Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.

 

For the Quarterly Period Ended June 30, 2004

 

Commission File Number 0-18044

 

PROCYTE CORPORATION

(Exact name of the registrant as specified in its charter)

 

 

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 ý                                                                                     No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes o                                                                                     No ý

 

As of July 31, 2004, there were issued and outstanding 15,807,171 shares of common stock, par value $.01 per share.

 

 

ProCyte Corporation

 

Index

 

Part I - Financial Information
Item 1. Condensed Consolidated Financial Statements (unaudited)
Balance Sheets - as of June 30, 2004 and December 31, 2003 (unaudited)
Statements of Operations - Three and Six Months Ended June 30, 2004 and 2003 (unaudited)
Statements of Cash Flows - Six Months Ended June 30, 2004 and 2003 (unaudited)
Statements of Stockholders’ Equity - Six Months Ended June 30, 2004 (unaudited)
Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
Item 4.  Controls and Procedures
Part II - Other Information
Item 4.  Submission of Matters to a Vote of Security Holders
Item 6.  Exhibits and Reports on Form 8-K
Signatures

 

 

2

 

Part I - Financial Information

 

Item 1. Condensed Consolidated Financial Statements (unaudited)

 

Balance Sheets - as of June 30, 2004 and December 31, 2003 (unaudited)

(in thousands)

 

		June 30, 2004			December 31, 2003
ASSETS
Current Assets
Cash and cash equivalents		$	5,729		$	3,796
Accounts receivable, net of allowance for doubtful accounts		1,202			1,336
Inventory		2,625			2,942
Prepaid and other		217			289
Total current assets		9,773			8,363
Property and equipment
Equipment		325			315
Leasehold improvements		3,226			3,520
Less accumulated depreciation and amortization		(3,380		)	(3,294		)
Property and equipment, net		171			541
Intangible assets		3,205			3,212
Note due from related party, net		781			781
Deferred tax asset		7,055			7,068
Other assets		38			38
Total Assets		$	21,023		$	20,003
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable, trade		$	631		$	147
Accrued salaries and benefits		310			246
Other accrued liabilities		195			239
Deferred revenue		527			60
Total current liabilities		1,663			692
Other liabilities		93			93
Total Liabilities		1,756			785
Stockholders’ Equity
Common stock and additional paid-in-capital		85,440			85,419
Deferred compensation		(52		)	(59		)
Accumulated deficit		(66,121		)	(66,142		)
Stockholders’ Equity		19,267			19,218
Total Liabilities and Stockholders’ Equity		$	21,023		$	20,003

 

See notes to condensed consolidated financial statements

 

3

 

Statements of Operations - Three and Six Months Ended June 30, 2004 and 2003 (unaudited)

(in thousands, except per share amounts)

 

		Three months ended June 30,						Six months ended June 30,
		2004			2003			2004			2003
Revenues
Product sales		$	3,454		$	2,313		$	6,315		$	5,195
Licenses and royalties		230			319			589			783
Total revenues		3,684			2,632			6,904			5,978
Cost of product sales		1,157			619			2,018			1,802
Gross profit		2,527			2,013			4,886			4,176
Operating Expenses
Marketing and selling		1,260			814			2,458			2,213
Research, general, and administrative		1,057			967			2,148			1,934
Loss on asset impairment		294			—			294			—
Total operating expenses		2,611			1,781			4,900			4,147
Operating income (loss)		(84		)	232			(14		)	29
Interest and other income		43			37			50			125
Net income (loss) before tax		(41		)	269			36			154
Provision (benefit) for income tax		(12		)	—			15			18
Net income (loss)		$	(29	)	$	269		$	21		$	136
Net earnings per share
Basic		$	0.00		$	0.02		$	0.00		$	0.01
Diluted		$	0.00		$	0.02		$	0.00		$	0.01
Shares used in per share computation
Basic		15,798			15,765			15,795			15,755
Diluted		15,798			16,040			16,030			15,979

 

See notes to condensed consolidated financial statements

 

4

 

Statements of Cash Flows – Six Months Ended June 30, 2004 and 2003 (unaudited)

(in thousands)

 

		Six months ended June 30,
		2004			2003
Operating Activities
Net income		$	21		$	136
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		100			153
Amortization of deferred proceeds		—			(134		)
Non-cash expense related to stock-based compensation		18			24
Amortization of promissory note discount		—			(16		)
Change in deferred tax asset, net of change in valuation allowance		13			—
Amortization of deferred compensation		10			4
Loss on asset impairment		294			—
Change in operating assets and liabilities:
Accounts receivable		134			152
Inventory		310			(385		)
Prepaid and other		72			171
Accounts payable, trade		484			48
Accrued salaries and benefits		64			(126		)
Other accrued liabilities		(44		)	(64		)
Deferred revenue		467			(2		)
Other liabilities		—			2
Net cash provided by (used in) operating activities		1,943			(37		)
Financing Activities
Proceeds from issuance of common stock		—			10
Investing Activities
Purchase of property and equipment		(10		)	(47		)
Net increase (decrease) in cash and cash equivalents		1,933			(74		)
Cash and Cash Equivalents
At beginning of period		3,796			4,556
At end of period		$	5,729		$	4,482

 

See notes to condensed consolidated financial statements

 

5

 

Statements of Stockholders’ Equity - Six Months Ended June 30, 2004 (unaudited)

(in thousands)

 

		Common Stock					Additional Paid-in			Deferred Compen-			Accumulated
		Shares		Par Value			Capital			sation			Deficit			Total
Balance, December 31, 2003		15,783		$	158		$	85,261		$	(59	)	$	(66,142	)	$	19,218
Shares issued under non-employee director stock plan		16		(*		)	18			—			—			18
Re-measurement of stock options granted to non-employees		—		—			3			(3		)	—			—
Amortization of deferred compensation		—		—			—			10			—			10
Net income		—		—			—			—			21			21
Balance, June 30, 2004		15,799		$	158		$	85,282		$	(52	)	$	(66,121	)	$	19,267

 

This statement contains rounding, and (*) is placed where the number rounds to less than $1,000.

 

See notes to condensed consolidated financial statements

 

6

 

ProCyte Corporation

Notes to Condensed Consolidated Financial Statements (unaudited)

 

1.              Basis of Presentation

 

The accompanying condensed consolidated financial statements (unaudited) include the accounts of ProCyte Corporation and its wholly-owned subsidiaries, NextDerm, Inc. (a Delaware corporation) and NextDerm, Inc. (a Washington corporation) (collectively “ProCyte” or the “Company”), for the three and six month periods ended June 30, 2004 and 2003, and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X.  Pursuant to such rules and regulations, the condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for audited financial statements.  Accordingly, this financial information should be read in conjunction with the complete audited financial statements, including the notes thereto, which are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.  In the opinion of management, all material adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the financial statements have been included.  Interim results are not necessarily indicative of the results that may be expected for the year.

 

Use of Estimates in Financial Statements

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 revenues and expenses during the reporting period and the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, particularly with respect to the valuation of inventory, notes receivable, goodwill, leasehold improvements and deferred tax assets.  Actual results could differ from those estimates.

 

Stock Based Compensation

The Company follows the intrinsic value based accounting method for stock options contained in APB Opinion No. 25, Accounting for Stock Issued to Employees, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation.  Under this method, no compensation expense has been recognized for employee incentive stock options, as the exercise price of options granted equaled the fair value on the date of grant.

 

The following table represents what the Company’s pro forma amounts of net income (loss) and net income (loss) per share would have been for the three and six months ended June 30, 2004 and 2003, had compensation expense for the Company’s stock options granted under the incentive compensation plan been recognized based upon the fair value of the awards granted.

 

7

 

		(in thousands, except per share amounts)
		Three months ended June 30,						Six months ended June 30,
		2004			2003			2004			2003
Net income (loss), as reported		$	(29	)	$	269		$	21		$	136
Stock option-based compensation (expense) benefit determined under fair value-based method		(63		)	(90		)	11			(217		)
Pro forma net income (loss)		$	(92	)	$	179		$	32		$	(81	)
Earnings per share:
As reported basic		$	0.00		$	0.02		$	0.00		$	0.01
As reported diluted		$	0.00		$	0.02		$	0.00		$	0.01
Pro forma basic		$	(0.01	)	$	0.01		$	0.00		$	(0.01	)
Pro forma diluted		$	(0.01	)	$	0.01		$	0.00		$	(0.01	)

 

The Company determined the fair value of stock options granted during the three and six months ended June 30, 2004 and 2003 using the Black-Scholes option pricing model and the following assumptions:

 

		Three months ended June 30,				Six months ended June 30,
Options Granted		2004		2003		2004		2003
Risk-free interest rate		2.49	%	2.58%-2.69	%	2.44%-2.61	%	2.58%-2.81	%
Expected option life (years)		6.00		6.00		6.00		6.00
Dividend yield		0.00		0.00		0.00		0.00
Expected volatility		63	%	59%-62	%	62%-63	%	59%-62	%

 

2.              Accounts Receivable

 

Two customers represented greater than 10% of the net accounts receivable balance at June 30, 2004 and December 31, 2003 as follows:

 

		June 30, 2004		December 31, 2003
Customer A		26	%	46	%
Customer B		14	%	—
Customer C		7	%	12	%

 

The Company provided an allowance for uncollectible receivables in the amount of $11,000 and $102,000 at June 30, 2004 and December 31, 2003, respective1y.  The bad debt expense, net of recoveries of $133,000 in 2004 and $3,000 in 2003, was a benefit of $187,000 and an expense of $19,000 for the three months ended June 30, 2004 and 2003, respectively.  The bad debt expense, net of recoveries of $134,000 in 2004 and $5,000 in 2003, was a benefit of $211,000 and an expense of $29,000 for the six months ended June 30, 2004 and 2003, respectively.  Accounts written off to the allowance amounted to $12,000 and $1,000 for the three-month periods ended June 30, 2004 and 2003, respectively.  Accounts written off to the allowance account amounted to $13,000 and $13,000 for the six-month periods ended June 30, 2004 and 2003, respectively.

 

8

 

3.              Inventory

 

Inventory consisted of the following:

 

		(in thousands)
		June 30, 2004			December 31, 2003
Finished Goods		$	2,074		$	2,235
Work in process		333			406
Raw materials		218			301
Total		$	2,625		$	2,942

 

4.              Intangible Assets

 

Intangible assets consisted of the following:

 

		(in thousands)
		June 30, 2004			December 31, 2003
Patents, net of amortization		$	61		$	70
Other intangibles, net of amortization		30			36
Goodwill		3,114			3,106
Intangible Assets, net		$	3,205		$	3,212

 

Patents are shown net of accumulated amortization of $229,000 and $221,000, at June 30, 2004 and December 31, 2003, respectively.  Patents are amortized over the term of the patent and the amortization expense related thereto was $4,000 for each of the three-month periods ended June 30, 2004 and 2003, respectively and $8,000 for each of the six-month periods ended June 30, 2004 and 2003, respectively.  Patent amortization expense is expected to be $16,000 for each of the years ending December 31, 2004 through 2007 and $6,000 for the year ending December 31, 2008.

 

Other intangible assets are shown net of accumulated amortization of $6,000 at June 30, 2004.  The assets consist of trademarks and a customer list acquired from Annette Hanson, Inc. on December 30, 2003.  The trademarks and customer list are being amortized over their expected lives and the amortization expense related thereto was $3,000 and $6,000 for the three and six months periods ended June 30, 2004, respectively. The amortization expense is expected to be $12,000 for each of the years ending December 31, 2004 through 2006.

 

Intangible assets also include goodwill of $3.1 million at June 30, 2004 and December 31, 2003.  The Company determined that it has one reporting unit, therefore, all of the goodwill is deemed to be associated with ProCyte’s overall business operations.

 

5.              Federal and State Income Taxes

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. As of June 30, 2004 and December 31, 2003, a partial valuation reserve for tax benefits of net operating losses and a full valuation reserve for research and development tax credit carry forwards remains in place due to the uncertainty of realizing the full tax benefits of the net operating losses and tax credits as a result of their expiration.  The net changes in the valuation allowance during the six months ended

 

9

 

June 30, 2004, and the year ended December 31, 2003, were a reduction of $33,000 and $7.9 million, respectively.

 

As of June 30, 2004, the Company’s U.S. federal net operating loss and general business credit carry forward for income tax purposes were approximately $67.4 million and $1.6 million, respectively.  If not utilized, the federal net operating loss carry forward and tax credit carry forwards will expire between 2005 and 2021 as follows:

 

		(in thousands)
		Net operating loss			General business credits
2005		$	2,002		$	178
2006		3,928			133
2007		5,173			158
2008		7,912			242
Thereafter		48,422			865
Total		$	67,437		$	1,576

 

Future changes in ownership, as defined by Section 382 of the IRC, may limit the amount of net operating loss carry forward used in any one year.

 

6.              Earnings per share

 

Basic and diluted per share results for all periods presented were computed based on the net earnings for the respective periods.  The weighted average number of common shares outstanding during the period was used in the calculation of basic earnings per share.  In accordance with FAS 128, “Earnings Per Share,” the weighted average number of common shares used in the calculation of diluted per share amounts is adjusted for the dilutive effects of stock options based on the treasury stock method only if an entity records earnings from operations, as such adjustments would otherwise be anti-dilutive to earnings per share from operations.  For the three months ended June 30, 2003, 275,342 dilutive stock options were included in the calculation of the average number of common shares outstanding for diluted computations.  For the three month periods ended June 30, 2004 and 2003, options and warrants to purchase 2,595,124 shares and 982,508 shares of common stock, respectively, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive either because the exercise prices were greater than the average fair market value of the Company’s common stock for the period of $1.10 and $1.16, respectively, or there was a net loss for the period.  For the six months ended June 30, 2004 and 2003, 235,096 and 223,502 dilutive stock options, respectively, were included in the calculation of the average number of common shares outstanding for diluted computations. For the six months ended June 30, 2004 and 2003, options to purchase 1,600,134 shares and 982,508 shares, respectively, of common stock with exercise prices greater than the average fair market value of the Company’s common stock for the period of $1.14 and $1.21, respectively, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive.

 

7.              Stock Options

 

The Company has stock option plans for directors, officers, employees and consultants that provide for grants of nonqualified and incentive stock options.  Options generally are granted at fair market value, expire between five and ten years from grant date and vest ratably over one to three years.

 

10

 

The following table summarizes information about stock option activity in six-month periods ended June 30, 2004 and 2003:

 

		2004					2003
Items		Number of Options		Wtd. Avg. Exercise Price			Number of Options		Wtd. Avg. Exercise Price
Outstanding, beginning of year		2,570,167		$	1.41		2,185,335		$	1.57
Granted		142,000		$	1.11		167,500		$	1.30
Exercised		—		$	—		(12,000	)	$	0.86
Canceled or expired		(127,833	)	$	1.59		(85,001	)	$	3.76
Outstanding, June 30,		2,584,334		$	1.38		2,255,834		$	1.47
Exercisable, June 30,		1,859,515		$	1.47		1,639,514		$	1.52

 

The options outstanding at June 30, 2004 consisted of the following:

 

Range of exercise prices		Number of Options Outstanding		Wtd. Avg. Remaining Life		Wtd. Avg. Exercise Price			Number of Options Exercisable		Wtd. Avg. Exercise Price
$ 0.49 - $0.77		564,000		5.57		$	0.74		564,000		$	0.74
$ 0.77 - $1.09		517,500		8.29		$	1.02		135,000		$	0.94
$ 1.11 - $1.30		581,000		7.41		$	1.23		360,171		$	1.25
$ 1.31 - $1.83		538,334		6.81		$	1.57		416,844		$	1.59
$ 2.16 - $3.44		383,500		1.64		$	2.78		383,500		$	2.78
$ 0.49 - $3.44		2,584,334		6.20		$	1.38		1,859,515		$	1.47

 

The weighted average fair value of options granted during the three-month periods ended June 30, 2004 and 2003 was approximately $0.49 and $0.74, respectively.  The weighted average fair value of options granted during the six months ended June 30, 2004 and 2003 were approximately $0.49 and $0.77, respectively.

 

On April 12, 2004, the Board of Directors adopted the ProCyte Corporation 2004 Stock Option Plan subject to stockholder approval, which approval was obtained on May 19, 2004.  2,000,000 shares of common stock have been reserved for the plan, which provides for the grant of nonqualified and incentive stock options.  At June 30, 2004 there were 53,328 shares reserved for issuance under the Company’s 1996 Stock Option Plan.

 

8.              Related Party Disclosures

 

The Company holds a promissory note in the principal amount of $2 million from Emerald Pharmaceutical L.P. (“Emerald”), received as partial consideration for the sale of its contract manufacturing operations in 2001.  Emerald is in default of its obligations under this promissory note and, at June 30, 2004, such note is recorded net of a valuation allowance of $1.2 million taken in December 2003.  The note is secured by a security agreement covering substantially all of the assets of Emerald and requires Emerald to make monthly interest-only payments equal to the effective yield on the 10 Year US Treasury Note, adjusted quarterly.  The Company also received a minority limited partnership interest in Emerald as part of the consideration received in the sale.  As part of the agreement, ProCyte subleased a portion of its current 34,532 square foot leased facility, including existing leasehold improvements, to Emerald.

 

11

 

Until Emerald suspended operations in February 2004, ProCyte engaged Emerald to manufacture copper peptide compounds, and to perform incoming quality testing and other analytical services.  Emerald billed ProCyte a total of $382,000 for the three-month period ended June 30, 2003, and $19,000 and $1.2 million for the six months ended June 30, 2004 and 2003, respectively, for such products and services.  Emerald provided no products or services during the three months ended June 30, 2004. ProCyte has other sources for these products and services at prices that do not materially differ from those charged by Emerald.  ProCyte had no trade payables to Emerald at June 30, 2004 and December 31, 2003.

 

One of the Company’s Directors also serves as Chairman and Chief Executive Officer of one of ProCyte’s customers.  ProCyte’s sales to the customer were $243,000 and $157,000 for the three month periods ended June 30, 2004 and 2003, respectively and $396,000 and $344,000 for the six month periods ended June 30, 2004 and 2003, respectively.  The customer’s trade receivable balances were $80,000 and $165,000 on June 30, 2004 and December 31, 2003, respectively.

 

An Officer owed the Company $104,000 under a promissory note dated June 30, 2002.  The note bore interest at 2.91%, due annually, with the principal and accrued interest being all due and payable at June 30, 2004.  The note was repaid pursuant to its terms.

 

9.              Loss on Asset Impairment

 

In February 2004, the General Partner of Emerald informed the Company that Emerald had suspended operations and terminated all employees in an effort to conserve remaining capital while it sought other entities to operate or purchase the facility.  Emerald was not successful in returning to operations and, therefore, ProCyte terminated the facility sublease effective June 25, 2004.  In addition, effective July 16, 2004, ProCyte, as a secured party, completed a strict foreclosure process of accepting substantially all of Emerald’s assets in satisfaction of Emerald’s obligations under the $2 million promissory note.  The Company is currently in negotiations to sell substantially all the assets it accepted under the strict foreclosure process to a third party.  The proposed sale is contingent upon entering into a binding definitive asset purchase agreement and the successful negotiation of new leases under terms acceptable to both ProCyte and the proposed buyer.  Based upon the information known at this time, including management’s assessment of the probability of completing the sale and considering the estimated fair value of the assets received, ProCyte has taken an impairment charge of $294,000 at June 30, 2004.

 

10.       Subsequent Event

 

On July 7, 2004 the Company received $166,761 representing full settlement of a judgment obtained in July 2003 against Osmotics Corporation for product and royalty receivables from 2000.  The bad debt recovery and interest earned is included in the Company’s statement of operations for the second quarter of 2004.

 

12

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This Quarterly Report on Form 10-Q contains forward-looking statements. These statements relate to future events or future financial performance.  In some cases you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “propose” or “continue,” the negative of these terms, or other terminology.  These statements are only predictions.  Actual events or results may differ materially.  In evaluating these statements, you should specifically consider various factors described below in the section entitled “Additional Information About the Company’s Business; Risk Factors.” These factors may cause our actual results to differ materially from any forward-looking statement.

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, product demand, performance or achievements.  You should not place undue reliance on our forward-looking statements, which speak only as of the date of this report. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Recent Events

 

On June 25, 2004, the Company terminated its facility sublease with Emerald Pharmaceutical, L.P. (“Emerald”).  On July 16, 2004, the Company, as a secured party, completed the strict foreclosure process of accepting substantially all of Emerald’s assets in satisfaction of Emerald’s obligations under the $2 million promissory note.  The Company currently is in negotiations to sell substantially all the assets it accepted under the strict foreclosure process.  The sale is contingent upon entering into a binding definitive asset purchase agreement with the buyer and the successful negotiation of new leases with the landlord, under terms acceptable to both ProCyte and the prospective buyer.  Based upon the information known at this time, including management’s assessment of the probability of completing the sale and considering the estimated fair value of the assets received, ProCyte has taken an impairment charge of $294,000 at June 30, 2004.

 

On June 30, 2004 the company received $106,520 from John F. Clifford in full payment of the outstanding principal and accrued interest pursuant to the terms of a promissory note dated June 30, 2002.

 

On July 7, 2004 the Company received $166,761 representing full settlement of a judgment obtained in July 2003 against Osmotics Corporation for invoices and royalties due the Company from 2000.  The bad debt recovery and interest earned is included in the Company’s statement of operations for the second quarter of 2004.

 

Critical Accounting Policies and Estimates

 

The “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures included elsewhere in this Form 10-Q, are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingencies.  On an ongoing basis, we evaluate the estimates used, including those related to impairment and useful lives of intangible assets, allowances for accounts receivable and notes receivable, and for excess and obsolete inventory.  We base our estimates on historical experience, current conditions and on various other assumptions that are believed to be

 

13

 

reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identifying and assessing our accounting treatment with respect to commitments and contingencies.  Actual results may differ from these estimates under different assumptions or conditions.  We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of the consolidated financial statements.

 

Under the guidance of SFAS 109, “Accounting for Income Taxes,” we review our net deferred tax assets to determine which amounts, if any, are “more likely than not” to be utilized in future periods.  Our analysis of whether these tax assets will be utilized involved a substantial amount of judgment related to our ability to generate taxable net income in future periods, including revenue trends, product mix, and estimated margins, the amount and timing of which impacts the amount of net operating tax losses that could be utilized prior to their expiration. 

 

Product revenues are recognized when products are shipped, license fees are recognized over the term of the license agreement, and royalties are recognized when earned.  On occasion, we will receive advance deposits with customer purchase orders.  These deposits are reported as a deferred revenue liability, until the product is shipped to the customer.

 

Under the guidance of SFAS 142, “Goodwill and Other Intangible Assets,” we analyze whether the fair value of recorded goodwill is impaired on an annual basis.  Application of the goodwill impairment test requires judgment, including the identification of reporting units and determining the fair value of each reporting unit.  Significant judgments required to estimate the fair value of the reporting unit include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value.

 

We maintain an allowance for doubtful accounts for estimated losses resulting from the potential inability of our customers or other debtors to make required payments.  The allowance is based upon historical experience and a review of individual customer balances.  If the financial condition of our customers or other debtors were to deteriorate, resulting in an impairment of their ability to make payments to us, additional allowances may be required.

 

Inventories are stated at the lower of cost or market value.  Cost is principally determined by the first-in, first-out method.  We record adjustments to the value of inventory based upon forecasted plans to sell our inventories.  The physical condition (e.g., age and quality) of the inventories is also considered in establishing its valuation.  These adjustments are estimates, which could vary significantly, either favorably or unfavorably, from the amounts that we may ultimately realize upon the disposition of inventories, if future economic conditions, customer inventory levels, product discontinuances or competitive conditions differ from our estimates and expectations.

 

We record impairment losses on long-lived assets used in operations when events and circumstances indicate that assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets.  Estimation of future values for the long-lived assets requires a significant amount of judgment related to assessing the possible outcomes and the timing related to each outcome.  The adjustments are estimates, which could vary significantly, either favorably or unfavorably, from the amounts that we may ultimately realize for these assets if the actual events differ significantly from our estimates and expectations.

 

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Results of Operations

 

Three Months Ended June 30, 2004 and 2003

 

Revenue

 

		(in thousands)
		Three Months Ended June 30,
		2004			2003			% Change
Products		$	2,730		$	2,021		35	%
Copper peptide compound		724			292			148	%
Royalties		230			319			(28	)%
		$	3,684		$	2,632		40	%

 

Product revenues for the second quarter of 2004 increased $709,000, or 35 percent over the second quarter of 2003.  The increase was primarily due to a 31 percent increase in sales to physicians and the additional sales related to the spa distribution business included in the 2004 second quarter.  In addition, product revenues in the second quarter of 2003 had been impacted by the slowdown in patient traffic experienced by our dermatology, plastic and cosmetic surgery customers at the beginning of the 2003 year.  Product revenues began recovering during the second half of 2003, in part reflecting certain actions taken such as changing our hiring profile for sales representatives, increasing sales training and expanding customer education programs. Sales to physicians and distributors have been increasing since the third quarter of 2003.

 

Copper peptide compound shipments are driven by the purchasing patterns of our largest licensee, Neutrogena, which can vary based upon production cycles, adjustments in safety stock and other factors beyond our control.  Neutrogena ordered more copper peptide compound in the second quarter of 2004 to support a new product expected to be launched later in 2004.  Management expects demand from Neutrogena for copper peptide compound, on an annualized basis, to be the same as or slightly higher than the 2003 full year.  Therefore, the increase in the second quarter of 2004 as compared to the comparable 2003 quarter is not indicative of the results to be expected in subsequent periods.

 

Royalty revenue is based upon sales generated by our licensees.  Royalty revenues may fluctuate from quarter to quarter, due to the licensees’ timing of new market launches, special promotions and other factors beyond the Company’s control.  Royalties received from Neutrogena in the second quarter of 2004 were 28 percent lower than the comparable 2003 quarter primarily due to differences in the timing of our licensees’ promotions and expansions into new territories.  New territory introductions, such as those which occurred in the 2003 quarter, require initial shipments that are larger than normal to support the product introductions and fill the pipeline, which can cause variations in quarterly comparisons.  Upon the expiration of the underlying patent in February 2005, the agreement specifies that lower royalty percentages be used for the remaining term, the impact of which is a reduction in the average effective royalty rate of approximately 32 percent. The actual dollar amount of royalty income recognized in future periods is dependent upon both the royalty percentages in effect during the period and the actual applicable sales reported by Neutrogena, which can vary from quarter to quarter.  Therefore, the historical growth in royalty revenue may not be an indication of future results.

 

Gross Profit

 

Gross profit for the 2004 second quarter increased by $514,000, or 26 percent, over the second quarter of 2003 to $2.5 million.  Gross margin for the 2004 quarter was 69 percent as compared to 77 percent in the

 

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2003 quarter.  The increase in gross profit is primarily from the 35% increase in product revenues for the second quarter, which was partially offset by the decrease in royalty revenue for the 2004 quarter.  The decrease in gross margin percentage is primarily due to the lower margin copper peptide compound sales representing 20% of revenue in the 2004 second quarter as compared to 11% of revenue in the 2003 second quarter.  Gross margin is sensitive to the revenue mix of packaged products, copper peptide compound and royalty revenue and will vary from period to period as a result.

 

Operating Expenses

 

		(in thousands)
		Three Months Ended June 30,
		2004			2003			% Change
Marketing and selling		$	1,260		$	814		55	%
Research, general and administrative		1,057			967			9	%
Loss on asset impairment		294			—			—
Total operating expenses		$	2,611		$	1,781		47	%

 

Marketing and selling expenses for the second quarter of 2004 increased primarily due to increased salary, benefit and travel costs from additional headcount in the 2004 second quarter, higher commission expense related to the 35% increase in current quarter product sales and $226,000 of expenses related to the spa distribution business in the 2004 quarter.  This is partially offset by $79,000 in costs related to the development and testing of an infomercial included in the second quarter of 2003 and not repeated in 2004.

 

Research, general and administrative expenses for the 2004 second quarter increased 9 percent over the comparable 2003 period.  This was primarily due to Emerald not making rental and other payments of approximately $120,000 under its sublease and other agreements with ProCyte because of Emerald’s cessation of business operations in February 2004.  Such payments offset the Company’s rent expense in the 2003 period.  In addition, when comparing the 2004 second quarter to the comparable 2003 period, compensation and employee benefit expenses increased due to the addition of personnel and general market increases, legal expenses increased due to the timing of patent related work, operating costs increased due to higher shipping volume, and the addition of spa operations in the 2004 second quarter period.  These increased expenses were partially offset by a $207,000 decrease in bad debt expense due to the receipt of payments in 2004 from accounts previously written off in prior periods and a lower accrual for estimated bonuses in the 2004 second quarter as compared to the comparable 2003 period.

 

Loss on asset impairment relates to the portion of our facility formerly sub-leased to Emerald.  The Company currently is in negotiations to sell substantially all the assets related to its former manufacturing operation (which it accepted from Emerald under the foreclosure process described above).  The sale is contingent upon entering into a binding definitive asset purchase agreement with the buyer and the successful negotiation of new leases with the landlord, under terms acceptable to both ProCyte and the prospective buyer.  Based upon the information known at this time, including management’s assessment of the probability of completing the sale and considering the estimated fair value of the assets received, ProCyte has taken an impairment charge of $294,000 at June 30, 2004.

 

Interest and Other Income

 

Interest and other income earned during the second quarter of 2004 increased primarily due to interest income of $34,000 recognized on the final settlement of accounts receivable from a former licensee and

 

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written off in 2002.  This increase was partially offset by a decrease in interest not received on the Emerald note.

 

Net Loss

 

For the second quarter ended June 30, 2004, ProCyte reported a net loss of $29,000 as compared to net income of $269,000 for the comparable 2003 period.  This decrease was primarily due to the $294,000 asset impairment charge recognized in June 2004.  The effect of this impairment was partially offset by a gross profit that increased at a greater rate than operating expenses, excluding the impairment.

 

Six Months Ended June 30, 2004 and 2003

 

Revenue

 

		(in thousands)
		Six Months Ended June 30,
		2004			2003			% Change
Products		$	5,151		$	3,980		29	%
Copper peptide compound		1,164			1,215			(4	)%
Royalties		589			783			(25	)%
		$	6,904		$	5,978		16	%

 

Product revenues for the first half of 2004 increased $1.2 million, or 29 percent, over the first half of 2003.  The increase was primarily due to a 28 percent increase in sales to physicians and the additional sales related to the spa distribution business included in the 2004 period.  Product revenues in the first half of 2003 had been impacted by the slowdown in patient traffic experienced by our dermatology, plastic and cosmetic surgery customers at the beginning of the 2003 year.  Product revenues began recovering during the second half of 2003, in part reflecting certain actions taken such as changing our hiring profile for sales representatives, increasing sales training and expanding customer education programs.

 

Copper peptide compound shipments are driven by the purchasing patterns of our largest licensee, Neutrogena, which can vary based upon production cycles, adjustments in safety stock and other factors beyond our control.  As a result of the additional orders of copper peptide compound from Neutrogena in the second quarter of 2004, the amount of copper peptide compound delivered to Neutrogena during the first half of 2004 is comparable to the amount delivered in the first half of 2003.

 

Royalty revenue is based upon sales generated by our licensees.  Royalty revenues may fluctuate from quarter to quarter, due to the licensees’ timing of new market launches, special promotions and other factors beyond the Company’s control.  Royalties received from Neutrogena in the first half of 2004 were 25 percent lower than the corresponding 2003 period principally due to a large one-time customer shipment by Neutrogena, mostly in the 2003 first quarter.

 

Gross Profit

 

Gross profit for the first half of 2004 increased by $710,000, or 17 percent, to $4.9 million.  Gross margin for the first half of 2004 was 71 percent as compared to 70 percent in the corresponding 2003 period.  The increase in gross profit during the first half of 2004 is primarily due to the 29% increase in product sales which was partially offset by the decrease in royalty revenue when compared to the first

 

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half of 2003. The increase in gross margin percentage is due to a slightly different revenue mix in the two periods being compared.

 

Operating Expenses

 

		(in thousands)
		Six Months Ended June 30,
		2004			2003			% Change
Marketing and selling		$	2,458		$	2,213		11	%
Research, general and administrative		2,148			1,934			11	%
Loss on asset impairment		294			—			—
Total operating expenses		$	4,900		$	4,147		18	%

 

Marketing and selling expenses for the first half of 2004 increased primarily due to increased activity during the period.  Of the increase, approximately $550,000 was related to higher salary, benefit and travel costs from increased headcount supporting selling efforts in the 2004 period, higher commission expense related to the 29% increase in current period product sales and increased legal expenses related to the establishment and defense of the Company’s trademarks.  In addition, the first half of 2004 includes approximately $367,000 of expenses related to the spa distribution business not included in the 2003 period.  These increases are partially offset by $687,000 in costs related to the development and testing of an infomercial included in the 2003 period and not repeated in 2004.

 

Research, general and administrative expenses for the first half of 2004 increased 11 percent over the comparable 2003 period.  This was primarily due to Emerald not making rental and other payments totaling $210,000 under its sublease and other agreements with ProCyte because of Emerald’s cessation of business operations in February 2004.  Such payments offset the Company’s rent expense in the 2003 period.  In addition, when comparing the first half of 2004 to the comparable 2003 period, compensation and employee benefit expenses increased due to the addition of personnel and general market increases, legal expenses increased due to the timing of patent related work, operating costs increased due to higher shipping volume, and the addition of spa operations in the 2004 period.  These increased expenses were mostly offset by a $240,000 decrease in bad debt expense due to the receipt of payments in 2004 from accounts previously written off or included in the allowance for doubtful accounts in prior periods and a lower accrual for estimated bonuses in the first half of 2004 as compared to the comparable 2003 period.

 

Interest and Other Income

 

Interest and other income earned during the first half of 2004 decreased $75,000 to $50,000 primarily due to a decrease of $53,000 in interest income not recognized on the Emerald note in the 2004 period due to Emerald’s suspension of operations in February 2004 and a termination settlement of $50,000 received from Merck KGaA in the first half of 2003.  These decreases were partially offset by interest income of $34,000 recognized on the final settlement of accounts receivable from a former licensee and written off in 2002.

 

Net Income

 

For the six months ended June 30, 2004, ProCyte reported net income of $21,000 as compared to net income of $136,000 for the comparable 2003 period.  This decrease was primarily due to the $294,000 asset impairment charge recognized in June 2004.  The effect of this impairment was partially offset by gross profit that increased at a greater rate than operating expenses, excluding the impairment.

 

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Liquidity and Capital Resources

 

The Company relies primarily on cash flow from operations to fund its operations and capital expenditures.  At June 30, 2004, the Company had approximately $5.7 million in cash and cash equivalents, compared to $3.8 million at December 31, 2003.  The net change in cash and cash equivalents during the first half of 2004 reflects a net increase in cash of $1.9 million.  The significant components of this positive cash increase are from the net reduction of the Company’s copper peptide compound inventory, the reduction in accounts receivable, the receipt of payment on a note due from an officer, an increase in trade payables for inventory received near the end of the period, and the receipt of a customer deposit under a supply contract.  Positive cash generated was partially offset by the reduction in cash flow from Emerald as discussed below, the payment of the 2003 management bonuses in March 2004 and net cash used in support of the recently acquired spa products distribution business (“Spa”). 

 

As of February 2004, Emerald Pharmaceuticals, L.P. suspended operations and in fiscal 2003 ProCyte recorded an impairment related to its $2.0 million note receivable due to the uncertainty that the full amount would be collected.  Emerald also leased its facility from ProCyte under an operating sublease.  During the first half of 2004, except for January rent, ProCyte did not receive the interest and rental payments due under its agreements with Emerald.  Therefore, cash flow from operations has been reduced by $40,000 per month, from the comparable 2003 period.  ProCyte terminated the sublease on June 25, 2004 in order to take back the facility and protect the Company’s collateral and other interests.  Effective that date, ProCyte become responsible for facility related operating expenses such as utilities, insurance and security estimated to be an additional $11,000 per month.  In addition, ProCyte will be responsible for facility shut down costs estimated to be $35,000 to $50,000.

 

Due to inventory limitations and the need to change certain packaging, Spa sales have developed slower than originally planned at the time of the acquisition and as such Spa sales activity has not provided positive cash from operations as of June 30, 2004.  Based upon recent experience and current plans, ProCyte believes that additional cash of up to $200,000 could be required over the next two quarters.

 

We may see fluctuations in operating cash flows in future periods as they depend in large part on the timing of deposits received from our licensees and their initiation of new product introductions and the timing of shipments to and payments received from our customers.  In addition to these factors, the second half of 2004 will have cash inflows of $167,000 from the cash payment the Company received in July 2004 as full settlement of a judgment ProCyte obtained against a former licensee. ProCyte is also in negotiations to sell substantially all the assets related to its former manufacturing operation to a third party.  The sale is contingent upon entering into a binding definitive asset purchase agreement with the proposed buyer and the successful negotiation of new leases with the landlord under terms acceptable to both ProCyte and the proposed buyer.  Based upon the information known at this time, including management’s assessment of the probability of completing the sale and considering the estimated fair value of the assets received, ProCyte took an impairment charge of $294,000.

 

The Company believes that its existing cash and cash equivalents and interest thereon, will be sufficient to meet its working capital requirements for at least the next two years.  However, there can be no assurance that the underlying forecasts of revenue and expense will prove to have been accurate.  The Company’s actual cash requirements will depend upon numerous factors, including the levels of resources that the Company devotes to taking advantage of strategic acquisitions and/or establishing and maintaining marketing, sales and distribution capabilities, the emergence of competitive products and other adverse market developments, the timing and amount of revenues and expense reimbursements resulting from relationships with third parties, the Company’s degree of success in commercializing new

 

19

 

products and the cost of preparing, filing, prosecuting, maintaining and enforcing patent claims and intellectual property rights, and actions by regulatory authorities.  The Company will depend on product revenues, royalties and license fees, interest income, equity financing, and funding from corporate alliances to meet its future capital needs.  See “Additional Information About the Company’s Business; Risk Factors.”

 

Additional Information About the Company’s Business; Risk Factors