10-Q 1 c89461e10vq.txt QUARTERLY REPORT Page 1 of 17 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File No. 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) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] YES [ ] NO Indicate by check mark whether the registrant is an accelerated filer. Yes [X] No [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, $.01 par value 14,102,449 ---------------------------- ---------- (class) (November 02, 2004) Page 2 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES Index
Page No. Part I. Financial Information Item 1. Financial Statements Condensed Consolidated Balance Sheets as of September 30, 2004 and June 30, 2004 3 Condensed Consolidated Statements of Operations for the Three Months Ended September 30, 2004 and September 30, 2003 4 Condensed Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2004 and September 30, 2003 5 Notes to Condensed Consolidated Financial Statements 6 - 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 - 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 14 Item 4. Controls and Procedures 14 Part II. Other Information Item 1. Legal Proceedings 15 Item 6. Exhibits and Reports on Form 8-K 15
Page 3 of 17 PART 1. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
SEPTEMBER 30, JUNE 30, 2004 2004 ------------ --------- (unaudited) ASSETS Current Assets Cash (including restricted cash of $8,381 and $12,499, respectively) $ 8,381 $ 12,499 Receivables, net of allowance for doubtful accounts of $4,976 and $5,444, respectively 126,444 130,770 Inventories 550,747 461,295 Other current assets 30,606 29,736 --------- --------- Total current assets 716,178 634,300 Property and Equipment, net of accumulated depreciation and amortization of $13,086 and $12,274, respectively 24,569 24,494 Other Assets 17,972 14,298 Goodwill, net of accumulated amortization 71,858 64,233 Other Intangible Assets, net of accumulated amortization 10,127 6,546 --------- --------- Total assets $ 840,704 $ 743,871 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Current maturities of long-term debt $ 926 $ 676 Accounts payable 311,232 219,580 Accrued expenses 22,539 31,144 --------- --------- Total current liabilities 334,697 251,400 Long-term Liabilities 3,053 2,663 Long-term Debt, excluding current maturities 321,886 307,693 Deferred Income Taxes 3,768 2,785 --------- --------- Total liabilities 663,404 564,541 Stockholders' Equity Common stock 153 152 Paid-in capital 126,370 125,552 Accumulated other comprehensive loss (1,294) (1,208) Deferred compensation - restricted stock (1,341) (730) Retained earnings 65,638 67,790 Less treasury stock (12,226) (12,226) --------- --------- Total stockholders' equity 177,300 179,330 --------- --------- Total liabilities and stockholders' equity $ 840,704 $ 743,871 ========= =========
The accompanying notes are an integral part of these statements. Page 4 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) For the three months ended September 30, (in thousands, except per share data)
2004 2003 --------- --------- Net Sales $ 725,676 $ 478,548 Cost of Sales 702,613 460,460 --------- --------- Gross profit 23,063 18,088 Operating Expenses 21,816 13,188 --------- --------- Income from operations 1,247 4,900 Other Income (Expense): Interest expense, net (4,091) (2,147) Other, net (35) 36 --------- --------- (4,126) (2,111) --------- --------- Income (Loss) before income tax provision and minority interest (2,879) 2,789 Income Tax Benefit (Provision) 1,123 (1,088) Minority Interest (185) (234) --------- --------- Net income (Loss) $ (1,941) $ 1,467 ========= ========= Earnings (Loss) Per Share - Basic $ (0.14) $ 0.11 Earnings (Loss) Per Share - Diluted $ (0.14) $ 0.10 Basic common shares outstanding 14,058 13,956 Diluted common shares outstanding 14,058 14,194
The accompanying notes are an integral part of these statements. Page 5 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) For the 3 months ended September 30, (in thousands)
2004 2003 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ (1,941) $ 1,467 Adjustments to reconcile net income (loss) to net cash flows from operating activities -- Depreciation and amortization 1,355 656 Amortization of debt issuance costs 424 407 Deferred income taxes (147) 862 Decrease in receivables, net 4,726 22,475 Increase in inventories (89,452) (63,872) Increase in other current assets (430) (2,480) Increase in accounts payable 91,652 1,015 Decrease in accrued expenses (9,393) (1,936) Other, net (308) 1,837 -------- -------- Net cash flows used in operating activities (3,514) (39,569) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Cash paid for acquired company (12,400) -- Purchases of property and equipment (1,564) (289) -------- -------- Net cash flows used in investing activities (13,964) (289) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Borrowings under revolving line of credit, net 13,018 39,337 Proceeds from secured financing 860 -- Payments of long-term debt (307) (238) Payment of dividends (211) (209) Purchase of treasury stock -- (816) -------- -------- Net cash flows provided by financing activities 13,360 38,074 -------- -------- Decrease in cash (4,118) (1,784) Cash, beginning of period 12,499 14,301 -------- -------- Cash, end of period $ 8,381 $ 12,517 -------- -------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid during the period for -- Interest $ 3,662 $ 1,760 Income taxes, net $ 2,126 $ 207
The accompanying notes are an integral part of these statements. Page 6 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES Notes to Condensed Consolidated Financial Statements (Unaudited) NOTE 1. BASIS OF PRESENTATION D & K Healthcare Resources, Inc. (the "Company") is a full-service, regional wholesale drug distributor, supplying customers from facilities in Missouri, Kentucky, Minnesota, Texas, Arkansas, and South Dakota. The Company distributes a broad range of pharmaceuticals and related products to its customers in 27 states primarily in the Midwest, Upper Midwest, and South. The Company focuses primarily on a target market sector, which includes independent retail, institutional, franchise, chain store and alternate site pharmacies. The Company also offers a number of proprietary information systems software products through two wholly owned subsidiaries, Tykon, Inc. and VC Services, Inc. (dba Viking Computer Services). In addition, the Company owns Pharmaceutical Buyers, Inc. ("PBI"), a leading alternate site group purchasing organization. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and include all of the information and disclosures required by accounting principles generally accepted in the United States of America for interim reporting, which are less than those required for annual reporting. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair representation have been included. The results of operations for the three-month period ended September 30, 2004, are not necessarily indicative of the results to be expected for the full fiscal year. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company's 2004 Annual Report to Stockholders. NOTE 2. ACQUISITION On September 30, 2004, the Company completed the acquisition of the remaining 30% of Pharmaceutical Buyers, Inc. (PBI), a Colorado-based group purchasing organization for alternate-site providers whose members include long-term care providers, home infusion providers and medical equipment distributors. The purchase price was $12.4 million. The transaction resulted in recognition of $7.7 million of goodwill, which was assigned to the PBI segment. Of that amount, none is expected to be deductible for tax purposes. Intangible assets of $3.8 million were also recorded with a weighted-average life of approximately 15 years. The intangible assets that make up that amount include customer relationships of $3.2 million (15-year weighted-average useful life) and other assets of $0.2 million (10-year weighted-average useful life). In addition, $0.4 million of intangible assets were determined to have indefinite lives. 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 and Texarkana, 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 unaudited pro forma information presents a summary of consolidated results of operations of the Company, PBI and Walsh for the three months ended September 30, 2004 and 2003, as if the Walsh and PBI acquisitions had occurred at July 1, 2003, with pro forma adjustments to give effect to amortization of intangible assets, interest expense on acquisition debt, minority interest, 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). Page 7 of 17
THREE MONTHS ENDED SEPTEMBER 30, -------------------------- 2004 2003 --------- --------- Net sales $ 725,676 $ 688,433 Net income (loss) before discontinued operations $ (1,791) $ 1,767 Net income (loss) $ (1,791) $ 1,607 Diluted earnings (loss) per share $ (0.13) $ 0.11
NOTE 3. 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 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 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. 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 unaudited pro forma net income and pro forma earnings per share would have been as follows:
Three Months Ended September 30, -------------------------- (in thousands, except per share data) 2004 2003 --------- --------- Net income (loss) - as reported $ (1,941) $ 1,467 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax (44) (393) --------- --------- Net income (loss) - pro forma $ (1,985) $ 1,074 Earnings (loss) per share: Basic - as reported $ (0.14) $ 0.11 Basic - pro forma $ (0.14) $ 0.08 Diluted - as reported $ (0.14) $ 0.10 Diluted - pro forma $ (0.14) $ 0.07
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. Page 8 of 17 NOTE 4. GOODWILL AND INTANGIBLE ASSETS Changes to goodwill and intangible assets during the three-month period ended September 30, 2004 are:
(in thousands) Goodwill Intangible Assets -------- ----------------- Balance at June 30, 2004, net of accumulated amortization $ 64,233 $ 6,546 Acquisition 7,679 3,756 Adjustment to Walsh purchase price (54) -- Amortization expense -- (175) -------- -------- Balance at September 30, 2004, net of accumulated amortization $ 71,858 $ 10,127 ======== ========
Intangible assets totaled $10.1 million, net of accumulated amortization of $1.0 million, at September 30, 2004. Of this amount, $0.6 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. Amortization expense for intangible assets is expected to approximate $0.7 million each year between 2004 and 2014 and $0.2 million from 2015 to 2018.
Goodwill Intangible Assets ------------------------- ------------------------ September 30, June 30, September 30, June 30, (in millions) 2004 2004 2004 2004 ------------- -------- ------------- --------- SEGMENT: Wholesale drug distribution $ 51.8 $ 51.8 $ 4.9 $ 5.0 PBI 18.7 11.0 5.2 1.5 Software 1.4 1.4 -- -- ------- ------- ------- ------- Total $ 71.9 $ 64.2 $ 10.1 $ 6.5 ======= ======= ======= =======
The Company tests goodwill annually as of April 30. A discounted cash flow model is used to determine the fair value of the Company's businesses for the purpose of testing goodwill for impairment. The discount rate used is based on a risk-adjusted weighted average cost of capital. NOTE 5. EARNINGS PER SHARE SFAS No. 128, "Earnings Per Share," requires dual presentation of basic and diluted earnings per share and requires a reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations. The reconciliation of the numerator and denominator of the basic and diluted earnings per share computations are as follows :
Three Months ended September 30, 2004 Three Months ended September 30, 2003 ---------------------------------------- ---------------------------------------- Income Shares Per-share Income Shares Per-share (in thousands, except for per share amounts) (Numerator) (Denominator)(1) Amount (Numerator) (Denominator)(1) Amount ----------- ---------------- --------- ----------- ---------------- --------- Basic Earnings per Share: Net income (loss) available to common stockholders $(1,941) 14,058 $ (0.14) $ 1,467 13,956 $ 0.11 Effect of Diluted Securities: Options -- -- -- 238 Convertible securities (66) -- (63) -- ------- ------ ------- ------ Diluted Earnings per Share: Net income (loss) available to common stockholders plus assumed conversions $(2,007) 14,058 $ (0.14) $ 1,404 14,194 $ 0.10 ======= ====== ======= ======= ====== =======
(1) Outstanding shares computed on a weighted average basis Page 9 of 17 As of September 30, 2004 and 2003, stock options to purchase 1.5 million and 0.9 million shares respectively were not dilutive and therefore not included in the diluted earnings per share calculation. NOTE 6. COMPREHENSIVE INCOME The Company's comprehensive income consists of net income and the net change in value of cash flow hedge instruments as follows: (in thousands)
Three Months Ended September 30, ---------------------- 2004 2003 ------- ------- Net income (loss) $(1,941) $ 1,467 Change in value of cash flow hedge, net of tax (86) 192 ------- ------- Total comprehensive income (loss) $(2,027) $ 1,659 ======= =======
NOTE 7. COMMITMENTS AND CONTINGENCIES 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 September 30, 2004, the Company was party to standby letters of credit of approximately $15.8 million and was the guarantor of certain customer obligations totaling approximately $0.3 million. 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 June 2006. At September 30, 2004, the remaining purchase commitment is approximately $25 million. On February 5, 2004, an individual named Gary Dutton filed a complaint in the United States District Court for the Eastern District of Missouri ("Court") 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. On April 30, 2004, United Food & Commercial Workers Union, Local 655, AFL-CIO, Food Employees Joint Pension Plan ("Local 655") filed a motion to become lead plaintiff. On October 5, 2004, the Court granted Local 655's motion appointing them lead plaintiff. The Company believes that the existing complaint describes types of transactions in which the Company has not engaged, contains a number of inaccurate statements, and does not state any valid cause of action, and further, that the Company will have substantial meritorious defenses to the complaint. The Defendants intend to vigorously defend the claims. 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 8. LONG-TERM DEBT The Company has a $600 million asset-based senior secured revolving credit facility. 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) and $600 million. Total credit available at September 30, 2004 was approximately $463 million of which approximately $128 million was unused. Page 10 of 17 The interest rate on the 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 4.34% at September 30, 2004. The facility expires in March 2007 and contains no subjective acceleration provision, and therefore, the related debt has been classified as long-term in the Company's financial statements. The Company is required under the terms of the credit facility 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 is also 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. In August 2004, the Company amended the credit facility modifying the loan covenants to make them less restrictive. The Company is in compliance with its debt covenants as of September 30, 2004. At this time, the Company projects that it will be in compliance with the debt covenants for the next 12 months. NOTE 9. 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, and 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 distribution of 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. The Company operates principally in the United States.
For The Three Months Ended -------------------------------------- (in thousands) September 30, 2004 September 30, 2003 ------------------ ------------------ Net Sales - Wholesale drug distribution $ 722,925 $ 475,677 PBI 2,118 2,319 Software/Other 633 552 --------- --------- Total $ 725,676 $ 478,548 Gross Profit - Wholesale drug distribution $ 20,472 $ 15,363 PBI(1) 2,118 2,319 Software/Other 473 406 --------- --------- Total $ 23,063 $ 18,088 Pre-tax earnings (loss) - Wholesale drug distribution $ (3,892) $ 1,497 PBI 1,054 1,232 Software/Other (41) 60 --------- --------- Total $ (2,879) $ 2,789
(1) Cost of operations recorded by PBI of $1.0 million in each period have been classified as operating expenses in the Company's Condensed Consolidated Statements of Operations. The increase in total assets from the Company's 2004 Annual Report relates primarily to increased inventory levels and the acquisition of the remaining portion of PBI. There are no other differences in the basis of segmentation or in the basis of measurement of segment profit or loss. Page 11 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The discussion below is concerned with material changes in financial condition and results of operations in the condensed consolidated balance sheets as of September 30, 2004 and June 30, 2004, and in the condensed consolidated statements of operations for the three-month periods ended September 30, 2004 and September 30, 2003, respectively. We recommend that this discussion be read in conjunction with the audited consolidated financial statements and accompanying notes included in our 2004 Annual Report to Stockholders. 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. The Company's actual results could differ materially from those currently anticipated due to a number of factors, including without limitation, the changing business and regulatory environment of the healthcare industry in which the Company operates, including manufacturers' pricing or distribution policies or practices, the competitive nature of the wholesale pharmaceutical distribution industry with many competitors having substantially greater resources than D & K Healthcare, the Company's ability to maintain or improve its operating margins with the industry's competitive pricing pressures, the Company's customers and suppliers generally having the right to terminate or reduce their purchases or shipments on relatively short notice, changes in the Company's prime vendor status with cooperative purchasing groups, the availability of investment purchasing opportunities, the loss of one or more key suppliers for which alternative sources may not be available, changes in private and governmental reimbursement or in the delivery systems for healthcare products, changes in interest rates, ability to complete and integrate acquisitions successfully, and other factors set forth in reports and other documents filed by D & K Healthcare with the Securities and Exchange Commission from time to time. 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. RECENT TRENDS AND EVENTS Sales in the national accounts trade class fell below expectations in the first quarter of fiscal 2005, as fewer than anticipated product price increases enacted by pharmaceutical manufacturers resulted in lower activity in this trade class. Changes in manufacturers' inventory management practices resulting in reduced availability of product 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 quarter of fiscal 2005. However, during this period sales trends in this trade class show continued growth that 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 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 Page 12 of 17 classes of trade rely on us as their primary pharmaceutical and over-the-counter products supplier. 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. 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 future results more difficult to project. We believe that 2005 earnings results will likely be `back-end' loaded, similar to 2004. RESULTS OF OPERATIONS NET SALES Net sales increased $247.1 million to $725.7 million, or 51.6%, for the three months ended September 30, 2004, compared to the corresponding period of the prior year. Sales to independent and regional pharmacies increased $334.0 million to $654.0 million, or 104.4%, approximately 64% of which relates to sales from the Walsh subsidiary. The majority of the remaining increase relates to new business. National accounts sales decreased $89.8 million to $38.1 million, or 70.2%, compared to the prior year period primarily due to fewer product price increases enacted by pharmaceutical manufacturers and 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. GROSS PROFIT Gross profit increased $5.0 million to $23.1 million, or 27.5%, for the three months ended September 30, 2004, compared to the corresponding period of the prior year. As a percentage of net sales, gross margin decreased from 3.78% to 3.18% for the quarter ended September 30, 2004, compared to the corresponding period of the prior year. Walsh gross margin was consistent with the rest of our wholesale drug distribution segment. The increase in gross profit was due to the addition of Walsh and additional sales related to new business and same store growth offset by lower national accounts sales and continued pricing pressure on new and existing business. The reduction in gross margin percentage was primarily due to fewer price increases during the quarter. OPERATING EXPENSES Operating expenses (including depreciation and amortization) increased $8.6 million to $21.8 million, or 65.4%, for the three months ended September 30, 2004 compared to the corresponding period of the prior year. The ratio of operating expenses to net sales was 3.01%, a 25 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 during the quarter. INTEREST EXPENSE, NET Net interest expense increased $1.9 million to $4.1 million, or 90.5%, for the three months ended September 30, 2004, compared to the corresponding period of the prior year. As a percentage of net sales, net interest expense increased to 0.56% from 0.45%, compared to the corresponding period of the prior year. The increase in net interest expense was primarily the result of higher inventory levels supporting sales growth and higher average borrowing levels driven by financing the purchase of Walsh. INCOME TAX PROVISION Our effective income tax rate was 39.0% for the three months ended September 30, 2004, the same as 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. PBI Net sales at PBI were $2.1 million for the three months ended September 30, 2004, down $0.2 million from the corresponding period of the prior year. The decrease relates to a lower volume of purchases by PBI members. Gross profit generated by PBI as a percentage of our total gross profit decreased from 12.8% to 9.2% as a result of our higher overall gross profit. PBI recorded pre-tax earnings of $1.1 million for the three months ended September 30, 2004, down $0.2 million from the corresponding period of the prior year. This was the result of the lower net sales for the period. Page 13 of 17 LIQUIDITY AND CAPITAL RESOURCES 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:
SEPTEMBER 30, JUNE 30, 2004 2004 ------------ --------- Working capital (1) (000s) $ 381,481 $ 382,900 Current ratio 2.14 to 1 2.52 to 1
(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. Our wholesale drug segment requires a substantial investment in working capital that is susceptible to large variations during the year as a result of inventory purchase patterns and seasonal demands. Inventory purchase activity is a function of sales activity, new customer build-up requirements and the desired level of investment inventory. Working capital and current ratio at September 30, 2004 are approximately the same as June 30, 2003 levels. At September 30, 2004, our inventory levels increased due to the start of normal seasonal inventory requirements and as the result of decreased sales in our national accounts trade class. The increase in inventory levels was offset by a corresponding increase in accounts payable associated with the inventory. On March 31, 2003, we entered into a new $600 million credit facility. 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) and $600 million. Total credit available at September 30, 2004 was approximately $463 million of which approximately $128 million was unused. The PBI acquisition and the increase in inventory levels account for the increase in outstanding long-term debt as the credit facility was used as the source of funds. The interest rate on the 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 4.34% at September 30, 2004. Under the terms of the credit facility, we are required to comply with certain financial covenants, including those related to a fixed charge coverage ratio and tangible net worth. We are required to reduce borrowings by cash received. We are also 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. In August 2004, we amended the credit facility modifying the loan covenants to make them less restrictive. We are in compliance with our debt covenants as of September 30, 2004. At this time, we project that we will be in compliance with the debt covenants for the next 12 months. Net cash used in operating activities totaled $3.5 million for the three months ended September 30, 2004 with net cash used in operating activities of $39.6 million in the prior year. This decrease is primarily the result of an increase in accounts payable levels due to timing of payments partially offset by increases in inventory levels. We invested $1.6 million in capital assets in the three months ended September 30, 2004 compared with $0.3 million in the corresponding period of the prior year. Current year and prior year additions relate primarily to the expansion of our Cape Girardeau distribution center. We believe that continuing investment in capital assets is necessary to achieve our goal of improving operational efficiency, thereby enhancing our productivity and profitability. Net cash inflows provided by financing activities totaled $13.4 million for the three months ended September 30, 2004 with net cash provided by financing activities of $38.1 million for last year. Borrowings under our revolving line of credit related to the purchase of PBI and to support our inventory levels produced this result. Stockholders' equity decreased $2.0 million to $177.3 million at September 30, 2004 from $179.3 million at June 30, 2004, due to the net loss during the period. We believe that funds available under the credit facility, together with internally generated funds, will be sufficient to meet our capital requirements for the foreseeable future. Page 14 of 17 CRITICAL ACCOUNTING POLICIES Refer to "Critical Accounting Policies" in our 2004 Annual Report on Form 10-K for information on accounting policies that we consider critical in preparing our consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, these estimates could change materially if different information or assumptions were used. NEW ACCOUNTING STANDARDS Refer to Note 14 of Notes to Consolidated Financial Statements in our 2004 Annual Report on Form 10-K for a discussion of recently issued accounting standards. Our adoption of these new accounting standards did not have a material effect on our financial position or results of operations. ITEM 3. 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 our operating results and the cash flow available to fund operations and expansion. Based on estimated average variable borrowings during fiscal 2005, a change of 25 basis points in the average variable borrowing rate would result in a change of approximately $0.9 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. ITEM 4. CONTROLS AND PROCEDURES Based on an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report, our Chief Executive Officer and our Chief Financial Officer have concluded that such controls and procedures were effective as of the end of the period covered by this report. In connection with such evaluation, no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. Page 15 of 17 D & K HEALTHCARE RESOURCES, INC. AND SUBSIDIARIES PART ll. OTHER INFORMATION ITEM 1. 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 ("Court") 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. On April 30, 2004, United Food & Commercial Workers Union, Local 655, AFL-CIO, Food Employees Joint Pension Plan ("Local 655") filed a motion to become lead plaintiff. On October 5, 2004, the Court granted Local 655's motion appointing them lead plaintiff. The Company believes that the existing complaint describes types of transactions in which the Company has not engaged, contains a number of inaccurate statements, and does not state any valid cause of action, and further, that the Company will have substantial meritorious defenses to the complaint. The Defendants intend to vigorously defend the claims. 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. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits See Exhibit Index on page 17. (b) Reports on Form 8-K 1. On August 10, 2004, the registrant filed a Current Report on Form 8-K under Items 7 and 12 with a press release announcing its financial results for the fiscal 2004 fourth quarter and full year. Page 16 of 17 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. D & K HEALTHCARE RESOURCES, INC. Date: November 9, 2004 By: /s/ J. Hord Armstrong, III -------------------------- J. Hord Armstrong, III Chairman of the Board and Chief Executive Officer By: /s/ Thomas S. Hilton --------------------- Thomas S. Hilton Senior Vice President Chief Financial Officer (Principal Financial & Accounting Officer) Page 17 of 17 EXHIBIT INDEX Exhibit No. Description 2.1** 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 registrant's Current Report on Form 8-K dated December 15, 2003. 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., filed as an exhibit to 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** Consent and Third Amendment to Sixth Amended and Restated Loan and Security Agreement, dated August 30, 2004, by and among Fleet Capital Corporation (individually and as Agent for Lenders), registrant, Jewett Drug Co., Diversified Healthcare, LLC, Medical & Vaccine Products, Inc., MYHCA, Inc., RxDirect, Inc., Walsh Distribution, L.L.C., Walsh Healthcare Solutions, Inc., and Walsh Heartland, L.L.C. 31.1** Section 302 Certification of Chief Executive Officer. 31.2** Section 302 Certification of Chief Financial Officer. 32** Section 906 Certification of Chief Executive Officer and Chief Financial Officer. * Incorporated by reference. ** Filed herewith.