SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1998. [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _______________ to______________ Commission file number: 0-16159 LECTEC CORPORATION (Exact name of Registrant as specified in its charter) Minnesota 41-1301878 - --------------------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10701 Red Circle Drive, Minnetonka, Minnesota 55343 - --------------------------------------------- ------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (612) 933-2291 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common stock, par value $0.01 per share. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the registrant's common stock as of February 11, 1999 was 3,870,329 shares. LECTEC CORPORATION FORM 10-Q - QUARTERLY REPORT FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 1998 TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Item 1. Financial Statements and Notes to Financial Statements . . . . . . I-1 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. . . . . . . . . . . . . . . . . . . . . . . I-8 Item 3. Quantitative and Qualitative Disclosures About Market Risk . . . . I-13 PART II - OTHER INFORMATION Item 1. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . II-1 Item 2. Changes in Securities. . . . . . . . . . . . . . . . . . . . . . . II-1 Item 3. Defaults Upon Senior Securities. . . . . . . . . . . . . . . . . . II-1 Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . . II-1 Item 5. Other Information. . . . . . . . . . . . . . . . . . . . . . . . . II-2 Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . II-2 Signature Page . . . . . . . . . . . . . . . . . . . . . . . . . . II-3 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS AND NOTES TO FINANCIAL STATEMENTS LECTEC CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
(Unaudited) December 31, June 30, 1998 1998 ----------- ----------- ASSETS CURRENT ASSETS Cash and cash equivalents $ 1,022,455 $ 2,186,532 Receivables Trade, net of allowances of $95,083 (unaudited) and $90,818 at December 31, 1998 and June 30, 1998 2,668,087 2,251,757 Refundable income taxes 7,544 59,544 Other 39,017 30,624 ----------- ----------- 2,714,648 2,341,925 Inventories Raw materials 1,130,201 1,184,778 Work-in-process 18,400 15,055 Finished goods 736,311 518,178 ----------- ----------- Total inventories 1,884,912 1,718,011 Prepaid expenses and other 228,677 103,063 Deferred income taxes 379,000 379,000 ----------- ----------- Total current assets 6,229,692 6,728,531 PROPERTY, PLANT AND EQUIPMENT - AT COST Building and improvements 1,919,402 1,816,277 Equipment 6,853,571 6,791,765 Furniture and fixtures 396,367 384,260 ----------- ----------- 9,169,340 8,992,302 Less accumulated depreciation 5,313,847 4,933,465 ----------- ----------- 3,855,493 4,058,837 Land 247,731 247,731 ----------- ----------- 4,103,224 4,306,568 OTHER ASSETS Patents and trademarks, less accumulated amortization of $1,072,636 (unaudited) and $1,001,157 at December 31, 1998 and June 30, 1998 255,968 273,999 Long-term investments 8,676 8,676 ----------- ----------- 264,644 282,675 ----------- ----------- $10,597,560 $11,317,774 =========== ===========
See accompanying notes to the consolidated financial statements. I - 1 LECTEC CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS - CONTINUED
(Unaudited) December 31, June 30, 1998 1998 ----------- ----------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 1,477,242 $ 809,147 Accrued expenses Payroll related 350,657 384,135 Other 182,327 199,388 ----------- ----------- Total current liabilities 2,010,226 1,392,670 DEFERRED INCOME TAXES 222,000 222,000 SHAREHOLDERS' EQUITY Common stock, $.01 par value: 15,000,000 shares authorized; issued and outstanding 3,870,300 shares (unaudited) at December 31, 1998 and 4,036,000 shares at June 30, 1998 38,703 40,360 Additional paid-in capital 11,246,373 11,769,053 Unrealized losses on securities available-for-sale (8,508) (8,508) Deficit in retained earnings (2,911,234) (2,097,801) ----------- ----------- 8,365,334 9,703,104 ----------- ----------- $10,597,560 $11,317,774 =========== ===========
See accompanying notes to the consolidated financial statements. I - 2 LECTEC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three months ended Six months ended December 31, December 31, ----------------------------- ----------------------------- 1998 1997 1998 1997 ----------- ----------- ----------- ----------- Net sales $ 3,103,277 $ 3,308,962 $ 6,006,334 $ 6,939,772 Cost of goods sold 2,177,539 2,362,392 4,063,343 4,784,343 ----------- ----------- ----------- ----------- Gross profit 925,738 946,570 1,942,991 2,155,429 Operating expenses Sales and marketing 545,938 244,879 879,471 505,224 General and administrative 781,630 470,347 1,368,091 1,001,693 Research and development 286,025 261,737 566,038 508,329 ----------- ----------- ----------- ----------- 1,613,593 976,963 2,813,600 2,015,246 ----------- ----------- ----------- ----------- Earnings (loss) from operations (687,855) (30,393) (870,609) 140,183 Other income, net 26,987 12,623 58,788 21,417 ----------- ----------- ----------- ----------- Earnings (loss) before income taxes (660,868) (17,770) (811,821) 161,600 Income tax expense (benefit) 348 (19,677) 1,612 8,000 ----------- ----------- ----------- ----------- Net earnings (loss) $ (661,216) $ 1,907 $ (813,433) $ 153,600 =========== =========== =========== =========== Net earnings (loss) per share Basic $ (0.17) $ 0.00 $ (0.21) $ 0.04 =========== =========== =========== =========== Diluted $ (0.17) $ 0.00 $ (0.21) $ 0.04 =========== =========== =========== =========== Weighted average shares outstanding Basic 3,907,995 4,062,354 3,945,599 3,952,586 =========== =========== =========== =========== Diluted 3,907,995 4,073,910 3,945,599 3,966,996 =========== =========== =========== ===========
See accompanying notes to the consolidated financial statements. I - 3 LECTEC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended December 31, ----------------------------- 1998 1997 ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings (loss) $ (813,433) $ 153,600 Adjustments to reconcile net earnings (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 451,861 427,226 Loss on sale of investments -- 9,810 Changes in operating assets and liabilities: Trade and other receivables (424,723) (496,923) Refundable income taxes 52,000 328,094 Inventories (166,901) 106,020 Prepaid expenses and other (125,614) (41,171) Accounts payable 608,632 322,452 Accrued expenses (50,539) (2,539) ----------- ----------- Net cash provided by (used in) operating activities (468,717) 806,569 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (177,038) (270,512) Investment in patents and trademarks (53,448) (39,498) Sale of investments -- 422,598 ----------- ----------- Net cash provided by (used in) investing activities (230,486) 112,588 CASH FLOWS FROM FINANCING ACTIVITIES: Retirement of common stock (464,874) -- ----------- ----------- Net cash used in financing activities (464,874) -- ----------- ----------- Net increase (decrease) in cash and cash equivalents (1,164,077) 919,157 Cash and cash equivalents at beginning of period 2,186,532 665,190 ----------- ----------- Cash and cash equivalents at end of period $ 1,022,455 $ 1,584,347 =========== ===========
See accompanying notes to the consolidated financial statements. I - 4 LECTEC CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED (UNAUDITED)
Six Months Ended December 31, ----------------------------- 1998 1997 ----------- ----------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest expense $ -- $ 872 Income taxes 22,010 10,676 SUPPLEMENTAL SCHEDULE OF NONCASH ACTIVITIES: Conversion of Pharmadyne minority shareholders' interest in the Pharmadyne subsidiary into LecTec Corporation common stock $ -- $ 1,369,411
See accompanying notes to the consolidated financial statements. I - 5 LECTEC CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERS ENDED DECEMBER 31, 1998 AND 1997 (1) GENERAL The accompanying consolidated financial statements include the accounts of LecTec Corporation (the "Company"), LecTec International Corporation, a wholly-owned subsidiary, and Pharmadyne Corporation, a wholly-owned subsidiary which was merged into LecTec Corporation on December 31, 1997. All significant intercompany balances and transactions have been eliminated in consolidation. The Company's financial statements for the three months and six months ended December 31, 1998 should be read in conjunction with its Annual Report on Form 10-K and its Annual Report to Shareholders for the fiscal year ended June 30, 1998. The interim financial statements are unaudited and in the opinion of management, reflect all adjustments necessary for a fair presentation of results for the periods presented. Results for interim periods are not necessarily indicative of results for the year. The Company's basic net earnings (loss) per share amounts have been computed by dividing net earnings (loss) by the weighted average number of outstanding common shares. The Company's diluted net earnings (loss) per share amounts have been computed by dividing net earnings (loss) by the weighted average number of outstanding common shares and common share equivalents, when dilutive. Options and warrants to purchase 873,066 and 753,355 shares of common stock with a weighted average exercise price of $7.70 and $8.29 were outstanding during the three months ended December 31, 1998 and 1997, but were excluded because they were antidilutive. Options and warrants to purchase 870,323 and 736,460 shares of common stock with a weighted average exercise price of $7.72 and $8.34 were outstanding during the six months ended December 31, 1998 and 1997, but were excluded because they were antidilutive. (2) STOCK REPURCHASE PROGRAM In April 1998, the Company's Board of Directors authorized a stock repurchase program pursuant to which up to 500,000 shares may be repurchased. The shares may be purchased from time to time through open market transactions, block purchases, tender offers, or in privately negotiated transactions. The total consideration for all shares repurchased under this program cannot exceed $2,000,000. During the quarter and six months ended December 31, 1998, 74,800 and 165,650 shares were repurchased for $223,663 and $524,338, including $59,463 which was settled after December 31, 1998. Through December 31, 1998 the Company has repurchased a total of 195,150 shares at a cost of $648,900. During the period from January 1, 1999 through February 10, 1999 the Company did not repurchase any additional shares. (3) COMPREHENSIVE INCOME As of July 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, which establishes new rules for the reporting and display of comprehensive income and it components. SFAS 130 requires companies to report, in addition to net income, other components of comprehensive income, including unrealized gains or losses on securities available-for-sale. Total comprehensive loss for the second quarter of fiscal 1998 was $661,216 and total comprehensive income for the second quarter of fiscal 1997 was $7,274. Total comprehensive loss for the first six months of fiscal 1998 was $813,433 and total comprehensive income for the first six months of fiscal 1997 was $174,487. Adoption of this disclosure standard had no effect on the Company's results of operations or financial position as reported in the consolidated financial statements. I - 6 LECTEC CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERS ENDED DECEMBER 31, 1998 AND 1997 (CONTINUED) (4) NEW ACCOUNTING PRONOUNCEMENTS Additionally, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," effective July 1, 1998. SFAS No. 131 requires the Company to disclose financial and other information about its business segments, their products and services, geographic areas, sales, profits, assets and other information. SFAS No. 131 is effective for financial statements for periods beginning after December 15, 1997, however the statement does not need to be applied to interim financial statements in the initial year of application. Comparative information for the interim period in the initial year of application will be reported in the Company's financial statements for interim periods in fiscal 2000. I - 7 PART I - FINANCIAL INFORMATION ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 1998 AND 1997 RESULTS OF OPERATIONS NET SALES Net sales for the second quarter of fiscal 1999 were $3,103,277 compared to net sales of $3,308,962 for the second quarter of fiscal 1998, a decrease of 6.2%. The decrease was primarily the result of decreased medical tape and conductive product sales which were partially offset by increased sales of therapeutic products. Conductive product sales, the Company's largest product group, decreased by 5.2% from the prior year while medical tape sales, the Company's second largest product group, decreased by 39.3% from the prior year and therapeutic product sales increased to $429,715 from $62,380 in the prior year. The conductive product sales decrease was primarily due to normal period-to-period fluctuations of sales to the Company's customers. Medical tape product sales decreased primarily due to the absence of sales in fiscal 1999 to several large international customers who purchase intermittently. The therapeutic product sales increase was primarily the result of sales of the various TheraPatch(R) brand products directly to retailers. In the prior year the Company had no patch sales to either CNS, Inc. (the Company's former distributor to retailers of its analgesic patch product), nor to a former direct marketing distributor. Effective July 1, 1998, the Company assumed responsibility for the retail distribution of the analgesic patch product that CNS, Inc. had previously handled, and in September 1998, the Company began the launch of its TheraPatch family of patch products. The product family launch included two patches for topical pain relief and two patches for cough suppression. Net sales for the first six months of fiscal 1999 were $6,006,334 compared to net sales of $6,939,772 for the first six months of fiscal 1998, a decrease of 13.5%. The decrease was primarily the result of decreased medical tape and conductive product sales. Conductive product sales decreased by 4.4% from the prior year, while medical tape product sales decreased by 34.0% and therapeutic product sales increased by 2.9%. Conductive product sales decreased primarily as a result of normal period-to-period fluctuations of sales to the Company's customers. Medical tape product sales decreased primarily due to the absence of sales in fiscal 1999 to several large international customers who purchase intermittently and due to the discontinuance of sales to several low-margin slit roll customers. The therapeutic product sales increase resulted from increased sales volumes of corn and callus therapeutic products. Patch product sales for the first six months of fiscal 1999 and fiscal 1998 were comparable in dollar amount. However, decreased unit volume in 1999 was offset by increased unit selling price as the Company sold directly to retailers rather than to CNS, Inc., the Company's exclusive distributor to retailers in the prior year. GROSS PROFIT Gross profit for the second quarter of fiscal 1999 was $925,738 compared to $946,570 for the second quarter of fiscal 1998, a decrease of 2.2%. Gross profit as a percent of net sales for the second quarter of fiscal 1999 was 29.8% compared to 28.6% for the second quarter of fiscal 1998. The increase in the gross profit percent for the quarter resulted primarily from a shift in the sales mix toward higher margin patch products. Gross profit for the first six months of fiscal 1999 was $1,942,991 compared to $2,155,429 for the first six months of fiscal 1998, a decrease of 9.9%. Gross profit as a percent of net sales for the first six months of fiscal 1999 was 32.3% compared to 31.1% for the first six months of fiscal 1998. The increase in the gross profit percent for the first six months resulted primarily from higher margins on patch sales, primarily as a result of sales directly to retailers rather than to a distributor, and lower obsolescence I - 8 expense, due in part to decreased inventory levels. These factors were partially offset by higher scrap and material usage costs, due primarily to the start-up of production on retail TheraPatch products. SALES AND MARKETING EXPENSES Sales and marketing expenses were $545,938 and $244,879 during the second quarters of fiscal 1999 and 1998, and as a percentage of net sales, were 17.6% and 7.4%. The increase in sales and marketing expenses for the quarter was primarily the result of expenses associated with the launch of the TheraPatch product family to retailers, as well as ongoing sales activities related to the Company's new Consumer Products Division. The increase in expenses was primarily due to increases in advertising, promotion and travel expense, as well as an increase in sales staff. These expenses associated with the Company's new Consumer Products Division were not present in the prior year. The Company anticipates that sales and marketing expenses, as a percentage of sales, will decrease as the sales volume of patch products increases. Sales and marketing expenses were $879,471 and $505,224 during the first six months of fiscal 1999 and 1998, and as a percentage of net sales, were 14.6% and 7.3%. The increase in sales and marketing expenses for the first six months of fiscal 1999 compared to the first six months of fiscal 1998 resulted from the same factors responsible for the increase in expenses for the second quarter of fiscal 1999. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses were $781,630 and $470,347 during the second quarters of fiscal 1999 and 1998, and as a percentage of net sales, were 25.2% and 14.2%. The increase in general and administrative expenses for the quarter included approximately $126,000 of expenses related to the re-negotiation and modification of the license agreement for the development and commercialization of cotinine, and $42,000 of legal expenses associated with work on new and existing patents. Increased regulatory and quality assurance expenses associated with achieving and maintaining ISO 9001 and EN 46001 certification were also factors in the increase in general and administrative expenses for the quarter. The Company anticipates that general and administrative expenses, as a percentage of sales, will be approximately 20% of net sales for the remainder of fiscal 1999. General and administrative expenses were $1,368,091 and $1,001,693 during the first six months of fiscal 1999 and 1998, and as a percentage of net sales, were 22.8% and 14.4%. The increase in general and administrative expenses for the first six months of fiscal 1999 compared to the first six months of fiscal 1998 resulted from the same factors responsible for the increase in expenses for the second quarter of fiscal 1999. RESEARCH AND DEVELOPMENT EXPENSES Research and development expenses for the second quarters of fiscal 1999 and 1998 were $286,025 and $261,737, and as a percentage of net sales, were 9.2% and 7.9%. The increase in research and development expenses for the quarter was primarily due to increases in staff. Research and development expenses for the first six months of fiscal 1999 and 1998 were $566,038 and $508,329, and as a percentage of net sales, were 9.4% and 7.3%. The increase in research and development expenses for the first six months reflects increased staffing levels and increased costs for testing and test runs of products under development. I - 9 OTHER INCOME, NET Other income, net increased in the second quarter of fiscal 1999 to $26,987 from $12,623 in the second quarter of 1998. Other income, net increased in the first six months of fiscal 1999 to $58,788 from $21,417 in the first six months of 1998. Other income was higher in both the second quarter and first six months of fiscal 1999 due to increased investment income as a result of higher cash and cash equivalent balances in fiscal 1999 compared to cash, cash equivalent and short-term investment balances during 1998, and a loss on the sale of investments incurred during fiscal 1998. EARNINGS (LOSS) BEFORE INCOME TAXES The Company recorded a loss before income taxes of $660,868 in the second quarter of fiscal 1999 compared to a loss before income taxes of $17,770 in fiscal 1998. For the first six months of fiscal 1999, the Company recorded a loss before income taxes of $811,821 compared to earnings before income taxes of $161,600 for the first six months of fiscal 1998. The loss for the second quarter and first six months of fiscal 1999 was primarily the result of increased sales and marketing expenses related to the Company's new Consumer Products Division and increased general and administrative expenses, primarily those expenses related to the modification of the cotinine license agreement and achievement of ISO 9001 and EN 46001 certification. INCOME TAX EXPENSE (BENEFIT) The Company recorded income tax expense of $348 in the second quarter of fiscal 1999 compared to an income tax benefit of $19,677 in the second quarter of fiscal 1998. For the first six months of fiscal 1999 the Company recorded income tax expense of $1,612 as compared to income tax expense of $8,000 in the first six months of fiscal 1998. Income tax expense for both the second quarter and first six months of fiscal 1999 reflect minimal tax expense associated with the Company's foreign sales corporation subsidiary and does not include any loss benefit as it may not be realizable. The income tax benefit recorded during the second quarter of fiscal 1998 reflects the adjustment of the income tax expense for the first six months of fiscal 1998 to reflect minimal income tax expense due to the utilization of NOL carryforwards. IMPACT OF INFLATION Inflation has not had a significant impact on the Company's operations or cash flow. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents decreased by $1,164,077 to $1,022,455 during the first six months of fiscal 1999. Receivables increased by $372,723 to $2,714,648 during the same period primarily as a result of higher sales in December of 1998 as compared to sales in June of 1998. Inventories increased by $166,901 during the six months ended December 31, 1998 to $1,884,912 primarily due to increased finished goods inventory of TheraPatch products necessary for the timely fulfillment of retail orders. Accounts payable increased by $668,095 to $1,477,242 during the first six months of fiscal 1999 primarily due to increased raw material, advertising and promotional payables related to the launch of the TheraPatch product family, amounts related to the modification of the cotinine license agreement, and repurchases of the Company's Common Stock made before, and settled after, December 31, 1998. Capital spending totaled $177,038 during the first six months of fiscal 1999. There were no material commitments for capital expenditures at December 31, 1998. I - 10 Working capital decreased to $4,219,466 at the end of the first six months of fiscal 1999 from $5,335,861 at the end of fiscal 1998. The Company had a current ratio at the end of the first six months of fiscal 1999 of 3.1 as compared to 4.8 at the end of fiscal 1998. The Company had no short or long-term debt as of December 31, 1998. During August 1997 the Company obtained an unsecured $1,000,000 working capital line of credit which expired in September 1998. There were no borrowings outstanding on the line of credit during fiscal 1998 or fiscal 1999. Shareholders' equity decreased by $1,337,770 to $8,365,334 during the first six months of fiscal 1999. Of this decrease, $524,337 was due to the repurchase of shares under the stock purchase program announced in April of 1998 authorizing the repuchase of up to 500,000 shares. As of February 10, 1999 the Company has repurchased a total of 195,150 shares at a cost of $648,900 under the share repurchase program. Management believes that existing cash and cash equivalents, internally-generated cash-flow and the expected renewal of the short-term line of credit will be sufficient to support anticipated operating and capital spending requirements for the next twelve to eighteen months. IMPACT OF THE YEAR 2000 ISSUE The Year 2000 ("Y2K") issue is the result of computer systems using a two-digit format, as opposed to four digits, to indicate the year. Such computer systems may be unable to interpret dates beyond the year 1999, which could cause a system failure or other computer errors, leading to disruptions in operations. A number of other date issues (i.e. incorrect handling of leap years) may also cause problems. All of these issues are collectively referred to as Y2K. In fiscal 1998, the Company developed a comprehensive program for Y2K compliance consisting of two parts; internal systems compliance and third party compliance. The internal systems compliance program includes informational, manufacturing, financial and communication systems. A committee consisting of representatives from all key areas of the Company developed the program. The internal systems compliance program consists of four-phases. Phase I is the identification of all internal computer systems in the Company, including embedded microprocessor or similar circuitry. Phase II is the determination of Y2K compliance for these systems. Phase III is development and implementation of action plans to achieve compliance where needed, and is followed by the testing in Phase IV of these systems after action plans have been completed. The third party compliance program consists of three phases with Phase I being the identification of major and/or critical third party vendors and customers. Phase II consists of contacting these third parties and determining their Y2K compliance. Phase III involves establishing risk and developing contingency plans where necessary (i.e. third party compliance can not be established or the risks associated with noncompliance are significant). The Company has completed Phases I and II of the internal systems compliance program and found the majority of its systems and all of its core systems to be Y2K compliant. The Y2K compliant status of the core systems benefited from upgrades undertaken during the past several years to make these systems adequate for the business needs of the Company. Plans to achieve Y2K compliance for the non-core systems were developed and completed by the end of calendar 1998 (Phase III). Phase IV of the program, testing of systems after implementation of changes, is currently underway and is expected to be completed by March 31, 1999. The Company is approximately 85% complete with Phase IV. The Company expects to have substantially completed all aspects of the internal systems compliance program by March 31, 1999, and considers the risk that compliance will not be achieved to be minimal. The Company has completed Phase I of the third party compliance program and is approximately 95% complete with Phase II. Initial questionnaires have been sent to major and/or critical third party vendors and customers, and approximately 90% of those contacted have responded. Responses are being sought from the remaining major and/or critical vendors and customers. The Company is I - 11 approximately 50% complete with Phase III, the evaluation of responses, establishment of risk and the development of contingency plans. Because of the diversity of sources available for the Company's raw material, packaging material and supplies, the Company believes that third party Y2K compliance issues for these third parties will not have a material adverse effect on the Company's financial position, operations or cash flow. There can, however, be no assurance that this will be the case. If certain critical third party providers, such as those providers supplying electricity, water or telephone service, experience difficulties resulting in disruption of service to the Company, a shutdown of the Company's operations at individual facilities could occur for the duration of the disruption. The Company expects to have substantially completed all phases of the third party compliance program by June 30, 1999. All costs for Y2K compliance have been expensed in the period incurred and have been paid from operating funds. The Company does not specifically track internal staff time spent on the Y2K issue, however, it has included an estimate of the cost of this time in the estimated total costs. The Company estimates the total costs for both the internal systems compliance program and the third party compliance program through December 31, 1998 to be approximately $20,000, while total costs for Y2K compliance are estimated to be less than $50,000. The Company's ability to successfully identify and address Y2K issues involves inherent risks and uncertainties, and depends upon a number of factors including, but not limited to, the availability of key Y2K personnel, the Company's ability to locate and correct all relevant computer codes, the readiness of third parties, and the Company's ability to respond to unforeseen Y2K complications. Depending upon such factors, the Y2K issues faced by the Company could result in, among other things, business disruption, operation problems, financial loss, legal liability and similar adverse consequences. FORWARD-LOOKING STATEMENTS From time to time, in reports filed with the Securities and Exchange Commission, in press releases, and in other communications to shareholders or the investment community, the Company may provide forward-looking statements concerning possible or anticipated future results of operations or business developments which are typically preceded by the words "believes", "expects", "anticipates", "intends", "will", "may", "should" or similar expressions. Such forward-looking statements are subject to risks and uncertainties which could cause results or developments to differ materially from those indicated in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the buying patterns of major customers; competitive forces including new products or pricing pressures; costs associated with and acceptance of the Company's new brand strategy; impact of interruptions to production; dependence on key personnel; need for regulatory approvals; changes in governmental regulatory requirements or accounting pronouncements, unforeseen Y2K complications and third party disruptions; and ability to satisfy funding requirements for operating needs, expansion or capital expenditures. I - 12 PART I - FINANCIAL INFORMATION ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not applicable. I - 13 PART II OTHER INFORMATION Item 1. LEGAL PROCEEDINGS None. Item 2. CHANGES IN SECURITIES There have been no changes in the rights of security holders. Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Regular Annual Meeting of Shareholders of the Company was held on November 19, 1998. The following matters were voted on by Shareholders: 1. The election of seven directors to serve on the Board of Directors for a term of one year and until their successors are duly elected and qualified. 2. The ratification of the appointment of Grant Thornton LLP as the Company's independent auditor for the Company's current fiscal year. 3. A proposal to approve the LecTec Corporation 1998 Stock Option Plan. 4. A proposal to approve the LecTec Corporation 1998 Directors' Stock Option Plan. 5. A proposal to approve the LecTec Corporation Employee Stock Purchase Plan. The results of the voting on these matters were as follows: 1. Board of Directors: Withhold For Authority Total --------- --------- --------- Lee M. Berlin 3,590,671 60,883 3,651,554 Alan C. Hymes, M.D. 3,585,779 65,775 3,651,554 Paul O. Johnson 3,196,563 454,991 3,651,554 Bert J. McKasy 3,590,386 61,168 3,651,554 Marilyn K. Speedie, Ph.D. 3,514,801 136,753 3,651,554 Donald C. Wegmiller 3,514,003 137,551 3,651,554 Rodney A. Young 3,513,299 138,255 3,651,554 2. Appointment of Grant Thornton LLP as independent auditor for the Company: For Against Abstain Non-Vote Total --------- ------- ------- -------- --------- 3,593,310 12,955 45,289 - 3,651,554 II - 1 3. Approval of the LecTec Corporation 1998 Stock Option Plan: For Against Abstain Non-Vote Total --------- ------- ------- -------- --------- 2,386,531 231,544 80,189 953,290 3,651,554 4. Approval of the LecTec Corporation 1998 Directors' Stock Option Plan: For Against Abstain Non-Vote Total --------- ------- ------- -------- --------- 2,387,161 171,270 139,833 953,290 3,651,554 5. Approval of the LecTec Corporation Employee Stock Purchase Plan: For Against Abstain Non-Vote Total --------- ------- ------- -------- --------- 2,511,797 94,358 92,109 953,290 3,651,554 Item 5. OTHER INFORMATION None. Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS Item No. Item Method of Filing -------- ---- ---------------- 10.01 First Amendment, dated December 31, 1998, to License Agreement dated March 9, 1993, between LecTec Corporation, Pharmaco Behavioral Associates, Inc. and The Regents of the University of Minnesota . . . Filed herewith.* 10.02 Separate License Agreement dated December 31, 1998 between LecTec Corporation and Robert M. Keenan, M.D., Ph.D. . . Filed herewith. 27.01 Financial data schedule . . . . . Filed herewith. (b) REPORTS ON FORM 8-K None. Notes: * Confidential treatment requested for portions of this Exhibit pursuant to Rule 24b-2 under the Securities Exchange Act of 1934 as amended, the confidential portions have been deleted and filed separately with the Securites and Exchange Commission together with a confidential treatment request. II - 2 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LECTEC CORPORATION Date February 12, 1999 /s/ Rodney A. Young ----------------- ---------------------------------------------------- Rodney A. Young, Chief Executive Officer & President Date February 12, 1999 /s/ Deborah L. Moore ----------------- ---------------------------------------------------- Deborah L. Moore, Chief Financial Officer II - 3