UNITED STATES 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 JUNE 30, 2003. [ ] 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: (952) 933-2291 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 [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The number of shares outstanding of the registrant's common stock as of August 12, 2003 was 3,966,395 shares. LECTEC CORPORATION FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003 TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Item 1. Condensed Financial Statements and Notes to Condensed Financial Statements (unaudited)................................................................. I-1 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................................. I-9 Item 3. Quantitative and Qualitative Disclosures About Market Risk.................. I-12 Item 4. Controls and Procedures..................................................... I-12 PART II - OTHER INFORMATION Item 1. Legal Proceedings........................................................... II-1 Item 2. Changes in Securities and Use of Proceeds................................... 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- CONDENSED FINANCIAL STATEMENTS AND NOTES TO CONDENSED FINANCIAL STATEMENTS LECTEC CORPORATION CONDENSED BALANCE SHEETS
June 30, December 31, 2003 2002 ----------- ------------ (UNAUDITED) ASSETS CURRENT ASSETS Cash and cash equivalents $ 411,284 $ 671,588 Trade receivables and other, net of allowances of $93,772 and $80,655 at June 30, 2003 and December 31, 2002 181,371 318,896 Inventories Raw materials 784,487 716,957 Work-in-process 39,312 24,294 Finished goods 520,868 269,538 ----------- ------------ 1,344,667 1,010,789 Prepaid expenses and other 261,096 112,831 ----------- ------------ Total current assets 2,198,418 2,114,104 PROPERTY, PLANT AND EQUIPMENT - AT COST, NET 582,387 1,750,241 OTHER ASSETS Patents and trademarks, less accumulated amortization of $1,375,104 and $1,319,840 at June 30, 2003 and December 31, 2002 274,591 285,862 ----------- ------------ $ 3,055,396 $ 4,150,207 =========== ============
The accompanying notes are an integral part of these condensed financial statements. I-1 LECTEC CORPORATION CONDENSED BALANCE SHEETS - CONTINUED
June 30, December 31, 2003 2002 ------------ ------------ (UNAUDITED) LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Current maturities of long-term obligations 276,888 1,154,404 Accounts payable 733,157 587,650 Accrued expenses 180,082 286,149 Accrued payroll 160,968 181,984 Reserve for sales returns and credits 178,549 312,378 Customer deposits 1,187,375 650,073 ------------ ------------ Total current liabilities 2,717,019 3,172,638 LONG-TERM OBLIGATIONS, LESS CURRENT MATURITIES 6,612 10,770 COMMITMENTS AND CONTINGENCIES -- -- SHAREHOLDERS' EQUITY Common stock, $.01 par value: 15,000,000 shares authorized; 3,966,395 shares issued and outstanding at June 30, 2003 and December 31, 2002 39,664 39,664 Additional paid-in capital 11,547,678 11,389,678 Accumulated deficit (11,255,577) (10,462,543) ------------ ------------ 331,765 966,799 ------------ ------------ $ 3,055,396 $ 4,150,207 ============ ============
The accompanying notes are an integral part of these condensed financial statements. I-2 LECTEC CORPORATION CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)
Three months ended Six months ended June 30, June 30, ------------------------------ ------------------------------ 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Net sales $ 1,624,416 $ 1,583,007 $ 3,270,106 $ 3,097,502 Cost of goods sold 1,233,409 1,126,759 2,387,800 2,176,395 ------------ ------------ ------------ ------------ Gross profit 391,007 456,248 882,306 921,107 Operating expenses Sales and marketing 165,598 461,283 363,675 929,860 General and administrative 555,430 609,571 1,037,795 1,204,983 Research and development 97,249 115,385 198,781 284,523 Loss on sale of building -- -- 52,375 -- ------------ ------------ ------------ ------------ 818,277 1,186,239 1,652,626 2,419,366 ------------ ------------ ------------ ------------ Loss from operations (427,270) (729,991) (770,320) (1,498,259) Other income (expenses) Interest expense (5,721) (38,065) (24,653) (76,831) Other, net (557) 453 1,939 506 ------------ ------------ ------------ ------------ Loss before income taxes (433,548) (767,603) (793,034) (1,574,584) Income taxes -- -- -- -- ------------ ------------ ------------ ------------ Net loss $ (433,548) $ (767,603) $ (793,034) $ (1,574,584) ============ ============ ============ ============ Net loss per share - basic and diluted $ (0.11) $ (0.19) $ (0.20) $ (0.40) ============ ============ ============ ============ Weighted average shares outstanding - basic and diluted 3,966,395 3,954,877 3,966,395 3,952,622 ============ ============ ============ ============
The accompanying notes are an integral part of these condensed financial statements. I-3 LECTEC CORPORATION STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended June 30, ------------------------------ 2003 2002 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (793,034) $ (1,574,584) Adjustments to reconcile net loss to net cash used in operating activities: Loss on sale of building 52,375 -- Depreciation and amortization 271,479 320,270 Common stock issued for consulting services -- 19,009 Changes in operating assets and liabilities: Trade and other receivables 137,525 90,827 Inventories (333,878) 168,329 Prepaid expenses and other 80,247 78,421 Accounts payable 145,507 (139,442) Accrued expenses (266,155) (178,435) Customer deposits 537,302 577,642 ------------ ------------ Net cash used in operating activities (168,632) (637,963) CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (11,005) (18,093) Investment in patents and trademarks (43,993) (40,703) ------------ ------------ Net cash used in investing activities (54,998) (58,796) CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of common stock -- 2,272 Proceeds from sale of building 845,000 -- Payoff of building mortgage loan (820,000) -- Repayment of long-term obligations (61,674) (58,470) ------------ ------------ Net cash used in financing activities (36,674) (56,198) ------------ ------------ Net decrease in cash and cash equivalents (260,304) (752,957) Cash and cash equivalents at beginning of period 671,588 1,425,205 ------------ ------------ Cash and cash equivalents at end of period $ 411,284 $ 672,248 ============ ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest expense $ 36,785 $ 77,101 Income taxes $ 1,500 $ -- SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: Sales credit obligation exchanged for a long-term note payable $ -- $ 220,000 Fair value of warrants issued in connection with the sale of the building $ 158,000 $ -- Value of free rent received in connection with the sale of the building $ 228,512 $ --
The accompanying notes are an integral part of these condensed financial statements. I-4 LECTEC CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) (1) GENERAL The accompanying condensed financial statements include the accounts of LecTec Corporation (the "Company") as of and for the three and six month periods ended June 30, 2003 and 2002. The Company's condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2002. The interim condensed 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. Certain reclassifications have been made to the statements of operations for the three and six month periods ended June 30, 2002, to conform to the presentation used in 2003. Such reclassifications had no effect on the previously reported net loss or stockholders' equity. (2) LIQUIDITY AND GOING CONCERN The accompanying financial statements have been prepared in conformity with generally accepted accounting principles, which contemplate continuation of the Company as a going concern. However, the Company has experienced recurring negative cash flows from operations and net losses resulting in an accumulated deficit of $11,255,577 as of June 30, 2003 and, as of that date, the Company's current liabilities exceeded its current assets by $518,601. In view of the matters described in the preceding paragraph, recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet is dependent upon profitable operations of the Company and access to working capital financing. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence. Management expects to continue to operate at a net loss and experience negative cash flow from operating activities through the foreseeable future. At June 30, 2003, the Company's cash resources and available borrowings are insufficient to fund operations for the next 12 months without additional borrowings or equity capital. These factors raise substantial doubt about its ability to continue as a going concern. Management currently is exploring available options for additional capital including borrowings secured by otherwise unencumbered assets or private issuances of common stock. However, there is no assurance that such funds will be available on terms acceptable to the Company. If the Company is not successful in obtaining additional funding it may not be able to continue as a going concern. (3) NET LOSS PER SHARE The Company's basic net loss per share amounts have been computed by dividing net loss by the weighted average number of outstanding common shares. The Company's diluted net loss per share amounts have been computed by dividing net loss by the weighted average number of outstanding common shares and common share equivalents, when dilutive. Options and warrants to purchase 1,315,945 and 1,252,680 shares of common stock with a weighted average exercise price of $1.89 and $1.95 were outstanding during the three and six months ended June 30, 2003, but were excluded from the calculation because they were antidilutive. Options and warrants to purchase 1,205,229 and 1,231,893 shares of common stock with a weighted average exercise price of $4.64 and $4.63 were outstanding during the three and six months ended June 30, 2002, but were excluded from the calculation because they were antidilutive. I-5 (4) SEGMENTS The Company operates its business in one reportable segment - the manufacture and sale of products based on advanced skin interface technologies. Each of the Company's major product lines has similar economic characteristics, technology, manufacturing processes, and regulatory environments. Customers and distribution and marketing strategies vary within major product lines as well as overlap between major product lines. The Company's executive decision makers evaluate sales performance based on the total sales of each major product line and profitability on a total company basis, due to shared infrastructures, to make operating and strategic decisions. The Company's initial sales of skin care products occurred during the three months ended March 31, 2002. The Company sold the conductive and medical tape product lines during the fiscal year ended June 30, 2001. Net sales by major product line for the three and six month periods ended June 30, 2003 and June 30, 2002 were as follows:
Three months ended Six months ended June 30, June 30, -------- -------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Therapeutic consumer products $ 1,625,340 $ 1,250,709 $ 3,266,954 $ 2,147,916 Skin care products (924) 66,191 3,152 358,263 Conductive products -- 266,107 -- 591,323 ------------ ------------ ------------ ------------ $ 1,624,416 $ 1,583,007 $ 3,270,106 $ 3,097,502 ============ ============ ============ ============
(5) LONG-TERM OBLIGATIONS AND SALE OF CORPORATE FACILITY The Company had a mortgage note payable to a bank. The principal balance of $820,000 was due in December 2002 and was extended until April 2003. Monthly interest payments were computed at the prime rate plus 5.0% (effective rate of 9.25% at December 31, 2002). The mortgage was collateralized by the Company's real property. On February 25, 2003, the Company sold its corporate facility in Minnetonka, Minnesota for an aggregate purchase price of $910,270, repaid the mortgage note payable, and recorded a loss on sale of $52,375 during the quarter ended March 31, 2003. In connection with the sale, the Company entered into a lease of its corporate facility which grants the Company free rent for the 12 months following the sale/leaseback transaction and thereafter extends the lease at costs based on current market conditions. Also in connection with the sale, the purchaser received a warrant to purchase 200,000 shares of common stock at $0.90 per share. In May 2002, the Company entered into a $220,000 promissory note with a major customer related to the costs incurred by the customer associated with resolving a packaging issue that previously had been recorded as a sales credit by the Company. The principal balance of the note is due in December 2003. Monthly payments of interest are computed at the prime rate plus 2.0% (effective rate of 6% at June 30, 2003). The promissory note is collateralized by substantially all of the Company's assets. (6) CUSTOMER DEPOSITS In May 2002, the Company renegotiated its Supply Agreement with a major customer. Pursuant to the revised agreement, the Company is receiving advance payments from this customer for future product orders. The Company is also receiving advance product payments from other customers. At June 30, 2003, the Company had recorded customer deposits of $1,187,375 from these customers. (7) SALE OF CONDUCTIVE BUSINESS ASSETS In April 2001, the Company sold its diagnostic electrode and electrically conductive adhesive hydrogel business assets that were used to produce the Company's conductive products. The conductive products included diagnostic electrodes and electrically conductive adhesive hydrogels. Under a manufacturing and supply agreement between the Company and the buyer, the Company continued to manufacture, and supply to the buyer, certain conductive products through January 2002. I-6 The Company supplied the products at its cost of production through October 2001, and at its cost of production plus ten percent from November 2001 through January 2002. The Company continued to manufacture and supply the buyer electrically conductive adhesive hydrogels, at margins of approximately 30%, through September 2002. The Company anticipates no additional sales to the buyer in 2003. (8) STOCK BASED COMPENSATION The Company utilizes the intrinsic value method of accounting for stock based employee compensation plans. All options granted had an exercise price equal to the market value of the underlying common stock on the date of grant and no compensation cost is reflected in net loss, for the three and six months ended June 30, 2003 and 2002. The following table illustrates the effect on net loss if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-based Compensation:
Three months ended Six months ended June 30, June 30, -------- -------- 2003 2002 2003 2002 ------------ ------------ ------------ ------------ Net loss, as reported $ (433,548) $ (767,603) $ (793,034) $ (1,574,584) Less: compensation expense Determined under the fair value Method (50,703) (64,772) (100,657) (129,544) ------------ ------------ ------------ ------------ Pro-forma net loss $ (484,251) $ (832,375) $ (893,691) $ (1,704,128) ============ ============ ============ ============ Net loss per share: Basic and diluted, as reported $ (0.11) $ (0.19) $ (0.20) $ (0.40) Basic and diluted, pro-forma $ (0.12) $ (0.21) $ (0.23) $ (0.43)
The pro-forma information above should be read in conjunction with the related historical information. The weighted average fair value of options granted during the six months ended June 30, 2003 and 2002 was $0.44 and $0.63. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions used for all grants during the six months ended June 30, 2003 and 2002, zero dividend yield, expected volatility of 153% and 121%, risk-free interest rates of 2.85% and 3.13% and expected lives of 4.0 years. Management believes the Black-Scholes option valuation model currently provides the best estimate of fair value. However, the Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of several subjective assumptions. The Company's employee and director stock options have characteristics different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. (9) INCOME TAXES The provision for income tax benefits for the three and six months ended June 30, 2003 and 2002 has been offset by a valuation allowance for deferred taxes. I-7 (10) RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the Financial Accounting Standards Board (FASB) issued Financial Interpretations No. 46 (FIN 46), "Consolidation of Variable Interest Entities." FIN 46 is an interpretation of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," and addresses consolidation by business enterprises of variable interest entities. FIN 46 applies immediately to variable interest entities created or obtained after January 31, 2003 and applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. This interpretation is not anticipated to have an impact on the Company's financial position or results of operations. In April 2003, the FASB issued Statement 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Statement 149 clarifies implementation issues and amends Statement 133, to include the conclusions reached by the FASB on certain FASB Staff Implementation Issues that, while inconsistent with Statement 133's conclusions, were considered by the Board to be preferable, amends discussion of financial guarantee contracts and the application of the shortcut method to an interest-rate swap agreement that includes an embedded option, and amends other pronouncements. Statement 149 is effective to contracts entered into or modified, and hedging arrangements designated after June 30, 2003, with various exceptions as outlined in the statement. Adoption of Statement 149 is not anticipated to have an impact on the Company's consolidated financial position or results of operations. In May 2003, the FASB issued Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Statement 150 changes the classification in the statement of financial position of certain common financial instruments from either equity or mezzanine presentation to liabilities and requires an issuer of those financial statements to recognize changes in fair value or redemption amount, as applicable, in earnings. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of Statement 150 is not anticipated to have an impact on the Company's financial position or results of operations. I-8 PART I - FINANCIAL INFORMATION ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS QUARTER AND SIX MONTHS ENDED JUNE 30, 2003 AND 2002 RESULTS OF OPERATIONS Net sales for the second quarter ended June 30, 2003 were $1,624,416 compared to net sales of $1,583,007 for the comparable quarter of 2002, an increase of 2.6%. The increase was the result of higher therapeutic consumer contract manufacturing sales as the Company rebounded from soft contract manufacturing sales in the prior year and also a shift in the Company's strategic focus from retail consumer products to contract manufacturing. Contract manufacturing net sales increased 53.1% to $1,492,001 for the second quarter of 2003 from $974,744 for the same period in the prior year. Therapeutic retail consumer product sales declined 51.7% in the second quarter of 2003 to $133,339 from $275,965 for the same period in the prior year. The retail consumer product sales decrease was primarily the result of a planned reduction in the number of products offered and the discontinued active promotion of the NeoSkin(R) line of skin care products due to the inability to fund national advertising programs. The Neoskin product line was launched in the second quarter of 2002 and includes pre-formed face masks and under eye gel patches. Net sales of skin care products totaled ($924) in the second quarter of 2003 compared to net sales of $66,191 for the second quarter of 2002. Also offsetting the contract manufacturing sales increase was the absence of conductive product sales in the second quarter of 2003. The Company supplied conductive products to the purchaser under the terms of the asset sale agreement through September 2002. The Company expects no future conductive product sales. Net sales for the first six months of 2003 were $3,270,106 compared to net sales of $3,097,502 for the first six months of 2002, an increase of 5.6%. The increase was primarily due to an increase in sales of consumer contract therapeutic patch products. Contract manufacturing net sales increased 113.2% to $2,825,539 from $1,325,416 for the first six months of 2003 compared to the same period of 2002. Offsetting the contract manufacturing sales increase was a decline in therapeutic retail consumer brand product sales, which decreased 46.3% to $441,415 for the six month period ended June 30, 2003, from $822,500 for the comparable six months of the prior year. The decline was attributable to a planned reduction in the number of products the Company offers to the retail market and the discontinued active promotion of the NeoSkin(R) line of skin care products due to the inability to fund national advertising programs. Net sales of skin care products totaled $3,152 for the six months ended June 30, 2003, compared to net sales of $358,263 for the same period in 2002. There were no sales of conductive products during the six months ended June 30, 2003, compared to net sales of $591,323 for the six months ended June 30, 2002. The decline was due to the reasons stated above. Gross profit for the second quarter of 2003 was $391,007, compared to $456,248 for the second quarter of 2002, a decrease of 14.3%. Gross profit as a percent of net sales for the second quarter of 2003 was 24.1% compared to 28.8% for the second quarter of the prior year. The decrease in gross profit dollars and gross profit as a percentage of net sales for the second quarter of 2003 compared to the same quarter of 2002 resulted primarily from the shift in sales mix to lower margin consumer contract manufacturing products and to higher inventory obsolescence costs related to the product discontinuations discussed above. Gross profit for the first six months of 2003 was $882,306 compared to $921,107 for the first six months of 2002, a decrease of 4.2%. Gross profit as a percent of net sales for the first six months of 2003 was 27.0% compared to 29.7% for the first six months of 2002. The decrease in gross profit dollars and gross profit as a percentage of net sales for the first six months of 2003 compared to the same period of 2002 resulted primarily from the shift in sales mix to lower margin consumer contract manufacturing products and to higher inventory obsolescence costs related to the product discontinuations discussed above. Sales and marketing expenses were $165,598 and $461,283 during the second quarters ended June 30, 2003 and 2002, and as a percentage of net sales were 10.2% and 29.1%, respectively. The decrease in sales and marketing expenses for the second quarter of 2003 was primarily due to a decrease of $123,067 in product promotional expenses and a decrease of $122,084 in compensation I-9 related expenses. These decreases resulted from aggressive cost control/ reduction programs implemented by management. Sales and marketing expenses were $363,675 and $929,860 during the first six months of 2003 and 2002, and as a percentage of net sales, were 11.1% and 30.0%, respectively. The decrease in sales and marketing expenses for the first six months of 2003 as compared with the same period of 2002 was primarily due to a decrease of $191,880 in product promotional expenses and a decrease of $274,186 in compensation related expenses. The Company anticipates that sales and marketing expenses as a percentage of net sales will continue to decrease in 2003 due to the implementation of additional cost control/reduction programs by management. General and administrative expenses were $555,430 and $609,571 during the second quarters of 2003 and 2002, and as a percentage of net sales, were 34.2% and 38.5%, respectively. The decrease in general and administrative expenses was primarily due to decreases in headcount and compensation related expenses of $73,974 and a reduction in professional fees and services of $39,261, which reductions were offset by an increase in rent expense of $57,128 due to the sale and leaseback of the Company's Minnetonka, Minnesota corporate facility during the first quarter of 2003. General and administrative expenses were $1,037,795 and $1,204,983 during the first six months of 2003 and 2002, and as a percentage of net sales, were 31.7% and 38.9%, respectively. The decrease in general and administrative expenses for the six months ended June 30, 2003 from the six months ended June 30, 2002 was primarily due to a decrease of $186,136 in compensation related expenses and a decrease of $41,537 in professional fees and services which reductions were offset by an increase in rent expense of $76,171 discussed above. The Company anticipates that general and administrative expenses as a percent of net sales for the remainder of 2003 will continue to decrease. Research and development expenses for the second quarters of 2003 and 2002 were $97,249 and $115,676, respectively, and as a percentage of net sales, were 6.0% and 7.3%, respectively. The decrease in research and development expenses was primarily due to decreases in headcount and compensation related expenses of $15,185. Research and development expenses were $198,781 and $284,523 during the first six months of 2003 and 2002, and as a percentage of net sales, were 6.1% and 9.2%, respectively. The decrease in research and development expenses for the six months ended June 30, 2003 from the six months ended June 30, 2002 was primarily due to a decrease of $76,759 in compensation related expenses. The Company anticipates that research and development expenses as a percent of net sales for the remainder of 2003 will continue to decrease. Interest expense declined in the second quarter of 2003 to $5,721 from $38,065 in the second quarter of 2002. The decline resulted primarily from the interest reduction related to the sale of the Minnetonka, Minnesota corporate facility and related payoff of debt in February 2003. Interest expense decreased in the first six months of 2003 to $24,653 from $76,831 in the first six months of 2002. The decrease resulted primarily from the absence of a line of credit in existence during a portion of 2002 and from the absence of interest expense associated with the mortgage on the corporate facility. The Company recorded a net loss of $433,548, or $0.11 per basic and fully diluted share, compared to a net loss of $767,603, or $0.19 per basic and fully diluted share for the second quarters ended June 30, 2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002 the Company recorded a net loss of $793,034, or $0.20 per basic and fully diluted share, compared to a net loss of $1,574,584, or $0.40 per basic and fully diluted share. The reduction in the net loss for the three and six months ended June 30, 2003 from the comparable periods in 2002 is due primarily to the reasons stated above including headcount reductions, a shift in strategic focus from retail consumer products to contract manufacturing and aggressive reductions of operating expenses. The provision for income tax benefits for the second quarter of fiscal 2003 and 2002 and the six months ended June 30, 2003 and 2002 has been offset by a valuation allowance for deferred taxes. Inflation has not had a significant impact on the Company's operations or cash flow. I-10 LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents decreased by $260,304 to $411,284 during the first six months of calendar 2003 compared to the cash and cash equivalent balance at December 31, 2002. The decrease in cash and cash equivalents during the period was primarily due to cash used in operating activities. Trade receivables decreased $137,525 during the six months ended June 30, 2003 to $181,371 from $318,896 at December 31, 2002, primarily due to increased collections from retail sales customers. Inventories increased during the six months ended June 30, 2003 from December 31, 2002 by $333,878, due primarily to increases in raw material purchases to meet future consumer contract manufacturing customer requirements. Accounts payable increased $145,507 during the six months ended June 30, 2003 to $733,157 from $587,650 at December 31, 2002, primarily due to increased payables related to inventory purchases to meet ramped up customer requirements. Capital spending for manufacturing equipment and plant improvements totaled $11,005 and investments in patents and trademarks totaled $43,993 for the six months ended June 30, 2003. There were no material commitments for capital expenditures at June 30, 2003. Net cash used in financing activities totaled $36,674 for the six months ended June 30, 2003, resulting primarily from the repayment of long-term capital lease obligations. The Company had a working capital deficit of $518,601 and a current ratio of 0.81 at June 30, 2003 compared to a working capital deficit of $1,058,534 and a current ratio of 0.67 at December 31, 2002. The improvement in current ratio and working capital deficit during the six month period ended June 30, 2003 is attributable to the payoff of the $820,000 mortgage payable related to the sale and leaseback of the Company's Minnetonka, Minnesota corporate facility in the first quarter of 2003, offset in part by the decline in cash and cash equivalents and trade receivables. See Note 5 of Notes to Condensed Financial Statements on page I-6 of this report for additional information on the corporate facility sale. In August 2002, the Company and its bank mutually agreed to terminate a two-year, $2,000,000 asset-based line of credit financing arrangement due to the Company's default of covenants relating to the minimum net worth and the maximum loss before income taxes. Management expects the Company to continue to operate at a net loss and experience negative cash flow from operating activities for the foreseeable future. Management is exploring other options for additional capital to fund the Company's operations. In 2002, the Company renegotiated its Supply Agreement with a major customer and is receiving advance payments from the customer for future product orders. The Company is also receiving advance product payments from other customers. Maintaining adequate levels of working capital depends in part upon the success of the Company's products in the marketplace, the relative profitability of those products, the continuation of advance product payments and the Company's ability to control operating expenses. Funding of the Company's operations for the balance of 2003 and in future years will require additional investments in the Company in the form of equity or debt either by outside investors or as part of a business combination transaction. The Company is currently pursuing various potential sources of capital and business combination transactions. There can be no assurance that the Company will achieve desired levels of sales or profitability, or that a future capital infusion or business combination transaction will be available. If such desired levels of sales and profitability are not reached, and infusions of capital or a business combination transaction are not available, the Company may be forced to cease operations in the near future. I-11 FORWARD-LOOKING STATEMENTS From time to time, in reports filed with the Securities and Exchange Commission (including this Form 10-Q), 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 that 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 TheraPatch brand strategy; impact of interruptions to production; dependence on key personnel; need for regulatory approvals; changes in governmental regulatory requirements or accounting pronouncements; ability to satisfy funding requirements for operating needs, expansion or capital expenditures; and the matters discussed on our "Cautionary Statements" filed as Exhibit 99.1 to Form 10-Q for the quarter ended March 31, 2003. ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has no history of, and does not anticipate in the future, investing in derivative financial instruments, derivative commodity instruments or other such financial instruments. Transactions with international customers are entered into in U.S. dollars with the exception of TheraPatch sales to Canadian customers, precluding the need for foreign currency hedges. Canadian sales have not been material. Additionally, the Company invests in money market funds that experience minimal volatility. Thus, the exposure to market risk is not material. ITEM 4 - CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our principal executive and financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 under the Securities Exchange Act of 1934) as of the last day of the period covered by this quarterly report. Based upon this evaluation, the principal executive and financial officer has concluded that, as of such date, our disclosure controls and procedures were effective in making him aware on a timely basis of the material information relating to the Company required to be included in our periodic filings with the Securities and Exchange Commission. There were no significant changes made in our internal controls over financial reporting (as defined in Rule 13(a)-15(f) under the Securities Exchange Act of 1934 during the period covered by this report that materially affected or are reasonable likely to materially affect our internal control over financial reporting. I-12 PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS None. ITEM 2(c) - CHANGES IN SECURITIES AND USE OF PROCEEDS None. ITEM 3 - DEFAULTS UPON SENIOR SECURITIES None. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Regular Annual Meeting of Shareholders of the Company was held on May 22, 2003. The following matters were voted on by Shareholders: 1. The election of five 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. The results of the voting on these matters were as follows: 1. Board of Directors:
Withhold For Authority Total ---------- --------- ---------- Lee M. Berlin 3,377,753 294,148 3,671,901 Alan C. Hymes, M.D. 3,381,355 290,546 3,671,901 Marilyn K. Speedie, Ph.D. 3,436,236 235,665 3,671,901 Donald C. Wegmiller 3,226,183 445,718 3,671,901 Rodney A. Young 3,223,530 448,371 3,671,901
2. Appointment of Grant Thornton LLP as independent auditor for the Company:
For Against Abstain Non-Vote Total ---------- ------- ------- -------- ---------- 3,562,631 12,704 96,566 -- 3,671,901
II-1 ITEM 5 - OTHER INFORMATION In May 2003, the Company entered into a new operating lease for 14,376 square feet of warehouse and office space in Edina, MN. In July 2003, the Company vacated approximately 29,000 square feet of warehouse and office space, also in Edina, MN, which lease had expired under an operating lease. On August 1, 2003, the Company announced that Rodney A. Young, Chairman, Chief Executive Officer and President, had resigned effective as of July 30, 2003, to pursue other opportunities. Dr. Alan C. Hymes, a co-founder and director of LecTec, has been appointed Chairman of the Board of Directors and interim Chief Executive Officer and President of the Company. Dr. Hymes will work in conjunction with other Board members to identify and recruit a new chief executive officer for the Company. The Company also announced that Board members Dr. Marilyn K. Speedie and Donald C. Wegmiller have tendered their resignations from the Board effective July 25, 2003. At a meeting of the Board held on July 30, 2003, Lee Berlin, a former director and Chief Executive Officer of LecTec, was reappointed to the Board. The Board of Directors now consists of Dr. Hymes, Lee Berlin and Judd Berlin, son of Lee Berlin. ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS
Item No. Item -------- ------------------------------------------------- 10.21 Office/warehouse lease dated May 23, 2003, by and between SMD Lincoln Investments LLC and LecTec Corporation. 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Acting Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.1 Cautionary Statements, incorporated herein by reference to Exhibit 99.1 to the Company's Form 10-K for the fiscal year ended December 31, 2002.
(b) REPORTS ON FORM 8-K The Company filed one Current Report on Form 8-K during the quarter ended June 30, 2003. The Report on Form 8-K was dated May 7, 2003, and disclosed the Company's financial results for the first quarter ended March 31, 2003. 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 August 12, 2003 By /s/ Alan C. Hymes, M.D. --------------- --------------------------------------------- Alan C. Hymes Chairman of the Board, Interim Chief Executive Officer & President (principal financial officer) II-3