ITEM 1. BUSINESS. -------- General -------
Incorporated in Texas in 1973, Carrington Laboratories, Inc. ("Carrington" or the "Company") is a research-based biopharmaceutical, medical device, raw materials and nutraceutical company engaged in the development, manufacturing and marketing of naturally-derived complex carbohydrates and other natural product therapeutics for the treatment of major illnesses, the dressing and management of wounds and nutritional supplements. The Company's research and proprietary product portfolios are based primarily on complex carbohydrates isolated from the Aloe vera L. plant. The Company is comprised of three business segments. See Note Thirteen to the consolidated financial statements in this Annual Report for financial information about these business segments: the Medical Services Division, Consumer Services Division and DelSite Biotechnologies Inc., ("DelSite"). The Company sells prescription and nonprescription medical products through its Medical Services Division and provides manufacturing services to customers in medical markets. Through its Consumer Services Division the Company sells consumer and bulk raw material products and also provides product development and manufacturing services to customers in the cosmetic and nutraceutical markets. DelSite was incorporated in 2001 as a wholly-owned subsidiary. DelSite operates independently from the Company's research and development program and is responsible for the research, development and marketing of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients.
Business Strategy -----------------
The Company's strategy is to continue to grow as a research-based biopharmaceutical company focused on offering quality products to customers and potential partners. Key aspects of the Company's strategy are to:
* enlarge and diversify our customer base to reduce dependence on a limited number of significant customers;
* increase revenues by offering innovative new products, growing existing product lines and continuing to offer exceptional customer service;
* increase profitability by continuing to improve operational efficiency, working capital management and modernization of equipment;
* develop and market the proprietary GelSite[R] polymer technology for delivery of vaccines and therapeutics;
* enter into strategic partnerships and collaboration arrangements related to the GelSite[R] technology; and
* continue to develop the knowledge of polymers and their relationship to vaccines and bioactive protein and peptide therapeutics.
Medical Services Division -------------------------
Carrington's Medical Services Division offers a comprehensive line of wound management products. Carrington products are used in a wide range of acute and chronic wounds, for skin conditions and incontinence care. The primary marketing emphasis for Carrington's wound and skin care products is directed toward hospitals, nursing homes, alternate care facilities, cancer centers, home health care providers and managed care organizations. The wound and skin care product lines are being promoted primarily to physicians and specialty nurses, for example, enterostomal therapists.
The Company distributes its Medical Services products through a single source distributor, Medline Industries, Inc. ("Medline"). Pursuant to its agreement with Medline, the Company manufactures its existing line of products and sells them to Medline at specified prices. The prices are subject to adjustment not more than once each year to reflect increases in manufacturing cost. If Medline elects to market any other products under any of the Company's trademarks, Medline will pay the Company a royalty of between one percent and five percent of the annual sales of the trademarked products, depending on the aggregate amount of the net sales under this agreement to Medline. In addition, pursuant to a Supply Agreement with Medline, which expires November 2008, the Company manufactures Medline- branded dermal management products.
The Company maintains dual control with Medline of certain national pricing agreements which cover hospitals, alternate care facilities, home health care agencies and cancer centers. These agreements allow Medline representatives to make presentations in member facilities throughout the country. In order to promote continued brand-name recognition, the Company engages in limited marketing and advertising to bolster Medline's efforts in these areas.
The Medical Services Division has several distribution and licensing agreements for the sale of its products into international markets. The Division also sells wound care products into international markets on a non- contract, purchase order basis. Opportunities in the Internet market are also addressed through the Company's websites, www.carringtonlabs.com and www.woundcare.com. These website addresses are included in this document as an inactive textural reference only and the information contained on these websites is not incorporated into this Form 10-K.
The Medical Services Division is aggressively pursuing the veterinary wound care markets, both equine and companion animal, based on the commercial and brand success the Company has had in the advanced wound care market for humans. The Company also produces Acemannan Immunostimulant[TM], a biologic product fully licensed by the United States Department of Agriculture ("USDA") as an adjuvant therapy for certain cancers in dogs and cats. This product, in addition to several wound and skin care products developed specifically for the veterinary market, are marketed through veterinary distributors. The Company is actively pursuing additional distribution arrangements for these products.
The Medical Services Division is actively involved in developing and promoting the SaliCept[R] line of products, which includes an oral rinse, patches for oral wounds and extraction sites, and other products. In 2006 the Company signed a three-year exclusive representative agreement with Executive Sales Associates. Under the terms of the agreement, the Company will supply Executive Sales Associates with the Salicept[R] line of products for use in the management of dry socket for distribution into the dental practitioner market in the United States and Canada. In return, Executive Sales Associates will be responsible for sales, marketing and distribution of these products through its diversified network of national and regional distributors.
Consumer Services Division --------------------------
The Consumer Services Division markets and licenses products in three distinct categories in the health and beauty markets: Bulk Raw Materials, Specialty Manufacturing Services and Finished Consumer Products. The Bulk Raw Materials category is comprised of proprietary bulk raw materials produced from Aloe vera L. utilizing the Company's patented alcohol- precipitation method. The premier product is Manapol[R] powder, a bulk raw material that contains greater than 60% polymeric polysaccharides. Manapol[R] powder is marketed to manufacturers of food and nutritional products who desire quality, clinically-proven ingredients for their finished products that can carry a structure/function claim for immune system enhancement. In addition to Manapol[R] powder, the Consumer Services Division markets the bulk raw material Hydrapol[TM] powder to manufacturers of bath, beauty and skin care products. Hydrapol[TM] powder is currently the only raw material from Aloe vera L. that has the International Nomenclature Cosmetic Ingredient ("INCI") name of Aloe Barbadensis Leaf Polysaccharides. The Company is also developing additional bulk raw materials to expand their market presence and increase opportunities to sell the Company's products to other potential customers.
Historically, the vast majority of the Manapol[R] powder manufactured by the Company was supplied to two customers, Mannatech, Inc. ("Mannatech") and Natural Alternatives International, Inc., ("Natural Alternatives") pursuant to a non-exclusive supply agreement, which expired in November 2005. During 2006, the Company supplied Manapol[R] powder to Mannatech on a non-contract, purchase order basis, resulting in decreased sales volumes and revenues in the Consumer Services Division. In December 2006, the company entered into a non-binding term sheet with Mannatech as the result of negotiations to re-establish a contractual supply arrangement. Subsequently, on January 25, 2007, the Company and Mannatech entered into a three-year Supply and Trademark Licensing Agreement that provides for purchase of minimum monthly volumes by Mannatech in the first two years. In 2006, combined sales to Mannatech and Natural Alternatives decreased $2.64 million, or 28.5% from 2005 levels. The Company anticipates 2007 sales to Mannatech under the agreement to be above the minimum levels required by the agreement but, due to inconsistency in the size and timing of Mannatech's orders, is uncertain as to by how much sales to Mannatech will exceed the contractual minimums. (See Note Nineteen - Subsequent Events). Additionally, the Company has continued its focused marketing effort to identify potential new Manapol[R] powder customers. See "Item 1A.
ITEM 1A. RISK FACTORS. -------------
You should carefully consider the following risk factors, in addition to those discussed elsewhere in this Form 10-K, in evaluating our company and our business.
Risks Related to Our Business
We may not achieve or sustain profitability.
We incurred a net loss for the year ended December 31, 2006 of $7,607,000. We reported a net loss of $5,336,000 for the year ended December 31, 2005. We reported nominal net income of approximately $36,000 for the year ended December 31, 2004.
We rely heavily on outside sources of funds to maintain our liquidity. Our prospects for achieving profitability will depend primarily on how successful we are in executing our business plan to:
* increase revenues by offering innovative new products, growing existing product lines and continuing to offer exceptional customer service;
* increase profitability by continuing to improve operational efficiency, working capital management and modernization of equipment;
* enlarge and diversify our customer base to reduce dependence on a limited number of significant customers;
* develop and market our proprietary GelSite[R] technology;
* enter into strategic partnerships and collaboration arrangements related to our GelSite[R] drug delivery programs and product candidates; and
* continue to develop our preclinical product candidates and advance them to the point where they are available for strategic partnerships and collaboration arrangements.
If we are not successful in executing our business plan, we may not achieve or sustain profitability.
We will require additional financing to sustain our operations and without it we may not be able to continue operations. Our inability to raise additional working capital, or to raise it on terms which are acceptable to us, or to raise it in a timely manner would negatively impact our ability to fund our operations to generate revenues, and to otherwise execute our business plan, leading to the possible reduction or suspension of our operations or ultimately to our going out of business.
At December 31, 2006 and December 31, 2005, we had operating cash flow deficit of $5.1 million and $3.4 million, respectively; and we had an operating cash flow of $2.4 million for the year ended December 31, 2004. We have received a report from our independent registered public accounting firm on our consolidated financial statements for our fiscal year ended December 31, 2006 in which our auditors have included explanatory paragraphs indicating that our significant net losses and working capital deficiency cause substantial doubt about our ability to continue as a going concern.
We are currently in default under our credit facility, due to our inability to meet certain financial covenants. Historically, our lender has waived the events of non-compliance under the terms of the facility. However, we believe that it is unlikely that Comerica will continue to grant such waivers after the second quarter of 2007, and can make no assurances that such waivers will be granted for events of non-compliance occurring subsequent to May 31, 2007. We are seeking additional funding that would enable us to repay our indebtedness under our credit facility and fund our working capital obligations. However, additional funds may not be available when required or on terms acceptable to us. If we are unable to cure our existing defaults under the credit facility, obtain waivers from our lender or obtain additional financing, our business prospects, operating results and financial condition may be materially and adversely affected to such an extent that we are forced to restructure, sell some of our assets or curtail our operations.
We are dependent on a limited number of customers.
A few large customers account for most of our revenue. For the year ended December 31, 2006, sales to Natural Alternatives, Mannatech, Medline and Wormser Corporation ("Wormser") accounted for approximately 13.5%, 10.3%, 26.2% and 9.8%, respectively, of our total revenue. During 2006 a new large customer, Wormser, was added to our client base. For the year ended December 31, 2005, sales to Natural Alternatives, Mannatech and Medline accounted for approximately 26.6%, 6.6% and 26.6%, respectively, of our total revenue. For the year ended December 31, 2004, sales to those three customers accounted for 44.8%, 1.9% and 22.6% of our total revenue. We expect that, for the foreseeable future, sales to a limited number of customers will continue to account, alone or in the aggregate, for a high percentage of our net revenues. Dependence on a limited number of customers exposes us to the risk that order reductions from any one customer may have a material adverse effect on our financial position and results of operations. For instance, in 2006, combined sales to Natural Alternatives and Mannatech decreased approximately $2.64 million, or 28.5%, from their 2005 levels and in 2005, combined sales to these two customers decreased approximately $5.12 million, or 35.5%, from their 2004 levels. On January 25, 2007, we executed a three-year Supply and Trademark Licensing Agreement with Mannatech. The agreement calls for minimum purchase quantities from Mannatech at fixed price levels. We anticipate 2007 sales to Mannatech under this agreement to be above the minimum levels required by the agreement but, due to inconsistency in the size and timing of Mannatech's orders, are uncertain as to by how much sales to Mannatech will exceed the contractual minimums. Presently, we are uncertain as to the future levels of sales, if any, to Wormser. A significant decrease in orders from Wormser would have a material adverse impact on our revenues and net income, as well as our ability to fund our continuing operations from cash flow.
We may be subject to product liability exposure.
We have recently been (See Item 3. Legal Proceedings regarding voluntary product recall discussions), and could in the future be, subject to product liability claims in connection with the use of products that we and our licensees are currently manufacturing, testing or selling or that we and any licensees may manufacture, test or sell in the future. We may not have sufficient resources to satisfy any liability resulting from these claims or would be able to have its customers indemnify or insure us against such claims. We currently carry product liability insurance in the amount of $10,000,000, but that coverage may not be adequate in terms and scope to protect us against material adverse effects in the event of a successful product liability claim.
We will need significant additional funds for future research and development.
Our research and development expenses for the years ended December 31, 2006, 2005, 2004 were $5,760,000, $5,796,000, and $4,737,000, respectively. Given our current level of cash reserves and rate of revenue generation, we may not be able to advance fully the development of our products unless we raise additional cash through financing from the sale of our securities and/or through additional partnering agreements or research grants, none of which may be available on terms acceptable to us or at all.
We will need significant funding to pursue our overall product development plans. In general, our products under development will require significant, time-consuming and costly research and development, clinical testing, regulatory approval and significant additional investment prior to their commercialization. The research and development activities we conduct may not be successful; our products under development may not prove to be safe and effective; our clinical development work may not be completed; and the anticipated products may not be commercially viable or successfully marketed.
The terms of our credit facility restrict our operational flexibility.
Our credit facility contains covenants that restrict, among other things, our ability to borrow money, make particular types of investments, including investments in our subsidiaries, or other restricted payments, swap or sell assets, merge or consolidate, or make acquisitions. Default under our credit facility could allow the lenders to declare all amounts outstanding to be immediately due and payable. We have pledged substantially all of our assets to secure the debt under our credit facility. If the lenders declare amounts outstanding under the credit facility to be due, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on our business if the creditors determine to exercise their rights and could cause us to be unable to repay all or a substantial portion of our then outstanding indebtedness. Our credit facility also requires us to maintain specified financial ratios. Our ability to meet these financial ratios can be affected by events beyond our control. On three occasions in the past two years, and currently, we have been required to seek and obtain waivers for failure to satisfy certain financial ratios under our credit facility. We may also incur future debt obligations that might subject us to restrictive covenants that could affect our financial and operational flexibility, restrict our ability to pay dividends on our common stock or subject us to other events of default. Any such restrictive covenants in any future debt obligations we incur could limit our ability to fund our businesses with equity investments or intercompany advances, which would impede our ability to operate or expand our business.
From time to time we may require consents or waivers from our lenders to permit actions that are prohibited by our credit facility. If, in the future, our lenders refuse to provide waivers of our credit facility's restrictive covenants and/or financial ratios, then we may be in default under our credit facility, and may be prohibited from making payments on our then outstanding indebtedness.
We may be unable to generate the cash flow to service our debt obligations.
Our business may not generate sufficient cash flow, and we may be unable to borrow funds under our credit facility in an amount sufficient to enable us to service our indebtedness or to make anticipated capital expenditures. Our ability to meet our expenses and debt obligations, to refinance our debt obligations and to fund planned capital expenditures will depend on our future performance, which will be affected by general economic, financial, competitive, legislative, regulatory and other factors beyond our control. If we are unable to generate sufficient cash flow from operations or to borrow sufficient funds in the future to service our debt, we may be required to sell assets, reduce capital expenditures, refinance all or a portion of our existing debt or obtain additional financing. We may not be able to refinance our debt, sell assets or borrow more money on terms acceptable to us, if at all.
We are subject to extensive governmental laws and regulations that may adversely affect the cost, manner or feasibility of doing business.
We are subject to regulation by numerous governmental authorities in the United States and other countries. The commercialization of certain of our proposed products will require approvals from the FDA, and comparable regulatory agencies in most foreign countries. To obtain such approvals, the safety and efficacy of the products must be demonstrated through extensive preclinical testing and human clinical trials. The safety or efficacy of a product, to the extent demonstrated in preclinical testing, may not be pertinent to the development of, or indicative of the safety or efficacy of, a product for the human market. In addition, the results of clinical trials of a product may not be consistent with results obtained in preclinical tests. Furthermore, there is no assurance that any product will be shown to be safe and effective or that regulatory approval for any product will be obtained on a timely basis, if at all.
Certain of our proposed products will require governmental approval or licensing prior to commercial use. Our research, development, preclinical and clinical trial activities, as well as the manufacture and marketing of any products that we may successfully develop, are subject to an extensive regulatory approval process by the FDA and other regulatory agencies abroad. The process of obtaining required regulatory approvals for some of our products is lengthy, expensive and uncertain, and any regulatory approvals may contain limitations on the indicated usage of a product, distribution restrictions or may be conditioned on burdensome post-approval study or other requirements, including the requirement that we institute and follow a special risk management plan to monitor and manage potential safety issues, all of which may eliminate or reduce the product's market potential. Post- market evaluation of a product could result in marketing restrictions or withdrawal from the market.
The results of preclinical and Phase 1 and Phase 2 clinical studies are not necessarily indicative of whether a product will demonstrate safety and efficacy in larger patient populations, as evaluated in Phase 3 clinical trials. Additional adverse events that could impact commercial success, or even continued regulatory approval, might emerge with more extensive post- approval patient use. Future United States or foreign legislative or administrative acts could also prevent or delay regulatory approval of our or our licensees' products. Failure to obtain requisite governmental approvals or failure to obtain approvals of the scope requested could delay or preclude us and any of our licensees from marketing our products, or could limit the commercial use of the products, and thereby have a material adverse effect on our liquidity and financial condition.
We operate in a highly competitive industry, and our failure to remain competitive with our competitors, many of which have greater resources than we do, could adversely affect our results of operations.
The biopharmaceutical field is expected to continue to undergo rapid and significant technological change. Potential competitors in the United States and abroad are numerous and include pharmaceutical, chemical and biotechnology companies. Many of these companies have substantially greater capital resources, research and development staffs, facilities and expertise (in areas including research and development, manufacturing, testing, obtaining regulatory approvals and marketing) than we have. This competition can be expected to become more intense as commercial applications for biotechnology and pharmaceutical products increase. Some of these companies may be better able than we to develop, refine, manufacture and market products that have application to the same indications as we are exploring. We understand that certain of these competitors are in the process of conducting human clinical trials of, or have filed applications with government agencies for approval to market, certain products that will compete in markets associated with products we currently have under development. We compete against many companies that sell products that are competitive with our products, with many of our competitors using very aggressive marketing efforts. Many of our competitors are substantially larger than we are in terms of sales and distribution networks and have substantially greater financial and other resources. Our ability to compete against these companies will depend in part on the expansion of the marketing network for our products.
The breadth, validity and enforceability of patents we have obtained cannot be predicted.
We attempt to protect our proprietary rights by filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of the our business. The patent positions of biotechnology and pharmaceutical companies can be highly uncertain and involve complex legal and factual questions, and therefore the breadth, validity and enforceability of claims allowed in patents we have obtained cannot be predicted.
Our pending applications or patent applications in preparation may or may not be issued as patents in the future. Additionally, our existing patents, patents pending and patents that we may subsequently obtain will not necessarily preclude competitors from developing products that compete with products we have developed and thus would substantially lessen the value of our proprietary rights. We intend to file additional patent applications, when appropriate, relating to our technologies, improvements to our technologies and specific products we may develop. If any of our patents are challenged, invalidated, circumvented or held to be unenforceable, we could lose the protection of rights we believe to be valuable, and our business could be materially and adversely affected. Also, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the U.S.
We also rely on trade secrets to protect our technology, especially where patent protection is not believed to be appropriate or obtainable. We protect our proprietary technology and processes, in part, by confidentiality agreements with our employees, consultants and certain contractors. These agreements may not ultimately provide us with adequate protection in the event of unauthorized use or disclosure of confidential or proprietary information, and, in addition, the parties may breach such agreements or our agreements may be deemed unenforceable. Our trade secrets may otherwise become known to, or be independently developed by, our competitors.
We are dependent on key personnel and the loss of any of these individuals could have a material adverse effect on our operations.
Our success depends in large part upon our ability to attract and retain highly qualified scientific, manufacturing, marketing and management personnel. We believe that we employ highly qualified personnel in all these areas. However, we face competition for such personnel from other companies, academic institutions, government entities and other organizations. We may not be successful in hiring or retaining the requisite personnel.
Risks Related to Our Common Stock ---------------------------------
We may be unable to maintain our listing on the Nasdaq Capital Market.
Our common stock currently is listed for trading on the Nasdaq Capital Market. If we are unable to continue to meet Nasdaq's continued listing standards, our common stock could be delisted from the Nasdaq Capital Market. For example, among other things, we could fail to maintain compliance with the Nasdaq Capital Market listing requirements if we did not maintain minimum stockholder equity of at least $2.5 million as a result of continuing losses, depending upon the type and amount of additional financing, if any, secured by the Company in 2007. If our common stock is not listed on the Nasdaq SmallCap Market or an exchange, trading of our common stock will be conducted in the over-the-counter market on an electronic bulletin board established for unlisted securities or directly through market makers in our common stock. If our common stock were to trade in the over-the-counter market, an investor would find it more difficult to dispose of, or to obtain accurate quotations for the price of, the common stock. A delisting from the Nasdaq Capital Market and failure to obtain listing on another market or exchange could subject our securities to so- called "penny stock rules" that impose additional sales practice and market- making requirements on broker-dealers that sell or make a market in such securities. Consequently, removal from the Nasdaq Capital Market and failure to obtain listing on another market or exchange could affect the ability or willingness of broker-dealers to sell or make a market in our common stock and the ability of purchasers of our common stock to sell their securities in the secondary market. Such delisting could also adversely affect our ability to obtain financing for the continuation of our operations and could result in the loss of confidence by investors.
The market price for our common stock may be volatile, and many factors could cause the market price of our common stock to fall.
Many factors could cause the market price of our common stock to rise and fall, including the following:
* variations in our quarterly results;
* announcements of technological innovations by us or by our competitors;
* introductions of new products or new pricing policies by us or by our competitors;
* acquisitions or strategic alliances by us or by our competitors;
* recruitment or departure of key personnel;
* the gain or loss of significant orders;
* the gain or loss of significant customers;
* changes in the estimates of our operating performance or changes in recommendations by any securities analysts that follow our stock; and
* market conditions in our industry, the industries of our customers, and the economy as a whole.
Since our initial public offering in 1983, the market price of our common stock has fluctuated over a wide range, and it is likely that the price of our common stock will fluctuate in the future. Announcements of a positive or negative nature regarding technical innovations, new commercial products, regulatory approvals, patent or proprietary rights or other developments concerning us or our competitors could have a significant impact on the market price of our common stock.
You may experience dilution of your ownership interests due to the future issuance of additional shares of our common stock, which could have an adverse effect on our stock price.
Future sales of shares of our common stock by existing shareholders, or by shareholders who receive shares of our common stock through the exercise of options or warrants, the conversion of preferred stock or otherwise, could have an adverse effect on the price of our common stock. Future sales of substantial amounts of our common stock, or the perception that sales could occur, could have a material adverse effect on the price of our common stock.
We do not pay cash dividends.
We have not paid any cash dividends on our common stock since our initial public offering in 1983 and do not anticipate that we will pay cash dividends in the foreseeable future. Instead, we intend to apply any earnings to the expansion and development of our business.
Certain provisions of Texas law, our restated articles of incorporation and our bylaws could make it more difficult for a third party to acquire us, discourage a takeover and adversely affect existing shareholders.
Our restated articles of incorporation and the Texas Business Corporation Act contain provisions that may have the effect of making more difficult or delaying attempts by others to obtain control of our company, even when these attempts may be in the best interests of shareholders. These include provisions limiting the shareholders' powers to remove directors or take action by written consent instead of at a shareholders' meeting. Our restated articles of incorporation also authorize our board of directors, without shareholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Our bylaws also include provisions that divide our directors into three classes that are elected for staggered three-year terms and that establish advance notice procedures with respect to submissions by shareholders of proposals to be acted on at shareholder meetings and of nominations of candidates for election as directors. Texas law also imposes conditions on certain business combination transactions with "interested shareholders."
We have also adopted a shareholder rights plan intended to encourage anyone seeking to acquire our company to negotiate with our board of directors prior to attempting a takeover. While the plan was designed to guard against coercive or unfair tactics to gain control of our company, the plan may have the effect of making more difficult or delaying any attempts by others to obtain control of our company.
These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which shareholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of shareholders to approve transactions that they may deem to be in their best interests.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS. -------------------------
None.
ITEM 2.
ITEM 2. PROPERTIES. ----------
The Company believes that all its farming property, manufacturing and laboratory facilities, as described below, and material farm, manufacturing and laboratory equipment are in satisfactory condition and are adequate for the purposes for which they are used, except that the farm is not adequate to supply all of the Company's needs for Aloe vera L. leaves. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for more information regarding the Company's arrangements to purchase Aloe vera L. leaves.)
Walnut Hill Facility. The Company's corporate headquarters and principal U.S. manufacturing facility occupy all of the 42,733 square foot office and manufacturing building (the "Walnut Hill Facility"), which is situated on an approximate 6.6-acre tract of land located in the Las Colinas area of Irving, Texas. The Company completed a sale of this property in December 2005 for $4,800,000 to private investors and simultaneously entered into a lease of the land and the building for a fifteen-year term. The manufacturing operations occupy approximately 17,279 square feet of the facility, administrative offices occupy approximately 17,204 square feet and with an additional 8,250 square feet undeveloped.
Laboratory and Warehouse Facility. The Company leases a 51,200 square foot building in close proximity to the Walnut Hill facility to house its Research and Development, Quality Assurance and Quality Control Departments. Laboratories and offices for DelSite are also located in this facility. In addition, the Company utilizes a portion of the building as warehouse space. The lease expires in June 2011.
Warehouse and Distribution Facility. The Company leases a 58,130 square foot building in close proximity to the Walnut Hill facility for use as additional warehouse space and for housing its distribution operations. The lease expires in February 2008.
Texas A & M University Research Park Facility. DelSite leases 5,773 square feet of laboratory and office space in the Texas A&M University Research Park in College Station, Texas, under a lease which expires May 2007. DelSite uses this facility primarily for vaccine delivery research and development.
Costa Rica Facility. The Company owns approximately 410 acres of land in the Guanacaste province of northwest Costa Rica. This land is being used for the farming of Aloe vera L. plants and is the site for a 30,700 square foot processing plant to produce bulk pharmaceutical and injectable mannans and freeze-dried purified extracts from Aloe vera L. used in the Company's operations. The processing plant became operational in 1993. The Company also produces liquid nutraceutical products and proprietary dental products at this facility.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS. -----------------
On August 26, 2005, the Company issued a voluntary recall of Medline-labeled alcohol-free mouthwash. As a result of this recall, Medline initiated a voluntary recall of Personal Hygiene Admission kits containing the same alcohol-free mouthwash. The mouthwash, which passed industry standard testing at the time of release, was recalled due to the possibility that it may contain Burkholderia cepacia. The Company continues to coordinate with the FDA and the Texas Department of Health in its recall efforts and in the investigation of this matter.
On January 11, 2006, a lawsuit was filed in Circuit Court of Etowah County, Alabama styled as Sonya Branch and Eric Branch vs. Carrington Laboratories, Inc., Medline Industries, Inc., and Gadsden Regional Medical Center. Plaintiffs alleged they were damaged by the mouthwash product. The amounts of damages were not specified.
On April 25, 2006, a lawsuit was filed in Circuit Court for Davidson County, Tennessee styled as Ralph Spraggins, as Administrator of the Estate of Yvonne Spraggins vs. Southern Hills Medical Center, Tristar Health System, HCA Inc., HCA Health Services of Tennessee, Inc., HCA Hospital Corporation of America, Medline Industries, Inc., and Carrington Laboratories, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking $2.0 million in compensatory damages. The case was dismissed without prejudice on January 11, 2007.
On August 28, 2006, a lawsuit was filed in United States District Court for the Western District of Oklahoma styled as Ruth Ann Jones, as Personal Representative of the Estate of Harold Dean Jones, Deceased, Mary Adams and Vera Anderson vs. Carrington Laboratories, Inc. and Medline Industries, Inc. Plaintiffs alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and were seeking an amount in excess of $75,000 in damages. The case was dismissed without prejudice on January 15, 2007.
On September 14, 2006, a lawsuit was filed in United States District Court for the Northern District of Illinois styled as Mutsumi Underwood, as Personal Administrator of the Estate of Ronald W. Underwood vs. Medline Industries, Inc. and Carrington Laboratories, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking an amount in excess of $75,000 in damages.
On September 22, 2006, a lawsuit was filed in Circuit Court for Macon County, Tennessee styled as Donna Green, Lois Bean, KHI Williams and David Long vs. Carrington Laboratories, Inc. and Medline Industries, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking $800,000 in compensatory and exemplary damages.
On November 2, 2006, a lawsuit was filed in Circuit Court of Etowah County, Alabama styled as Myra Maddox, vs. OHG of Gadsden, Inc., d/b/a Gadsden Regional Medical Center; Medline Industries, Inc.; Carrington Laboratories, Inc.; Fictitious Defendants "1-15". Plaintiffs have alleged they were damaged by the mouthwash product. The amounts of the damages have not been specified.
The Company has $10.0 million of product liability insurance. The Company and its insurance carrier intend to defend against each of these claims.
On February 1, 2007, a lawsuit styled Glamourpuss, Inc. v. Carrington Laboratories, Inc., was filed in Dallas County, Texas. Plaintiffs have alleged they have been injured as a result of acts and omissions of Carrington in violation of the Texas Deceptive Trade Practices Act ("DTPA"). Plaintiffs are seeking $200,000 in damages plus attorney's fees and expenses.
The Company believes that Plaintiffs' claims are without merit and intends to vigorously defend against the claim.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. ---------------------------------------------------- The Company did not submit any matter to a vote of security holders during the fourth quarter of the fiscal year covered by this Annual Report.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. ---------------------------------------------------------------------
The Common Stock of the Company is traded on the NASDAQ Capital Market under the symbol "CARN." The following table sets forth the high and low sales prices per share of the Common Stock for each of the periods indicated.
Fiscal 2006 High Low ----------- ---- ---- First Quarter $7.53 $4.42 Second Quarter 6.84 3.44 Third Quarter 4.65 3.02 Fourth Quarter 4.24 2.76
Fiscal 2005 High Low ----------- ---- ---- First Quarter $7.40 $4.84 Second Quarter 5.39 3.12 Third Quarter 5.65 3.10 Fourth Quarter 5.74 3.31
At March 19, 2007, there were 855 holders of record (including brokerage firms) of Common Stock and the closing price of the Company's Common Stock was $2.96.
The Company has not paid any cash dividends on the Common Stock and presently intends to retain all earnings for use in its operations. Any decision by the Board of Directors of the Company to pay cash dividends in the future will depend upon, among other factors, the Company's earnings, financial condition and capital requirements.
Equity Compensation Plan Information ------------------------------------ Number of Number of Weighted- securities remaining securities to average available for be issued upon exercise price future issuance exercise of of outstanding under equity outstanding options, compensation plans options, warrants warrants and (excluding securities Plan Category and rights rights reflected in column a) ----------------------------------------------------------------------------- (a) (b) (c) Equity compensation plans approved by security holders 1,700,586 $3.37 352,193
Equity compensation plans not approved by security holders 0 0 0 --------- ---- ------- Total 1,700,586 $3.37 352,193 ========= ==== =======
Performance Graph -----------------
The following graph sets forth for the years indicated the cumulative total shareholder return for the Company's Common Stock, the Nasdaq Stock Market - U.S. Index, and a Company-constructed Peer Group(2). The information reflected in the graph was provided to the Company by Research Holdings, Ltd. of San Francisco, California.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Carrington Laboratories, Inc., The NASDAQ Composite Index, A New Peer Group And An OldPeer Group
[ PERFORMANCE GRAPH APPEARS HERE ]
* $100 invested on 12/31/00 in stock or index-including reinvestment of dividends. Fiscal year ending December 31.
Cumulative Total Return (1) --------------------------------------------- 12/01 12/02 12/03 12/04 12/05 12/06 ----- ----- ----- ----- ----- ----- Carrington Laboratories, Inc. 100.00 89.13 403.53 600.39 463.27 279.02 NASDAQ Composite 100.00 69.66 99.71 113.79 114.47 124.20 New Peer Group (2) 100.00 54.60 57.72 54.38 68.60 79.06 Old Peer Group (2) 100.00 96.90 125.10 96.79 91.79 103.45
(1) Total return assuming reinvestment of dividends. Assumes $100 invested on December 31, 2001 in the Company's Common Stock, The Nasdaq Stock Market - U.S. Index.
(2) The Peer Group comprises the following companies: Biomira, Inc., Cell Therapeutics Inc., Cellegy Pharmaceuticals Inc., Collagenex Pharmaceuticals Inc., Columbia Labs Inc., Depomed, Inc., Dusa Pharmaceuticals Inc., Dyadic International, Immunogen Inc., Insite Vision Inc., LaJolla Pharma, Nastech Pharmaceutical Inc., Natures Sunshine Products Inc., Quigley Corp., Regeneron Pharmaceuticals, Schiff Nutrition International, Inc. (formerly Weider Nutrition), Sciclone Pharmaceuticals, Inc., Spectrum Pharmaceuticals, Inc., Titan Pharmaceuticals Inc., Tutogen Medical, Inc., Vertex Pharmaceutical and Viropharma Inc. The following companies were previously included in the Company-constructed Peer Group, and have been omitted from the Peer Group: Cubist Pharmaceuticals, Inc., Draxis Health, Inc., KOS Pharmaceuticals, Inc., Onyx Pharmaceuticals Corp, and Forest Laboratories. Our Peer Group was changed to the above identified companies based on the determination that such companies serve as a better comparison for companies competing in our industry and are more representative of our lines of business.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA. -----------------------
The selected consolidated financial data below should be read in conjunction with the consolidated financial statements of the Company and notes thereto and "Item 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND --------------------------------------------------------------- RESULTS OF OPERATIONS. ---------------------
Company Overview ----------------
The Company is a research-based biopharmaceutical, medical device, raw materials and nutraceutical company engaged in the development, manufacturing and marketing of naturally-derived complex carbohydrates and other natural product therapeutics for the treatment of major illnesses, the dressing and management of wounds and nutritional supplements. The Company is comprised of three business segments. The Company generates revenues through the sales of prescription and non-prescription medical products through its Medical Services Division. It also generates revenues through the sales of consumer and bulk raw material products and sales of specialized product development and manufacturing services to customers in the cosmetic and nutraceutical markets through its Consumer Services Division. In addition, the Company generates revenues from research grant awards through its DelSite subsidiary that is engaged in the research, development and marketing of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients.
Products sold through the Medical Services Division include hydrogels, wound cleansers, hydrocolloids, advanced wound covering products, incontinence- care products and two lines of condition-specific products. Many products sold through this division contain the Company's proprietary, medical-grade raw material, Acemannan Hydrogel[TM]. The Company regularly engages in development projects to create line extensions and other new products for this category. Products sold through the Consumer Services Division include Manapol[R] and other proprietary and non-proprietary raw materials sold to nutraceutical and cosmetic customers; nutritional products sold under the AloeCeuticals[R] brand; skin care products sold under the Snow or Sun[TM] brand and private-labeled products manufactured to customer specifications, including powders, creams, liquids, gels, lotions, drinks, tablets and capsules for various customers.
Prior to 1996, the Company generated most of its revenues from product sales in its Medical Services Division. In 1996, the Company launched its line of raw materials, including Manapol[R] powder, through its Consumer Services Division. In 2001, the Company created its specialty manufacturing group to provide services to cosmetic and nutraceutical markets, and in December 2002, the Company acquired the assets of the custom division of CBI, resulting in increased revenues for the Consumer Services Division.
In 2006, approximately 32% of the Company's revenues were generated through product sales, services and royalties in its Medical Services Division, 61%, through sales of products and services in its Consumer Services Division and 7% through U.S. Federal grant income in its DelSite research and development subsidiary.
Sales to Natural Alternatives, Mannatech, Medline and a new large customer, Wormser, accounted for approximately 13.5%, 10.3%, 26.2% and 9.8%, respectively, of our total revenue. In 2006, combined sales to Natural Alternatives and Mannatech decreased approximately $2.64 million, or 28.5%, from their 2005 levels and in 2005, combined sales to these two customers decreased approximately $5.12 million, or 35.5%, from their 2004 levels. On January 25, 2007, the Company and Mannatech entered into a three-year Supply and Trademark Licensing Agreement. (See Note Nineteen - Subsequent Events). The agreement calls for minimum purchase quantities from Mannatech at fixed price levels. The Company anticipates 2007 sales to Mannatech under this agreement to be above the minimum levels required by the agreement but, due to inconsistency in the size and timing of Mannatech's orders, is uncertain as to by how much sales to Mannatech will exceed the contractual minimums.
Revenues -------- Year- Year- over-Year over-Year Growth Growth 2006 2005 ($) (%) ----------------------------------------------------------------------- ($ in thousands)
Net product sales $25,000 $24,038 $ 962 4.0% Royalty income 417 2,299 (1,882) (81.9%) Grant income 1,989 1,624 365 22.5% ------ ------ ------ ---- Total revenues $27,406 $27,961 $ (555) (2.0%) ====== ====== ====== ====
Grant Awards ------------
In March 2004, DelSite received an SBIR grant award of up to $888,000 over a two-year period. The grant has funded additional development of GelVac[TM], DelSite's intranasal vaccine delivery platform technology. In January 2006, DelSite applied for and received a six-month extension of time to complete the approved work under this grant. In November 2006, DelSite received the permission to further extend the grant to May 2007. The research covered under the grant has been completed and the extension is mainly for further expanding the development activities. In October 2004 DelSite received notification of a $6 million grant over a three-year period from the National Institute of Allergy and Infectious Diseases. The $6 million grant is funding the development of an inactivated influenza nasal powder vaccine against the H5N1 strain, commonly known as bird flu, utilizing the Company's proprietary GelVac[TM] delivery system. The grant was awarded under a biodefense and SARS product development initiative and is funding a three- year preclinical program.
The Company's costs and expenses generally fall into five broad categories: cost of product sales; sales and distribution expenses in support of product sales; general and administrative expenses; product support and DelSite research and development expenses. In recent years, the Company has shifted a greater percentage of its overall research and development expenses to its DelSite subsidiary. General and administrative expenses represent corporate infrastructure costs, such as accounting, human resources and information systems, and executive management expenses. In addition to its operating expenses, the Company also incurs interest expense arising from the debt portion of its capital structure.
Costs and Expenses ------------------ Year- Year- over-Year over-Year Growth Growth 2006 2005 ($) (%) ----------------------------------------------------------------------- ($ in thousands)
Cost of product sales $20,586 $18,581 $2,005 10.8% Selling, general and 7,662 8,731 (1,069) (12.2%) administrative Research and development 670 822 (152) (18.5%) Research and development, 5,090 4,974 116 2.3% DelSite Other expenses (income) (9) (131) 122 (93.1%) Interest expense (income), net 1,014 301 713 236.9%
Financing Transactions ----------------------
On November 18, 2005, the Company sold $5,000,000 aggregate principal amount of 6.0% subordinated notes. The notes have a term of four years and mature on November 18, 2009. Interest on the notes is payable quarterly in arrears. In connection with the sale of the notes, the purchasers of the notes received (i) Series A Common Stock Purchase Warrants ("Series A Warrants") to purchase an aggregate of 2,500,000 shares of the Company's common stock, par value $.01 per share, and (ii) Series B Common Stock Purchase Warrants ("Series B Warrants") to purchase an aggregate of 2,500,000 shares of the Company's common stock. The 5,000,000 warrants have a fair value of $4.8 million and an allocated value of $2.7 million based on their relative fair value with the associated debt, which was recorded as a debt discount. In addition, the placement agent involved in the offering of the notes and warrants received a Series A Warrant to purchase 200,000 shares of the Company's common stock. All of the Series A Warrants have an exercise price of $5.00 per share, are immediately exercisable and expire, subject to certain acceleration events relating to the closing stock price, on November 18, 2009. All of the Series B Warrants have an exercise price of $10.00 per share, are immediately exercisable and expire on November 18, 2009. As of December 31, 2006, there was $5,000,000 outstanding on the notes with an associated debt discount of $2,254,000 for a net balance of $2,746,000. Additionally, the Company incurred $674,000 of debt issue costs related to this financing arrangement, which will be amortized over the term of the debt. As a result of the debt discount associated with the value of the warrants the effective interest rate on this transaction was 30%.
On December 23, 2005, the Company completed a sale and leaseback transaction involving its corporate headquarters and manufacturing operations located in Irving, Texas to the Busby Family Trust and the Juice Trust, both of which are assignees of the original purchaser, none of which are related to the Company. The building and land were sold for a total sale price of $4.8 million. Net proceeds from the transaction amounted to $4.1 million, after deducting transaction-related costs and retiring the mortgage note related to the property. Simultaneously, the Company agreed to lease the land and building from the purchaser for a period of 15 years, subject to two five- year renewal options. The rental payment for the first five years of the lease term is $470,000 per year and increases by 10.4% for each of the next two five-year increments. Rent for the renewal terms under this lease agreement will be the greater of 95% of the then current market rent or the rent for the last year prior to renewal. The Company has provided the lessor a $100,000 letter of credit which is used as security on the lease. The Company has accounted for this lease as an operating lease.
Cash Flow --------- Year- Year- over-Year over-Year Growth Growth 2006 2005 ($) (%) ----------------------------------------------------------------------- ($ in thousands) Net cash provided by (used in) operating activities $(5,039) $(3,430) $(1,609) (46.9%) Net cash provided by (used in) investing activities (383) 4,006 (4,389) (109.6%) Net cash provided by financing activities 38 3,256 (3,218) (98.8%)
The decrease in net cash provided by operating activities was primarily related to the $7.6 million net loss for the year as compared to net loss of $5.3 million in 2005. The decrease in cash provided by investing activities is the result of a $383,000 investment in facilities and equipment in 2006, as compared to the 2005 disposal of assets in the sale/leaseback transaction with a book value of $4.6 million, which was partially offset by investment in facilities and equipment of $610,000. The decrease in net cash provided by financing activities reflects proceeds of $253,000 from common stock issuances offset in part by $215,000 in debt repayments in 2006 as compared to the sale of $5.0 million 6% subordinated notes partially offset by principal payments on debt and capital lease obligations of $1.5 million and a cash payment for debt issue costs of $426,000 in 2005.
The Company utilizes the cash flow generated from its manufacturing and sales operations and borrowings to fund additional capital projects in support of manufacturing operations and to fund the research activities of its wholly-owned subsidiary, DelSite. DelSite, which was incorporated in 2001, operates separately from the Company's product-support research and development program and is responsible for the research, development and marketing of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. DelSite's business plan is to develop its data in support of it technologies and then partner with biotechnology and pharmaceutical companies to provide novel delivery solutions for their drugs and vaccines.
Key Performance Indicators --------------------------
The following table illustrates the key performance indicators that the Company uses to measure the performance and manage the business.
FISCAL YEARS ENDED ------------------ 2006 2005 ------ ------ (Dollars in thousands) Days Sales Outstanding: Accounts receivable $ 2,659 $ 2,679 Fourth quarter sales 6,739 5,809 Divided by 90 days equals average daily sales 74.9 64.5 ------ ------ Accounts receivable divided by average daily sales equals days sales outstanding 35.5 41.5 ====== ====== Months Inventory on Hand: Inventory $ 3,405 $ 4,705 Fourth quarter cost of product sales 5,328 4,935 Divided by 3 equals average monthly cost of product sales 1,776 1,645 ------ ------ Inventory divided by average monthly cost of product sales equals Months inventory on hand 1.9 2.9 ====== ====== Current Ratio: Current assets $ 7,097 $14,038 Divided by current liabilities 6,061 7,063 ------ ------ Equals current ratio 1.17 1.99 ====== ====== Quick Ratio: Quick assets $ 3,537 $ 8,941 Divided by current liabilities 6,061 7,063 ------ ------ Equals quick ratio 0.58 1.27 ====== ====== Debt to Equity: Current liabilities $ 6,061 $ 7,063 Long-term debt 3,745 3,418 ------ ------ Total debt $ 9,806 $10,481 Divided by equity 4,192 11,508 ------ ------ Equals debt to equity 2.34 0.91 ====== ====== Long-Term Debt to Equity: Long-term debt $ 3,745 $ 3,418 Divided by equity 4,192 11,508 ------ ------ Equals long-term debt to equity 0.89 0.30 ====== ====== Working Capital: Current assets $ 7,097 $14,038 Less current liabilities 6,061 7,063 ------ ------ Equals working capital $ 1,036 $ 6,975 ====== ======
Liquidity and Capital Resources -------------------------------
The Company's financial statements have been prepared on a going concern basis, which assumes the Company will realize its assets and discharge its liabilities in the normal course of business. As reflected in the accompanying consolidated financial statements and as the result of its significant investment in the research and development activities of DelSite, the Company incurred cumulative net losses of $12.9 million and used cash from operations of $6.1 million during the three years ended December 31, 2006. The Company has historically depended on operating cash flows, bank financing, advances on royalty payments under certain of its existing contracts and equity financing to fund its operations, capital projects and research and development projects, with the majority of funds generated from operating cash flows. The Company also has available to it various leasing arrangements for financing equipment purchases, and it is seeking additional grant awards and other potential collaborative or sponsorship funding for DelSite projects and potential licensing revenues from DelSite projects.
The following table summarizes the Company's contractual obligations at December 31, 2006 (dollars in thousands):
Payments Due by Period --------------------------------------- Less than One to Three to More than One Three Five Five Total Year Years Years Years ---------------------------------------------------------------------------- Contractual Obligations
Notes Payable Line of Credit with Comerica Bank (8.75% at December 31, 2006) $ 1,811 $ 1,811 $ - $ - $ - Private Placement note payable (6.0% at December 31, 2006) 5,000 - - 5,000 - Swiss American Products note payable (6.0% at December 31, 2006) 400 - - 400 - Bancredito note payable (U.S. prime plus 2.25%, 10.5% at December 31, 2006) 592 103 227 210 52 Other - - - - - Capital leases 224 110 109 5 - Operating leases 10,481 1,394 2,249 1,897 4,941 ------ ------ ------ ------ ------ Total contractual obligations $18,508 $ 3,418 $ 2,585 $ 7,512 $ 4,993 ====== ====== ====== ====== ======
Sales to Natural Alternatives, Mannatech, Medline and Wormser accounted for approximately 13.5%, 10.3%, 26.2% and 9.8%, respectively, of our total revenue. During 2006 a new large customer, Wormser, was added to our client base. Further, in 2006, combined sales to Natural Alternatives and Mannatech decreased approximately $2.64 million, or 28.5%, from their 2005 levels and in 2005, combined sales to these two customers decreased approximately $5.12 million, or 35.5%, from their 2004 levels. On January 25, 2007, the Company and Mannatech entered into a three-year Supply and Trademark Licensing Agreement. (See Note Nineteen - Subsequent Events). The agreement calls for minimum purchase quantities from Mannatech at fixed price levels. The Company anticipates 2007 sales to Mannatech under this agreement to be above the minimum levels required by the agreement but, due to inconsistency in the size and timing of Mannatech's orders, is uncertain as to by how much sales to Mannatech will exceed the contractual minimums.
At December 31, 2006 and 2005, the Company held cash and cash equivalents of $878,000 and $6,262,000, respectively, a decrease of $5,384,000. The decrease was primarily due to the losses from operations of $7,607,000, which was partially offset by non-cash items for depreciation and amortization of fixed assets, debt discount, debt-issue costs and deferred revenue of $2,379,000. (See discussion in "Results of Operations.") Additionally, the Company utilized $383,000 in capital expenditures to acquire operating assets. Customers with significant accounts receivable balances at the end of 2006 included Mannatech ($711,000), Medline ($1,033,000) and Wormser ($329,000), and of these amounts $1,952,000 (94.2%) has been collected as of February 28, 2007.
As reflected in the Company's consolidated financial statements, the Company incurred net losses of $2.16 million and used cash from operations of $806,000 during the three months ended December 31, 2006. The Company projects operating deficits for fiscal 2007 before consideration of potential funding sources for this same period.
At December 31, 2006, the Company's debt/equity ratio was 2.34 to 1. After giving effect to the borrowings under the Banco Nacional line of credit drawn in February 2007, the Company's debt/equity ratio was 2.70 to 1. Management believes that the expected cash flows from operations and licensing agreements and expected revenues from government grant programs, will provide the funds necessary to service its existing indebtedness and finance its operations until September 2007. The Company is currently engaged in efforts to restructure certain existing indebtedness in order to increase available funds on a near-term basis, and is also seeking additional financing through public or private equity offerings, additional debt financing, corporate collaborations, or licensing transactions. The Company cannot be certain that additional funding will be available on acceptable terms, or at all. If adequate funds are not available, the Company may be required to delay, reduce the scope of, or eliminate one or more of the research or development programs or commercialization efforts.
While management is confident that they will raise the capital necessary to fund operations and achieve successful commercialization of the products under development, there can be no assurances in that regard.
The Company has a line of credit with Comerica Bank Texas ("Comerica") that provides for borrowings of up to $3 million based on the level of qualified accounts receivable and inventory. The line of credit is collateralized by accounts receivable and inventory. Borrowings under the line of credit bear interest at the bank's prime rate (8.25% at December 31, 2006) plus 0.5%. As of December 31, 2006, there was $1,811,000 outstanding on the credit line with $839,000 of credit available for operations, net of outstanding letters of credit of $350,000. The line of credit has no expiration date and is payable on demand.
The Company's credit facilities with Comerica require the Company to maintain certain financial ratios. The covenants and the Company's position at December 31, 2006 are as follows:
Covenant Covenant Requirement Company's Position --------- -------------------- ------------------ Total net worth $12,200,000 $3,994,247 Current ratio 1.60 1.35 Liquidity ratio 1.75 1.95
Although the Company was not in compliance with two of its financial-ratio covenants under the Comerica line of credit for the period ended December 31, 2006, Comerica has waived the events of non-compliance through May 31, 2007. The Company believes that it is unlikely that Comerica will continue to grant such waivers after the second quarter of 2007, and can make no assurances that such waivers will be granted for events of non-compliance occurring subsequent to May 31, 2007. If the Company is unable to obtain such waivers and the existing covenant defaults continue, Comerica could accelerate the indebtedness under the Company's credit facility as well as all other debt that the Company has outstanding with Comerica, if any. The Company is presently seeking additional funding that would enable it to repay its indebtedness under the Comerica credit facility and fund the Company's working capital obligations. If Comerica accelerates the indebtedness under the Company's credit facility prior to the Company obtaining such additional funding, the Company would be forced to refinance all of the Comerica indebtedness with another lender. Any additional financing secured by the Company or the Company's refinancing of the Comerica credit facility will likely contain interest rates and terms which are more burdensome for the Company than those presently in place under the Comerica facility, resulting in an adverse impact on liquidity.
On February 12, 2007, the Company entered into a credit facility with Banco National of Costa Rica. The facility provides for borrowings of up to $2.99 million and is secured by the land and buildings the Company owns in Costa Rica. The proceeds from this transaction will be used to finance operations. For a more detailed discussion of the new credit facility see Note Nineteen - "Subsequent Events."
In September 2004, the Company received a loan of $350,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate plus 2.5% (10.75%). The loan is secured by certain of the Company's equipment. The proceeds of the loan were used in the Company's operations. As of December 31, 2006, there was $282,000 outstanding on the loan.
In March 2003, the Company received a loan of $500,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate plus 2.0% (10.25%). The loan is secured by a mortgage on an unused, 164-acre parcel of land owned by the Company in Costa Rica plus a lien on specified oral patch production equipment. The proceeds of the loan were used in the Company's operations. As of December 31, 2006, there was $310,000 outstanding on the loan.
In July 1998, the Company provided a $187,000 cash advance to Rancho Aloe, which is evidenced by a note receivable, due in installments, with payments being made monthly based upon farm production. The Company also advanced $300,000 to Rancho Aloe in November 1998 for the acquisition of an irrigation system to improve production on the farm and allow harvesting of leaves year-round. In the fourth quarter of 1998, the Company fully reserved all amounts owed to it by Rancho Aloe, in the total amount of $487,000, due to the start-up nature of the business. In 2006, the Company received payments totaling $9,000 from Rancho Aloe against the amount due.
In December 2002, the Company acquired the assets of the custom division of Cosmetic Beauty Innovations ("CBI") for $1.0 million plus a royalty on the Company's sales to custom division customers for five years and $0.6 million for useable inventories. The royalty amount is equal to 9.0909% of the Company's net sales of CBI products to CBI's transferring customers up to $6.6 million per year and 8.5% of the Company's net sales of CBI products to CBI's transferring customers over $6.6 million per year. The Company recorded expenses of $308,000 and $262,000 in 2006 and 2005, respectively, for royalties due under the agreement. The CBI custom division provided product development and manufacturing services to customers in the cosmetic and skin care markets. Included in the purchase were intellectual property, certain inventories and specified pieces of equipment. The Company provides services to these customers through the Consumer Services Division development and manufacturing services group. The Company began producing products for the transferring CBI customers in February 2003 at its Irving, Texas facility.
The Company anticipates capital expenditures in 2007 of approximately $348,000. The expenditures will primarily be comprised of production and laboratory equipment and facility modifications and will be financed through leases or out of the Company's operating cash flows.
In March 2001, the Board of Directors authorized the repurchase of up to 1,000,000 shares, or approximately 9.3% of the Company's outstanding Common Stock, dependent on market conditions. Under the authorization, purchases of Common Stock may be made on the open market or through privately negotiated transactions at such times and prices as are determined jointly by the Chairman of the Board and the President of the Company. The Board authorized the repurchase program based on its belief that the Company's stock is undervalued in light of the Company's future prospects and that it would be in the best interest of the Company and its shareholders to repurchase some of its outstanding shares. Through February 2007, the Company had repurchased 2,400 of its outstanding Common Stock under the program. The Company does not presently expect to repurchase shares under this program.
The Company is subject to regulation by numerous governmental authorities in the United States and other countries. Certain of the Company's proposed products will require governmental approval prior to commercial use. The approval process applicable to pharmaceutical products and therapeutic agents usually takes several years and typically requires substantial expenditures. The Company and any licensees may encounter significant delays or excessive costs in their respective efforts to secure necessary approvals. Future United States or foreign legislative or administrative acts could also prevent or delay regulatory approval of the Company's or any licensee's products. Failure to obtain requisite governmental approvals or failure to obtain approvals of the scope requested could delay or preclude the Company or any licensees from marketing their products, or could limit the commercial use of the products, and thereby have a material adverse effect on the Company's liquidity and financial condition.
The Company's common stock currently is listed for trading on the Nasdaq Capital Market. If the Company is unable to continue to meet Nasdaq's continued listing standards, its common stock could be delisted from the Nasdaq Capital Market. For example, among other things, the Company could fail to maintain compliance with the Nasdaq Capital Market listing requirements if the Company does not maintain minimum stockholder equity of at least $2.5 million as a result of continuing losses, depending upon the type and amount of additional financing, if any, secured by the Company in 2007. Such delisting could adversely affect the Company's ability to obtain financing for the continuation of its operations and could result in the loss of confidence by investors.
Off-Balance Sheet Arrangements ------------------------------
As of December 31, 2006, the Company has outstanding a letter of credit in the amount of $250,000, which is used as security on the lease for the Company's laboratory and warehouse facility. The Company also has outstanding a letter of credit in the amount of $100,000, which is used as security on the lease for the Company's corporate headquarters and manufacturing facility.
Results of Operations ---------------------
The information presented in this financial review should be read in conjunction with other financial information provided throughout this 2006 Annual Report. The following discussion of operating results focuses on the Company's three reportable business segments: Medical Services Division, Consumer Services Division and DelSite.
Net Revenue ----------- Net revenues in 2006 were $27.4 million, a 2.0% decrease from $28.0 million in 2005. The sales decrease of $600,000 was primarily attributable to reduced sales of bulk raw materials to Mannatech and Natural Alternatives, with a year-over-year sales decrease of $2.6 million, as well as a $1.9 million decrease in royalty income in 2006 over 2005. This was partially offset by sales increases to other Consumer Services customers in the amount of $3.4 million, increased DelSite grant revenue of $365,000 and increased Medical Services revenue of $173,000.
Net revenues in 2005 were $28.0 million, a 9.1% decrease from $30.8 million in 2004. The sales decrease of $2.8 million was primarily attributable to reduced sales of bulk raw materials to Mannatech and Natural Alternatives, with a year-over-year decrease or $5.1 million. This was partially offset by sales increases to other Consumer Services customers in the amount of $1.3 million, increased Delsite grant revenue of $857,000 and increased Medical Services revenue of $152,000.
Comparative net revenue information related to the Company's operating segments is shown in the following tables.
2006 vs. 2005 Change % of ---------------- Net Revenue 2006 Total $ % ----------- ------ ----- ------ ----- Medical Services Division $ 8,834 32.2% $(1,709) (16.2%) Consumer Services Division 16,583 60.5% 789 5.0% DelSite 1,989 7.3% 365 22.5% ------ ----- ------ ----- Total $27,406 100.0% $ (555) (2.0%) ====== ===== ====== =====
2005 vs. 2004 Change % of ---------------- Net Revenue 2005 Total $ % ----------- ------ ----- ------ ----- Medical Services Division $10,543 37.7% $ 152 1.5% Consumer Services Division 15,794 56.5% (3,869) (19.7%) DelSite 1,624 5.8% 857 111.7% ------ ----- ------ ----- Total 27,961 100.0% $(2,860) (9.3%) ====== ===== ====== =====
Medical Services Division revenues in 2006 decreased $1.7 million, or 16.2% from 2005, primarily due to a $1.9 million decrease in royalty revenue, down from $2.3 million in 2005 to $417,000 in 2006. The royalty revenue decrease was due to the expiration of the original five-year term of the Medline Distribution and Licensing Agreement in November 2005, and the commencing of the three-year extension period of the agreement with its associated lower royalties. Revenues from domestic sales of the Division's Carrington- branded wound care products decreased by $429,000, or 11.3%, from $3.79 million in 2005 to $3.36 million in 2006. These decreases were partially offset by $990,000 in the Division's international wound care product sales in 2006, an increase of $278,000, or 39.1%, over 2005 levels. This increase is related to increased demand in the European and South American markets of Carrington-branded wound care products. Sales of Medline-branded dermal management products, which are sold to Medline under a non-exclusive supply agreement entered into in 2000, were $3.98 million in 2006, an increase of $377,000, or 10.5%, over 2005 sales of $3.60 million.
Medical Services Division revenues in 2005 increased $152,000, or 1.5%, from 2004, primarily due to increased demand of Medline-branded dermal management products. Sales under this agreement totaled $3.60 million in 2005, compared to $2.97 million in 2004, an increase of $630,000. This increase was partially offset by a decrease in domestic sales of the Division's Carrington-branded wound care products from $4.10 million in 2004 to $3.93 million in 2005, as Medline decreased its inventory stock levels at year end, and by a decrease in sales of the Division's international wound care products from $844,000 in 2004 to $712,000 in 2005, due to decreased European sales. The Division also recorded royalty revenue of $2.30 million in 2005 versus $2.47 million in 2004, a decrease of $170,000, due to the expiration of the original five-year term of the Medline Distribution and Licensing Agreement in November 2005, and the commencing of the three-year extension period of the agreement with its associated lower royalties.
The Company's Consumer Services Division recorded revenues of $16.58 million in 2006, an increase of $789,000, or 5.0%, when compared to revenues of $15.79 million in 2005. Sales of bulk Manapol[R] powder decreased $2.42 million in 2006 to $6.93 million, down from $9.36 million in 2005. In recent years the Division has sold bulk Manapol[R] to Mannatech and Natural Alternatives under one-year, non-exclusive, supply and licensing agreements, which were renewed annually. The most recent contract expired on November 30, 2005, and was not renewed by Mannatech. The Division supplied Manapol[R] during 2006 to both companies on a non-contract, purchase order basis. On January 25, 2007, the Company and Mannatech entered into a three- year Supply and Trademark Licensing Agreement. (See Note Nineteen - Subsequent Events). The agreement calls for minimum purchase quantities from Mannatech at fixed price levels. The Company anticipates 2007 sales to Mannatech under this agreement to be above the minimum levels required by the agreement but, due to inconsistency in the size and timing of Mannatech's orders, is uncertain as to by how much sales to Mannatech will exceed the contractual minimums. Total sales to these two customers were $6.64 million, $9.29 million and $14.41 million for the years 2006, 2005 and 2004, respectively. Sales of the Division's specialty manufacturing services business, which develops and manufactures a variety of gels, creams, lotions and drinks for customers in the cosmetic, skin care and nutraceutical markets, increased $3.26 million from $5.89 million in 2005 to $9.15 million in 2006, due mostly to the gain of a major new customer.
In 2005, the Consumer Services Division recorded a decrease in revenues of $3.87 million, or 19.7%, to $15.79 million in 2005 from revenues of $19.66 million in 2004. Sales of bulk Manapol[R] powder decreased $5.20 million to $9.36 million in 2005 from $14.56 million in 2004. Sales for the Division's specialty manufacturing services business increased $1.23 million to $5.89 million in 2005 from $4.66 million in 2004, due to the gain of a major new customer and the re-launch of a customer's product previously sold in 2003. Additionally, sales of the Division's Aloeceuticals[R] line of immune- enhancing dietary supplements increased by $105,000 to $547,000 in 2005 from $442,000 in 2004.
The Company's DelSite subsidiary recorded an increase in revenues of $365,000, or 22.5%, to $1.99 million in 2006 over revenues of $1.62 million in 2005. In 2006, $69,000 of revenue was recognized under the SBIR grant, awarded in March 2004, as compared to $334,000 in 2005. Additionally, in 2006 $1.92 million of revenue was recognized under the $6 million NIAID grant for preclinical development of an intranasal vaccine against avian influenza. Revenue in 2005 under this grant was $1.3 million. Approximately $2.7 million of funds remain to be drawn under this grant.
In 2005, the Company's DelSite subsidiary recorded an increase in revenues of $857,000, or 112%, to $1.6 million versus revenues of $767,000 in 2004. In 2005, $334,000 of revenue was recognized under the SBIR grant, awarded in March 2004, as compared to $447,000 in 2004. Additionally, in 2005 $1.3 million of revenue was recognized under the $6 million NIAID grant for preclinical development of an intranasal vaccine against avian influenza. Revenues recorded under this grant in 2004 were $320,000.
Product-Related Gross Margin ---------------------------- The product-related gross margin of $4.83 million in 2006 was $2.93 million, or 38.5%, decrease from 2005 levels. This decrease reflected the $1.9 million, or 81.9%, decrease in royalty revenue, which has no associated cost of goods sold. Additionally, the sales mix in the Consumer Services Division has shifted from bulk raw material sales, which traditionally carry a higher gross margin percentage, to specialty contract manufacturing sales. The product-related gross margins of $7.76 million in 2005 reflect a $4.04 million, or 34.3%, decrease from 2004 levels. This reduction reflected the decreased revenue levels for the Consumer Services Division, specifically sales of bulk raw materials, plus unfavorable manufacturing variances from manufacturing operations in Costa Rica attributable to decreased Manapol[R] production in the second half of the year.
2006 vs. 2005 Change ---------------- Product-Related Gross Margin 2006 Total $ % ---------------------------- ------ ----- ------ ----- Medical Services Division $ 184 3.8% $(1,958) (91.4%) Consumer Services Division 4,646 96.2% (968) (17.2%) ------ ----- ------ ----- Total $ 4,830 100.0% $(2,926) (37.7%) ====== ===== ====== =====
2005 vs. 2004 Change ---------------- Product-Related Gross Margin 2005 Total $ % ---------------------------- ------ ----- ------ ----- Medical Services Division $ 2,142 27.6% $ (408) (16.0)% Consumer Services Division 5,614 72.4% (3,640) (39.3)% ------ ----- ------ ----- Total $ 7,756 100.0% $(4,048) (34.3)% ====== ===== ====== =====
Product-related gross margin for the Medical Services Division, which includes $417,000 of royalty revenue for 2006, decreased 91.4% to $184,000 in 2006 from $2.14 million in 2005. This reduction in 2006 is primarily the result of decreased royalty revenue, which has no associated cost of goods sold.
In 2005, product-related gross margin for the Medical Services Division, which includes $2.30 million of royalty revenue for 2005 and 2004, decreased 16.0% to $2.14 million from $2.55 million in 2004. The reduction in 2005 is primarily the result of decreased royalty revenue plus costs incurred as a result of the mouthwash product recall.
The Consumer Services Division reported a decline of $968,000, or 17.2%, in product-related gross margin, decreasing to $4.65 million in 2006 from $5.61 million in 2005. The decrease was primarily related to the fact that the sales mix in the Consumer Services Division has shifted from bulk raw material sales, which traditionally carry a higher gross margin percentage, to specialty contract manufacturing sales.
In 2005, the Consumer Services Division reported a decline of $3.64 million, or 39.3%, in product-related gross margin, decreasing to $5.61 million in 2005, from $9.25 million in 2004. The decrease was primarily related to the reduced sales of bulk Manapol[R] powder and increased unfavorable manufacturing variances from the operations in Costa Rica attributed to reduced Manapol[R] production in the second half of the year.
DelSite's 2006 and 2005 revenues were $2.0 million and $1.6 million, respectively. DelSite has no direct cost of goods sold, only research and development cost.
Selling, General and Administrative Expenses -------------------------------------------- The Company experienced a decrease of 12.2% in selling, general and administrative expenses during 2006. These expenses totaled $7.66 million in 2006, a decrease of $1.07 million from $8.73 million in 2005. The decrease was primarily related to $1.05 million in expense recorded as the result of the settlement of the Swiss American Products ("Swiss-American") lawsuit, which was entered into on December 20, 2005. The agreement provided for, among other things, a cash payment of $400,000, the issuance of a promissory note in favor of Swiss-American with an original principal balance of $400,000 and the issuance to Swiss-American of a Series C Common Stock Purchase Warrant to purchase a total of 200,000 shares of the Company's common stock, with a fair value of $248,000. These items are more fully discussed in the notes to the consolidated financial statements.
In 2005, the Company experienced an increase of $1.17 million, or 15.5%, in selling, general and administrative expenses. These expenses totaled $8.73 million versus $7.56 million in 2004. The increase was primarily related to $1.05 million in expense recorded as the result of the settlement of the Swiss American Products lawsuit.
Research and Development ------------------------ In 2006, specialized research and development expenses in support of the Company's ongoing operations fell by 18.5%, decreasing to $670,000 in 2006 from $822,000 in 2005. The decrease in 2006 was a result of lower new product development research activities by the Company in 2006 as opposed to 2005.
In 2005, specialized research and development expenses in support of the Company's ongoing operations fell by 9.8%, decreasing to $822,000 in 2005 from $911,000 in 2004.
DelSite operates independently from the Company's specialized research and development program and is responsible for the research, development and marketing of the Company's proprietary Gelsite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. DelSite's expenses totaled $5.09 million in 2006, a 2.3% increase over the 2005 expenditures of $4.97 million. This increase is the result of continuing product development efforts for its Gelvac[TM] intranasal delivery platform, as well as increased business development efforts. The 2005 expenditures were a 29.8% increase over the 2004 expenditures of $3.83 million. The 2005 increase was primarily due to expenses from the first full year of work on the preclinical, avian influenza vaccine grant program.
Combined research and development expenses totaled $5.76 million, $5.80 million and $4.74 million for the years 2006, 2005 and 2004, respectively.
Other Expense (Income) ---------------------- Other expense or income primarily consists of collections the Company has received from Rancho Aloe against a fully reserved note receivable balance. Interest Expense
Net interest expense of $1.01 million was recorded in 2006 versus net interest expense of $301,000 in 2005. The increase of $709,000 was due to additional cash interest expense of $324,000 related to the financing entered into in late 2005 in the form of $5.0 million in 6% subordinate notes, plus $437,000 of non-cash debt discount amortization related to the same financing, and $169,000 of non-cash debt-issue cost amortization. Net interest expense of $301,000 was recorded in 2005 versus net interest expense of $205,000 in 2004. The increase of $96,000 was due to the charge- off of unamortized debt-issue costs associated with the note retired as part of the sale/leaseback of the Company's corporate headquarters, plus the amortization of new debt-issue costs associated with the sale of the $5.0 million 6% subordinate notes.
Income Taxes ------------ The Company incurred no foreign income tax expense related to the Company's operations in Costa Rica in 2006 as a result of net losses for the period. In 2005, the Company incurred $19,000 of foreign income tax related to the Company's operations in Costa Rica. The tax expense was the result of an income tax true-up related to operations in 2004. The Company commenced operations in Costa Rica in July 1992 and was granted a 100% exemption for the first twelve years of operation and a 50% exemption for the next six years of operation. The Company's current tax rate in Costa Rica is 15% and will increase to 30% effective July 1, 2010.
There was no benefit or expense for U.S. income taxes in 2006, 2005 or 2004 as the Company has provided a valuation allowance against all U.S. deferred tax asset balances at December 31 of each year due to the uncertainty regarding realization of the asset.
Net Earnings and Earnings Per Share ----------------------------------- The Company's net loss for 2006 was $7.61 million, or basic and diluted loss per share of $0.70. Net loss was $5.34 million in 2005, or basic and diluted loss per share of $0.50, compared to a net income of $36,000, or basic and diluted earnings per share of $0.00, in 2004. Basic and diluted average shares outstanding for 2006 were 10,855,448, compared to basic and diluted average shares outstanding for 2005 of 10,762,342, and basic and diluted average shares outstanding for 2004 of 10,590,062, and 11,171,305, respectively. The increase in basic and diluted average shares outstanding was primarily due to employee share purchases and additional stock option grants.
Impact of Inflation ------------------- The Company does not believe that inflation has had a material impact on its results of operations.
New Pronouncements ------------------ In November 2004, the FASB issued SFAS No. 151 "Inventory Costs." This Statement amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. This Statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of "so abnormal." In addition, this Statement requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of SFAS No. 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company anticipates no material effect from the adoption of SFAS No. 151.
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payments", which replaces SFAS No. 123 "Accounting for Stock-Based Compensation", and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows." SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. As such, pro forma disclosure in lieu of expensing is no longer an alternative. Beginning January 1, 2006, the Company adopted SFAS 123(R). The Company recorded expenses of $38,000 during the year ended December 31, 2006, under SFAS No. 123(R).
In May 2006, the State of Texas passed a bill replacing the current franchise tax with a new margin tax that will go into effect on January 1, 2008. The Company estimates that the new margin tax will not have a significant impact on tax expense or deferred tax assets and liabilities.
In July 2006, the FASB issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." FIN 48 clarifies the accounting for uncertainty in income taxes recognized by prescribing a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for years beginning after December 15, 2006. The Company is in the process of determining the impact of this Interpretation on the Company's consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157 "Fair Value Measurements." This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and will apply to the Company starting in its 2008 fiscal year. The Company anticipates no material effect from the adoption of SFAS No. 157.
In February 2007, the FASB issued SFAS No. 159 "Fair Value Option for Financial Assets and Financial Liabilities." This statement's objective is to reduce both complexity in accounting for financial instruments and volatility in earnings caused by measuring related assets and liabilities differently. This statement also requires information to be provided to the readers of financial statements to explain the choice to use fair value on earnings and to display the fair value of the assets and liabilities chosen on the balance sheet. This statement is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. The Company anticipates no material effect from the adoption of SFAS No. 159.
Critical Accounting Policies ----------------------------
The Company has identified the following accounting policies as critical. The Company's accounting policies are more fully described in Note Two of the Financial Statements. The preparation of consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to bad debts and inventories. The Company bases its estimates on historical experience 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. Actual results may differ from these estimates under different assumptions or conditions.
The Company records reductions to revenue for estimated returns based upon recent history. Historical returns have been $27,000, $72,000 and $144,000 for the years ending December 31, 2006, 2005, and 2004, respectively. Accordingly, the Company has a $35,000 reserve recorded for customer returns at December 31, 2006. If market conditions were to decline or inventory was in danger of expiring or becoming obsolete, the Company may be required to implement customer incentive offerings, such as price discounts, resulting in an incremental reduction of revenue at the time the incentive is offered. Additionally, if demand for the Company's product were to drop, the Company's distributors may request permission from the Company to return product for credit causing a need to re-evaluate and possibly increase the reserve for product returns. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company's customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company writes down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. The Company has provided a valuation allowance against the net deferred tax assets, based on available evidence that the assets may not be realized, based on the Company's history of losses and uncertainty as to future income.
Forward Looking Statements --------------------------
All statements other than statements of historical fact contained in this report, including but not limited to statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations (and similar statements contained in the Notes to Consolidated Financial Statements) concerning the Company's financial position, liquidity, capital resources and results of operations, its prospects for the future and other matters, are forward-looking statements. Forward-looking statements in this report generally include or are accompanied by words such as "anticipate", "believe", "estimate", "expect", "intend", "will", "would", "should" or words of similar import. Such forward-looking statements include, but are not limited to, statements regarding the ability of local suppliers of Aloe vera L. leaves in Costa Rica to supply the Company's need for leaves; the condition, capacity and adequacy of the Company's manufacturing and laboratory facilities and equipment; the adequacy of the protection that the Company's patents provide to the conduct of its business operations; the adequacy of the Company's protection of its trade secrets and unpatented proprietary know-how; the Company's belief that the claims of the Plaintiffs identified under Item 3 of Part I of this report are without merit; the adequacy of the Company's cash resources and cash flow from operations to finance its current operations; and the Company's intention, plan or ability to repurchase shares of its outstanding Common Stock, to initiate, continue or complete clinical and other research programs, to obtain financing when it is needed, to fund its operations from revenue and other available cash resources, to enter into licensing agreements, to develop and market new products and increase sales of existing products, to obtain government approval to market new products, to file additional patent applications, to rely on trade secrets, unpatented proprietary know-how and technological innovation, to reach satisfactory resolutions of its disputes with third parties, to acquire sufficient quantities of Aloe vera L. leaves from local suppliers at significant savings, to collect the amounts owed to it by its distributors, customers and other third parties, and to use its tax loss carryforwards before they expire, as well as various other matters.
Although the Company believes that the expectations reflected in its forward-looking statements are reasonable, no assurance can be given that such expectations will prove correct. Factors that could cause the Company's results to differ materially from the results discussed in such forward-looking statements include but are not limited to the possibilities that the Company may be unable to obtain the funds needed to carry out large-scale clinical trials and other research and development projects, that the results of the Company's clinical trials may not be sufficiently positive to warrant continued development and marketing of the products tested, that new products may not receive required approvals by the appropriate government agencies or may not meet with adequate customer acceptance, that the Company may not be able to obtain financing when needed, that the Company may not be able to obtain appropriate licensing agreements for products that it wishes to market or products that it needs assistance in developing, that the Company's efforts to improve its sales and reduce its costs may not be sufficient to enable it to fund its operating costs from revenues and available cash resources, that one or more of the customers that the Company expects to purchase significant quantities of products from the Company may fail to do so, that competitive pressures may require the Company to lower the prices of or increase the discounts on its products, that the Company's sales of products it is contractually obligated to purchase from suppliers may not be sufficient to enable and justify its fulfillment of those contractual purchase obligations, that other parties who owe the Company substantial amounts of money may be unable to pay what they owe the Company, that the Company's patents may not provide the Company with adequate protection, that the Company's manufacturing facilities may be inadequate to meet demand, that the Company's distributors may be unable to market the Company's products successfully, that the Company may not be able to resolve its disputes with third parties in a satisfactory manner, that the Company may be unable to reach a satisfactory agreement with other important suppliers, that the Company may not be able to use its tax loss carryforwards before they expire, that the Company may not have sufficient financial resources necessary to repurchase shares of its outstanding Common Stock, that the Company may be unable to maintain effective internal controls over financial reporting, that the Company may not be able to attract or retain qualified personnel in key positions, that the Company may not be able to generate sufficient cash flow to service its debt obligations, and that the Company may be unable to produce or obtain, or may have to pay excessive prices for, the raw materials or products it needs.
All forward-looking statements in this report are expressly qualified in their entirety by the cautionary statements in the two immediately preceding paragraphs.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. ----------------------------------------------------------
Foreign Currency ----------------
The Company's manufacturing operation in Costa Rica accounted for 21.0% of cost of sales for the year ended December 31, 2006. The Company's functional currency in Costa Rica is the U.S. Dollar. As a result, the Company's financial results could be significantly affected by factors such as changes in foreign currency exchange rates or economic conditions in Costa Rica. When the U.S. Dollar strengthens against the Costa Rica Colon the cost of sales decreases. During 2006, the exchange rate from U.S. Dollar to Costa Rica Colon increased by 3.8% to 516 at December 31, 2006. The effect of an additional 10% strengthening in the value of the U.S. Dollar relative to the Costa Rica Colon in 2006 would have resulted in an increase of $393,269 in gross profit. The Company's sensitivity analysis of the effects of changes in foreign currency rates does not factor in a potential change in sales levels or local currency prices.
Sales of products to foreign markets comprised 5.9% of sales for 2006. These sales are generally denominated in U.S. Dollars. The Company does not believe that changes in foreign currency exchange rates or weak economic conditions in foreign markets in which the Company distributes its products would have a significant effect on operating results. If sales to foreign markets increase in future periods, the effects could become significant.
Changes in short-term interest rates on debt balances with variable interest rates could have an affect on the Company's earnings. At December 31, 2006, a hypothetical one percent increase in interest rates would result in an increase in interest expense of $22,000 on an annual basis.
For quantitative and qualitative disclosures about market risk related to the supply of Aloe vera L. leaves, see "Business - Raw Materials and Processing."
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. -------------------------------------------
The response to Item 8 is submitted as a separate section of this Form 10-K. See Item 15.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND --------------------------------------------------------------- FINANCIAL DISCLOSURE. --------------------
On June 20, 2006, the Audit Committee of the Board of Directors approved the engagement of Weaver and Tidwell, LLP as the Company's independent auditors for the fiscal year ending December 31, 2006. On the same day, Weaver and Tidwell, LLP formally advised the Company that it was accepting the position as the Company's independent auditors. As previously reported on the Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission on March 30, 2006, Grant Thornton LLP notified the Company on March 29, 2006 that it would decline to stand for reappointment as the Company's independent registered public accounting firm for the year ending December 31, 2006. On May 15, 2006, Grant Thornton ceased to serve as the Company's independent registered public accounting firm of record.
During the fiscal years ended December 31, 2003, 2004 and 2005 and through June 20, 2006, there were no disagreements with Grant Thornton, LLP on any matter of accounting principle or practice, financial statement disclosure or auditing scope or procedures or any reportable events.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES. -----------------------
Management of the Company, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company's disclosure controls and procedures. Based on their evaluation, as of the end of the period covered by this Form 10-K, the Company's Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) are effective.
There have been no changes in internal control over financial reporting, for the period covered by this report, that have materially affected or are reasonably likely to materially affect, the Company's internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION. ----------------- None.
PART III --------
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. --------------------------------------------------
The information required by Item 10 of Form 10-K is hereby incorporated by reference from the information appearing under the captions "Election of Directors", "Corporate Governance and Board Committees", "Executive Officers" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement relating to its 2007 annual meeting of shareholders, which will be filed pursuant to Regulation 14A within 120 days after the Company's fiscal year ended December 31, 2006.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION. ----------------------
The information required by Item 11 of Form 10-K is hereby incorporated by reference from the information appearing under the caption "Executive Compensation" in the Company's definitive Proxy Statement relating to its 2007 annual meeting of shareholders, which will be filed pursuant to Regulation 14A within 120 days after the Company's fiscal year ended December 31, 2006.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND --------------------------------------------------------------- RELATED STOCKHOLDERS MATTERS. ----------------------------
The information required by Item 12 of Form 10-K is hereby incorporated by reference from the information appearing under the captions "Security Ownership of Management" and "Principal Shareholders" in the Company's definitive Proxy Statement relating to its 2007 annual meeting of shareholders, which will be filed pursuant to Regulation 14A within 120 days after the Company's fiscal year ended December 31, 2006.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. ----------------------------------------------
The information, if any, required by Item 13 of Form 10-K is hereby incorporated by reference from the information appearing under the caption "Certain Transactions", if any, in the Company's definitive Proxy Statement relating to its 2007 annual meeting of shareholders, which will be filed pursuant to Regulation 14A within 120 days after the Company's fiscal year ended December 31, 2006.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES. --------------------------------------
The information required by Item 14 of Form 10-K is hereby incorporated by reference from the information appearing under the captions "Principal Accountant Fees and Services" in the Company's definitive Proxy Statement relating to its 2007 annual meeting of shareholders, which will be filed pursuant to Regulation 14A within 120 days after the Company's fiscal year ended December 31, 2006.
PART IV -------
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. ------------------------------------------
(1) Financial Statements.
Reference is made to the index on page for a list of all financial statements filed as a part of this Annual Report.
(2) Financial Statement Schedules.
Reference is made to the index on page for a list of the financial statement schedule filed as a part of this Annual Report.
(3) Exhibits.
Reference is made to the Index of Exhibits on pages E-1 through E-6 for a list of all exhibits to this report.
CARRINGTON LABORATORIES, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
Consolidated Financial Statements of the Company:
Consolidated Balance Sheets -- December 31, 2006 and 2005
Consolidated Statements of Operations -- years ended December 31, 2006, 2005, and 2004
Consolidated Statements of Shareholders' Equity -- years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows -- years ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements
Financial Statement Schedule Valuation and Qualifying Accounts
Reports of Independent Registered Public Accounting Firms
Consolidated Balance Sheets (Amounts in thousands, except share and per share amounts)
December 31, ---------------------- 2006 2005 -------- -------- ASSETS: Current Assets: Cash and cash equivalents $ 878 $ 6,262 Accounts receivable, net of allowance for doubtful accounts of $306 and $329 at December 31, 2006 and 2005, respectively 2,659 2,679 Inventories, net 3,405 4,705 Prepaid expenses 155 392 -------- -------- Total current assets 7,097 14,038
Property, plant and equipment, net 6,093 6,755 Customer relationships, net 199 392 Other assets, net 609 804 -------- -------- Total assets $ 13,998 $ 21,989 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY: Current Liabilities: Line of credit $ 1,811 $ 1,812 Accounts payable 1,324 2,092 Accrued liabilities 1,820 1,585 Current portion of long-term debt and capital lease obligations 203 188 Deferred revenue 903 1,386 -------- -------- Total current liabilities 6,061 7,063
Long-term debt and capital lease obligations, net of debt discount 3,745 3,418
Commitments and contingencies
SHAREHOLDERS' EQUITY: Common stock, $.01 par value, 30,000,000 shares authorized, 10,896,524 and 10,805,725 shares issued at December 31, 2006 and 2005, respectively 109 108 Capital in excess of par value 57,475 57,185 Accumulated deficit (53,389) (45,782) Treasury stock at cost, 2,400 shares at December 31, 2006 and 2005 (3) (3) -------- -------- Total shareholders' equity 4,192 11,508 -------- -------- Total liabilities and shareholders' equity $ 13,998 $ 21,989 ======== ========
The accompanying notes are an integral part of these statements.
Consolidated Statements of Operations (Amounts in thousands, except per share amounts)
Years Ended December 31, ---------------------------- 2006 2005 2004 ------ ------ ------ Revenues: Net product sales $25,000 $24,038 $27,584 Royalty income 417 2,299 2,470 Grant income 1,989 1,624 767 ------ ------ ------ Total net revenues 27,406 27,961 30,821
Cost and expenses: Cost of product sales 20,586 18,581 18,250 Selling, general and administrative 7,662 8,731 7,560 Research and development 670 822 911 Research and development, DelSite 5,090 4,974 3,826 Other income (9) (131) (92) Interest expense, net 1,014 301 205 ------ ------ ------ Net income (loss) before income taxes (7,607) (5,317) 161 Provision for income taxes 0 19 125 ------ ------ ------ Net income (loss) $(7,607) $(5,336) $ 36 ====== ====== ======
Basic and diluted earnings (loss) per share $ (0.70) $ (0.50) $ 0.00 ====== ====== ======
Basic shares outstanding 10,855 10,762 10,590
Diluted shares outstanding 10,855 10,762 11,171
The accompanying notes are an integral part of these statements.
Consolidated Statements of Cash Flows (Amounts in thousands) Years Ended December 31, -------------------------- 2006 2005 2004 ------ ------ ------ Operating activities: Net income (loss) $(7,607) $(5,336) $ 36 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Provision for bad debts 179 243 48 Provision for inventory obsolescence 473 318 205 Depreciation and amortization 1,357 1,238 1,241 Legal settlement - 647 - Share-based compensation expense 38 - - Amortization of debt discount 437 - - Changes in operating assets and liabilities: Accounts receivable (159) 403 (275) Inventories 827 (409) 1,141 Prepaid expenses 237 (195) 56 Other assets 195 62 46 Accounts payable and accrued liabilities (533) 675 (639) Deferred revenue (483) (1,076) 553 ------ ------ ------ Net cash provided by (used in) operating activities (5,039) (3,430) 2,412
Investing activities: Disposal of property, plant, and equipment in sale/leaseback transaction - 4,616 - Purchases of property, plant and equipment (383) (610) (2,172) ------ ------ ------ Net cash provided by (used in) investing activities (383) 4,006 (2,172)
Financing activities: Borrowings on line of credit - - 300 Payments on line of credit (1) (75) - Proceeds from debt issuances - 2,263 350 Proceeds from warrant issuances - 2,737 - Principal payments on debt and capital lease obligations (214) (1,483) (1,096) Issuances of common stock 253 240 716 Debt issuance costs - (426) - ------ ------ ------ Net cash provided by financing activities 38 3,256 270
Net increase (decrease) in cash and cash equivalents (5,384) 3,832 510 ------ ------ ------ Cash and cash equivalents at beginning of year 6,262 2,430 1,920 ------ ------ ------ Cash and cash equivalents at end of year $ 878 $ 6,262 $2,430 ====== ====== ====== Supplemental disclosure of cash flow information Cash paid during the year for interest $ 465 $ 260 $ 225 Cash paid during the year for income taxes - $ 140 - Non-cash warrant issue to broker - $ 248 - Property plant and equipment acquired under capital leases $ 119 $ 104 -
The accompanying notes are an integral part of these statements.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE ONE. BUSINESS
Carrington Laboratories, Inc. (the "Company") is a research-based biopharmaceutical, medical device, raw materials and nutraceutical company engaged in the development, manufacturing and marketing of naturally-derived complex carbohydrates and other natural product therapeutics for the treatment of major illnesses, the dressing and management of wounds and nutritional supplements.
The Company's Medical Services Division offers a comprehensive line of wound management products to hospitals, nursing homes, alternative care facilities, cancer centers, home health care providers and managed care organizations. The Company and Medline Industries, Inc. ("Medline") entered into a Distributor and License Agreement dated November 3, 2000, under which the Company granted to Medline the exclusive right, subject to certain limited exceptions, to distribute all of the Company's wound and skin care products (the "Products") in the United States, Canada, Puerto Rico and the U.S. Virgin Islands for a term of five years that began December 1, 2000. The agreement provides that Carrington will continue to manufacture its existing line of Products and sell them to Medline at specified prices. The prices, which were generally firm for the first two years of the contract term, are thereafter subject to adjustment not more than once each year to reflect increases in manufacturing cost.
The agreement also grants Medline a nonexclusive license to use certain of the Company's trademarks in connection with the marketing of the Products. In addition, it permits Medline, if it so elects, to use those trademarks in connection with the marketing of various Medline products and other products not manufactured by the Company (collectively, "Other Products").
The agreement required Medline to pay the Company a base royalty totaling $12,500,000 in quarterly installments that began on December 1, 2000 and ended on September 1, 2005. In addition to the base royalty, if Medline elects to market any of the Other Products under any of the Company's trademarks, Medline must pay the Company a royalty of between one percent and five percent of Medline's aggregate annual net sales of the Products and the Other Products, depending on the amount of the net sales. The Company and Medline amended the Distributor and License Agreement in April 2004 to extend the term of the agreement through November 30, 2008. The amended agreement specified an advance payment of $1,250,000, which the Company has received.
The Company entered into a Supply Agreement with Medline effective December 1, 2000, which among other things, provides that the Company will manufacture Medline-brand dermal management products. The Supply Agreement is co-terminus with the amended Distributor and License Agreement.
The Consumer Services Division markets or licenses bulk raw materials, specialty manufacturing services and finished consumer products. Principal sales of the Division are bulk raw materials which are sold to U.S. manufacturers who include the high quality extracts from Aloe vera L. in their finished products.
The Company formed a subsidiary, DelSite Biotechnologies, Inc., in October 2001 as a vehicle to further the development and commercialization of its new proprietary complex carbohydrate (GelSite[R] polymer) that the Company is developing for use as a drug and vaccine delivery system.
In December 2002, the Company entered into an agreement to acquire certain assets of the Custom Division of Creative Beauty Innovations, Inc. ("CBI"), including specialized manufacturing customer information, intellectual property and equipment. CBI is a privately-held manufacturer of skin and cosmetic products with operations in Fort Worth, Texas.
Under the agreement, the Company paid CBI $1.6 million, including $0.6 million for inventory of CBI. In addition, for the five-year period ending in December 2007, the Company agreed to pay CBI an amount equal to 9.0909% of its net sales of CBI products to CBI's transferring customers up to $6.6 million per year and 8.5% of its net sales of CBI products to CBI's transferring customers over $6.6 million per year. The acquired assets include equipment and other physical property previously used by CBI's Custom Division to compound and package cosmetic formulations of liquids, creams, gels and lotions into bottles, tubes or cosmetic jars. The Company uses these assets in a substantially similar manner. The Company provides services to these customers through the Consumer Services Division's development and manufacturing services group. The Company recorded $100,000 for the purchase of equipment and $980,000 for the purchase of customer relationship intangibles in connection with the acquisition.
The Company's products are produced at its plants in Irving, Texas and Costa Rica. A portion of the Aloe vera L. leaves used for manufacturing the Company's products are grown on a Company-owned farm in Costa Rica. The remaining leaves are purchased from other producers in Central and South America.
The accompanying financial statements have been prepared on a going concern basis, which assumes the Company will realize its assets and discharge its liabilities in the normal course of business. As reflected in the accompanying consolidated financial statements and as the result of its significant investment in the research and development activities of DelSite, the Company incurred cumulative net losses of $12.9 million and used cash from operations of $6.1 million during the three years ended December 31, 2006. The Company projects a net loss for fiscal 2007 before consideration of potential funding sources for this same period. These conditions raise doubt about the Company's ability to continue as a going concern.
Funding of the Company's working capital requirements has resulted principally from operating cash flows, bank financing, advances on royalty payments under certain of its existing contracts and debt and equity financing. In November 2005, the Company closed a $5.0 million private placement of term notes due in December 2009 and warrants with 16 investors. In February 2007, Sabila Industrial, S.A., a wholly-owned subsidiary of the Company, entered into a revolving credit facility with Banco Nacional de Costa Rica for $2,990,000, which matures in February 2010, and borrowed $1.5 million under the facility. These transactions are described throughout the footnotes.
The Company has $1.0 million available under its Comerica credit facility, provided however, the Company's current accounts receivable and inventory balances (which provide security for borrowed funds) are not sufficient to permit any additional borrowings at this time. The Company also has $1.5 million available under its Banco Nacional credit facility. The Company believes that the expected cash flows from operations and licensing agreements and expected revenues from government grant programs will provide the funds necessary to service its existing indebtedness and finance its operations until September 2007.
The Company is currently engaged in efforts to restructure certain existing indebtedness in order to increase available funds on a near-term basis, and it also intends to seek additional financing during the next six months through one or more public or private equity offerings, additional debt financings, corporate collaborations, or licensing transactions. The Company cannot be certain that additional funding will be available on acceptable terms, or at all. If adequate funds are not available, the Company may be required to delay, reduce the scope of, or eliminate one or more of its research or development programs or commercialization efforts.
There are currently no commitments in place for these debt and equity transactions, nor can assurances be given that such financing will be available. While the Company is confident that it will raise the capital necessary to fund operations and achieve successful commercialization of the products under development, there can be no assurances in that regard. The financial statements do not include any adjustments that may arise as a result of this uncertainty.
NOTE TWO. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of Carrington Laboratories, Inc., and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.
CASH EQUIVALENTS. The Company's policy is that all highly liquid investments purchased with a maturity of three months or less at date of acquisition are considered to be cash equivalents unless otherwise restricted. None of the cash equivalents are restricted for any years presented.
INVENTORY. Inventories are recorded at the lower of cost (first-in, first- out) or market. The Company records a reserve for inventory obsolescence based on an analysis of slow moving and expired products.
PROPERTY, PLANT AND EQUIPMENT. Property, plant and equipment are recorded at cost less accumulated depreciation. Buildings and improvements, furniture and fixtures and machinery and equipment are depreciated on the straight-line method over their estimated useful lives. Leasehold improvements and equipment under capital leases are amortized over the terms of the respective leases or the estimated lives of the assets, whichever is less. Expenditures for maintenance and repairs are charged to expense as incurred.
LONG-LIVED ASSETS. The Company reviews long-lived assets, including finite- lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. If the sum of the expected future undiscounted cash flows is less than the carrying amount of the asset, a loss is recognized for the difference between the fair value and carrying value of the asset. There have been no impairment charges recorded in the years presented.
CUSTOMER RELATIONSHIPS. In connection with the CBI acquisition described in Note One, the Company recorded a finite-lived intangible asset of $980,000 for customer relationships acquired. The Company is amortizing this intangible asset over five years, which is based on the estimated life of the customer relationships. Future amounts paid to the sellers based on a percentage of sales of CBI products as described in Note One will be recorded as an expense in the same period the corresponding sales are recorded. The Company recorded expenses of $308,000, $262,000, $271,000 in 2006, 2005 and 2004, respectively, for royalties due under the agreement. The Company recorded expense for amortization of the intangible asset of approximately $193,000 in each of the years 2006, 2005 and 2004, and accumulated amortization of $781,000, $588,000 and $395,000 at December 31, 2006, 2005 and 2004, respectively. Amortization expense over the next year is expected to be approximately $200,000.
TRANSLATION OF FOREIGN CURRENCIES. The functional currency for international operations (Costa Rica) is the U.S. Dollar. Accordingly, such foreign entities translate monetary assets and liabilities at year-end exchange rates, while non-monetary items are translated at historical rates. Revenue and expense accounts are translated at the average rates in effect during the year, except for depreciation and amortization, which are translated at historical rates. Translation adjustments and transaction gains or losses are recognized in the consolidated statement of operations.
REVENUE RECOGNITION. The Company recognizes revenue for product sales at the time of shipment when title to the goods transfers and collectibility is reasonably assured, net of a reserve for estimated returns. Royalty income is recognized over the period of the licensing and royalty agreement. Grant income is recognized ratably as the grant budget-approved expenses are incurred.
DEFERRED REVENUE. Deferred revenue is primarily related to the licensing and royalty agreement with Medline and represents amounts received in excess of amounts amortized to royalty income.
INCOME TAXES. The Company uses the liability method of accounting for income taxes. Under this method, deferred income taxes are recorded to reflect the tax consequences of differences between the tax basis of assets and liabilities and the financial reporting basis. Valuation allowances are provided against net deferred tax assets when it is more likely than not, based on available evidence, that assets may not be realized.
RESEARCH AND DEVELOPMENT. Research and development costs are expensed as incurred. Certain laboratory and test equipment determined to have alternative future uses in other research and development activities has been capitalized and is depreciated as research and development expense over the life of the equipment.
FREIGHT COSTS. Shipping costs incurred by the Company are included in the consolidated statement of operations in selling, general and administrative expenses and were approximately $1,099,000, $1,032,000 and $914,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
ADVERTISING COSTS. Advertising costs, included in selling, general and administrative, are expensed as incurred and were approximately $28,000, $136,000 and $240,000 for the years ended 2006, 2005 and 2004, respectively.
STOCK-BASED COMPENSATION. On January 1, 2006, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board ("FASB") Statement No. 123(R), "Share-Based Payment", ("SFAS 123(R)"). Prior to January 1, 2006, the Company accounted for share-based payments under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related Interpretations, as permitted by FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). In accordance with APB 25, no compensation cost was required to be recognized for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant.
The Company adopted SFAS 123(R) using the modified-prospective-transition method. Under this transition method, compensation cost recognized in future interim and annual reporting periods includes: (1) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, and (2) compensation cost for all share- based payments granted subsequent to January 1, 2006, based on the grant- date fair value estimated in accordance with the provisions of SFAS 123(R). The results for the prior periods have not been restated.
NET INCOME (LOSS) PER SHARE. Basic net income (loss) per share is based on the weighted-average number of shares of common stock outstanding during the year. Diluted net income (loss) per share includes the effects of options, warrants and convertible securities unless the effect is antidilutive. The Company uses its weighted-average close price of its stock for the reporting period to determine the dilution of its stock options and warrants related to its EPS calculation.
USE OF ESTIMATES. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates include accounts receivable bad debt, inventory obsolescence and return reserves. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS. The carrying value of the Company's cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities estimate fair value due to their relative short-term nature. The majority of the Company's debt approximates fair value due to the nature of the floating interest rates being charged. The fair value of the $5.0 million note payable is approximately $4.0 million, based on a valuation calculation using a market interest rate of 12.5%.
NEW PRONOUNCEMENTS. In November 2004, the FASB issued SFAS No. 151 "Inventory Costs." This statement amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material. This statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of "so abnormal." In addition, this statement requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of SFAS No. 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Adoption of SFAS No. 151 had no material effect on the Company.
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payments", which replaces SFAS No. 123 "Accounting for Stock-Based Compensation", and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees" and amends SFAS No. 95, "Statement of Cash Flows." SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. As such, pro forma disclosure in lieu of expensing is no longer an alternative. The new standard is effective in the first annual reporting period beginning after June 15, 2005. The Company recorded expense of $38,000 during the year ended December 31, 2006, under SFAS No. 123(R).
In May 2006, the State of Texas passed a bill replacing the current franchise tax with a new margin tax that will go into effect on January 1, 2008. The Company estimates that the new margin tax will not have a significant impact on tax expense or deferred tax assets and liabilities.
In July 2006, the FASB issued Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." FIN 48 clarifies the accounting for uncertainty in income taxes recognized by prescribing a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for years beginning after December 15, 2006. The Company is in the process of determining the impact of this Interpretation on the Company's consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157 "Fair Value Measurements." This Statement defines fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007, and will apply to the Company starting on its 2008 fiscal year. The Company anticipates no material effect from the adoption of SFAS No. 157.
In February 2007, the FASB issued SFAS No. 159 "Fair Value Option for Financial Assets and Financial Liabilities." This statements objective is to reduce both complexity in accounting for financial instruments and volatility in earnings caused by measuring related assets and liabilities differently. This statement also requires information to be provided to the readers of financial statements to explain the choice to use fair value on earnings and to display the fair value of the assets and liabilities chosen on the balance sheet. This statement is effective as of the beginning of an entity's first fiscal year beginning after November 15, 2007. The Company anticipates no material effect from the adoption of SFAS No. 159.
NOTE THREE. INVENTORIES
The following summarizes the components of inventory at December 31, 2006 and 2005, in thousands:
2006 2005 --------------------------------------------------------------------------- Raw materials and supplies $2,478 $2,652 Work-in-process 319 322 Finished goods 1,511 2,522 Less obsolescence reserve (903) (791) --------------------------------------------------------------------------- Total $3,405 $4,705 ---------------------------------------------------------------------------
NOTE FOUR. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consisted of the following at December 31, 2006 and 2005, in thousands:
Estimated 2006 2005 Useful Lives --------------------------------------------------------------------------- Land $ 151 $ 151 Buildings and improvements 2,709 2,702 7 to 25 years Furniture and fixtures 839 773 4 to 8 years Machinery and equipment 10,989 10,754 3 to 10 years Leasehold improvements 1,332 1,327 3 to 10 years Equipment under capital leases 427 490 5 years --------------------------------------------------------------------------- Total 16,447 16,197 Less accumulated depreciation and amortization 10,354 9,442 --------------------------------------------------------------------------- Property, plant and equipment, net $ 6,093 $ 6,755 ---------------------------------------------------------------------------
The net book value for equipment under capital leases as of December 31, 2006 and 2005, was $292,000 and $355,000, respectively.
The net book value of property, plant and equipment in Costa Rica at December 31, 2006 and 2005 was $3,822,000 and $4,209,000, respectively.
NOTE FIVE. ACCRUED LIABILITIES
The following summarizes significant components of accrued liabilities at December 31, 2006 and 2005, in thousands:
2006 2005 --------------------------------------------------------------------------- Accrued payroll $ 293 $ 215 Accrued insurance 83 166 Accrued taxes 178 117 Accrued professional fees 152 260 Accrued rent 230 165 Accrued interest 95 37 Accrued product recall costs 415 251 Other 374 374 --------------------------------------------------------------------------- Total $1,820 $1,585 ---------------------------------------------------------------------------
NOTE SIX. LINE OF CREDIT
The Company has a line of credit with Comerica Bank Texas ("Comerica") that provides for borrowings of up to $3 million based on the level of qualified accounts receivable and inventory. The line of credit is collateralized by accounts receivable and inventory. Borrowings under the line of credit bear interest at the bank's prime rate (8.25% at December 31, 2006) plus 0.5%. As of December 31, 2006, there was $1,811,000 outstanding on the credit line with $839,000 of credit available for operations, net of outstanding letters of credit of $350,000. The line of credit has no expiration date and is payable on demand.
The Company's credit facilities with Comerica require the Company to maintain certain financial ratios. The covenants and the Company's position at December 31, 2006 are as follows:
Covenant Covenant Requirement Company's Position --------- -------------------- ------------------ Total net worth $12,200,000 $3,994,247 Current ratio 1.60 1.35 Liquidity ratio 1.75 1.95
The total net worth, current ratio and liquidity ratio covenant amounts and the Company's position are calculated as defined in the credit agreement, as amended. The covenant amounts for these ratios will remain at these same fixed amounts until maturity. Although the Company was not in compliance with two of its financial-ratio covenants under the Comerica line of credit for the period ended December 31, 2006, Comerica has waived the events of non-compliance through May 31, 2007.
The Company believes that it is unlikely that Comerica will continue to grant such waivers after the second quarter of 2007, and can make no assurances that such waivers will be granted for events of non-compliance occurring subsequent to May 31, 2007. If the Company is unable to obtain such waivers and the existing covenant defaults continue, Comerica could accelerate the indebtedness under the Company's credit facility as well as all other debt that the Company has outstanding with Comerica, if any. The Company is presently seeking additional funding that would enable it to repay its indebtedness under the Comerica credit facility and fund the Company's working capital obligations. If Comerica accelerates the indebtedness under the Company's credit facility prior to the Company obtaining such additional funding, the Company would be forced to refinance all of the Comerica indebtedness with another lender. Any additional financing secured by the Company or the Company's refinancing of the Comerica credit facility will likely contain interest rates and terms which are more burdensome for the Company than those presently in place under the Comerica facility, resulting in an adverse impact on liquidity.
NOTE SEVEN. LONG-TERM DEBT
In March 2003, the Company received a loan of $500,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate (8.25%) plus 2.0%. As of December 31, 2006, there was $310,000 outstanding on the loan.
In September 2004, the Company received a loan of $350,000 from Bancredito, a Costa Rica bank, with interest and principal to be repaid in monthly installments over eight years. The interest rate on the loan is the U.S. Prime Rate (8.25%) plus 2.5%. As of December 31, 2006, there was $282,000 outstanding on the loan.
Both the loans through Bancredito are secured by land and equipment in Costa Rica (with a carrying value of approximately $660,000).
On November 18, 2005, the Company sold $5,000,000 aggregate principal amount of 6.0% subordinated notes. The notes mature, subject to certain mandatory prepayments discussed below, on November 18, 2009. Interest on the notes is payable quarterly in arrears. The notes require mandatory prepayment of all principal and interest in the event that the holder of such note exercises its Series A Warrant, which was also issued as part of the transaction, in full. The note is subordinate to the Company's indebtedness to Comerica Bank and certain other indebtedness. As of December 31, 2006, there was $5,000,000 outstanding on the note with an associated debt discount of $2,254,000 for a net balance of $2,746,000. The 5,000,000 warrants have a fair value of $4.8 million as determined by independent appraisers, and an allocated value of $2.7 million, which was recorded as a debt discount. Additionally, the Company incurred $674,000 of debt issue costs related to this financing arrangement, which will be amortized using the effective interest method over the term of the debt. As a result of the debt discount associated with the value of the warrants. The effective interest rate on the debt is 30%.
On December 20, 2005, the Company entered into a settlement agreement with Swiss-American Products, Inc. ("Swiss-American") and G. Scott Vogel to resolve all claims related to a lawsuit filed by Swiss-American in June 2001. The settlement agreement provides for, among other things, a cash payment of $400,000 and the issuance of a promissory note in favor of Swiss- American with an original principal balance of $400,000. The note bears interest at the rate of 6.0% per annum, payable quarterly in arrears, and all outstanding principal is due and payable in full, subject to certain mandatory prepayments discussed below, on December 20, 2009. The note requires mandatory prepayment of all principal and interest in the event that the holder of such note exercises its Series C Warrant, which was also issued as part of the settlement agreement, in full. The note is subordinate to the Company's indebtedness to Comerica Bank and certain other indebtedness. As of December 31, 2006, there was $400,000 outstanding on the note.
The following summarizes annual maturities at December 31, 2006, in thousands:
2007 $ 107 2008 112 2009 5,517 2010 125 2011 86 Thereafter 52 ------ Subtotal 5,999 Debt Discount (2,254) ------ Total $ 3,745 ======
NOTE EIGHT. COMMON STOCK
SHARE PURCHASE RIGHTS PLAN. The Company has a share purchase rights plan which provides, among other rights, for the purchase of common stock by existing common stockholders at significantly discounted amounts in the event a person or group acquires or announces the intent to acquire 15% or more of the Company's common stock. The rights expire in 2011 and may be redeemed at any time at the option of the Board of Directors for $.001 per right.
EMPLOYEE STOCK PURCHASE PLAN. The Company has an Employee Stock Purchase Plan under which employees may purchase shares of the Company's common stock. Prior to January 1, 2006, employees purchased shares at a price equal to the lesser of 85% of the market price of the Company's common stock on the last business day preceding the enrollment date (defined as January 1, April 1, July 1 or October 1 of any plan year) or 85% of the market price on the last business day of each month. Effective January 1, 2006, the purchase price is 95% of the market price of the Company's common stock on the last business day of each month. A maximum of 1,250,000 shares of common stock was reserved for purchase under this Plan. As of December 31, 2006, a total of 991,507 shares had been purchased by employees at prices ranging from $0.77 to $29.54 per share.
STOCK OPTIONS. The Company has an incentive stock option plan which was approved by the shareholders in 2004 under which incentive stock options and nonqualified stock options may be granted to employees, consultants and non- employee directors. Options are granted at a price no less than the market value of the shares on the date of the grant, except for incentive options to employees who own more than 10% of the total voting power of the Company's Common Stock, which must be granted at a price no less than 110% of the market value. Employee options are normally granted for terms of 10 years. Options granted in 2006 vest at the rate of 50% per year beginning in the first anniversary of the grant date. Options granted in 2005 were 100% vested on December 20, 2005. Options granted in 2004 vested at the rate of 50% per year beginning on the first anniversary of the grant date, with the remaining 50% receiving accelerated vesting on December 20, 2005. Options to non-employee directors have terms of ten years and are 100% vested on the grant date. The Company has reserved 500,000 shares of Common Stock for issuance under this plan. As of December 31, 2006, options to purchase 93,700 shares were available for future grants under the plan.
The Company also has an incentive stock option plan which was approved by the shareholders in 1995 under which incentive stock options and nonqualified stock options were granted to employees, consultants and non- employee directors. Options were granted at a price no less than the market value of the shares on the date of the grant, except for incentive options to employees who own more than 10% of the total voting power of the Company's Common Stock, which were required to be granted at a price no less than 110% of the market value. Employee options were normally granted for terms of 10 years. Options granted through 2001 had various vesting rates and all such options still outstanding were fully vested at December 31, 2005. Options granted subsequent to 2001 vested at the rate of 50% per year beginning on the first anniversary of the grant date and all options outstanding received accelerated vesting on December 20, 2005. Options to non-employee directors have terms of ten years and are 100% vested on the grant date. The Company has reserved 2,250,000 shares of Common Stock for issuance under this plan. The Plan expired on April 1, 2005, after which no additional grants have been or may be made under the plan. In accordance with the provisions of the plan, all options issued under the plan and outstanding on the expiration date of the plan shall remain outstanding until the earlier of their exercise, forfeiture or lapse.
Beginning January 1, 2006, the Company was required to adopt the provisions of Statement of Financial Accounting Standards No. 123(R) "Share-Based Payment" ("SFAS 123(R)"), which requires the recognition of stock-based compensation associated with stock options as an expense in financial statements. The primary purpose of the vesting acceleration was to reduce the non-cash compensation expense that would have been recorded in future periods following the Company's adoption of SFAS 123(R). As a result of accelerating these options in advance of the adoption of SFAS 123(R), the Company reduced the pre-tax stock option expense it would otherwise be required to record by $162,500 in 2006 and an estimated reduction of $4,400 in 2007.
STOCK-BASED COMPENSATION. The Company adopted the provisions of revised Statement of Financial Accounting Standards No. 123 ("SFAS 123(R)"), "Share-Based Payment," including the provisions of Staff Accounting Bulletin No. 107 ("SAB 107") on January 1, 2006, the first day of 2006, using the modified prospective transition method to account for the Company's employee share-based awards. The valuation provisions of SFAS 123(R) apply to new awards and to awards that are outstanding at the effective date and subsequently modified or cancelled. The Company's Board of Directors approved the acceleration of the vesting on all outstanding unvested options held by officers and employees under the incentive stock option plan as of December 18, 2005. The primary purpose of the vesting acceleration was to reduce the non-cash compensation expense that would have been recorded in future periods following the Company's adoption of SFAS 123(R). The Company's consolidated financial statements as of December 31, 2006 and for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company's consolidated financial statements for prior periods were not restated to reflect, and do not include, the impact of SFAS 123(R).
Share-based compensation expense recognized during a period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Share-based compensation expense recognized in the consolidated statement of operations for 2006 includes compensation expense for share-based payment awards granted in 2006, expenses are amortized under the straight-line attribution method. As share- based compensation expense recognized in the consolidated statement of operations for 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Pre-vesting forfeitures were estimated to be approximately 0% for the grant made to employees on January 5, 2006 and 6% for grant made to employees on May 18, 2006, based on our historical experience.
The adoption of SFAS 123(R) resulted in incremental share-based compensation expense of $38,000 in the year ended December 31, 2006. The incremental share-based compensation caused the net loss before income taxes and the net loss to increase by the same amount and did not affect the basic and diluted loss per share. Total compensation expense related to both of the Company's share-based awards, recognized under SFAS 123(R), for 2006 were comprised of the following:
------ Selling, general and administrative expense $ 13 Research and development expense 25 ------ Share-based compensation expense before taxes 38 Related income tax benefits - Share-based compensation expense $ 38 ====== Net share-based compensation expense per common share - basic and diluted $ 0.00
The entire portion of the share-based compensation expense in 2006 is from incentive stock option grants. As of December 31, 2006, the Company has $78,000 of total unrecognized compensation cost related to non-vested options granted under the Company's stock option plan. That cost is expected to be recognized over a weighted average period of seventeen months. Since the Company has a net operating loss carry-forward as of December 31, 2006, no excess tax benefits for the tax deductions related to share-based awards were recognized in the consolidated statement of operations. Additionally, no incremental tax benefits were recognized from stock options exercised in 2006 that would have resulted in a reclassification to reduce net cash provided by operating activities with an offsetting increase in net cash provided by financing activities. Compensation expense relating to employee share-based awards was not recognized in the years ended December 31, 2005 and 2004.
Prior to January 1, 2006, the Company accounted for share-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, " Accounting for Stock Issued to Employees " and related interpretations and provided the required pro forma disclosures of SFAS 123.
The following table summarizes the pro forma effect on the Company's net income (loss) and per share data if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee compensation for 2005 and 2004.
--------------------------------------------------------------------------- 2005 2004 --------------------------------------------------------------------------- Net income (loss) (in thousands): As reported $(5,336) $ 36 Less: Stock-based compensation expense determined under fair value-based method (1,055) (1,496) ------ ------ Pro forma net loss $(6,391) $(1,460) ====== ======
Basic and diluted shares outstanding 10,762 10,590
Net income (loss) per share: Basic and diluted as reported $ (0.50) $ 0.00 Basic and diluted pro forma (0.59) (0.14) ---------------------------------------------------------------------------
For employee stock options granted in 2005 and 2004, the Company determined pro forma compensation expense under the provisions of SFAS 123 using the Black-Scholes model and the following assumptions: (1) an expected volatility of 61.9% and 79.2%, respectively, (2) an expected term of 5 years, (3) a risk-free interest rate of 4.35% and 3.51%, respectively, and (4) an expected dividend yield of 0%. The weighted average fair value of options granted in 2005 and 2004 was $2.22 and $3.11 per share, respectively.
During 2006 the Company made two stock option grants to employees, with one on January 5, 2006, and the other on May 18, 2006. Both of these grants were made to employees under the 2004 plan and the Company's policy is to issue new shares upon the exercise of stock options.
Summaries of stock options outstanding and changes during 2006 are presented below.
Weighted Weighted Average Average Remaining Number Exercise Contractua Aggregate of Price Per l Term Intrinsic Shares Share (in Years) Value ----------------------------------------------------------------------------- Balance, January 1, 2004 1,625 $2.82 Granted 632 $4.66 Forfeited (204) $4.95 Exercised (231) $1.62 ----------------------------------------------------------------------------- Balance, December 31, 2004 1,822 $3.38 Granted 226 $3.95 Forfeited (192) $4.31 Exercised (42) $1.98 ----------------------------------------------------------------------------- Balance, December 31, 2005 1,814 $3.39 Granted 55 $3.92 Forfeited (100) $4.69 Exercised (68) $2.40 ----------------------------------------------------------------------------- Balance, December 31, 2006 1,701 $3.37 5.4 $(884,500)
Vested and expected to vest in the future, December 31, 2006 1,701 $3.37 5.4 $(884,500) -----------------------------------------------------------------------------
Exercisable, December 31, 2006 1,649 $3.35 5.1 $(824,500) -----------------------------------------------------------------------------
Exercisable, December 31, 2005 1,814 $3.39 -----------------------------------------------------------------------------
Exercisable, December 31, 2004 1,440 $3.13 -----------------------------------------------------------------------------
The aggregate intrinsic value in the table above represents the total pre- tax intrinsic value, based on the Company's closing common stock price of $2.85 on December 31, 2006, which would have been received by the option holders had all option holders exercised their options on that date. The weighted average grant-date fair values of options granted during 2006, 2005 and 2004 were $2.24, $2.22 and $3.11 per share, respectively. The total intrinsic value of options exercised during 2006 was $119,000, based on the differences in market prices on the dates of exercise and the option exercise prices.
The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model ("Black-Scholes model") that uses the assumptions noted in the following table. Expected volatilities are based on historical volatility of the Company's common stock and other factors. The expected term of options granted is based on analyses of historical employee termination rates and option exercises. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant.
Assumptions used in the Black-Scholes model for options granted during 2006, 2005 and 2004 were as follows:
2006 2005 2004 ------ ------ ------ Expected volatility 61.9% 61.9% 79.2% Average expected term in years 5.0 5.0 5.0 Risk-free interest rate (zero coupon 5.1% 4.35% 3.51% U.S. Treasury Note) Expected dividend yield 0% 0% 0%
The following table summarizes information concerning outstanding and exercisable stock options as of December 31, 2006:
Options Outstanding Options Exercisable -------------------------------- ----------------------- Weighted Average Weighted Weighted Range of Number Remaining Average Average Exercise Out- Contractual Exercise Number Exercise Prices standing Life in Years Price Exercisable Price ---------------------------------------------------------------------------- $ 7.50 - $ 7.50 25 0.01 $7.50 25 $7.50 $ 5.30 - $ 3.85 968 6.27 $4.51 916 $4.55 $ 2.50 - $ 1.75 341 2.80 $2.06 341 $2.06 $ 1.50 - $ 1.05 367 4.32 $1.29 367 $1.29 ----- ----- 1,701 5.35 $3.37 1,649 $3.35 ===== =====
STOCK WARRANTS. From time to time, the Company has granted warrants to purchase common stock to the Company's research consultants and other persons rendering services to the Company. The exercise price of such warrants was normally the market price or in excess of the market price of the common stock at date of issuance.
On November 18, 2005, the Company sold $5,000,000 aggregate principal amount of 6.0% subordinated notes. In connection with the sale of the notes, the purchasers of the notes received (i) Series A Common Stock Purchase Warrants to purchase an aggregate of 2,500,000 shares of the Company's common stock, par value $.01 per share, and (ii) Series B Common Stock Purchase Warrants to purchase an aggregate of 2,500,000 shares of the Company's common stock. The 5,000,000 warrants have a fair value of $4.8 million, as determined by an independent appraisal, and an allocated value of $2.7 million, which was recorded as a debt discount. In addition, the placement agent involved in the offering of the notes and warrants received a Series A Warrant to purchase 200,000 shares of the Company's common stock, with a fair value of $248,000. All of the Series A Warrants have an exercise price of $5.00 per share, are immediately exercisable and expire, subject to certain acceleration events relating to the closing stock price, on November 18, 2009. All of the Series B Warrants have an exercise price of $10.00 per share, are immediately exercisable and expire on November 18, 2009.
On December 20, 2005, the Company entered into a settlement agreement with Swiss-American and G. Scott Vogel to resolve all claims related to a lawsuit filed by Swiss-American in June 2001. The settlement agreement provides for, among other things, the issuance to Swiss-American of a Series C Common Stock Purchase Warrant to purchase a total of 200,000 shares of the Company's common stock, with a fair value of $248,000, and with an exercise price per share equal to $5.00 and which expires, subject to certain acceleration events relating to the closing stock price, on November 18, 2009.
COMMON STOCK RESERVED. At December 31, 2006, the Company had reserved a total of 7,454,779 common shares for future issuance relating to the employee stock purchase plan, stock option plan and warrants.
NOTE NINE. COMMITMENTS AND CONTINGENCIES
On August 26, 2005, the Company issued a voluntary recall of Medline-labeled alcohol-free mouthwash. As a result of this recall, Medline initiated a voluntary recall of Personal Hygiene Admission kits containing the same alcohol-free mouthwash. The mouthwash, which passed industry standard testing at the time of release, was recalled due to the possibility that it may contain Burkholderia cepacia. The Company continues to coordinate with the FDA and the Texas Department of Health in its recall efforts and in the investigation of this matter. The Company has accrued at December 31, 2006, $415,000 as a reserve for costs incurred related to this product recall.
On January 11, 2006, a lawsuit was filed in Circuit Court of Etowah County, Alabama styled as Sonya Branch and Eric Branch vs. Carrington Laboratories, Inc., Medline Industries, Inc., and Gadsden Regional Medical Center. Plaintiffs alleged they were damaged by the mouthwash product. The amounts of damages were not specified.
On April 25, 2006, a lawsuit was filed in Circuit Court for Davidson County, Tennessee styled as Ralph Spraggins, as Administrator of the Estate of Yvonne Spraggins vs. Southern Hills Medical Center, Tristar Health System, HCA Inc., HCA Health Services of Tennessee, Inc., HCA Hospital Corporation of America, Medline Industries, Inc., and Carrington Laboratories, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking $2.0 million in compensatory damages. The case was dismissed without prejudice on January 11, 2007.
On August 28, 2006, a lawsuit was filed in United States District Court for the Western District of Oklahoma styled as Ruth Ann Jones, as Personal Representative of the Estate of Harold Dean Jones, Deceased, Mary Adams and Vera Anderson vs. Carrington Laboratories, Inc. and Medline Industries, Inc. Plaintiffs alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and were seeking an amount in excess of $75,000 in damages. The case was dismissed without prejudice on January 15, 2007.
On September 14, 2006, a lawsuit was filed in United States District Court for the Northern District of Illinois styled as Mutsumi Underwood, as Personal Administrator of the Estate of Ronald W. Underwood vs. Medline Industries, Inc. and Carrington Laboratories, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking an amount in excess of $75,000 in damages.
On September 22, 2006, a lawsuit was filed in Circuit Court for Macon County, Tennessee styled as Donna Green, Lois Bean, KHI Williams and David Long vs. Carrington Laboratories, Inc. and Medline Industries, Inc. Plaintiffs have alleged they were damaged by the Company's Medline-labeled alcohol-free mouthwash product and are seeking $800,000 in compensatory and exemplary damages.
On November 2, 2006, a lawsuit was filed in Circuit Court of Etowah County, Alabama styled as Myra Maddox, vs. OHG of Gadsden, Inc., d/b/a Gadsden Regional Medical Center; Medline Industries, Inc.; Carrington Laboratories, Inc.; Fictitious Defendants "1-15". Plaintiffs have alleged they were damaged by the mouthwash product. The amounts of the damages have not been specified.
The Company has $10.0 million of product liability insurance. The Company and its insurance carrier intend to defend against each of these claims.
On February 1, 2007, a lawsuit styled Glamourpuss, Inc. v. Carrington Laboratories, Inc., was filed in Dallas County, Texas. Plaintiffs have alleged they have been injured as a result of acts and omissions of Carrington in violation of the Texas Deceptive Trade Practices Act ("DTPA"). Plaintiffs are seeking $200,000 in damages plus attorney's fees and expenses.
The Company believes that Plaintiffs' claims are without merit and intends to vigorously defend against the claim.
On December 23, 2005, the Company completed a sale and leaseback transaction involving its corporate headquarters and manufacturing operations located in Irving, Texas to the Busby Family Trust and the Juice Trust, both of which are assignees of the original purchaser, none of which are related to the Company. The building and land were sold for a total sale price of $4.8 million. Net proceeds from the transaction amounted to $4.1 million, after deducting transaction-related costs and retiring the mortgage note related to the property. The Company recorded a gain on the transaction of approximately $30,000, which is being amortized over the term of the lease described below. Simultaneously, the Company agreed to lease the land and building from the purchaser for a period of 15 years, subject to two five- year renewal options. The rental payment for the first five years of the lease term is $470,000 per year and increases by 10.4% for each of the next two five-year increments. Rent for the renewal terms under this lease agreement will be the greater of 95% of the then current market rent or the rent for the last year prior to renewal. The Company has accounted for this lease as an operating lease.
The Company conducts a significant portion of its operations from four office/ warehouse/distribution/laboratory facilities under operating leases. In addition, the Company leases certain office equipment under operating leases and certain manufacturing and transportation equipment under capital leases. Future minimum lease payments under noncancelable operating leases and the present value of future minimum capital lease payments as of December 31, 2006 were as follows, in thousands:
Capital Operating Leases Leases --------------------------------------------------------------------- 2007 $ 110 $ 1,394 2008 71 1,168 2009 38 1,081 2010 5 1,106 2011 0 791 Thereafter 0 4,941 --------------------------------------------------------------------- Total minimum lease payments $ 224 $10,481 ====== Amounts representing interest (21) ----- Present value of capital lease obligations 203 Less current portion of capital lease obligations (96) ----- Obligations under capital lease agreements, excluding the current portion $ 107 =====
Total rental expense under operating leases was $1,544,000, $1,035,000, and $881,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
From time to time in the normal course of business, the Company is a party to various matters involving claims or possible litigation. Management believes the ultimate resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations.
The Company has outstanding a letter of credit in the amount of $250,000 which is used as security on the lease for the Company's laboratory and warehouse facility. The Company has outstanding a letter of credit in the amount of $100,000 which is used as security on the lease for the Company's corporate headquarters and manufacturing facility.
NOTE TEN. INCOME TAXES
The tax effects of temporary differences that gave rise to deferred tax assets at December 31, 2006, 2005 and 2004 were as follows, in thousands:
2006 2005 2004 ---------------------------------------------------------------------------- Net operating loss carryforward $ 13,829 $ 11,488 $ 9,274 Research and development and other credits 174 185 343 Property, plant and equipment 160 18 210 Inventory 344 317 341 Foreign tax credits 144 144 125 Other, net 53 52 55 Bad debt reserve 247 255 198 Deferred income 290 449 827 ACI Stock Valuation 204 204 204 Accrued liability 27 4 16 Less - Valuation allowance (15,472) (13,116) (11,593) ------ ------ ------ $ 0 $ 0 $ 0 ====== ====== ======
The Company has provided a valuation allowance against the entire net deferred tax asset at December 31, 2006, 2005 and 2004 due to the uncertainty as to the realization of the asset.
The Company incurred $0, $19,000, and $125,000 of foreign income tax expense related to the Company's operations in Costa Rica in 2006, 2005 and 2004, respectively.
The provision (benefit) for income taxes varies from the federal statutory rate as follows (in thousands):
2006 2005 2004 ------ ------ ------ Taxes (benefit) at federal statutory rate $(2,586) $(1,814) $ 55 Permanent differences 13 14 13 Unbenefitted foreign income taxes - 19 125 Unbenefitted foreign losses 151 252 - Prior year adjustments 55 (114) - Expired and unbenefitted net operating loss carryforwards - - (5,575) Expired research and development 11 158 (42) Other - (19) 82 Change in valuation allowance credits 2,356 1,523 5,467 ------ ------ ------ Total tax provision $ 0 $ 19 $ 125 ====== ====== ======
At December 31, 2006, the Company had net operating loss carryforwards of approximately $40.7 million for federal income tax purposes, which begin to expire in 2009, and research and development tax credit carryforwards of approximately $174,000, which began to expire in 2006, all of which are available to offset federal income taxes due in future periods. All net operating loss carryforwards will expire between the year 2009 and the year 2025.
NOTE ELEVEN. CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of trade accounts receivable. The Company's customers are not concentrated in any specific geographic region but are concentrated in the health care industry. Significant sales were made to four customers. Sales to Natural Alternatives International, Inc., ("Natural Alternatives"), a customer in the Consumer Services Division, accounted for 14%, 27%, and 45% of the Company's net sales in 2006, 2005 and 2004, respectively. Accounts receivable from Natural Alternatives represented 0% and 10% of gross accounts receivable at December 31, 2006 and 2005, respectively. Sales to Wormser Corporation, ("Wormser"), a customer in the Consumer Services Division, accounted for 10%, 0% and 0% of the Company's net sales in 2006, 2005 and 2004, respectively. Accounts receivable from Wormser represented 12% and 0% of gross accounts receivable at December 31, 2006 and 2005, respectively. Sales to Mannatech, Inc., ("Mannatech"), a customer in the Consumer Services Division, accounted for 10%, 7% and 2% of the Company's net sales in 2006, 2005 and 2004, respectively. Accounts receivable from Mannatech represented 26% and 21% of gross accounts receivable at December 31, 2006 and 2005, respectively. Sales to Medline Industries, Inc., ("Medline") a customer in the Medical Services Division, accounted for 26%, 27% and 23% of the Company's sales during 2006, 2005 and 2004, respectively. Accounts receivable from Medline represented 38% and 32% of the Company's gross accounts receivable at December 31, 2006 and 2005, respectively. The Company performs initial and ongoing credit evaluations of new and existing customers' financial condition and establishes an allowance for doubtful accounts based on factors surrounding the credit risk of specific customers and historical trends and other information.
Accounts are considered past due after contractual terms (net 30 days) and are written-off after extensive collection efforts and nine months time. The following table summarizes the allowance for doubtful accounts activity for the period ended December 31, 2006 and 2005, in thousands.
Balance at Beginning Charges to Balance at End of Period Expenses Deductions of Period --------------------------------------------------------------------------- A/R Reserve-2006 $329 $179 $202 $306 A/R Reserve-2005 $162 $243 $ 76 $329
NOTE TWELVE. NET INCOME (LOSS) PER SHARE
The Company calculates basic earnings (loss) per share by dividing net earnings (loss) by the weighted average number of shares outstanding. Diluted earnings (loss) per share reflect the impact of outstanding stock options and warrants during the periods presented using the treasury stock method. The following table provides a reconciliation of the denominators utilized in the calculation of basic and diluted earnings (loss) per share with the amounts rounded to the nearest thousands, except per share amounts:
2006 2005 2004 ------ ------ ------ Net income (loss) $(7,607) $(5,336) $ 36 Basic earnings (loss) per share: Weighted average number of common shares outstanding 10,855 10,762 10,590 Basic per share amount $ (0.70) $ (0.50) $ 0.00 ====== ====== ====== Diluted earnings (loss) per share: Weighted average number of common shares outstanding 10,855 10,762 10,590 Dilutive effect of stock options and warrants 0 0 581
Diluted weighted average number of common shares outstanding 10,885 10,762 11,171 Diluted per share amount $ (0.70) $ (0.50) $ 0.00 ====== ====== ======
At December 31, 2006, all of the Company's 1,700,586 common stock options and 5,400,000 warrants were excluded from its diluted earnings per share calculation as their effect was antidilutive due to the Company's net loss for the year.
At December 31, 2005, all of the Company's 1,814,081 common stock options and 5,400,000 warrants were excluded from its diluted earnings per share calculation as their effect was antidilutive due to the Company's net loss for the year.
At December 31, 2004, 691,787 common stock options were excluded from the diluted earnings per share calculation using a weight-average close price of $4.34 per share, as their effect was antidilutive.
NOTE THIRTEEN. REPORTABLE SEGMENTS
Based on the economic characteristics of the Company's business activities, the nature of its products, customers and markets it serves, and the performance evaluation by management and the Company's Board of Directors, the Company has identified three reportable segments: Medical Services Division, Consumer Services Division and DelSite.
The Medical Services Division sells a comprehensive line of wound and skin care medical products and provides manufacturing services to customers in medical products markets. These products are primarily sold through a domestic, sole source distributor, where the products are ultimately marketed to hospitals, nursing homes, alternative care facilities, cancer centers, home health care providers and managed care organizations. International sales of these products account for less than 10% of the Division's consolidated net sales for the years ended December 31, 2006, 2005, and 2004.
The Consumer Services Division sells and licenses consumer products and bulk raw materials that utilize the Company's patented complex carbohydrate technology into the consumer health and beauty care products markets. The Division also sells finished products, provides product development and manufacturing services to customers in the cosmetic and nutraceutical markets. These products are primarily sold domestically, with international sales accounting for less than 10% of the Division's consolidated net sales for the years ended December 31, 2006, 2005, and 2004.
DelSite is a research and development subsidiary responsible for the research, development and marketing of the Company's proprietary GelSite[R] technology for controlled release and delivery of bioactive pharmaceutical ingredients. Revenues for DelSite currently consist of research grant awards.
Prior to January 1, 2004, the Company reported its results in two segments: Medical Services Division and Caraloe, Inc. The Caraloe activities have been renamed the Consumer Services Division. In addition, due to the growing significance of DelSite's operations, in 2004 the Company began reporting DelSite as a separate segment. DelSite was previously reported as part of the corporate operations category.
The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes.
Net revenues represent revenues from external customers. Assets which are used in more than one segment are reported in the segment where the predominant use occurs. Total cash for the Company is included in the Corporate Assets figure. The accounting policies for segments are the same as described in Note Two.
The segment data for the years ended December 31, 2006, 2005 and 2004 were as follows:
2006 2005 2004 ------ ------ ------ Net revenues: Medical Services Division $ 8,834 $10,543 $10,391 Consumer Services Division 16,583 15,794 19,663 DelSite 1,989 1,624 767 ------ ------ ------ $27,406 $27,961 $30,821 ====== ====== ====== Income (loss) before income taxes Medical Services Division $(3,821) $(2,673) $(1,861) Consumer Services Division (365) 706 5,081 DelSite (3,421) (3,350) (3,059) ------ ------ ------ $(7,607) $(5,317) $ 161 ====== ====== ====== Identifiable assets: Medical Services Division $ 4,739 $ 4,487 $ 6,094 Consumer Services Division 6,400 8,636 12,129 DelSite 1,251 1,428 1,978 Corporate 1,608 7,438 2,816 ------ ------ ------ $13,998 $21,989 $23,017 ====== ====== ====== Capital expenditures: Medical Services Division $ 89 $ 0 $ 0 Consumer Services Division 154 419 278 DelSite 140 191 1,894 ------ ------ ------ $ 383 $ 610 $ 2,172 ====== ====== ====== Depreciation and amortization: Medical Services Division $ 234 $ 197 $ 244 Consumer Services Division 638 595 711 DelSite 485 446 286 ------ ------ ------ $ 1,357 $ 1,238 $ 1,241 ====== ====== ======
NOTE FOURTEEN. RELATED PARTY TRANSACTIONS
At December 31, 2006, the Company had a 21.5% interest in a company which was formed in 1998 to acquire and develop a 5,000-acre tract of land in Costa Rica to be used for the production of Aloe vera L. leaves, the Company's primary raw material. The Company's initial investment was written off in 1998 and no additional investments have been made or are expected to be made. The Company has no influence on the business or operating decisions of this company and receives no timely financial information. Additionally, $9,000 and $132,675 were collected in 2006 and 2005, respectively, from this company against the fully reserved note receivable balances. The Company is accounting for its investment on the cost basis. The Company purchases Aloe vera L. leaves from this company at prices the Company believes are competitive with other sources. Such purchases totaled $127,000, $888,000 and $1,447,000 in 2006, 2005, and 2004, respectively.
On November 18, 2005, the Company sold $5,000,000 aggregate principal amount of 6.0% subordinated notes. The notes have a term of four years and mature on November 18, 2009. Interest on the notes is payable quarterly in arrears. In connection with the sale of the notes, the purchasers of the notes received (i) Series A Common Stock Purchase Warrants to purchase an aggregate of 2,500,000 shares of the Company's common stock, par value $.01 per share, and (ii) Series B Common Stock Purchase Warrants to purchase an aggregate of 2,500,000 shares of the Company's common stock. In addition, the placement agent involved in the offering of the notes and warrants received a Series A Warrant to purchase 200,000 shares of the Company's common stock. All of the Series A Warrants have an exercise price of $5.00 per share, are immediately exercisable and expire, subject to certain acceleration events relating to the closing stock price, on November 18, 2009. All of the Series B Warrants have an exercise price of $10.00 per share, are immediately exercisable and expire on November 18, 2009. The majority of the purchasers of the notes were existing shareholders of the Company's common stock. On November 18, 2005, immediately preceding the transaction, the largest individual investor held 6.3% of the Company's outstanding shares and collectively the group held 16.4%.
NOTE FIFTEEN. DEFERRED REVENUE
Pursuant to the Distributor and License Agreement with Medline, as amended on April 9, 2004, the Company received, subject to certain refund rights more specifically described in the Amendment, an additional $1.25 million of royalties, paid upon the signing of the Amendment, in consideration of the extended term of the Distributor and License Agreement. The Company continues to recognize royalty income under this agreement, as amended, on a straight-line basis. At December 31, 2006, the Company had received $799,000 more in royalties than it had recognized in income, which is included in deferred revenue on the balance sheet.
NOTE SIXTEEN. UNAUDITED SELECTED QUARTERLY FINANCIAL DATA
The unaudited selected quarterly financial data below reflect the years ended December 31, 2006 and 2005, respectively.
(Amounts in thousands, except per share amounts) --------------------------------------------------------------------------- 2006 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter --------------------------------------------------------------------------- Net revenue $7,487 $6,524 $6,656 $6,739 Cost of product sales 5,600 5,043 4,615 5,328 Net income (loss) (1,532) (2,155) (1,764) (2,156) Basic and diluted income (loss) per share $(0.14) $(0.20) $(0.16) $(0.20)
--------------------------------------------------------------------------- 2005 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter --------------------------------------------------------------------------- Net revenue $8,182 $8,337 $5,633 $5,809 Cost of product sales 4,872 4,718 4,056 4,935 Net income (loss) (80) 87 (1,574) (3,769) Basic and diluted income (loss) per share $(0.01) $ 0.01 $(0.15) $ (0.35)
NOTE SEVENTEEN. SUPPLY CONCENTRATION
Commodities or components used in the Company's production processes that can only be obtained from a single supplier could potentially expose the Company to risk of production interruption should the supplier be unable to deliver the necessary materials in a timely manner. The Company utilizes alcohol as a key part of its production process in Costa Rica. The Company engages the services of an alcohol refinery company, located adjacent to its facility, to repurify the alcohol used in its production utilizing a distillation process. The purified alcohol is then returned to the Company's inventory for further use. The Company is unaware of any other providers of this service in Costa Rica. Senior managers from the Company's Costa Rica operations meet regularly with owners and managers of the refinery company to discuss operational issues.
NOTE EIGHTEEN. EMPLOYEE BENEFIT PLANS
The Company has a 401(k) Plan to provide eligible employees with a retirement savings plan. All employees are eligible to participate in the plan if they are age 21 years or older. Company matching contributions are made dollar for dollar up to 3% of pay and 50% for contributions greater than 3% of pay but not in excess of 5% of pay. The Company may make discretionary contributions upon direction of the Board of Directors. The Company's contribution expense for the years ended December 31, 2006, 2005 and 2004 was approximately $143,000, $138,000 and $129,000, respectively.
NOTE NINETEEN. SUBSEQUENT EVENTS
On January 25, 2007, the Company and Mannatech entered into a three-year Supply and Trademark License Agreement. Under the non-exclusive agreement, the Company will supply the trademarked ingredient Manapol[R] powder to Mannatech for a period of up to three years with minimum purchase quantities at fixed price levels for the first twenty-four months. Quantities for the final twelve months of the agreement are to be negotiated 90 days prior to the expiration of the twenty-fourth month.
On February 12, 2007, Sabila Industrial, S.A., a wholly-owned subsidiary of the Company, entered into a revolving credit facility with Banco Nacional de Costa Rica for $2,990,000, which matures in February 2010. Borrowings under the facility bear interest at 6-month LIBOR plus a margin of 3.0%, with a minimum rate of 6%; are secured by land and buildings owned by Sabila, and are guaranteed by a principal executive officer of the Company.
The loan agreement contains customary representations, warranties and covenants. Under the terms of the agreement, Sabila may borrow amounts at its discretion, with each advance under the credit facility considered a separate loan with a six-month maturity date. Borrowings under the facility must be reduced to zero for a minimum of two consecutive weeks in each 52 week period during the term of the facility.
On February 13, 2007, Sabila borrowed $1,500,000 under the facility. Borrowings under the facility will be used for the general corporate purposes of Sabila and its affiliates, but loans under the facility are non- recourse to the Company.
Financial Statement Schedule Valuation and Qualifying Accounts (In thousands)
Description Additions ---------------- Balance Charged Charged at to to Balance Beginning Cost and Other at End of Period Expenses Accounts Deductions of Period --------------------------------------------------------------------------- --------------------------------------------------------------------------- Bad debt reserve $ 329 $ 179 $ - $ 202 $ 306 Inventory reserve 791 473 - 361 903 Reserve Aloe & Herbs non-current notes and investments included in other assets 2 7 - 9 - Reserve for returns 35 - - - 35 --------------------------------------------------------------------------- --------------------------------------------------------------------------- Bad debt reserve $ 162 $ 243 $ - $ 76 $ 329 Inventory reserve 819 318 - 346 791 Reserve Aloe & Herbs non-current notes and investments included in other assets 135 - - 133 2 Reserve for returns 35 - - - 35 --------------------------------------------------------------------------- --------------------------------------------------------------------------- Bad debt reserve $ 181 $ 48 $ - $ 67 $ 162 Inventory reserve 735 205 - 121 819 Reserve Aloe & Herbs non-current notes and investments included in other assets 227 - - 92 135 Reserve for returns 35 - - - 35
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors Carrington Laboratories, Inc.
We have audited the accompanying consolidated balance sheet of Carrington Laboratories, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, shareholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Carrington Laboratories, Inc. and subsidiaries as of December 31, 2006, and the consolidated results of their operations and their consolidated cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note One to the consolidated financial statements, the Company has reported significant losses from operations and requires additional financing to fund future operations. These conditions raise substantial doubt about its ability to continue as a going concern. Management's plans regarding those matters also are described in Note One. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Our audit was conducted for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The related financial statement Schedule II is presented for purposes of additional analysis and is not a required part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole.
/s/ WEAVER AND TIDWELL, L.L.P.
Dallas, Texas April 2, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Shareholders and Board of Directors Carrington Laboratories, Inc.
We have audited the accompanying consolidated balance sheet of Carrington Laboratories, Inc. and subsidiaries as of December 31, 2005, and the related consolidated statements of operations, shareholders' equity and cash flows for the periods ended December 31, 2005 and 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financia l statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Carrington Laboratories, Inc. and subsidiaries as of December 31, 2005, and the consolidated results of their operations and their consolidated cash flows for the periods ended December 31, 2005 and 2004, in conformity with accounting principles generally accepted in the United States of America.
Our audit was conducted for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The related financial statement Schedule II is presented for purposes of additional analysis and is not a required part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole.
/s/ Grant Thornton LLP
Dallas, Texas March 1, 2006
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Carrington Laboratories, Inc.
Date: April 2, 2007 By: /s/ Carlton E. Turner, Ph.D., D.Sc. ---------------------------------------- Carlton E. Turner, President, Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
/s/ Carlton E. Turner President, Chief Executive April 2, 2007 ------------------------- Officer and Director Carlton E. Turner, Ph.D. (principal executive officer) D.Sc.
/s/ Robert W. Schnitzius Vice President and Chief April 2, 2007 ------------------------- Financial Officer Robert W. Schnitzius (principal financial and accounting officer)
/s/ Ronald R. Blanck Director April 2, 2007 ------------------------- Ronald R. Blanck, D.O.
/s/ R. Dale Bowerman Director April 2, 2007 ------------------------- R. Dale Bowerman
/s/ George DeMott Director April 2, 2007 ------------------------- George DeMott
/s/ Thomas J. Marquez Director April 2, 2007 ------------------------- Thomas J. Marquez
/s/ Edwin Meese, III Director April 2, 2007 ------------------------- Edwin Meese, III
/s/ Selvi Vescovi Director April 2, 2007 Selvi Vescovi
INDEX TO EXHIBITS -----------------
Sequentially Exhibit Numbered Number Exhibit Page ------ --------------------------------------------------- ---- 3.1 Restated Articles of Incorporation of Carrington Laboratories, Inc. (incorporated by reference to Exhibit 3.1 to Carrington's 1999 Annual Report on Form 10-K).
3.2 Statement of Change of Registered Office and Registered Agent of Carrington Laboratories, Inc. (incorporated by reference to Exhibit 3.2 to Carrington's 1999 Annual Report on Form 10-K).
3.3 Statement of Resolution Establishing Series D Preferred Stock of Carrington Laboratories, Inc. (incorporated by reference to Exhibit 3.3 to Carrington's 1999 Annual Report on Form 10-K).
3.4 Bylaws of Carrington Laboratories, Inc., as amended through March 3, 1998 (incorporated herein by reference to Exhibit 3.8 to Carrington's 1997 Annual Report on Form 10-K).
4.1 * Form of certificate for Common Stock of Carrington Laboratories, Inc
4.2 Rights Agreement dated as of September 19, 1991 between Carrington Laboratories, Inc. and Ameritrust Company National Association (incorporated by reference to Exhibit 4.2 to Carrington's 1999 Annual Report on Form 10-K).
4.3 Amended and Restated Rights Agreement dated October 15, 2001, between Carrington Laboratories, Inc. and American Stock Transfer & Trust Company, as successor Rights Agent (incorporated by reference to Exhibit 4.1 to the Company's Form 8-A/A Post-Effective Amendment No. 2).
4.4 Amendment No. 1 to the Amended and Restated Rights Agreement, dated effective as of December 17, 2003, between Carrington Laboratories, Inc. and American Stock Transfer & Trust Company, as Rights Agent (incorporated by reference to Exhibit 4.2 to the Company's Form 8-A/A Post- Effective Amendment No. 3).
4.5 Form of 6% Subordinated Promissory Note due November 18, 2009 dated November 18, 2005 between Carrington and several investors (incorporated by reference to Exhibit 4.1 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
4.6 Form of Series A Common Stock Purchase Warrant dated November 18, 2005 between Carrington Laboratories, Inc. and several investors (incorporated by reference to Exhibit 4.2 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
4.7 Form of Series B Common Stock Purchase Warrant dated November 18, 2005 between Carrington Laboratories, Inc. and several investors (incorporated by reference to Exhibit 4.3 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
4.8 6% Subordinated Promissory Note due December 20, 2009 dated December 20, 2005 between Carrington and Swiss American Products, Inc. (incorporated by reference to Exhibit 4.1 to Carrington's Form 8-K as filed with the SEC on December 22, 2005).
4.9 Form of Series C Common Stock Purchase Warrant dated November 22, 2005 between Carrington and Swiss American Products, Inc. (incorporated by reference to Exhibit 4.2 to Carrington's Form 8-K as filed with the SEC on December 22, 2005).
10.1 + Employee Stock Purchase Plan of Carrington Laboratories, Inc., as amended through June 15, 1995 (incorporated by reference to Exhibit 10.9 to Carrington's 1999 Annual Report on Form 10-K).
10.2 Non-exclusive Sales and Distribution Agreement dated August 22, 1995 between Innovative Technologies Limited and Carrington Laboratories, Inc. (incorporated herein by reference to Exhibit 10.6 to Carrington's Third Quarter 1995 Report on Form 10-Q).
10.3 Supplemental Agreement dated October 16, 1995 to Non-exclusive Sales and Distribution Agreement between Innovative Technologies Limited and Carrington Laboratories, Inc.(incorporated herein by reference to Exhibit 10.7 to Carrington's Third Quarter 1995 Report on Form 10-Q).
10.4 # Distributor and License Agreement dated November 3, 2000 between Carrington Laboratories, Inc. and Medline Industries, Inc. (incorporated by reference to Exhibit 10.1 to Carrington's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000).
10.5 # Supply Agreement dated November 3, 2000 between Carrington Laboratories, Inc. and Medline Industries, Inc. (incorporated by reference to Exhibit 10.2 to Carrington's Quarterly Report on Form 10-Q for the quarter ended September 30,
10.6 Lease Agreement dated January 22, 2001 between Plazamerica, Inc and Carrington Laboratories, Inc. (incorporated by reference to Exhibit 10.84 to Carrington's 2000 Annual Report on Form 10-K).
10.7 + Employee Stock Purchase Plan of Carrington Laboratories, Inc., as amended through May 17, 2001 (incorporated by reference to Exhibit 10.1 to Carrington's Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).
10.8 + 1995 Stock Option Plan of Carrington Laboratories, Inc., as Amended and Restated Effective January 15, 1998 and further amended through May 17, 2001 (incorporated by reference to Exhibit 10.2 to Carrington's Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).
10.9 Credit Agreement dated as of September 1, 2002, between Carrington Laboratories, Inc. and Comerica Bank.
10.10 Advance Formula Agreement dated as of September 1, 2002, between Carrington Laboratories, Inc., and Comerica Bank, Caraloe, Inc., and DelSite Biotechnologies, Inc.
10.11 Amendment to Distributor and License Agreement and Supply Agreement between Carrington Laboratories, Inc., and Medline Industries, Inc. (incorporated by reference to Exhibit 10.1, filed on Carrington's Form 8-K on April 22, 2004).
10.12 2004 Stock Option Plan of Carrington Laboratories, Inc., (incorporated by reference to Exhibit 4.1 to Carrington's Form S-8 Registration Statement (No. 333-118303) filed with the SEC on August 17, 2004).
10.13 Employee Stock Purchase Plan as amended through May 20, 2004 of Carrington Laboratories Inc. (incorporated by reference to Exhibit 4.1 to Carrington's Form S-8 Registration Statement (No. 333-118304) filed with the SEC on August 17, 2005).
10.14 Certificate of Pledge between Sabila Industrial, S.A., a Costa Rica Corporation and wholly-owned subsidiary of Carrington Laboratories, Inc., and Banco Credito Agricola de Cartago dated August 6, 2004 (incorporated by reference to Exhibit 10.1 to Carrington's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004).
10.15 Amendment dated October 15, 2004 and effective as of July 1, 2004, to Credit agreement and Advanced Formula Agreement dated September 1, 2002, between Carrington Laboratories, Inc., and Comerica Bank, Caraloe, Inc., and DelSite Biotechnologies, Inc. (incorporated by reference to Exhibit 10.1, filed on Carrington's Form 8-K on October 21, 2004).
10.16 Manufacturing Agreement between Sabila Industrial, S.A., a Costa Rica Corporation and wholly-owned subsidiary of Carrington Laboratories, Inc., and Miradent Products of Costa Rica, S.A., dated January 21, 2005 (incorporated by reference to Exhibit 10.34 to Carrington's Form 10-K as filed with the SEC on March 28, 2005).
10.17 One-year extension of the Strategic Collaboration Agreement between Carrington Laboratories, Inc., and Southern Research Institute, dated January 25, 2005 (incorporated by reference to Exhibit 10.1 to Carrington's Form 8-K as filed with the SEC on February 22, 2005).
10.18# Supply Agreement dated June 1, 2005 between MedTrade Products, Ltd., and Carrington Laboratories, Inc., (incorporated by reference to Exhibit 10.1 filed on Carrington's quarterly report on Form 10-Q for the quarter ended June 30, 2005).
10.19 Purchase and Sale Agreement dated October 20, 2005, between Carrington and Rainier Capital Management, L.P. (incorporated by reference to Exhibit 99.3 to Carrington's Form 8-K as filed with the SEC on December 29, 2005).
10.20 Promissory Note and Warrant Purchase Agreement dated November 18, 2005 between Carrington Laboratories, Inc. and several investors (incorporated by reference to Exhibit 10.1 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
10.21 Placement Agent Agreement dated October 7, 2005, between Carrington and Stonewall Securities, Inc. (incorporated by reference to Exhibit 10.2 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
10.22 Amendment to Placement Agent Agreement effective October 7, 2005, between Carrington and Stonewall Securities, Inc. (incorporated by reference to Exhibit 10.3 to Carrington's Form 8-K as filed with the SEC on November 22, 2005).
10.23 Settlement Agreement and Mutual Release of All Claims dated as of December 20, 2005, by and among Swiss American Products, Inc., G. Scott Vogel and Carrington (incorporated by reference to Exhibit 10.1 as filed with SEC on Carrington's Form 8-K on December 22, 2005).
10.24 Master Lease Agreement among the Busby Family Trust and the Juice Trust (Landlords) and Carrington (Tenant) (incorporated by reference to Exhibit 99.2 to Carrington's Form 8-K as filed with the SEC on December 29, 2005).
10.25 First Amendment to Purchase and Sale Agreement dated November 21, 2005 between Carrington and Ranier Capital Management, L.P. (incorporated by reference to Exhibit 99.4 to Carrington's Form 8-K as filed with the SEC on December 29, 2005).
10.26 + Employee Stock Purchase Plan of Carrington Laboratories, Inc., Amendment No. 2 dated December 29, 2005 and effective as of January 1, 2006 (incorporated by reference to Exhibit 10.35 to Carrington's Form 10-K as filed with the SEC on March 31, 2006).
10.27 # Trademark License and Supply Agreement dated January 25, 2007, between Carrington Laboratories, Inc., and Mannatech, Incorporated (incorporated by reference to Exhibit 99.1 to Carrington's Form 8-K as filed with the SEC on January 31, 2007).
10.28 On February 12, 2007, Sabila Industrial, S.A., a wholly-owned subsidiary of Carrington Laboratories, Inc., entered into a revolving credit facility with Banco Nacional de Costa Rica.
16.1 Letter of Grant Thornton LLP dated March 30, 2006, addressed to the Securities and Exchange Commission (incorporated by reference to Exhibit 16.1 to Carrington's Form 8-K as filed with the SEC on March 30, 2006).
21.1 * Subsidiaries of Carrington.
23.1 * Consent of Weaver and Tidwell L.L.P.
23.2 * Consent of Grant Thornton LLP
31.1 * Certification of Chief Executive Officer Required by Rule 13a-14(a)(17 CFR 240.13a-14(a).
31.2 * Certification of Chief Financial Officer Required by Rule 13a-14(a)(17 CFR 240.13a-14(a).
32.1 * Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 * Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Filed herewith. # Application has been made to the Securities and Exchange Commission for confidential treatment of certain provisions of this exhibit. Omitted material for which confidential treatment has been requested has been filed with the Securities and Exchange Commission. + Management contract or compensatory plan.