ITEM 1. BUSINESS.
1. General.
MEDTOX Scientific, Inc. (formerly EDITEK, Inc.), a Delaware corporation, was organized in September 1986. MEDTOX Scientific, Inc. and its subsidiaries, MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and New Brighton Business Center, LLC are referred to herein as “the Company.” The Company is engaged primarily in two distinct, but very much related businesses. The business of forensic and clinical laboratory services is conducted by MEDTOX Laboratories, Inc. at its facility in St. Paul, Minnesota, and the business of manufacturing and distribution of diagnostic devices is executed by MEDTOX Diagnostics, Inc. from its facility in Burlington, North Carolina. For the year ended December 31, 2003, sales from the forensic and clinical laboratory services conducted by MEDTOX Laboratories, Inc. accounted for 77% of the Company’s revenues. Revenue from the manufacture and distribution of diagnostic devices and other similar products, including some contract manufacturing conducted by MEDTOX Diagnostics, Inc., accounted for 23% of the total revenues of the Company for the year ended December 31, 2003.
2. Principal Services, Products, and Markets.
General. The Company has two reportable segments: “Laboratory Services” conducted by the Company’s wholly owned subsidiaries, MEDTOX Laboratories, Inc. and New Brighton Business Center, LLC and “Product Sales” conducted by the Company’s wholly owned subsidiary MEDTOX Diagnostics, Inc. Laboratory Services include forensic toxicology, clinical toxicology, clinical testing for the pharmaceutical industry (central laboratory services, bioanalytical and pharmacokinetic testing), and analysis of heavy and trace metals. In addition, the Laboratory Services segment provides logistical support, data management and overall program management services. Product Sales include sales of a variety of on-site screening products and contract manufacturing. For financial information relating to the Company’s segments, see Note 2 of Notes to the Consolidated Financial Statements.
Laboratory Services
A. Employment Drug Testing Laboratory Services. The primary source of revenue for the Company is derived from the provision of laboratory testing services for the identification of drugs-of-abuse. These tests are conducted using methodologies that include various immunoassays, gas liquid chromatography, gas chromatography/mass spectrometry and high performance liquid chromatography with tandem mass spectrometry (LC/MS/MS). MEDTOX Laboratories, Inc. was one of the charter laboratories to be certified by the federal government to perform drug testing of employees covered by the Federal Workplace Drug Testing Guidelines. The Company pioneered security and chain of custody procedures, including sample bar coding and automated sample handling as well as specific confirmation methods that assist in maintaining specimen integrity and the accuracy and confidentiality of test results.
The Company’s customers for substance abuse testing include public and private corporations. In addition to public and private corporations, substance abuse testing is also conducted on behalf of service firms such as drug treatment counseling centers, occupational health clinics, third party administrators and hospitals.
B. Clinical Toxicology. The Company has a fully certified clinical toxicology reference laboratory specializing in esoteric therapeutic drug monitoring and emergency toxicology. The tests performed in the clinical laboratory are conducted using methodologies such as various immunoassays, gas liquid chromatography, high performance liquid chromatography, gas chromatography/mass spectrometry and tandem mass spectrometry. The Company performs analytical testing for a wide variety of drug classes including: analgesic, antianxiety, anticholinergic, anticoagulant, anticonvulsant, antidepressant, antidiabetic, antiemetic, antihistamine, antiinflammatory, antimicrobial, antipsychotic, bronchodilator, cardiovascular, stimulant, decongestant, immunosuppressant, local anesthetic, muscle relaxant, narcotic analgesic, and sedative medications.
The Company’s clients for this market consist of hospitals, clinics and other laboratories. Laboratory specimens are delivered to the Company from clients throughout the country by the Company’s own couriers, contracted delivery services and commercial overnight couriers.
C. Clinical Testing for the Pharmaceutical Industry. The Company provides laboratory testing for Phase I-IV clinical trials, including general laboratory services, assay development, bio-analytical and pharmacokinetic testing. These tests are performed in the Company’s clinical and GLP (Good Laboratory Practices)-bioanalytical laboratories and are conducted using methodologies such as immunoassay, gas chromatography, high performance liquid chromatography, gas chromatography/mass spectrometry and tandem mass spectrometry.
The Company’s clients for this market are clinical trial sponsors (pharmaceutical and biotech Companies), clinical research organizations (CRO’s), site management organizations, and clinical trials sites.
D. Heavy Metal, Trace Element, and Solvent Analyses. The Company operates a laboratory in which blood and urine are tested for heavy metals, trace elements, and solvents. The tests are performed using methodologies such as inductively coupled plasma-mass spectrometry, and head space-gas chromatography.
The Company’s clients for this market are other laboratories, occupational health clinics, companies that are required to comply with OSHA (Occupational Safety and Health Administration) guidelines for monitoring occupational exposure to hazardous materials, and pediatricians who test children for exposure to lead.
E. Logistics, Data, and Program Management Services. The Company also provides services in the areas of logistics management, data management, and program management. These services support the Company’s underlying business of laboratory analysis and provide added value to its clients. Value-added services include courier services for medical specimen transportation, management programs for laboratory-based and on-site drug testing, coordination of specimen collection sites, and data collection/reporting services including the use of its WEBTOX® internet-based reporting system.
Product Sales
The Company has taken a leadership role in the development and distribution of diagnostic drug screening devices. The demand for fast, inexpensive screening technology that detects the presence of a number of substances in human urine, blood samples and other biological specimens continues to increase.
In 1998, the Company received FDA 510(k) clearance on the first of its second-generation on-site test products, PROFILE®-II. PROFILE®-II is a five-drug, lateral flow device that detects drugs-of-abuse in human urine. This single-step, immunoassay device has been combined with the Company’s data delivery system and laboratory confirmation capability to produce the PROFILE-II Test System®. This integrated, on-site testing system is currently marketed to occupational health clinics, corporate clients, third party administrators, and drug abuse counseling and treatment centers
In July 2000, the Company filed a 510(k) with the FDA (Food and Drug Administration) for an additional test strip that includes benzodiazepines, barbiturates, methadone and TCA (tricyclic antidepressants). The Company received pre-marketing approval for this strip in early 2001, incorporated this test strip with the PROFILE®-II test strip, and created the PROFILE-II ER®, a dual-window device that can test for nine substances in a single device. The PROFILE-II ER® is marketed primarily to hospital laboratories.
In 2001, the Company brought to market the seven-panel PROFILE®-II and the PROFILE®-II LFAS, a five-panel device with an “on-board” lateral flow adulteration strip. The adulteration strip tests for pH, specific gravity, gluteraldehyde, nitrites and a variety of oxidants.
In 2003, the Company expanded the PROFILE®-II A Test Systems to include the use of six and nine panel drug screening devices. The Company believes it has the most complete line of diagnostic screening devices available in the market.
The Company also manufactures and distributes the VERDICT®-II line of diagnostic drug screening products within the criminal justice, temporary service and drug rehabilitation markets. These devices are sold in multiple assay configurations, providing clients with flexibility in terms of drug panel options and potential cost savings.
The Company continues to market the EZ-SCREEN® tests. These tests are qualitative assays utilized in agricultural diagnostics to detect mycotoxins and antibiotic residues. Mycotoxins are hazardous substances produced by fungal growth and frequently contaminate corn, wheat, rye, barley, peanuts, tree nuts, cottonseed, milk, rice, and livestock feeds. The EZ-SCREEN® agridiagnostic tests are marketed to regulatory authorities and producers of foodstuffs and feeds.
The Company distributes diagnostic tests for the detection of alcohol with the EZ-SCREEN® Breath Alcohol Test. The test consists of a small tube containing chemically treated crystals that change color in the presence of alcohol. The Company purchases the EZ-SCREEN® Breath Alcohol Test through a distribution agreement.
3. Marketing and Sales.
The Company believes that the combined operations of the Laboratory Services business and the on-site test kits manufactured by the Product Sales segment have created synergy in the marketing of comprehensive, on-site and laboratory testing programs to a common customer base. The Company is in a position to offer a full line of products and services for the substance abuse testing and occupational medicine marketplace, including (1) on-site tests for the detection of substance of abuse drugs; (2) SAMHSA (Substance Abuse Mental Health Services Administration) certified laboratory testing (screening and confirmation); (3) biological monitoring of occupational toxins; (4) consultation; and (5) logistic, data management and program management services.
The Company has expanded its sales effort in the pharmaceutical market by offering testing services for Phase I - IV clinical trials and working with sponsors and CROs on assay development and bio-analytical and pharmacokinetic studies. In addition, the Company has begun to market clinical chemistry testing services to clinics, hospitals and physician offices on a regional basis. With the acquisition of Leadtech in October 2001, the Company expanded its presence in the pediatric lead testing market.
Major Customers. The Company had no single customer whose sales amounted to more than 10% of consolidated revenues during 2003, 2002, or 2001.
4. New Products, Research and Development.
Laboratory Services. The research and development group for Laboratory Services develops assays for new drugs and compounds, develops new assays for existing drugs and other toxins, and improves existing assays with the goal of improving assay robustness, sensitivity, accuracy, precision, specificity, and efficiency. This group also investigates and develops assays for commonly tested compounds in alternative matrices and novel formats. Numerous new laboratory-based assays were developed during 2003 using immunochemistry, liquid chromatography (LC), gas chromatography (GC), gas chromatography with mass spectrometry (GC/MS), inductively coupled plasma mass spectrometry (ICP/MS), and LC with tandem mass spectrometry (LC/MS/MS). These activities continue to enhance the Company’s test menu and realize efficiencies of new technologies. A significant effort in 2003 was invested in the development of new tests and markers for the pharmaceutical industry and clinical trials.
The clinical toxicology laboratory menu was further expanded in 2003 to encompass additional diagnostic testing focused in specific areas such as bone metabolism and renal disease. These new tests are offered both as a part of the routine test menu and as an adjunct to clinical trials testing. Significant effort was also expended on the continued transfer of current technology to state of the art LC/MS/MS methodology. Development of multi-component assays with enhanced sensitivity and specificity continues to improve the efficiency and strengthen the market position of this core business unit.
Product Sales. The Company continues to develop new and innovative products and services while expanding its test menu to meet the demands of both the drug testing and clinical markets. In 2003, the Company expanded the number of diagnostic product configurations to a total of 56, and added new device configurations to the ER, corporate and government markets.
Research and Development Expenses. The Company incurred costs of $1.9 million, $1.2 million, and $1.3 million for research and development activities in 2003, 2002, and 2001, respectively.
5. Raw Materials.
Laboratory Services. The raw materials required by the laboratory for urine drug testing consist primarily of two types: specimen collection supplies and reagents for laboratory analysis. The collection supplies include drug testing custody and control forms that identify the specimen and the client, as well as document the chain-of-custody. Collection supplies also consist of specimen bottles and shipping supplies. Reagents for drug testing are primarily immunoassay screening products and various chemicals used for confirmation testing. The Company believes all of these materials are available at competitive prices from numerous suppliers.
Product Sales. The primary raw materials required for the immunoassay-based test kits produced by the Company consist of antibodies, antigens and other reagents, plastic molded devices, wicking materials, filter materials, absorbent materials, and packaging materials. The Company maintains an inventory of raw materials which, to date, has been acquired primarily from third parties. Currently, most raw materials are available from several sources. The Company possesses the technical capability to produce its own antibodies and antigens. It has initiated production of antibodies and antigens for certain tests. If the Company were to change certain raw materials used in a specific test, additional development, validation, and accompanying costs may be required to adapt the alternate material to the specific diagnostic test.
6. Patents, Trademarks, Licensing and Other Proprietary Information.
Laboratory Services. The Company believes that the basic technologies requisite to the production of antibodies are in the public domain and are not patentable. The Company intends to rely upon trade secret protection of certain proprietary information, rather than patents, where it believes disclosure could cause the Company to be vulnerable to competitors that could successfully replicate the Company’s techniques and processes.
Product Sales. The Company was issued a second patent on the system that it developed which integrates on-site scientific analysis with state-of-the-art data collection and delivery. The system is currently being utilized with the Company’s PROFILE®-II and VERDICT®-II product lines.
The Company was issued a patent on a lateral flow test strip and the integration of adulteration strip testing into on-site devices. This is currently being utilized with the Company’s PROFILE®-II A and VERDICT®-II A product lines.
The Company holds eight additional United States issued patents. Seven of these patents generally form the basis for the EZ-SCREEN® and one-step technologies, which include PROFILE®-II and VERDICT®-II product lines. The other patent relates to methods of utilizing whole blood as a sample medium on its immunoassay devices. Applications have also been made for additional patents.
Of the seven U.S. patents mentioned above which generally form the basis for the EZ-SCREEN® and one-step technologies, one expires in 2004, two expire in 2007, one expires in 2009, two expire in 2010 and one expires in 2013. The patent relating to the methods of utilizing whole blood as a sample medium expires in 2012.
There can be no guarantee that there will not be a challenge to the validity of one or more of the patents. In the event of such a challenge, the Company might be required to spend significant funds to defend its patents, and there can be no assurance that the Company would be successful in any such action.
General. As of December 31, 2003, the Company held 14 registered trade names and/or trademarks in reference to its products and corporate names. The trade names and/or trademarks of the Company range in duration from 10 years to 20 years with expiration dates ranging from 2004 to 2013. Applications have also been made for additional trade names.
7. Seasonality.
Laboratory Services. The Company believes that the laboratory testing business is subject to seasonal fluctuations in pre-employment screening. These seasonal fluctuations include reduced volume in the summer months, year-end holiday periods, and other major holidays. In addition, inclement weather may have a negative impact on volume thereby reducing net revenues and cash flow.
Product Sales. The Company does not believe that seasonality is a significant factor in the sale of its on-site immunoassay testing devices.
8. Backlog.
Laboratory Services. There exists a delay in recognition of revenues when setting up new accounts for Laboratory Services. The time from when an account becomes a client of the Company to the time the laboratory starts receiving specimens may be up to four months. The delay in receiving samples is primarily due to the necessity of establishing communication capabilities between the client and the Company, the requirement to ship out collection kits and forms, and the establishment of a collection site network. At December 31, 2003, the Company had several accounts, which were in the process of being set up where revenues are not expected to be realized until 2004.
Product Sales. At December 31, 2003, MEDTOX Diagnostics, Inc. did not have any significant backlog. The Company does not believe that sales backlog is a significant factor in the Product Sales segment of its business.
9. Competition.
Laboratory Services. As of December 31, 2003, 52 labs, including MEDTOX Laboratories, Inc., were certified by the Department of Health and Human Services as having met the standards for Subpart C of Mandatory Guidelines for Federal Workplace Drug Testing Programs (59 FR 29916, 29925). Competitors and potential competitors include forensic testing units of large clinical laboratories and other independent laboratories, specialized laboratories, and in-house testing facilities maintained by hospitals.
Competitive factors include reliability and accuracy of tests, price structure, service, transportation and collection networks and the ability to establish relationships with hospitals, physicians, and users of drug abuse testing programs. It should be recognized, however, that many of the competitors and potential competitors have substantially greater financial and other resources than the Company.
The industry in which the Company competes is characterized by service issues including: turn-around time of reporting results, price, the quality and reliability of results, and an absence of patents or other proprietary protection. In addition, since tests performed by the Company are not protected by patents or other proprietary rights, any of these tests could be performed by competitors. However, there are proprietary assay protocols for the more specialized testing that are unique to the Company.
The Company’s ability to successfully compete in the future and maintain its margins will be based on its ability to maintain its quality and customer service strength while maintaining efficiencies and low operating costs. There can be no assurance that price competitiveness will not increase in importance as a competitive factor in the laboratory testing business.
Product Sales. The diagnostics market has become highly competitive with respect to the price, quality and ease of use of various tests, and is characterized by rapid technological and regulatory changes. The Company has designed its on-site tests as inexpensive and for use by unskilled personnel, and has not endeavored to compete with laboratory-based systems. Numerous large companies with greater research and development, marketing, financial, and other capabilities, as well as smaller research firms, are engaged in research, development and marketing of diagnostic assays for application in the areas for which the Company produces its products.
The Company has experienced increased competition with respect to its immunoassay tests from systems and products developed by others, many of whom compete solely on price. As the number of firms marketing diagnostic tests has grown, the Company has experienced increased price competition. A further increase in competition may have a material adverse effect on the business and future financial prospects of the Company.
10. Government Regulations.
The products and services of the Company are subject to the regulations of a number of governmental agencies as listed below. It is believed that the Company is currently in compliance with all regulatory authorities. The Company cannot predict whether future changes in governmental regulations might significantly increase compliance costs or adversely affect the time or cost required to develop and introduce new products.
A. Substance Abuse and Mental Health Services Administration (SAMHSA). MEDTOX Laboratories, Inc. has been certified by SAMHSA since 1988. SAMHSA certifies laboratories meeting strict standards under Subpart C of Mandatory Guidelines for Federal Workplace Drug Testing Programs. Continued certification is accomplished through periodic inspection by SAMHSA to assure compliance with applicable regulations.
B. Food and Drug Administration (FDA). Certain tests for human diagnostic purposes must be cleared by the FDA prior to their marketing for in vitro diagnostic use in the United States. The FDA regulated products produced by the Company are in vitro diagnostic products subject to FDA clearance through the 510(k) process which requires the submission of information and data to the FDA that demonstrates that the device to be marketed is substantially equivalent to a currently marketed device. This data is generated by performing clinical studies comparing the results obtained using the Company’s device to those obtained using an existing test product. Although no maximum statutory response time has been set for review of a 510(k) submission, as a matter of policy the FDA has attempted to complete review of 510(k) submissions within 90 days. To date, the Company has received 510(k) clearance for 18 different products. Products subject to 510(k) regulations may not be marketed for in vitro diagnostic use until the FDA issues a letter stating that a finding of substantial equivalence has been made.
As a registered manufacturer of FDA regulated products, the Company is subject to a variety of FDA regulations including the Good Manufacturing Practices (GMP) regulations which define the conditions under which FDA regulated products are to be produced. These regulations are enforced by the FDA and failure to comply with GMP or other FDA regulations can result in the delay of pre-market product reviews, fines, civil penalties, recalls, seizures, injunctions and criminal prosecution.
As an accredited laboratory performing testing for clinical trials, the laboratory is subject to FDA regulations including Good Laboratory Practices (GLP) and related requirements.
C. Canadian Medical Devices Conformity Assessment System (CMDCAS). MEDTOX Diagnostics, Inc. maintains a Quality System which satisfies the requirements for ensuring the safety and effectiveness of MEDTOX products and meeting the customer needs in accordance with FDA requirements as described in 21 CFR part 820 (Quality Systems), and that satisfies the requirements of the Canadian Medical Devices Regulations (CMDR) and CAN/CSA ISO 13485:1998 and ISO 9001:1994.
The policy on the Canadian Medical Devices Conformity Assessment System (CMDCAS) addresses the Quality System requirements found in the CMDR. To sell a medical device in Canada, manufacturers must meet the regulatory requirements as defined in the Medical Devices Regulations. The Quality System implemented by the manufacturer for design and manufacture of medical devices must satisfy the Quality System requirements of ISO 13485 and the manufacturer is required to have its Quality System registered by an approved CMDCAS Registrar. A CMDCAS approved Registrar audits the manufacturer’s Quality System to ISO 13485:1998 and ISO 9001:1994. MEDTOX Diagnostics, Inc. maintains a quality management system fulfilling the requirements of EN ISO 13485 and CMDCAS ISO 13485, Quality Systems - Medical Devices and ISO 9001:2000 - Quality Management Systems - Requirements. MEDTOX Diagnostics, Inc. has been issued the TUV Rheinland Product Safety GmbH quality system certificate to EN ISO 13485:2000 and the TUV Rheinland of North America Inc., quality system certificate to ISO 13485 under CMDCAS.
D. Centers for Medicare and Medicaid Services (CMS) formerly Health Care Financing Administration (HCFA). The Clinical Laboratory Improvement Act (CLIA) introduced in 1992 requires that all in vitro diagnostic products be categorized as to level of complexity. A request for CLIA categorization of any new clinical laboratory test system must be made simultaneously with FDA 510(k) submission. The EZ-SCREEN®, PROFILE®, PROFILE®-II, VERDICT® and VERDICT®-II drugs-of-abuse tests currently marketed by MEDTOX Diagnostics, Inc. have been categorized as moderately complex. The complexity category to which a clinical laboratory test system is assigned may limit the number of laboratories qualified to use the test system thus impacting product sales. MEDTOX Laboratories, Inc. is a CLIA licensed high complexity laboratory and is accredited by the College of American Pathologists (CAP) Laboratory Accreditation Program.
E. Drug Enforcement Administration (DEA). The primary business of the Company involves either testing for drugs-of-abuse or developing test kits for the detection of drugs/drug metabolites in urine. MEDTOX Laboratories, Inc. is registered with the DEA to conduct chemical analyses with controlled substances. The MEDTOX Diagnostics, Inc. facility in Burlington, NC is registered by the DEA to manufacture and distribute controlled substances and to conduct research with controlled substances. Maintenance of these registrations requires that the Company comply with applicable DEA regulations.
F. Additional Laboratory Regulations. The laboratories of MEDTOX Laboratories, Inc. and certain of its laboratory personnel are licensed or otherwise regulated by certain federal agencies, states, and localities in which it conducts business. Federal, state and local laws and regulations require MEDTOX Laboratories, Inc., among other things, to meet standards governing the qualifications of laboratory owners and personnel, as well as the maintenance of proper records, facilities, equipment, test materials, and quality control programs. In addition, the laboratories are subject to a number of other federal, state, and local requirements that provide for inspection of laboratory facilities and participation in proficiency testing, as well as govern the transportation,
packaging, and labeling of specimens tested by either laboratory. The laboratories are also subject to laws and regulations prohibiting the unlawful rebate of fees and limiting the manner in which business may be solicited. As applicable federal and state regulations become final and effective it is the Company’s policy to be in compliance with these laws, such as the HIPAA Final Privacy Rule safeguarding the privacy and confidentiality of patient’s protected health information.
The laboratory receives and uses small quantities of hazardous chemicals and radioactive materials in its operations and is licensed to handle and dispose of such chemicals and materials. Any business handling or disposing of hazardous and radioactive waste is subject to potential liabilities under certain of these laws.
11. Product and Professional Liability.
Laboratory Services. The Company’s laboratory testing services are primarily diagnostic and expose the Company to the risk of liability claims. The Company’s laboratories have maintained continuous professional and general liability insurance since 1984. The insurance policy covers those amounts the Company is legally obligated to pay for damages resulting from a medical incident, which arises out of a failure to render professional services. To date, the Company has not paid any material amounts for claims of this type and no material professional service claims are currently pending.
Product Sales. Manufacturing and marketing of products by the Company entail a risk of product liability claims. Since 1993, the Company has maintained insurance coverage against the risk of product liability arising out of events after such date, but such insurance does not cover claims made after that date based on events that occurred prior to that date. The insurance policy covers damages that the Company is legally obligated to pay as a result from bodily injury and property damage. Consequently, for uncovered claims, the Company could be required to pay any and all costs associated with any product liability claims brought against it, the cost of defense whatever the outcome of the action, and possible settlement or damages if a court rendered a judgment in favor of any plaintiff asserting such a claim against the Company. Damages may include punitive damages, which may substantially exceed actual damages. The obligation to pay such damages could have a material adverse effect on the Company and exceed its ability to pay such damages. No product liability claims are pending.
12. Employees.
As of December 31, 2003, the Company had a total of 417 full-time employee equivalents as compared to 473 full-time employee equivalents at December 31, 2002. Of the 417 employees, 366 work for MEDTOX Laboratories, Inc., while the remaining 51 work for MEDTOX Diagnostics, Inc.
The Company’s employees are not covered by any collective bargaining agreements and the Company has not experienced any work stoppages. The Company believes that it maintains good relations with its employees.
ITEM 2.
ITEM 2. PROPERTIES.
The administrative offices and laboratory operations for the Laboratory Services segment of the Company’s business are located primarily in a 53,576 square foot facility in St. Paul, Minnesota. Until March 16, 2001, the Company leased this space. On March 16, 2001 the Company purchased the entire three building complex with a total of 129,039 square feet, which included the 53,576 square feet utilized by the Company’s Laboratory Services segment. The purchasing entity was New Brighton Business Center LLC, a wholly owned limited liability company, established by the Company for the sole purpose of purchasing the entire three building complex. The facility includes other commercial tenants that have individual leases that range from ten years to less than one year in duration. In 2003, the annual rent paid by such third-party tenants, excluding their pro-rata share of operating expenses, was approximately $245,000. In addition, effective September 1, 2001, the Laboratory Services segment entered into a seven-year lease for 30,000 square feet to be used in connection with its courier business and also as additional warehouse and shipping space. This building is a special purpose
facility and enables the Company to store its vehicles indoors, when appropriate, and to perform routine maintenance of the vehicles. The annual base rent on this second facility, exclusive of operating expenses is currently $141,000 per year.
The operations for the Product Sales segment of the Company’s business are located in Burlington, North Carolina where the Company maintains the offices, research and development laboratories, production operations, and warehouse for MEDTOX Diagnostics, Inc. In March 2001, the Company entered into a 10-year lease of the entire building (approximately 39,500 square feet) for an annual base rent of $197,000, exclusive of operating expenses. In addition, under the lease $600,000 of tenant improvements made to the building by the Company are being amortized over the life of the lease as additional rent. Effective February 1, 2003, the Company entered into a month-to-month lease for an additional 30,000 square feet of space located in an adjacent building. The additional space is used for warehousing and distribution for a monthly base rent of $9,400, exclusive of operating expenses. In November 2003, the Company amended and restated these leases. Under the terms of the new lease, the original leases have been combined and the term of the new lease has been extended to March 31, 2016, for an annual base rent of $385,279, exclusive of operating expenses, effective January 2004, including amortization of the $600,000 of improvements.
The Burlington facilities have always been owned and leased to the Company by Dr. Samuel C. Powell, a member of the Board of Directors of the Company. The Company believes it is renting these facilities in Burlington on terms similar to those available from third parties for equivalent premises.
The Company believes that its existing facilities are adequate for the purposes being used to accommodate its product development, and manufacturing and laboratory testing requirements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
Not applicable.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.
No matter was submitted to a vote of the security holders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.
Common Stock
Since September 27, 1993, the Company’s common stock has been listed on the American Stock Exchange and is currently trading under the symbol “TOX”. As of March 5, 2004, the number of holders of record of the Common Stock was 1,860. The following tables set forth, for the calendar quarters indicated, the high, low, and closing prices per share for the common stock, as reported by the American Stock Exchange. The quotations shown represent inter dealer prices without adjustment for retail markups, markdowns or commissions, do not necessarily reflect actual transactions, and have been adjusted for the 10% stock dividend paid on July 5, 2002.
*Closing price as of the last day of the calendar quarter
No cash dividends have been declared or paid by the Company since its inception and management of the Company has no plans to pay a cash dividend in the foreseeable future. The Company’s financial covenants under its debt instrument may effectively preclude the Company from paying cash dividends without approval.
In September 1998, the Company’s Board of Directors authorized and declared a dividend of one preferred share purchase right (Right) for each share of common stock then outstanding. Subsequent to that date the Company maintains a plan in which one Right exists for each common share of the Company. These Rights are exercisable only if a person or group acquires beneficial ownership of 20 percent or more of the Company’s outstanding common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is derived from the consolidated financial statements of the Company and should be read in conjunction with the consolidated financial statements, related notes, and other financial information.
All share and per share amounts have been restated for the 10% stock dividends paid on July 5, 2002 and November 9, 2001.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
General
MEDTOX Scientific, Inc. (formerly EDITEK, Inc.), a Delaware corporation, was organized in September 1986. MEDTOX Scientific, Inc. and its wholly owned subsidiaries, MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and New Brighton Business Center, LLC are referred to herein as “the Company.” The Company is engaged primarily in two distinct, but very much related businesses. The business of forensic and clinical laboratory services is conducted by MEDTOX Laboratories, Inc. at its facility in St. Paul, Minnesota, and the business of manufacturing and distribution of diagnostic devices is executed by MEDTOX Diagnostics, Inc. from its facility in Burlington, North Carolina.
The Company has two reportable segments: “Laboratory Services” conducted by the Company’s wholly owned subsidiaries, MEDTOX Laboratories, Inc. and New Brighton Business Center, LLC and “Product Sales” conducted by the Company’s wholly owned subsidiary MEDTOX Diagnostics, Inc. Laboratory Services include forensic toxicology (primarily workplace drugs-of-abuse testing) and Specialty Laboratory Services, including clinical toxicology, clinical testing for the pharmaceutical industry (central laboratory services, bioanalytical and pharmacokinetic testing), and analysis of heavy and trace metals. In addition, the Laboratory Services segment provides logistical support, data management and overall program management services. Product Sales include sales of a variety of on-site screening products and contract manufacturing. For the years ended December 31, 2003, 2002, and 2001, Laboratory Services revenue accounted for 77%, 76% and 77% of the Company’s revenues, respectively. Revenue from Product Sales accounted for 23%, 24% and 23% of the total revenues of the Company for the years ended December 31, 2003, 2002, and 2001, respectively.
Critical Accounting Policies
The Company has identified the policies outlined below as critical to understanding its business and results of operations. The listing is not intended to be a comprehensive list of all accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for management’s judgment in their application. The impact and any associated risks related to these policies on the Company’s business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 in the Notes to the Consolidated Financial Statements in Item 15 on Form 10-K, beginning on page 41. Note that the preparation of this Form 10-K requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates.
The Company’s critical accounting policies are as follows:
Accounts Receivable:
The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customers’ current credit worthiness, as determined by management’s review of their current credit information. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon the Company’s historical experience and any specific customer collection issues that have been identified. While such credit losses have generally been within the Company’s historical expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same credit loss rates that have occurred in the past. The Company’s consolidated trade accounts receivable balance as of December 31, 2003 was $7.9 million, net of allowance for doubtful accounts of $0.4 million.
Some of the Company’s Laboratory Services revenues for certain types of tests are billed to third-party payors including insurance companies, state Medicaid and Medicare agencies. These payors pay for such services at established amounts, which are typically lower than gross amounts billed by the Company. However, the tests are sometimes billed directly to patients or other parties and paid at the gross amount billed for these tests. In addition, billings for the tests are occasionally re-billed to alternative payors in situations where incorrect billing information was submitted to the Company by the customer. The Company estimates a discount on the billings for these tests, and recognizes revenue and related accounts receivable at a net amount, after discount, in order to state revenue and accounts receivable at the amount expected to be paid. While the Company believes that estimated discounts and the related net revenue and net accounts receivable from these testing services are materially correct, there can be differences in amounts ultimately paid compared to estimated amounts. These differences are recorded upon payment and may affect previously recorded amounts. The Company considers historical discounts when estimating future discounts on a monthly basis.
Off-Site Supplies Inventory:
Off-site supplies represents collection kits and forms located at collections sites throughout the United States used by Laboratory Services’ customers to submit specimens for testing services. At December 31, 2003, off-site inventory was $0.7 million. The process for valuing off-site inventory involves significant assumptions regarding the average time that a collection site uses the inventory, as well as the amount of inventory expected to be scrapped.
Goodwill and Other Intangible Assets:
The Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002. SFAS No. 142 provides that goodwill and indefinite-lived intangible assets are no longer amortized, but are instead reviewed for impairment at least annually and between annual test dates in certain circumstances. The Company completed the necessary transition impairment review for goodwill and other intangible assets in 2002, and determined that there was no impairment. The Company performs its annual impairment test for goodwill and other intangible assets in the fourth quarter of each year. No impairments were indicated as a result of the annual impairment reviews for goodwill and other intangible assets in 2003 and 2002. In assessing the recoverability of goodwill and other intangible assets, projections regarding estimated future cash flows and other factors are made to determine the fair value of the respective assets. If these estimates or related projections change in the future, the Company may be required to record impairment charges for these assets in future periods.
Accounting for Income Taxes:
As part of the process of preparing the consolidated financial statements, the Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. The Company must then assess the likelihood that deferred tax assets will be recovered from future taxable income and tax planning strategies, and to the extent management believes that recovery is not likely, the Company must establish a valuation allowance. To the extent the Company increases or decreases the valuation allowance in a period, the Company must include an expense or benefit within the tax provision in the consolidated statement of operations.
Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against net deferred tax assets. The Company’s deferred tax assets primarily consist of certain net operating losses (NOLs) carried forward. At December 31, 2003, the Company has a valuation allowance on deferred tax assets of $1.4 million, which represents the portion of its NOL carryforwards that will more likely than not expire unused in 2004 and future years. The valuation allowance is based on management’s estimate of taxable income, the period over which NOLs will be recoverable, and tax planning strategies. In the future, subsequent revisions to the estimated net realizable value of these deferred tax assets could cause the provision for income taxes to vary significantly from period to period, although the Company’s cash payments would remain unaffected until the benefit of the NOL is completely utilized or expires unused.
Results of Operations
Revenues declined slightly in 2003 and continued to be impacted by the softness in new business employment. Gross margin was also down, reflecting a reduced margin in the Product Sales segment, despite improvement in the Laboratory Services segment. Operating expenses were higher due to the continued investment in research and development and severance costs related to staffing reductions. Other expense was also higher than last year due to reduced rental income from the Company’s building rental activities. In 2002, the Company recorded a $10.2 million non-cash tax benefit as part of net income. The following table sets forth the percentages of total revenues represented by certain items reflected in the Company’s Consolidated Statements of Operations:
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
Revenues
Revenues decreased 1.1% to $51.5 million in 2003, reflecting a $0.3 million, or 2.4% decline in Product Sales revenues and a $0.2 million, or 0.6% decline in Laboratory Services revenues.
Laboratory Services revenues were impacted by a decline in the average price per testing specimen for workplace drugs-of-abuse testing. The lower pricing was part of the Company’s strategy to attract new business to offset the impact of the reduced specimen volume experienced in the first half of 2003. For the full year, specimen volume from the Company’s occupational health and corporate clients increased 2.4%. This improvement reflects the Company’s continued success in acquiring new client relationships and gaining market share, despite the continued softness in new business employment. Revenues from the Company’s Specialty Laboratory Services remain strong, increasing 4.9% in 2003.
In the Product Sales segment, sales of substance abuse testing products, which incorporates the PROFILE®-II, PROFILE-II ER®, PROFILE®-II A and VERDICT®-II on-site test kits and other ancillary products for the detection of abused substances, declined 3.3% to $10.3 million in 2003. The decline is primarily attributable to lower sales within the VERDICT®-II product line to government clients for probation, parole and rehabilitation. The economic uncertainty and budget constraints that the Company’s government clients are experiencing resulted in lower purchasing levels among these clients. The Company anticipates that the government sector will continue to be a challenging environment, and will continue to pursue new sales efforts that the Company believes will improve this portion of its business going forward. Principally, during the second quarter of 2003, the Company introduced a proprietary value added service called DARS™ (Drug Abuse Recognition System) that it believes will increase sales in the government marketplace. Sales of PROFILE®-II devices to existing workplace and occupational clients were also down from last year and continue to be impacted by the reduction in nationwide hiring. Additionally, some customers are alternatively purchasing the PROFILE®-II A device, which screens for the same five drugs-of-abuse, but also includes a patented lateral flow test strip to screen for the five most common adulterants. Sales of the PROFILE®-II A increased 74.1% in 2003. The PROFILE-II ER® product, targeted at hospital laboratories for emergency response screening in drugs-of-abuse overdose situations, continues to grow, increasing 44.5% in 2003.
Product sales from agricultural diagnostic products increased 23.0% to $0.3 million in 2003 primarily as a result of increased purchases from the U.S. Department of Agriculture (USDA) for the Company’s products. Sales of contract manufacturing services, microbiological and associated products of $1.4 million in 2003 were flat compared to 2002.
Gross profit
Consolidated gross margin declined to 38.8% in 2003 compared to 39.5% in 2002. Gross margin from Product Sales declined to 57.1% in 2003, compared to 62.1% in 2002. This decline was largely due to the costs associated with the expansion and improvement of the production facility on lower than projected sales volume, as well as increased spending in quality control. Laboratory Services gross margin was 33.1% in 2003, up from 32.5% in 2002. The margin improvement was driven by labor savings associated with staffing reductions and improved operating efficiencies resulting from LEAN project initiatives. The increase in margin was partially offset by a decline in the average price per testing specimen.
Selling, general and administrative expenses
Selling, general and administrative expenses were $16.7 million, or 32.5% of revenues, in 2003, compared to $16.3 million, or 31.4% of revenues, in 2002. The increase was primarily due to severance costs associated with staffing reductions and higher business insurance expenses. During the third and fourth quarters of 2003, selling, general and administrative expenses were 30.6% and 31.3% of sales, respectively. The improvement during the second half of 2003 reflects savings from steps taken earlier in the year to reduce expenses, including certain staffing reductions. In the second half of 2003, the Company also initiated three significant LEAN projects with the objective of further reducing expenses in the Laboratory Services segment in the first quarter of 2004. In the first quarter of 2004, the Company launched a LEAN initiative at the Product Sales segment to improve operating efficiencies and reduce expenses.
Research and development expenses
Research and development increased 56.9%, or $0.7 million in 2003. The increase was driven primarily by increased development activity associated with new product configurations and assays and other new product research in the Product Sales segment. The increase was also due to recruiting and hiring costs associated with the addition of a new Vice President of Technology, Research and Development at the Company’s Product Sales segment, as well as severance and other costs associated with the reorganization of the department.
Other expense
Other income and expense consists primarily of interest expense and the net expenses associated with the Company’s building rental activities. These expenses increased 14% to $1.6 million in 2003. The increase was primarily due to reduced rental income as a result of higher vacancy rates. While the Company is actively seeking additional tenants for the building, there can be no assurance it will be able to lower overall vacancy rates in 2004. This increase was partially offset by a reduction in interest expense due to lower average interest rates.
Income taxes
The Company did not record a tax provision or benefit for 2003. At December 31, 2003, the Company has a valuation allowance on deferred tax assets of $1.4 million, which represents the portion of its net operating loss (NOL) carryforwards that will more likely than not expire unused in 2004 and future years. Should operating results for 2004 fail to meet expectations, the valuation allowance against the Company’s NOL carryforwards and the related deferred tax asset may require adjustment in future periods.
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
Revenues
Revenues increased 6.0% to $52.0 million in 2002, driven by a $1.3 million, or 11.3% increase in Product Sales revenues and a $1.7 million, or 4.4% increase in Laboratory Services revenues.
The growth in Laboratory Services was primarily due to a 22.2% increase in the Company’s Specialty Laboratory Services revenues. This increase is due to the expansion of clinical testing for the pharmaceutical industry and the October 2001 acquisition of Leadtech Corporation (Leadtech), a pediatric lead-testing laboratory. Specimen volume from occupational health and corporate clients increased 1.4% in 2002. The slow economy and poor labor market caused volume from existing occupational health and corporate clients to be below expectations. However, this impact was largely mitigated by the Company’s continued success in acquiring new client relationships and gaining market share.
In the Product Sales segment, sales of substance abuse testing products, which incorporates the PROFILE®-II, PROFILE-II ER®, PROFILE®-II A and VERDICT®-II on-site test kits and other ancillary products for the detection of abused substances, increased 11.3% during 2002. Sales of PROFILE®-II devices to existing workplace clients were down from last year and continued to be impacted by the reduction in nationwide hiring. However, continuing success in acquiring new client relationships and gaining market share helped to mitigate the negative impact of lower volumes from existing clients. Sales of PROFILE-II ER® and the Company’s new PROFILE®-II A devices continued to grow and accounted for a combined $2.4 million, or 19.4% of Product Sales, in 2002. In the VERDICT®-II product line, sales to government clients for probation, parole and rehabilitation, were up 5.5% during 2002, despite reductions in state budgets.
Sales of contract manufacturing services, microbiological and associated products increased $0.1 million, or 8.0% in 2002. Product sales from agricultural diagnostic products decreased 22.4% to $0.3 million primarily as a result of decreased purchases by the U.S. Department of Agriculture (USDA) for the Company’s products.
Gross profit
Consolidated gross margin declined fractionally to 39.5% in 2002 compared to 39.6% in 2001. Laboratory Services gross margin was 32.5% in 2002, up from 31.9% in 2001. This increase was primarily the result of the Company’s continued focus on higher-margin Specialty Laboratory testing services. Gross margin from Product Sales declined to 62.1% in 2002 compared to 66.1% in 2001, largely due to changing product mix.
Selling, general and administrative expenses
Selling, general and administrative expenses were $16.3 million, or 31.4% of revenues, in 2002, compared to $14.4 million, or 29.4% of revenues, in 2001. The increase primarily reflected the Company’s increased sales and marketing expenses related to acquiring new business and increased spending on client service support for clinical trials services. Selling, general and administrative expenses in 2001 included $0.9 million in goodwill amortization. No goodwill amortization expense was recorded in 2002 as a result of the adoption of SFAS No. 142 on January 1, 2002.
Other expense
Other expense consisted primarily of interest expense, which increased by $0.2 million or 18.6% in 2002, reflecting higher average debt levels that were partially offset by lower interest rates. Other expense also included a loss of $95,000 from the Company’s rental activities.
Income tax benefit
The Company recorded a $10.2 million non-cash tax benefit in 2002 and reduced its valuation allowance on deferred tax assets. The reduction in the valuation allowance was based on the available evidence, including the Company’s recent historical performance, tax planning strategies, and projected future results.
Liquidity and Capital Resources
The working capital requirements of the Company have been funded primarily by various combinations of profitable operations, cash received from debt financing, and the sale of equity securities. Cash and cash equivalents at December 31, 2003 were $0.7 million, compared to $0.4 million at December 31, 2002.
Net cash provided by operating activities was $3.2 million in 2003 compared to $4.2 million and $3.5 million in 2002 and 2001, respectively. The decrease in 2003 was primarily due to lower income before income taxes as well as a reduction in accounts payable and accrued expenses, partially offset by a reduction in accounts receivable and inventories.
Accounts payable and accrued expenses decreased $1.6 million in 2003 compared to an increase of $1.1 million in 2002. The significant reduction in the current year was primarily the result of the more timely payment of outstanding invoices.
Accounts receivable decreased $0.4 million in 2003 compared to an increase of $1.2 million in 2002. The significant increase in accounts receivable in 2002 was primarily the result of an increase in receivables due from third-party payors such as insurance companies, state Medicaid and Medicare agencies. Payment cycles from such payors can be lengthy, and in certain cases, were adversely affected in 2002 by incomplete or incorrect billing information provided to the Company by its customers. In 2003, the Company was able to shorten the payment cycle for such payors through a better understanding of the insurance claim filing requirements and by converting manual billings to an electronic format for certain Medicaid state agencies.
Inventories decreased $0.8 million in 2003 compared to an increase of $0.5 million in 2002. The decrease in 2003 reflects better management of required inventory levels within the Product Sales segment.
Net cash used in investing activities was $2.6 million in 2003 compared to $4.3 million and $10.9 million in 2002 and 2001, respectively. In 2003 and 2002, the Company’s investing activities consisted of capital expenditures. In 2001, the Company’s investing activities consisted of capital expenditures (primarily the building purchase discussed below) and cash paid for the acquisition of Leadtech.
In March 2001, the Company purchased the three building, 129,039 square foot complex in St. Paul, Minnesota, where the Company’s Laboratory Services segment formerly leased 53,576 square feet. The purchase price, exclusive of expenses and closing costs, was $6.35 million and was financed by a mortgage loan from Principal Life Insurance Company of Des Moines, Iowa in the amount of $6.2 million. The mortgage loan has a term of 10 years and is being repaid based on a 20-year amortization schedule with a balloon payment at the end of the ten-year term. The interest rate is fixed at an annual rate of 7.23% for the first five years at which time the rate will be renegotiated by the parties. The facility includes other commercial tenants who have individual leases that range from 10 years to less than 1 year in duration. In 2003, the annual rent paid by such third party tenants, excluding their pro-rata share of operating expenses, was $245,000.
In October 2001, the Company completed the acquisition of Leadtech, a private company operating as an independent clinical laboratory devoted primarily to the examination of blood lead concentrations in pediatric patients. The $6.1 million purchase price consisted of $2.5 million in cash, the issuance of $2.7 million of the Company’s common stock and $0.9 million of seller financing payable over 24 months. The initial cash payment of $2.5 million was funded primarily from proceeds received from private placement of subordinated debt in October 2001, net proceeds from the legal settlement with Morgan Capital LLC and operating cash flows.
The Company expects equipment and capital improvement expenditures to be between $3.0 million and $4.0 million in 2004. These expenditures are intended primarily to continue to improve efficiencies and reduce operating costs within the Laboratory Services and Product Sales businesses. Such expenditures are expected to be funded through borrowings under the Company’s credit facilities and cash provided by operating activities.
Net cash used in financing activities was $0.3 million in 2003, compared to net cash provided by financing activities of $0.5 million and $7.3 million in 2002 and 2001, respectively. The change in 2003 as compared to 2002 was primarily the result of a reduction in the use of the revolving credit facility. In 2001, the Company received proceeds from the mortgage loan discussed above and from the private placement of subordinated debt (discussed below).
The Company has a Credit Security Agreement (the Wells Fargo Credit Agreement) with Wells Fargo Business Credit, Inc. (Wells Fargo). The Wells Fargo Credit Agreement, as amended, consists of (i) a term loan of $3.185 million bearing interest at prime + 0.75% and (ii) a revolving line of credit, payable on demand, of not more than $8.0 million or 85% of the Company’s eligible trade accounts receivable bearing interest at prime + 1%; and (iii) a capex note of up to $3.5 million for the purchase of capital equipment bearing interest at prime + 0.75% to 1.25%. According to the terms of the agreement, the capex note may be amended, supplemented or restated from time to time and is generally done so on an annual basis. During the third quarter of 2003, an amendment to the capex note was required in order to allow further borrowing. The amendment was not completed in 2003 and no funding from the note was available during the second half of the year. In March 2004, the Company and Wells Fargo amended the Wells Fargo Credit Agreement to allow for borrowing under the capex note of up to $1.5 million for the purchase of capital equipment bearing interest at prime + 1.5%.
The Wells Fargo Credit Agreement requires the Company to comply with certain financial covenants, including a minimum quarterly debt service coverage ratio and a minimum quarterly pre-tax net income level. It also sets a maximum level for capital expenditures, as well as a limitation on the year-over-year increase in compensation of any director, shareholder or consultant. At December 31, 2003 the Company was not in compliance with the minimum debt service coverage and the minimum quarterly pre-tax income level covenants of the Wells Fargo Credit Agreement. The Company was also not in compliance with the covenant restricting the year-over-year increase in compensation. Wells Fargo has waived the aforementioned defaults of the Company.
In 2003, the Company entered into a Credit and Security Agreement with Wells Fargo Equipment Finance, Inc. for the acquisition of various pieces of equipment. In connection with the agreement, the Company signed notes payable for $2.0 million, payable in monthly installments over 3.5 years. Interest is payable at a variable rate of 1.25% over prime. The note is secured by the equipment purchased with the proceeds of the loan.
The Company received a total of $1.05 million from private placements of subordinated debt and warrants in October and November 2001. The notes require payment of the principal amounts on September 30, 2004. Interest at 10% per annum is paid semi-annually on June 30 and December 31. In connection with the issuance of the subordinated notes, the Company issued warrants to purchase 60,294 shares of common stock at $8.71 per share. The Company determined the value of the warrants at the dates of issuance was $281,000, based upon the Black-Scholes option pricing model. The value of the warrants was accounted for as additional paid-in capital and deducted from the principal of the subordinated notes as discount on debt issued. The discount is being amortized to interest expense over the term of the debt using the effective interest method. The effective interest rate of the subordinated debt, including the warrants, is 23.0%.
The Company is relying on expected positive cash flow from operations and its line of credit to fund its future working capital and asset purchases. The amount available on the revolving line of credit is based primarily on the receivables of the Company and, as such, varies with accounts receivable. As of December 31, 2003, the Company had total borrowing capacity of $5.4 million on its line of credit, of which $5.1 million was borrowed, leaving a net availability of $0.3 million and a cash balance of $0.7 million.
In the short term, the Company believes that the aforementioned capital will be sufficient to fund the Company’s planned operations through 2004. While there can be no assurance that the available capital will be sufficient to fund the future operations of the Company beyond 2004, the Company believes that future profitable operations, as well as access to additional capital through debt or equity financings, will be the primary means for funding the operations of the Company for the long term.
The Company continues to follow a plan which includes (i) aggressively monitoring and controlling costs, (ii) increasing revenue from sales of the Company’s existing products and services (iii) developing new products and services, as well as (iv) continuing to selectively pursue synergistic acquisitions to increase the Company’s critical mass. However, there can be no assurance that costs can be controlled, revenues can be increased, financing may be obtained, acquisitions successfully consummated, or that the Company will be profitable.
Disclosures about Contractual Obligations and Commercial Commitments
The following table aggregates all contractual commitments and commercial obligations that affect the Company’s financial condition and liquidity position as of December 31, 2003:
Off-Balance Sheet Transactions
The Company does not maintain any off-balance sheet transactions, arrangements, obligations or other relationships with unconsolidated entities or others that are reasonably likely to have a material current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Impact of Inflation and Changing Prices
The impact of inflation and changing prices on the Company has been primarily limited to salary, laboratory and operating supplies and rent increases and has historically not been material to the Company’s operations. In the future, the Company may not be able to increase the prices of laboratory testing by an amount sufficient to cover the cost of inflation, although the Company is responding to these concerns by refocusing the laboratory operations towards higher margin testing (including clinical and pharmaceutical trials) as well as emphasizing the marketing, sales and operations of the Product Sales business.
Impact of New Accounting Standards
In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others” (FIN 45). FIN 45 clarifies the requirements for a guarantor’s accounting for and disclosure of certain guarantees issued and outstanding. The initial recognition and initial measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The adoption of FIN 45 did not have a material impact on the Company’s results of operations or financial position.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” as revised in December 2003 (FIN 46R). FIN 46R addresses consolidation by business enterprises of variable interest entities and significantly changes the consolidation application of consolidation policies to variable interest entities and, thus improves comparability between enterprises engaged in similar activities when those activities are conducted through variable interest entities. The consolidation requirements of FIN 46R will apply to variable interest entities as of March 31, 2004. The Company does not hold an interest in any variable interest entities.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 was effective for certain contracts entered into or modified by the Company after June 30, 2003. The adoption of SFAS No. 149 did not have a material impact on the Company’s results of operations or financial position.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 was effective immediately for all financial instruments entered into or modified after May 31, 2003. For all other instruments, SFAS No. 150 was effective at the beginning of the third quarter of 2003. The adoption of SFAS No. 150 did not have a material impact on the Company’s results of operations or financial position.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk is the risk that the Company will incur losses due to adverse changes in interest rates or currency exchange rates and prices. The Company’s primary market risk exposures are to changes in interest rates. During 2003, 2002, and 2001, the Company did not have sales denominated in foreign currencies nor did it have any subsidiaries located in foreign countries. As such, the Company is not exposed to market risk associated with currency exchange rates and prices.
At December 31, 2003, the Company had a $5.8 million mortgage loan payable to Principal Life Insurance Company at a fixed annual rate of 7.23% until March 1, 2006, at which time the rate will be renegotiated by the parties. At December 31, 2003, the Company had $0.9 million of subordinated notes outstanding at a fixed interest rate of 10%, and various vehicle loans totaling $0.1 million. The Company also had capital leases at various fixed rates. These fixed-rate financial instruments are subject to interest rate risk and will increase or decrease in value if market interest rates change.
The Company had approximately $8.5 million and $8.0 million outstanding on its line of credit and long-term debt issued under the Wells Fargo Credit Agreement as of December 31, 2003 and 2002. The debt under the Wells Fargo Credit Agreement is held at variable interest rates. The Company has cash flow exposure on its committed and uncommitted line of credit and long-term debt due to its variable prime rate pricing. At December 31, 2003, a 1% change in the prime rate would not materially increase or decrease interest expense or cash flows.
The Company does not enter into derivative or other financial instruments or hedging transactions for trading or speculative purposes.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Reference is made to the financial statements, financial statement schedule, and notes thereto included later in this report under Item 15.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A.
CONTROL AND PROCEDURES.
Evaluation of Disclosure Controls Procedures.
As of the end of the period covered by this report, the Company conducted an evaluation under the supervision and with the participation of the company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, regarding the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rules 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information that is required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the rules of the Securities Exchange Commission.
Changes in Internal Controls.
There were no changes in the Company’s internal control over financial reporting that occurred during 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.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this Item is incorporated by reference to the section labeled “Proposal 1- Election of Directors” that appears in the Definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Stockholders of MEDTOX Scientific, Inc.
The Company has adopted the MEDTOX Scientific, Inc. Code of Ethics for senior financial and executive officers (“Code of Ethics”). The Code of Ethics is available at no charge to anyone who sends a request for a paper copy to MEDTOX Scientific, Inc. 402 West County Road D, St. Paul, Minnesota, 55112. If the Company makes any substantive amendments to the Code of Ethics or grants any waiver, including any implicit waiver from a provision of the Code of Ethics to its directors or executive officers, the Company will disclose the nature of such amendments or waiver on its website or in a report on Form 8-K.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference to the sections labeled “Executive Compensation” and “Summary Compensation Table” that appear in the Definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Stockholders of MEDTOX Scientific, Inc.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
The information required by this Item is incorporated by reference to the sections labeled “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” that appear in the Definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Stockholders of MEDTOX Scientific, Inc.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference to the section labeled “Certain Relationships and Related Transactions” that appears in the Definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Stockholders of MEDTOX Scientific, Inc.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by this Item is incorporated by reference to the section labeled “Fees to Independent Auditors” that appears in the Definitive Proxy Statement to be used in connection with the 2004 Annual Meeting of Stockholders of MEDTOX Scientific, Inc.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
a. (i) Financial Statements Page
Independent Auditors' Report
Consolidated Balance Sheets at December 31, 2003 and 2002
Consolidated Statements of Operations for the Years Ended
December 31, 2003, 2002 and 2001
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
(ii) Consolidated Financial Statement Schedule
Schedule II - Valuation and Qualifying Accounts
All other financial statement schedules normally required under Regulation S-X are omitted as the required information is inapplicable.
(iii)
Exhibits
The exhibits included in the Report are set forth on the exhibit index and follow the signature page of this Annual Report on Form 10-K.
3.1
Bylaws of the Registrant (incorporated by reference to Exhibit 4.2 filed with the Registrant's Report on Form 10-Q for the quarter ended December 31, 1986).
3.2
Restated Certificate of Incorporation of the Registrant filed with the Delaware Secretary of State on July 29, 1994 (incorporated by reference to Exhibit 3.8 filed with the Registrant's Form 10-K for fiscal year ended December 31, 1994).
3.3
Certificate of Amendment of Certificate of Incorporation of the Registrant, filed with the Delaware Secretary of State on November 27, 1995 (incorporated by reference to Appendix A filed with the Registrant's Proxy Statement on September 29, 1995).
3.4
Amended Certificate of Designations of Preferred Stock (Series A Convertible Preferred Stock) of the Registrant, filed with the Delaware Secretary of State on January 29, 1996 (incorporated by reference to Exhibit 3.1 filed with the Registrant's report on Form 8-K dated January 30, 1996).
3.5
Certificate of Amendment of Certificate of Incorporation of MEDTOX Scientific, Inc. filed with Delaware Secretary of State on September 17, 1998 (incorporated by reference to Exhibit 3.5 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 1998).
3.6
Certificate of Amendment of Certificate of Incorporation of MEDTOX Scientific, Inc. filed with Delaware Secretary of State on November 19, 1999 (incorporated by reference to Exhibit 3.6 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 1999).
4.1
Form of Warrant accompanying the Stock Purchase Agreement dated July 31, 2000. (Incorporated by reference to Exhibit 4.3 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).
4.2
Form of 10% Subordinated Notes issued by the Registrant in October and November 2001 to raise an aggregate amount of $1.5 million in subordinate debt, all with a maturity of September 30, 2004. (Incorporated by reference to Exhibit 4.4 filed with the Registrant's Report on Form 10-Q for the quarter ended September 30, 2001).
4.3
Form of Warrant accompanying the 10% Subordinated Notes issued in October and November 2001. (Incorporated by reference to Exhibit 4.5 filed with the Registrant's Report on Form 10-Q for the quarter ended September 30, 2001).
4.4
Rights Agreement dated September 18, 1998 between the Registrant and American Stock Transfer & Trust Company (incorporated by reference to Exhibit 4.1 filed with the Registrant's Report on Form 8-K dated September 21, 1998).
10.1
Second Amendment dated December 31, 1986 to Exclusive License Agreement amending and restating exclusive license granted by the Registrant to Disease Detection International, Inc. (incorporated by reference to Exhibit 10.25 filed with the Registration Statement on Form S-1 dated August 26, 1987, Commission File No. 33-15543).
10.2
Stock Option Agreement dated May 4, 1990 between the Registrant and Samuel C. Powell amending and restating the Non-Qualified Stock Option Agreement between the Registrant and Samuel C. Powell dated as of May 23, 1988. (Incorporated by reference to Exhibit 10.34 filed with the Registrant's Form 10-K for the fiscal year ended December 31, 1990).**
10.3
Registrant's Amended and Restated Qualified Employee Stock Purchase Plan (incorporated by reference to Exhibit 4 filed with the Registrant's Registration Statement on Form S-8 dated November 11, 1993, Commission File No. 33-71596).
10.4
Agreement regarding rights to "MEDTOX" name dated as of January 30, 1996 between the Registrant and Harry G. McCoy. (Incorporated by reference to Exhibit 10.38 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 1995.)**
10.5
Employment Agreement dated January 1, 2000 between the Registrant and Harry G. McCoy. (Incorporated by reference to Exhibit 10.45 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 1999.)**
10.6
Registrant's Restated Equity Compensation Plan dated May 10, 2000. (Incorporated by reference to exhibit 10.46 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000.)**
10.7
Form of Severance Agreement between the Registrant and James B. Lockhart, James A. Schoonover, B. Mitchell Owens, and Kevin J. Wiersma. (Incorporated by reference to exhibit 10.47 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).**
10.8
Purchase and Sale Agreement dated July 27, 2000 by and between the Registrant and NMRO, Inc. (Incorporated by reference to exhibit 10.48 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).
10.9
Registration Rights Agreement dated July 31, 2000 among the Registrant, certain investors, and Miller, Johnson, & Kuehn, Inc. ("MJK"). (Incorporated by reference to exhibit 10.50 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).**
10.10
Stock Purchase Agreement dated July 31, 2000 between the Registrant and certain investors. (Incorporated by reference to exhibit 10.51 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).**
10.11
Purchase and Sale Agreement dated December 29, 2000 by and between MEDTOX Laboratories, Inc. and PHL-OPCO, LP. (Incorporated by reference to exhibit 10.52 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).
10.12
Mortgage and Security Agreement dated March 16, 2001 by and between New Brighton Business Center LLC and Principal Life Insurance Company. (Incorporated by reference to exhibit 10.53 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).
10.13
Secured Promissory Note dated March 16, 2001 by and between New Brighton Business Center LLC and Principal Life Insurance Company. (Incorporated by reference to exhibit 10.54 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2000).
10.14
Nova Building Lease dated March 28, 2001 by and between Samuel C. Powell and Karen G. Powell and MEDTOX Diagnostics, Inc. (Incorporated by reference to exhibit 10.55 filed with the Registrant's Report on Form 10-Q for the quarter ended September 30, 2001).
10.15
Amendment No. 1 to Nova Building Lease dated April 1, 2001 by and between Samuel C. Powell and Karen G. Powell and MEDTOX Diagnostics, Inc. (Incorporated by reference to exhibit 10.56 filed with the Registrant's Report on Form 10-Q for the quarter ended September 30, 2001).
10.16
Amended and Restated Credit and Security Agreement dated March 31, 2001 by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., Consolidated Medical Services, Inc. and Wells Fargo Business Credit, Inc. (Incorporated by reference to exhibit 10.57 filed with the Registrant's Report on Form 10-Q for the quarter ended September 30, 2001).
10.17
First Amendment dated October 24, 2001 to the Amended and Restated Credit and Security Agreement dated March 31, 2001 by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., Consolidated Medical Services, Inc. and Wells Fargo Business Credit, Inc. (Incorporated by reference to exhibit 10.58 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).
10.18
Employment Agreement dated January 1, 2003, between the Registrant and Richard J. Braun. (Incorporated by reference to exhibit 10.59 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).**
10.19
Second Amendment to Amended and Restated Credit and Security Agreement dated May 1, 2002, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., Consolidated Medical Services, Inc. and Wells Fargo Business Credit, Inc. (Incorporated by reference to exhibit 10.60 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).
10.20
Security Agreement dated December 10, 2002, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and Wells Fargo Equipment Finance, Inc. (Incorporated by reference to exhibit 10.61 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).
10.21
Secured Promissory Note dated December 10, 2002, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and Wells Fargo Equipment Finance, Inc. (Incorporated by reference to exhibit 10.62 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).
10.22
Intercreditor Agreement dated December 16, 2002, by and between MEDTOX Scientific, Inc. and Wells Fargo Equipment Finance, Inc. (Incorporated by reference to exhibit 10.63 filed with the Registrant's Report on Form 10-K for the fiscal year ended December 31, 2002).
10.23
Amended and Restated Nova Building Lease dated November 1, 2003 by and between Powell Enterprises and MEDTOX Diagnostics, Inc.*
10.24
Non-Qualified Stock Option Agreement between the Registrant and Robert C. Bohannon dated December 3, 2003.* & **
10.25
Restricted Stock Inducement Award Agreement between the Registrant and Robert C. Bohannon dated December 3, 2003.* & **
10.26
Purchase and Sale Agreement dated July 1, 2003 by and between MEDTOX Laboratories, Inc. and CoxHealth.*
10.27
Third Amendment to Amended and Restated Credit and Security Agreement dated August 15, 2003, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., Consolidated Medical Services, Inc. and Wells Fargo Business Credit, Inc. *
10.28
Secured Promissory Note dated January 22, 2003, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and Wells Fargo Equipment Finance, Inc.*
10.29
Secured Promissory Note dated June 6, 2003, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and Wells Fargo Equipment Finance, Inc.*
10.30
Fourth Amendment to Amended and Restated Credit and Security Agreement dated March 5, 2004, by and among MEDTOX Scientific, Inc., MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., Consolidated Medical Services, Inc. and Wells Fargo Business Credit, Inc. *
21.1
Subsidiaries of Registrant*
31.1
Section 302 Certification of Chief Executive Officer pursuant to the Sarbanes-Oxley Act of 2002.*
31.2
Section 302 Certification of Chief Financial Officer pursuant to the Sarbanes-Oxley Act of 2002.*
32.1
Section 906 Certification of Chief Executive Officer pursuant to the Sarbanes-Oxley Act of 2002.*
32.2
Section 906 Certification of Chief Financial Officer pursuant to the Sarbanes-Oxley Act of 2002.*
*
Filed herewith
**
Denotes a management contract or compensatory plan or arrangement
b. Reports on Form 8-K
On December 4, 2003, the Company filed a Form 8-K dated December 4, 2003, announcing that U.S. Bancorp Piper Jaffray published a research report containing information about fourth quarter personnel reductions not previously disclosed by the Company.
On December 4, 2003, the Company filed a Form 8-K dated December 4, 2003 announcing that the Company had received ISO Certification and was granted a new patent for its “On-Site Drug Testing Method.” The Company also announced that Dr. Robert C. Bohannon had joined MEDTOX Diagnostics, Inc. as Vice President of Technology, Research and Development and as an inducement to accept the position was granted 20,000 non-qualified stock options and 5,500 restricted shares.
On November 4, 2003, the Company filed a Form 8-K dated November 4, 2003, announcing and furnishing results for the third quarter ended September 30, 2003.
On November 6, 2003, the Company filed a Form 8-K dated November 4, 2003, stating it held its quarterly conference call and announced results for the third quarter ended September 30, 2003.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized on the 18th of March, 2004.
MEDTOX Scientific, Inc.
Registrant
By: /s/ Richard J. Braun
Richard J. Braun
President, Chief Executive Officer and
Chairman of the Board of Directors
Pursuant to the requirements of the Securities Act of 1934, this Registration Statement has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.
Signature Title Date
/s/ Richard J. Braun President, Chief Executive Officer, and March 18, 2004
Richard J. Braun Chairman of the Board of Directors
(Principal Executive Officer)
/s/ Kevin J. Wiersma Vice President and Chief Financial Officer March 18, 2004
Kevin J. Wiersma (Principal Financial Officer)
/s/ Samuel C. Powell Director March 18, 2004
Samuel C. Powell, Ph.D
/s/ Brian P. Johnson Director March 18, 2004
Brian P. Johnson
/s/ Robert A. Rudell Director March 18, 2004
Robert A. Rudell
/s/ Robert J. Marzec Director March 18, 2004
Robert J. Marzec
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INDEPENDENT AUDITORS’ REPORT
To the Stockholders and Board of Directors
MEDTOX Scientific, Inc.
We have audited the accompanying consolidated balance sheets of MEDTOX Scientific, Inc. (the Company) as of December 31, 2003 and 2002 and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the index as Item 15.a. (ii). These consolidated financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit 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 our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of MEDTOX Scientific, Inc. as of December 31, 2003 and 2002 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Minneapolis, Minnesota
March 15, 2004
MEDTOX SCIENTIFIC, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2003 AND 2002
(In thousands, except share and per share data)
See notes to consolidated financial statements.
MEDTOX SCIENTIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(In thousands, except share and per share data)
(1) Share and per share amounts have been restated for the ten percent stock dividends paid on July 5, 2002 and November 9, 2001.
See notes to consolidated financial statements.
MEDTOX SCIENTIFIC, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)
See notes to consolidated financial statements.
MEDTOX SCIENTIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(In thousands)
See notes to consolidated financial statements.
MEDTOX SCIENTIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The Company - The consolidated financial statements include the accounts of MEDTOX Scientific, Inc. and its wholly owned subsidiaries, MEDTOX Laboratories, Inc. (MEDTOX Laboratories), MEDTOX Diagnostics, Inc. (MEDTOX Diagnostics), and New Brighton Business Center, LLC (NBBC) (collectively referred to as the Company).
MEDTOX Laboratories provides laboratory analyses, logistics management, data management, and program management services. Laboratory analyses include clinical testing services for the detection of substances of abuse and other toxins in biological fluids and tissues. Logistics, data, and program management services include courier services for medical specimen transportation, management programs for on-site drug testing, data collection and reporting services, coordination of specimen collection sites, and medical surveillance program management.
MEDTOX Diagnostics is engaged in the research, development, and sale of products based upon enzyme immunoassay technology for the detection of antibiotic residues, mycotoxins, drugs-of-abuse and other hazardous substances as well as distribution of agridiagnostic and food safety testing products.
NBBC conducts the Company’s building rental activities that are not related to the Company’s operations. The operations of NBBC are shown in the statements of operations as “other expense.”
All significant intercompany transactions and balances have been eliminated.
Use of Estimates - The preparation of the consolidated 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 consolidated financial statements and accompanying notes. The more significant estimates include the valuation of accounts receivable, inventories, goodwill and other intangible assets, deferred income taxes, and the recorded amounts for certain accruals. Actual results could differ from those estimates.
Cash and Cash Equivalents - Cash equivalents include highly liquid investments maturing within three months of purchase.
Trade Accounts Receivable - Sales are made to local and national customers including corporations, clinical laboratories, government agencies, medical professionals, law enforcement agencies, and health care facilities. The Company extends credit based on an evaluation of the customer’s financial condition, and receivables are generally unsecured. The Company provides an allowance for doubtful accounts equal to the estimated losses expected to be incurred in the collection of accounts receivable. In addition, some of the Company’s Laboratory Services revenues for certain types of tests are billed to third-party payors including insurance companies, state Medicaid and Medicare agencies. These payors pay for such services at established amounts, which are typically lower than gross amounts billed by the Company. The Company estimates a discount on the billings for these tests, and recognizes revenue and related accounts receivable at a net amount after discount in order to state revenue and accounts receivable at the amount expected to be paid.
Inventories - Inventories are valued at the lower of cost (first-in, first-out method) or market.
Equipment and Improvements - Equipment and improvements are stated at cost. Provisions for depreciation have been computed using the straight-line method to amortize the cost of depreciable assets over their estimated useful lives. Leasehold improvements are amortized over the lesser of the lease term or the economic useful lives of the improvements.
Goodwill and Other Intangible Assets - The Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” on January 1, 2002. SFAS No. 142 provides that goodwill and indefinite-lived intangible assets are no longer amortized, but are instead reviewed for impairment at least annually and between annual test dates in certain circumstances. The Company completed the necessary transition impairment review for goodwill and other intangible assets in 2002, and determined that there was no impairment. The Company performs its annual impairment test for goodwill and other intangible assets in the fourth quarter of each year. No impairments were indicated as a result of the annual impairment reviews for goodwill and other intangible assets in 2003 or 2002. In assessing the recoverability of goodwill and other intangible assets, projections regarding estimated future cash flows and other factors are made to determine the fair value of the respective assets. If these estimates or related projections change in the future, the Company may be required to record impairment charges for these assets.
The effect of the adoption of SFAS No. 142 on the reported net income (loss) and earnings (loss) per share for all periods presented in the accompanying statements of operations is as follows:
Goodwill and other intangible assets are allocated to the Company’s reporting units, which are either the operating segment or one reporting level below the operating segment. SFAS No. 142 requires the Company to compare the fair value of the reporting unit to its carrying amount on an annual basis to determine if there is potential impairment. If the fair value of the reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the fair value of the goodwill and other intangible assets within the reporting unit is less than their carrying value. If the carrying amount of the goodwill and other intangible asset exceeds its fair value, an impairment loss is recognized. Fair values for goodwill and other intangible assets are determined based on discounted cash flows.
Amortizable intangible assets are amortized on a straight-line or accelerated basis based upon estimated useful lives as follows as of December 31, 2003:
Customer lists: 5 - 20 years
Non-compete agreements: 2 - 5 years
Revenue Recognition - Revenues from Laboratory Services are recognized as earned at such time as the Company has completed services. The Company’s services are considered to be complete when it has performed the applicable laboratory testing services and the results have been sent to the Company’s customers or posted to the Company’s secure website. Revenues from Product Sales are recognized FOB shipping point net of an allowance for estimated returns. When shipment occurs, the sales price is fixed and determinable, and collection of the resulting receivable is reasonably assured.
Freight charges to customers are included in product sales and freight costs are included in cost of sales.
Research and Development - Research and development expenditures are charged to expense as incurred.
Income Taxes - The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the 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. A valuation allowance against deferred tax assets is established for the estimated amount of net operating losses that will more likely than not expire unused in future periods.
Earnings (Loss) per Common Share - Basic earnings (loss) per common share equals net earnings (loss) divided by the weighted average common shares outstanding during the period. Diluted earnings (loss) per common share equals net earnings (loss) divided by the sum of weighted average common shares outstanding during the period plus common stock equivalents. Common stock equivalents are shares assumed to be issued if outstanding stock options or warrants were exercised. Common stock equivalents that are anti-dilutive are excluded from net earnings per common share. Common stock equivalents are not considered in periods with a net loss as the effect would be anti-dilutive.
Fair Value of Financial Instruments - The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses are considered to be representative of their respective fair values due to their short-term nature. The carrying amount of the line of credit and long-term debt approximated fair value at December 31, 2003 and 2002. The fair value of the Company’s debt was estimated using interest rates that are representative of debt with similar terms and maturities.
Concentrations of Credit Risk - Concentrations of credit risk with respect to accounts receivable are limited due to the diversity of the Company’s clients as well as their dispersion across many different geographic regions. The Company had no customers that accounted for more than 10% of consolidated revenues in 2003, 2002, or 2001 or accounts receivable at December 31, 2003 or 2002.
Stock-Based Compensation - SFAS No. 123, “Accounting for Stock-Based Compensation,” requires companies to measure employee stock compensation plans and non-employee stock-based compensation based on the fair value method of accounting. However, for stock compensation granted to employees, SFAS No. 123 allows the alternative of continued use of Accounting Principles Board Opinion (APBO) No. 25, “Accounting for Stock Issued to Employees,” with pro forma disclosure of net income and earnings per share determined as if the fair value method had been applied in measuring compensation cost. The Company elected the continued use of APBO No. 25.
Had the Company determined compensation expense based on the fair value at the grant date for its stock options under SFAS No. 123 (as amended by SFAS No. 148), the Company’s net income (loss) and earnings (loss) per share would have been changed to the pro forma amounts indicated below:
The fair value of the options at the grant date was estimated using the Black-Scholes model with the following assumptions:
The weighted average fair value of options granted in 2003, 2002, and 2001, using the above assumptions, was $2.90, $5.74, and $5.30 and per share, respectively.
Comprehensive Income (Loss) - Comprehensive income (loss) is a measure of all nonowner changes in shareholders’ equity and includes such items as net income (loss), certain foreign currency translation items, minimum pension liability adjustments, and changes in the value of available-for-sale securities. In 2003, 2002, and 2001, comprehensive income (loss) for the Company was equal to net income (loss) as reported.
New Accounting Standards - In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others” (FIN 45). FIN 45 clarifies the requirements for a guarantor’s accounting for and disclosure of certain guarantees issued and outstanding. The initial recognition and initial measurement provisions of FIN 45 are applicable to guarantees issued or modified after December 31, 2002. The adoption of FIN 45 did not have a material impact on the Company’s results of operations or financial position.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” as revised in December 2003 (FIN 46R). FIN 46R addresses consolidation by business enterprises of variable interest entities and significantly changes the consolidation application of consolidation policies to variable interest entities and, thus improves comparability between enterprises engaged in similar activities when those activities are conducted through variable interest entities. The consolidation requirements of FIN 46R will apply to variable interest entities as of March 31, 2004. The Company does not hold an interest in any variable interest entities.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 was effective for certain contracts entered into or modified by the Company after June 30, 2003. The adoption of SFAS No. 149 did not have a material impact on the Company’s results of operations or financial position.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 was effective immediately for all financial instruments entered into or modified after May 31, 2003. For all other instruments, SFAS No. 150 was effective at the beginning of the third quarter of 2003. The adoption of SFAS No. 150 did not have a material impact on the Company’s results of operations or financial position.
Reclassifications - Certain reclassifications have been made to the 2002 and 2001 consolidated financial statements to conform with the 2003 presentation. These reclassifications had no effect on net income (loss) or total stockholders’ equity as previously reported.
2.
SEGMENTS
The Company has two reportable segments: Laboratory Services and Product Sales. The Laboratory Services segment consists of MEDTOX Laboratories and NBBC. Services provided include forensic toxicology (primarily workplace drugs-of-abuse testing) and Specialty Laboratory Services, which include clinical toxicology, clinical testing for the pharmaceutical industry, pediatric lead testing, heavy metals analyses, courier delivery, and medical surveillance. The Product Sales segment, which includes POC (point of care) disposable diagnostics devices, consists of MEDTOX Diagnostics. Products manufactured include easy to use, inexpensive, on-site drug tests such as PROFILE®-II, PROFILE-II ER®, and VERDICT®-II in addition to a variety of agricultural testing products. MEDTOX Diagnostics also provides contract manufacturing services in its FDA/GMP facility.
The Company’s reportable segments are strategic business units that offer different products and services. They are managed separately as each business requires different products, services and marketing strategies.
In evaluating financial performance, management focuses on income from operations as a segment’s measure of profit or loss. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 1).
(In thousands)
(In thousands)
The following is a summary of revenues from external customers for each group of services provided within the Laboratory Services segment:
(In thousands)
The following is a summary of revenues from external customers for each group of products and services provided within the Product Sales segment:
(In thousands)
3.
ACQUISITIONS
In July 2003, the Company completed the acquisition of the forensic drug testing customer list from Cox Toxicology, a full-service, SAMHSA-certified drug testing laboratory and a division of CoxHealth. The purchase price of the transaction is based on varying percentages of the revenue realized from the transitioned business over the next three years. During this period, the Company estimates that revenue from these accounts will total approximately $1.2 million and that the sum of the payments for the acquisition should not exceed 25% of this total. Per the terms of the agreement, $50,000 was paid in 2003, which was recorded as a customer list asset and is being amortized on a straight-line basis over a five-year period. Pro forma results related to the Cox Toxicology customer list acquisition are not material to the financial condition or results of operations of the Company.
In October 2001, the Company completed the acquisition of Leadtech Corporation (Leadtech), a private company operating as an independent clinical laboratory devoted primarily to the examination of blood lead concentrations in pediatric patients. The purchase price of $6.1 million consisted of $2.5 million in cash, the issuance of 250,462 shares of the Company’s common stock valued at $2.7 million, and $0.9 million of seller financing payable over 24 months. The value of the 250,462 shares issued was determined based on the average market price of the Company’s common stock over the two-day period before and after the number of shares issuable became fixed and determinable.
The following table summarizes the fair value of the Leadtech assets acquired at the time of purchase and represents the final purchase price allocation:
(In thousands)
In accordance with SFAS No. 142, the goodwill is assessed for impairment annually and is not amortized. The customer list is being amortized over a ten-year period on an accelerated basis based upon projected future cash flows, and the non-compete agreement was being amortized on a straight-line basis over its two-year term. Goodwill is not expected to be tax deductible.
The following unaudited pro forma information presents a summary of combined results of operations of the Company and Leadtech as if the acquisition had occurred on January 1, 2001, along with certain pro forma adjustments to give effect to amortization of intangible assets, interest expense on acquisition debt, and the stock issued to purchase Leadtech. The pro forma results were derived using Leadtech’s unaudited results. The pro forma information also does not attempt to show performance on a combined basis had the companies been combined throughout these periods. The following pro forma information, therefore, although helpful in illustrating the financial characteristics of the combined Company under one set of assumptions, does not attempt to predict or suggest future results:
(In thousands, except share and per share data)
4.
INVENTORIES
Inventories consisted of the following at December 31:
5.
GOODWILL AND OTHER INTANGIBLE ASSETS
Intangible assets, resulting primarily from acquisitions, include the value assigned to customer lists, non-compete agreements and goodwill. Amortizable intangible assets are amortized on a straight-line or accelerated basis based upon their estimated useful lives.
The components of goodwill and other intangible assets were as follows as of December 31:
Goodwill amortization expense was $0.9 million for the year ended December 31, 2001.
Other intangible asset amortization expense was $0.5 million, $0.5 million, and $0.2 million during 2003, 2002, and 2001, respectively. Future amortization expense for other intangible assets is estimated to be as follows (in thousands):
The entire amount of goodwill is included in the Laboratory Services segment, which is tested annually for impairment during the fourth quarter, after the Company’s annual forecasting process. No goodwill impairment was recognized in 2003 or 2002. There were no other changes in the carrying amount of goodwill for the years ended December 31, 2003 and 2002.
The changes in the carrying amount of other intangible assets for the year ended December 31, 2003 were as follows (in thousands):
6.
BUILDING, EQUIPMENT AND IMPROVEMENTS
Building, equipment and improvements consisted of the following at December 31:
Depreciation expense was $2.2 million, $1.7 million and $1.5 million for the years ended December 31, 2003, 2002 and 2001, respectively.
7.
DEBT
Long-term debt consisted of the following at December 31:
Long-term debt maturities at December 31, 2003 were as follows:
Wells Fargo Credit Agreement - The Company has a Credit Security Agreement (the Wells Fargo Credit Agreement) with Wells Fargo Business Credit, Inc. (Wells Fargo). The Wells Fargo Credit Agreement, as amended, consists of (i) a term loan of $3.185 million bearing interest at prime + 0.75%; (ii) a revolving line of credit, payable on demand, of not more than $8.0 million or 85% of the Company’s eligible trade accounts receivable bearing interest at prime + 1%; and (iii) a capex note of up to $3.5 million for the purchase of capital equipment bearing interest at prime + 0.75% to 1.25%. According to the terms of the agreement, the capex note may be amended, supplemented or restated from time to time and is generally done so on an annual basis. During the third quarter of 2003, an amendment to the capex note was required in order to allow further borrowing. The amendment was not completed in 2003 and no funding from the note was available during the second half of the year. In March 2004, the Company and Wells Fargo amended the Wells Fargo Credit Agreement to allow for borrowing under the capex note of up to $1.5 million for the purchase of capital equipment bearing interest at prime + 1.5%.
At December 31, 2003, $5.1 million was outstanding under the revolving line of credit, and $0.3 million was available to be advanced under the borrowing base formula. The Wells Fargo Credit Agreement is secured by virtually all of the Company’s assets, including equipment, general intangibles, inventories, and receivables. The weighted average interest rate on borrowings outstanding under the revolving line of credit was 4.5%, 5.1% and 6.8% during 2003, 2002, and 2001, respectively.
The Wells Fargo Credit Agreement requires the Company to comply with certain financial covenants, including a minimum quarterly debt service coverage ratio and a minimum quarterly pre-tax net income level. It also sets a maximum level for capital expenditures, as well as a limitation on the year-over-year increase in compensation of any director, shareholder or consultant. At December 31, 2003 the Company was not in compliance with the minimum debt service coverage and the minimum quarterly pre-tax income level covenants of the Wells Fargo Credit Agreement. The Company was also not in compliance with the covenant restricting the year-over-year increase in compensation. Wells Fargo has waived the aforementioned defaults of the Company.
In 2003, the Company entered into a Credit and Security Agreement with Wells Fargo Equipment Finance, Inc. for the acquisition of various pieces of equipment. In connection with the agreement, the Company signed notes payable for $2.0 million, payable in monthly installments over 3.5 years. Interest is payable at a variable rate of 1.25% over prime. The note is secured by the equipment purchased with the proceeds of the loan.
Subordinated Debt - In October and November 2001, the Company received approximately $1.05 million from private placements of subordinated debt. The notes require payment of the principal amounts on September 30, 2004. Interest at 10% per annum is paid semi-annually on June 30 and December 31. In connection with the issuance of the subordinated notes, the Company issued warrants to purchase 60,294 shares of common stock at $8.71 per share. The Company determined the value of the warrants at the dates of issuance to be $281,000 based upon the Black-Scholes option-pricing model. The value of the warrants was accounted for as additional paid-in capital and deducted from the principal of the subordinated notes as discount on debt issued. The effective interest rate of the subordinated debt including the warrants is 23.0%. The discount is being amortized to interest expense over the term of the debt using the effective interest method.
Cash paid for interest for all outstanding debt was $1.1 million, $1.3 million and $1.2 million for the years ended December 31, 2003, 2002 and 2001, respectively.
8.
STOCKHOLDERS’ EQUITY
On April 19, 2002, the Board of Directors declared a 10% stock dividend on the Company’s common stock, which was paid on July 5, 2002 to stockholders of record on May 22, 2002. The dividend was charged to accumulated deficit in the amount $5.0 million, which was based on the fair value of the Company’s common stock. Accordingly, all stock option, warrant, share, and per share data included in the consolidated financial statements have been restated to reflect the 10% stock dividend.
On September 26, 2001, the Board of Directors declared a 10% stock dividend on the Company’s common stock, which was paid on November 9, 2001 to stockholders of record on October 26, 2001. The dividend was charged to accumulated deficit in the amount of $5.2 million, which was based on the fair value of the Company’s common stock. Accordingly, all stock option, warrant, share, and per share data included in the consolidated financial statements have been restated to reflect the 10% stock dividend.
At December 31, 2003, shares of common stock reserved for future issuance upon exercise of outstanding common stock warrants were as follows:
In addition, at December 31, 2003, 755,386 shares of common stock were reserved for future issuances under the stock option plans discussed in Note 9.
In September 1998, the Company’s Board of Directors declared a dividend of one preferred share purchase right for each common share then outstanding. The Rights were distributed pursuant to a Rights Agreement between the Company and American Stock Transfer & Trust Company. Each Right entitles the holder to purchase one one-hundredth of a share of a new series of junior participating preferred stock at an exercise price of $29.80, subject to adjustment. The Rights are exercisable only if a person or group acquires beneficial ownership of 20 percent or more of the Company’s outstanding common stock.
9.
STOCK OPTION AND PURCHASE PLANS
The Company has provided stock option plans to serve as incentives to eligible employees, officers, and directors in the form of incentive stock options, nonqualified stock options, stock appreciation rights, restricted and unrestricted stock awards, performance shares, and other stock-based awards. The Compensation Committee of the Board of Directors determined the exercise price (not to be less than the fair market value of the underlying stock) of stock options at the date of grant. Options generally become exercisable in installments over a period of one to five years and expire ten years from the date of grant. Restricted stock awards are awarded with a fixed restriction period. At December 31, 2003, all of the Company’s stock option plans had expired, and no options are available for future grant.
The following table summarizes information about stock options outstanding at December 31, 2003:
Nonqualified Stock Options - At December 31, 2003, 2002, and 2001, the Company had 142,224, 122,224 and 122,224, respectively, of nonqualified stock options outstanding to certain current and former officers and new employees of the Company. The weighted average exercise price of nonqualified stock options outstanding was $6.95, $7.16 and $7.16 per share, at December 31, 2003, 2002 and 2001, respectively. The shares of common stock covered by nonqualified options are restricted as to transfer under applicable securities laws.
Restricted Stock Awards- Restricted stock awards are issued to certain key employees and directors of the Company as an incentive for the performance of future services that will contribute materially to the successful operation of the Company. Owners of restricted stock awards have the rights of shareowners, including the right to vote. The Company awarded 165,653, 36,391, and 49,005 restricted shares in 2003, 2002, and 2001, respectively, to certain key employees and directors of the Company with restriction periods of three to five years. The market value of the awards on the date of the grant was recorded as deferred stock-based compensation and additional paid-in capital. Compensation is charged to operations on a straight-line basis over the restriction periods and amounted to $520,000, $344,000, and $183,000 in 2003, 2002, and 2001, respectively. Unvested restricted stock awards totaled 246,398 and 133,960 at December 31, 2003 and 2002, respectively, with a weighted average grant date fair value of $6.96 and $8.16 in 2003 and 2002, respectively.
Qualified Employee Stock Purchase Plan - The Company has a Qualified Employee Stock Purchase Plan (the Purchase Plan) under which all employees meeting certain criteria may subscribe to and purchase shares of common stock. The number of shares of common stock authorized to be issued under the Purchase Plan is 181,500. The subscription price of the shares is 85% of the fair market value of the common stock on the day the executed subscription form is received by the Company. The purchase price for the shares is the lesser of the subscription price or 85% of the fair market value of the shares on the day the right to purchase is exercised. Payment for common stock is made through a payroll deduction plan. Shares issued under the Purchase Plan were 8,861, 14,878, and 22,812 during 2003, 2002, and 2001, respectively. As of December 31, 2003, 97,950 shares of common stock were available for issuance under the Purchase Plan.
10.
EARNINGS (LOSS) PER SHARE
The following table sets forth the computation of basic and diluted earnings (loss) per common share:
Options and warrants to purchase an aggregate 1,702,520 shares of common stock were outstanding during 2003 and were excluded from the computation of dilutive earnings per share as their inclusion would have been anti-dilutive due to a net loss. Options and warrants to purchase 928,065 and 828,160 shares of common stock were outstanding during 2002 and 2001, respectively, but were not included in the computation of diluted earnings per share as their exercise prices were greater than the average market price of the common shares.
11.
INCOME TAXES
Income tax benefit consisted of:
Following is a reconciliation of federal income tax at the statutory rate of 34% to the actual income taxes provided for:
Deferred income taxes reflect the 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 assets (liabilities) were as follows:
At December 31, 2003, the Company had federal net operating loss carryforwards (NOLs) of approximately $27.9 million which are available to offset taxable income in 2004 through 2023. In addition, at December 31, 2003, the Company had state NOLs of approximately $10.8 million, which are available to offset taxable income in 2004 through 2029. For financial reporting purposes, a valuation allowance has been recorded to offset deferred tax assets that, more likely than not, will not be realized based on the Company’s projected future taxable income, the timing of expiring NOLs, and the Company’s tax planning strategies. Section 382 of the Internal Revenue Code restricts the annual utilization of certain NOLs incurred prior to a change in ownership. However, such limitation is not expected to impair the realization of these NOLs.
12.
EMPLOYEE BENEFIT PLAN
The Company has a defined contribution benefit plan that covers substantially all employees who meet certain age and length of service requirements. Contributions to the plan are at the discretion of the Company’s Board of Directors. The 401(k) expense for 2003, 2002 and 2001 was $0.1, $0.2 and $0.2 million, respectively.
13.
COMMITMENTS AND CONTINGENCIES
Leases - The Company leases office and research facilities from a director under a fixed term operating lease. Rental payments to the director were approximately $347,000, $197,000, and $138,000 during 2003, 2002 and 2001, respectively.
The Company leases other offices and facilities and office equipment under certain operating leases, which expire on various dates through March 2016. Under the terms of the facility leases, a pro rata share of operating expenses and real estate taxes are charged as additional rent.
As of December 31, 2003, the Company is obligated for future minimum lease payments without regard to sublease payments under noncancelable leases as follows:
Rent expense (including amounts for the facilities leased from the director) amounted to $1.7 million, $1.3 million and $1.4 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Legal - The Company is party to various legal proceedings arising in the normal course of business activities, none of which, in the opinion of management, are expected to have a material adverse impact on the Company’s consolidated financial position or results of operations.
Legal Settlement - In 2001, the Company received a favorable judgment relating to the Company’s Section 16(b) claim against a former stockholder. The Company was paid $715,000 in cash, the net proceeds of which were recorded as additional paid in capital.
14.
RELATED PARTY TRANSACTIONS
In March 2001, the Company entered into a 10-year lease of the Burlington, North Carolina production facility for an annual base rent of $197,000, exclusive of operating expenses. In addition, under the lease $600,000 of tenant improvements made to the building by the Company are being amortized over the life of the lease as additional rent. The Company received $300,000 for reimbursement of tenant improvements completed in 2001. Effective February 1, 2003, the Company entered into a month-to-month lease of a warehousing and distribution facility in an adjacent building for a monthly rent of $9,400, exclusive of operating expenses. These facilities
have always been owned and leased to the Company by a director of the Company. In 2003, the Company completed additional tenant improvements to the premises of $300,000. In November 2003, the Company amended and restated these leases. Under the terms of the new lease, the original leases have been combined and the term of the new lease has been extended to March 31, 2016, for an annual base rent of $385,279, exclusive of operating expenses, effective January 2004, including amortization of the $600,000 of improvements. In January 2004, the director reimbursed the Company $300,000 for the tenant improvements completed in 2003. The Company believes it is renting these facilities on terms similar to those available from third parties for equivalent premises.
In October and November 2001, the Company received approximately $1.05 million from private placements of subordinated debt. Of this amount, $290,000 was received from an officer and two directors of the Company (see Note 7). In the first quarter of 2003, the Company repaid the $40,000 received from the officer prior to the scheduled maturity in September 2004.
In October 2000, Harry McCoy was replaced as Chairman and President of the Company but continued to receive payments as an employee under an employment agreement with the Company. At that time, the Company recorded $600,000 as the estimated amount payable to Mr. McCoy under the employment agreement. The Company and Mr. McCoy disputed the effect of the termination of his employment with the Company. In September 2001, the Company entered into an agreement with Mr. McCoy resolving these issues. The parties agreed to a mutual release of claims. Mr. McCoy resigned his position on the Board of Directors and agreed to serve as an ongoing consultant to the Company. In exchange, the Company agreed to provide Mr. McCoy with a lump sum payment of $250,000, and an additional amount of $250,000 in restricted common stock. In exchange for McCoy’s ongoing consulting relationship, he will receive $35,000 annually over the next five years. The Company also advanced Mr. McCoy $102,500 in cash, subject to a five-year promissory note, representing the amount necessary for Mr. McCoy to exercise his previously held options to 44,000 shares of the Company’s common stock. Mr. McCoy repaid the promissory note in full in 2002.
15.
QUARTERLY INFORMATION (UNAUDITED)
(In thousands, except per share amounts)
During the fourth quarter of 2002, the Company reported a net loss of $1.1 million as a result of income tax expense of $633,000 and decreased sample volume from existing drugs-of-abuse clients due to the slowing economy. The income tax expense was based on refinements in the Company’s tax strategy for utilizing future net operating loss carryforwards and related year-end computations of taxable income and deferred taxes. The fourth quarter adjustment reduced the total amount of income tax benefit recorded for the year to $10.2 million compared to the $10.8 million recorded in the third quarter of 2002. The net loss in the fourth quarter was reduced, however, due to lower compensation expenses resulting from a change in the Company’s vacation policy.
All per share amounts have been restated for the ten percent stock dividend paid on July 5, 2002.
SCHEDULE II-VALUATION & QUALIFYING ACCOUNTS
(1) Uncollectible accounts written off, net of recoveries.
(2) Represents payments of lease obligations.