Item 1. Business
Forward-Looking Statements
This annual report on Form 10-K includes forward-looking statements that describe anticipated results for Span-America Medical Systems, Inc. (the “Company” or “Span-America”). These statements are estimates or forecasts about Span-America and its markets based on our beliefs, assumptions and expectations. These forward-looking statements therefore involve numerous risks and uncertainties. We wish to caution the reader that these forward-looking statements, such as, but not limited to, our expectations for future sales or future expenses, are only predictions. Actual events or results may differ materially as a result of risks and uncertainties in our business. Such risks include but are not limited to the “Risk Factors” listed in Item 1A
Item 1A. Risk Factors
The Secure I.V. product line has limited sales history and market exposure and therefore involves greater risks and uncertainties than our more established product lines. We completed design and development of the Secure I.V. safety catheter in late fiscal 2005 and immediately began sales and marketing efforts for this new product line. The product line has been available to the market through select distributors for approximately one year with limited success. At this early stage in the product’s life cycle, we cannot accurately predict the degree of future success that Secure I.V. might achieve in the marketplace. Although our product has a unique design that to our knowledge is not available elsewhere in the market, we are competing against larger companies with more experience in the safety catheter market, well-established distribution channels and greater resources than Span-America. Consequently, it could take a significant amount of time and additional investment for Secure I.V. sales and earnings to have a meaningful impact on our operating results. We cannot offer assurance that Secure I.V. sales will become meaningful or that the safety catheter segment will become profitable. If the safety catheter segment does not become profitable, the assets related to this segment could become impaired. See “Impairment of Long-Lived Assets” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 17 in the Notes to Financial Statements for more information on the safety catheter segment.
We currently have a sole source contract manufacturer for the Secure I.V. product line. The Secure I.V. product line is presently being manufactured for Span-America by a single unaffiliated company that specializes in contract manufacturing operations. Having a sole-source manufacturer for the Secure I.V. product line creates additional risks for the safety catheter segment that we do not have in our other segments. Since the products are manufactured by an unaffiliated company, we have somewhat less control over product costs, manufacturing efficiency and quality than we do for products manufactured directly by us. These risks are mitigated by the terms of our agreement with our supplier and by procedures put in place to ensure that the products meet necessary quality standards. Our agreement with the contract manufacturer expires in September 2007 but may be terminated by either party with 90 days notice under certain conditions as specified in the agreement. Our source of supply is also subject to risks related to the contract manufacturer, including management or strategic changes and property and casualty risks for an off-site location. If we were required to move our production equipment to another location, it could cause a delay in supplying our products to the market and additional expenses for moving, set-up and re-validation of the production line.
The loss of a key distributor or customer in the Company’s medical or custom products segments could cause a rapid and significant sales decline, which would likely result in a decline in earnings. Many of our medical products are sold through large national distributors in the United States and Canada. We do not maintain long-term distribution agreements with most of these distributors. Instead, we supply them based on purchase orders that are issued by the customers on a daily or weekly basis. These supplier-customer relationships can generally be ended by either party with minimal notice. Consequently, if a large customer or distributor decided to discontinue purchasing our products, our sales and earnings could quickly decline. Our largest customers in the medical segment are PSS World Medical and Hill-Rom. In addition, all of our consumer foam products are sold through our exclusive distributor, Louisville Bedding Company, under a marketing and distribution agreement that expires in December 2006. The agreement automatically renews for successive three-year terms unless either party provides notice of their intent not to renew at least 60 days prior to the expiration date. Neither party has given notice of non-renewal. Both parties are currently negotiating non-material amendments to the agreement, which have not been finalized. For more information on major customers and information on our business segments, see the discussion under “Major Customers” on page 9 and Notes 16 and 17 in the Notes to Financial Statements, Item 1. “Business - Industry Segment Data - Medical - Distributor Relationships” and Item 1. “Business - Industry Segment Data - Custom Products.”
Our earnings could be negatively affected by raw material cost increases that we are unable to recover through sales price increases or expense reductions. The cost of polyurethane foam represented approximately 40% of our total cost of goods sold in fiscal 2006. An increase in foam raw material costs that we are not able to offset could have a significant negative effect on our profitability. Besides polyurethane foam, our other major raw material categories include nylon mattress covers, vinyl bags, vinyl air cylinders, electronic components for mattresses and corrugated cartons. Raw materials are our single largest cost category in the business, representing approximately 72% of our total cost of goods sold in fiscal 2006. Cost increases in these raw materials could have a significant adverse effect on earnings if we are unable to recover the higher costs through sales price increases or other means.
Our sales volume could decline as a result of competition from low-cost foreign imports. Within the last two years, we have experienced increased competition in our medical and custom products segments from low-cost foreign imports. In the medical segment, the number of low-cost, imported mattress products has increased in the last two years, but it has not yet had a significant impact on our medical business. We have potentially greater exposure to low-cost imports in our consumer bedding product lines because those products have more commodity-like characteristics than our medical products and our customers, who are generally national retailers, are more likely to change suppliers to buy lower-cost products. Therefore, we could lose significant parts of our consumer bedding business and certain parts of our medical business if we are unable to compete effectively with low-cost imports.
Our business is subject to the loss of existing sales or slower growth rates due to the impact of competitive products and pricing. All three of our business segments operate in highly competitive market environments. For each of our product lines, there are a number of alternative products in the market with similar features and benefits offered by several competitors, some of whom have greater resources than Span-America.
Our medical business could lose sales volume or could have lower sales growth rates as a result of government reimbursement changes in the medical market. A number of our medical products are eligible for reimbursement by Medicare. We have no direct dealings with Medicare reimbursement, but our customers often submit reimbursement requests to Medicare. For example, we might sell therapeutic mattresses to a home health care dealer who in turn rents our mattresses to patients. Medicare reimburses the dealer for some or all of the patient’s rental cost. If Medicare reimbursement rates are reduced, the demand for our medical products that are covered by Medicare could also be reduced.
Certain of our medical products and all of our Secure I.V. products are classified as medical devices and are regulated by the FDA. These regulations require, among other things, that medical device manufacturers register with the FDA, list devices manufactured by them, and file various types of reports. In addition, our manufacturing facilities and those of our contract manufacturer for the Secure I.V. products are subject to periodic inspections by regulatory authorities and must comply with “good manufacturing practices” as required by the FDA and state regulatory authorities. Although we believe we are in substantial compliance with applicable regulations, the existence of the regulations creates the risk of a product recall and related expenses as well as the risk of additional expenses required to meet the regulatory requirements.
Item 1B.
Item 1B. Unresolved Staff Comments
None
Item 2.
Item 2. Properties
We own our principal office and manufacturing facility which is located in Greenville, South Carolina. This facility contains approximately 188,000 square feet used by the medical and custom products segments and is located on a 13-acre site. This includes a 58,000 square foot plant expansion completed in fiscal 2006. The addition is being used for manufacturing and warehousing purposes.
We lease 15,000 square feet of warehouse space in Salt Lake City, Utah for use as a distribution center for our medical products. The lease rate for the facility is $6,750 per month. The lease expires in August 2008 unless renewed by mutual agreement. Until October 31, 2006 we leased a manufacturing facility in Norwalk, California. The lease expired on October 31, 2006.
We consider the South Carolina and Utah facilities to be suitable and adequate for their intended purposes.
Item 3.
Item 3. Legal Proceedings
From time to time we are a party to various legal actions arising in the normal course of business. We believe that as a result of legal defenses and insurance arrangements with parties believed to be financially capable, there are no proceedings threatened or pending against us that, if determined adversely, would have a material adverse effect on our financial position or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of our 2006 fiscal year.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Repurchases of Equity Securities
The common stock of Span-America Medical Systems, Inc. trades on The NASDAQ Global Market® under the symbol SPAN. As of September 30, 2006, there were 2,660,345 common shares outstanding. As of December 15, 2006, there were 215 shareholders of record and approximately 1,000 beneficial shareholders. The closing price of Span-America's stock on December 15, 2006 was $14.13 per share.
Selected quarterly stock price data is shown on the following table.
The Company has paid a regular quarterly cash dividend since January 1990. In July 2004, the Board increased the quarterly dividend to $0.04 per share from $0.035 per share. In December 2004, the Board declared a special cash dividend of $0.40 per share payable on January 12, 2005 to all shareholders of record on December 22, 2004. In July 2005, the Board increased the quarterly dividend to $0.045 per share from $0.04 per share. In July 2006, the Board increased the quarterly dividend to $0.06 per share from $.045 per share. The Company expects to continue to pay quarterly dividends for the foreseeable future, though the Board may discontinue paying dividends at any time. Future dividend payments will depend upon the Company’s earnings and liquidity position.
Each non-employee Director of the Company receives 1,000 shares of Company common stock per year in lieu of annual cash compensation. As compensation for additional duties, the Chairman of the Board receives an additional 1,000 shares, and the Chairman of the Audit Committee receives an additional 500 shares of Company common stock per year. The following table sets forth information about unregistered shares of common stock issued in fiscal year to our non-employee Directors for their service as Directors.
We did not register the shares issued to non-employee Directors in reliance on the exemption provided by Section 4(2) of the Securities Act of 1933, as amended, which exempts stock issued outside of a public offering from registration requirements.
The information regarding equity compensation plans set forth under Item 12 below is incorporated herein by reference.
Item 6.
Item 6. Selected Financial Data
Selected Financial Data for the Company’s last five fiscal years is shown in the table below.
Five-Year Financial Summary
(Amounts in thousands, except per share and employee data)
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Span-America’s business is divided into three market segments: medical, custom products and safety catheters. In the medical segment, we manufacture and market a comprehensive selection of pressure management products, including Geo-Matt®, PressureGuard®, Geo-Mattress®, Span-Aids®, Isch-Dish®, and Selan® products. In the custom products segment, we manufacture consumer mattress pads and pillows for the retail bedding market and various engineered foam products for the industrial market. Our consumer mattress pads and pillows are marketed by our exclusive distributor, Louisville Bedding Company. The industrial product line is sold directly by Span-America. The safety catheter segment consists of two product lines: the Secure I.V.® short peripheral intravenous catheter and the HuberPro® safety Huber needle infusion set. Secure I.V. is manufactured for Span-America by an unaffiliated contract manufacturer according to our specifications. The HuberPro product line is manufactured by Command Medical Products, Inc. and sold by Span-America under a license agreement. Our revenues, profits and cash flows are derived from the development, manufacture and sale of these products.
RESULTS OF OPERATIONS FISCAL 2006 VS. 2005
Summary
Net sales in fiscal 2006 increased 6% to $51.6 million compared with $48.4 million in fiscal 2005. The sales increase was the result of higher volumes in the medical segment where sales increased 21% to $36.7 million. Sales in the custom products segment fell by 18% to $14.8 million.
Net income rose 25% in fiscal 2006 to a record $3.1 million, or $1.10 per diluted share, compared with $2.4 million, or $0.89 per diluted share, in fiscal 2005. The increase in earnings resulted mainly from higher unit sales in our PressureGuard® line of therapeutic surfaces for the medical segment and a decline in research and development expenses in the safety catheter segment compared with fiscal 2005.
Sales
Sales in our medical segment rose 21% to $36.7 million in fiscal 2006 compared with $30.3 million the previous year. The medical sales growth was led by our proprietary therapeutic support surfaces (or mattresses), sales of which increased by 28% over 2005 levels. We sell these specialty mattresses to hospitals, long-term care facilities and home care dealers throughout the United States and Canada. Our PressureGuard CFT® support surfaces, which are sold primarily in the acute care market, made up about two-thirds of the total growth in the medical segment. Other top performing mattress products included the PressureGuard APM2® alternating pressure mattresses, the PressureGuard Easy Air® low-air-loss mattress and our private label therapeutic surfaces manufactured for Hill-Rom. The APM2 and Easy Air products are sold primarily in the long-term care and home care sections of the medical market. In other medical product lines, Selan® skin care products rose by 11%. Mattress overlay sales were up by 6%. Sales of seating products increased 2%, and sales of patient positioners climbed by 1%. The majority of the sales increases in our positioners, seating and overlay product lines were due to sales price increases that were passed along to customers in response to raw material cost increases we received in the first quarter of fiscal 2006.
Our medical business achieved solid growth in fiscal 2006 primarily because of increased customer demand for our therapeutic support surfaces, particularly in the long-term care market, and the success of our private label support surfaces in the acute care market. Therapeutic support surfaces made up approximately 73% of our total medical sales in fiscal 2006, and are our fastest growing medical product lines. The growth in medical mattress sales could make our total medical sales more volatile from quarter to quarter because mattresses are capital purchase items with longer selling cycles, whereas our other medical products are generally consumable items where repeat orders are common. We expect total medical sales to increase during fiscal 2007, but the rate of growth will likely be slower than that achieved in fiscal 2006.
Our custom products segment consists of consumer bedding products and specialty foam products for the industrial market. Sales in the custom products segment declined 18% during fiscal 2006 to $14.8 million from $18.1 million in fiscal 2005. The entire decline occurred in the consumer portion of the custom products segment, where sales of consumer bedding products were down 29% to $11.2 million. The consumer sales decline was caused primarily by the phase out of our previous line of Geo-Comfort foam overlays sold to Wal-Mart, increased competition from imported and domestic visco foam products and lost business to one customer that was acquired by a larger company. The weakness in consumer sales was the main factor causing the operating loss in the custom products segment during fiscal 2006. To help reverse this trend, we developed a new Fusion™ mattress overlay during the year, which began shipping late in our fourth fiscal quarter. The Fusion pad replaces the Geo-Comfort line and is being sold under Wal-Mart’s HomeTrends brand. We are also selling the Fusion products to other retailers. As a result of the new product introduction and other new programs with our marketing partner Louisville Bedding Company, we expect consumer sales to grow modestly in fiscal 2007.
In the other part of the custom products segment, industrial sales increased by 46% to $3.6 million. The industrial sales increase was primarily attributable to higher demand from existing customers. We believe industrial sales in fiscal 2007 will be slightly higher than those of fiscal 2006.
Sales in the safety catheter segment were $120,000 in fiscal 2006 and consisted of $75,000 in sales of Secure I.V. catheters and $45,000 in sales of the HuberPro infusion sets. Sales of Secure I.V. were $6,000 in fiscal 2005. There were no comparable HuberPro sales in the year-earlier period. Results in the safety catheter business continued to be below our expectations. However, we made progress in the segment and were encouraged by three positive events during fiscal 2006. First, we signed a license agreement in the second quarter that added the HuberPro™ product line to the safety catheter business unit. Our investment in the HuberPro product line is limited to the purchase of inventory, which we will stock and then resell through our distributors. The HuberPro is a safety Huber needle infusion set sold in the alternate site market, mainly to oncology clinics. The addition of the HuberPro line allows us to leverage our distribution and sales efforts that were previously focused only on Secure I.V. Second, in the third quarter we signed an agreement to offer Secure I.V. to Novation, the industry’s leading health care contracting services company. The agreement does not require a purchase commitment, but it should significantly increase the visibility of Secure I.V. within Novation’s network of 2,500 VHA and UHC members. And finally, during the fourth fiscal quarter, we finalized arrangements to sell Secure I.V. through Bound Tree Medical, which serves as our exclusive distributor for Secure I.V. in the emergency medical market.
We expect sales of Secure I.V. and HuberPro to increase in fiscal 2007, but we do not yet have enough market feedback to accurately project growth. We plan to expand our sales and distribution efforts within the safety catheter segment in the coming year, but we do not expect the segment to be profitable in fiscal 2007. We believe, however, that the operating loss for the segment in fiscal 2007 will be less than that of fiscal 2006. Our main focus for this segment in fiscal will be to increase sales volume and market exposure for these two product lines and gain enough customer feedback to evaluate the potential for future success in the safety catheter business.
Gross Profit
Our gross profit level increased by 7% during fiscal 2006 to $15.7 million compared with $14.7 million in fiscal 2005. The gross profit margin percentage remained level at 30.4%. The increase in gross profit level was due to higher sales volumes in the medical segment. The medical segment typically has a higher gross margin than the custom products segment because many of our medical products are patented and proprietary. In addition, higher material costs were also partly offset by lower labor costs due to improved manufacturing efficiencies and lower overtime requirements related to higher inventory levels. We expect the gross margin percentage during fiscal 2007 to be slightly lower than that of fiscal 2006 because of an expected shift in sales mix toward the lower margin custom products segment.
Selling, Research & Development and Administrative Expenses
Selling and marketing expenses increased 7% to $8.2 million, or 15.9% of net sales, in fiscal 2006 compared with $7.7 million, or 15.8% of sales, in fiscal 2005. Most of the increase occurred in the medical segment and was due to higher expenses for commissions and shipping costs related to higher sales volumes. We believe that total selling and marketing expenses for fiscal 2007 will increase over 2006 levels due to planned programs and expected future growth in the medical and safety catheter segments.
Total research and development expenses decreased 44% to $634,000 in fiscal 2006 compared with $1.1 million in fiscal 2005. The entire decrease occurred in the safety catheter segment where R&D expenses dropped by $621,000, or 85%, to $112,000 compared with $733,000 in the prior year. R&D expenses were high in the safety catheter segment during the first three quarters of fiscal 2005 because of design changes being made to Secure I.V. The design changes were completed in the fourth quarter of fiscal 2005, which significantly lowered R&D expenses related to Secure I.V. in fiscal 2006. We expect research and development expenses for the safety catheter segment during fiscal 2007 to be similar to those of fiscal 2006. We consider safety catheters to be a separate reportable segment based on product type and distribution channels. See Note 17 in the Notes to Financial Statements for additional information on the safety catheter segment.
In the medical segment, R&D expenses increased 27% in fiscal 2006 to $520,000 compared with $407,000 in 2005, offsetting part of the expense decline in the safety catheter segment. The expense increase in the medical segment was related to new product development efforts. We expect total R&D expenses in fiscal 2007 to be slightly higher than those of fiscal 2006.
General and administrative expenses remained level at $2.8 million in fiscal 2006. Increases in incentive compensation and bad debt expense were offset by a decline in insurance expense. We expect general and administrative expenses for 2007 to be slightly higher than 2006 levels.
The operating loss in the safety catheter segment for fiscal 2006 declined by 28% to $1.1 million ($0.26 per diluted share after taxes) compared with $1.5 million ($0.35 per diluted share after taxes) in fiscal 2005. The decline in operating loss was primarily due to a reduction in R&D expenses. We believe that the operating loss in the safety catheter segment for fiscal 2007 will be less than that of fiscal 2006.
The custom products segment also showed an operating loss in fiscal 2006. The custom products operating loss for fiscal 2006 increased to $1.1 million ($0.26 per diluted share after taxes) compared with a loss of $226,000 ($0.05 per diluted share after taxes) in fiscal 2005. The increase in the operating loss was primarily caused by the decline in sales volume of consumer bedding products as described above. The custom products segment receives an allocated share of our total manufacturing overhead and administrative expenses. Since these allocated expenses are largely fixed within a reasonable range of sales volume, a sales decline within the segment can result in a proportionally larger decline in segment operating income. However, we believe that the custom products segment makes a positive contribution to the Company’s earnings because the segment absorbs overhead and administrative expenses that would be reallocated to the medical segment if we exited the custom products business. If that occurred, the medical segment and the total company would likely be less profitable.
Total operating profit increased 28% to $4.0 million compared to $3.1 million in fiscal 2005. The increase was primarily the result of higher sales volume in the medical segment and lower R&D expenses in the safety catheter segment.
Non-Operating Income
Investment income increased by 80% to $204,000 in fiscal 2006 compared with $113,000 in fiscal 2005. The increase in investment income was the result of higher interest rates and slightly higher average balances of marketable securities in fiscal 2006.
Royalty income fell 50% in fiscal 2006 to $247,000 compared with $498,000 in fiscal as a result of the expiration in December 2005 of our license agreement for the Safety-Lok® shielded syringe product licensed to Becton Dickinson and Company (BD). The license agreement ended due to the expiration of the related patents. We received the final royalty payment from BD in February 2006.
Other non-operating income for 2006 included a $99,000 gain on the sale of manufacturing equipment. We expect total non-operating income for fiscal 2007 to be significantly lower than 2006 levels because of lower royalty income as described above and the lack of additional gains on asset sales.
Net Income and Dividends
Net income for fiscal 2006 increased 25% to $3.1 million, or $1.10 per diluted share, compared with $2.4 million, or $0.89 per diluted share, in fiscal 2005. The increase was due primarily to higher sales volume in the medical segment, lower R&D expenses in the safety catheter segment and lower labor costs due to improved manufacturing efficiencies.
During fiscal 2006, we paid dividends of approximately $517,000, or 17% of net income, for the year. This amount represented three quarterly dividends of $0.045 per share and one quarterly dividend of $0.06 per share.
RESULTS OF OPERATIONS FISCAL 2005 VS. 2004
Summary
Net sales in fiscal 2005 decreased 3% to $48.4 million compared with $49.9 million in fiscal 2004. The decrease was the result of sales declines in the custom products segment that were not fully offset by strong sales growth in the medical segment. Sales in the custom products segment declined 32% to $18.1 million while sales in the medical segment rose by 30% to $30.3 million.
Net income rose 23% in fiscal 2005 to $2.4 million, or $0.89 per diluted share, compared with $2.0 million, or $0.73 per diluted share, in fiscal 2004. The increase in earnings resulted primarily from higher unit sales of PressureGuard® and Geo-Mattress® therapeutic surfaces for the medical market and a more profitable product mix, as sales rose in the higher margin medical segment and fell in the lower margin custom products segment.
Sales
Sales in our medical segment rose 30% to $30.3 million in fiscal 2005 compared with $23.3 million the previous year. The medical sales growth was led by our therapeutic support surfaces which increased by 58% over 2004 levels. We sell these specialty mattresses to hospitals, long-term care facilities and home care dealers throughout the United States and Canada. Increased sales of the PressureGuard CFT® mattresses, sold mostly in the acute care market, made up about half of the total growth in the medical segment. The PressureGuard APM® and Easy Air® powered therapeutic surfaces and the Geo-Mattress foam mattresses also made up a significant portion of our medical sales growth during the year. The APM, Easy Air and Geo-Mattress products are sold primarily in the long-term care and home care sections of the medical market. In other medical product lines, sales of seating products increased 10%, Selan® skin care products rose by 9%, and patient positioners decreased by 9% due to lower export sales. Sales of overlays were down by 14%, continuing a long-term trend of customers switching to replacement mattresses from mattress overlays. Our medical business achieved solid growth in fiscal 2005 primarily because of increased customer acceptance of our therapeutic mattresses, particularly in the long-term care market, and the initial success of our private label mattresses in the acute care market.
Our custom products segment consists of consumer bedding products and specialty foam products for the industrial market. Sales in the custom products segment declined 32% during fiscal 2005 to $18.1 million from $26.5 million in fiscal 2004. Most of the custom products 2005 sales decrease was due to lower unit volumes of pillows and Geo-Systems® mattress pads sold to major retailers through Louisville Bedding Company. Sales of consumer bedding products decreased 34% in 2005 to $15.6 million. The decline in consumer bedding sales resulted from increased competition in the mattress pad business, particularly from visco foam products, and in pillow products where a portion of our business was lost to a competing visco foam pillow manufactured in China. In addition, we lost a smaller part of our mattress pad business due to a customer switching from our branded products to a lower cost private-label version.
In the other part of the custom products segment, industrial sales declined by 14% to $2.5 million. The industrial sales decline was caused by the loss of business with several existing customers due to a temporary acquisition-related purchase slowdown by a large customer, a customer’s manufacturing operation being moved outside the United States, and pricing competition.
In the safety catheter segment, sales were $6,000 as we recorded the first shipments of the redesigned Secure I.V. product line in the fourth quarter of fiscal 2005. The Secure I.V. safety catheter was not offered for sale in the first three quarters of fiscal 2005 pending the completion of design enhancements. We began shipping market test samples of the product in the latter part of fiscal 2004. However, in December 2004 we decided to delay the full release of the Secure I.V. as a result of initial customer feedback that revealed the potential benefits of making three design improvements to the product. The design improvements were completed in the fourth quarter of fiscal 2005, and we began limited shipments of the new products.
Gross Profit
Our gross profit level increased by 16% to $14.7 million during fiscal 2005 from $12.7 million in fiscal 2004. The gross profit margin percentage rose to 30.4% for fiscal 2005 compared with 25.4% for fiscal 2004. The increases in gross profit level and margin were due to higher sales volumes in the medical segment.
Selling, Research & Development and Administrative Expenses
Selling and marketing expenses increased 11% to $7.7 million, or 15.8% of sales, in fiscal 2005 compared with $6.9 million, or 13.9% of sales, in fiscal 2004. Most of the increase occurred in the medical segment and was due to higher expenses for commissions, salespersons’ salaries and shipping costs. Selling and marketing expenses increased as a percent of sales primarily because of the decline in custom products sales during the year.
Total R&D expenses increased 66% to $1.1 million in fiscal 2005 compared with $686,000 in fiscal 2004. The majority of the increase occurred in the safety catheter segment and was related to new product development efforts for the Secure I.V. product line. R&D expense for the safety catheter segment in fiscal 2005 increased 102% to $733,000 compared with $364,000 in the prior year. The increased costs were primarily due to higher expenses for labor, scrapped material, engineering and product development related to design changes and production test runs.
General and administrative expenses remained level at $2.8 million in fiscal 2005. Lower professional fees, incentive compensation and bad debt expenses were offset by higher costs for property and casualty insurance and administrative salaries.
Operating profit increased 36% to $3.1 million compared to $2.3 million in fiscal 2004. The increase was primarily caused by higher medical sales volume and a more profitable product mix.
Non-Operating Income
Investment income increased by 11% to $113,000 in fiscal 2005 compared with $102,000 in fiscal 2004. The increase in investment income was the result of higher interest rates and slightly higher average balances of marketable securities in fiscal 2005.
Royalty income decreased 9% to $498,000 in fiscal 2005 compared with $545,000 in fiscal 2004 as a result of lower sales volume of the Safety-Lok® shielded syringe product licensed to Becton Dickinson and Company (BD).
Other non-operating income for 2005 included a $26,000 gain on the sale of manufacturing equipment.
Net Income and Dividends
Net income for fiscal 2005 increased 23% to $2.4 million, or $0.89 per diluted share, compared with $2.0 million, or $0.73 per diluted share, in fiscal 2004. The increase was due primarily to higher sales volume in the medical segment and a more profitable sales mix.
During fiscal 2005, we paid dividends of approximately $1.5 million, or 60% of net income, for the year. This amount represented three quarterly dividends of $0.04 per share, one quarterly dividend of $0.045 per share and one special dividend of $0.40 per share.
LIQUIDITY AND CAPITAL RESOURCES
We generated cash from operations of $2.5 million during fiscal 2006, which was a 4% decline compared with $2.6 million in fiscal 2005. The major factors contributing to the change in cash flow during the year were increased inventory and decreased accounts payable and accrued expenses. These reductions in operating cash flow were largely offset by increases in net income and a decrease in accounts receivable.
Working capital increased by $2.7 million, or 25%, to $13.3 million during fiscal 2006. The increase was caused by higher year-end balances of cash and marketable securities related to improved sales. Our working capital level was also affected by an increase in inventory levels as discussed below and a decrease in accounts payable and accrued liabilities. Our current ratio increased to 3.8 at September 30, 2006 from 3.0 at fiscal year end 2005.
Accounts receivable, net of allowances, decreased 3% to $7.0 million at the end of fiscal 2006 compared with $7.2 million at the end of fiscal 2005. The decrease resulted from higher sales in the medical segment in the fourth quarter of 2005 which were collected in the first quarter of fiscal 2006. The days sales outstanding (or average collection time), calculated using a 12-month average for accounts receivable balances, increased to 47 days in 2006 compared with 44 days in 2005. The increase resulted from a higher percentage of medical sales in fiscal 2006. Medical sales typically have longer collection times than custom products sales. All of our accounts receivable are unsecured.
Inventory, net of reserves, increased by $1.1 million (35%) to $4.4 million at September 30, 2006 compared with $3.2 million at October 1, 2005. The increases occurred in the medical segment and in the newly acquired HuberPro line, which is part of the safety catheter segment. The increase in the medical product line was intended to support higher medical sales levels and reduce order fill times particularly for medical mattress products. The increase in medical inventory was also affected by the release of an updated version of our patented low-air-loss mattress. Inventory turns for fiscal 2006 decreased to 9.5 times from 11.4 times in fiscal 2005 primarily because of higher inventory levels in the medical and safety catheter segments. We expect inventory levels in fiscal 2007 to be slightly higher than those of fiscal 2006.
Prepaid expenses increased 32% to $736,000 during fiscal 2006 from $557,000 at the end of fiscal 2005. The increase was primarily the result of an increase in income taxes receivable at year end fiscal 2006.
Net property and equipment increased by less than 1% during fiscal 2006. The change resulted from the combination of building and equipment purchases of $1.1 million partially offset by regular depreciation expense. Approximately $628,000 of the capital expenditures for fiscal 2006 was related to the 58,000 square foot expansion to our South Carolina manufacturing plant, which was completed in November 2005. We expect capital expenditures in fiscal 2007 to be less than fiscal 2006 primarily because no building expansion is planned in 2007 and capital expenditures will be limited mainly to investments in new equipment.
From time to time, we purchase forward contracts for foreign currency to lock in exchange rates for future payments on manufacturing equipment that we order. The foreign exchange contracts are used to eliminate foreign currency fluctuations during the six to nine month period between the date the order is placed and the date of final payment. Realized gains and losses, if any, are included in the cost of the related equipment. Unrealized gains and losses on open contracts are not material to our results of operations or financial condition. We held no forward contracts as of September 30, 2006. We have not engaged in foreign currency transactions since fiscal year 2003; however, it is possible that we will do so again in fiscal 2007 due to anticipated purchases of equipment manufactured in Germany.
Other assets increased by 5% to $2.8 million during fiscal 2006 compared with $2.6 million at fiscal year end 2005 mainly due to an increase in the cash surrender value of life insurance policies and expenditures for patents and trademarks.
Our trade accounts payable decreased 12% in fiscal 2006 to $2.4 million. The decrease in payables was primarily the result of higher sales levels and associated purchases during the last two months of fiscal 2005 related to unusually high sales volume in the fourth quarter of fiscal 2005, which was not repeated in the fourth quarter of fiscal 2006. Accrued and sundry liabilities decreased by 7% during the year to $2.5 million compared with $2.7 million last year. The decrease was mostly due to lower accruals for income taxes.
We believe that funds on hand and funds generated from operations are adequate to finance our operations and expected capital requirements during fiscal 2007 and for the foreseeable future. The terms of our supply agreement with the contract manufacturer for our Secure I.V. product line require us to pay approximately $9,100 per week in labor and overhead charges for production of the Secure I.V. catheter in lieu of a per unit charge. This weekly charge is expected to remain in effect for the next six to 12 months, depending on actual production volume, and can be changed by the mutual agreement of both parties.
OFF-BALANCE-SHEET ARRANGEMENTS
We have no off-balance-sheet arrangements.
CONTRACTUAL OBLIGATIONS
The following table summarizes our significant contractual obligations and commercial commitments at September 30, 2006 and the future periods in which such obligations are expected to be settled in cash. For additional information regarding these obligations, see the referenced footnotes in the Notes to Financial Statements under Item 8 below.
IMPACT OF INFLATION AND COST OF RAW MATERIALS
Inflation was a moderate factor for our operations in fiscal 2006. We received price increases on certain of our polyurethane foam and other raw materials in our first fiscal quarter. We recovered the majority of the cost of these increases by selectively raising sales prices, improving manufacturing efficiencies and reducing other costs. Our raw material pricing largely stabilized in the second fiscal quarter, and further increases during the remainder of the fiscal year were not material. Based on current conditions in the markets for our primary raw materials, we do not expect inflation to be a significant factor in our operations in fiscal 2007. However, volatile oil prices, additional increases in the cost of polyurethane foam or other raw materials could negatively affect our profitability if we are unable to recover the higher costs through sales price increases or other cost reduction efforts.
CRITICAL ACCOUNTING POLICIES
This discussion and analysis of financial condition and results of operations is based on our financial statements which we prepare in conformity with accounting principles generally accepted in the United States of America. The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are based on historical experience and on various other factors that we believe are 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. These estimates and assumptions also require the application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. We periodically review our accounting policies and estimates and make adjustments when facts and circumstances dictate.
Actual results may differ from these estimates under different assumptions or conditions. Any differences may have a material impact on our financial condition and results of operations.
In addition to the accounting policies which are more fully described in the Notes to Financial Statements included in this report, we have identified the following critical accounting policies used in the preparation of our financial statements.
Allowance for Doubtful Accounts
Credit evaluations are undertaken to set credit limits for all customers. On a quarterly basis, we evaluate past due items in the accounts receivable listing and provide what we estimate to be adequate reserves for doubtful accounts. Customer economic conditions may change and increase the risk of non-collectibility and may require additional provisions which would negatively impact our operating results. As of September 30, 2006, our provision for doubtful accounts represented approximately 1.7% of total accounts receivable, or $117,000.
Inventories
We regularly review inventory quantities on hand and adjust for excess and obsolete inventory based primarily on historical usage rates and our estimated forecast of product demand and production. Actual demand may differ from our estimate, in which case we may have understated or overstated the provision required for obsolete and excess inventory, which would have an impact on our operating results. As of September 30, 2006, our provision for excess and obsolete inventory represented approximately 10.2% of total inventories, or $446,000.
We began to carry Secure I.V. inventory in fiscal 2005 and HuberPro inventory in fiscal 2006. Since we have limited sales and production history for these new product lines, our future estimates for safety catheter inventory reserves could be more volatile than those in our medical and custom products segments.
Warranty Obligations
We warrant certain of our products for a specific period of time against manufacturing or performance defects. We provide for the estimated future cost of warranty obligations in cost of goods sold when the related revenue is recognized. The accrued warranty cost represents our best estimate at the time of sale of the total cost that we will incur to repair or replace covered products or parts. The amount of accrued estimated warranty cost is primarily based on historical experience as well as current information on repair costs. Actual warranty cost could differ from the estimated amounts. On a quarterly basis, we review the accrued balances and update the historical warranty cost trends. If we were required to accrue additional warranty cost in the future, it would negatively affect operating results. Our actual warranty expense was approximately $185,000 in fiscal 2006 and $174,000 in fiscal 2005. See Notes 7 and 8 in the Notes to Financial Statements for more information on product warranties.
Impairment of Goodwill
As required by SFAS No. 142, “Goodwill and Other Intangible Assets”, we evaluate goodwill in our medical business unit for impairment at least annually or more frequently if events occur or circumstances change that could reduce the fair value of our medical business unit. For fiscal year end 2006, we determined that the fair value of the medical business unit exceeded its carrying value and thus no impairment charge was required. In assessing the value of goodwill, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the medical business unit. If these estimates or their related assumptions change in the future, we may be required to record impairment charges which would negatively impact operating results. As of September 30, 2006, the carrying value of goodwill was $1.9 million.
Impairment of Long-Lived Assets
“Impairment” is the condition that exists when the carrying amount of a long-lived asset or asset group is greater than its fair value. As required by SFAS No. 144, we evaluate long-lived assets for potential impairment whenever events occur or circumstances indicate that the carrying amount of the assets may not be recoverable. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the carrying amount of a long-lived asset is not recoverable and is greater than its fair value, the asset is impaired and an impairment loss must be recognized. To date, we have had no indicators of impairment for long-lived assets. However, our investment in the safety catheter business unit raises the possibility of a future impairment loss. Since the Secure I.V. product line has limited sales history and is in the process of emerging from development stage, it involves greater risks and uncertainties than our more established product lines. We completed the initial design and development of Secure I.V. during the third quarter of fiscal 2005. We have been marketing the product line through select distributors since approximately September 2005. During fiscal year 2006, sales of Secure I.V. were $75,000. The continued passage of time without an improvement in sales increases the possibility of a future impairment charge in the safety catheter segment. If Secure I.V. sales do not show a meaningful increase in the near future, it is possible that the assets associated with Secure I.V. could become impaired, resulting in a material impairment charge against our earnings and a material reduction in our assets. If the assets associated with the safety catheter segment became impaired, the impairment loss could be as much as the total assets of the safety catheter segment. (See Note 17 in the Notes to Financial Statements.) If such an event had occurred as of September 30, 2006, our assets and operating income would have been reduced by up to $3.3 million, and net income after taxes would have been reduced by up to $2.2 million, or $0.81 per diluted share, using the weighted average diluted shares outstanding at fiscal year end 2006. The actual amount of any future impairment loss could be more or less, depending on the level of assets and the degree of impairment at the time we determine an impairment charge is necessary.
Present Value of Deferred Compensation
We are obligated to make fixed payments under a retirement agreement over the remaining life of Span-America’s founder as discussed in Note 10 “Deferred Compensation” in the Notes to Financial Statements. We have fully accrued the present value of the expected payments due over the executive’s estimated life expectancy. In calculating this present value we estimated an effective long-term interest rate of 8%. If actual long-term interest rates declined significantly and we were required to accrue additional deferred compensation costs in the future, it would negatively affect operating results. As of September 30, 2006, we had recorded a deferred compensation liability of approximately $945,000, including current and long-term portions. If we reduced the discount rate by 1%, the deferred compensation liability would be increased by approximately $58,000 and pre-tax income would be reduced by the same amount.
Item 7A.
Item 7A. Qualitative and Quantitative Disclosures About Market Risk
We are exposed to financial market risk in two areas: short-term investments and cash value of life insurance. As of September 30, 2006, we had short-term investments of $5.1 million which were classified as available for sale. Included in these short-term investments are approximately $4.8 million of high quality and highly liquid corporate commercial paper and bonds known as “variable rate demand notes” or “low floaters.” The bonds are issued by municipalities or companies and are backed by letters of credit from federally insured banks. The bonds carry the credit rating of the underlying bank and are therefore highly rated. The interest rate on the bonds is a floating rate which is reset weekly or monthly, depending on the issue, by the re-marketing agent based on market rates for comparable securities or through an auction process. We can liquidate the bonds at any time with a settlement date of seven to 35 days after the trade date. Using the level of securities available for sale at fiscal year end 2006, a 100 basis point increase or decrease in interest rates for one year would increase or decrease after-tax earnings by approximately $48,000. The effect of a 100 basis point increase or decrease in interest rates will vary from period to period with the dollar amount invested in our low floater portfolio.
Our $5.1 million in short-term investments at fiscal year end also included approximately $365,000 in a portfolio of investment grade preferred stocks. The preferred shares are generally callable within three to five years and have after-tax dividend yields currently higher than the variable rate demand notes described above. Dividends from the preferred stocks are generally paid quarterly and qualify for the 70% dividends received deduction available to corporate holders of the preferred shares. These shares are traded on the New York Stock Exchange and per share prices are subject to interest rate risks similar to intermediate-term bonds as well as specific company risk factors. We believe that substantial fluctuations in long-term interest rates or prices of the preferred stocks would not have a material effect on our financial position.
In addition, our other assets at September 30, 2006 include $1.8 million in cash value of life insurance, which is subject to market risk related to equity pricing and interest rate changes. The cash value is generated from life insurance policies which are being used as the funding vehicle for a retirement program for Span-America’s founder and former chairman. The cash value is invested in a combination of fixed income life insurance contracts and a portfolio of mutual funds managed by an insurance company. The fixed income contracts are similar to fixed income bond funds and are therefore subject to interest rate and company risk. The mutual fund portfolios invest in common stocks and bonds in accordance with their individual investment objectives. These portfolios are exposed to stock market and interest rate risk similar to comparable mutual funds. We believe that substantial fluctuations in equity markets and interest rates and the resulting changes in cash value of life insurance would not have a material adverse effect on our financial position. During the fiscal year ended September 30, 2006, cash value of life insurance increased by 6%, creating after-tax income of approximately $94,000.
Item 8.
Item 8. Financial Statements and Supplementary Data
Span-America Medical Systems, Inc.
Financial Statements
September 30, 2006
Contents
Report of Independent Registered Public Accounting Firm
Shareholders and Board of Directors
Span-America Medical Systems, Inc.
Greenville, South Carolina
We have audited the accompanying balance sheets of Span-America Medical Systems, Inc. as of September 30, 2006 and October 1, 2005 and the related statements of income, changes in shareholders’ equity and comprehensive income, and cash flows for each of the years in the three year period ended September 30, 2006. 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Span-America Medical Systems, Inc., as of September 30, 2006 and October 1, 2005 and the results of its operations and its cash flows for each of the years in the three year period ended September 30, 2006 in conformity with accounting principles generally accepted in the United States of America.
/s/ ELLIOTT DAVIS, LLC
Greenville, South Carolina
November 1, 2006
Statements of Income
The accompanying notes are an integral part of these financial statements.
Balance Sheets
The accompanying notes are an integral part of these financial statements.
Statements of Changes in Shareholders' Equity and Comprehensive Income
The accompanying notes are an integral part of these financial statements.
Statements of Cash Flows
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
September 30, 2006
1. SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Company manufactures and distributes replacement mattresses, mattress overlays, patient positioners, seating cushions, and skin care products for the medical market and pillows, mattress pads and various foam products for the custom products market throughout the United States and Canada. In addition, the Company has recently begun manufacturing and marketing the Secure I.V. line of intravenous catheters to the health care market in North America. The catheter product line was acquired in early development stage in 2002. The Company began selling the HuberPro needle infusion set in April 2006 primarily to oncology clinics.
Cash and Cash Equivalents
The Company considers all cash equivalents to be highly liquid investments with a maturity when purchased of three months or less. Depending on market conditions, the Company may maintain a centralized cash management program whereby its excess cash balances are invested in commercial paper and are considered cash equivalents. Cash balances in the Company’s accounts usually exceed federally insured limits.
Accounts Receivable
The Company provides credit in the normal course of business and performs ongoing credit evaluations on certain of its customers, but generally does not require collateral to support such receivables. The Company also establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information. Account balances are charged against the allowance after all collection efforts have been exhausted and potential for recovery is considered remote.
Inventories
Inventories are valued at the lower of cost (first-in, first-out method) or market.
Property and Equipment
Property and equipment is stated at cost. Maintenance, repairs, and minor replacements that do not improve or extend the useful lives of assets are expensed when incurred. Depreciation is computed using the straight-line method. Estimated useful lives for buildings and land improvements range from 15 to 35 years. The estimated useful lives of all other property and equipment range from 3 years to 15 years. For income tax purposes, substantially all depreciation is computed using accelerated methods.
Construction in progress is stated at cost, which includes the cost of construction and other direct costs attributable to the construction. No provision for depreciation is made on construction in progress until the relevant assets are completed and put into use. As of October 1, 2005, the balance in construction in progress represented costs incurred relating to a 58,000 square foot expansion of the Greenville, SC plant. The total cost of the expansion was $2.9 million. The building was occupied in November 2005. (See Note 4.)
Intangibles
Intangible assets are amortized using the straight-line method. Costs of patents are amortized over periods ranging from 10 to 17 years, and trademarks are amortized over periods of 5 or 10 years. Goodwill, costs in excess of the fair value of net assets, acquired from two separate acquisitions, is accounted for under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” See Note 5. Accumulated amortization of intangible assets at September 30, 2006 and October 1, 2005 was approximately $2,546,000 and $2,419,000, respectively. The Company reviews annually the recoverability of the carrying value of these assets in accordance with SFAS No. 142 and SFAS No. 144 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of.” The Company also reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable.
Revenue Recognition
Revenue is recognized by the Company when goods are shipped and title passes to the customer. There are no customer acceptance provisions, and the right to return exists only in cases of damaged product, non-compliance with customer specifications or warranty claims.
The Company has applied the accounting and disclosure requirements of Securities and Exchange Commission Staff Accounting Bulletin (SAB) No. 101.
Advertising Costs
Advertising costs are expensed as incurred.
Shipping and Handling Costs
Shipping and handling costs that are not reimbursed by customers are charged to selling and marketing expenses and were approximately $1,697,000 in 2006, $1,516,000 in 2005, and $1,445,000 in 2004.
Fair Value of Financial Instruments
The carrying amounts reported in the balance sheet for cash and cash equivalents, securities available for sale, accounts receivable, cash value of life insurance, accounts payable, and debt approximate their fair values. The fair values of the Company’s securities available for sale are based on quoted market prices when available, or quoted market prices of financial instruments with similar characteristics.
Earnings Per Share of Common Stock
Earnings per share of common stock are computed based on the weighted average number of shares outstanding during each period in accordance with SFAS No. 128, “Earnings Per Share.” (See Note 13).
Stock-Based Compensation
During December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R “Share-Based Payment,” which requires the Company to measure and recognize compensation expense for all stock-based payments at fair value. This statement eliminated the ability to account for share-based compensation transactions using Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). Stock-based payments include stock option grants. The Company grants options to purchase common stock to some of its employees under various plans at prices equal to the market value of the stock on the dates the options were granted. The Company adopted SFAS No. 123R in the fourth quarter of fiscal 2005 using the modified prospective method.
Prior to adopting SFAS No. 123R, the Company accounted for stock options under APB No. 25. Accordingly, no compensation expense was charged to operations in previous fiscal years. If compensation expense for the plans had been determined based on the fair value at the grant dates for awards under the plans consistent with the accounting method available under SFAS No. 123 “Accounting for Stock Based Compensation,” the Company's net income and net income per common share would have been reduced to the proforma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for grants made in 2006, 2005 and 2004, respectively: risk-free interest rates of 4.58%, 4.08% and 4.14%; dividend yields of 1.5%, 1.5% and 1.1%; volatility factors of the expected market price of the Company's common stock of 35.7%, 32.3% and 38.9%; and a weighted average expected life of the option of 8.2 years for fiscal year 2006 and 8.0 years for fiscal years 2005 and 2004.
Fiscal Year
The Company’s fiscal year ends on the Saturday nearest to September 30. Fiscal years 2006 and 2005 were 52-week years. Fiscal year 2004 was a 53-week year. Fiscal year 2007 will be a 52 -week year.
Income Taxes
In accordance with SFAS No. 109, “Accounting for Income Taxes,” the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
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 amounts reported in the financial statements and accompanying notes. Although these estimates are based on management’s knowledge of current events and actions planned for the future, the estimates may ultimately differ from actual results.
Recently Issued Accounting Standards
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. It also established a fair value hierarchy that prioritizes information used in developing assumptions when pricing an asset or liability. SFAS 157 will be effective for us beginning in fiscal 2008. We are evaluating the statement to determine the effect on our financial statements and related disclosures.
In September 2006, the Securities and Exchange Commission (SEC) issued SAB No. 108, “Financial Statements - Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 requires companies to quantify the impact of all correcting misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. This pronouncement is effective for us in fiscal 2008. We do not believe SAB 108 will have a material effect on our financial statements and related disclosures.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the 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 derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 will be effective for us beginning in fiscal 2007. We are evaluating the interpretation to determine the effect on our financial statements and related disclosures.
Other accounting standards that have been issued or proposed by FASB or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on the Company's financial statements upon adoption.
2. SECURITIES AVAILABLE FOR SALE
The variable rate demand notes included in securities available for sale are carried at aggregate cost which approximates market. Preferred stocks are carried at market value. Unrealized holding losses were $3,495 and $1,712 during fiscal years 2006 and 2005. The Company had no unrealized holding gains or losses during fiscal year 2004.
3. INVENTORIES
4. PROPERTY AND EQUIPMENT
5. GOODWILL AND OTHER INTANGIBLES
As of September 30, 2006 and October 1, 2005 the Company had goodwill (net of accumulated amortization) of $1,924,131 and patents and trademarks (net of accumulated amortization) of $720,221 as of September 30, 2006 and $762,757 as of October 1, 2005. All goodwill is part of the medical segment. Patents and trademarks are part of the medical and safety catheter segments. The Company has re-assessed the useful lives of goodwill and patents and trademarks. Goodwill was determined to have an indefinite useful life. Amortization of goodwill ceased on September 29, 2001 as a result of the Company’s adoption of SFAS No. 142 at the beginning of fiscal year 2002. The useful lives of individual patents and trademarks were reviewed and no material changes were required. No impairment losses were recorded on the Company’s intangible assets as a result of the adoption of SFAS No. 142 based on the annual goodwill impairment test.
Amortization expense for patents and trademarks during fiscal years 2006, 2005, and 2004 was $128,971, $128,769, and $98,449, respectively. Estimated amortization expense for the next five fiscal years is as follows:
6. OTHER ASSETS
7. ACCRUED AND SUNDRY LIABILITIES
8. PRODUCT WARRANTIES
The Company offers warranties of various lengths to its customers depending on the specific product sold. The Company’s warranties require it to repair or replace non-performing products during the warranty period at no cost to the customer. At the time revenue is recognized for covered products, the Company records a liability for estimated costs that may be incurred under its warranties. The costs are estimated based on historical experience and any recent warranty trends that have been identified. (Although historical warranty costs have been within expectations, there can be no assurance that future warranty costs will not exceed historical amounts.) The Company periodically assesses the adequacy of its recorded liability and adjusts the balance as necessary.
Changes in the Company’s product warranty liability for the years ended September 30, 2006 and October 1, 2005 are as follows:
9. BORROWINGS
The Company paid no interest expense during fiscal years 2006, 2005, or 2004.
10. DEFERRED COMPENSATION
The Company is obligated to make fixed payments of approximately $114,000 per year to its founder and former chief executive officer pursuant to a retirement agreement. The payments will be made for the longer of the executive’s remaining life or his ex-wife's remaining life, if she survives him. The Company has fully accrued the present value of the expected payments due over the combined life expectancy of the executive and his ex-wife. The Company recognized expenses of approximately $78,000 in 2006, $81,000 in 2005, and $83,000 in 2004 related to this agreement. An 8% discount rate was used in measuring the present value of the Company's deferred compensation obligation.
11. SHAREHOLDERS’ EQUITY
In March 1997, the Board adopted the 1997 Stock Option Plan (“1997 Plan”). The 1997 Plan authorized the Board to grant options to key officers and employees of the Company for up to 200,000 shares of the Company's common stock. Options granted under the 1997 Plan are generally granted at the fair market value on the date of grant. These options become exercisable and vested at the greater of 1,000 shares per year or 20% of the grant. Vested options expire 10 years from the date of grant for continuing employees, or three months after termination for employees who leave the Company.
In November 1991, the Board adopted the 1991 Stock Option Plan (“1991 Plan”). The 1991 Plan authorized the Board to grant options of up to 200,000 shares of the Company's common stock to officers and key employees and 50,000 shares to directors who are neither officers nor employees of the Company. All other terms and conditions of the 1991 Plan are similar to the 1997 Plan. The 1991 Plan was terminated on November 7, 2001. The termination does not affect options outstanding under the plan, but no further options can be granted under the 1991 Plan.
In March 1987, the Board of Directors adopted the 1987 Stock Option Plan (“1987 Plan”). The 1987 Plan authorized the Board to grant options of up to 200,000 shares of the Company's common stock to officers and key employees of the Company. All other terms and conditions of the 1987 Plan are similar to the 1997 Plan. The 1987 Plan was terminated on March 31, 1997. The termination does not affect options outstanding under the plan, but no further options can be granted under the 1987 Plan.
A summary of activity under the Company’s three stock option plans is as follows.
A summary of stock options outstanding and exercisable at fiscal year end 2006 is shown below.
The Board of Directors adopted a stock purchase incentive plan in February 2000. The 2000 Restricted Stock Plan was created to encourage management employees of the Company to purchase and hold the Company's common stock. Plan benefits are paid in shares of the Company’s common stock. Benefits earned and accrued under the plan were $11,212 in 2006, $13,392 in 2005, and $11,977 in 2004. The Company issued stock valued at $13,392 in 2006, leaving a vested balance of $11,212 at September 30, 2006.
In March 1997 the Board of Directors approved the 1997 Long-Term Incentive Stock Option Plan for certain executives of the Company based on achievement of specified financial goals by fiscal year end 1999. As of September 30, 2006, the Company has accrued compensation expense of $23,150 related to this plan.
12. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax liabilities and assets as of September 30, 2006 and October 1, 2005 are as follows:
The Company made cash income tax payments, net of refunds, of approximately $1,960,000, $974,000, and $617,000 in fiscal years 2006, 2005, and 2004, respectively.
Federal and state income tax provisions consist of the following:
Income tax expense differs from the amounts computed by applying the federal tax rate to income before income taxes as follows:
13. EARNINGS PER SHARE OF COMMON STOCK
The following table sets forth the computation of basic and diluted earnings per share of common stock in accordance with SFAS No. 128.
14. EMPLOYEE BENEFITS AND INCENTIVE PLANS
The Company has an employee savings and investment plan (401(k) plan) available to employees meeting eligibility requirements. The Company matches a percentage of the employee contributions, with certain limitations. Contributions by the Company amounted to approximately $190,000, $164,000, and $158,000 for the 2006, 2005, and 2004 fiscal years, respectively.
15. RELATED-PARTY TRANSACTIONS
The Company paid approximately $138,000 in 2004 in legal fees to a firm having a member who was also a director of the Company until July 2004.
16. MAJOR CUSTOMERS
The Company has a business relationship with a customer to manufacture private label mattresses. Sales to this customer made up approximately 16% of net sales in 2006, 8% in 2005 and 1% in 2004. The largest of our medical customers are distributors who sell our products to acute care hospitals and other treatment facilities throughout the United States. Sales generated by the largest of these distributors amounted to approximately 11% of net sales in 2006, 13% in 2005, and 8% in 2004.
The Company has a business relationship with another customer to distribute certain of its consumer products. Sales to this customer amounted to 20% of net sales in 2006, 33% in 2005, and 47% in 2004.
See Note 17 for further information about sales to major customers.
17. OPERATIONS AND INDUSTRY SEGMENTS
The Company reports on three segments of business: medical, custom products, and safety catheters. This industry segment information corresponds to the markets in the United States and Canada for which the Company manufactures and distributes its polyurethane foam, packaging and other products and therefore complies with the requirements of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.”
The following table summarizes certain information on industry segments:
Total sales by industry segment include sales from unaffiliated customers as reported in the Company’s statements of income. In calculating operating profit, non-allocable general corporate expenses, interest expense, other income, and income taxes are not included, but certain corporate operating expenses incurred for the benefit of all segments are included on an allocated basis.
Identifiable assets are those assets that are used in the operations of each segment on an allocated basis. Amounts shown for corporate assets consist primarily of cash, marketable securities, and cash surrender value of life insurance.
The Company has several customers whose sales represent significant portions of sales in their respective business segments. In the medical segment, sales to the top four distributors represented 58% of net medical sales in 2006, 59% in 2005, and 52% in 2004. In the custom products segment, sales to one customer accounted for 69% of net custom products sales in 2006, 87% in 2005 and 89% in 2004.
Export sales, primarily to Canada and Great Britain, were approximately, $3,162,000 in 2006, $2,127,000 in 2005 and $2,988,000 in 2004.
18. OPERATING LEASES
The Company leases truck equipment in South Carolina. Until October 31, 2006, the Company leased manufacturing space in California. The lease was terminated on that date. In October 2006, the company began to lease a 15,000 square foot distribution facility in Utah for $6,750 per month. The lease is cancellable by either party with 60 days notice. All of the leases require the Company to pay certain insurance and maintenance costs.
Rental expense for all operating leases was $212,000 in 2006, $321,000 in 2005 and $339,000 in 2004.
19. COMMITMENTS AND CONTINGENCIES
The Company is committed to minimum purchases of $625,000 of Selan® skin care products per calendar year through 2010. Previously, the Company was committed to purchases of $500,000 per calendar year through 2005. For the fiscal years ended 2006, 2005 and 2004, purchases under this commitment were $757,000, $763,000 and $635,000, respectively.
The Company’s supply terms with the contract manufacturer for its Secure I.V. product line require payment of approximately $9,100 per week in labor and overhead charges for production of the Secure I.V. catheter in lieu of a per unit charge. This weekly charge is expected to remain in effect for the next six to 12 months, depending on actual production volume, and can be changed by the mutual agreement of both parties.
From time to time the Company is a defendant in legal actions involving claims arising in the normal course of business. The Company believes that, as a result of legal defenses and insurance arrangements, none of these actions should have a material adverse effect on its operations or financial condition.
20. QUARTERLY FINANCIAL DATA (Unaudited)
Selected quarterly financial data are shown in the following table.
Quarterly Financial Data (Unaudited)
(Amounts in thousands, except per share data)
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A. Controls and Procedures
The Company has evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this annual report (the “Evaluation Date”), and, based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that these controls and procedures were effective at the Evaluation Date. There were no changes in the Company’s internal controls over financial reporting during the last quarter of fiscal 2006 that have materially affected or are reasonably likely to materially affect its internal control over financial reporting.
Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosure.
Item 9B.
Item 9B. Other Information
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Information required under Item 10 of Part III is incorporated herein by reference to portions of the definitive Proxy Statement filed or to be filed with the Securities and Exchange Commission on or prior to 120 days following the end of the Company's 2006 fiscal year under the headings “Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Election of Directors - Code of Ethics.”
Item 11.
Item 11. Executive Compensation
Information required under Item 11 of Part III is incorporated herein by reference to portions of the definitive Proxy Statement filed or to be filed with the Securities and Exchange Commission on or prior to 120 days following the end of the Company's 2006 fiscal year under the heading “Compensation of Directors and Executive Officers.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information under the heading “Security Ownership of Certain Beneficial Owners and Management” set forth in the Company’s definitive Proxy Statement filed or to be filed with the Securities and Exchange Commission on or prior to 120 days following the end of the Company’s 2006 fiscal year is incorporated herein by reference.
The following table summarizes information regarding the Company’s equity compensation plans as of September 30, 2006:
For additional information on the Company’s stock option plans, see Note 11 in the Notes to Financial Statements for the year ended September 30, 2006.
See Item 5 of Part II for more information on shares of the Company’s common stock issued to Directors in lieu of their annual cash compensation.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required under Item 13 of Part III is incorporated herein by reference to portions of the definitive Proxy Statement filed or to be filed with the Securities and Exchange Commission on or prior to 120 days following the end of the Company's 2006 fiscal year under the heading “Certain Relationships and Related Transactions.”
Item 14.
Item 14. Principal Accountant Fees and Services
Additional information required under Item 14 of Part III is incorporated herein by reference to portions of the definitive Proxy Statement filed or to be filed with the Securities and Exchange Commission on or prior to 120 days following the end of the Company's 2006 fiscal year under the heading “Principal Accountant Fees and Services.”
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a) (1) Financial Statements
The response to this portion of Item 15 is submitted under Item 8, Financial Statements and Supplementary Data, beginning on page 30.
(2) Financial Statement Schedules
The response to this portion of Item 15 is submitted below under Item 15(c).
(3) Listing of Exhibits
3.1
Restated Articles of Incorporation: Incorporated by reference to Exhibit 3(a) to the Company’s Registration Statement on Form S-18, Commission File No. 0-11392.
3.1.1
Articles of Amendment filed with the South Carolina Secretary of State on February 6, 1989: Incorporated by reference to Exhibit 3.1.1 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 1991.
3.1.2
Articles of Amendment filed with the South Carolina Secretary of State on March 5, 1992: Incorporated by reference to Exhibit 4.4 to the Company’s Registration Statement on Form S-2 dated May 11, 1992, Commission File No. 33-47670.
3.1.3
Articles of Amendment filed with the South Carolina Secretary of State on April 22, 1993: Incorporated by reference to Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended April 3, 1993.
3.2
Amended and Restated By-Laws dated February 4, 1997: Incorporated by reference to Exhibit 3.0 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 29, 1997.
3.2.1
Amendment to the Company's By-laws dated March 13, 2003: Incorporated by reference to Exhibit 3.2 to the Company's report on Form 8-K dated March 13, 2003, Commission File No. 000-11392.
3.2.2
Amendment to the Company's By-laws dated November 7, 2003: Incorporated by reference to Exhibit 3.2.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 2003 (the “2003 10-K”), Commission File No. 0-11392.
4.1
Specimen of Common Stock certificate: Incorporated by reference to Exhibit 1 to the Form S-8 filed on January 8, 1990, Commission File No. 33-32896.
4.2
The Registrant hereby agrees to furnish to the Securities and Exchange Commission upon request a copy of any instrument with respect to long-term debt not being registered in a principal amount less than 10% of the total assets of the Registrant on a consolidated basis.
4.3
Amended and Restated Shareholder Rights Agreement dated March 24, 2003, between Span-America Medical Systems, Inc. and American Stock Transfer & Trust Company as Rights Agent: Incorporated by reference to Exhibit 4.1 to the Company's report on Form 8-K dated March 24, 2003.
4.3.1
Amendment No. 1 to the Amended and Restated Shareholder Rights Agreement dated November 19, 2003: Incorporated by reference to Exhibit 4.1 to the Company's report on Form 8-K dated December 2, 2003.
4.4
Agreement among Span-America Medical Systems, Inc., Jerry Zucker, and Robert B. Johnston, dated December 17, 2003, regarding nomination of Mr. Johnston to the Span-America Board of Directors: Incorporated by reference to Exhibit 4.4 to the 2003 10-K.
10.1
Patent Assignment and Royalty Agreement between Donald C. Spann and the Company, with letter amendment thereto: Incorporated by reference to Exhibit 10(c) to the Form S-18 filed on June 2, 1983, Commission File No. 2-832-74-A.
10.2*
Stock Option Plan: Incorporated by reference to Exhibit 10 to the Company's Annual Report on Form 10-K for the fiscal year ended October 2, 1987, Commission File No. 0-11392.
10.2.1*
Amendment No. 1 to the 1987 Stock Option Plan: Incorporated by reference to Exhibit 10.2.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended October 3, 1998 (the “1998 10-K”), Commission File No. 0-11392.
10.3*
Stock Option Plan: Incorporated by reference to Exhibit 10.6 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 1991 (the “1991 10-K”), Commission File No. 0-11392.
10.3.1*
Amendment No. 1 to the 1991 Stock Option Plan: Incorporated by reference to Exhibit 10.4.2 to the 1998 10-K.
10.4*
Retirement Agreement dated February 6, 1991 between the Company and Donald C. Spann: Incorporated by reference to Exhibit 10.7 to the 1991 10-K.
10.5*
Voluntary Resignation Agreement dated July 30, 1993 between the Company and Donald C. Spann: Incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1993, Commission File No. 0-11392.
10.6*
Stock Option Plan: Incorporated by reference to Exhibit 10.14 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 27, 1997 (the “1997 10-K”), Commission File No. 0-11392.
10.6.1*
Amendment No. 1 to the 1997 Stock Option Plan: Incorporated by reference to Exhibit 10.14.2 to the 1998 10-K.
10.7*
Long Term Incentive Stock Option Plan: Incorporated by reference to Exhibit 10.15 to the 1997 10-K.
10.8
Distribution Agreement dated March 1, 1999 between the Company and Louisville Bedding Corporation: Incorporated by reference to Exhibit 10.16 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2000 (the “2000 10-K”), Commission File No. 000-11392.
10.8.1
Addendum to Distribution Agreement between Louisville Bedding Company and Span-America Medical Systems, Inc. dated January 1, 2002: Incorporated by reference to Exhibit 10.17 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 30, 2002.
10.9
Asset Purchase Agreement By and Among Span-America Medical Systems, Inc., Vadus, Inc., and Certain Stockholders of Vadus, Inc. dated February 1, 2002, including amendments dated May 20, 2002 and July 9, 2002: Incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 29, 2002.
10.10
Production, Marketing and Product Development Support Agreement between Span-America Medical Systems, Inc. and Vadus, Inc. dated February 1, 2002: Incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 29, 2002.
10.11*
Severance Protection Agreement between the Company and James D. Ferguson dated July 25, 2002: Incorporated by reference to Exhibit 10.20 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2002 (the “2002 10-K”), Commission File No. 000-11392.
10.12*
Severance Protection Agreement between the Company and Robert E. Ackley dated July 25, 2002: Incorporated by reference to Exhibit 10.21 of the 10-K.
10.13*
Severance Protection Agreement between the Company and Richard C. Coggins dated July 25, 2002: Incorporated by reference to Exhibit 10.22 of the 10-K.
10.14*
Severance Protection Agreement between the Company and James R. O’Reagan dated July 25, 2002: Incorporated by reference to Exhibit 10.23 of the 10-K.
10.15*
Severance Protection Agreement between the Company and Clyde A. Shew dated July 25, 2002: Incorporated by reference to Exhibit 10.24 of the 2002 10-K.
10.16*
Severance Protection Agreement between the Company and Wanda J. Totton dated February 11, 2004: Incorporated by reference to Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended April 3, 2004.
10.17*
Span-America Medical Systems, Inc. 2000 Restricted Stock Plan: Incorporated by reference to Exhibit B to the Company’s Definitive Proxy Statement filed with the Commission on January 11, 2001.
10.18
Amended Private Label Product Supply Agreement between the Company and Hill-Rom Company, Inc. dated September 14, 2004. Incorporated by reference to Exhibit 10.18 of the Company’s Annual Report on Form 10-K for the fiscal year ended October 1, 2005 (the “2005 10-K”), Commission File No. 000-11392.
23.1
Consent of Elliott Davis, LLC.
31.1
Officer Certifications Pursuant to Section 302.
32.1
Officer Certifications Pursuant to Section 906.
*
Management contract or compensatory plan or arrangement.
(b)
Exhibits
The exhibits required by this section of Item 15 are attached hereto or incorporated by reference
(c)
Financial Statement Schedules
Schedule VIII Valuation and Qualifying Accounts
(a) Uncollectible accounts written off.
All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
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.
SPAN-AMERICA MEDICAL SYSTEMS, INC.
By: /s/ Thomas D. Henrion
December 20, 2006
Thomas D. Henrion
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the date indicated.
/s/ James D. Ferguson
President, Chief Executive Officer
James D. Ferguson
(Principal Executive Officer)
/s/ Richard C. Coggins
Chief Financial Officer and Director
Richard C. Coggins
(Principal Financial Officer)
/s/ Gwendolyn L. Randolph
Controller
Gwendolyn L. Randolph
/s/ Robert H. Dick
Director
Robert H. Dick
/s/ Thomas F. Grady, Jr.
Director
Thomas F. Grady, Jr.
/s/ Guy R. Guarch
Director
Guy R. Guarch
/s/ Thomas D. Henrion
Director
Thomas D. Henrion
/s/ Robert B. Johnston
Director
Robert B. Johnston
/s/ Linda D. Norman
Director
Linda D. Norman
/s/ Peter S. Nyberg
Director
Peter S. Nyberg
December 20, 2006