million of "dock-to-dock" sales, which are excluded from net sales due to the Company's policy of recording only the commission on such transactions as a reduction against cost of goods sold in the consolidated statements of operations. The Company had no dock-to-dock sales in 2004 and 2003. Dock-to-dock sales represent large volume sales of pharmaceuticals to major self-warehousing retail chain pharmacies whereby the Company acts as an intermediary in the order and subsequent delivery of products to the customers' warehouses. Stock-Based Compensation The Company has adopted the disclosure requirements of Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation and also amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the methods of 26 accounting for stock-based employee compensation and the effect of the method used on reported results. As permitted by SFAS 148 and SFAS 123, the Company continues to apply the accounting provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." The Company generally grants its stock options at exercise prices equal to the fair market value of the underlying stock on the date of grant and, therefore, under APB 25, no compensation expense is recognized in the statements of operations. The fair value of each option grant was estimated on the date of the grant using the Black-Scholes option-pricing model using the following weighted-average assumptions:
2004 2003 2002 --------- --------- --------- Risk free interest rates 2.91% 3.05% 4.19% Expected life of options 4.0 years 4.0 years 5.0 years Volatility of stock price 81% 61% 43% Expected dividend yield 0.002% 0.002% 0.002% Fair value of options granted $9.64 $10.82 $10.50
Had the Company recorded compensation expense based on the estimated grant date fair values, as defined by SFAS 123, for awards granted under its stock option plans and stock purchase plan, the pro forma net income and earnings per share would have been as follows (in thousands, except per share data):
2004 2003 2002 ---------- ---------- ---------- Net income - as reported $ 10,214 $ 9,686 $ 21,059 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax (1,354) (1,454) (2,059) Net income - pro forma $ 8,860 $ 8,232 $ 19,000 Earnings per share: Basic - as reported $ 0.73 $ 0.68 $ 1.48 Basic - pro forma $ 0.64 $ 0.58 $ 1.33 Diluted - as reported $ 0.71 $ 0.65 $ 1.42 Diluted - pro forma $ 0.62 $ 0.56 $ 1.29
These pro forma amounts may not be representative of the effects for future years as options vest over several years and additional awards are generally granted each year. Restricted Cash Restricted cash of $12.5 million and $14.3 million, respectively, at June 30, 2004 and June 30, 2003, represents cash receipts from customers that must be used to reduce borrowings under the credit facility and are included in cash. Receivables Receivables are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company's best estimate of the amount of probable credit losses in the Company's existing receivables. The Company determines the allowance based on historical write-off experience. The Company reviews its allowance for doubtful accounts monthly. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is remote. Inventories Inventories consist of pharmaceutical drugs and related over-the-counter items, which are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Reserves are established for our inventory to reflect situations in which the cost of the inventory is not expected to be recovered. Provisions for inventory reserves are recorded as part of cost of sales. 27 Property and Equipment Property and equipment is stated at cost, net of accumulated depreciation and amortization. Depreciation and amortization are charged to operations primarily using the straight-line method over the shorter of the estimated useful lives of the various classes of assets, which vary from two to 30 years, or the lease term for leasehold improvements. For income tax purposes, accelerated depreciation methods are used. Repairs and maintenance costs are expensed as incurred. Intangible Assets Intangible assets are stated at cost less accumulated amortization. Amortization is determined using the straight-line method over the estimated useful lives of the related assets. Impairment of Long-Lived Assets SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets," establishes a single accounting model for long-lived assets to be disposed of. Adopting this standard did not have a material impact on the Company's consolidated financial statements. In accordance with SFAS No. 144, long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. Goodwill The Company accounts for goodwill under SFAS 142, "Goodwill and Other Intangible Assets," which requires the Company to review for impairment of goodwill on an annual basis, and between annual tests whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company performed its goodwill impairment tests upon adoption of SFAS 142 and again as of April 30, 2004. Upon adoption of SFAS 142 on July 1, 2002, the Company ceased amortization of its existing net goodwill balance. Prior to adoption of SFAS 142, goodwill was amortized on a straight-line basis over the expected periods to be benefited and assessed for recoverability by determining whether the amortization of the goodwill balance over its remaining life could be recovered through undiscounted future operating cash flows of the acquired operation. See Note 3 for further information regarding the adoption of SFAS 142 and the on-going impact. Interest Rate Risk Management In accordance with Statement of Financial Accounting Standard No. 133, "Accounting for Derivatives and Hedging Activities", as amended by SFAS No. 138 "Accounting for Certain Derivative Instruments and Certain Hedging Activities", all derivative instruments are recorded at fair value on the balance sheet and all changes in fair value are recorded to earnings or to stockholders' equity through other comprehensive income. The Company does not use derivative instruments for trading or speculative purposes. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective basis for income tax purposes. Deferred tax assets and liabilities are measured and recorded using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. Book Overdrafts 28 Accounts payable includes book overdrafts (outstanding checks) of $12.2 million and $10.4 million at June 30, 2004 and June 30, 2003, respectively. Stockholders' Equity Treasury Stock. In May 1999, the board of directors authorized the repurchase of up to 600,000 shares of the Company's outstanding common stock. 592,800 shares were acquired in the open market during the twelve-month period from the date of authorization. In September 2002, the board of directors authorized the repurchase of up to 1.0 million shares, which expired in September 2003. During fiscal 2004, an additional 56,500 shares were repurchased under this authorization bring the total number of shares repurchased to 656,500. Authorization of additional shares of Common Stock. In January 2002, the Board of Directors amended the Certificate of Incorporation of the Company to increase the number of authorized shares of common stock to 25 million shares. Stock Split. On March 13, 2002, the Company declared a two-for-one stock split in the form of a stock dividend that was distributed on April 12, 2002 to shareholders of record on March 29, 2002. All share and per share amounts included in the consolidated financial statements have been adjusted to retroactively reflect this stock split. Deferred compensation - restricted stock. The Company issued restricted shares of stock to certain key management personnel in 2004 and 2003. This stock will vest three years from the date of grant. The Company recorded the cost of the stock at the time of grant as deferred compensation and will amortize this cost over the vesting period. Earnings per Share Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS No. 128) requires a dual presentation of basic and diluted earnings per share. Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock. All share and per share amounts have been stated in accordance with the provisions of SFAS No. 128 (see Note 13). NOTE 2. ACQUISITIONS: On December 5, 2003, the Company acquired 100 percent of the outstanding common stock of Walsh HealthCare Solutions, Inc. ("Walsh") of Texarkana, Texas. Walsh is a full-service pharmaceutical distributor with distribution centers located in San Antonio, Texas and Paragould, Arkansas. The results of Walsh have been included in the condensed consolidated financial statements since that date. The aggregate purchase price of $104.4 million in cash before consideration of cash acquired includes the repayment of all Walsh bank debt and other direct acquisition costs. D&K utilized its existing revolving credit facility to finance the transaction. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition. The Company is in the process of finalizing the valuation of certain assets and liabilities acquired. Thus, the allocation of the purchase price is subject to refinement.
(in thousands) At December 5, 2003 ------------------- Current assets $154,289 Property and equipment 11,574 Other assets 994 Intangible assets 5,199 Goodwill 19,485 -------- Total assets acquired 191,541 -------- Current liabilities 82,356 Long-term liabilities 4,771 -------- Total liabilities assumed 87,127 -------- Net assets acquired $104,414 ========
29 The $5.2 million of acquired intangible assets has a weighted-average life of approximately 10 years. The intangible assets that make up that amount include customer relationships of $5.1 million (10-year weighted-average useful life) and other assets of $0.1 million (3-year weighted-average useful life). The $19.5 million of goodwill was assigned to the wholesale distribution segment. Of that amount, none is expected to be deductible for tax purposes. The following unaudited pro forma information presents a summary of consolidated results of operations of the Company and Walsh for the periods indicated as if the acquisition had occurred at July 1, 2002, with pro forma adjustments to give effect to amortization of intangible assets, interest expense on acquisition debt and certain other adjustments, together with related income tax effects. The unaudited pro forma information has been prepared for comparative purposes only and does not purport to be indicative of results of operations had these transactions been completed as of the assumed dates or which may be obtained in the future (in thousands, except per share amounts).
Twelve Months Ended June 30, ----------------------------- 2004 2003 ------------ ----------- Net sales $ 2,881,728 $ 3,075,889 Net income before discontinued operations and cumulative effect of accounting change $ 1,662 $ 18,256 Net income $ 106 $ 11,315 Diluted earnings per share $ 0.00 $ 0.77
Pro forma net income for the year ended June 30, 2004 included adjustments of $11.0 million ($6.7 million, net of tax) recorded by Walsh prior to acquisition relating to, among other items, accounts receivable determined by Walsh to be uncollectible, and obsolete inventory. The year ended June 30, 2003 included a gain of $4.1 million ($2.5 million, net of tax) related to the sale by Walsh of its interest in Walsh Dohmen Southeast, LLC In July 2001, as part of the secondary stock offering, the Company increased its ownership percentage in Pharmaceutical Buyers, Inc. (PBI) to 68% and in August 2001, acquired an additional 2%. These additions were accomplished with individuals exchanging PBI stock for shares of the Company's common stock. The aggregate purchase price was valued at $6.9 million based on the initial price of the secondary stock offering for the first increase and the closing price of the stock for the second increase. This arrangement was part of the original transaction when we acquired our initial 50% ownership interest. This transaction was accounted for under the purchase method of accounting. Goodwill recognized in this transaction amounted to $11.3 million, but is not deductible for tax purposes. Intangible assets other than goodwill recognized in this transaction amounted to $1.9 million and have a weighted-average useful life of approximately 15 years. In June 2004, the Company reached agreement to acquire the remaining 30% interest in PBI for $12.4 million. This transaction is subject to certain financing contingencies, but is expected to close by September 30, 2004. See Note 5 for further information on PBI. NOTE 3. GOODWILL AND INTANGIBLE ASSETS: The Company adopted Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets" effective July 1, 2002. Under the new statement, impairment should be tested at least annually at the reporting unit level using a two-step impairment test. The reporting unit is the same as or one level below the operating segment level as described in SFAS Statement 131, "Disclosures about Segments of an Enterprise and Related Information. Under step 1 of this approach, the fair value of the reporting unit as a whole is compared to the book value of the reporting unit (including goodwill) and, if a deficiency exists, impairment would need to be calculated. In step 2, the impairment is measured as the difference between the implied fair value of goodwill and its carrying amount. The implied fair value of goodwill is the difference between the fair value of the reporting unit as a whole and the fair value of the reporting unit's individual assets and liabilities, including any unrecognized intangible assets. Under this standard, goodwill and intangibles with indefinite lives are no longer amortized. A discounted cash flow model was used to determine the fair value of the Company's businesses for the purpose of testing goodwill for impairment. The discount rate used was based on a risk-adjusted weighted average cost of capital. 30 The effects of adopting the new standard on net income and earnings per share for the years ended June 30, 2004, 2003 and 2002 are:
NET INCOME BASIC EPS DILUTED EPS --------------------------- --------------------------- ---------------------------- (in thousands, except per share amounts) 2004 2003 2002 2004 2003 2002 2004 2003 2002 - ---------------------------------------- ------- ------- ------- ------- ------- ------- ------- -------- -------- Net income $10,214 $ 9,686 $21,059 $ 0.73 $ 0.68 $ 1.48 $ 0.71 $ 0.65 $ 1.42 Add: cumulative effect of accounting change, net -- 4,249 -- -- 0.30 -- -- 0.30 -- --------------------------- --------------------------- ---------------------------- Income before cumulative effect of accounting change 10,214 13,935 21,059 0.73 0.98 1.48 0.71 0.95 1.42 Add: goodwill amortization, net of tax -- -- 1,580 -- -- 0.11 -- -- 0.11 --------------------------- --------------------------- ---------------------------- Income before cumulative effect of accounting change and goodwill amortization $10,214 $13,935 $22,639 $ 0.73 $ 0.98 $ 1.59 $ 0.71 $ 0.95 $ 1.53 =========================== =========================== ============================
As a result of this adoption and assessment, the Company recognized an impairment loss of approximately $7.0 million ($4.2 million net of tax) during the first quarter of fiscal 2003. This was recognized as the cumulative effect of a change in accounting principle. This impairment results from an appraisal valuation and relates to goodwill originally established for the acquisition of Jewett Drug Co., which is included in the Company's wholesale drug distribution segment. Changes to goodwill and intangible assets during the year ended June 30, 2004, including the effects of adopting the new accounting standard, are: (in thousands)
INTANGIBLE GOODWILL ASSETS -------- ---------- Balance at June 30, 2003, net of accumulated amortization $44,105 $1,810 Acquisition 19,485 5,212 Adjustment to purchase price 643 -- Amortization expense -- (476) ------- ------ Balance at June 30, 2004, net of accumulated amortization $64,233 $6,546 ======= ======
Intangible assets totaled $6.5 million, net of accumulated amortization of $0.8 million, at June 30, 2004. Of this amount, $0.2 million represents intangible assets with indefinite useful lives, consisting primarily of trade names that are not being amortized under SFAS No. 142. The remaining intangibles relate to customer or supplier relationships and licenses which are being amortized using the straight-line method over periods of 5 to 15 years with an approximate weighted-average amortization period of 11 years Amortization of intangible assets totaled $0.5 million in 2004 and is estimated to be approximately $0.7 million for the next five years. Goodwill and other intangible assets, net of accumulated amortization, by segment is as follows:
Goodwill Intangible Assets ------------------------ ------------------------ June 30, June 30, June 30, June 30, (in millions) 2004 2003 2004 2003 ---------- ---------- ---------- ---------- SEGMENT: Wholesale drug distribution $ 51.8 $ 32.3 $ 5.0 $ 0.2 PBI 11.0 10.4 1.5 1.6 Software 1.4 1.4 -- -- ---------- ---------- ---------- ---------- Total $ 64.2 $ 44.1 $ 6.5 $ 1.8 ========== ========== ========== ==========
31 NOTE 4. PROPERTY AND EQUIPMENT: Property and equipment consisted of the following (in thousands):
JUNE 30, 2004 JUNE 30, 2003 ------------- ------------- Land $ 1,010 $ 320 Building and improvements 5,960 2,115 Fixtures and equipment 23,870 15,336 Leasehold improvements 5,514 3,634 Vehicles 414 408 ------------- ------------- 36,768 21,813 Less - Accumulated depreciation and amortization (12,274) (10,673) ------------- ------------- $ 24,494 $ 11,140 ============= =============
Total depreciation and amortization relating to property and equipment was $3.3 million in 2004, $2.3 million in 2003, and $2.1 million in 2002. The Company leases certain properties under capital leases. Capital lease asset balances consist of buildings and equipment of $1.3 million at both June 30, 2004 and 2003. Related accumulated amortization amounted to approximately $680,000 and $502,000, respectively. NOTE 5. INVESTMENT IN PBI: In November 1995, the Company purchased approximately 50% of the capital stock of Pharmaceutical Buyers, Inc. ("PBI"), a Colorado-based group purchasing organization. Pursuant to the transaction, the Company acquired approximately 50% of the voting and non-voting common stock of PBI for $3.75 million in cash. The Company's investment in PBI was accounted for under the equity method until July 2001 at which time an additional 18% ownership interest was acquired and PBI was consolidated for financial reporting purposes. An additional 2% was acquired in August 2001 to bring the Company's total ownership to 70%. See Note 2 for further information on the acquisition of the additional 20% interest in PBI in 2001. In connection with its investment in PBI, the Company entered into an agreement pursuant to which MassMutual, which holds 30% of the capital stock of PBI, is entitled to exchange its capital stock of PBI with the Company at fair market value. The Company has the right, and it is its intention, to satisfy this exchange with cash. If the Company elects not to satisfy the exchange with cash, the Company could satisfy the exchange with shares of its common stock, in which case MassMutual would have certain registration rights. If the Company were to acquire the remaining interest in PBI, the agreement would be for MassMutual to exchange their interest in PBI for cash. NOTE 6. LONG-TERM DEBT: Long-term debt consists of the following (in thousands):
JUNE 30, 2004 JUNE 30, 2003 ------------- ------------- Revolving line of credit with banks $ 306,241 $ 108,484 Other, including capital lease obligations 2,128 3,616 ------------- ------------- 308,369 112,100 Less -- Current maturities (676) (1,677) ------------- ------------- $ 307,693 $ 110,423 ============= =============
On March 31, 2003, the Company entered into a new $600 million credit facility. The credit facility, an asset-based senior secured revolving credit facility, increased the Company's available credit from $430 million to $600 million. The new single credit facility replaced a $230 million revolving bank line of credit and a $200 million accounts receivable securitization program. Under the credit facility, the total amount of loans and letters of credit outstanding at any time cannot exceed the lesser of an amount based on percentages of eligible receivables and inventories (the borrowing base formula). Total credit available at June 30, 2004 was approximately $390 million of which approximately $83 million was unused. The interest rate on the new credit facility is based on the 30-day London Interbank Offering Rate (LIBOR) plus a factor based on certain financial criteria. The interest rate was 3.59% at June 30, 2004. The agreement expires in March 2007 and contains no subjective acceleration provision, and, therefore, the related debt has been classified as long-term. The Company is required to pay an annual facility fee, 32 which was $100,000 in 2004. In addition, the Company is charged a monthly fee of 0.375% of the unused balance of the facility. The Company is required under the terms of its debt agreements to comply with certain financial covenants, including those related to fixed charge coverage ratio and tangible net worth. The Company is required to reduce borrowings by cash received. The Company also is limited in its ability to make loans and investments, enter into leases, or incur additional debt, among other things, without the consent of its lenders. The Company is in compliance with its debt covenants as of June 30, 2004. In June 2000, the Company entered into a $965,000 equipment financing arrangement with a five-year term ending July 2005. The arrangement provides for monthly payments bearing interest at LIBOR plus 1.95%. The equipment purchased with the proceeds secures this arrangement. At June 30, 2004, maturities of long-term debt, including capital lease obligations, were as follows (in thousands):
FISCAL YEAR ENDING JUNE 30, - --------------------------- 2005 $ 676 2006 1,374 2007 306,280 2008 -- 2009 -- Thereafter 39 -------- $308,369 ========
At June 30, 2004 and June 30, 2003, the fair value of long-term debt approximated its current carrying value. NOTE 7. ACCOUNTS RECEIVABLE SECURITIZATION: During 1999, the Company and its wholly owned, bankruptcy-remote subsidiary ("Seller") established an accounts receivable securitization program. Under the program, undivided interests in a pool of eligible trade receivables, which had been sold on a non-recourse basis by the Company to the Seller, were then sold to a multi-seller, asset backed commercial paper conduit ("Conduit"). Purchases by the Conduit were financed with the sale of highly rated commercial paper. The Company utilized proceeds from the sale of its accounts receivable to repay long-term debt, effectively reducing its overall borrowing costs. The Company's $600 million credit facility, entered into in March 2003, resulted in the termination of the existing accounts receivable securitization agreement. As a result, a one-time charge of $2.0 million was incurred during the third fiscal quarter of 2003. These costs were associated with eliminating a $50 million fixed rate component of the accounts receivable securitization program that had an interest rate of 4.85%. NOTE 8. DERIVATIVE INSTRUMENTS: In June, 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which was amended by SFAS No. 138, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133", which was required to be adopted in years beginning after June 15, 2000. At June 30, 2004, the Company had recorded a long-term asset of approximately $66,000 and a long-term liability of approximately $233,000 relating to derivative instruments. At June 30, 2003, the Company had recorded a long-term asset of approximately $114,000 and a long-term liability of approximately $2,035,000 relating to derivative instruments. Through an interest rate swap agreement, the Company effectively fixed the interest rate on $100 million of its revolving line of credit at a nominal rate of 3.15%. This interest rate derivative instrument has been designated as a cash flow hedge. Such instruments are those that effectively convert variable interest payments on debt instruments into fixed payments. For qualifying hedges, SFAS No. 133 and No. 138 allow derivative gains and losses to offset related results on hedged items in the consolidated statements of operations. The Company formally documents, designates and assesses the effectiveness of transactions that receive hedge accounting. Changes in the fair value of 33 interest rate agreements designated as hedging instruments of the variability of cash flows associated with floating-rate debt obligations are reported in accumulated other comprehensive loss. During fiscal 2004, approximately $163,000 (net of $104,000 of tax) was recorded as other comprehensive income and in fiscal 2003, $484,000 (net of $318,000 of tax), was recorded as other comprehensive loss. In May 2004, the Company terminated an interest rate swap agreement that effectively fixed the interest rate on $20 million of its revolving line of credit at a nominal rate of 6.19%. The termination cost of $1,047,000 is being amortized on a straight-line basis through August 2005, the original expiration date of the agreement. To hedge a portion of its exposure to variability in cash flows related to interest payments under the revolving credit facility, on March 28, 2003, the Company entered into a three-year interest rate cap agreement at a cost of $0.3 million. The notional amount of the instrument is $50 million and it caps the 30-day LIBOR rate at 3.5% in the first year, 4.25% in the second year and 5% in the third year. The Company's analysis of this hedge under SFAS No. 133, shows this to be an effective hedge. As such, any change in the intrinsic value of this instrument will be reported in accumulated other comprehensive loss. Any change in time value of this instrument will be reflected on the Company's statement of operations. NOTE 9. COMMITMENTS AND CONTINGENCIES: The Company leases office and warehouse space and other equipment through noncancelable operating leases. Rental expense under operating leases was $5.2 million, $3.4 million, and $2.9 million in 2004, 2003, and 2002, respectively. Minimum rental payments under these leases with initial or remaining terms of one year or more at June 30, 2004, are $30.9 million and payments during the succeeding five years are: 2005, $6.0 million; 2006, $5.6 million; 2007, $4.7 million; 2008, $4.0 million; 2009, $3.5 million; and thereafter $7.1 million. In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk, such as standby letters of credit and other guarantees, which are not reflected in the accompanying balance sheets. At June 30, 2004, the Company was party to standby letters of credit of $0.75 million and was the guarantor of certain customer obligations totaling approximately $260,000. Management does not expect any material losses to result from these off-balance-sheet items. The Company has entered into an agreement with Parata Systems, LLC to become the exclusive distributor of their robotic dispensing system (RDS) for independent and regional pharmacies in a 23-state region and Puerto Rico. The Parata RDS is specifically designed to meet the needs of retail pharmacies by automating up to 150 prescriptions per hour. The RDS uses a bar-coded maintenance system to ensure accuracy and eliminate potential for operator error. The Parata RDS can be a significant tool to increase efficiency, effectiveness and accuracy, and provide pharmacists with more time for interactions with patients. As part of the agreement, the Company has committed to purchase machines during a period that ends March 2006. At June 30, 2004, the remaining purchase commitment was approximately $32 million. During 2004, the Company recorded gains totaling $3.1 million ($1.9 million net of tax) related to the settlement of two class action lawsuits. These gains were treated as a reduction to cost of sales in the period that they occurred. On February 5, 2004, an individual named Gary Dutton filed a complaint in the United States District Court for the Eastern District of Missouri against the Company and its Chief Executive, Operating and Financial Officers ("Defendants") asserting a class action for alleged breach of fiduciary duties and violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that the Company's press releases and reports filed with the Securities and Exchange Commission between April 23, 2001 and September 16, 2002 were materially false and misleading in that they failed to disclose that the Company's results were based, in material part, on arrangements with a single supplier which the Company allegedly knew could not be sustained. The complaint also claims that as a result of the alleged omissions, the market prices of the Company's common shares during the period were artificially inflated. The complaint seeks unspecified compensatory damages. The Company believes that the complaint describes types of transactions in which the Company has not engaged, contains a number of inaccurate statements, does not state any valid cause of action and that the Company will have substantial meritorious defenses to the complaint. The Court has not selected lead class counsel and the Company has not yet had an opportunity to assert its defenses to the complaint. The Defendants intend to vigorously defend the claims. 34 There are various pending claims and lawsuits arising out of the normal course of the Company's business. In the opinion of management, the ultimate outcome of these claims and lawsuits will not have a material adverse effect on the financial position or results of operations of the Company. However, there can be no assurance that these claims and lawsuits will not have such an impact. NOTE 10. STOCK OPTIONS AND RESTRICTED STOCK: In 1992, the Company adopted a Long-Term Incentive Plan that authorized the Stock Option and Compensation Committee of the Board of Directors (the Committee) to grant key employees and officers of the Company incentive or non-qualified stock options, stock appreciation rights, performance shares, restricted shares and performance units. Options to purchase up to 400,000 shares of common stock were authorized under the Long-Term Incentive Plan. The Committee determines the price (which may not be less than fair market value on the date of grant) and terms at which awards may be granted, along with the duration of the restriction periods and performance targets. In 1999, the Company's shareholders approved an Amended and Restated Long-Term Incentive Plan (Long-Term Incentive Plan) that increased the number of shares available for grant to 1,700,000 shares. Stock options granted under the Long-Term Incentive Plan are not exercisable earlier than six months from the date of grant (except in the case of death or disability of the employee holding the same), nor later than ten years from the date of grant. In February 1993, the Board of Directors of the Company adopted the D&K Wholesale Drug, Inc. 1993 Stock Option Plan (the 1993 Plan) to grant key employees of the Company non-qualified stock options to purchase up to 700,000 shares of the Company's common stock. The 1993 Plan is administered by the Company's Board of Directors, which determines the price and terms at which awards may be granted. Stock options granted under the 1993 Plan are immediately exercisable from the date of grant and expire not later than ten years from the date of grant. The exercise price of all options granted pursuant to the 1993 Plan was equal to the fair market value of stock on the respective dates of grant. In November 2001, the Board of Directors adopted, and the Company's shareholders approved, the 2001 Long Term Incentive Plan (the 2001 Plan). Under the 2001 Plan, the Committee may grant to directors, officers and key employees of the Company up to an aggregate of 1,000,000 incentive or non-qualified stock options, stock appreciation rights, performance shares, restricted shares and performance units. The Committee determines the price of stock options, which may not be less than the fair market value on the date of grant. Stock options granted under the 2001 Plan vest over a three year period from the date of grant, and may be exercised no later than five years from the date of grant. The following tables summarize information about options at June 30, 2004:
Options Options Exercisable ------------------------------------------------- ------------------------------- Weighted Average Number Remaining Weighted Average Number Weighted Average Range of Exercise Price Outstanding Contractual Life Exercise Price Exercisable Exercise Price - ----------------------- ----------- ---------------- ---------------- ----------- ----------------- $1.875 to $6.900 540,616 6.10 years $ 6.17 540,616 $ 6.17 $6.901 to $11.700 129,700 5.20 years $ 9.07 98,237 $ 9.00 $11.701 to $16.500 302,000 3.91 years $ 15.86 1,667 $ 14.10 $16.501 to $21.300 245,000 7.13 years $ 20.66 245,000 $ 20.66 $12.301 to $26.100 145,000 3.35 years $ 24.46 55,000 $ 24.42 $26.101 to $30.8550 140,400 2.68 years $ 30.59 93,600 $ 30.59 --------- -------- 1,502,716 5.17 years $ 14.78 1,034,120 $ 13.06 ========= =========
Changes in options outstanding under the Company's stock option plans are as follows:
Number of Weighted Average Shares Exercise Price --------- ---------------- OUTSTANDING AT JUNE 30, 2001 1,053,396 5.69 Granted 477,000 24.09 Exercised (424,946) 4.75 Forfeitures (13,334) 6.50 --------- ----- OUTSTANDING AT JUNE 30, 2002 1,092,116 13.69
35 Granted 202,200 20.47 Exercised -- -- Forfeitures (6,000) 30.86 --------- ------- OUTSTANDING AT JUNE 30, 2003 1,288,316 $ 15.01 Granted 315,000 15.92 Exercised (15,000) 10.69 Forfeitures (85,600) 23.19 --------- ------- OUTSTANDING AT JUNE 30, 2004 1,502,716 $ 14.78
Stock options exercisable at June 30, 2004, June 30, 2003, and June 30, 2002 were 1,034,120, 940,785, and 874,773, respectively, with a weighted average exercise price of $13.06, $12.28, and $11.95, respectively. Shares available to be granted at June 30, 2004, June 30, 2003, and June 30, 2002 were 329,433, 604,636, and 841,000, respectively. The Company issued restricted shares of stock to certain key management personnel in 2004 and 2003. This stock will vest three years from the date of grant. The Company recorded the cost of the stock at the time of grant as deferred compensation and will amortize this cost over the vesting period. This expense was $380,000 and $205,000 in 2004 and 2003, respectively. NOTE 11. INCOME TAXES: The components of the income tax provision were as follows (in thousands):
2004 2003 2002 -------- -------- --------- Current tax provision $ 5,283 $ 9,394 $ 15,909 Deferred tax provision 1,673 (336) (1,796) -------- -------- --------- Income tax provision $ 6,956 $ 9,058 $ 14,113 ======== ======== =========
The actual income tax provision differs from the expected income tax provision, computed by applying the U.S. statutory Federal tax rates of 35.0% in 2004, 2003 and 2002, respectively, to income before income tax provision, as follows (in thousands):
2004 2003 2002 ------- ------- --------- Expected income tax provision $ 6,284 $ 8,297 $ 12,569 Amortization of intangible assets not deductible for income tax purposes -- -- 120 State income taxes, net of Federal benefit 450 775 1,276 Other, net 222 (14) 148 ------- ------- -------- $ 6,956 $ 9,058 $ 14,113 ======= ======= ========
At June 30, 2004 and June 30, 2003, the tax effects of temporary differences that give rise to significant portions of the Company's deferred tax assets and liabilities are as follows (in thousands):
2004 2003 ---- ---- Deferred tax assets: Allowance for doubtful accounts $ 2,557 $ 641 Accrued expenses 4,022 1,463 Capital lease obligations 53 53 Inventories 2,800 909 Net operating loss and AMT carryforwards 2,543 641 Costs related to derivative instruments 360 814 Property and equipment 444 32 Intangibles -- 376 Other 369 334 --------- --------- Total deferred tax assets $ 13,148 $ 5,263 --------- --------- Deferred tax liabilities: Property and equipment $ (2,807) $ --
36 Inventories -- -- Intangibles (3,422) -- Prepaid expenses (784) (600) Accounts receivable -- -- Other (1,046) (552) --------- --------- Total deferred tax liabilities $ (8,059) $ (1,152) --------- --------- Net deferred tax assets $ 5,089 $ 4,111 ========= =========
The use of pre-acquisition operating losses is subject to limitations imposed by the Internal Revenue Code or individual states and if not utilized by the Company, the net operating loss carryforwards will expire beginning in 2007. The Company acquired net operating loss carryforwards of approximately $2.6 million and alternative minimum tax carryforwards of approximately $0.9 million in the Walsh transaction. The net operating loss carryforwards expire in 2022 and the alternative minimum tax carryforwards have no expiration date. In assessing the realization of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during periods in which those temporary differences become deductible. The Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, the Company believes it is more likely than not that the benefit of these deductible differences will be realized. NOTE 12. EMPLOYEE BENEFIT PLANS The Company has a defined contribution 401(k) plan covering substantially all of its employees. Plan participants may contribute up to 20% of their annual compensation, subject to certain limitations. The Company contribution is discretionary and was equivalent to 50% of employees' contributions up to a maximum contribution based on 6% of eligible compensation. Company match expenses related to the plan were $373,000 in 2004, $339,000 in 2003, and $260,000 in 2002. Jewett Drug Company (Jewett) had a defined contribution 401(k)/profit sharing plan covering substantially all of its employees prior to becoming part of the Company's 401(k) plan in January 2003. Jewett made a discretionary contribution of $100,000 to its plan in 2002. Jewett also participates in the Central States Pension, a multi-employer pension plan, on behalf of its union employees in accordance with the union agreement. The expenses relating to this plan during 2004, 2003 and 2002 were approximately $27,000, $24,000 and $21,000, respectively. The Company also has an executive retirement benefit plan, implemented in 1998, that provides supplemental pre-retirement life insurance plus supplemental retirement income to key executives. The life insurance benefit is calculated at three times the participant's annual salary. The retirement income benefit is provided through discretionary contributions to each participant's account, which vest 20% annually and are fully vested upon attaining age 65. Upon retirement, the accumulated account balance is paid to the participant over 15 years in quarterly benefit payments. The Company's expense related to the plan was $75,000 in 2002. In July 2002, this plan was terminated with participants receiving their vested retirement income benefit balance in the plan. There was no income statement impact as a result of this termination. The life insurance benefit will continue for each participant. NOTE 13. EARNINGS PER SHARE: SFAS No. 128, "Earnings Per Share", requires dual presentation of basic and diluted earnings per share and requires reconciliation of the numerators and denominators of the basic and diluted earnings per share calculation. The reconciliation of the numerator and denominator of the basic and diluted earnings per common share computations are as follows (in thousands, except for shares and per share amounts):
2004 ------------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------ --------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $ 10,214 13,934,546 $ 0.73 EFFECT OF DILUTED SECURITIES: Options -- 202,498 Convertible securities (202) -- -------- ---------- DILUTED EARNINGS PER SHARE: Net income available to common shareholders plus assumed conversions $ 10,012 14,137,044 $ 0.71 ======== ==========
37
2003 ------------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ---------- ------------- --------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $ 13,935 14,327,646 $0.98 Cumulative effect of accounting change, net (4,249) -- (0.30) -------- ---------- ----- 9,686 $0.68 EFFECT OF DILUTED SECURITIES: Options -- 185,470 Convertible securities (182) -- -------- ---------- DILUTED EARNINGS PER SHARE: Net income available to common shareholders plus assumed conversions $ 9,504 14,513,116 $0.65 ======== ==========
2002 ------------------------------------------ Income Shares Per-Share (Numerator) (Denominator) Amount ---------- ------------- --------- BASIC EARNINGS PER SHARE: Net income available to common shareholders $ 21,059 14,246,751 $1.48 EFFECT OF DILUTED SECURITIES: Options -- 419,852 Convertible securities (169) 11,178 -------- ------- DILUTED EARNINGS PER SHARE: Net income available to common shareholders plus assumed conversions $ 20,890 14,677,781 $1.42 ======== ==========
As of June 30, 2004 and 2003, stock options to purchase 0.8 million, 0.6 million shares respectively were not dilutive and therefore not included in the diluted earnings per share calculation. At June 30, 2002, all shares were dilutive. NOTE 14. EFFECT OF NEW ACCOUNTING STANDARDS: In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends SFAS No. 133 for decisions made as part of the FASB's Derivatives Implementation Group process, other FASB projects dealing with financial instruments, and in connection with implementation issues raised in relation to the application of the definition of a derivative. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on our consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 modifies the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position and affects an issuer's accounting for (1) mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets, (2) instruments, other than outstanding shares, that do or may require the issuer to buy back some of its shares in exchange for cash or other assets, or (3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies inversely with the value of the issuer's shares. In addition to its requirements for the classification and measurement of financial instruments within its scope, SFAS 150 also requires disclosures about alternative ways of settling those instruments and the capital structure of entities, all of whose shares are mandatorily redeemable. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on our consolidated financial statements. NOTE 15. BUSINESS SEGMENTS: Pursuant to SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Company has three identifiable business segments: Wholesale drug distribution, the Company's interest in PBI, and Software/Other. Two wholly owned software subsidiaries, Tykon, Inc. and Viking Computer Services, Inc., and the 38 newly formed D&K Pharmacy Solutions constitute the Software/Other segment. Viking markets a pharmacy management software system and Tykon developed and markets a proprietary PC-based order entry/order confirmation system to the drug distribution industry. Pharmacy Solutions provides additional services to pharmacy customers including the marketing and distributing Parata robotic dispensing systems. Though the Wholesale drug distribution segment operates from several different facilities, the nature of its products and services, the types of customers and the methods used to distribute its products are similar and thus they have been aggregated for presentation purposes. Sales to independent and regional pharmacies consist of branded pharmaceuticals (approximately 89% of net sales in fiscal 2004), generic pharmaceuticals (approximately 8% of net sales in fiscal 2004) and over-the-counter health and beauty aid products (approximately 3% of net sales in fiscal 2004). Our national accounts business deals predominantly with branded pharmaceuticals. The Company operates principally in the United States. Interest and corporate expenses are allocated to wholly owned subsidiaries only. Assets have been identified with the segment to which they relate.
For the Years Ended ------------------------------------------------- (in thousands) JUNE 30, 2004 JUNE 30, 2003 JUNE 30, 2002 ------------- ------------- ------------- Sales to unaffiliated customers - Wholesale drug distribution $ 2,528,577 $ 2,213,257 $ 2,444,290 PBI 8,823 7,768 7,539 Software and Other 3,790 2,363 1,919 ------------- ------------- ------------- TOTAL $ 2,541,190 $ 2,223,388 $ 2,453,748 Intersegment sales -- Wholesale drug distribution $ -- $ -- $ -- PBI -- -- -- Software and Other -- -- 1,197 Intersegment eliminations -- -- (1,197) ------------- ------------- ------------- TOTAL $ -- $ -- $ -- Gross profit -- Wholesale drug distribution $ 92,401 $ 81,193 $ 92,578 PBI (2) 8,823 7,768 7,539 Software and Other 2,171 1,738 2,714 ------------- ------------- ------------- TOTAL $ 103,395 $ 90,699 $ 102,831 Depreciation and amortization -- Wholesale drug distribution $ 3,698 $ 2,410 $ 4,107 PBI 53 47 97 Software and Other 31 35 249 ------------- ------------- ------------- TOTAL $ 3,782 $ 2,492 $ 4,453 Interest expense -- Wholesale drug distribution $ 14,241 $ 10,680 $ 9,955 PBI 240 336 380 Software and Other 50 54 51 ------------- ------------- ------------- TOTAL $ 14,531 $ 11,070 $ 10,386 Earnings before income tax provision -- Wholesale drug distribution $ 13,079 $ 19,424 $ 31,271 PBI 4,152 3,833 4,029 Software and Other 723 449 610 ------------- ------------- ------------- TOTAL $ 17,954 $ 23,706 $ 35,910 Purchases of property and equipment -- Wholesale drug distribution $ 4,411 $ 679 $ 988 PBI 363 33 40 Software and Other 126 5 23 Other unallocated Corporate amounts 492 1,654 2,394 ------------- ------------- ------------- TOTAL $ 5,392 $ 2,371 $ 3,445 Identifiable assets -- Wholesale drug distribution $ 709,189 $ 450,263 $ 464,494 PBI 4,821 4,448 3,810 Software and Other 14,815 2,693 2,301 Other unallocated Corporate amounts (1) 14,880 15,291 12,533 ------------- ------------- ------------- TOTAL $ 743,705 $ 472,695 $ 483,138
39 (1) Amounts represent assets at corporate headquarters consisting primarily of deferred tax assets, property and equipment and deferred debt costs. (2) Cost of operations recorded by PBI of $4.4 million, $3.6 million, and $3.2 million, respectively, have been classified as operating expenses in the Company's Consolidated Statements of Operations. NOTE 16. QUARTERLY RESULTS (UNAUDITED) Quarterly results are determined in accordance with annual accounting policies. They include certain items based upon estimates for the entire year. Summarized quarterly results for the last two years were as follows:
(in thousands, except per share data) 2004 QUARTER 2004 ------------------------------------------------ ---------- FIRST SECOND THIRD FOURTH YEAR -------- -------- -------- -------- ---------- Net sales $478,548 $510,945 $833,933 $717,764 $2,541,190 Gross profit 18,088 19,455 (1) 35,177 30,675 (1) 103,395 Net income 1,467 177 5,404 3,166 10,214 Basic earnings per share $ 0.11 $ 0.01 $ 0.39 $ 0.23 $ 0.73 Diluted earnings per share 0.10 0.01 0.38 0.22 0.71
(in thousands, except per share data) 2003 QUARTER 2003 ------------------------------------------------- ---------- FIRST SECOND THIRD FOURTH YEAR --------- -------- -------- -------- ---------- Net sales $533,966 $530,843 $628,618 $529,961 $2,223,388 Gross profit 21,053 21,222 27,018 21,406 90,699 Net income (1,387) 2,675 4,235 4,163 9,686 Basic earnings (loss) per share ($ 0.09) $ 0.18 $ 0.30 $ 0.30 $ 0.68 Diluted earnings (loss) per share (0.10) 0.18 0.29 0.29 0.65
(1) Include gains from legal settlements of $0.8 million in the second quarter and $2.3 million in the fourth quarter. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None Item 9A. Controls and Procedures Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. Item 9B. Other Information. None. 40 PART III Item 10. Directors and Executive Officers of the Registrant The information set forth under the caption "Election of Directors" in the Proxy Statement for our 2004 Annual Meeting of Stockholders (the "2004 Proxy Statement") is incorporated herein by this reference. We will file the 2004 Proxy Statement with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the close of the fiscal year. Code of Business Conduct and Ethics The Company has adopted a Code of Business Conduct and Ethics (the "Code") that applies to all companies, their officers, directors and employees. This Code and the charters of the Audit, Compensation and Nominating and Corporate Governance committees are posted on the Company's website at www.dkhealthcare.com. The Company intends to post any amendments to or waivers from the Code on our website. Item 11. Executive Compensation The information set forth under the captions "Directors' Fees" and "Compensation of Executive Officers" in the 2004 Proxy Statement, to be filed with the SEC pursuant to Regulation 14A of the Exchange Act, is incorporated herein by this reference. Item 12. Security Ownership of Certain Beneficial Owners and Management The information set forth under the captions "Voting Securities and Principal Holders Thereof" and "Security Ownership By Management" in the 2004 Proxy Statement, to be filed with the SEC pursuant to Regulation 14A of the Exchange Act, is incorporated herein by this reference. Item 13. Certain Relationships and Related Transactions The information set forth under the caption "Certain Transactions" in the 2004 Proxy Statement, to be filed with the SEC pursuant to Regulation 14A of the Exchange Act, is incorporated herein by this reference. Item 14. Principal Accountant Fees and Services A description of the fees paid to our independent auditors will be set forth in the section titled "Independent Public Accountants" of the Proxy Statement and is incorporated herein by reference. 41 PART IV Item 15. Exhibits, Financial Statements, Schedules and Reports on Form 8-K (a) (1) Financial statements: See Item 8 above. (2) The following financial statement schedule and auditors' report thereon are included in Part IV of this report: Page Schedule II - Valuation and Qualifying Accounts 44 Schedules other than those listed above have been omitted because they are either not required or not applicable or because the information is presented in the consolidated financial statements or the notes thereto. (3) Exhibits. See Exhibit Index. (b) Reports on Form 8-K On April 21, 2004, the registrant filed a Current Report on Form 8-K to furnish as an exhibit registrant's press release announcing its results for its fiscal 2004 third quarter and first nine months. (c) See Item 15(a)(3) above. (d) See Item 15(a)(2) above. 42 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. D & K HEALTHCARE RESOURCES, INC. (Registrant) By /s/ J. Hord Armstrong, III --------------------------------- J. Hord Armstrong, III, Chairman of the Board, Chief Executive Officer and Treasurer Date: September 13, 2004 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ---- /s/ J. Hord Armstrong, III Chairman, Chief Executive Officer, September 13, 2004 - ------------------------------ Treasurer and Director J. Hord Armstrong, III /s/ Martin D. Wilson President, Chief Operating Officer September 13, 2004 - ------------------------------ and Director Martin D. Wilson /s/ Thomas S. Hilton Senior Vice President, Chief Financial September 13, 2004 - ------------------------------ Officer (Principal financial and Thomas S. Hilton accounting officer) /s/ Richard F. Ford Director September 13, 2004 - ------------------------------ Richard F. Ford /s/ Bryan H. Lawrence Director September 13, 2004 - ------------------------------ Bryan H. Lawrence /s/ Mary Ann Van Lokeren Director September 13, 2004 - ------------------------------ Mary Ann Van Lokeren /s/ Thomas F. Patton Director September 13, 2004 - ------------------------------ Thomas F. Patton /s/ Louis B. Susman Director September 13, 2004 - ------------------------------ Louis B. Susman /s/ Harvey C. Jewett, IV Director September 13, 2004 - ------------------------------ Harvey C. Jewett, IV
43 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS FOR FISCAL 2002, FISCAL 2003, AND FISCAL 2004
Additions ------------------------------ Balance at Charged to Balance at Beginning Costs and End of Description of Period Expenses Acquisitions Deductions Period ----------- ---------- ---------- ------------ ---------- ---------- Valuation Allowances for Doubtful Receivables: Fiscal Year 2002 $ 2,197,000 $ 525,000 $ -- $ (1,348,000) $1,374,000 =========== ========= ============ ============= ========== Fiscal Year 2003 $ 1,374,000 $ 230,000 $ -- $ -- $1,604,000 =========== ========= ============ ============= ========== Fiscal Year 2004 $ 1,604,000 $ 333,000 $ 3,776,000 $ (269,000) $5,444,000 =========== ========= ============ ============= ==========
44 EXHIBIT INDEX Exhibit No. Description 2.1* Stock Purchase and Redemption Agreement, dated as of November 30, 1995, by and among Pharmaceutical Buyers, Inc., J. David McCay, The J. David McCay Living Trust, Robert E. Korenblat and the registrant filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended March 28, 1997. 2.2* Stock Purchase Agreement dated June 1, 1999 by and between the registrant and Harvey C. Jewett, IV, filed as an exhibit to Form 8-K dated June 14, 1999. 3.1* Restated Certificate of Incorporation, filed as an exhibit to registrant's Registration Statement on Form S-1 (Reg. No. 33-48730). 3.2* Certificate of Amendment to the Restated Certificate of Incorporation of D&K Wholesale Drug, Inc filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1998. 3.3* Certificate of Designations for Series B Junior Participating Preferred Stock of D&K Healthcare Resources, Inc. filed as an exhibit to the registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2001. 3.4* By-laws of the registrant, as currently in effect, filed as an exhibit to registrant's Registration Statement on Form S-1 (Reg. No. 33-48730). 3.5* Certificate of Amendment of Certificate of Incorporation of D&K Healthcare Resources, Inc., dated March 13, 2002, filed as an exhibit to the registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2002. 4.1* Form of certificate for Common Stock, filed as an exhibit to registrant's Registration Statement on Form S-1 (Reg. No. 33-48730). 4.2* Form of Rights Agreement dated as of November 12, 1998 between registrant and Harris Trust and Savings Bank as Rights Agent, which includes as Exhibit B the form of Right Certificate, filed as an exhibit to Form 8-K dated November 17, 1998. 10.1* D & K Healthcare Resources, Inc., Amended and Restated 1992 Long Term Incentive Plan, filed as Annex A to the registrant's 1999 Proxy Statement. 10.2* D & K Wholesale Drug, Inc. 401(k) Profit Sharing Plan and Trust, dated January 1, 1995, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended March 29, 1996. 10.2a* Amendment Number 1 to D & K Wholesale Drug, Inc. 401(k) Profit Sharing Plan and Trust, dated December 20, 1996, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.2b* Amendment Number 2 to D & K Wholesale Drug, Inc. 401(k) Profit Sharing Plan and Trust, dated September 17, 1997, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.2c* Resolution to D & K Wholesale Drug, Inc. 401(k) Profit Sharing Plan and Trust, dated March 27, 2000, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.3* Amended and Restated Lease Agreement, dated as of January 16, 1996, by and between Morhaert Development, L.L.C. and the registrant, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended March 29, 1996. 10.4* Purchase and Sale Agreement dated as of August 7, 1998 between registrant, certain of its subsidiaries and D&K Receivables Corporation, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1998. 10.5* Sixth Amended and Restated Loan and Security Agreement, dated March 28, 2003, by and among Fleet Capital Corporation (individually and as Agent for Lenders), registrant, Jewett Drug Co., Diversified Healthcare, LLC, and Medical & Vaccine Products, Inc. filed as an exhibit to the registrant's Current Report on Form 8-K dated March 31, 2003. 45 EXHIBIT INDEX Exhibit No. Description 10.7* Prime Vendor Agreement dated as of August 25, 1999, between Tennessee Pharmacy Purchasing Alliance and the registrant, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.7a* First Amendment to Prime Vendor Agreement dated effective as of April 1, 2001 between The Pharmacy Cooperative formerly known as Tennessee Pharmacy Purchasing Alliance and the registrant filed as an exhibit to the registrant's Registration Statement, Amendment No. 2 to Form S-3 dated June 27, 2001. 10.8* Lease Agreement, dated as of May 18, 1999, by and between BSRT Lexington Trust and the registrant, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.9* Lease Agreement, dated as of January 1, 1997, by and between Jewett Family Investments, LLC and Jewett Drug Co, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.10* First Amendment to Lease, dated as of June 1, 1999, by and between Jewett Family Investments, LLC and Jewett Drug Co, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.11* Lease Agreement dated as of July 1, 1997 by and between Jewett Family Investments, LLC and the registrant, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.12* First Amendment to Lease, dated as of June 1, 1999, by and between Jewett Family Investments, LLC and Jewett Drug Co, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 1999. 10.13* Employment agreement for J. Hord Armstrong, III dated September 15, 2000, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.14* Employment agreement for Martin D. Wilson dated August 28, 2000, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.15* Employment agreement for Thomas S. Hilton dated August 31, 2000, filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.16* D&K Healthcare Resources, Inc. Executive Retirement Benefit Plan, dated January 1, 1998. filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2000. 10.17* D & K Healthcare Resources, Inc. 2001 Long Term Incentive Plan, dated November, 2001, filed as an exhibit to the registrant's 2001 Proxy Statement. 10.18* Lease Agreement dated as of October 10, 2001 by and between Forsyth Centre Associates, L.L.C., and the registrant filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2002. 10.18a* Amendment to Lease Agreement dated February 26, 2002 by and between Forsyth Centre Associates, L.L.C., and the registrant filed as an exhibit to the registrant's Annual Report on Form 10-K for the year ended June 30, 2002. 10.19* Lease Agreement, dated February 7, 2001, by and between Industrial Property Fund III, L.P. and the registrant, filed as an exhibit to the registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001. 46 EXHIBIT INDEX Exhibit No. Description 10.20* Lease Agreement, dated August 2003, by and between Hillwood Metro No. 10, L.P., LCS Land Partners II, Ltd and the registrant, filed as an exhibit to the registrants Annual Report on Form 10-K for the year ended June 30, 2003. 10.21* Agreement and Plan of Merger dated as of October 21, 2003 between D&K Healthcare Resources, Inc., Walsh HealthCare Solutions, Inc. and D&K Acquisition Corp filed as an exhibit to the registrant's Current Report on Form 8-K dated December 15, 2003. 10.22** Lease Agreement, dated August 18, 2004, by and between Gazelle, LLC and the registrant. 13** Registrant's 2004 Annual Report to Stockholders. 14** Registrant's Code of Business Conduct and Ethics. 21** Subsidiaries of the registrant. 23** Consent of Independent Registered Public Accounting Firm 31.1** Certification by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2** Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32** Certification by Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Incorporated by reference. ** Filed herewith. 47 EX-10.22 2 c88104exv10w22.txt LEASE AGREEMENT EXHIBIT 10.22 JEFFERSON METROPOLITAN DISTRIBUTION CENTER INDUSTRIAL LEASE (MULTI-TENANT FACILITY) ARTICLE ONE: BASIC TERMS This Article One contains the Basic Terms of this Lease between the Landlord and Tenant named below. Other Articles, Sections and Paragraphs of the Lease referred to in this Article One explain and define the Basic Terms and are to be read in conjunction with the Basic Terms. Section 1.01. DATE OF LEASE: August ___, 2004 Section 1.02. LANDLORD: Gazelle, LLC, an Alabama limited liability company Address of Landlord: 2200 Woodcrest Place, Suite 210, Birmingham, Alabama 35209 Section 1.03. TENANT (INCLUDE LEGAL ENTITY): D&K Healthcare Resources Inc., a Delaware Corporation Address of Tenant: 8235 Forsyth Boulevard, St. Louis, MO 63105-1623 (All notices to Tenant shall be sent to this address marked to the attention of Tenant's "General Counsel"). Section 1.04. PREMISES: The Premises are part of Landlord's multi-tenant real property development known as Jefferson Metropolitan Distribution Center in McCalla, Alabama, a legal description and depiction of which appears on Exhibit "A" (the "Project"). The term "Project" includes the land, Building One and Building Two (as those terms are defined below), all other improvements located on the land, and the common areas described and depicted on Exhibit "A". At the present time, the term "Project" shall mean and include both the building in which the Premises are located ("Building One") and the adjacent building that Landlord is constructing which will comprise approximately 240,240 square feet ("Building Two"). The Premises includes approximately 180,180 square feet of space, designated as street address of 6775 Jefferson Metropolitan Parkway, McCalla, AL, 35111, along with the exclusive right to certain parking areas and paved areas outside trucking docks, all as shown more particularly on Exhibit "A" as "D&K Parking Areas". The locations of Building One, the proposed Building Two, the Premises, and the Common Areas are shown and described on Exhibit "A". Section 1.05. LEASE TERM: Ten (10) years commencing on December 1, 2004 and ending on November 30, 2014. Section 1.06. PERMITTED USES: (See Article Five) Sales, distribution, storage and related functions for wholesale pharmaceuticals, consumers goods generally purchased in retail pharmacies. Section 1.07. TENANT'S GUARANTOR: None Section 1.08. BROKERS: (See Article Fourteen) (If none, so state) Landlord's Broker: Graham & Company, Inc. Tenant's Broker: Stream Realty Partners, L.P. Section 1.09. COMMISSION PAYABLE TO LANDLORD BROKERS: (See Article Fourteen) To be paid by Landlord pursuant to terms of a separate agreement. Section 1.10. SECURITY DEPOSIT: (See Section 3.03) Waived Section 1.11. VEHICLE PARKING SPACES ALLOCATED TO TENANT: (See Section 4.05) The areas adjacent to Property so designated on Exhibit A. Section 1.12. RENT AND OTHER CHARGES PAYABLE BY TENANT: (a) BASE RENT. Commencing December 1, 2004, Tenant shall pay Base Rent of Fifty-Four Thousand Fifty-Four and 00/100 Dollars ($54,054.00) per month for twelve (12) consecutive months, as provided in Section 3.01. Beginning on December 1, 2005, and on each subsequent December 1 of the Lease Term, the Base Rent shall be increased by 1.75%. (b) ADDITIONAL RENT. Commencing December 1, 2004, Tenant shall also pay the Additional Rent in accordance with Section 4.01 (c) TOTAL RENT. Beginning December 1, 2004, the Base Rent 1.12(a) and the estimate of Additional Rent 1.12(b) is due on the first day of each month. As of December 1, 2004, this amount will be equal to Sixty-Two Thousand Three Hundred Twelve and 25/100 Dollars ($62,312.25). Thereafter, such amount will be adjusted in accordance with Section 1.12(a) and Section 4.01. (d) PAYMENT UPON LEASE EXECUTION. Upon execution of this Lease, Tenant shall pay Landlord the sum of $62,312.25 representing an advance payment of the rent due for the first month of the Lease Term, which Landlord shall apply to the rent due on December 1, 2004. Section 1.13. LANDLORD'S SHARE OF PROFIT ON ASSIGNMENT OR SUBLEASE: (See Section 9.05) Fifty Percent (50%) of the Profit (the "Landlord's Share"). Initials: ________ ________ 1 Section 1.14. EXHIBITS: The following exhibits are attached to and made a part of this Lease: Exhibit A - The Project Exhibit B - Tenant Plans and Specifications Exhibit C - Additional Terms of the Lease ARTICLE TWO: LEASE TERM Section 2.01. LEASE OF PREMISES FOR LEASE TERM. Landlord leases the Premises to Tenant and Tenant leases the Premises from Landlord for the Lease Term. The Lease Term is for the period stated in Section 1.05 above and shall begin and end on the dates specified in Section 1.05 above, unless the beginning or end of the Lease Term is changed under any provision of this Lease. The "Commencement Date" shall be the date specified in Section 1.05 above for the beginning of the Lease Term. Section 2.02. EARLY ACCESS. Prior to the Commencement Date, but only after Tenant shall have provided Landlord with the evidence that it has procured the insurance required under Section 4.04(a) with respect to the Premises, Tenant shall have a right of early access to the Premises during which Tenant shall be permitted to install its equipment and supervise the construction of its improvements to the Premises, Section 2.03. [This Section intentionally left blank.] Section 2.04. HOLDING OVER. Tenant shall vacate the Premises upon the expiration or earlier termination of this Lease. Tenant shall reimburse Landlord for and indemnify Landlord against all damages which Landlord incurs from Tenant's delay in vacating the Premises; provided, however, if Tenant pays to Landlord the rental payments described in this Section 2.04, then Tenant shall not be required to reimburse Landlord for or indemnify Landlord against any damages which Landlord incurs from Tenant's delay in vacating the Premises. If Tenant does not vacate the Premises upon the expiration or earlier termination of the Lease and Landlord thereafter accepts rent from Tenant, Tenant's occupancy of the Premises shall be a "month-to-month" tenancy, subject to all of the terms of this Lease applicable to a month-to-month tenancy, except that the Base Rent then in effect shall be increased by fifty percent (50%). ARTICLE THREE: BASE RENT Section 3.01. TIME AND MANNER OF PAYMENT. Commencing December 1, 2004, and on the first day of each month thereafter, Tenant shall pay Landlord the Base Rent, in advance, without offset (except to the extent permitted under Sections 4.01 and 15.03), deduction or prior demand. The Base Rent shall be payable at Landlord's address or at such other place as Landlord may designate in writing. As noted in Section 1.12(d) above, Landlord shall apply the sum remitted to it by Tenant upon execution of this Lease to the rent due on December 1, 2004. Section 3.02. [This Section intentionally left blank.] Section 3.03. TERMINATION; ADVANCE PAYMENTS. Upon termination of this Lease under Article Seven (Damage or Destruction), Article Eight (Condemnation) or any other termination not resulting from Tenant's default, and after Tenant has vacated the Premises in the manner required by this Lease, Landlord shall refund or credit to Tenant (or Tenant's successor) any advance rent or other advance payments made by Tenant to Landlord, including any Base Rent or Additional Rent that apply to any time periods after termination of the Lease. ARTICLE FOUR: OTHER CHARGES PAYABLE BY TENANT Section 4.01. ADDITIONAL RENT. All charges payable by Tenant under this Section 4.01 are called "Additional Rent." The term "rent" shall mean Base Rent and Additional Rent. During each month of the Term of this Lease on the same day that Base Rent is due hereunder, Tenant shall pay to Landlord an amount equal to 1/12th of the Landlord's good faith estimate of the annual Additional Rent. The annual Additional Rent shall include only: (a) Tenant's Pro Rata Share of Real Property Taxes (as defined in Section 4.02(b)); (b) Tenant's Pro Rata Share of Insurance Premiums described in Section 4.04(c); and (c) Tenant's Pro Rata Share of Common Area Expenses (as defined in Section 4.05(e)). As used herein, the term "Tenant's Pro Rata Share" shall mean 33.33% of the foregoing costs which are applicable to the entire Project; provided, however, that (x) if Building One becomes a part of a tax parcel that does not include Building Two, then Tenant's Pro Rata Share of Real Property Taxes shall thereafter mean 60.00%, or (y) if Landlord obtains separate insurance policies for Building One and Building Two, then Tenant's Pro Rata Share of Insurance Premiums under Section 4.04(c) shall thereafter mean 60.00%, and/or (z) if Landlord elects to maintain the Common Areas for Building One and Building Two separately, then Tenant's Pro Rata Share of Common Area Expenses (as defined in Section 4.05(e)) shall thereafter mean 60.00%. For the year beginning December 1, 2004, the Landlord's good faith estimate of 1/12 of the annual Additional Rent is Eight Thousand Two Hundred Fifty-Eight and 25/100 Dollars ($8,258.25). Tenant authorizes Landlord to use the funds deposited with Landlord under this Section 4.01 to pay such costs and expenses that comprise the Real Property Taxes, Insurance Premiums, Common Area Expenses. Within sixty (60) days after the end of each calendar year of the Lease Term, Landlord shall deliver to Tenant a statement prepared in accordance with generally accepted accounting principles setting forth, in reasonable detail, the annual Additional Rent actually incurred by Landlord during the preceding calendar year. If the Tenant's (x) total payments under Section 4.01 are less than (y) the annual Additional Rent actually incurred by Landlord; then Tenant shall pay the difference to Landlord within ten (10) days after demand. If the Tenant's (x) total escrow payments under Section 4.01 are greater than (y) the annual Additional Rent actually incurred by Landlord; then Landlord shall pay the difference to Tenant within ten (10) days after demand. Landlord may adjust its good faith estimate of the annual Additional Rent at any time based upon Landlord's Initials: ________ ________ 2 experience and reasonable anticipation of costs. Such adjustments shall be effective as of the next rent payment date after notice to Tenant. Tenant acknowledges that Landlord may subdivide the land now comprising the Project, or otherwise separate the ownership of Buildings One and Two, and if Landlord does so, the term "Project" as used in this Lease shall thereafter refer only to the land and Common Areas associated with Building One, whereupon Landlord shall properly segregate (or otherwise reasonably allocate) the costs of maintaining the Common Areas associated with each such building. In no event shall Tenant be required to pay any Common Area costs to the extent such costs relate solely to costs incurred by Landlord during or related to the construction of Building Two. Tenant and its agents will have the right to examine and copy Landlord's books and records relating to the Additional Rent during normal business hours at Landlord's principal place of business according to this section. If Tenant's examination reveals that it has overpaid its proportionate share of Real Property Taxes, Insurance Premiums, Common Area Expenses, then the overpayment will be deducted from the next accruing rent payment. If the overpayment exceeds the amount that should have been charged by more than $5,000.00, but less than $8,000.00, then Landlord will pay not more than $2,000.00 in Tenant's reasonable out-of-pocket costs incurred in connection with the examination. If the overpayment exceeds the amount that should have been charged by more than $8,000.00, then Landlord will pay not more than $4,000.00 in Tenant's reasonable out-of-pocket costs incurred in connection with the examination. Tenant's sole remedy in the event of an overpayment plus interest will be the offset against its rent. Tenant will not have the right to terminate the Lease on account of an overpayment. Section 4.02. PROPERTY TAXES. (a) REAL PROPERTY TAXES. Landlord shall pay the "Real Property Taxes" during the Lease Term. Tenant acknowledges that the Project may currently be fully or partially exempt from certain Real Property Taxes and that if this exemption should expire during the Lease Term, additional Real Property Taxes may then become payable on the Project. (b) DEFINITION OF "REAL PROPERTY TAX." The term "Real Property Taxes" means: (i) any fee, license fee, license tax, business license fee, commercial rental tax, levy, charge, assessment, penalty or tax imposed by any taxing authority against the Project; (ii) any tax that might be levied in the future on the Landlord's right to receive, or the receipt of, rent or income from the Premises or against Landlord's business of leasing the Premises (a "rental tax"); provided, however, that in the event of the passage of any such rental tax, Tenant's obligation to reimburse Landlord therefore shall be capped at an amount not to exceed seven cents ($.07) per square foot per year; (iii) any tax or charge for fire protection, streets, sidewalks, road maintenance, refuse or other services provided to the Project by any governmental agency; (iv) any tax imposed upon this transaction or based upon a re-assessment of the Project; and (v) any charge or fee replacing any tax previously included within the definition of Real Property Tax. "Real Property Tax" does not, however, include Landlord's federal or state income, franchise, inheritance or estate taxes. (c) PERSONAL PROPERTY TAXES. Tenant shall pay all taxes charged against trade fixtures, furnishings, equipment or any other personal property belonging to Tenant. To the extent possible, Tenant shall have its personal property taxed separately from the Premises. Section 4.03. UTILITIES. Tenant shall pay, directly to the appropriate supplier, the cost of all natural gas, heat, light, power, sewer service, telephone, water, refuse disposal and other utilities and services supplied to the Premises. All utilities used by Tenant shall be separately metered other than water and sewer service, with the meters for electrical power and natural gas to be installed by Tenant at its expense in connection with the construction of the improvements to be made by Tenant to the Premises, as described on Exhibit C. Landlord shall make a reasonable, good-faith determination of Tenant's proportionate share of the cost of water and sewer services. The determination and allocation of the cost of such utilities and services will take into account the nature and use of the Premises. Section 4.04. INSURANCE POLICIES. (a) TENANT'S INSURANCE. During the Lease Term, Tenant shall maintain a policy of commercial general liability insurance insuring Tenant against liability for bodily injury, property damage (including loss of use of property) and personal injury arising out of the operation, use or occupancy of the Premises. Tenant shall name Landlord as an additional insured under such policy. The amount of such insurance shall be Three Million Dollars ($3,000,000) per occurrence. The liability insurance obtained by Tenant under this Section 4.04(a) shall (i) be primary and noncontributing; (ii) contain cross-liability endorsements; and (iii) contain contractual liability coverage. The amount and coverage of such insurance shall not limit Tenant's liability nor relieve Tenant of any other obligation under this Lease. Within 10 days after the Commencement Date and upon each renewal of such insurance policy, Tenant shall deliver to Landlord a certificate evidencing that it has obtained the insurance coverage required by this Section 4.04(a). (b) LANDLORD'S INSURANCE. During the Lease Term, Landlord shall maintain a policy of commercial general liability insurance in an amount and with coverage determined by Landlord (but in no event less that One Million Dollars per occurrence) insuring Landlord against liability arising out of ownership, operation, use or occupancy of the Project. The policy obtained by Landlord shall not be contributory and shall not provide primary insurance. During the Lease Term, Landlord shall also maintain policies of insurance covering loss of or damage to the Project in the full amount of its replacement value. Such policy shall contain an Inflation Guard Endorsement and shall provide protection against all perils included within the classification of fire, extended coverage, vandalism, malicious mischief, special extended perils (all risk), sprinkler leakage and any other perils which Landlord deems reasonably necessary. Landlord shall have the right to obtain flood and earthquake insurance if required by any lender holding a security interest in the Project. Landlord shall not obtain insurance for Tenant's fixtures or equipment or building improvements installed by Tenant in the Premises. During the Lease Term, Landlord shall also maintain a rental income insurance policy, with loss payable to Landlord, in an amount equal to not less than one year's Base Rent, plus estimated real property taxes and insurance Initials: ________ ________ 3 premiums. Tenant shall not do or permit anything to be done which invalidates any such insurance policies. Upon request of Tenant from time-to-time, Landlord shall deliver to Tenant a certificate evidencing that it has obtained the insurance coverage required by this Section 4.04(b). (c) PAYMENT OF PREMIUMS. (i) Landlord shall pay the premiums for the insurance policies maintained by Landlord under Section 4.04(b) and Section 4.05. (ii) If the insurance policies maintained by Landlord cover improvements or real property other than the Premises, Landlord shall also deliver to Tenant a statement of the amount of the premiums applicable to the Premises showing, in reasonable detail, how such amount was computed. If the Lease Term expires before the expiration of the insurance period, Tenant's liability shall be pro rated on an annual basis. (d) GENERAL INSURANCE PROVISIONS. (i) Any insurance which Tenant is required to maintain under this Lease shall include a provision which requires the insurance carrier to give Landlord not less than either (x) thirty (30) days' written notice prior to any cancellation or material modification of such coverage relating to the insurance Tenant is required to maintain with respect to the Premises, or (y) ten (10) days written notice of cancellation in the event of non-payment of premiums. (ii) If Tenant fails to deliver any policy, certificate or renewal to Landlord required under this Lease within the prescribed time period or if any such policy is cancelled or modified during the Lease Term without Landlord's consent, Landlord may obtain such insurance, in which case Tenant shall reimburse Landlord for the cost of such insurance within fifteen (15) days after receipt of a statement that indicates the cost of such insurance. (iii) Tenant shall maintain all insurance required under this Lease with companies holding a "General Policy Rating" of A-VIII or better, as set forth in the most current issue of "Best Key Rating Guide". Landlord and Tenant acknowledge the insurance markets are rapidly changing and that insurance in the form and amounts described in this Section 4.04 may not be available in the future. Tenant acknowledges that the insurance described in this Section 4.04 is for the primary benefit of Landlord. If at any time during the Lease Term, Tenant is unable to maintain the insurance required under the Lease, Tenant shall nevertheless maintain insurance coverage which is customary and commercially reasonable in the insurance industry for Tenant's type of business, as that coverage may change from time to time. Landlord makes no representation as to the adequacy of such insurance to protect Landlord's or Tenant's interests. Therefore, Tenant shall obtain any such additional property or liability insurance which Tenant deems necessary to protect Landlord and Tenant. (iv) Landlord and Tenant each hereby waive any and all rights of recovery against the other, or against the officers, employees, agents or representatives of the other, for loss of or damage to its property or the property of others under its control, if such loss or damage is covered by any insurance policy in force (whether or not described in this Lease) at the time of such loss or damage. Upon obtaining the required policies of insurance, Landlord and Tenant shall give notice to the insurance carriers of this mutual waiver of subrogation. Section 4.05. COMMON AREAS; USE, MAINTENANCE AND COSTS. (a) COMMON AREAS. As used in this Lease, "Common Areas" shall mean all areas within the Project which are available for the common use of tenants of the Project and which are not leased or held for the exclusive use of Tenant or other tenants, including, but not limited to, parking areas, driveways, sidewalks, loading areas, access roads, corridors, landscaping and planted areas. Landlord, from time to time, may change the size, location, nature and use of any of the Common Areas, convert Common Areas into leasable areas, construct additional parking facilities (including parking structures) in the Common Areas, and increase or decrease Common Area land and/or facilities. Tenant acknowledges that such activities may result in inconvenience to Tenant. Such activities and changes are permitted if they do not materially affect Tenant's use of the Premises or interfere with Tenant's business. (b) USE OF COMMON AREAS. Tenant shall have the nonexclusive right (in common with other tenants and all others to whom Landlord has granted or may grant such rights) to use the Common Areas for the purposes intended, subject to such reasonable rules and regulations as Landlord may establish from time to time, provided that such rules and regulations do not materially affect Tenant's use of the Premises or interfere with Tenant's business. Tenant shall abide by such rules and regulations and shall use its best effort to cause others who use the Common Areas with Tenant's express or implied permission to abide by Landlord's rules and regulations. At any time, Landlord may close any Common Areas to perform any acts in the Common Areas as, in Landlord's judgment, are desirable to improve the Project, provided that such closure does not materially affect Tenant's use of the Premises or interfere with Tenant's business. Tenant shall not interfere with the rights of Landlord, other tenants or any other person entitled to use the Common Areas. (c) VEHICLE PARKING. Tenant shall be entitled to use the number of vehicle parking spaces in the Project allocated to Tenant in Section 1.11 of the Lease without paying any additional rent. Tenant shall have the exclusive right to use parking spaces and loading areas for those areas included within the Premises, as shown more particularly on Exhibit "A". Temporary parking of large delivery vehicles in the Project is permitted, but shall be subject to reasonable rules and regulations established by Landlord. Vehicles shall be parked only in striped parking spaces and not in Initials: ________ ________ 4 driveways, loading areas or other locations not specifically designated for parking. Handicapped spaces shall only be used by those legally permitted to use them. (d) MAINTENANCE OF COMMON AREAS. Landlord shall maintain the Common Areas in good order, condition and repair and shall operate the Project, in Landlord's sole discretion, as a first-class industrial/commercial real property development. As used herein, the term "Common Area Expenses" include, but are not limited to, costs and expenses for the following: gardening and landscaping; utilities, water and sewage charges; fire sprinkler maintenance and monitoring; maintenance of signs (other than tenants' signs); premiums for liability, property damage, fire and other types of casualty insurance on the Common Areas and worker's compensation insurance; all property taxes and assessments levied on or attributable to the Common Areas and all Common Area improvements; all personal property taxes levied on or attributable to personal property used exclusively in connection with the Common Areas; rental or lease payments paid by Landlord for rented or leased personal property used exclusively in the operation or maintenance of the Common Areas; fees for required licenses and permits; repairing (including roof repairs), resurfacing, repaving, maintaining, exterior painting, lighting, cleaning, refuse removal, security and similar items; and a reasonable allowance to Landlord for Landlord's supervision of the Common Areas (not to exceed three percent (3%) of the gross rents of the Project for the calendar year). Landlord may cause any or all of such services to be provided by third parties and the cost of such services shall be included in Common Area costs. Common Area costs shall not include depreciation of real property which forms part of the Common Areas. Following the first full calendar year of the Lease Term, Tenant's Pro Rata Share of "controllable" Common Area costs for any calendar year shall not exceed the amount of Tenant's Pro Rata Share of "controllable" Common Area costs for the immediately preceding calendar year by more than six percent (6%). For the purposes hereof, the term "controllable" Common Area costs shall mean all Common Area costs in the reasonable control of Landlord excluding real property taxes, insurance and utilities. Notwithstanding the foregoing, "Common Area Expenses" shall not include (i) depreciation of real property which forms part of the Common Areas; (ii) any ground lease rental; (iii) except to the extent described above, costs of items considered capital repairs, replacements, improvements and equipment under generally accepted accounting principles; (iv) costs incurred by Landlord for the repair of damage, to the extent that Landlord is reimbursed by insurance proceeds; (v) costs, including permit, license and inspection costs, incurred with respect to the installation of tenant or other occupants' improvements in the Building or incurred in renovating or otherwise improving, decorating, painting or redecorating vacant space for tenants of the Project; (vi) depreciation, amortization and interest payments, except on materials, tools, supplies and vendor-type equipment purchased by Landlord to enable Landlord to supply services Landlord might otherwise contract for with a third party where such depreciation, amortization and interest payments would otherwise have been included in the charge for such third party's services, all as determined in accordance with generally accepted accounting principles, consistently applied, and when depreciation or amortization is permitted or required, the item will be amortized over its reasonably anticipated useful life; (vii) marketing costs, including without limitation, leasing commissions, attorneys' fees in connection with the negotiation and preparation of letters, deal memos, letters of intent, leases, subleases or assignments, space planning costs, and other costs and expenses incurred in connection with lease, sublease or assignment negotiations, and transactions with present or prospective tenants or other occupants of the Project; (viii) expenses in connection with services or other benefits that are not offered to Tenant or for which Tenant is charged for directly but that are provided to another tenant or occupant of the Project at a lesser cost; (ix) costs incurred by Landlord due to the violation by Landlord or any tenant of the terms and conditions of any lease of space in the Project; (x) overhead and profit increment paid to Landlord or to subsidiaries or affiliates of Landlord for goods and services in or to the Project to the extent the same exceeds the costs of such goods and services rendered by unaffiliated third parties on a competitive basis; (xi) Interest, principal, points and fees on debts or amortization on any mortgage or mortgages or any other debt instrument encumbering the Project; (xii) landlord's general corporate overhead and general and administrative expenses; (xiii) costs incurred in connection with upgrading any portion of the Project to comply with life, fire and safety codes, ordinances, statutes or other laws in effect prior to the Commencement Date including, without limitation, the ADA, including penalties or damages incurred due to non-compliance (but costs incurred in connection with upgrading any portion of the Project to comply with life, fire and safety codes, ordinances, statutes or other laws not in effect before the Commencement Date, including, without limitation, the ADA, may be included); (xiv) despite any contrary provision of the Lease including without limitation, any provision relating to capital expenditures, any and all costs arising from the presence of hazardous materials or substances (as defined by applicable laws in effect on the date this Lease is executed) in or about the Premises, the Building, or the Project including, without limitation, hazardous substances or the ground water or soil, not placed by Tenant; (xv) costs arising from latent defects in the base, shall or core of the Building or improvements installed by Landlord or repair to them; or (xvi) costs incurred by Landlord in satisfying its obligations under Section 6.03. Section 4.06. LATE CHARGES. Tenant's failure to pay rent promptly may cause Landlord to incur unanticipated costs. The exact amount of such costs is impractical or extremely difficult to ascertain. Such costs may include, but are not limited to, processing and accounting charges and late charges which may be imposed on Landlord by any ground lease, mortgage or trust deed encumbering the Premises. Therefore, if Landlord does not receive any rent payment within ten (10) days after it becomes due and Tenant has failed to make any rent payment on one (1) prior occasion during the immediately preceding 12-month period, then Tenant shall pay Landlord a late charge equal to five percent (5%) of the overdue amount. The parties agree that such late charge represents a fair and reasonable estimate of the costs Landlord will incur by reason of such late payment. Section 4.07. INTEREST ON PAST DUE OBLIGATIONS. If any amount owed by Tenant to Landlord is not paid within thirty (30) days after it becomes due, then such amount shall bear interest at the rate of fifteen percent (15%) per annum from the due date of such amount. The payment of interest on such amounts shall not excuse or cure any default by Tenant under this Lease. If the interest rate specified in this Lease is higher than the rate permitted by law, the interest rate is hereby decreased to the maximum legal interest rate permitted by law. Section 4.08. [This Section intentionally left blank.] ARTICLE FIVE: USE OF PREMISES Initials: ________ ________ 5 Section 5.01. PERMITTED USES. Tenant may use the Premises only for the Permitted Uses set forth in Section 1.06 above. Section 5.02. MANNER OF USE. Tenant shall not cause or permit the Premises to be used in any way which constitutes a violation of any law, ordinance, or governmental regulation or order, which annoys or interferes with the rights of tenants of the Project, or which constitutes a nuisance or waste, and Landlord shall take reasonable measures to not allow any other tenant of the Project to do the same. Tenant shall obtain and pay for all permits, including a Certificate of Occupancy, required for Tenant's occupancy of the Premises and shall at its expense promptly take all actions necessary to comply with all applicable statutes, ordinances, rules, regulations, orders and requirements regulating the use by Tenant of the Premises, including, without limitation, the Occupational Safety and Health Act ("OSHA") and the American with Disabilities Act ("ADA"). Section 5.03. HAZARDOUS MATERIALS. As used in this Lease, the term "Hazardous Material" means any flammable items, explosives, radioactive materials, hazardous or toxic substances, material or waste or related materials, including any substances defined as or included in the definition of "hazardous substances", "hazardous wastes", "hazardous materials" or "toxic substances" now or subsequently regulated under any applicable federal, state or local laws or regulations, including without limitation petroleum-based products, paints, solvents, lead, cyanide, DDT, printing inks, acids, pesticides, ammonia compounds and other chemical products, asbestos, PCBs and similar compounds, and including any different products and materials which are subsequently found to have adverse effects on the environment or the health and safety of persons. Tenant shall not cause or permit any Hazardous Material to be generated, produced, brought upon, used, stored, treated or disposed of in or about the Premises by Tenant, its agents, employees, contractors, sublessees or invitees without the prior written consent of Landlord. Landlord shall be entitled to take into account such other factors or facts as Landlord may reasonably determine to be relevant in determining whether to grant or withhold consent to Tenant's proposed activity with respect to Hazardous Material. In no event, however, shall Landlord be required to consent to the installation or use of any storage tanks on the Premises. Section 5.04. SIGNS AND AUCTIONS. Tenant shall not place any signs on the Premises without Landlord's prior written consent and approval of any architectural review committee. Tenant shall not conduct or permit any auctions or sheriff's sales at the Premises. Section 5.05. INDEMNITY. Tenant shall indemnify Landlord against and hold Landlord harmless from any and all costs, claims or liability arising from: (a) Tenant's use of the Premises; (b) the conduct of Tenant's business or anything else done or permitted by Tenant to be done in or about the Premises, including any contamination of the Premises or any other property resulting from the presence or use of Hazardous Material caused or permitted by Tenant; (c) any breach or default in the performance of Tenant's obligations under this Lease; (d) any misrepresentation or breach of warranty by Tenant under this Lease; or (e) other acts or omissions of Tenant. Tenant shall defend Landlord against any such cost, claim or liability at Tenant's expense with counsel reasonably acceptable to Landlord or, at Landlord's election, Tenant shall reimburse Landlord for any reasonable legal fees or costs incurred by Landlord in connection with any such claim. As a material part of the consideration to Landlord, Tenant assumes all risk of damage to property or injury to persons in or about the Premises arising from any cause other than Landlord's negligent acts or omissions, and Tenant hereby waives all claims in respect thereof against Landlord, except for any claim arising out of Landlord's gross negligence or willful misconduct. As used in this Section, the term "Tenant" shall include Tenant's employees, agents, contractors and invitees, if applicable. Section 5.06. LANDLORD'S ACCESS. With the Tenant's advance written consent, which shall not be unreasonably withheld or delayed, but which may be conditioned upon the presence of a representative of the Tenant, Landlord or its agents may enter the Premises to show the Premises to potential buyers, investors or tenants or other parties; to do any other act or to inspect and conduct tests in order to monitor Tenant's compliance with all applicable laws, including all laws governing the presence and use of Hazardous Material; or for any other reasonable purpose Landlord deems necessary. Tenant will at all times provide Landlord with the contact information for on "on-call" representative of Tenant who can be present in the case of an emergency requiring immediate access by Landlord. No sooner than six (6) months prior to the expiration of the Lease Term, Landlord may place customary "For Lease" signs on the Premises. Section 5.07. QUIET POSSESSION. If Tenant pays the rent and complies with all other terms of this Lease in all material respects, Tenant use and enjoy the Premises for the full Lease Term, subject to the provisions of this Lease, and Landlord covenants that Tenant's use and enjoyment of the Premises will not be disturbed by or through any person acting under Landlord's authority during the term of this Lease. ARTICLE SIX: CONDITION OF PREMISES; MAINTENANCE, REPAIRS AND ALTERATIONS Section 6.01. EXISTING CONDITIONS. Tenant accepts the Premises in its condition as of the execution of the Lease, subject to all recorded matters, laws, ordinances, and governmental regulations and orders. Except as provided herein, Tenant acknowledges that neither Landlord nor any agent of Landlord has made any representation as to the condition of the Premises or the suitability of the Premises for Tenant's intended use. Tenant represents and warrants that Tenant has made its own inspection of and inquiry regarding the condition of the Premises and is not relying on any representations of Landlord or any Broker with respect thereto. Section 6.02. EXEMPTION OF LANDLORD FROM LIABILITY. Landlord shall not be liable for any damage or injury to the person, business (or any loss of income therefrom), goods, wares, merchandise or other property of Tenant, Tenant's employees, invitees, customers or any other person in or about the Premises, whether such damage or injury is caused by or results from: (a) fire, steam, electricity, water, gas or rain; (b) the breakage, leakage, obstruction or other defects of pipes, sprinklers, wires, appliances, plumbing, air conditioning or lighting fixtures or any other cause; (c) conditions arising in or about the Premises or upon other portions of the Project, or from other sources or places; or (d) any act or omission Initials: ________ ________ 6 of any other tenant of the Project. Landlord shall not be liable for any such damage or injury even though the cause of or the means of repairing such damage or injury are not accessible to Tenant. The provisions of this Section 6.02 shall not, however, exempt Landlord from liability for Landlord's gross negligence or willful misconduct. Section 6.03. LANDLORD'S OBLIGATIONS. Subject to the provisions of Article Seven (Damage or Destruction) and Article Eight (Condemnation), and except for damage caused by any act or omission of Tenant, or Tenant's employees, agents, contractors or invitees, Landlord shall keep the foundation, roof and structural portions of exterior walls of the improvements on the Project (including Building One and the Premises) in good order, condition and repair. If any portion of the Project or any system or equipment in the Project which Landlord is obligated to repair cannot be fully repaired or restored, Landlord shall promptly replace such portion of the Project or system or equipment in the Project; provided, however, that in no event shall Landlord be required to maintain or replace any of the heating, ventilation or air conditioning equipment serving the warehouse portions of the Premises. However, Landlord shall not be obligated to maintain or repair windows, doors, plate glass or the surfaces of walls, unless such maintenance or repair is necessitated by Landlord's failure to satisfy its obligations described in this Section 6.03. Landlord shall not be obligated to make any repairs under this Section 6.03 until a reasonable time after receipt of a written notice from Tenant of the need for such repairs, provided however that Landlord shall make such repairs immediately after receiving notice from Tenant that Tenant's goods or products stored on the Premises are at risk of damage or peril. Section 6.04. TENANT'S OBLIGATIONS. Except as provided in Section 6.03, Article Seven (Damage or Destruction) and Article Eight (Condemnation), Tenant shall keep all portions of the Premises (including structural, nonstructural, interior, systems and equipment) in good order, condition and repair. If any portion of the Premises or any system or equipment in the Premises which Tenant is obligated to repair cannot be fully repaired or restored, Tenant shall promptly replace such portion of the Premises or system or equipment in the Premises, regardless of whether the benefit of such replacement extends beyond the Lease Term. If the Tenant reasonably determines that the benefit or useful life of any such replacement extends beyond the length of the Lease Term, including any potential extension term, then the Landlord shall within thirty (30) days of the Landlord's receipt of the Expenditure Notice reimburse the Tenant for the Landlord's Portion. The term "Expenditure Notice" means a written notice from the Tenant to the Landlord setting forth (a) the cost of any such repair; (b) the Tenant's good faith estimate of the useful life of such repair in months, subject to Landlord's concurrence therewith; (c) an amount equal to the cost of such repairs multiplied by a fraction the numerator of which is the current term of the lease and the denominator of which is the useful life of such repair (as determined in accord with Section 6.04(b)); (d) an amount equal to the cost of such repairs multiplied by a fraction the numerator of which is the sum of the months remaining in the current term of the lease, plus the number of months in all possible remaining extended terms of the lease, and the denominator of which is the useful life of such repair (as determined in accord with Section 6.04(b)); and (e) an amount equal to the cost of such repairs, less the amounts described in Section 6.04(d). The "Landlord's Portion" shall mean the amount described by Section 6.04(e). If the Tenant does not extend this Lease beyond the current Lease Term, then upon termination or expiration of the current Lease Term, the Landlord shall remit to the Tenant an amount equal to the difference between the amounts described in Section 6.04(c) and Section 6.04(d). Notwithstanding the foregoing, in no event shall Landlord be required to maintain or replace any of the heating, ventilating or air conditioning equipment serving the warehouse portions of the Premises or to replace (or share in the cost of replacing) any coolers or other special equipment installed by Tenant within the Premises. Tenant shall maintain a preventive maintenance contract providing for the regular inspection and maintenance of (a) the dock levelers (Landlord agrees that Tenant may perform this maintenance itself if Tenant so elects, in which event Tenant shall provide Landlord with documentation reflecting that Tenant is performing this work on a regular basis and in accordance with the manufacturer's recommendations), and (b) the heating and air conditioning system by a licensed heating and air conditioning contractor. If Tenant fails to provide such maintenance, Landlord shall have the right, upon written notice to Tenant, to undertake the responsibility for preventive maintenance of the heating and air conditioning system at Tenant's expense. In addition, Tenant shall, at Tenant's expense, repair any damage to the roof, foundation or structural portions of walls caused by Tenant's acts or omissions. It is the intention of Landlord and Tenant that, at all times during the Lease Term, Tenant shall maintain the Premises and Landlord shall maintain the Project (exclusive of the Premises), in an attractive, first-class and fully operative condition. Except as otherwise provided herein, Tenant shall fulfill all of Tenant's obligations under this Section 6.04 at Tenant's sole expense. If Tenant fails to maintain, repair or replace the Premises as required by this Section 6.04, Landlord may, upon ten (10) days' prior notice to Tenant (except that no notice shall be required in the case of an emergency), enter the Premises and perform such maintenance or repair (including replacement, as needed) on behalf of Tenant. In such case, Tenant shall reimburse Landlord for all costs incurred in performing such maintenance or repair immediately upon demand. Section 6.05. ALTERATIONS, ADDITIONS, AND IMPROVEMENTS. Tenant shall not make any alterations, additions, or improvements to the Premises without Landlord's prior written consent, except for non-structural alterations which do not exceed Ten Thousand Dollars ($10,000) in cost cumulatively over the Lease Term and which are not visible from the outside of any building of which the Premises is part (except that Tenant shall be permitted, subject to obtain approval of the Architectural Review Committee governing the Project, to erect a fence around a portion of the exterior of the Premises as shown on Exhibit A . Landlord may require Tenant to provide demolition and/or lien and completion bonds in form and amount satisfactory to Landlord. Upon Landlord's written request, Tenant shall promptly remove any alterations, additions, or improvements constructed in violation of this Section 6.05(a). All alterations, additions, and improvements shall be done in a good and workmanlike manner, in conformity with all applicable laws and regulations, and by a contractor approved by Landlord. Upon completion of the initial Tenant improvements as described on Exhibit C, and upon completion of other improvements permitted above, Tenant shall provide Landlord with copies of the plans and specifications pertaining thereto which are submitted to the applicable governmental agencies as part of obtaining any required building permits and/or certificates of occupancy, together with proof of payment for all labor and materials associated therewith. Tenant shall pay when due all claims for labor and material furnished to the Premises. Tenant shall give Landlord at least twenty (20) days' prior written notice of the commencement of any work on the Premises, regardless of whether Landlord's consent to such work is required. Landlord may elect to record and post notices of nonresponsibility on the Premises. Initials: ________ ________ 7 Section 6.06. CONDITION UPON TERMINATION. Subject to the provisions of Article Seven and Article Eight, upon the termination of the Lease, Tenant shall surrender the Premises to Landlord, broom clean, all operating systems functioning properly, and in the same condition as received except for ordinary wear and tear which Tenant was not otherwise obligated to remedy under any provision of this Lease. However, Tenant shall not be obligated to repair any damage which Landlord is required to repair under Article Seven (Damage or Destruction). In addition, Landlord may require Tenant to remove any alterations, additions or improvements (whether or not made with Landlord's consent) prior to the expiration of the Lease and to restore the Premises to its prior condition, all at Tenant's expense, provided that Landlord has advised Tenant at the time it approves the requested improvements that it may require Tenant to remove the same upon termination of the Lease. All alterations, additions and improvements which Landlord has not required Tenant to remove shall become Landlord's property and shall be surrendered to Landlord upon the expiration or earlier termination of the Lease, except that Tenant may remove any of Tenant's machinery or equipment which can be removed without material damage to the Premises. In no event shall Tenant remove any improvements (or equipment) installed or located in the Premises which were constructed (or purchased) by Tenant with funds provided by Landlord pursuant to Exhibit C, but Tenant may remove any specialty equipment purchased and/or installed at the Premises by Tenant from Tenant's funds. Tenant shall repair, at Tenant's expense, any damage to the Premises caused by the removal of any such machinery or equipment. In no event, however, shall Tenant remove any of the following materials or equipment (which shall be deemed Landlord's property) without Landlord's prior written consent: any power wiring or power panels; lighting or lighting fixtures; wall coverings; drapes, blinds or other window coverings; carpets or other floor coverings; heaters, air conditioners or any other heating or air conditioning equipment; fencing or security gates; or other similar building operating equipment and decorations. ARTICLE SEVEN: DAMAGE OR DESTRUCTION Section 7.01. PARTIAL DAMAGE TO PREMISES. (a) SUFFICIENT INSURANCE PROCEEDS. Tenant shall notify Landlord in writing immediately upon the occurrence of any damage to the Premises. If the Premises is only partially damaged (i.e., less than twenty-five percent (25%) of the Premises is untenantable as a result of such damage or less than twenty-five percent (25%) of Tenant's operations are materially impaired) and if the proceeds received by Landlord from the insurance policies described in Section 4.04(b) are sufficient to pay for the necessary repairs, this Lease shall remain in effect and Landlord shall repair the damage as soon as reasonably possible, but in no event later than 120 days after the date the Premises are damaged. Landlord may elect (but is not required) to repair any damage to Tenant's fixtures, equipment, or improvements. (b) INSUFFICIENT INSURANCE PROCEEDS. If the insurance proceeds received by Landlord are not sufficient to pay the entire cost of repair, or if the cause of the damage is not covered by the insurance policies which Landlord maintains under Section 4.04, Landlord may elect either to (i) repair the damage as soon as reasonably possible, but in no event later than 120 days after the date the Premises are damaged, in which case this Lease shall remain in full force and effect, or (ii) terminate this Lease as of the date the damage occurred. Landlord shall notify Tenant within fifteen (15) business days after receipt of notice of the occurrence of the damage whether Landlord elects to repair the damage or terminate the Lease. If Landlord elects to repair the damage, and if the damage was due to an act or omission of Tenant, or Tenant's employees, agents, contractors or invitees, then Tenant shall pay Landlord the "deductible amount" (if any) under Landlord's insurance policies. If Landlord elects to terminate the Lease, Tenant may elect to continue this Lease in full force and effect, in which case Tenant shall repair any damage to the Premises and any building in which the Premises is located. Tenant shall pay the cost of such repairs, except that upon satisfactory completion of such repairs, Landlord shall deliver to Tenant any insurance proceeds received by Landlord for the damage repaired by Tenant. Tenant shall give Landlord written notice of such election within ten (10) days after receiving Landlord's termination notice. (c) DURING LAST SIX MONTHS OF LEASE TERM. If the damage to the Premises occurs during the last six (6) months of the Lease Term and such damage will require more than thirty (30) days to repair, either Landlord or Tenant may elect to terminate this Lease as of the date the damage occurred, regardless of the sufficiency of any insurance proceeds. The party electing to terminate this Lease shall give written notification to the other party of such election within thirty (30) days after Tenant's notice to Landlord of the occurrence of the damage. Section 7.02. SUBSTANTIAL OR TOTAL DESTRUCTION. If the Premises is substantially or totally destroyed by any cause whatsoever (i.e., the damage to the Premises is greater than partial damage as described in Section 7.01), and regardless of whether Landlord receives any insurance proceeds, this Lease shall terminate as of the date the destruction occurred. Notwithstanding the preceding sentence, if the Premises can be rebuilt within one hundred twenty (120) days after the date of destruction, Landlord may elect to rebuild the Premises at Landlord's own expense, in which case this Lease shall remain in full force and effect. Landlord shall notify Tenant of such election within fifteen (15) business days after Tenant's notice of the occurrence of total or substantial destruction. Section 7.03. TEMPORARY REDUCTION OF RENT. If the Premises is destroyed or damaged and Landlord or Tenant repairs or restores the Premises pursuant to the provisions of this Article Seven, any rent payable during the period of such damage, repair and/or restoration shall be reduced according to the degree, if any, to which Tenant's use of the Premises is impaired. However, the reduction shall not exceed the sum of one year's payment of Base Rent, Insurance Premiums and Real Property Taxes. Except for such possible reduction in Base Rent, Insurance Premiums and Real Property Taxes, Tenant shall not be entitled to any compensation, reduction, or reimbursement from Landlord as a result of any damage, destruction, repair, or restoration of or to the Premises. ARTICLE EIGHT: CONDEMNATION If all or any portion of the Premises is taken under the power of eminent domain or sold under the threat of that power (all of which are called "Condemnation"), this Lease shall terminate as to the part taken or sold on the date the condemning authority takes title or possession, whichever occurs first. If more than twenty percent (20%) of the floor area Initials: ________ ________ 8 of the building in which the Premises is located, or which is located on the Premises, is taken, either Landlord or Tenant may terminate this Lease as of the date the condemning authority takes title or possession, by delivering written notice to the other within ten (10) days after receipt of written notice of such taking (or in the absence of such notice, within ten (10) days after the condemning authority takes title or possession). If neither Landlord nor Tenant terminates this Lease, this Lease shall remain in effect as to the portion of the Premises not taken, except that the Base Rent and Additional Rent shall be reduced in proportion to the reduction in the floor area of the Premises. Any Condemnation award or payment shall be distributed in the following order: (a) first, to any ground lessor, mortgagee or beneficiary under a deed of trust encumbering the Premises, the amount of its interest in the Premises; (b) second, to Tenant, only the amount of any award specifically designated for loss of or damage to Tenant's trade fixtures or removable personal property but only if such an award is specifically made by the condemning authority; and (c) third, to Landlord, the remainder of such award, whether as compensation for reduction in the value of the leasehold, the taking of the fee, or otherwise. If this Lease is not terminated, Landlord shall repair any damage to the Premises caused by the Condemnation, except that Landlord shall not be obligated to repair any damage for which Tenant has been reimbursed by the condemning authority. If the severance damages received by Landlord are not sufficient to pay for such repair, Landlord shall have the right to either terminate this Lease or make such repair at Landlord's expense. ARTICLE NINE: ASSIGNMENT AND SUBLETTING Section 9.01. LANDLORD'S CONSENT REQUIRED. No portion of the Premises or of Tenant's interest in this Lease may be acquired by any other person or entity, whether by sale, assignment, mortgage, sublease, transfer, operation of law, or act of Tenant, without Landlord's prior written consent, except as provided in Section 9.02 below. Landlord has the right to grant or withhold its consent on the basis set forth in Section 9.05 below, but Landlord shall not unreasonably withhold or delay giving its consent after Tenant has submitted the information required under Section 9.05. Any attempted transfer without consent shall be void and shall constitute a non-curable breach of this Lease. Section 9.02. TENANT AFFILIATE. Tenant may assign this Lease or sublease the Premises, without Landlord's consent, to any corporation which controls, is controlled by or is under common control with Tenant, or to any corporation with which Tenant merges or which results from a consolidation with Tenant ("Tenant's Affiliate"). In such case, Tenant's Affiliate shall assume in writing all of Tenant's obligations under this Lease. Section 9.03. NO RELEASE OF TENANT. No transfer permitted by this Article Nine, whether with or without Landlord's consent, shall release Tenant or change Tenant's primary liability to pay the rent and to perform all other obligations of Tenant under this Lease. Landlord's acceptance of rent from any other person is not a waiver of any provision of this Article Nine. Consent to one transfer is not a consent to any subsequent transfer. If Tenant's transferee defaults under this Lease, Landlord may proceed directly against Tenant without pursuing remedies against the transferee. Landlord may consent to subsequent assignments or modifications of this Lease by Tenant's transferee, without notifying Tenant or obtaining its consent. Such action shall not relieve Tenant's liability under this Lease. Section 9.04. OFFER TO TERMINATE. If Tenant desires to assign the Lease or sublease the Premises, Tenant shall have the right to offer, in writing, to terminate the Lease as of a date specified in the offer. If Landlord elects in writing to accept the offer to terminate within twenty (20) days after notice of the offer, the Lease shall terminate as of the date specified and all the terms and provisions of the Lease governing termination shall apply. If Landlord does not so elect, the Lease shall continue in effect until otherwise terminated and the provisions of Section 9.05 with respect to any proposed transfer shall continue to apply. Section 9.05. LANDLORD'S CONSENT. Tenant's request for consent to any transfer described in Section 9.01 shall set forth in writing the details of the proposed transfer, including the name, business and financial condition of the prospective transferee, and the financial details of the proposed transfer (e.g., the term of and the rent and security deposit payable under any proposed assignment or sublease). Landlord shall have the right to withhold consent, if reasonable, or to grant consent, based on the following factors: (i) the business of the proposed assignee or subtenant and the proposed use of the Premises; (ii) the net worth and financial reputation of the proposed assignee or subtenant; and (iii) Tenant's compliance with all of its obligations under the Lease. If Landlord objects to a proposed assignment solely because of the net worth and/or financial reputation of the proposed assignee, Tenant may nonetheless sublease (but not assign), all or a portion of the Premises to the proposed transferee, but only on the other terms of the proposed transfer. If Tenant assigns or subleases, the following shall apply: (i) Tenant shall pay to Landlord as Additional Rent under the Lease the Landlord's Share (stated in Section 1.14) of the Profit (defined below) on such transaction as and when received by Tenant, unless Landlord gives written notice to Tenant and the assignee or subtenant that Landlord's Share shall be paid by the assignee or subtenant to Landlord directly. The "Profit" means (A) all amounts paid to Tenant for such assignment or sublease, including "key" money, monthly rent in excess of the monthly rent payable under the Lease, and all fees and other consideration paid for the assignment or sublease, including fees under any collateral agreements, less (B) reasonable and customary costs and expenses directly incurred by Tenant in connection with the execution and performance of such assignment or sublease for real estate broker's commissions and costs of renovation or construction of tenant improvements required under such assignment or sublease. Tenant is entitled to recover such costs and expenses before Tenant is obligated to pay the Landlord's Share to Landlord. The Profit in the case of a sublease of less than all the Premises is the rent allocable to the subleased space as a percentage on a square footage basis. (ii) Tenant shall provide Landlord a written statement certifying all amounts to be paid from any assignment or sublease of the Premises within thirty (30) days after the transaction documentation is signed. On written request, Tenant shall promptly furnish to Landlord copies of all the transaction documentation, all of which shall be certified by Tenant to be complete, true and correct. Landlord's Initials: ________ ________ 9 receipt of Landlord's Share shall not be a consent to any further assignment or subletting. The breach of Tenant's obligation under this Section 9.05(b) shall be a material default of the Lease. Section 9.06. NO MERGER. No merger shall result from Tenant's sublease of the Premises under this Article Nine, Tenant's surrender of this Lease or the termination of this Lease in any other manner. In any such event, Landlord may terminate any or all subtenancies or succeed to the interest of Tenant as sublandlord under any or all subtenancies. ARTICLE TEN: DEFAULTS; REMEDIES Section 10.01. COVENANTS AND CONDITIONS. Landlord's and Tenant's performance of their respective obligations under this Lease are covenants. Time is of the essence in the performance of all covenants and conditions. Section 10.02. DEFAULTS. Tenant shall be in material default under this Lease: (a) If Tenant abandons the Premises or if Tenant's vacation of the Premises results in the cancellation of any insurance described in Section 4.04; (b) If Tenant fails to pay rent or any other charge when due and such failure continues for a period of ten (10) days after Tenant receives written notice of such default from Landlord; provided that Landlord shall not be required to provide Tenant with more than once such 10-day notice in any twelve-month period; (c) If Tenant fails to perform any of Tenant's non-monetary obligations under this Lease for a period of thirty (30) days after written notice from Landlord; provided that if more than thirty (30) days are required to complete such performance, Tenant shall not be in default if Tenant commences such performance within the thirty (30) day period and thereafter diligently pursues its completion. The notice required by this Section is intended to satisfy any and all notice requirements imposed by law on Landlord and is not in addition to any such requirement. (d) (i) If Tenant makes a general assignment or general arrangement for the benefit of creditors; (ii) if a petition for adjudication of bankruptcy or for reorganization or rearrangement is filed by or against Tenant and is not dismissed within thirty (30) days; (iii) if a trustee or receiver is appointed to take possession of substantially all of Tenant's assets or of Tenant's interest in this Lease and possession is not restored to Tenant within thirty (30) days; or (iv) if substantially all of Tenant's assets located at the Premises or of Tenant's interest in this Lease is subjected to attachment, execution or other judicial seizure which is not discharged within thirty (30) days. If a court of competent jurisdiction determines that any of the acts described in this subparagraph (d) is not a default under this Lease, and a trustee is appointed to take possession (or if Tenant remains a debtor in possession) and such trustee or Tenant transfers Tenant's interest hereunder, then Landlord shall receive, as Additional Rent, the excess, if any, of the rent (or any other consideration) paid in connection with such assignment or sublease over the rent payable by Tenant under this Lease. Section 10.03. REMEDIES. On the occurrence of any material default by Tenant, Landlord may, at any time thereafter, with or without notice or demand and without limiting Landlord in the exercise of any right or remedy which landlord may have: (a) Terminate Tenant's right to possession of the Premises by any lawful means, in which case this Lease shall terminate and Tenant stall immediately surrender possession of the Premises to Landlord. In such event, Landlord shall be entitled to recover from Tenant all damages incurred by Landlord by reason of Tenant's default, including (i) the worth at the time of the award of the unpaid Base Rent, Additional Rent and other charges which Landlord had earned at the time of the termination; (ii) the worth at time of the award of the amount by which the unpaid Base Rent, Additional Rent and other charges which Landlord would have earned after termination until the time of the award exceeds the amount of such rental loss that Tenant proves Landlord could have reasonably avoided; (iii) the worth at the time of the award of the amount by which the unpaid Base Rent, Additional Rent and other charges which Tenant would have paid for the balance of the Lease Term after the time of award exceeds the amount of such rental loss that Tenant proves Landlord could have reasonably avoided; and (iv) any other amount necessary to compensate Landlord for all the detriment proximately caused by Tenant's failure to perform its obligations under the Lease or which in the ordinary course of things would be likely to result therefrom, including, but not limited to, any costs or expenses Landlord incurs in maintaining or preserving the Premises after such default, the cost of recovering possession of the Premises, expenses of reletting, including necessary renovation or alteration of the Premises, Landlord's reasonable attorneys' fees incurred in connection therewith, and any real estate commission paid or payable. As used in subparts (i) and (ii) above, the "worth at the time of the award" is computed by allowing interest on unpaid amounts at the rate of fifteen percent (15%) per annum, or such lesser amount as may then be the maximum lawful rate. As used in subpart (iii) above, the "worth at the time of the award" is computed by discounting such amount at the discount rate of the Federal Reserve Bank of Atlanta at the time of the award, plus one percent (1%). If Tenant has abandoned the Premises, Landlord shall have the option of (i) retaking possession of the Premises and recovering from Tenant the amount specified in this Section 10.03(a), or (ii) proceeding under Section 10.03(b); (b) Maintain Tenant's right to possession, in which case this Lease shall continue in effect whether or not Tenant has abandoned the Premises. In such event, Landlord shall be entitled to enforce all of Landlord's rights and remedies under this Lease, including the right to recover the rent as it becomes due; (c) Pursue any other remedy now or hereafter available to Landlord under the laws or judicial decisions of the state in which the Premises is located. Section 10.04. MITIGATION. If an event of default occurs, Landlord and Tenant will each use reasonable efforts to mitigate their damages. Landlord will be conclusively deemed to have fulfilled its obligation to do so if it lists the Premises for lease with a real estate broker on terms recommended by the broker. Landlord will not be obligated to accept less than the then current market rent for the Premises; lease (or accept an assignment or sublease) to a then existing tenant Initials: ________ ________ 10 of the Building if Landlord is then offering space in the Building for lease; deviate from its then established guidelines for tenants including without limitation use, experience, reputation, and creditworthiness; expand or contract the Premises; extend the term of this Lease; or expend any money on behalf of a new tenant. Tenant will not have any claim against Landlord on account of Landlord's failure to mitigate its damages; however, it will have a defense to a claim by Landlord to the extent allowed by law. Section 10.05. AUTOMATIC TERMINATION. Notwithstanding any other term or provision hereof to the contrary, the Lease shall terminate on the occurrence of any act which affirms the Landlord's intention to terminate the Lease as provided in Section 10.03 hereof, including the filing of an unlawful detainer action against Tenant. On such termination, Landlord's damages for default shall include all costs and fees, including reasonable attorneys' fees that Landlord incurs in connection with the filing, commencement, pursuing and/or defending of any action in any bankruptcy court or other court with respect to the Lease; the obtaining of relief from any stay in bankruptcy restraining any action to evict Tenant; or the pursuing of any action with respect to Landlord's right to possession of the Premises. All such damages suffered (apart from Base Rent and other rent payable hereunder) shall constitute pecuniary damages which must be reimbursed to Landlord prior to assumption of the Lease by Tenant or any successor to Tenant in any bankruptcy or other proceeding. Section 10.06. CUMULATIVE REMEDIES. Landlord's exercise of any right or remedy shall not prevent it from exercising any other right or remedy. ARTICLE ELEVEN: PROTECTION OF LENDERS Section 11.01. SUBORDINATION. Landlord shall have the right to subordinate this Lease to any ground lease, deed of trust or mortgage encumbering the Premises, any advances made on the security thereof and any renewals, modifications, consolidations, replacements or extensions thereof, whenever made or recorded. Tenant shall cooperate with Landlord and any lender which is acquiring a security interest in the Premises or the Lease. Tenant shall execute such further documents and assurances as such lender may require, provided that Tenant's obligations under this Lease shall not be increased in any material way (the performance of ministerial acts shall not be deemed material), and Tenant shall not be deprived of its rights under this Lease. Tenant's right to quiet possession of the Premises during the Lease Term shall not be disturbed if Tenant pays the rent and performs all of Tenant's obligations under this Lease and is not otherwise in default. If any ground lessor, beneficiary or mortgagee elects to have this Lease prior to the lien of its ground lease, deed of trust or mortgage and gives written notice thereof to Tenant, this Lease shall be deemed prior to such ground lease, deed of trust or mortgage whether this Lease is dated prior or subsequent to the date of said ground lease, deed of trust or mortgage or the date of recording thereof. Section 11.02. ATTORNMENT. If Landlord's interest in the Premises is acquired by any ground lessor, beneficiary under a deed of trust, mortgagee, or purchaser at a foreclosure sale, Tenant shall attorn to the transferee of or successor to Landlord's interest in the Premises and recognize such transferee or successor as Landlord under this Lease. Tenant waives the protection of any statute or rule of law which gives or purports to give Tenant any right to terminate this Lease or surrender possession of the Premises upon the transfer of Landlord's interest. Section 11.03 NON-DISTURBANCE. As a condition to the effectiveness of the subordination and attornment in this Article Eleven, Landlord will obtain a reasonably acceptable non-disturbance agreement from the holder of any ground lease, deed of trust or mortgage. The non-disturbance agreement will provide that Tenant will not be disturbed by such holder so long as Tenant is in compliance with the terms of this Lease. Section 11.04. SIGNING OF DOCUMENTS. Tenant shall sign and deliver to Landlord, within ten (10) business days after written consent therefor, any instrument or documents (which shall be in form and substance substantially similar to that signed by Tenant in connection with the execution and delivery of this Lease) necessary or appropriate to evidence any such attornment or subordination or agreement to do so. Section 11.05. ESTOPPEL CERTIFICATES. (a) Upon Landlord's written request, Tenant shall execute, acknowledge and deliver to Landlord a written statement certifying: (i) that none of the terms or provisions of this Lease have been changed (or if they have been changed, stating how they have been changed); (ii) that this Lease has not been cancelled or terminated; (iii) the last date of payment of the Base Rent and other charges and the time period covered by such payment; (iv) that Landlord is not in default under this Lease (or, if Landlord is claimed to be in default, stating why); and (v) such other representations or information with respect to Tenant or the Lease as Landlord may reasonably request or which any prospective purchaser or encumbrancer of the Premises may require. Tenant shall deliver such statement to Landlord within ten (10) days after Landlord's request. Landlord may give any such statement by Tenant to any prospective purchaser or encumbrancer of the Premises. Such purchaser or encumbrancer may rely conclusively upon such statement as true and correct. (b) If Tenant does not deliver such statement to Landlord within such ten (10) day period, Landlord, and any prospective purchaser or encumbrancer, may conclusively presume and rely upon the following facts: (i) that the terms and provisions of this Lease have not been changed except as otherwise represented by Landlord; (ii) that this Lease has not been cancelled or terminated except as otherwise represented by Landlord; (iii) that not more than one month's Base Rent or other charges have been paid in advance; and (iv) that Landlord is not in default under the Lease. In such event, Tenant shall be estopped from denying the truth of such facts. Section 11.06. TENANT'S FINANCIAL CONDITION. Within ten (10) days after written request from Landlord, Tenant shall deliver to Landlord such financial statements as Landlord reasonably requires to verify the net worth of Tenant or any assignee, subtenant, or guarantor of Tenant. In addition, Tenant shall deliver to any lender designated by Landlord any financial statements required by such lender to facilitate the financing or refinancing of the Premises. Tenant represents and warrants to Landlord that each such financial statement is a true and accurate statement as of the date of such statement. All financial statements shall be confidential and shall be used only for the purposes set forth in this Initials: ________ ________ 11 Lease. Notwithstanding the foregoing, Tenant shall not be required to deliver the foregoing financial information to Landlord during any period in which (a) Tenant is subject to the reporting obligations under Section 13 or 15(d) of the Securities Exchange Act of 1934, and (b) Tenant has not materially delayed the filing of all such required reports with the United States Securities and Exchange Commission. ARTICLE TWELVE: LEGAL COSTS Section 12.01. LEGAL PROCEEDINGS. If Tenant shall be in breach or default under this Lease, Tenant shall reimburse Landlord upon demand for any costs or expenses that the Landlord incurs in connection with any breach or default of Tenant under this Lease, whether or not suit is commenced or judgment entered. Such costs shall include legal fees and costs incurred for the negotiation of a settlement, enforcement of rights or otherwise. Furthermore, if any action for breach of or to enforce the provisions of this Lease is commenced, the court in such action shall award to Landlord, a reasonable sum as attorneys' fees and costs. Tenant shall also indemnify Landlord against and hold Landlord harmless from all costs, expenses, demands and liability Landlord may incur if Landlord becomes or is made a party to any claim or action (a) instituted by Tenant against any third party, or by any third party against Tenant, or by or against any person holding any interest under or using the Premises by license of or agreement with Tenant; (b) for foreclosure of any lien for labor or material furnished to or for Tenant or such other person; (c) otherwise arising out of or resulting from any act or transaction of Tenant or such other person; or (d) necessary to protect Landlord's interest under this Lease in a bankruptcy proceeding, or other proceeding under Title 11 of the United States Code, as amended. Tenant shall defend Landlord against any such claim or action at Tenant's expense with counsel reasonably acceptable to Landlord or, at Landlord's election, Tenant shall reimburse Landlord for any legal fees or costs Landlord incurs in any such claim or action. Section 12.02. LANDLORD'S CONSENT. Tenant shall pay Landlord's reasonable attorneys' fees incurred in connection with Tenant's request for Landlord's consent under Article Nine (Assignment and Subletting), or in connection with any other act which Tenant proposes to do and which requires Landlord's consent, but in no event more than $2,500.00 per requested consent. ARTICLE THIRTEEN: MISCELLANEOUS PROVISIONS Section 13.01. LANDLORD'S LIABILITY; CERTAIN DUTIES. (a) As used in this Lease, the term "Landlord" means only the current owner or owners of the fee title to the Premises or Premises or the leasehold estate under a ground lease of the Premises or Project at the time in question. Each Landlord is obligated to perform the obligations of Landlord under this Lease only during the time such Landlord owns such interest or title. Any Landlord who transfers its title or interest is relieved of all liability with respect to the obligations of Landlord under this Lease to be performed on or after the date of transfer. However, each Landlord shall deliver to its transferee all funds that Tenant previously paid if such funds have not yet been applied under the terms of this Lease. (b) Tenant shall give written notice of any failure by Landlord to perform any of its obligations under this Lease to Landlord and to any ground lessor, mortgagee or beneficiary under any deed of trust encumbering the Premises whose name and address have been furnished to Tenant in writing. Landlord shall not be in default under this Lease unless Landlord (or such ground lessor, mortgagee or beneficiary) fails to cure such non-performance within thirty (30) days after receipt of Tenant's notice. However, if such non-performance reasonably requires more than thirty (30) days to cure, Landlord shall not be in default if such cure is commenced within such thirty (30) -day period and thereafter diligently pursued to completion. (c) Notwithstanding any term or provision herein to the contrary, the liability of Landlord for the performance of its duties and obligations under this Lease is limited to Landlord's interest in the Premises and the Project, and neither the Landlord nor its partners, shareholders, officers or other principals shall have any personal liability under this Lease. Section 13.02. SEVERABILITY. A determination by a court of competent jurisdiction that any provision of this Lease or any part thereof is illegal or unenforceable shall not cancel or invalidate the remainder of such provision or this Lease, which shall remain in full force and effect. Section 13.03. INTERPRETATION. The captions of the Articles or Sections of this Lease are to assist the parties in reading this Lease and are not a part of the terms or provisions of this Lease. Whenever required by the context of this Lease, the singular shall include the plural and the plural shall include the singular. The masculine, feminine and neuter genders shall each include the other. In any provision relating to the conduct, acts or omissions of Tenant, the term "Tenant" shall include Tenant's agents, employees, contractors, invitees, successors or others using the Premises with Tenant's expressed or implied permission. Section 13.04. INCORPORATION OF PRIOR AGREEMENTS; MODIFICATIONS. This Lease is the only agreement between the parties pertaining to the lease of the Premises and no other agreements are effective. All amendments to this Lease shall be in writing and signed by all parties. Any other attempted amendment shall be void. Section 13.05. NOTICES. All-notices required or permitted under this Lease shall be in writing and shall be personally delivered or sent by certified mail, return receipt requested, postage prepaid. Notices to Tenant shall be delivered to the address specified in Section 1.03 above, except that upon Tenant's taking possession of the Premises, the Premises shall be Tenant's address for notice purposes. Notices to Landlord shall be delivered to the address specified in Section 1.02 above. All notices shall be effective upon delivery. Either party may change its notice address upon written notice to the other party. Initials: ________ ________ 12 Section 13.06. WAIVERS. All waivers must be in writing and signed by the waiving party. Landlord's failure to enforce any provision of this Lease or its acceptance of rent shall not be a waiver and shall not prevent Landlord from enforcing that provision or any other provision of this Lease in the future. No statement on a payment check from Tenant or in a letter accompanying a payment check shall be binding on Landlord. Landlord may, with or without notice to Tenant, negotiate such check without being bound to the conditions of such statement. Section 13.07. NO RECORDATION. Tenant shall not record this Lease without prior written consent from Landlord. However, either Landlord or Tenant may require that a "Short Form" memorandum of this Lease executed by both parties be recorded. The party requiring such recording shall pay all recording taxes and recording fees. Section 13.08. BINDING EFFECT; CHOICE OF LAW. This Lease binds any party who legally acquires any rights or interest in this Lease from Landlord or Tenant. However, Landlord shall have no obligation to Tenant's successor unless the rights or interests of Tenant's successor are acquired in accordance with the terms of this Lease. The laws of the state in which the Premises are located shall govern this Lease. Section 13.09. CORPORATE AUTHORITY; PARTNERSHIP AUTHORITY. If Tenant is a corporation, each person signing this Lease on behalf of Tenant represents and warrants that he has full authority to do so and that this Lease binds the corporation. If Tenant is a partnership, each person or entity signing this Lease for Tenant represents and warrants that he or it is a general partner of the partnership, that he or it has full authority to sign for the partnership and that this Lease binds the partnership and all general partners of the partnership. Tenant shall give written notice to Landlord of any general partner's withdrawal or addition. Within thirty (30) days after this Lease is signed, Tenant shall deliver to Landlord a copy of Tenant's recorded statement of partnership or certificate of limited partnership. Section 13.10. JOINT AND SEVERAL LIABILITY. All parties signing this Lease as Tenant shall be jointly and severally liable for all obligations of Tenant. Section 13.11. FORCE MAJEURE. (a) If either party is prevented from complying (the "Non-compliant Party"), either totally or in part with any of the terms or provisions set forth herein (except for an obligation to make monetary payments), by reason of Force Majeure (as defined below), the Non-compliant Party shall provide written notice of same to the other party (the "Other Party"). Said notice (i) shall be provided within ten (10) business days of the date that the Other Party first notifies the Non-compliant Party of its obligations hereunder (whether pursuant to Article Ten, Article Fifteen, or otherwise) and shall identify the requirements of this Lease or such of its obligations as may be affected, and (ii) to the extent so affected and beyond the Non-compliant Party's reasonable control, said obligations shall be suspended during the period of such disability. (b) The Non-compliant Party shall use its best efforts to remove such disability, and shall continue performance whenever such causes are removed. The Non-compliant Party shall give to the Other Party a good faith estimate of the continuing effect of the Force Majeure condition and the duration of the Non-compliant Party's nonperformance. (c) If the period of any previous actual nonperformance of a Non-compliant Party because of such Noncompliant Party's Force Majeure conditions plus the anticipated future period of such Non-compliant Party's nonperformance because of such conditions will exceed an aggregate of thirty (30) days within any twenty-four (24) month period, the Other Party may pursue its rights and remedies under the Lease or at law or equity (but in no event including a right to terminate this Lease. If permitted under applicable law) irrespective of the Force Majeure event and this Section 13.11 shall have no further force or effect with respect to such Force Majeure event. (d) As used herein, the term "Force Majeure" means any event or condition, not existing as of the Commencement Date and not reasonably within the control of either party, which prevents in whole or in material part the performance by the Non-compliant Party of its obligations (other than payment of monies) hereunder. Without limiting the foregoing, the following shall constitute events or conditions of Force Majeure: acts of God or State (or governmental agencies or instrumentalities), or governmental action, riots, civil disturbance, war, rebellion, terrorism, fire, flood, storm, hurricane, earthquake, lightning, accidents, and explosion, or any other external or non-negligent internal cause or externally induced casualty, which, in each instance, are beyond its reasonable control, whether similar to the foregoing contingencies or not. Notwithstanding the foregoing, no event of casualty or condemnation governed by Article Seven or Article Eight shall be deemed to be an event of "Force Majeure". Section 13.12. EXECUTION OF LEASE. This Lease may be executed in counterparts and, when all counterpart documents are executed, the counterparts shall constitute a single binding instrument. Landlord's delivery of this Lease to Tenant shall not be deemed to be an offer to lease and shall not be binding upon either party until executed and delivered by both parties. Section 13.13. SURVIVAL. All representations and warranties of Landlord and Tenant shall survive the termination of this Lease. Section 13.14 LANDLORD'S CONSENT. Notwithstanding anything contained herein to the contrary, in any instance in which the Landlord is requested to grant a consent or approval or otherwise exercise its discretion hereunder Landlord shall not unreasonably withhold, condition (subject, however, to any conditions expressly set forth herein as applicable to a particular consent), or delay any such consent or approval and should only exercise its discretion in good faith. Section 13.15 WAIVER OF LANDLORD LIEN. Landlord hereby waives any lien upon, or security interest in, the personal property of the Tenant located at the Premises, that it may have under applicable law. Initials: ________ ________ 13 ARTICLE FOURTEEN: BROKERS Section 14.01. BROKER'S FEE. When this Lease is signed by and delivered to both Landlord and Tenant, Landlord shall pay a real estate commission to Landlord's and Tenant's Brokers named in Section 1.08 above, if any, as provided in the written agreement between Landlord and Brokers, or the sum stated in Section 1.09. If a Tenant's Broker is named in Section 1.08 above, Landlord's Broker shall pay an appropriate portion of its commission to Tenant's Broker if so provided in any agreement between Landlord's Broker and Tenant's Broker. Nothing contained in this Lease shall impose any obligation on Landlord to pay a commission or fee to any party other than Landlord's Broker. Section 14.02. AGENCY DISCLOSURE; NO OTHER BROKERS. Landlord and Tenant each warrant that they have dealt with no other real estate broker(s) in connection with this transaction except: Graham & Company, Inc. who represents the Landlord and Stream Realty Partners, L.P. who represents the Tenant. ARTICLE FIFTEEN: LANDLORD REPRESENTATIONS AND DEFAULT Section 15.01 LANDLORD'S REPRESENTATIONS AND WARRANTIES. In addition to any other representation or warranty contained herein, Landlord covenants and warrants that: (i) The Landlord is a limited liability company duly organized, validly existing, and in good standing under the laws of the jurisdiction of its organization. The Landlord has full power and authority (including full limited liability company power and authority) to execute and deliver this Lease and to perform its obligations hereunder. This Lease constitutes the valid and legally binding obligation of the Landlord, enforceable in accordance with its terms and conditions. Neither the execution and the delivery of this Lease, nor the consummation of the transactions contemplated hereby, will violate any constitution, statute, regulation, rule, injunction, judgment, order, decree, ruling, charge, or other restriction of any government, governmental agency ("Applicable Law"), or court to which the Landlord is subject or any provision of the organizational documents of the Landlord. (ii) To the best of Landlord's knowledge, Landlord has good and marketable title to the Project, subject to (a) those matters set forth on the title insurance policy issued to Landlord by Lawyers Title Insurance Corporation dated December 22, 2003, Policy Number A75-0942599, a true and complete copy of which has been provided to Tenant, (b) any matters of record applicable to the Project subsequent to the date of said title policy, and (c) matters that would be revealed by a current survey or inspection of the Project. (iii) As of the date of this Lease, Building One has been constructed and maintained in accordance with normal industry practice, is in good operating condition and repair. Section 15.02 LANDLORD DEFAULT. The following events shall be deemed to be events of default by Landlord under this Lease ("Landlord Default"): (a) If Landlord fails to maintain the insurance required under Section 4.04(b); (b) If Landlord fails to maintain the Common Areas as required in Section 4.05(d); (c) If Landlord fails to maintain and/or repair the foundation, roof and structural portions of the exterior walls as required in Section 6.03; (d) If any of the representations and warranties made by Landlord herein are not true when made and, to the extent practical, if Landlord fails to take such remedial action as is necessary to render such representation and/or warranty true within a period of thirty (30) days after written notice from Tenant; provided that if more than thirty (30) days are required to complete such action, Landlord shall not be in default if Landlord commences such action within the thirty (30) day period and thereafter diligently pursues its completion. Section 15.03 TENANT REMEDIES. If Landlord fails to perform any maintenance or repair required to be performed by Landlord under Sections 4.05(d) or 6.03 of this Lease within ten (10) business days from Landlord's receipt of written notice thereof from Tenant which specifies the condition requiring maintenance or repair and declares that it is delivered pursuant to this Section 15.03 (the "Tenant's Repair Notice") and as a result Tenant's ability to conduct its business in the Premises is materially impaired, then Tenant shall be entitled to cause such repairs to me made and to offset rent in the amount of the reasonable out-of-pocket costs it incurs in making such repairs (provided that such costs are properly documented by Tenant with copies of such documentation being promptly provided to Landlord) until Tenant recovers all such costs, provided that in no event shall Tenant make offsets for any claims with value in excess of $50,000 without obtaining a final court order. The remedies set forth in this Section shall be in addition to any rights available to Tenant at law or equity, but in no event shall Tenant have the right to terminate this Lease. If Landlord is unable to correct the breach of any representation or warranty which is untrue when made within the time permitted in Section 15.02(d), Tenant may elect to prosecute a claim against Landlord for all out-of-pocket, direct (but not consequential) damages which it sustains as a direct result of any such breach by Landlord. [The remainder of this page left blank intentionally.] Initials: ________ ________ 14 Landlord and Tenant have signed this Lease at the place and on the dates specified adjacent to their signatures below and have initialed all Riders which are attached to or incorporated by reference in this Lease. "LANDLORD" Gazelle, LLC, an Alabama limited liability company Sworn to and subscribed before me By: Graham & Company, Inc., its Manager this _____ day of _________,2004. By: ______________________________________ _________________________________ Its: ____________________________________ Notary Public My commission expires:___________ Signed on __________________________, 2004 [NOTARIAL SEAL] at _______________________________________ "TENANT" D&K Healthcare Resources Inc., a Delaware Corporation Sworn to and subscribed before me this _____ day of _________,2004. By: ______________________________________ _________________________________ Its: ____________________________________ Notary Public My commission expires:___________ Signed on __________________________, 2004 [NOTARIAL SEAL] at _______________________________________ Initials: _______ _______ 15 EXHIBIT A THE PROJECT Initials: ________ ________ 16 EXHIBIT B TENANT PLANS AND SPECIFICATIONS Initials: ________ ________ 17 EXHIBIT C ADDITIONAL TERMS OF THE LEASE The following additional terms are made a part of the Lease: TENANT IMPROVEMENT REIMBURSEMENT: Landlord shall reimburse Tenant in an amount not to exceed $920,000 (the "Improvement Allowance") for the cost of constructing certain interior improvements to the Premises, as reflected on Exhibit B attached hereto (Tenant Plans and Specifications). Tenant hereby covenants and agrees to construct all of its improvements in accordance with all applicable building codes, laws and regulations. All improvements constructed with this allowance shall be the property of Landlord. The Improvement Allowance shall be paid to Tenant as construction progresses (but not more than once per month). Landlord shall make payments to Tenant within 10 calendar days after Tenant submits to Landlord appropriate documentation of Tenant's costs (including a certificate from Tenant's architect and lien waivers covering the work for which payment is requested from all contractors and subcontractors performing work at the Premises. The final $100,000 of this allowance shall not be disbursed to Tenant until Tenant has satisfied the foregoing conditions and (a) Tenant has received a certificate of occupancy from Jefferson County (a copy of which shall be provided to Landlord), and (b) Tenant has commenced to pay Rent. AMORTIZED RENT: In addition to the improvement allowance described above, at Tenant's request, Landlord shall make available to Tenant an additional sum in an amount of up to $970,000 (the "Additional Allowance") to be used by Tenant to make pre-approved permanent improvements to the Premises (but not to purchase and equipment or trade fixtures). The amount of the Additional Allowance provided to Tenant shall be repaid to Landlord in the form of "Amortized Rent", which shall be computed by amortizing the amount so paid by Landlord over the initial Lease Term at 9% interest per annum. The Amortized Rent will be due and payable commencing on December 1, 2004 (or on the first of the month on which all improvements have been completed) and thereafter on the first day of each month without demand, but will not escalate each year with the Base Rent. The Additional Allowance shall be paid to Tenant as improvements are made (but not more than once per month). Landlord shall make payments to Tenant within 10 calendar days after Tenant submits to Landlord appropriate documentation of Tenant's costs (including a certificate from Tenant's architect and lien waivers covering the work for which payment is requested) from all contractors and subcontractors performing work at the Premises. EXPANSION: During the term of this Lease, provided Tenant is not then in default and Tenant's financial condition is acceptable to Landlord, Tenant shall have the right of first offer ("Right of First Offer") to lease all (but not less than all) of the six (6) adjoining bays (120.120 s.f.) currently occupied by Decoma International ("Decoma") (the "Offer Space"), subject to the following terms. If Landlord receives notice that Decoma has terminated its lease, Landlord shall notify Tenant of such event, whereupon Tenant shall have five (5) business days to notify Landlord in writing of its election to lease the Offer Space. If Tenant declines to lease the Offer Space, or fails to respond within this allowed time period. Tenant's Right of First Offer shall terminate and cease to be effective. If Tenant elects to lease the Offer Space, such space shall be added to the Premises and become a part thereof upon and subject to all of the terms and conditions of this Lease after Tenant has notified Landlord that it elects to the lease the Offer Space effective upon the date Landlord has delivered the Offer Space. Landlord and Tenant shall, within 30 days after Tenant elects to add the Offer Space to the Lease, execute an amendment to the Lease confirming in writing the terms applicable to the Offer Space. RENEWAL OPTION: Provided Tenant is not then in default under the terms of this Lease, Tenant shall have the right to renew this lease for one term of seven (7) additional years (the "Option Term"). To exercise this option, Tenant shall give Landlord not less than 180 days written notice prior to November 30, 2014. Failure to do so shall constitute an irrevocable waiver of this renewal option. The Base Rent during the option period shall the Base Rent during the last year of the primary Lease Term increased by 1.75%. The Base rent shall continue to increase at the rate of 1.75% each year during the Option Term. ADA: Landlord represents and warrants to Tenant that on the Commencement Date, the building shell and parking lots will be in compliance with current Initials: ________ ________ 18 ADA requirements. HAZARDOUS MATERIALS: Notwithstanding anything in the Lease to the contrary, Landlord shall indemnify and hold Tenant harmless from any costs or damages Tenant sustains arising from (a) the presence of any Hazardous Materials on the Premises in violation of applicable law as of the Commencement Date, and (b) during the Lease Term, the presence of any Hazardous Materials on the Premises in violation of applicable law caused solely by the Landlord. ELECTRICAL SERVICE: Tenant shall have exclusive rights to use up to 1,600 amps from the main building electrical service. SECURITY DEPOSIT: Landlord shall not require a security deposit from Tenant, provided that Landlord receives the most recent audited financial statements of Tenant and approves the same. Initials: ________ ________ 19 EX-13 3 c88104exv13.txt REGISTRANT'S 2004 ANNUAL REPORT TO STOCKHOLDERS . . . EXHIBIT 13 REGISTRANT'S 2004 ANNUAL REPORT TO SHAREHOLDERS FINANCIAL HIGHLIGHTS:
Fiscal Year Ended Income Statement Data (1) --------------------------------------------------------------- - ------------------------- June 30, June 30, June 30, June 30, June 30, (in thousands, except share and per share data) 2004 2003 2002 2001 2000 - ----------------------------------------------- ----------- ----------- ----------- ----------- ----------- Net sales $ 2,251,190 $ 2,223,388 $ 2,453,748 $ 1,645,993 $ 1,458,047 Gross profit 103,395 90,699 102,831 68,824 56,422 Income from operations 31,739 36,387 46,339 26,946 22,299 Net income 10,214 9,686 21,059 9,144 8,199 Pro forma net income (2) 10,214 15,140 21,059 9,144 8,199 Diluted earnings per share (2) 0.71 0.65 1.42 1.01 0.92 Pro forma diluted earnings per share(2)(3) 0.71 1.03 1.42 1.01 0.92 Diluted common shares outstanding 14,137,044 14,513,116 14,677,781 9,131,514 9,099,752
Balance Sheet Data - ------------------ (in thousands) June 30, 2004 June 30, 2003 June 30, 2002 June 30, 2001 June 30, 2000 - ------------------ ------------- ------------- ------------- ------------- ------------- Current assets $634,300 $404,129 $413,914 $270,050 $237,494 Working capital 382,900 215,639 182,636 97,533 93,556 Total assets 743,871 472,695 483,138 330,204 294,419 Long-term debt 307,693 110,423 81,457 94,489 99,647 Stockholders' equity 179,330 170,079 167,397 57,510 45,265
(1) Refer to page 2 of the Form 10-K for a description of significant company events that explain income statement and balance sheet trends. (2) In fiscal 2003, pro forma net income and pro forma diluted earnings per share exclude a one-time charge for an accounting change related to the adoption of SFAS 142 (reduced diluted EPS by $0.30 and net income by $4,249) and the termination of the company's accounts receivable securitization program (reduced diluted EPS by $0.08 and net income by $1,205). (3) Adjusted to reflect 2-for-1 stock split effective April 12, 2002. PRICE RANGE PER COMMON SHARE: D&K Healthcare's common stock trades on the Nasdaq Stock Market under the trading symbol "DKHR". Prior to July 1, 2003, D&K Healthcare's common stock was traded on the Nasdaq Stock Market under the trading symbol "DKWD". As of September 7, 2004, there were approximately 4,600 shareholders based on the number of record holders and an estimated number of beneficial holders of the company's common stock. The following table sets forth the high and low sale prices of D&K Healthcare common stock for the periods indicated.
2004 Low High First Quarter $ 13.09 $ 18.35 Second Quarter 12.02 15.90 Third Quarter 9.70 14.50 Fourth Quarter 10.00 14.91
2003 Low High First Quarter $ 8.12 $ 34.81 Second Quarter 7.38 10.75 Third Quarter 8.25 10.56 Fourth Quarter 10.18 16.43
CORPORATE OFFICES: D&K Healthcare Resources, Inc. 8235 Forsyth Boulevard St. Louis, Missouri 63105 (888) 727-3485 (314) 727-3485 Fax: (314) 727-5759 web: www.dkhealthcare.com TRANSFER AGENT REGISTRAR: Computershare Investor Services LLC 2 North LaSalle Street Chicago, Illinois 60602 (312) 588-4192 www.computershare.com/contactus AUDITORS: KPMG LLP St. Louis, Missouri COUNSEL: Armstrong Teasdale LLP St. Louis, Missouri ANNUAL MEETING: The annual meeting of stockholders will be held at 10:00 a.m. Wednesday, November 10, 2004, at the company's corporate office, 8235 Forsyth Boulevard, 9th Floor, St. Louis, Missouri. EX-14 4 c88104exv14.txt REGISTRANT'S CODE OF BUSINESS CONDUCT AND ETHINCS EXHIBIT 14 D & K HEALTHCARE RESOURCES, INC. CODE OF BUSINESS CONDUCT AND ETHICS (ADOPTED ON NOVEMBER 12, 2003) INTRODUCTION The Code of Business Conduct and Ethics of D & K Healthcare Resources, Inc. and its subsidiaries (collectively the "Company"), is embodied in the following standards and is a guide to ethical decision-making. We are committed to uncompromising integrity in all that we do and how we relate to each other and to persons outside the Company. While the standards in the Code are mainly based on laws to which we are all subject, in some cases they go beyond legal obligations. In this respect, the Code reflects the values that define the Company and the principle that we must strive to avoid any circumstances that may give rise to even an appearance of impropriety. The standards in this Code may be further explained or implemented through policy memoranda or other compliance manuals, including those relating to specific areas of our business. This Code and related memoranda and manuals are available from the Company's General Counsel or Director of Human Resources. Each of us is personally responsible for making sure that our business decisions and actions comply at all times with the letter and spirit of this Code. Given the pace of changes in our industry, no set of standards should be considered the final word in all circumstances. When you have doubts about the application of a standard or where we have not addressed a situation that presents an ethical issue, you should seek guidance from your immediate supervisor or from the General Counsel of the Company. In addition, each of us has a duty to report behavior on the part of others that appears to violate this Code or any other compliance policy or procedure of the Company. All supervisory and management personnel, including all officers and directors of the Company, have a special responsibility to lead according to the standards in this Code, in both words and action. Our supervisory and management personnel are also expected to adhere to and promote our "open door" policy. This means that they are available to anyone with ethical concerns, questions or complaints. The Company's Audit Committee also maintains a confidential post office box that you can use in those circumstances, the details of which are set out at the end of this Code. Concerns may also be raised with the Company's General Counsel. All concerns, questions and complaints will be taken seriously and handled promptly, confidentially and professionally. No retaliation will be taken against any employee for raising any concern, question or complaint in good faith. The following standards of conduct will be enforced at all organizational levels. Anyone who violates them will be subject to prompt disciplinary action, including dismissal for cause. COMPLIANCE WITH LAWS, RULES AND REGULATIONS, ETC. It is the Company's policy to be a good "corporate citizen." Wherever we do business, employees of the Company are required to comply with all applicable laws, rules and regulations. Employees are also responsible for complying with requirements of contracts that we have entered into with other parties, such as intellectual property licenses (e.g., software licenses related to software packages used in our business), confidentiality agreements, leases, etc. The standards in this Code must of course be interpreted in light of the law and practices where we operate, as well as good common sense. Reasons such as "everyone does it" or "it's not illegal" are unacceptable as excuses for violating our Code. Any suspected or actual violation of any applicable law, rule or regulation or our contractual undertakings should be reported immediately to the employee's immediate supervisor or the General Counsel. CONFLICTS OF INTEREST A conflict of interest occurs whenever our private interests interfere with the interests of the Company as a whole. In order for the Company to carry out its business effectively, it must be assured of its employees' loyalty. Employees must therefore refrain from entering into relationships that might impair their judgment as to what is best for the Company. Even relationships that give the appearance of a conflict of interest should be avoided. You cannot avoid these standards by acting through someone else, such as a friend or family member. There are many different ways in which conflicts of interest arise. For example, personal financial interests, obligations to another company or governmental entity or the desire to help a relative or friend are all factors that might divide our loyalties. To clarify what we mean, we have set out below our policies about the most common types of conflicts of interest. Employees who believe it is not possible to avoid a conflict of interest must bring this to the attention of, and make full written disclosure of the surrounding circumstances to, their immediate supervisor, who should in appropriate circumstances bring it to the attention of the General Counsel. - OUTSIDE EMPLOYMENT AND DIRECTORSHIPS Members of the Board of Directors of the Company, officers and employees may not work, or receive compensation, for services from any competitor, customer or supplier unless the relationship and compensation have been approved by the Chief Executive Officer or the Chief Operating Officer of the Company (or in the case of members of the Board of Directors or executive officers, by the independent members of the Board of Directors of the Company.) Most of these situations are likely to present conflicts of interest. Even where approval is granted, employees, officers and members must take appropriate steps 2 to separate Company and non-Company activities. The General Counsel will assist you in determining what steps are appropriate. - INVESTMENTS Employees, officers and members of the Board of Directors of the Company may not have financial interests in any competitor, customer, distributor or supplier where this would influence, or appear to influence, their actions on behalf of the Company. If there is any doubt about how an investment might be perceived, you should discuss it in advance with your immediate supervisor or the General Counsel. - USING THE COMPANY'S TIME AND ASSETS FOR PERSONAL BENEFIT You may not perform non-Company work or solicit that work on the Company's premises or while working on the Company's time, including any paid leave you are granted by the Company. Also, you are not permitted to use Company assets (including equipment, telephones, materials, resources or proprietary information) for any outside work. - LOANS TO EMPLOYEES Loans to and guarantees of obligations of employees incurred for personal reasons can also present conflicts of interest. Such loans are prohibited by law in the case of the Company's directors and executive officers. It is the Company's policy that such loans will generally not be made to other employees. - ACCEPTANCE OF GIFTS AND ENTERTAINMENT The acceptance of gifts and entertainment from customers or suppliers by employees or members of their families may present a conflict of interest. While employees are permitted to accept gifts of nominal value (approximately $100 or less), such as unsolicited promotional items, they are prohibited from accepting anything that might reasonably be deemed to affect their judgment or that is accompanied by any express or implied understanding that the recipient is in any way obligated do to something in exchange for the gift. Similarly, employees may accept entertainment, but only insofar as it is reasonable in the context of the business at hand and facilitates the Company's interests. When practical, hospitality should be reciprocated. Employees are strictly prohibited from soliciting gifts, gratuities or business courtesies for the benefit of any family member or friend. - FAMILY MEMBERS AND CLOSE PERSONAL RELATIONSHIPS The Company's standards of conduct are not intended to intrude on our personal lives. Situations may arise, however, where our relationships with 3 family members and friends create conflicts of interest. Generally, employees are prohibited from being in the position of supervising, reviewing or having any influence on the job evaluation or salary of their close relatives. Employees who have family members or friends that work for businesses seeking to provide goods or services to the Company may not use their personal influence to affect negotiations. Employees who have relatives or friends that work for competitors should bring this fact to the attention of their immediate supervisor and discuss any difficulties that might arise and appropriate steps to minimize any potential conflict of interest. - PUBLIC SERVICE We encourage our employees to be active in the political and civic life of their communities, including charitable or educational activities. When doing so and making any public communication, you should clarify that your views are yours individually and are not being expressed as an employee of the Company. Your participation in or service to the community may also at times place you in a situation in which a conflict of interest with the Company could arise. This could occur, for example, where the community is engaged in a negotiation with the Company for goods or services or with respect to some other matter. The law may require or permit you to abstain from any decision where these circumstances exist, depending on your position within the Company and other factors. Before participating in such a decision, you should seek advice from legal counsel for the community and the General Counsel and should in any event make it clear to the responsible persons that you are an employee of the Company. If you do abstain, you should make it clear that your action is to avoid a potential conflict of interest or the appearance of one. You may not engage in any type of solicitation or distribution activities not relating to the business of the Company on Company premises without the approval of your immediate supervisor. You may not make any political contribution as a representative of the Company. You must also avoid lobbying activities or even the appearance of lobbying any governmental body or public official as a representative of the Company without the express approval of the General Counsel. QUESTIONS AND ANSWERS ABOUT CONFLICTS OF INTEREST Q: I HAVE DEVELOPED A FRIENDSHIP WITH A SUPPLIER AND AM CONSIDERING ENTERING INTO A PARTNERSHIP WITH HIM IN A BUSINESS VENTURE UNRELATED TO THE COMPANY. IS THIS AGAINST COMPANY POLICY? A: Most likely. Even if you are able to keep your personal and financial dealings from affecting your judgment on behalf of the Company, others may perceive that you are biased. You should discuss your plans with your supervisor or the General Counsel before proceeding. 4 Q: I DO A LOT OF TRAVELING FOR THE COMPANY. CAN I USE THE FREQUENT FLYER COUPONS I RECEIVE FROM AIRLINES FOR MY PERSONAL TRAVEL PLANS? A: It is generally permissible for you to use the frequent flyer coupons and other non-cash benefits you acquire for personal travel. You may not, however, attempt to manipulate the travel plans the Company makes for you in order to receive such benefits. Any additional expense you cause the Company to incur for your benefit amounts to a misappropriation of Company funds. Q: MY HUSBAND OWNS A LANDSCAPING BUSINESS. I'M SURE HE CAN PROVIDE THE COMPANY WITH A PRODUCT THAT IS COMPETITIVE IN TERMS OF QUALITY AND PRICE. CAN HE SOLICIT WORK FROM THE COMPANY? A: Your husband might be able to solicit work from the Company, provided that he does not use your employment with the Company to influence the selection process. CORPORATE OPPORTUNITIES Employees may not appropriate to themselves, or to any other person or organization, the benefit of any business venture, opportunity or potential opportunity that they learn about in the course of their employment and that is in the Company's line of business without first obtaining the Company's consent. It is never permissible for employees to compete against the Company, either directly or indirectly. Employees, officers and directors owe a duty to the Company to advance its legitimate interests when the opportunity to do so arises. SECURITIES LAWS AND INSIDER TRADING In the course of their duties, employees may be exposed to information about the Company or other companies that is not available to the general public. The use of such nonpublic or "inside" information for securities trading purposes is strictly forbidden, whether by the employee or any of his or her family members or any other person to whom the employee may have communicated the information. It is not only unethical, but also illegal and could expose the employee to civil and criminal penalties. U.S. law prohibits anyone who possesses "material" non-public information about a company to trade its stock or other securities. "Material" information is usually defined as any information that might influence a reasonable investor to buy, sell or hold stock. Common examples include financial results, financial forecasts, possible mergers, acquisitions or divestitures, significant product developments and major changes in business direction. U.S. law also prohibits anyone who possesses material, non-public information from using it to tip anyone else who might trade on it. Violation of the law may result in civil and criminal penalties, including fines or jail sentences. Employees who are uncertain about the legal rules governing purchases and sales of securities they wish to make should review the Company's Policy Against Insider Trading 5 and, if questions persist, consult the General Counsel before trading. Any employee who engages in insider trading will be subject to immediate termination. QUESTIONS AND ANSWERS ABOUT INSIDER TRADING Q: WHEN I BEGAN WORK, THE COMPANY OFFERED ME A STOCK OPTION ALLOWING ME TO BUY COMPANY STOCK AT A GOOD PRICE. DOES THE COMPANY'S INSIDER TRADING POLICY LIMIT WHEN I CAN EXERCISE THE OPTION? A: While insider trading laws do not apply to the exercise of stock options, they do apply to the sale of stock received through options. It is permissible for you to exercise a stock option even though you possess material, inside information. However, you must not sell the stock you receive (or any other Company stock) until the information has been made public. Q: I TOLD MY SISTER-IN-LAW ABOUT A NEW PRODUCT ONE OF OUR VENDORS IS PLANNING TO INTRODUCE ON THE MARKET. NOW SHE WOULD LIKE TO BUY STOCK IN THE COMPANY. OUR INSIDER TRADING POLICY DOESN'T APPLY TO HER, DOES IT? A: If you possess material, inside information, you are not only prohibited from using it yourself, but you must not reveal the information to anyone else who might use it for personal gain. A friend or relative who trades on inside information you acquired at work will be subject to the same penalties as you would be if you traded on it. In addition, you might be penalized for revealing the information. CONFIDENTIAL AND PROPRIETARY INFORMATION Information is a valuable corporate asset. All employees have a duty to safeguard confidential and proprietary information about the Company and information that our suppliers and customers have entrusted to us. Generally speaking, confidential and proprietary information is information that has not been disclosed to the general public or that gives our business an advantage over our competitors or could expose us to harm or liability if released prematurely or inappropriately. Common examples include trade secrets, as well as financial information, corporate strategy and information about relationships with our customers and suppliers. Employees who are unsure about whether information should be treated as confidential or proprietary must consult with their immediate supervisor or the General Counsel. Employees must remain conscious at all times of their duty to protect confidential and proprietary information. For example, confidential or proprietary information should never be discussed in public places such as elevators, airplanes or restaurants. In no event should confidential or proprietary information be disclosed to third parties without the express consent of the General Counsel, unless this is otherwise legally required. 6 ' The duty to preserve the Company's confidential and proprietary information is not limited to our employees' period of employment, but continues even after they have left the Company. QUESTIONS AND ANSWERS ABOUT CONFIDENTIAL AND PROPRIETARY INFORMATION Q: CAN I REVEAL CONFIDENTIAL INFORMATION ABOUT THE COMPANY TO MY SPOUSE WHEN I TALK WITH HER ABOUT MY WORK? I'M SURE THAT SHE WILL KEEP IT SECRET. A: It is not permissible for you to reveal confidential information about the Company to your spouse. Although you and your spouse have a confidential relationship with each other, she does not have a confidential relationship with the Company. Because of this, you must be careful not to discuss confidential information with her. This is true of anyone outside the Company, including other close family members. Q: HOW CAN I TELL IF INFORMATION IS PROPRIETARY OR CONFIDENTIAL IF IT ISN'T MARKED? A: There are no hard and fast rules with respect to information that is not marked. Such information must be judged on the basis of its content. However, the following tip may help you. If you are not certain whether information has been made available to the public, you should presume it is proprietary if: (1) it is used in conducting the Company's business; (2) it grants a competitive advantage over those who do not possess it; or (3) it is distributed on a strictly internal basis within the Company. FAIR DEALING The Company is committed to dealing fairly and honestly with its customers, suppliers, competitors and employees. - OUR CUSTOMERS Doing business in an honest and fair manner with our customers means that we must earn their business based on the quality of our products and services and our ability to fulfill our commitments. Where our products or services are required to meet customer specifications, employees are prohibited from using false data or manipulating data in such a way as to suggest compliance with these specifications when it has not been achieved. In addition, it is against the Company's policy to refuse to deal with customers because they are also buying products and services from our competitors (failure to adhere to this policy could also constitute a violation of antitrust laws). Employees responsible for customer invoicing are required to reflect accurately on invoices the cost of services or 7 products purchased and all other terms. Employees may not offer customers any benefits or rewards that violate applicable law or our business practices or policies (e.g., the Company's policies on customer discounts) or that have more than nominal value (approximately $100 or less). Reasonable business entertainment is permitted, including at traditional promotional events, so long as it is not in violation of applicable law and would not subject the Company to criticism if disclosed publicly. OUR SUPPLIERS Doing business in an honest and fair manner with our suppliers means that employees responsible for buying or leasing materials and services on behalf of the Company must do so objectively. We choose to deal with our suppliers on the basis of the price, quality and desirability of their goods and services. Employees must not accept or seek out any benefit from a supplier or potential supplier that would even appear to compromise their judgment. In addition, it is against Company policy to require that suppliers give up trade with our competitors or purchase our products and services in order to continue their relationship with us, unless there is a legitimate business purpose for doing so (failure to adhere to this policy could also constitute a violation of antitrust laws). OUR COMPETITORS It is the Company's policy to compete solely on the merits of our products and services. Accordingly, false or misleading statements or innuendo about our competitors, their products or their services will not be tolerated. All comparisons of our products or services with those of our competitors must be accurate and factually supported. Employees are strictly forbidden from using any illegal or unethical methods to gather competitive information. This includes stealing proprietary information or trade secret information or attempting to induce disclosure of such information by past or present employees of other companies through misrepresentation or other means. Anyone with even the slightest concern about the legality of information they possess or the means by which it was gathered should consult with the General Counsel. Employees should treat information about our competitors with sensitivity and discretion. This information should be made available only in the proper context and to employees with a legitimate need to know. OUR EMPLOYEES The Company recognizes that its employees are its most valuable resource. The Company values the contributions that each of its employees makes and is committed to treating every employee with respect. This includes preserving the confidentiality of employee records, refraining from unwarranted intrusions into employees' privacy and supporting to the greatest extent possible employees' aspirations in the workplace. 8 COMPETITION RESTRICTIONS In most countries, there are laws that govern the ways in which the Company may compete. The purpose of these laws (sometimes known as "competition" or "antitrust" laws) is to prevent interference with a competitive market system. Under these laws, companies or individuals may not enter into formal or informal agreements with other companies or individuals or engage in certain other activities that unreasonably restrict competition. Illegal practices can include, among others, price fixing, allocating customers or territories or unlawfully abusing a dominant market position. In contacts with competitors, employees are generally prohibited from discussing competitively sensitive information, such as pricing policies, contract terms, costs, inventories, marketing and product plans, market surveys and other proprietary or confidential information. Such discussions or any collaboration with a competitor about competitively sensitive matters can be illegal. While discussions of some sensitive information may, under certain circumstances, be permissible, no such discussions with competitors should take place without prior approval of the General Counsel. Employees are required to report promptly to the General Counsel any instance in which a competitor has raised any of these topics or otherwise suggested collaboration with respect to any of them. PROTECTION AND PROPER USE OF COMPANY ASSETS The Company's success requires a commitment on the part of all of its employees to the proper allocation and use of its assets, tangible and intangible. For these purposes, the Company's assets include equipment, supplies, real estate, tools, inventory, funds, computer systems and equipment, computer software, computer data, vehicles, records or reports, nonpublic information, intellectual property or other sensitive information or materials and telephone, voice mail or e-mail communications, as well as Company funds in any form. We have a duty to protect the Company's assets from loss, damage, misuse, theft or sabotage. We must also ensure the efficient use of the Company's assets. The Company's assets are to be used for business purposes only. Management must approve any use of Company assets or services that is not solely for the Company's benefit. ACCURATE BOOKS AND RECORDS U.S. law requires the Company to make sure that its books and records accurately and fairly represent transactions and dispositions of our assets in reasonable detail. In all of our operations, it is a violation of Company policy, and possibly illegal, for any employee to cause our books and records to be inaccurate in any way. Employees must never create or participate in the creation of records that are misleading or artificial. Employees are expected to cooperate fully with our internal and independent auditors. In particular, the following requirements must be strictly respected by all employees. 9 - ACCESS TO COMPANY ASSETS, TRANSACTIONS ON MANAGEMENT'S AUTHORIZATION Access to Company assets is permitted only in accordance with management's general or specific authorization and transactions must be executed only in accordance with management's general or specific authorizations. Transactions involving the Company must be recorded to permit preparation of our financial statements in conformity with generally accepted accounting principles and related requirements and to maintain accountability for the Company's assets. - ACCURATE BOOKS All Company books and records must be true and complete. False or misleading entries are strictly prohibited, and the Company will not condone any undisclosed liabilities or unrecorded bank accounts or assets established for any purpose. - PROPER PAYMENTS No employee may authorize payment of Company funds knowing that any part of the payment will be used for any purpose other than the purpose described in the documents supporting the payment. - APPROPRIATE CONTROLS Administrative and accounting controls must be implemented to provide reasonable assurance that the Company is in compliance with the above requirements and that financial and other reports are accurately and reliably prepared, and fully and fairly disclose all required or otherwise material information. COMPLETE, ACCURATE AND TIMELY DISCLOSURE The Company is owned by the public and its shares are listed for trading on the Nasdaq Stock Market. As a result, the Company is obligated to make various disclosures to the public. The Company is committed to full compliance with all requirements applicable to its public disclosures. The Company has implemented disclosure controls and procedures to assure that its public disclosures are timely, compliant and otherwise full, fair, accurate and understandable. All employees responsible for the preparation of the Company's public disclosures, or who provide information as part of that process, have a responsibility to assure that such disclosures and information are complete, accurate and in compliance with the Company's disclosure controls and procedures. 10 DISCRIMINATION OR HARASSMENT The Company is committed to providing a work environment that is free from any form of discrimination on the basis of race, ethnicity, gender, creed, religion, age, disability or sexual preference. It is our policy to provide equal opportunity to all employees with regard to hiring, pay rates, training and development, promotions and other terms of employment. Employment decisions will comply with all applicable employment laws. The Company will not tolerate harassment, including sexual harassment, in any form. This includes verbal or physical conduct (including verbal or physical sexual advances or innuendo) that demeans or threatens any employee, creates a hostile work environment, unreasonably interferes with an individual's work performance or otherwise adversely affects an individual's employment. HEALTH AND SAFETY The Company strives to provide its employees with a safe and healthy work environment. We are all responsible for helping to achieve this goal by following safety and health rules. Employees must learn the safety procedures applicable to their jobs and abide by them. PAYMENTS TO GOVERNMENT PERSONNEL Practices that are considered acceptable in the commercial business environment, such as providing meals, transportation, entertainment or other things of value, may violate certain local, state, federal or foreign laws when we are dealing with governmental agents. Employees must not give anything of value to governmental agents if this could be interpreted as an attempt to curry favor on behalf of the Company. Consult the General Counsel if there is any uncertainty about permitted interactions with governmental agents. The U.S. Foreign Corrupt Practices Act ("FCPA") generally prohibits giving money or anything of value to foreign government officials, foreign political parties or candidates for foreign political office for the purpose of influencing a foreign government. This includes making any payments through intermediaries, such as sales representatives or consultants. Before making any payment or giving anything of value to a foreign official, employees should consult with the General Counsel. Violations of the FCPA can result in stiff civil and criminal penalties for both the Company and the individuals involved. Commercial bribery of any nature is a violation of Company policy and is illegal under U.S. law. Employees are strictly prohibited from offering any form of bribe, kickback or inducement to any person. 11 WAIVERS OF THE CODE OF BUSINESS CONDUCT AND ETHICS Any request for a waiver of any standard in this Code may be granted only by an employee's immediate supervisor and must be notified in advance to the General Counsel. Waivers involving any of the Company's executive officers or directors may be made only by the independent members of the Board of Directors of the Company, and all waivers granted to executive officers and directors will be disclosed to the Company's shareholders. All personnel should be aware that the Company generally will not grant such waivers and will do so only when good cause is shown for doing so. GOVERNMENT INVESTIGATIONS The Company will cooperate fully with any governmental investigation. Any employee who reasonably believes that a government investigation or inquiry may be threatened or under consideration with respect to any of the Company's operations or practices (including any outside such employee's scope of responsibilities) should so notify the General Counsel and provide the basis for such belief. Routine dealings with the government, such as our tax audits, are not covered by this standard. The Company may not always be able to protect both its own interests and those of an employee, without giving rise to a conflict of interest. In that case, the employee may need his or her own counsel. Whether the Company can pay for the employee's legal expenses will depend on legal or other restrictions and the facts and circumstances of the matter. AUDITS; INVESTIGATIONS; DISCIPLINARY ACTION The Company may conduct periodic audits of compliance with this Code. Allegations of potential wrongdoing will be investigated by the proper corporate or departmental personnel and, upon the advice of the General Counsel, will be reported to the Board of Directors (or an appropriate committee thereof) and to the relevant authorities. Knowingly false accusations of misconduct will be subject to disciplinary action. All employees are required to cooperate fully with any internal or external investigation. Employees must also maintain the confidentiality of any investigation and related documentation, unless specifically authorized by the General Counsel to disclose such information. Appropriate disciplinary penalties for violations of this Code may include counseling, reprimands, warnings, suspensions with or without pay, demotions, salary reductions, dismissals and restitution. Disciplinary action may also extend to a violator's supervisor insofar as the Company determines that the violation involved the participation of the supervisor or reflected the supervisor's lack of diligence in causing compliance with this Code. Any person who takes any action whatsoever in retaliation against any employee who has in good faith raised any question or concern about compliance with this Code will be subject to serious sanctions, which may include dismissal for cause. 12 Employees are reminded that the Company's document retention policies strictly prohibit the destruction or alteration of documentation undertaken with the intent to obstruct any pending or threatened investigation or proceeding of any nature or in contemplation of a proceeding. WHERE TO TURN FOR ADVICE Employees who have questions about this Code of Business Conduct and Ethics should turn to their immediate supervisors in the first instance. The Company's "open door" policy gives employees the freedom to approach any member of management with ethical questions or concerns without fear of retaliation. The Company's Audit Committee has also established a post office box for this purpose. Questions or concerns submitted to this post office box may be made anonymously. Employees who use the post office box are guaranteed confidential treatment. The post office box address is D & K Healthcare Resources, Inc., Attention: Audit Committee, P.O. Box 50363, St. Louis, Missouri 63105-9998. All employee communications made in good faith will be treated promptly and professionally and without risk of retribution whatsoever. 13 ACKNOWLEDGEMENT I acknowledge that I have received, read and understood the D & K Healthcare Resources, Inc. Code of Business Conduct and Ethics and that my conduct as an employee of the Company must at all times comply with the standards and policies set out in the Code, as well as any other legal or compliance policies or procedures of the Company. Employee: _________________________ Date: _____________________________ 14 CODE OF ETHICS FOR SENIOR FINANCIAL OFFICERS (As required by Section 406 of the Sarbanes-Oxley Act) As ________________ of D & K Healthcare Resources, Inc. (the "Company"), I certify that I will adhere to the following principles and responsibilities, as well as the Company's Code of Business Conduct and Ethics and other legal and compliance policies and procedures: - Act with honesty and integrity, avoiding actual or apparent conflicts of interest involving personal and professional relationships; - Provide other officials and constituents of the Company information that is full, fair, accurate, complete, objective, timely and understandable; - Comply with rules and regulations of all U.S. governmental entities, as well as state and other private and public regulatory agencies to which the Company is subject; - Act at all times in good faith, responsibly, with due care, competence and diligence, and without any misrepresentation of material facts; - Act objectively, without allowing my independent judgment to be subordinated; - Respect the confidentiality of Company information, except when authorized or otherwise required to make any disclosure, and avoid the use of any Company information for personal advantage; - Share my knowledge and skills with others to improve the Company's communications to its constituents; - Promote ethical behavior among employees under my supervision at the Company; and - Achieve responsible use of and control over all assets and resources of the Company entrusted to me. Employee: __________________________ Date: ______________________________ 15 EX-21 5 c88104exv21.txt SUBSIDIARIES OF THE REGISTRANT . . . EXHIBIT 21 SUBSIDIARIES OF THE REGISTRANT
SUBSIDIARY NAME STATE OF INCORPORATION % OWNED --------------- ---------------------- ------- Associated Pharmacies, Inc. (inactive) Arkansas 100% VC Services, Inc. Minnesota 100% Pharmaceutical Buyers, Inc. Arkansas 70% Jaron, Inc. Florida 100% D & K Receivables Corporation Delaware 100% Jewett Drug Co. South Dakota 100% Tykon, Inc. Wisconsin 100% Southwest Computer Systems, Inc. Arkansas 100% (inactive) U.P.C., Inc. (inactive) Minnesota 100% Diversified Healthcare, LLC Kentucky 100% Medical & Vaccine Products, Inc. Puerto Rico 100% D&K Pharmacy Solutions, Inc. Delaware 100% Walsh Heartland, L.L.C. Arkansas 100% Walsh Distribution L.L.C. Arkansas 100% Walsh Healthcare Solutions, Inc. Arkansas 100% Myhca, Inc. Texas 100% Healthcare Alliance LLC Alabama 50%
EX-23 6 c88104exv23.txt CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM EXHIBIT 23 Consent of Independent Registered Public Accounting Firm The Board of Directors D&K Healthcare Resources, Inc. We consent to the incorporation by reference in registration statement Nos. 333-67976 and 333-60146 on Form S-3, No. 333-64112 on Form S-3 MEF, and Nos. 333-98437, 333-50506, and 333-24263 on Form S-8 of D&K Healthcare Resources, Inc. of our report dated August 6, 2004, with respect to the consolidated balance sheets of D&K Healthcare Resources, Inc. and subsidiaries as of June 30, 2004 and 2003 and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended June 30, 2004, and the related financial statement schedule, which report appears in the June 30, 2004 annual report on Form 10-K of D&K Healthcare Resources, Inc. Our report refers to a change in accounting for goodwill and intangible assets. KPMG LLP St. Louis, Missouri September 13, 2004 EX-31.1 7 c88104exv31w1.txt CERTIFICATION EXHIBIT 31.1 CHIEF EXECUTIVE OFFICER CERTIFICATION I, J. Hord Armstrong, III, certify that: 1) I have reviewed this annual report on Form 10-K of the registrant.; 2) Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3) Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: September 13, 2004 /s/ J. Hord Armstrong, III ---------------------------------- Title: Chairman of the Board and Chief Executive Officer (Principal Executive Officer) EX-31.2 8 c88104exv31w2.txt CERTIFICATION EXHIBIT 31.2 CHIEF FINANCIAL OFFICER CERTIFICATION I, Thomas S. Hilton, certify that: 1) I have reviewed this annual report on Form 10-K of the registrant.; 2) Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3) Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4) The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting ; and 5) The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: September 13, 2004 /s/ Thomas S. Hilton --------------------------------- Title: Senior Vice President and Chief Financial Officer (Principal Financial Officer) EX-32 9 c88104exv32.txt CERTIFICATION EXHIBIT 32 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of D & K Healthcare Resources, Inc. ("Company") on Form 10-K for the year ended June 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), we certify, to the best of our knowledge, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Dated: September 13, 2004 /s/ J. Hord Armstrong, III -------------------------------- J. Hord Armstrong, III Chairman of the Board and Chief Executive Officer /s/ Thomas S. Hilton -------------------------------- Thomas S. Hilton Senior Vice President and Chief Financial Officer A SIGNED ORIGINAL OF THIS WRITTEN STATEMENT REQUIRED BY SECTION 906 HAS BEEN PROVIDED TO THE COMPANY AND WILL BE RETAINED BY THE COMPANY AND FURNISHED TO THE SECURITIES AND EXCHANGE COMMISSION OR ITS STAFF UPON REQUEST. THE FOREGOING CERTIFICATION IS BEING FURNISHED IN ACCORDANCE WITH SECURITIES AND EXCHANGE COMMISSION RELEASE NO. 34-47551 AND SHALL NOT BE CONSIDERED FILED AS PART OF THE FORM 10-K. -----END PRIVACY-ENHANCED MESSAGE-----