UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

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 September 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 November 5, 2004, there were issued and outstanding 15,816,762 shares of common stock, par value $.01 per share.

 

 

 

ProCyte Corporation

 

Index

 

 

Part I - Financial Information	3
Item 1. Condensed Consolidated Financial Statements (unaudited)	3
Balance Sheets - as of September 30, 2004 and December 31, 2003 (unaudited)	3
Statements of Operations - Three and Nine Months Ended September 30, 2004 and 2003 (unaudited)	4
Statements of Cash Flows — Nine Months Ended September 30, 2004 and 2003 (unaudited)	5
Statements of Stockholders’ Equity — Nine Months Ended September 30, 2004 (unaudited)	6
Notes to Condensed Consolidated Financial Statements (unaudited)	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3. Quantitative and Qualitative Disclosures About Market Risk	25
Item 4. Controls and Procedures	25
Part II - Other Information	27
Item 6. Exhibits	27
Signatures	27

 

2

 

Part I—Financial Information

 

Item 1. Condensed Consolidated Financial Statements (unaudited)

 

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

(in thousands)

		September 30, 2004			December 31, 2003
Assets
Current Assets
Cash and cash equivalents		$	5,321		$	3,796
Accounts receivable, net of allowance for doubtful accounts		1,317			1,336
Inventory		2,977			2,942
Assets held for sale		814			—
Prepaid and other		295			289
Total current assets		10,724			8,363
Property and equipment
Equipment		325			315
Leasehold improvements		3,141			3,520
Less accumulated depreciation and amortization		(3,392		)	(3,294		)
Property and equipment, net		74			541
Intangible assets		3,198			3,212
Note due from related party, net		—			781
Deferred tax asset		6,938			7,068
Other assets		38			38
Total Assets		$	20,972		$	20,003
Liabilities and Stockholders’ Equity
Current Liabilities
Accounts payable, trade		$	542		$	147
Accrued salaries and benefits		293			246
Other accrued liabilities		200			239
Deferred revenue		381			60
Total current liabilities		1,416			692
Other liabilities		75			93
Total Liabilities		1,491			785
Stockholders’ Equity
Common stock and additional paid-in-capital		85,443			85,419
Deferred compensation		(42		)	(59		)
Accumulated deficit		(65,920		)	(66,142		)
Stockholders’ Equity		19,481			19,218
Total Liabilities and Stockholders’ Equity		$	20,972		$	20,003

 

See notes to condensed consolidated financial statements

 

3

 

Statements of Operations—Three and Nine Months Ended September 30, 2004 and 2003
(unaudited)

(in thousands, except per share amounts)

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
Revenues
Product sales		$	2,883		$	2,286		$	9,198		$	7,481
Licenses and royalties		353			437			942			1,220
Total revenues		3,236			2,723			10,140			8,701
Cost of product sales		756			675			2,774			2,477
Gross profit		2,480			2,048			7,366			6,224
Operating Expenses
Marketing and selling		1,091			1,024			3,549			3,237
Research, general, and administrative		1,055			797			3,203			2,731
Loss on asset impairment		25			—			319			—
Total operating expenses		2,171			1,821			7,071			5,968
Operating income		309			227			295			256
Interest and other income		14			34			64			159
Net income before tax		323			261			359			415
Provision (benefit) for income tax		122			—			137			(18		)
Net income		$	201		$	261		$	222		$	397
Net earnings per share
Basic		$	0.01		$	0.02		$	0.01		$	0.03
Diluted		$	0.01		$	0.02		$	0.01		$	0.02
Shares used in per share computation
Basic		15,807			15,774			15,799			15,761
Diluted		15,954			15,974			16,000			15,973

 

See notes to condensed consolidated financial statements

 

4

 

Statements of Cash Flows—Nine Months Ended September 30, 2004 and 2003
(unaudited)

(in thousands)

 

		Nine months ended September 30,
		2004			2003
Operating Activities
Net income		$	222		$	397
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		119			244
Amortization of deferred proceeds		—			(201		)
Non-cash expense related to stock-based compensation		41			40
Amortization of promissory note discount		—			(23		)
Change in deferred tax asset, net of change in valuation allowance		130			—
Loss on asset impairment		319			—
Change in operating assets and liabilities:
Accounts receivable		19			206
Inventory		(15		)	(882		)
Prepaid and other		(6		)	132
Accounts payable, trade		395			13
Accrued salaries and benefits		47			(144		)
Other accrued liabilities		(39		)	(69		)
Deferred revenue		321			228
Other liabilities		(18		)	2
Net cash provided by (used in) operating activities		1,535			(57		)
Financing Activities
Proceeds from issuance of common stock		—			10
Investing Activities
Purchase of property and equipment		(10		)	(53		)
Net increase (decrease) in cash and cash equivalents		1,525			(100		)
Cash and Cash Equivalents
At beginning of period		3,796			4,556
At end of period		$	5,321		$	4,456
Supplemental Non-Cash Financing Activities
Assets received in settlement of note receivable		841			—

See notes to condensed consolidated financial statements

 

5

 

Statements of Stockholders’ Equity—Nine Months Ended September 30, 2004
(unaudited)

(in thousands)

 

		Common Stock
		Shares		Par Value			Additional Paid-in Capital			Deferred Compen- sation			Accumulated Deficit			Total
Balance, December 31, 2003		15,783		$	158		$	85,261		$	(59	)	$	(66,142	)	$	19,218
Shares issued under non-employee director stock plan		24		(*		)	27			—			—			27
Re-measurement of stock options granted to non-employees		—		—			(3		)	3			—			—
Amortization of deferred compensation		—		—			—			14			—			14
Net income		—		—			—			—			222			222
Balance, September 30, 2004		15,807		$	158		$	85,285		$	(42	)	$	(65,920	)	$	19,481

 

 

                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 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 nine month periods ended September 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, assets held for sale, 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 and net income per share would have been for the three and nine months ended September 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.

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
		(in thousands, except per share amounts)
Net income, as reported		$	201		$	261		$	222		$	397
Stock option-based compensation expense determined under fair value-based method		(58		)	(97		)	(47		)	(224		)
Pro forma net income		$	143		$	164		$	175		$	173

 

 

7

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
		(in thousands, except per share amounts)
Earnings per share:
As reported basic		$	0.01		$	0.02		$	0.01		$	0.03
As reported diluted		$	0.01		$	0.02		$	0.01		$	0.02
Pro forma basic		$	0.01		$	0.01		$	0.01		$	0.01
Pro forma diluted		$	0.01		$	0.01		$	0.01		$	0.01

 

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

 

		Three months ended September 30,				Nine months ended September 30,
		2004		2003		2004		2003
Options Granted
Risk-free interest rate		3.26	%	2.35	%	2.44-3.26	%	2.35-2.81	%
Expected option life (years)		6.00		6.00		6.00		6.00
Dividend yield		0.00		0.00		0.00		0.00
Expected volatility		59	%	60	%	59-63	%	59-62	%

 

2.              Accounts Receivable

 

Three customers represented greater than 10% of the net accounts receivable balance at September 30, 2004 and two of such customers represented greater than 10% of the net accounts receivable balance at December 31, 2003 as follows:

 

		September 30, 2004		December 31, 2003
Customer A		27	%	46	%
Customer B		17	%	5	%
Customer C		12	%	12	%

 

The Company provided an allowance for uncollectible receivables in the amount of $18,000 and $102,000 at September 30, 2004 and December 31, 2003, respective1y.  The bad debt expense, net of recoveries of $38,000 in 2004 and $1,000 in 2003, was a benefit of $29,000 and an expense of $15,000 for the three months ended September 30, 2004 and 2003, respectively.  The bad debt expense, net of recoveries of $172,000 in 2004 and $6,000 in 2003, was a benefit of $240,000 and an expense of $44,000 for the nine months ended September 30, 2004 and 2003, respectively.  Accounts written off to the allowance amounted to $2,000 and $1,000 for the three-month periods ended September 30, 2004 and 2003, respectively.  Accounts written off to the allowance account amounted to $16,000 and $14,000 for the nine-month periods ended September 30, 2004 and 2003, respectively.

 

 

8

 

 

3.              Inventory

 

Inventory consisted of the following:

 

		September 30, 2004			December 31, 2003
		(in thousands)
Finished Goods		$	2,153		$	2,235
Work in process		416			406
Raw materials		408			301
Total		$	2,977		$	2,942

 

4.              Intangible Assets

 

Intangible assets consisted of the following:

 

		September 30, 2004			December 31, 2003
		(in thousands)
Patents, net of amortization		$	57		$	70
Other intangibles, net of amortization		27			36
Goodwill		3,114			3,106
Intangible Assets, net		$	3,198		$	3,212

 

Patents are shown net of accumulated amortization of $233,000 and $221,000, at September 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 September 30, 2004 and 2003, respectively and $12,000 for each of the nine-month periods ended September 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 $9,000 at September 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 $9,000 for the three and nine months periods ended September 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 September 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 September 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 nine months

 

 

9

 

 

 

ended September 30, 2004, and the year ended December 31, 2003, were a reduction of $33,000 and $7.1 million, respectively.

 

As of September 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:

 

		Net operating loss			General business credits
		(in thousands)
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 September 30, 2004 and 2003, 146,830 and 200,823 dilutive stock options were included in the calculation of the average number of common shares outstanding for diluted computations, respectively.  For the three month periods ended September 30, 2004 and 2003, options and warrants to purchase 1,924,180 shares and 1,043,007 shares of common stock, respectively, were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive because the exercise prices were greater than the average fair market value of the Company’s common stock for the period of $0.98 and $1.16, respectively.  For the nine months ended September 30, 2004 and 2003, 201,176 and 211,601 dilutive stock options, respectively, were included in the calculation of the average number of common shares outstanding for diluted computations. For the nine months ended September 30, 2004 and 2003, options to purchase 1,826,580 shares and 981,342 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 $1.08 and $1.19, 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 over one to three years.

 

 

10

 

The following table summarizes information about stock option activity in nine-month periods ended September 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		162,000		1.10			169,500		1.29
Exercised		—		—			(12,000	)	0.86
Canceled or expired		(136,167	)	1.57			(149,835	)	2.74
Outstanding, September 30,		2,596,000		$	1.38		2,193,000		$	1.47
Exercisable, September 30,		1,861,348		$	1.47		1,633,179		$	1.51

 

The options outstanding at September 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		5.32		$	0.74		564,000		$	0.74
$ 0.77 - $1.09		536,000		8.09		1.02			135,667		0.94
$ 1.11 - $1.30		576,000		7.14		1.23			360,171		1.25
$ 1.31 - $1.83		536,500		6.55		1.57			418,010		1.59
$ 2.16 - $3.44		383,500		1.39		2.78			383,500		2.78
$ 0.49 - $3.44		2,596,000		5.97		$	1.38		1,861,348		$	1.47

 

The weighted average fair value of options granted during the three-month periods ended September 30, 2004 and 2003 was approximately $0.43 and $0.51, respectively.  The weighted average fair value of options granted during the nine months ended September 30, 2004 and 2003 were approximately $0.49 and $0.76, 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 September 30, 2004 there were 41,662 shares reserved for issuance under the Company’s 1996 Stock Option Plan.

 

8.              Related Party Disclosures

 

In July 2001 the Company sold its contract manufacturing operations to Emerald Pharmaceutical L.P. (“Emerald”) and received a promissory note in the principal amount of $2 million as part of the consideration.  The note was 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.  As part of the agreement, ProCyte subleased a portion of its leased facility, including existing leasehold improvements, to Emerald.  The Company also received a minority limited partnership interest in Emerald as part of the consideration received in the sale.

 

Emerald suspended operations in February 2004 and until that time ProCyte had engaged Emerald to manufacture copper peptide compounds, and to perform incoming quality testing and other analytical

 

 

11

 

 

 

services.  Emerald billed ProCyte a total of $415,000 for the three-month period ended September 30, 2003, and $19,000 and $1.6 million for the nine months ended September 30, 2004 and 2003, respectively, for such products and services.  Emerald provided no products or services during the three months ended September 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 September 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 $235,000 and $248,000 for the three month periods ended September 30, 2004 and 2003, respectively and $632,000 and $593,000 for the nine month periods ended September 30, 2004 and 2003, respectively.  The customer’s trade receivable balances were $158,000 and $165,000 on September 30, 2004 and December 31, 2003, respectively.

 

9.              Loss on Asset Impairment ; Assets Held For Sale

 

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 ultimately 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.  Based upon the information known at the time, ProCyte recorded a $294,000 impairment charge in the period ended June 30, 2004. The fair value of assets received upon completion of the strict foreclosure in July 2004 was estimated to be $841,000.  Assets received that related to the contract manufacturing operation were made available for immediate sale and the estimated fair value of such assets was recorded as assets held for sale.  As a result of the sale of the assets described in note 10, management concluded that the carrying value of the assets should be reduced an additional $25,000, which was recorded as a loss on asset impairment in the third quarter ended September 30, 2004.

 

10.       Subsequent Event

 

On October 22, 2004, ProCyte entered into a definitive agreement to sell substantially all of the assets described in footnote 9 and simultaneously closed the sale transaction contemplated by the agreement.  The sale agreement contained customary representations, warranties and covenants, including a covenant from ProCyte to defend, indemnify and hold harmless the buyer and its affiliates, successors and assigns from and against any loss, liability, claim, damage or expense arising out of our related to any breach by ProCyte of its representations, warranties or covenants under the agreement, including a warranty of good and valid title to the assets transferred by the agreement.  Net proceeds, after deducting costs related to the sale incurred in October, were $814,000, which was equal to the net carrying value of the assets sold recorded on the balance sheet at September 30, 2004.

 

In connection with the agreement, ProCyte also entered into an amendment to its current facilities lease dated October 1, 1993, as amended (the “Lease”).  The amendment removes 20,600 square feet from ProCyte’s existing facility lease, reducing ProCyte’s future operating lease obligation immediately after the sale by approximately $16,000 per month.  The total reduction in the future lease obligation as a result of this amendment is approximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of its contingent obligation to reimburse the landlord for certain facility restoration work provided for in the lease.  Other principle terms of the lease, including the expiration dates (December 2005 for 1,727 square feet and June 2007 for the remaining 12,182 square feet), were not modified by the amendment.

 

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 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.  Based upon the information known at the time, including management’s assessment of the estimated fair value of the assets received, ProCyte recorded an impairment charge of $294,000 at June 30, 2004.  Assets received that related to the contract manufacturing operation were made available for immediate sale and the estimated fair value of such assets was recorded as assets held for sale.  At September 30, 2004, management reviewed the cost estimates related to the selling activity for these assets and concluded that the carrying value of the assets should be reduced an additional $25,000, which was recorded as a loss on asset impairment in the third quarter ended September 30, 2004.

 

On October 22, 2004, ProCyte entered into a definitive agreement to sell the above described assets and simultaneously closed the sale transaction contemplated by the agreement.  The sale agreement contained customary representations, warranties and covenants, including a covenant from ProCyte to defend, indemnify and hold harmless the buyer and its affiliates, successors and assigns from and against any loss, liability, claim, damage or expense arising out of our related to any breach by ProCyte of its representations, warranties or covenants under the agreement, including a warranty of good and valid title to the assets transferred by the agreement.  Net proceeds, after deducting costs incurred in October related to the sale were $814,000, the net carrying value on the balance sheet of the assets sold.

 

In connection with the agreement, ProCyte also entered into an amendment to its current facilities lease dated October 1, 1993, as amended (the “Lease”).  The amendment removes 20,600 square feet from ProCyte’s existing facility lease, reducing ProCyte’s future operating lease obligation immediately after the sale by approximately $16,000 per month, a benefit that increases in June 2005 when there is a scheduled rate increase.  The total reduction in the future lease obligation as a result of this amendment is approximately $668,000 over the remaining term of the lease.  The amendment also relieves ProCyte of its contingent obligation to reimburse the landlord for certain facility restoration work provided for in the lease.  Other principle terms of the lease, including the expiration dates (December 2005 for 1,727 square feet and June 2007 for the remaining 12,182 square feet), were not modified by the amendment.

 

13

 

 

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 assets held for sale, 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 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.

 

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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.

 

Assets acquired in settlement of debt and held for sale are valued at their estimated fair value as of the date of foreclosure.  Management evaluates the value of foreclosed assets held for sale periodically and decreases the carrying value of the assets for any subsequent declines in fair value.  Changes in the valuation of and gains/losses on sales of foreclosed assets are included in loss on asset impairment.

 

Results of Operations

 

Three Months Ended September 30, 2004 and 2003

 

Revenue

 

		Three Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Products		$	2,683		$	1,918		40	%
Copper peptide compound		200			368			(46	)%
Royalties		353			437			(19	)%
		$	3,236		$	2,723		19	%

 

Product revenues for the third quarter of 2004 increased $765,000, or 40 percent over the third quarter of 2003.  The increase was primarily due to a $339,000, or 247 percent increase in sales to international distributors, a $187,000 or 12 percent increase in sales to physicians and the additional sales related to the spa distribution business included in the 2004 third quarter.  During 2004, we directed specific efforts at growing our international business, including the addition of a new international sales director in November 2003.  During the third quarter of 2004, we completed the negotiations for a new distribution agreement with our current Korean distributor and entered into distribution agreements with four new distributors located in Taiwan, Hong Kong, Malaysia and Australia.  Due to the number of new agreements occurring in a single quarter and the buying patterns of our international distributors, the results of the 2004 third quarter are not necessarily an indication of future quarterly international sales results for a single quarter.  Sales to physicians have been improving each quarter, on a comparable quarter basis, since the third quarter of 2003 driven in part by the introduction of new products in the first and second quarter of 2004 and the implementation of new sales and training 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 these factors, 46% less copper peptide compound was shipped in the third quarter of 2004 as compared to the comparable 2003 quarter.

 

Royalty revenue is based upon sales generated by our licensees, principally Neutrogena.  Royalty revenues may fluctuate from quarter to quarter, due to the licensees’ timing of new market launches,

 

 

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special promotions and other factors beyond the Company’s control.  Royalties received from Neutrogena in the third quarter of 2004 were 19 percent lower than the comparable 2003 quarter.  Royalty revenue varies from quarter to quarter due to differences in the timing of our licensees’ promotions and expansions into new territories and therefore quarterly comparisons are expected to vary as a result.

 

Gross Profit

 

Gross profit for the 2004 third quarter increased by $432,000, or 21 percent, over the third quarter of 2003 to $2.5 million.  Gross margin for the 2004 third quarter was 77 percent as compared to 76 percent in the 2003 third quarter.  The increase in gross profit is primarily from the 40% increase in product revenues for the 2004 third quarter, which was partially offset by the decrease in royalty revenue for that quarter.

 

Operating Expenses

 

		Three Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Marketing and selling		$	1,092		$	1,024		7	%
Research, general and administrative		1,055			797			32	%
Loss on asset impairment		25			—			—
Total operating expenses		$	2,171		$	1,821		19	%

 

Marketing and selling expenses for the third quarter of 2004 increased primarily due to expenses related to the spa distribution business in the 2004 quarter.  This is partially offset by $83,000 in costs related to the development and testing of an infomercial included in the third quarter of 2003 and not repeated in 2004.

 

Research, general and administrative expenses for the 2004 third quarter increased $258,000 over the comparable 2003 period.  This was primarily due to approximately $111,000 in expenses related to Emerald not making rental and other payments under its sublease and other agreements and costs related to supporting the manufacturing facility.  Such payments partially offset the Company’s rent expense in the 2003 quarter.  The remaining increase for the 2004 third quarter over the comparable 2003 period was from general market increases in compensation and employee benefit expenses, a provision for estimated bonuses included in the 2004 third quarter but not in the 2003 third quarter due to lower performance in 2003, legal expense increases due to the timing of contract and general corporate work, and additional expenses from the inclusion of spa operations in the 2004 third quarter period.  These increased expenses were partially offset by a $38,000 decrease in bad debt expense due to the receipt of payments in the 2004 third quarter from accounts previously written off in prior periods.

 

Loss on asset impairment relates to the assets held for sale.  The Company sold these assets on October 22, 2004.  Considering the proceeds received in October and the remaining cost incurred to sell, ProCyte took a loss on asset impairment charge of $25,000 at September 30, 2004.

 

 

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Interest and Other Income

 

Interest and other income earned during the third quarter of 2004 decreased primarily due to interest income not received on the Emerald note during the 2004 quarter.

 

Net Income

 

Net income before income taxes was $323,000 for the third quarter of 2004, an increase of 24% as compared to $261,000 for the 2003 period.  As a result of the partial reversal of our deferred tax asset valuation allowance in the fourth quarter of 2003, ProCyte’s 2004 third quarter reflects a provision for income tax expense while in the comparable 2003 period no income tax expense was recorded.  Accordingly, third quarter 2004 net income, after a $122,000 provision for income tax expense was $201,000 or $0.01 per diluted share as compared to net income of $261,000 or $0.02 per diluted share in the 2003 third quarter.

 

Nine Months Ended September 30, 2004 and 2003

 

Revenue

 

		Nine Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Products		$	7,834		$	5898		33	%
Copper peptide compound		1,364			1,583			(14	)%
Royalties		942			1,220			(23	)%
		$	10,140		$	8,701		17	%

 

Product revenues for the first nine months of 2004 increased $1.9 million, or 33 percent, over the first nine months of 2003. The increase was primarily due to a $1.1 million or 23 percent increase in sales to physicians, a $330,000 or 68 percent increase in sales to international distributors, and $594,000 in sales related to the spa distribution business included in the comparable 2004 period.  Sales to physicians have been improving each quarter, on a comparable quarter basis, since the third quarter of 2003 driven in part by the introduction of new products in the first and second quarter of 2004 and the implementation of new sales and training 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.  Accordingly, the quarterly comparisons can be volatile and inconsistent and they have been so in 2004 as compared to comparable quarters of 2003.  For the first nine months of 2004 Copper peptide compound revenues were 14 percent lower than the comparable 2003 period.

 

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 earned in the first nine months of 2004 decreased 23 percent as compared to the corresponding 2003 period, principally due to lower reported sales of licensed products by Neutrogena.  In addition, upon the expiration of the underlying ProCyte patent in February 2005, the license agreement specifies that lower royalty percentages be used for the remaining term, the impact of which will be a reduction in the average effective royalty rate of approximately 34 percent. The actual dollar amount of royalty income recognized in future periods is dependent upon both the royalty

 

 

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percentages in effect during the period and the actual applicable sales reported by Neutrogena, which can vary from quarter to quarter.  Therefore, historic royalty revenue is not an indication of future results.

 

 

Gross Profit

 

Gross profit for the first nine months of 2004 increased by $1.1 million, or 18 percent, to $7.4 million.  Gross margin for the first nine months of 2004 was 73 percent as compared to 72 percent in the corresponding 2003 period.  The increase in gross profit during the first nine months of 2004 was primarily due to the 33% increase in product sales, which was partially offset by the decrease in royalty revenue when compared to the first nine months of 2003. The increase in gross margin percentage is due to a slightly different revenue mix in the two periods being compared.

 

Operating Expenses

 

		Nine Months Ended September 30,
		2004			2003			% Change
		(in thousands)
Marketing and selling		$	3,549		$	3,237		10	%
Research, general and administrative		3,203			2,731			17	%
Loss on asset impairment		319			—			—
Total operating expenses		$	7,071		$	5,968		19	%

 

Marketing and selling expenses for the first nine months of 2004 increased $312,000 primarily due to increased selling activity during the period.  Of the net increase, approximately $407,000 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 33% 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 nine months of 2004 includes expenses related to the spa distribution business not included in the 2003 period.  These increases are partially offset by $770,000 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 nine months of 2004 increased $472,000 over the comparable 2003 period.  This was primarily due to approximately $343,000 in expenses related to Emerald not making rental and other payments under its sublease and other agreements and costs related to supporting the manufacturing facility.  Such payments from Emerald partially offset the Company’s rent expense in the 2003 period.  The remaining increase for the nine months of 2004 over the comparable 2003 period was from general market increases in compensation and employee benefit expenses, legal expenses increasing due to the timing of contract and general corporate work, and expenses from the addition of spa operations in the 2004 period.  These increased expenses were partially offset by a $285,000 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 first nine months of 2004 as compared to the comparable 2003 period.