<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
- ----- SECURITIES EXCHANGE ACT 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1997
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
- ----- SECURITIES EXCHANGE ACT 1934
FOR THE TRANSITION PERIOD FROM TO
---------- ----------
COMMISSION FILE NUMBER 0-10521
QUEST MEDICAL, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
TEXAS 75-1646002
- ------------------------------- ------------------------------------
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
ONE ALLENTOWN PARKWAY, ALLEN, TEXAS 75002
---------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
(972) 390-9800
----------------------------------------------------
(Registrant's Telephone Number, Including Area Code)
Indicate by check X 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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
<TABLE>
<CAPTION>
NUMBER OF SHARES OUTSTANDING AT
TITLE OF EACH CLASS OCTOBER 31, 1997
- ---------------------------- -------------------------------
<S> <C>
COMMON STOCK, $.05 PAR VALUE 8,511,046
</TABLE>
<PAGE> 2
QUEST MEDICAL, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
<TABLE>
<S> <C>
PART I. FINANCIAL INFORMATION 2
ITEM 1. Financial Statements
Condensed Consolidated Balance Sheets
September 30, 1997 and December 31, 1996 3-4
Condensed Consolidated Statements of Operations
For the Three Months and Nine Months Ended
September 30, 1997 and 1996 5
Condensed Consolidated Statements of Cash Flows
For the Nine Months Ended
September 30, 1997 and 1996 6
Condensed Consolidated Statements of Stockholders' Equity
For the Year Ended December 31, 1996
and the Nine Months Ended September 30, 1997 7
Notes to Condensed Consolidated
Financial Statements 8-11
ITEM 2. Management's Discussion and Analysis of
Financial Condition and Results of
Operations 12-17
PART II. OTHER INFORMATION 18
ITEM 6. Exhibits and Reports on
Form 8-K 18
SIGNATURES 19
</TABLE>
1
<PAGE> 3
PART I
FINANCIAL INFORMATION
2
<PAGE> 4
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 1997 AND DECEMBER 31, 1996
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
ASSETS (UNAUDITED)
- ------ ----------- -----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 647,324 $ 696,196
Restricted certificate of deposit 350,000 --
Marketable securities 896,018 1,366,089
Receivables:
Trade accounts, less allowance for doubtful accounts of $209,337 in
1997 and $174,337 in 1996 4,813,238 4,829,827
Net investment in sales-type leases 318,065 176,875
Interest and other 194,599 134,162
----------- -----------
Total receivables 5,325,902 5,140,864
----------- -----------
Inventories:
Raw materials 2,865,582 3,931,282
Work-in-process 1,583,187 1,400,712
Finished goods 3,289,104 3,032,600
----------- -----------
Total inventories 7,737,873 8,364,594
----------- -----------
Deferred income taxes 317,276 317,276
Prepaid expenses and other current assets 486,931 668,808
----------- -----------
Total current assets 15,761,324 16,553,827
----------- -----------
Property, plant and equipment:
Land 1,930,289 1,930,289
Building and improvements 5,320,199 5,296,125
Furniture and fixtures 3,947,192 3,827,738
Machinery and equipment 5,532,639 4,962,846
Cardioplegia equipment rented to customers 450,211 --
----------- -----------
17,180,530 16,016,998
Less accumulated depreciation and
amortization 5,859,249 4,832,468
----------- -----------
Net property, plant and equipment 11,321,281 11,184,530
----------- -----------
Cost in excess of net assets acquired, net of
accumulated amortization of $1,255,929 in 1997
and $817,784 in 1996 10,568,941 10,931,849
Patents, net of accumulated amortization of
$1,574,161 in 1997 and $1,311,556 in 1996 3,801,238 4,063,843
Purchased technology from acquisitions, net of
accumulated amortization of $968,688 in 1997
and $730,775 in 1996 3,729,312 3,967,225
Tradenames, net of accumulated amortization
of $312,500 in 1997 and $218,750 in 1996 2,187,500 2,281,250
Other assets 9,931 9,931
----------- -----------
$47,379,527 $48,992,455
=========== ===========
</TABLE>
3
<PAGE> 5
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 1997 AND DECEMBER 31, 1996
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
LIABILITIES AND STOCKHOLDERS' EQUITY (UNAUDITED)
- ------------------------------------ ------------ ------------
<S> <C> <C>
Current liabilities:
Accounts payable $ 833,056 $ 2,269,269
Short-term notes payable and current maturities
of long-term notes payable 8,472,065 2,084,122
Accrued salary and employee benefit costs 801,840 924,309
Other accrued expenses 279,974 188,605
------------ ------------
Total current liabilities 10,386,935 5,466,305
------------ ------------
Notes payable 3,680,633 11,912,036
Deferred income taxes 1,029,893 620,631
Commitments and contingencies
Stockholders' equity:
Common stock of $.05 par value. Authorized
25,000,000 shares; issued 8,511,046 shares
in 1997 and 8,338,510 in 1996 425,553 416,926
Additional paid-in capital 39,386,138 38,699,517
Retained earnings (deficit) (7,483,102) (7,992,082)
Unrealized loss on marketable securities net of
tax benefit of $23,966 in 1997 and $67,423 in 1996 (46,523) (130,878)
------------ ------------
Total stockholders' equity 32,282,066 30,993,483
------------ ------------
$ 47,379,527 $ 48,992,455
============ ============
</TABLE>
See accompanying notes to condensed consolidated financial statements
4
<PAGE> 6
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30 SEPTEMBER 30
---------------------------- ----------------------------
1997 1996 1997 1996
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Net revenue $ 7,826,978 $ 6,486,521 $ 21,637,830 $ 19,305,266
Cost of revenue 3,410,542 2,699,883 9,601,120 8,089,737
------------ ------------ ------------ ------------
Gross profit 4,416,436 3,786,638 12,036,710 11,215,529
------------ ------------ ------------ ------------
Operating expenses:
Research and development 488,703 724,252 1,621,177 2,493,440
Marketing 1,680,760 1,788,939 5,176,507 4,850,522
General and administrative 1,245,120 1,149,198 3,640,558 3,504,544
------------ ------------ ------------ ------------
3,414,583 3,662,389 10,438,242 10,848,506
------------ ------------ ------------ ------------
Earnings from operations 1,001,853 124,249 1,598,468 367,023
------------ ------------ ------------ ------------
Other income (expenses):
Interest expense (266,845) (198,287) (782,856) (571,375)
Interest and other income 29,194 48,250 74,156 162,485
Gain (loss) on sale of assets and
marketable securities 9,497 61,352 (14,982) 123,881
------------ ------------ ------------ ------------
(228,154) (88,685) (723,682) (285,009)
------------ ------------ ------------ ------------
Earnings before income taxes 773,699 35,564 874,786 82,014
Income taxes 324,337 28,816 365,806 55,515
------------ ------------ ------------ ------------
Net earnings $ 449,362 $ 6,748 $ 508,980 $ 26,499
============ ============ ============ ============
Net earnings per common and
common equivalent share $ .05 $ -- $ .06 $ --
============ ============ ============ ============
Weighted average number of common and
common equivalent shares 8,941,087 8,707,989 8,688,575 8,601,470
</TABLE>
See accompanying notes to condensed consolidated financial statements.
5
<PAGE> 7
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30
--------------------------
1997 1996
----------- -----------
<S> <C> <C>
Cash flows from operating activities:
Net earnings $ 508,980 $ 26,499
----------- -----------
Adjustments to reconcile net earnings to
net cash provided by (used in) operating activities:
Depreciation and amortization 2,075,950 1,607,160
Loss (gain) on sale of assets and marketable
securities 14,982 (125,686)
Increase in inventory reserve 510,407 9,900
Deferred income taxes 365,806 (99,874)
Changes in assets and liabilities:
Receivables (260,275) (96,969)
Inventories 112,167 (2,487,850)
Prepaid expenses and other assets 181,877 371,274
Accounts payable (1,436,213) 890,996
Other -- (1,300)
Accrued expenses (31,102) (571,909)
----------- -----------
Total adjustments 1,533,599 (504,258)
----------- -----------
Net cash provided by (used in) operating activities 2,042,579 (477,759)
----------- -----------
Cash flows from investing activities:
Purchases of marketable securities (1,181,383) (1,231,940)
Proceeds from sales of marketable securities 1,403,607 1,941,754
Additions to property, plant and equipment (1,173,154) (1,499,884)
Net proceeds from sale of assets 7,690 1,805
----------- -----------
Net cash used in investing activities (943,240) (788,265)
----------- -----------
Cash flows from financing activities:
Exercise of stock options 695,248 405,276
Redemption of rights plan -- (103,146)
Proceeds from short-term obligations 461,221 328,881
Payment of short-term obligations (1,255,568) (220,761)
Payment of long-term debt (1,049,113) (111,834)
----------- -----------
Net cash provided by (used in) financing activities (1,148,212) 298,416
----------- -----------
Net decrease in cash and cash equivalents (48,873) (967,608)
Cash and cash equivalents at beginning of period 696,197 1,325,630
----------- -----------
Cash and cash equivalents at September 30 $ 647,324 $ 358,022
=========== ===========
Supplemental cash flow information is presented below:
Income taxes paid $ -- $ --
=========== ===========
Interest paid $ 707,098 $ 530,600
=========== ===========
</TABLE>
See accompanying notes to condensed consolidated financial statements
6
<PAGE> 8
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
UNREALIZED
LOSS ON
COMMON STOCK ADDITIONAL RETAINED MARKETABLE TOTAL STOCK-
SHARES AMOUNT PAID-IN CAPITAL EARNINGS (DEFICIT) SECURITIES HOLDERS' EQUITY
--------------------------- --------------- ------------------ ---------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 8,147,349 $ 407,367 $ 38,253,670 $ (7,579,925) $ (211,062) $ 30,870,050
Shares issued upon exercise
of stock options 159,178 7,959 479,207 -- -- 487,166
Adjustment to unrealized losses
on marketable securities -- -- -- -- 80,184 80,184
Issuance of 31,983 new common
shares for employee bonuses
and cancellation of a stock
option 31,983 1,600 69,786 -- -- 71,386
Redemption of rights plan
dividend -- -- (103,146) -- -- (103,146)
Net loss -- -- -- (412,157) -- (412,157)
------------ ------------ ------------ ------------ ------------ ------------
Balance at December 31, 1996 8,338,510 416,926 38,699,517 (7,992,082) (130,878) 30,993,483
Shares issued upon exercise
of stock options 172,536 8,627 686,621 -- -- 695,248
Adjustment to unrealized losses
on marketable securities -- -- -- -- 84,355 84,355
Net earnings -- -- -- 508,980 -- 508,980
------------ ------------ ------------ ------------ ------------ ------------
Balance at September 30, 1997 8,511,046 $ 425,553 $ 39,386,138 $ (7,483,102) $ (46,523) $ 32,282,066
============ ============ ============ ============ ============ ============
</TABLE>
See accompanying notes to condensed consolidated financial statements
7
<PAGE> 9
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) BUSINESS
Quest Medical, Inc. and its subsidiaries (the "Company") design,
develop, manufacture and market a variety of healthcare products used
primarily in cardiovascular surgery, interventional pain management and
intravenous fluid delivery applications. The Company's revenues are
derived primarily from sales throughout the United States, Europe and
Australia.
The research and development, manufacture, sale and distribution of
medical devices is subject to extensive regulation by various public
agencies, principally the Food and Drug Administration and
corresponding state, local and foreign agencies. Product approvals and
clearances can be delayed or withdrawn for failure to comply with
regulatory requirements or the occurrence of unforeseen problems
following initial marketing.
In addition, the Company's products are purchased primarily by
hospitals and other users which then bill various third party payors
including Medicare, Medicaid, private insurance companies and managed
care organizations. These third party payors reimburse fixed amounts
for services based on a specific diagnosis. The impact of changes in
third party payor reimbursement policies and any amendments to existing
reimbursement rules and regulations which restrict or terminate the
eligibility of the Company's products could have an adverse impact on
the Company's financial condition and results of operations.
(2) CONDENSED FINANCIAL STATEMENTS
The unaudited consolidated financial information contained in this
report reflects all adjustments (consisting of normal recurring
accruals) considered necessary, in the opinion of management, for a
fair presentation of results for the interim periods presented. The
preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from these estimates.
Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted. These financial
statements should be read in conjunction with the financial statements
and notes thereto included in the Company's December 31, 1996 Annual
Report on Form 10-K. The results of operations for periods ended
September 30 are not necessarily indicative of operations for the full
year.
The consolidated financial statements include the accounts of Quest
Medical, Inc. and subsidiaries (the "Company"). All significant
intercompany balances and transactions have been eliminated in
consolidation.
8
<PAGE> 10
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(3) MARKETABLE SECURITIES
The following is a summary of available-for-sale securities at
September 30, 1997:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Investment grade preferred
securities $307,596 $ 2,833 $ 32,317 $278,112
Real estate investment
trusts 293,908 3,751 3,620 294,039
Other 365,004 1,348 42,485 323,867
-------- -------- -------- --------
$966,508 $ 7,932 $ 78,422 $896,018
======== ======== ======== ========
</TABLE>
At September 30, 1997, no individual security represented more than 30
percent of the total portfolio or 1 percent of total assets. The
Company did not have any investments in derivative financial
instruments at September 30, 1997.
(4) CURRENT AND LONG-TERM NOTES PAYABLE
On March 3, 1997, the Company amended its $5 million working capital
line of credit. Under the amended agreement, the working capital line
of credit was increased to $5,650,000 and a $350,000 term loan facility
was added. Borrowings under the working capital line of credit bear
interest at prime plus 100 basis points, or at the Company's option,
LIBOR plus 275 basis points. Borrowings under the term loan bear
interest at prime plus 100 basis points, or at the Company's option,
LIBOR plus 225 basis points. The facilities are collateralized by all
of the Company's assets with the exception of the real property,
building, and equipment that collateralize the long-term financing on
the Allen facility described below. The Company is subject to certain
covenants related to the loan agreement including the maintenance of a
minimum fixed charge ratio, a maximum total liabilities to tangible net
worth ratio, and a maximum margin ratio (as defined). Under the amended
agreement, the Company is prohibited from paying cash dividends. Under
the working capital line of credit, the Company is required to make
monthly payments of $90,000 with interest payable quarterly. Under the
term loan, no principal payments are due until maturity and interest is
payable quarterly. These facilities will expire on January 31, 1998. On
March 3, 1997, the company increased its borrowings under the working
capital line of credit by $1,100,000 and borrowed $350,000 under the
term loan facility. These additional borrowings were utilized to pay a
portion of the debt under the February 6, 1997 Settlement discussed
below. At September 30, 1997, the Company had advances in the amount of
$4,950,000 outstanding under its working capital line with a weighted
average interest rate of 8.48 percent. At September 30, 1997, the
Company had advances in the amount of $350,000 under the term loan
facility with a weighted average interest rate of 7.96 percent.
On February 21, 1997, the Company borrowed $2,000,000 from a
nonaffiliate shareholder pursuant to a promissory note. The promissory
note bears interest at the rate of 6 percent per annum. Under the terms
of the promissory note, the
9
<PAGE> 11
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Company is required to make quarterly interest payments with a
principal payment of $2,000,000 due and payable at the maturity of the
note on February 21, 1998. In conjunction with the promissory note, the
Company issued the shareholder five-year warrants to purchase 100,000
shares of common stock at an exercise price of $6.50 per share, the
closing sales price on the date the indebtedness was incurred. Under
the warrant agreement, the shareholder has the right to one demand
registration in addition to piggyback registration rights. The loan is
subordinated to the bank debt described above and the shareholder has a
second lien on all of the assets collateralizing the bank debt.
Proceeds of the loan were utilized to pay a portion of the debt under
the Settlement described below.
At December 31, 1996, the Company had a short-term, noninterest-bearing
note payable in the amount of $972,197 due in connection with certain
purchase price adjustments (primarily tax refunds and tax credits)
awarded through an arbitration to the former owner of Neuromed, Inc. (a
company acquired in March 1995). The note was paid during January 1997
from cash reserves. In addition, on February 6, 1997, the Company
reached a Settlement (the "Settlement") on all outstanding issues with
the former owner of Neuromed relating to the Neuromed acquisition.
Under the Settlement, the Company agreed to pay $4.5 million in
settlement of the earn-out provisions of the purchase agreement and the
purchase of certain patent rights. Of the Settlement, $3.5 million was
paid in the form of an interest-bearing note at 10.25 percent per annum
from February 6, 1997 which was due and payable on March 3, 1997. The
Company paid such note on March 3, 1997, utilizing proceeds from the
bank debt and shareholder debt described above. In addition, the
Company issued the former owner a promissory note in the amount of
$1,000,000. The promissory note bears interest at the rate of 10
percent per annum with interest payable monthly and a principal payment
of $1,000,000 due and payable on February 6, 1998. The loan is
subordinated to the bank debt described above and is collateralized
with a second lien that is pari passu with the shareholder's lien.
The Company also has two agreements for long-term financing of its
principal office and manufacturing facility in the amounts of
$2,888,487 and $964,211 at September 30, 1997.
Scheduled payments of current and long-term notes payable are
as follows:
<TABLE>
<S> <C>
1997 (October-December).......... $ 310,662
1998............................. $ 8,208,566
1999............................. $ 192,082
2000............................. $ 208,336
2001............................. $ 225,824
Thereafter....................... $ 3,007,228
============
</TABLE>
The carrying value of the Company's debt approximates its fair
value.
10
<PAGE> 12
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(5) COMMITMENTS AND CONTINGENCIES
As a consequence of the Neuromed Acquisition in March 1995, the Company
is a party to product liability claims related to SCS devices sold by
Neuromed prior to the acquisition. Product liability insurers have
assumed responsibility for defending the Company against these claims,
subject to reservation of rights in certain cases. While historically
product liability claims against Neuromed have not resulted in
significant monetary liability for Neuromed beyond its insurance
coverage, there can be no assurances that the Company will not incur
significant monetary liability to the claimants if such insurance is
unavailable or inadequate for any reason, or that the Company's SCS
business and new SCS product lines will not be adversely affected by
these product liability claims.
Except for such product liability claims and other ordinary routine
litigation incidental or immaterial to its business, the Company is not
currently a party to any other pending legal proceeding. The Company
maintains general liability insurance against risks arising out of the
normal course of business.
(6) INCOME TAXES
The Company recorded income tax expense during the nine months ended
September 30, 1997, of $365,806, an effective tax rate of 41.8 percent.
The Company's expense for amortization of costs in excess of net assets
acquired (goodwill) is not deductible for tax purposes, thus explaining
the higher effective tax rate compared to the U.S. statutory rate for
corporations of 34 percent. During the nine months ended September 30,
1996, the Company recorded income tax expense of $55,515, an effective
tax rate of 67.7 percent as a consequence of the nondeductibility of
amortization expense of costs in excess of net assets acquired.
(7) NEW ACCOUNTING PRONOUNCEMENT
In February 1997, the Financial Accounting Standards Board issued
Statement No. 128, Earnings per Share, which is required to be adopted
on December 31, 1997. At that time, the Company will be required to
change the method currently used to compute earnings per share and to
restate all prior periods. Under the new requirements for calculating
primary earnings per share, the dilutive effect of stock options will
be excluded. Utilizing the new method would not impact primary earnings
per share for the three months and nine months ended September 30, 1997
or the three months and nine months ended September 30, 1996. The
impact of Statement 128 on the calculation of fully diluted earnings
per share for these quarters is not expected to be material.
(8) RECENT EVENTS
On March 10, 1997, the Company announced that the Company's Board of
Directors had engaged Smith Barney and Rauscher Pierce Refsnes to seek
strategic alternatives to enhance shareholder value. These strategic
alternatives may include a merger, sale of assets, other business
combination, or a joint venture or strategic alliance.
11
<PAGE> 13
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations of
the Company should be read in conjunction with the Condensed Consolidated
Financial Statements of the Company and the related Notes thereto.
RESULTS OF OPERATIONS
COMPARISON OF THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996
Revenues. Net revenue of $7.83 million for the three months ended September 30,
1997 was $1.34 million, or 20.7 percent, above the level for the comparable 1996
period of $6.49 million. For the nine months ended September 30, 1997, net
revenue of $21.64 million was $2.33 million, or 12.1 percent, above the
comparable 1996 level of $19.31 million. This increase during both periods in
1997 compared to 1996 was primarily the result of higher unit sales volume at
the Company's Advanced Neuromodulation Systems ("ANS") subsidiary, formerly
Neuromed, which was acquired on March 31, 1995 and provides electronic spinal
cord stimulation ("SCS") devices used to manage chronic severe pain. During 1996
and into the first quarter of 1997, the Company dedicated significant
engineering and marketing resources to build the infrastructure of ANS and
improve the current products of ANS to transform ANS into an industry leader and
compete effectively in the SCS market. Management believes these measures
account for the increase in net revenue of ANS products to $4.22 million and
$10.82 million for the three months and nine months ended September 30, 1997,
respectively, a 45.8 percent and 29.7 percent increase over the corresponding
periods in 1996. Management expects that ANS revenues will slow somewhat from
the third to the fourth quarter as patients tend to delay semi-elective
procedures until after the holiday season.
Since the commercial introduction of the MPS system for cardioplegia delivery
during September 1996, clinical use of the MPS has validated that the MPS
provides simpler, more flexible and cost-effective management of myocardial
protection. As a consequence of the current hospital consolidation trend,
coupled with the intense pressure hospitals are under to minimize capital
expenditures however, hospitals have been reluctant to make timely purchase
decisions on new capital equipment. Therefore, to accelerate adoption of MPS and
shorten the selling process, in March 1997, the Company began to offer MPS on a
one-year rental basis and on a lease/purchase basis. While this strategy will
not generate the level of short-term revenues that sales would, because the
rental approach does not qualify as a sale, management believes this strategy is
more likely to accelerate placement of MPS systems and generate related
disposable revenue. The Company believes that once a surgeon changes the
protocol using features of MPS, the surgeon will find it difficult to return to
the old, make-shift system. While management believes that the rental strategy
will accelerate placements of the MPS system and therefore increase revenue of
the related disposables, there can be no assurance to this effect. Net revenue
of MPS systems and related disposables increased to $570,000 and $877,000 for
the three months and nine months ended September 30, 1997, respectively, from
$170,000 and $170,000 for the three months and nine months ended September 30,
1996, respectively.
12
<PAGE> 14
Net revenue from sales of the Company's other cardiovascular products, pressure
monitoring kits used in labor and delivery and specialized fluid delivery tubing
sets decreased from $3.42 million during the three months ended September 30,
1996 to $3.04 million for the same period during 1997 primarily due to lower
unit sales volume from the Company's specialized intravenous fluid delivery
tubing sets and pressure monitoring kits. For the nine months ended September
30, 1997, net revenue of the Company's other cardiovascular products, pressure
monitoring kits and specialized fluid delivery tubing sets decreased to $9.94
million from $10.79 million during 1996, again due to lower unit sales volume
from the Company's specialized tubing sets and pressure monitoring kits.
Gross Profit. Gross profit of $4.42 million for the three months ended September
30, 1997 was $630,000 above the level for the comparable 1996 period of $3.79
million, but as a percentage of net revenue, gross profit decreased during the
three months ended September 30, 1997 to 56.4 percent as compared to 58.4
percent for the comparable 1996 period. This dollar increase in gross profit
during the third quarter of 1997 compared to the same period a year ago was
primarily the result of the increase in ANS revenue discussed above. The
decrease in gross profit margin to 56.4 percent during 1997 from 58.4 percent in
1996 was due to unfavorable manufacturing variances caused by inefficiencies and
scrap from a component utilized in the MPS disposable. The Company has resolved
the manufacturing process for this component and does not expect the negative
variances to continue. For the nine months ended September 30, 1997, gross
profit increased to $12.04 million compared to $11.22 million during the same
period in 1996 although, as a percentage of net revenue, gross profit decreased
to 55.6 percent in 1997 from 58.1 percent during 1996. This dollar increase in
gross profit during the nine-month period in 1997 compared to 1996 was primarily
the result of the increase in ANS revenue discussed above. The decrease in gross
profit margin during the nine-month period during 1997 compared to 1996 was due,
for the most part, to a $479,000 expense during the second quarter of 1997 for
the write-off of ANS inventory of previous designs, and to a lesser extent, the
unfavorable manufacturing variances during the third quarter of 1997 from the
component used in the MPS disposable discussed above.
Operating Expenses. Research and development expense decreased to $489,000
during the three months ended September 30, 1997 compared to $724,000 for the
same period a year ago and decreased as a percentage of net revenue from 11.2
percent in 1996 to 6.2 percent in 1997. For the nine months ended September 30,
1997, research and development expense decreased to $1.62 million compared to
$2.49 million for the same period a year ago and decreased as a percentage of
net revenue from 12.9 percent during 1996 to 7.5 percent in 1997. This decrease
in expense during 1997 compared to 1996 was the result of a reduction in salary
and contract labor expense due to the completion of MPS's development.
Management expects research and development expenditures to approximate $700,000
in the fourth quarter of 1997 and expects about 60 percent of such expenditures
to be directed to developing next generation ANS products. The remaining
expenditures during 1997 will be directed to continued developments in the MPS
system. Management expects that the Company will continue to finance its
research and development activities during the remainder of 1997 through
internally generated funds.
Marketing expense, as a percentage of net revenue, decreased to 21.5 percent for
the three months ended September 30, 1997 compared to 27.6 percent for the
comparable period in 1996, and the dollar amount decreased by $108,000. This
decrease in marketing expense during the third quarter of 1997 compared to 1996
was the result of lower commissions, samples and travel expense associated with
the sales force which sells the MPS system. For
13
<PAGE> 15
the nine months ended September 30, 1997, marketing expense, as a percentage of
net revenue, decreased to 23.9 percent compared to 25.1 percent for the same
period in 1996, although the dollar amount increased by $326,000. This dollar
increase for the nine-month period in 1997 compared to 1996 was attributable to
additional marketing expense of ANS related to higher commissions, clinical
study and training expense for new users of ANS products.
General and administrative expense, as a percentage of net revenue, decreased to
15.9 percent during the three months ended September 30, 1997 compared to 17.7
percent for the same period during 1996, while the dollar amount increased by
$96,000. For the nine months ended September 30, 1997, general and
administrative expense, as a percentage of net revenue, decreased to 16.8
percent compared to 18.2 percent for the same period during 1996, while the
dollar amount increased by $136,000. The dollar increase in expense during both
1997 periods compared to 1996 was the result of higher amortization expense of
ANS intangibles and an expense of $35,000 to increase the Company's reserves for
bad debt.
Earnings From Operations. Earnings from operations increased to $1.00 million
during the three months ended September 30, 1997 compared to $124,000 for the
same period in 1996 due to increased gross profit from higher sales of ANS
products combined with an overall reduction in operating expenses from lower
marketing and research and development expenses. For the nine months ended
September 30, 1997, earnings from operations increased to $1.60 million compared
to $367,000 for the same period in 1996 due to increased gross profit from
higher sales of ANS products combined with an overall reduction in operating
expenses due to lower research and development expense. Earnings from operations
during the nine months ended September 30, 1997 was reduced by an expense of
$479,000 recorded during the second quarter of 1997 to write-off inventory of
ANS products of previous design.
Other Expense. Other expense increased to $228,000 during the three months ended
September 30, 1997 compared to $89,000 for the same period in 1996. For the nine
months ended September 30, 1997, other expense increased to $724,000 compared to
$285,000 for the same period in 1996. This increase in other expense during both
periods of 1997 compared to 1996 was the result of higher interest expense and
lower interest income and gains on the sale of marketable securities. During the
first quarter of 1997, the Company incurred additional indebtedness of $4.45
million which was utilized to pay contingent consideration and purchase certain
patent rights from Neuromed's former owner. See Note 3 of the Notes to Condensed
Consolidated Financial Statements. In addition, higher overall interest rates on
borrowed money also contributed to the increase in interest expense during the
1997 periods compared to 1996.
Income Taxes. The Company recorded income tax expense of $324,000 and $366,000
for the three months and nine months ended September 30, 1997, respectively.
This represents an effective tax rate of 41.8 percent for the nine-month period
ended September 30, 1997. The Company's expense for amortization of costs in
excess of net assets acquired (goodwill) is not deductible for tax purposes,
thus explaining the higher effective tax rate compared to the U.S. statutory
rate for corporations of 34 percent. For the three months and nine months ended
September 30, 1996, the Company recorded income tax expense of $29,000 and
$56,000, respectively. This represented an effective tax rate of 67.7 percent
for the nine-month period ended September 30, 1996. Again, the effective tax
rate was higher compared to the U.S. statutory rate for corporations of 34
percent as a consequence of the nondeductibility of amortization expense of
costs in excess of net assets acquired.
14
<PAGE> 16
Net Earnings. Net earnings increased to $449,000, or $.05 per share, during the
three months ended September 30, 1997 compared to $6,700, or nil per share, for
the same period during 1996 due to the increase in earnings from operations
discussed above. For the nine months ended September 30, 1997, net earnings
increased to $509,000, or $.06 per share, compared to $26,000, or nil per share,
for the same period during 1996 again due to the increase in earnings from
operations discussed above.
LIQUIDITY AND FINANCIAL POSITION
The Company's working capital decreased from $11.1 million at year end 1996 to
$5.4 million at September 30, 1997, principally due to a reclassification of
notes payable from long term to short term. The ratio of current assets to
current liabilities was 1.5:1 at September 30, 1997 compared to 3.0:1 at
December 31, 1996.
Inventories decreased to $7.7 million at September 30, 1997 compared to $8.4
million at December 31, 1997. This decrease was the result of reclassifying
$450,000 of MPS rental systems from inventory to property, plant and equipment
and the $479,000 ANS inventory write-off during the second quarter of 1997
discussed above.
During the nine months ended September 30, 1997, the Company invested $723,000
in capital expenditures for additional manufacturing tooling and equipment
(excluding the $450,000 of MPS rental systems transferred from inventory). The
Company expects to invest an additional $250,000 during the remainder of fiscal
1997.
During February 1997, the Company reached a settlement ("Settlement") of certain
disputes with the former owner of Neuromed. Under terms of the Settlement, the
Company agreed to pay $3.0 million in cash during March 1997 to purchase certain
patent rights from Neuromed's former owner and $500,000 in cash and $1.0 million
in a promissory note payable on February 6, 1998 for full settlement of certain
contingent earn-out considerations. The promissory note bears interest at the
rate of 10 percent per annum with interest due and payable monthly. On March 3,
1997, the Company made payment of the $3.5 million in cash pursuant to the
Settlement with borrowed funds discussed below. See Note 4 of the Notes to
Condensed Consolidated Financial Statements.
On February 21, 1997, the Company borrowed $2.0 million from a shareholder
pursuant to a promissory note. The promissory note is due and payable on
February 21, 1998, and bears interest at the rate of 6 percent per annum. In
addition, the Company issued the shareholder five-year warrants to purchase
100,000 shares of common stock at an exercise price of $6.50 per share, the
closing sale price on the date the indebtedness was incurred. The Company
utilized the proceeds from the loan to pay a portion of the Settlement discussed
above. See Note 4 of the Notes to Condensed Consolidated Financial Statements.
On March 3, 1997, the Company amended its $5.0 million working capital line of
credit with NationsBank of Texas, N.A. Under the amended agreement, the working
capital line of credit was increased to $5.65 million, and a $350,000 term loan
facility was added. Both credit facilities expire on January 31, 1998.
Borrowings under the working capital line of credit bear interest at prime plus
100 basis points, or at the Company's option, LIBOR plus 275 basis points.
Borrowings under the term loan facility bear interest at prime plus 100 basis
points, or at the Company's option, LIBOR plus 225 basis points. Under the
working capital line, the Company is required to make monthly payments of
$90,000. Under the term loan facility, no
15
<PAGE> 17
principal payments are due until maturity. On March 3, 1997, the Company
increased its borrowings under the working capital line of credit by $1.1
million and borrowed $350,000 under the term loan facility. Proceeds from these
additional borrowings were utilized to pay a portion of the Settlement described
above. See Note 4 of the Notes to Condensed Consolidated Financial Statements.
Through September 30 1997, the Company had repaid $700,000 of its working
capital line of credit indebtedness and had borrowings of $4.95 million under
the working capital line at September 30, 1997.
Management believes that its current cash, cash equivalents and marketable
securities and funds generated from operations will be sufficient to satisfy
normal cash operating requirements, debt service and capital requirements during
the remainder of 1997. During the first quarter of 1998, however, $8.0 million
of debt will become due and payable. The Company is exploring various means to
either refinance or pay off the debt entirely, including without limitation, a
new loan facility, alternative debt or equity financing, asset or division sale,
technology transfer or other arrangements.
CASH FLOWS
Net cash provided by operating activities increased to $2.04 million during the
nine months ended September 30, 1997 compared to a net use of cash in operating
activities during the same period in 1996 of $478,000. This increase during 1997
was primarily the result of increased net earnings and a reduction of the
Company's investment in inventories. During 1996, the Company utilized $2.49
million of cash to increase its investment in inventories primarily related to
the MPS system in preparation for market introduction in September 1996 while
during 1997, the Company reduced its overall investment in inventories by
$112,000, a net reduction of the use of cash of $2.60 million. Net cash provided
by operating activities during 1997 was reduced by $1.44 million due to the use
of cash to decrease the Company's level of accounts payable.
Net cash used in investing activities increased to $943,000 during the nine
months ended September 30, 1997 compared to a net use of cash during the same
period in 1996 of $788,000. This increase in net cash used in investing
activities during the 1997 period compared to 1996 was attributable to a
$538,000 reduction in proceeds from the sales of marketable securities.
Net cash used in financing activities for the nine months ended September 30,
1997 was $1.15 million while financing activities during the same period in 1996
provided net cash of $298,000. This decrease was primarily due to the use of
$2.30 million in 1997 to reduce debt under short-term and long-term notes
payable.
RECENT EVENTS
On March 10, 1997, the Company announced that the Company's Board of Directors
had engaged Smith Barney and Rauscher Pierce Refsnes to seek strategic
alternatives to enhance shareholder value. These strategic alternatives may
include a merger, sale of assets, other business combination, or a joint
venture or strategic alliance. When the Board of Directors approves the
implementation of a plan, the Company will announce such plans to its
shareholders, which management expects during the fourth quarter of 1997.
16
<PAGE> 18
FORWARD LOOKING STATEMENTS
The following is a "safe harbor" statement under the Private Securities
Litigation Reform Act of 1995: The matters discussed in this Management's
Discussion and Analysis of Financial Condition and Results of Operations contain
statements that constitute forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). The words "expect," "estimate," "anticipate," "predict," "believe," and
similar expressions and variations thereof are intended to identify
forward-looking statements. Such statements appear in a number of places in this
MD&A and include statements regarding the intent, belief or current expectations
of the Company, its directors or its officers with respect to, among other
things: (i) trends affecting the Company's financial condition or results of
operations; (ii) the Company's financing plans; and (iii) the Company's business
and growth strategies. Readers are cautioned that any such forward-looking
statements are not guarantees of future performance and involve risks and
uncertainties, and that actual results may differ materially from those
projected in the forward-looking statements as a result of various factors.
These risks and uncertainties include but are not limited to the Company's
ability to develop, clinically validate and gain market acceptance for new
products, including the MPS system, new generation ANS products and other
products; accelerating the adoption of MPS systems and related disposables
utilizing one-year rental agreements; successful resolution of the manufacturing
process involving the MPS component; continued growth in ANS revenue consistent
with management expectation; restraining research and development and marketing
expenses; finalizing plans for strategic alternatives during the fourth quarter
of 1997; government regulation; competition and technological changes that may
render the Company's products obsolete or noncompetitive; general domestic and
international economic conditions and other risks detailed from time to time in
the Company's SEC public filings. Consequently, if such management assumptions
prove to be incorrect or such risks or uncertainties materialize, the Company's
actual results could differ materially from the results forecasted in the
forward-looking statements.
CURRENCY FLUCTUATIONS
Substantially all of the Company's international sales are denominated in U.S
dollars. Fluctuations in currency exchange rates in other countries could reduce
the demand for the Company's products by increasing the price of the Company's
products in the currency of the countries in which the products are sold,
although management does not believe currency fluctuations have had a material
effect on the Company's results of operations.
17
<PAGE> 19
PART II
OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit 27 -- Financial Data Schedule
(b) No reports on Form 8-K have been filed during the quarter
ended September 30, 1997.
18
<PAGE> 20
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.
QUEST MEDICAL, INC.
DATE: NOVEMBER 12, 1997 BY: /S/ F. ROBERT MERRILL III
--------------------------
F. ROBERT MERRILL III
SENIOR VICE PRESIDENT FINANCE/CHIEF
FINANCIAL OFFICER AND TREASURER
19
<PAGE> 21
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
27 Financial Data Schedule
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 647,324
<SECURITIES> 1,246,018
<RECEIVABLES> 4,813,238
<ALLOWANCES> 209,337
<INVENTORY> 7,737,873
<CURRENT-ASSETS> 15,761,324
<PP&E> 17,180,530
<DEPRECIATION> 5,859,249
<TOTAL-ASSETS> 47,379,527
<CURRENT-LIABILITIES> 10,386,935
<BONDS> 0
0
0
<COMMON> 425,553
<OTHER-SE> 31,856,513
<TOTAL-LIABILITY-AND-EQUITY> 47,379,527
<SALES> 21,637,830
<TOTAL-REVENUES> 21,637,830
<CGS> 9,601,120
<TOTAL-COSTS> 9,601,120
<OTHER-EXPENSES> 10,438,242
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 782,856
<INCOME-PRETAX> 874,786
<INCOME-TAX> 365,806
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 508,980
<EPS-PRIMARY> 0.06
<EPS-DILUTED> 0.06
</TABLE>
