UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005.
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT FOR THE
TRANSITION PERIOD FROM _______________ to______________
Commission file number: 0-16159
LECTEC CORPORATION
------------------
(Exact name of small business issuer as specified in its charter)
Minnesota 41-1301878
- ---------------------------------------- --------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
5616 Lincoln Drive, Edina, Minnesota 55436
- ---------------------------------------- --------------------------------
(Address of principal executive offices) (Zip Code)
(952) 933-2291
---------------------------
(Issuer's telephone number)
Not Applicable
--------------
(Former name, former address and former fiscal year, if changed from last
report)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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 issuer's common stock as of August 15,
2005 was 4,153,998 shares.
Transitional Small Business Disclosure Format (Check one):
Yes [ ] No [X]
LECTEC CORPORATION
REPORT ON FORM 10-QSB FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005
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 or Plan of Operation ................................... I-9
Item 3. Controls and Procedures ..................................................................... I-12
PART II - OTHER INFORMATION
Item 1. Legal Proceedings ........................................................................... II-1
Item 2. Unregistered Sales of Equity 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-1
Item 6. Exhibits .................................................................................... II-1
Signature Page .............................................................................. II-2
FORWARD-LOOKING STATEMENTS
From time to time, in reports filed with the Securities and Exchange
Commission (including this Form 10-QSB), 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 Company's dependence on
royalty payments from Novartis Consumer Health, Inc. ("Novartis") and on key
personnel, the success or failure of any attempt by the Company to protect or
enforce its patents, issuance of new accounting pronouncements; available
opportunities for licensing agreements related to patents that the Company
holds, and other risks and uncertainties as described in the "Cautionary
Statements" filed as Exhibit 99.01 to the Company's Report on Form 10-KSB for
the year ended December 31, 2004.
PART 1 - FINANCIAL INFORMATION
ITEM 1 - CONDENSED FINANCIAL STATEMENTS AND NOTES TO CONDENSED FINANCIAL
STATEMENTS
LECTEC CORPORATION
CONDENSED BALANCE SHEETS
June 30, December 31,
2005 2004
------------- -------------
(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 1,477,575 $ 2,239,318
Royalty receivable 39,182 -
Prepaid expenses and other 63,261 137,981
Discontinued operations 1,224 192,629
------------ ------------
Total current assets 1,581,242 2,569,928
------------ ------------
OTHER ASSETS:
Patents and trademarks 41,766 50,693
Prepaid insurance - director and officer 162,234 182,513
------------ ------------
204,000 233,206
------------ ------------
$ 1,785,242 $ 2,803,134
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Current maturities of long-term obligations $ - $ 2,525
Accounts payable 9,321 4,944
Accrued expenses 77,660 240,293
Discontinued operations 98,350 273,290
------------ ------------
Total current liabilities 185,331 521,052
------------ ------------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock, $.01 par value; 15,000,000 shares
authorized; 4,153,998 and 4,030,330 shares
issued and outstanding at June 30, 2005
and December 31, 2004, respectively 41,490 40,303
Additional contributed capital 11,923,436 11,689,404
Accumulated deficit (10,365,015) (9,447,625)
------------ ------------
1,599,911 2,282,082
------------ ------------
$ 1,785,242 $ 2,803,134
============ ============
The accompanying notes are an integral part of these condensed financial
statements.
I-1
LECTEC CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended June 30, Six Months Ended June 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
(Restated) (Restated)
CONTINUING OPERATIONS:
Revenue - royalty and licensing fee income $ 39,182 $ - $ 120,478 $ -
Operating expenses 105,835 232,642 565,442 592,374
----------- ----------- ----------- -----------
Loss from continuing operations (66,653) (232,642) (444,964) (592,374)
----------- ----------- ----------- -----------
DISCONTINUED OPERATIONS EARNINGS (LOSS) (15,666) 241,481 (225,602) 675,940
----------- ----------- ----------- -----------
NET EARNINGS (LOSS) $ (82,319) $ 8,839 $ (670,566) $ 83,566
=========== =========== =========== ===========
EARNINGS (LOSS) PER SHARE:
Basic and diluted:
Continuing operations $ (0.02) $ (0.06) $ (0.11) $ (0.15)
Discontinued operations 0.00 0.06 (0.05) 0.17
----------- ----------- ----------- -----------
Total $ (0.02) $ 0.00 $ (0.16) $ 0.02
=========== =========== =========== ===========
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic and diluted 4,148,723 4,016,089 4,119,228 3,997,708
=========== =========== =========== ===========
The accompanying notes are an integral part of these condensed financial
statements.
I-2
LECTEC CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months ended June 30,
2005 2004
------------ ------------
(Restated)
Cash flows from operating activities:
Loss from continuing operations $ (444,964) $ (592,374)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Earnings (loss) from discontinued operations (225,602) 675,940
Depreciation and amortization 8,926 182,091
Compensation expense related to stock options 144,992 -
Changes in continuing operating assets and liabilities:
Royalty receivable (39,182) -
Prepaid expenses and other 95,000 30,660
Accounts payable 4,377 (7,899)
Accrued expenses (162,633) 38,346
Change in net assets and liabilities of discontinued operations 16,465 174,256
----------- -----------
Net cash provided by (used in) operating activities (602,621) 501,020
----------- -----------
Cash flows from investing activities:
Purchase of property, plant and equipment - (74,550)
Investment in patents and trademarks - (31,473)
----------- -----------
Net cash used in investing activities - (106,023)
----------- -----------
Cash flows from financing activities:
Cash dividends paid (246,824) -
Proceeds from exercise of stock options 90,227 18,707
Repayment of long-term obligations (2,525) (5,906)
----------- -----------
Net cash provided by (used in) financing activities (159,122) 12,801
----------- -----------
Net increase (decrease) in cash and cash equivalents (761,743) 407,798
----------- -----------
Cash and cash equivalents - beginning of period 2,239,318 483,844
----------- -----------
Cash and cash equivalents - end of period $ 1,477,575 $ 891,642
=========== ===========
Supplemental disclosures of cash flow information:
Cash paid for interest $ 4,122 $ 3,299
The accompanying notes are an integral part of these condensed financial
statements.
I-3
LECTEC CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
JUNE 30, 2005 AND 2004
(UNAUDITED)
(1) GENERAL
The accompanying condensed financial statements include the accounts
of LecTec Corporation (the "Company") as of June 30, 2005 and December 31, 2004
and for the three and six month periods ended June 30, 2005 and 2004. 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-KSB
for the year ended December 31, 2004. 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 full year.
(2) BUSINESS SUMMARY AND CRITICAL ACCOUNTING POLICIES
BUSINESS SUMMARY
The Company is an intellectual property licensing and holding
company. The Company receives royalties and licensing fees from licensing
agreements pertaining to the Company's patents. The Company has one licensing
agreement ("Novartis Agreement" or "Agreement") with Novartis Consumer Health,
Inc. ("Novartis"), which pays royalties to the Company on a semi-annual basis or
from time to time based upon a percentage of Novartis net sales of licensed
products. The Company was a contract manufacturer of hydrogel topical patches
which were sold to major pharmaceutical customers until the Company ceased its
manufacturing operations in December 2004. See the discussion under "Licensing
and Supply Agreement" in Note 5 of Notes to Condensed Financial Statements for a
description of the agreement with Novartis.
CRITICAL ACCOUNTING POLICIES
Some of the Company's most critical accounting policies include:
Revenue Recognition. Royalty and licensing income is recognized when
earned under the terms of the agreements with customers and collection is
reasonably assured. Revenue from sales from discontinued operations were
recognized when the product was shipped to the customer and collection was
probable.
Long-Lived Assets. The carrying value of long-lived assets is
reviewed periodically or when factors indicating impairment are present. The
amount of impairment loss is measured as the amount by which the carrying value
of the assets exceeds the fair value of the assets. The Company believes no
impairment exists as of June 30, 2005.
Royalty Receivable. The Company currently has a royalty receivable
under the terms of the Agreement with Novartis. The Company granted credit to
Novartis in the normal course of business and management believes, based upon
past experience, that all amounts outstanding are fully collectible. Royalty
income recognized during the three and six months periods ended June 30, 2005
was based on net sales information provided by Novartis, covering sales of
products under the licensing agreement. Pursuant to the Agreement, the Company
has the right to audit the validity of the net annual sales of products covered
under the Agreement. See the discussion under "Licensing and Supply Agreement"
in Note 5 of Notes to Condensed Financial Statements for a description of the
Agreement with Novartis.
I-4
Accounting for Discontinued Operations. Under the provisions of
Statement of Financial Accounting Standard ("SFAS") No. 144, if a component of
an entity is either classified as held-for-sale or has been disposed of during
the period, the results of its operations are to be reported in discontinued
operations, provided that both of the following conditions are met:
- The operations and cash flows of the component have been
or will be removed from the ongoing operations of the
entity as a result of the disposal transaction, and
- The entity will have no significant continuing
involvement in the operations of the component after the
disposal transaction.
The Company exited from manufacturing operations of topical patches
and sold off substantially all of its manufacturing assets related to the
production of patches to its only remaining customer, Novartis, as of December
31, 2004. The assets related to the Company's manufacturing operations have been
classified as discontinued operations due to the sale of the manufacturing
assets prior to December 31, 2004. The operations and cash flows of the contract
manufacturing operations were eliminated from the ongoing operations as a result
of the sale transaction. The surviving entity (intellectual property licensing
and holding company) will not have any significant involvement in the operations
of the previously sold manufacturing operations. It is therefore management's
position that the conditions for reporting the Company's financial statements
under the requirements of SFAS 144 as discontinued operations have been
satisfied. The comparative 2004 condensed statements of operations and cash
flows have been restated to conform to the 2005 presentation.
The Company used reasonable judgment combined with quantitative
analysis in determining the amounts of assets, liabilities, revenues and
expenses that would be allocated between continuing operations and discontinued
operations.
Stock Based Compensation. In January 2005, the Company extended the
exercise period for options held by two former executive officers of the Company
and one former employee by two years from the date of their respective
termination dates (but not longer than the options normal expiration date, if
earlier). There were 222,667 options with a weighted average exercise price of
$0.83 per share subject to this modification to the exercise period. Normally
these options would expire ninety days from the employees termination date.
Because of this modification to the exercise period of these options for former
employees, the Company recorded compensation expense of $99,957 in the first
quarter ended March 31, 2005. There was no compensation expense related to these
options during the second quarter ended June, 30, 2005.
In July 2002, 803,958 stock options with a weighted average exercise
price of $4.54 per share were re-priced to $0.81 per share. At June 30, 2005,
120,000 of these options were outstanding and were exercisable. No compensation
expense was recorded by the Company in connection with the re-pricing because
the exercise price exceeded the market price on the date of the re-pricing. On
June 30, 2005, the market price for the Company's common stock was above the
exercise price of the re-priced options but below the market price on March 31,
2005. Accordingly, the Company incrementally reversed compensation expense of
$34,715 for the three months ended June 30, 2005. For the six months ended June
30, 2005, the Company recorded net compensation expense of $45,035 in connection
with the re-pricing.
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 related to stock option grants is reflected in
net income or loss for the three and six months ended June 30, 2005 and 2004.
The following table illustrates the effect on net earnings (loss) if the Company
had applied the fair value recognition provisions of SFAS No. 123, Accounting
for Stock-Based Compensation:
I-5
Three months ended June 30, Six months ended June 30,
---------------------------- ----------------------------
2005 2004 2005 2004
---------- ----------- ----------- ----------
Net earnings (loss), as reported $ (82,319) $ 8,839 $ (670,566) $ 83,566
Less: compensation income (expense)
determined under the fair value method 118 (26,771) 236 (53,576)
--------- ---------- ---------- ----------
Proforma net earnings (loss) $ (82,201) $ (17,932) $ (670,330) $ 29,990
========= ========== ========== ==========
Net earnings (loss) per share:
As reported -
Basic and diluted earnings (loss) per share:
Continuing operations $ (0.02) $ (0.06) $ (0.11) $ (0.15)
Discontinued operations (0.00) 0.06 (0.05) 0.17
--------- ---------- ---------- ----------
Total $ (0.02) $ 0.00 $ (0.16) $ 0.02
========= ========== ========== ==========
Proforma -
Basic and diluted earnings (loss) per share:
Continuing operations $ (0.02) $ (0.06) $ (0.11) $ (0.16)
Discontinued operations (0.00) 0.06 (0.05) 0.17
--------- ---------- ---------- ----------
Total $ (0.02) $ 0.00 $ (0.16) $ 0.01
========= ========== ========== ==========
The proforma information above should be read in conjunction with
the related historical information.
There were no stock options granted during the six months ended June
30, 2005. The weighted average fair value of options granted during the six
months ended June 30, 2004 was $1.09. 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, 2004 and 2005; zero dividend yield, expected
volatility of 179%, risk-free interest rate of 2.72% and expected life of 3.0
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.
(3) EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share is computed by dividing net earnings
(loss) by the weighted average number of common shares outstanding. Diluted
earnings (loss) per share is computed by dividing net earnings (loss) by the
weighted average number of common shares outstanding and common share
equivalents related to stock options and warrants when dilutive.
Common stock options and warrants to purchase 598,250 and 615,500
shares of common stock with a weighted average exercise price of $1.95 and $1.97
were outstanding during the three and six months ended June 30, 2005,
respectively. Common stock options and warrants to purchase 551,528 and 427,195
shares of common stock with a weighted average exercise price of $2.75 and $3.33
were outstanding during the three and six months ended June 30, 2004,
respectively. As the Company had losses from continuing operations for the three
and six months ended June 30, 2005 and 2004, those shares were excluded from the
earnings (loss) per share computations because they were antidilutive.
I-6
(4) INCOME TAXES
The provision for income tax benefits for the three and six months
ended June 30, 2005, was offset principally by a valuation allowance for
deferred taxes. No federal or state income taxes were provided for the three and
six months ended June 30, 2004, due to available tax credit and net operating
loss carryforwards.
(5) LICENSING AND SUPPLY AGREEMENT
On July 19, 2004, the Company entered into the Novartis Agreement,
effective as of January 1, 2004. The Agreement replaced the Company's prior
licensing and supply agreement with Novartis dated May 8, 2002. The Agreement
required the Company to manufacture, sell and deliver to Novartis vapor patches
for sale to the pediatric market in the United States, Canada and Mexico. In
order to provide the Company with working capital funds necessary to enable it
to manufacture and deliver vapor patches to Novartis in accordance with the
Agreement, Novartis advanced up to $2,000,000 for use by the Company to pay
accounts payable and expenses incurred exclusively for the manufacture and
delivery of vapor patches. In consideration of any advanced funds, the Company
executed and delivered to Novartis a promissory note of $2,000,000 and a
security agreement. Under the security agreement, the Company pledged
substantially all of its assets. The Company repaid the note by the delivery to
Novartis of vapor patches under the Agreement. All amounts owed were repaid as
of December 31, 2004. Under the Agreement, Novartis had the option until March
31, 2005, to extend the use of vapor patches to the adult cough/cold category in
the United States, Canada and Mexico at no additional cost and under the same
terms and conditions as set forth in the Agreement. On March 31, 2005, Novartis
notified the Company of its intention to enter the adult market pursuant to the
Agreement.
Under the Agreement, the Company granted Novartis an exclusive
license (the "License") to all of the intellectual property of the Company to
the extent that it is used or useful in the production of the vapor patches
being supplied under the Agreement for a fee of $1,065,000, which was paid to
the Company by Novartis as follows: (1) release of $250,000 in promissory note
debt as of the date of the Agreement, (2) payment of $407,500 in cash in July
2004, and (3) payment of $407,500 in cash in September 2004. The License began
on July 19, 2004, and will continue for the duration of any patents included in
the licensed intellectual property and, with respect to all other elements of
the licensed intellectual property, for the maximum duration permitted under
applicable law (fourteen years). Upon the expiration of the patents included in
the licensed intellectual property, Novartis will have a non-revocable,
perpetual, fully paid-up license to the intellectual property used or useful in
the production of vapor patches for the pediatric market and the adult
cough/cold market. Commencing on January 1, 2005, Novartis is required by the
Agreement to pay royalties, at an agreed upon percentage, to the Company, based
upon the net sales of vapor patches by Novartis for each year the License is in
effect.
The supply portion of the Agreement continued in effect until
February 5, 2005, except that the provisions relating to the License will
continue in effect until the conclusion of the term of the License. The Company
may not assign or otherwise transfer the Agreement (other than to an affiliate)
without the prior written consent of Novartis, except that the Company may
assign the Agreement in connection with the transfer or sale of all or
substantially all of its assets or business or its merger or consolidation with
another company, so long as (1) such acquirer or successor in interest agrees in
writing to be bound by all conditions of the Agreement, and (2) the Company
gives Novartis written notice of any such assignment and 15 days to object.
Novartis may object to an assignment only if such acquirer or successor is a
direct competitor of Novartis.
In conjunction with the signing of the Agreement, Novartis purchased
certain manufacturing equipment from the Company for approximately $900,000
during the second half of 2004.
On May 31, 2005 the Company received a royalty payment of $81,296
based on net sales by Novartis of products covered under the Agreement that were
sold during the first quarter ended March 31, 2005.
I-7
(6) DISCONTINUED OPERATIONS
Discontinued operations assets and liabilities and income statement information
include the following:
(Unaudited)
June 30, December 31,
2005 2004
------------- ------------
DISCONTINUED OPERATIONS - ASSETS
Accounts receivable, net $ - $ 176,207
Prepaid expenses and other 1,224 16,422
------------- ------------
Total discontinued operations - assets $ 1,224 $ 192,629
============= ============
DISCONTINUED OPERATIONS - LIABILITIES
Accounts payable $ - $ 21,267
Accrued expenses - 152,023
Reserve for sales returns and credits 98,350 100,000
------------- ------------
Total discontinued operations - liabilities $ 98,350 $ 273,290
============= ============
DISCONTINUED OPERATIONS
EARNINGS (LOSS) (UNAUDITED):
Three months ended June 30, Six months ended June 30,
--------------------------- -------------------------
2005 2004 2005 2004
----------- ---------- ----------- ----------
Discontinued operations revenues $ - $1,520,146 $ - $3,999,446
========== ========== ========== ==========
Earnings (loss) from discontinued operations $ (18,396) $ 241,481 $ (292,954) $ 675,940
Gain on sale of property and equipment from
discontinued operations * 2,730 - 67,352 -
---------- ---------- ---------- ----------
Discontinued operations earnings (loss) $ (15,666) $ 241,481 $ (225,602) $ 675,940
========== ========== ========== ==========
* The assets sold for the three and six month periods ended June 30, 2005 were
fully depreciated at the time of sale.
I-8
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
RESULTS OF OPERATIONS
In July 2004, management determined that the Company would wind down
and cease its contract manufacturing operations by December 31, 2004. Because of
this, the past and future financial results related to contract manufacturing
have been treated as discontinued operations for financial reporting purposes.
Continuing operations consist of operations related to the surviving
intellectual property licensing and holding company. The Company accounts for
its discontinued operations under the provisions of SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets ". Accordingly, results of
operations and the related charges for discontinued operations have been
classified as "Earnings (loss) from discontinued operations" in the accompanying
Condensed Statements of Operations. Assets and liabilities of the discontinued
operations have been reclassified and reflected on the accompanying Balance
Sheets as "Discontinued operations". For comparative purposes, all prior periods
presented have been restated to reflect the reclassifications on a consistent
basis.
COMPARISON OF THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND 2004
RESULTS OF CONTINUING OPERATIONS
The Company recorded royalty income of $39,182 and $120,478 during
the three and six months ended June 30, 2005, respectively, related to its
licensing agreement with Novartis (See Note 5 of Notes to Condensed Financial
Statements on page I-7 of this Report) . The Company had no revenue from
continuing operations for the three or six months ended June 30, 2004.
For the second quarter ended June 30, 2005, the Company recorded a
net loss from continuing operations of $(66,653) , or $(0.02) per basic and
diluted share, compared to a net loss from continuing operations of $(232,642),
or $(0.06) per basic and diluted share, for the same quarter in 2004. For the
six months ended June 30, 2005, the Company recorded a net loss from continuing
operations of $(444,964), or $(0.11) per basic and diluted share, compared to a
net loss from continuing operations of $(592,374), or $(0.15) per basic and
diluted share, for the same period in the 2004. The decrease in net loss from
continuing operations for both the three and six month periods in 2005 compared
to the same periods in the prior year was primarily due to the recognition of
royalty income in 2005, coupled with reductions in operating expenses associated
with the Company's move from its Minnetonka, Minnesota facility to its leased
facility in Edina, Minnesota, and general staffing and benefit reductions.
RESULTS OF DISCONTINUED OPERATIONS
The loss from discontinued operations for the second quarter ended
June 30, 2005 was $(15,666), or $(0.00) per basic and diluted share, compared to
earnings from discontinued operations of $241,481 or $0.06 per basic and diluted
share for the same period in 2004. For the six months ended June 30, 2005, the
loss from discontinued operations was $(225,602), or $(0.05) per basic and
diluted share, compared to earnings from discontinued operations of $675,940 or
$0.17 per basic and diluted share for the same period in 2004. For the three and
six months ended June 30, 2004, sales to the Company's largest customer,
Novartis, were $1,280,672 and $2,787,706, respectively. There were no product
sales to any customer during 2005. The decline in the earnings from discontinued
operations for both the three and six month periods in 2005 compared to the same
periods in 2004 is attributable to the completion of the wind down of contract
manufacturing operations (lack of sales and gross profit for 2005), coupled with
higher stock compensation expense in 2005.
NET RESULTS OF OPERATIONS
The net loss for the second quarter ended June 30, 2005 was
$(82,319), or $(0.02) per basic and diluted share, compared to net earnings of
$8,839, or $0.00 per basic and diluted share for the same period in 2004. For
the six months ended June 30, 2005, the net loss was $(670,566), or $(0.16) per
basic and diluted share, compared to net earnings of $83,566, or $0.02 per basic
and diluted share for the same period in 2004. The overall decline in results of
operations for the three and six month periods ended June 30, 2005 over the same
periods in the prior year is primarily due to the absence of net sales and gross
profit from discontinued operations related to the wind down of contract
manufacturing operations and the reasons stated above.
I-9
INCOME TAXES
The provision for income tax benefits for the three and six months
ended June 30, 2005 was offset principally by a valuation allowance for deferred
taxes. No federal or state income taxes were provided for the three and six
months ended June 30, 2004, due to available tax credit and net operating loss
carryforwards for those periods.
EFFECT OF INFLATION
Inflation has not had a significant impact on the Company's
operations or cash flow.
WIND DOWN OF MANUFACTURING OPERATIONS
In September 2003, the Company learned that, as a result of a change
in its internal supplier selection criteria, Novartis, the Company's largest
customer, intended to stop using the Company as a contract manufacturer for its
topical patches by the end of 2004. In addition, Johnson & Johnson Consumer
Products Company, the Company's second largest customer, also indicated that it
intended to stop using the Company as a contract manufacturer during 2004. Based
on this situation and without any other manufacturing prospects, in July 2004,
the Board of Directors determined that the Company would cease manufacturing
operations by December 31, 2004 and decided to become an intellectual property
licensing and holding company.
On July 19, 2004, the Company entered into the Novartis Agreement,
effective as of January 1, 2004. The Agreement replaced the Company's prior
licensing and supply agreement with Novartis dated May 8, 2002. The Agreement
required the Company to manufacture, sell and deliver to Novartis vapor patches
for sale to the pediatric market in the United States, Canada and Mexico. In
order to provide the Company with working capital funds necessary to enable it
to manufacture and deliver vapor patches to Novartis in accordance with the
Agreement, Novartis advanced up to $2,000,000 for use by the Company to pay
accounts payable and expenses incurred exclusively for the manufacture and
delivery of vapor patches. In consideration of any advanced funds, the Company
executed and delivered to Novartis a promissory note of $2,000,000 and a
security agreement. Under the security agreement, the Company pledged
substantially all of its assets. The note was repaid by the Company by the
delivery to Novartis of vapor patches under the Agreement. All amounts owed were
repaid as of December 31, 2004. Under the Agreement, Novartis had the option
until March 31, 2005 to extend the use of vapor patches to the adult cough/cold
category in the United States, Canada and Mexico at no additional cost and under
the same terms and conditions as set forth in the Agreement. On March 31, 2005,
Novartis notified the Company of its intention to enter the adult market
pursuant to the Agreement
Under the Agreement, the Company granted Novartis an exclusive
license (the "License") to all of the intellectual property of the Company to
the extent that it is used or useful in the production of the vapor patches
being supplied under the Agreement for a fee of $1,065,000, which was paid to
the Company by Novartis as follows: (1) release of $250,000 in promissory note
debt as of the date of the Agreement, (2) payment of $407,500 in cash in July
2004, and (3) payment of $407,500 in cash in September 2004. The License began
on July 19, 2004, and will continue for the duration of any patents included in
the licensed intellectual property and, with respect to all other elements of
the licensed intellectual property, for the maximum duration permitted under
applicable law (maximum fourteen years). Upon the expiration of the patents
included in the licensed intellectual property, Novartis will have a
non-revocable, perpetual, fully paid-up license to the intellectual property
used or useful in the production of vapor patches for the pediatric market and
the adult cough/cold market. Commencing on January 1, 2005, Novartis is required
by the Agreement to pay royalties, at an agreed upon percentage, to the Company,
based upon the net sales of vapor patches by Novartis for each year the License
is in effect.
In August 2004, Novartis purchased a cartoning machine from the
Company for a purchase price of $162,000. In December , 2004, the Company
entered into a capital equipment purchase agreement (the "Purchase Agreement")
with Novartis. Under the Purchase Agreement, Novartis paid the Company the
contract price of $733,100 in exchange for the Company's hydrogel coating and
therapeutic converting machinery and equipment. The contract price was based
upon Novartis taking delivery of the equipment at the Company's facility. Upon
closing of this disposition of assets to Novartis on December 29, 2004, the
Company's transformation from a manufacturing operation to an intellectual
property licensing and holding company was complete.
I-10
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents decreased by $761,743 during the first six
months of 2005 to $1,477,575 at June 30, 2005. The decrease in cash and cash
equivalents during the first six months of 2005 was due to cash used in
operating activities of $602,621 consisting primarily of cash used for
continuing operations as well as severance and other manufacturing wind down
costs, the payment of a cash dividend of $246,824 during the first quarter of
2005, which was partially offset by the receipt of $81,296 in cash under the
Novartis agreement See the discussion under "Licensing and Supply Agreement" in
Note 5 of Notes to Condensed Financial Statements for a description of the
agreement with Novartis.
During the first six months of 2005, the Company received $176,207
from Novartis under accounts receivable related to discontinued operations and
received proceeds of $90,227 related to exercises of stock options. The Company
also received proceeds of $67,352 from the sale of miscellaneous equipment and
office furniture having no book value during the first six months of 2005. There
were no future material commitments for capital expenditures at June 30, 2005.
The Company had working capital of $1,395,911 and a current ratio of
8.53 at June 30, 2005 compared to working capital of $2,048,876 and a current
ratio of 4.93 at December 31, 2004. The decrease in working capital during the
first six months of 2005 is primarily attributable to lower payables and accrued
expenses as the Company paid the majority of its severance and manufacturing
wind down obligations, the payment of a cash dividend, and a reduction in
accounts receivable partially offset with an increase in royalty receivable. The
improvement in the current ratio is a result of the settlement of liabilities
associated with the Company's discontinued operations.
Shareholders' equity decreased to $1,599,911 at June 30, 2005 from
$2,282,082 at December 31, 2004, primarily due to the net loss for six months
ended June 30, 2005 and the cash dividend paid in March 2005, all of which have
been discussed above.
The Company believes its existing cash and cash equivalents will be
sufficient to fund continuing operations through 2005. However, cash and cash
equivalents may not be sufficient to fund continuing operations beyond 2005. The
Company's working capital requirements are dependent upon adequate levels of
royalty and licensing income to fund continuing operations. Royalty income is
uncertain because it is subject to factors that the Company cannot control. Such
factors include, but are not limited to, seasonality of the product resulting
from the severity of the flu/cough and cold conditions in the marketplace,
marketing efforts by Novartis, markets Novartis enters the product into, and
other factors which can cause fluctuations in the amount of royalty income the
Company earns. There can be no assurance because of these uncertainties that
future royalty income will be sufficient to fund continuing operations. The
royalty income of $120,478 recorded for the six months ended June 30, 2005 was
based upon information provided by Novartis calculated as a percentage of net
sales of products covered under the licensing agreement the Company has with
Novartis. There can be no assurance that this result will be indicative of
results for the full year. Furthermore, future royalties and licensing income
the Company anticipates earning is dependent on the success of the product in
the marketplace by Novartis and other firms or individuals with whom the Company
may enter into licensing agreements. Additionally, the Company does not
presently have any other financing resources in place from which it can borrow
or obtain additional working capital.
CRITICAL ACCOUNTING POLICIES
Management believes that the Company has not adopted any critical
accounting policies which, if changed, would result in a material change in
financial estimates, financial condition, results of operation or cash flows for
the three and six months ended June 30, 2005 and 2004. The critical accounting
policies appear in Note 2 of Notes to Condensed Financial Statement in this Form
10-QSB.
I-11
ITEM 3 - 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(e) and 15d-15(e) under the Securities
Exchange Act of 1934 (the "Exchange Act")). Based upon this evaluation, the
principal executive and financial officer has concluded that, as of the end of
the period covered by this report, our disclosure controls and procedures were
effective.
During the three months ended June 30, 2005, there were no changes
in the Company's internal control over financial reporting (as defined in Rule
13a-15(f) under the Exchange Act) that has materially affected, or is reasonably
likely to materially affect, the Company's internal control over financial
reporting.
I-12
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
None.
ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5 - OTHER INFORMATION
None.
ITEM 6 - EXHIBITS
EXHIBITS
Exhibit No. Description
----------- --------------------------------------------------------------
3.01 Articles of Incorporation of LecTec Corporation, as amended
(Incorporated herein by reference to the Company's Form S-1
Registration Statement (file number 33-9774C) filed on October
31, 1986 and amended on December 12, 1986).
3.02 Bylaws of LecTec Corporation (Incorporated herein by reference
to the Company's Form S-1 Registration Statement (file number
33-9774C) filed on October 31, 1986 and amended on December 12,
1986).
31.01 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002, filed herewith.
31.02 Certification of Acting Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
32.01 Chief Executive Officer and Acting Chief Financial Officer
Certification Pursuant to #18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
filed herewith.
99.01 Cautionary Statements (Incorporated herein by reference to
Exhibit 99.01 to the Company's Report on Form 10-KSB for the
fiscal year ended December 31, 2004).
II-1
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.
LECTEC CORPORATION
Date August 15, 2005 By /s/ Alan C. Hymes, M.D.
--------------------------------------------
Alan C. Hymes, M.D.
Chief Executive Officer & Director
(principal financial officer and duly
authorized officer)
II-2
EXHIBIT INDEX
Exhibit No. Description
- ----------- -------------------------------------------------------------------
3.01 Articles of Incorporation of LecTec Corporation, as amended
(Incorporated herein by reference to the Company's Form S-1
Registration Statement (file number 33-9774C) filed on October
31, 1986 and amended on December 12, 1986).
3.02 Bylaws of LecTec Corporation (Incorporated herein by reference to
the Company's Form S-1 Registration Statement (file number
33-9774C) filed on October 31, 1986 and amended on December 12,
1986).
31.01 Certification of Chief Executive Officer Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002, filed herewith.
31.02 Certification of Acting Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002, filed herewith.
32.01 Chief Executive Officer and Acting Chief Financial Officer
Certification Pursuant to #18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed
herewith.
99.01 Cautionary Statements (Incorporated herein by reference to Exhibit
99.01 to the Company's Report on Form 10-KSB for the fiscal year
ended December 31, 2004).