<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 MARCH 31, 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
Incorporation or Organization) Identification No.)
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 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.
NUMBER OF SHARES OUTSTANDING AT
TITLE OF EACH CLASS APRIL 25, 1997
- ----------------------------- --------------------------------
COMMON STOCK, $.05 PAR VALUE 8,355,938
<PAGE> 2
QUEST MEDICAL, INC. AND SUBSIDIARIES
TABLE OF CONTENTS
<TABLE>
<S> <C> <C>
PART I. FINANCIAL INFORMATION 2
ITEM 1. Financial Statements
Condensed Consolidated Balance Sheets
March 31, 1997 and December 31, 1996 3-4
Condensed Consolidated Statements of Operations
For the Three Months Ended
March 31, 1997 and 1996 5
Condensed Consolidated Statements of Cash Flows
For the Three Months Ended
March 31, 1997 and 1996 6
Condensed Consolidated Statements of Stockholders' Equity
For the Year Ended December 31, 1996
and the Three Months Ended March 31, 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
MARCH 31, 1997 AND DECEMBER 31, 1996
<TABLE>
<CAPTION>
MARCH 31,
1997 DECEMBER 31,
ASSETS (UNAUDITED) 1996
- ------ ----------- -----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 530,705 $ 696,196
Marketable securities 954,161 1,366,089
Receivables:
Trade accounts, less allowance for doubtful
accounts of $174,337 in 1997 and $174,337
in 1996 4,430,334 4,829,827
Net investment in sales-type leases 173,473 176,875
Interest and other 135,484 134,162
----------- ------------
Total receivables 4,739,291 5,140,864
----------- ------------
Inventories:
Raw materials 3,611,702 3,931,282
Work-in-process 1,663,474 1,400,712
Finished goods 3,046,562 3,032,600
----------- ------------
Total inventories 8,321,738 8,364,594
----------- ------------
Deferred income taxes 213,246 317,276
Prepaid expenses and other current assets 540,062 668,808
----------- ------------
Total current assets 15,299,203 16,553,827
----------- ------------
Property, plant and equipment:
Land 1,930,289 1,930,289
Building and improvements 5,317,282 5,296,125
Furniture and fixtures 3,831,031 3,827,738
Machinery and equipment 5,066,349 4,962,846
----------- ------------
16,144,951 16,016,998
Less accumulated depreciation and
amortization 5,157,817 4,832,468
----------- ------------
Net property, plant and equipment 10,987,134 11,184,530
----------- ------------
Cost in excess of net assets acquired, net of
accumulated amortization of $956,261 in 1997
and $817,784 in 1996 10,868,610 10,931,849
Patents, net of accumulated amortization of
$1,404,840 in 1997 and $1,311,556 in 1996 3,970,559 4,063,843
Purchased technology from acquisitions, net of
accumulated amortization of $810,080 in 1997
and $730,775 in 1996 3,887,920 3,967,225
Tradenames, net of accumulated amortization
of $250,000 in 1997 and $218,750 in 1996 2,250,000 2,281,250
Other assets 9,931 9,931
----------- ------------
$47,273,357 $48,992,455
=========== ===========
</TABLE>
3
<PAGE> 5
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, 1997 AND DECEMBER 31, 1996
<TABLE>
<CAPTION>
MARCH 31,
1997 DECEMBER 31,
LIABILITIES AND STOCKHOLDERS' EQUITY (UNAUDITED) 1996
- ------------------------------------ ------------ -----------
<S> <C> <C>
Current liabilities:
Accounts payable $ 1,265,047 $ 2,269,269
Short-term notes payable and current maturities
of long-term notes payable 9,234,416 2,084,122
Accrued salary and employee benefit costs 1,028,723 924,309
Other accrued expenses 216,768 188,605
------------ -----------
Total current liabilities 11,744,954 5,466,305
------------ -----------
Notes payable 3,769,122 11,912,036
Deferred income taxes 587,339 620,631
Commitments and contingencies
Stockholders' equity:
Common stock of $.05 par value. Authorized
25,000,000 shares; issued 8,355,938 shares
in 1997 and 8,338,510 in 1996 417,797 416,926
Additional paid-in capital 38,755,572 38,699,517
Retained earnings (deficit) (7,897,716) (7,992,082)
Unrealized loss on marketable securities net of
tax benefit of $53,427 in 1997 and
$67,423 in 1996 (103,711) (130,878)
------------ -----------
Total stockholders' equity 31,171,942 30,993,483
$47,273,357 $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 ENDED MARCH 31, 1997 AND 1996
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------------
1997 1996
-------------- --------------
<S> <C> <C>
Net revenue $ 6,669,133 $ 6,149,126
Cost of revenue 2,806,803 2,652,150
-------------- --------------
Gross profit 3,862,330 3,496,976
-------------- --------------
Operating expenses:
Research and development 604,851 896,343
Marketing 1,659,069 1,411,993
General and administrative 1,186,016 1,163,844
-------------- --------------
3,449,936 3,472,180
-------------- --------------
Earnings from operations 412,394 24,796
-------------- --------------
Other income (expenses):
Interest expense (237,978) (178,080)
Interest and other income 12,704 66,835
Gain (loss) on sale of assets and
marketable securities (36,011) 10,224
-------------- --------------
(261,285) (101,021)
-------------- --------------
Earnings (loss) before income taxes 151,109 (76,225)
Income taxes 56,743 18,347
-------------- --------------
Net earnings (loss) $ 94,366 $ (94,572)
============== ==============
Net earnings (loss) per common and
common equivalent share $ .01 $ (.01)
============== ==============
Weighted average number of common and
common equivalent shares 8,753,639 8,185,710
</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 THREE MONTHS ENDED MARCH 31, 1997 AND 1996
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1997 1996
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net earnings (loss) $ 94,366 $ (94,572)
--------- --------
Adjustments to reconcile net earnings (loss) to
net cash provided by operating activities:
Depreciation and amortization 674,408 532,882
Loss (gain) on sale of assets and marketable
securities 36,011 (10,724)
Deferred income taxes 56,743 (33,291)
Changes in assets and liabilities:
Receivables 326,337 271,032
Inventories 37,672 (418,868)
Prepaid expenses and other assets 128,746 (86,151)
Accounts payable (1,004,222) 623,080
Accrued expenses 132,575 (138,781)
---------- ----------
Total adjustments 388,270 739,179
---------- ----------
Net cash provided by operating activities 482,636 644,607
---------- ----------
Cash flows from investing activities:
Purchases of marketable securities (199,410) (742,527)
Proceeds from sales of marketable securities 614,929 322,081
Additions to property, plant and equipment (127,953) (413,011)
Net proceeds from sale of assets -- 500
---------- ----------
Net cash provided by (used in) investing activities 287,566 (832,957)
---------- ----------
Cash flows from financing activities:
Exercise of stock options 56,926 218,279
Proceeds from short-term obligations 293,673 277,056
Payment of short-term obligations (1,106,691) --
Payment of long-term debt (179,601) (36,526)
---------- ----------
Net cash provided by (used in) financing activities (935,693) 458,809
---------- ----------
Net increase (decrease) in cash and cash equivalents (165,491) 270,459
Cash and cash equivalents at beginning of year 696,196 1,325,630
---------- ----------
Cash and cash equivalents at March 31 $ 530,705 $1,596,089
========= =========
Supplemental cash flow information is presented below:
Income taxes paid $ -- $ --
========== ==========
Interest paid $ 229,635 $ 161,263
========== ==========
See accompanying notes to condensed consolidated financial statements
</TABLE>
6
<PAGE> 8
QUEST MEDICAL, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Unrealized
Retained loss on Total
Common Stock Additional earnings marketable Treasury stockholders'
Shares Amount paid-in capital (deficit) securities stock equity
--------- --------- -------------- ------------ ---------- -------- -------------
<S> <C> <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 17,428 871 56,055 -- -- -- 56,926
Adjustment to unrealized losses
on marketable securities -- -- -- -- 27,167 -- 27,167
Net earnings -- -- -- 94,366 -- -- 94,366
--------- --------- -------------- ------------ ---------- -------- -----------
Balance at March 31, 1997 8,355,938 $ 417,797 $ 38,755,572 $ (7,897,716) $ (103,711) -- $31,171,942
========= ========= ============== ============ ========== ======== ===========
</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 March 31
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 March 31,
1997:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Investment grade preferred
securities $ 307,596 $ - $ 48,056 $ 259,540
Publicly traded limited
partnerships 263,004 - 42,845 220,159
Real estate investment
trusts 159,445 2,416 9,188 152,673
Other 381,255 13 59,479 321,789
---------- ---------- ---------- ----------
$1,111,300 $ 2,429 $ 159,568 $ 954,161
========== ========== ========== ==========
</TABLE>
At March 31, 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 March
31, 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 March 31, 1997, the
Company had advances in the amount of $5,560,000 outstanding under its
working capital line with a weighted average interest rate of 8.42
percent. At March 31, 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
9 (Continued)
<PAGE> 11
QUEST MEDICAL, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
rate of 6 percent per annum. Under the terms of the promissory note, the
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.
At March 31, 1997, the Company had a 7.75 percent note payable for
$159,179. This note was collateralized by certain of the Company's
marketable security investments, held by an investment company, which had
a carrying value of $516,875. Borrowings under this note are restricted
to 50 percent of the market value of the Company's marketable securities
held by the investment company. At March 31, 1997, the amount available
for additional borrowing under this note was $99,259.
The Company also has two agreements for long-term financing of its
principal office and manufacturing facility in the amounts of $2,911,916
and $1,355,071 at March 31, 1997.
Scheduled payments of current and long-term notes payable are as
follows:
<TABLE>
<S> <C>
1997 (April-December) ................... $1,091,502
1998 .................................... $8,278,566
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 (Continued)
<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 three months ended
March 31, 1997, of $56,743, an effective tax rate of 37.6 percent. The
Company's expense for amortization 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 three months ended March 31, 1996, the Company
recorded income tax expense of $18,347, despite incurring a loss before
income taxes of $76,225, 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
(loss) per share for the quarters ended March 31, 1997 or March 31, 199.
The impact of Statement 128 on the calculation of fully diluted earnings
(loss) 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 ENDED MARCH 31, 1997 AND 1996
Revenues. Net revenue of $6.67 million for the three months ended March 31,
1997 was $520,000, or 8.5 percent above the level for the comparable 1996
period of $6.15 million. This increase 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 the first quarter of 1996, management announced
plans to build the infrastructure and improve the current products of ANS to
transform ANS into an industry leader and compete effectively in the SCS
market. During 1996 and into the first quarter of 1997, the Company dedicated
significant engineering and marketing resources in these efforts. Management
believes these measures account for the increase in net revenue of ANS products
for the three months ended March 31, 1997 to $3.14 million, an increase of
$700,000, or 28.3 percent, over the comparable 1996 period.
During the third quarter of 1996, the Company completed clinical validation of
the MPS system for cardioplegia delivery and began commercial shipments during
September 1996. Revenue from the MPS system and related disposable products
since that time have not met management's expectations. Clinical use of the MPS
since its introduction 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. This strategy will not generate the level
of short-term revenues that sales would because the rental approach does not
qualify as a sale. In management's opinion, however, this strategy is more
likely to accelerate placement of MPS systems and generate related disposable
revenue. The Company believes that once a surgeon uses MPS, it will be very
difficult to return to old, make-shift systems. There can be no assurance, or
course, that the Company's rental strategy will accelerate placement of MPS
systems.
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 $3.70 million during the three months ended March
31, 1996 to $3.38 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.
12
<PAGE> 14
Gross Profit. Gross profit of $3.86 million for the three months ended March
31, 1997, was $365,000, or 10.4 percent above the level for the comparable 1996
period. As a percentage of net revenue, gross profit increased during the three
months ended March 31, 1997 to 57.9 percent as compared to 56.9 percent for the
comparable 1996 period. This increase in gross profit and gross profit margin
was attributable to the increased revenue generated by ANS, since ANS products
contribute higher gross profit margins than the Company's other product lines.
Operating Expenses. Research and development expense decreased to $605,000
during the three months ended March 31, 1997, compared to $896,000 for the same
period a year ago, and decreased as a percentage of net revenue from 14.6
percent in 1996 to 9.1 percent in 1997. This decrease in expense during 1997
compared to 1996 was the result of a reduction in salary and contract labor
expense from staffing reductions due to the completion of the development of
the MPS system. Management expects research and development expenditures to
approximate $2.2 million for the remainder of 1997 and expects about half of
such expenditures to be directed to refining current ANS products and
developing next generation ANS products for market introduction during 1998.
The other half of expenditures for the remainder of 1997 will be directed to
continued developments in the MPS system. Management expects that most of its
research and development activities during 1997 will continue to be financed
through internally generated funds.
Marketing, general and administrative expenses as a percentage of net revenue
increased to 42.7 percent for the three months ended March 31, 1997, compared
to 41.9 percent for the comparable period during 1996, and the dollar amount
increased by $269,000. The largest increase occurred in marketing expense with
expenditures in 1997 increasing by $247,000 over the comparable period a year
ago, and as a percentage of net revenue, increased to 24.9 percent in 1997
compared to 23.0 percent in 1996. Of such increase, $209,000 was additional
marketing expense of ANS related to additional salary, benefit, commission, and
consulting expense. During the first quarter of 1997, the Company continued
implementing ANS training, customer support, and sales and marketing materials
and videos. The Company has also reestablished relationships with key
implanters who had discontinued using the ANS products prior to the Company's
acquisition during March 1995. The remainder of the increase in marketing
expense of $62,000 in 1997 compared to 1996 was primarily the result of
additional promotional expense and convention expense directed toward sales
efforts of the MPS system. Currently, the Company has five direct salespersons
marketing the MPS system and does not anticipate adding additional salespersons
during the remainder of 1997. In early 1997, the Company decided to offer MPS
on a one-year rental basis and on a lease/purchase basis to accelerate the
adoption of MPS and shorten the selling process. If this strategy is
successful, management would reevaluate adding salespersons during 1997, as
circumstances warrant. Management expects to continue to focus its efforts for
MPS during the remainder of 1997 on the U.S. and Canadian markets, and does not
plan market introduction of the MPS internationally until fiscal 1998.
General and administrative expense as a percentage of net revenue decreased to
17.8 percent during the three months ended March 31, 1997 compared to 18.9
percent for the same period during 1996, while the dollar amount increased by
$22,000. This slight increase in expense during 1997 compared to 1996 was the
result of higher amortization expense of ANS intangibles.
13
<PAGE> 15
Earnings From Operations. Earnings from operations increased to $412,000 during
the three months ended March 31, 1997 compared to $25,000 for the comparable
1996 period. This increase during 1997 compared to 1996 was the result of the
$365,000 increase in gross profit discussed above and an overall decrease of
$22,000 in operating expenses.
Other Expense. Other expense increased to $261,000 during the three months
ended March 31, 1997, compared to $101,000 for the comparable 1996 period as a
result of three factors. First, interest expense increased by $60,000 during
1997 compared to 1996. During the first quarter of 1997, the Company incurred
additional indebtedness of $4.45 million which was utilized to pay contingent
earn-out consideration and purchase certain patent rights from Neuromed's
former owner. See Note 4 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 1997 compared to 1996.
Second, interest income decreased $54,000 during 1997, compared to 1996,
reflecting lower funds available for investment. Finally, the Company incurred
a net loss of $36,000 during the three months ended March 31, 1997 from the
sale of certain marketable security investments compared to net gains on the
sale of certain marketable security investments during the same period in 1996
of $10,000.
Income Taxes. The Company recorded income tax expense during the three months
ended March 31, 1997, of $57,000, an effective rate of 37.6 percent. The
Company's expense for amortization 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 three months ended March 31, 1996, the Company recorded
income tax expense of $18,000, despite incurring a loss before income taxes of
$76,000, as a consequence of the nondeductibility of amortization expense of
costs in excess of net assets acquired.
Net Earnings (Loss). Net earnings increased to $94,000 during the three months
ended March 31, 1997 compared to a net loss of $95,000 during the same period a
year earlier. This increase during 1997 compared to 1996 was the result of 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
$3.55 million at March 31, 1997, principally due to a reclassification of notes
payable from long-term to short-term. The ratio of current assets to current
liabilities was 1.3:1 at March 31, 1997, compared to 3.0:1 at December 31,
1996.
Inventories decreased slightly to $8.32 million at March 31, 1997, compared to
the December 31, 1996 level of $8.36 million. The Company anticipates a
decrease in its investment in inventories of approximately $1.0 million by
year-end 1997 from the year-end 1996 level.
During the three months ended March 31, 1997, the Company invested $128,000 in
capital expenditures for additional manufacturing tooling and equipment. The
Company expects to incur approximately $1.3 million of additional capital
expenditures during the remainder of fiscal 1997, principally for manufacturing
tooling and equipment for the Company's current ANS SCS products and next
generation neuromodulation products.
14
<PAGE> 16
In connection with the Neuromed acquisition in March 1995, the Company agreed
to pay contingent earn-out consideration in January 1996 and January 1997,
depending on Neuromed's attainment of certain sales objectives. At year-end
1995, the Company had a note payable in connection with the 1995 earn-out
consideration in the amount of $1.5 million, payable in January 1996. The
Company withheld payment of the $1.5 million obligation pending arbitration of
certain disputes between the Company and Neuromed's former owner. In October
1996, the sales objectives for the 1996 earn-out were reached and the Company
recorded a note payable in the amount of $3.37 million which was due and
payable in January 1997. The Company similarly withheld payment of this note
pending arbitration. In addition, the Company had a short-term note payable to
the former owner of Neuromed at December 31, 1996, in the amount of $972,000
due in January 1997, related to certain purchase price adjustments (principally
tax refunds and future tax credits) awarded through an arbitration. The Company
paid the $972,000 obligation during January 1997 utilizing a portion of its
cash reserves. On February 6, 1997, the Company and the former owner of
Neuromed reached a settlement (the "Settlement") of all issues between them.
Under terms of the Settlement, the Company agreed to pay $3.0 million in cash
on March 3, 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 the 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 sales price on the date the indebtedness was incurred. The Company
utilized 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 and $15 million acquisition line of credit with NationsBank of Texas,
N.A. Under the third amended agreement, the working capital line of credit was
increased to $5.65 million and a $350,000 term loan facility replaced the
acquisition line of credit. Both 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. 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 Company's facility in Allen, Texas. Under the working capital
line, the Company is required to make monthly principal payments of $90,000,
with interest payable quarterly. Under the term loan facility, no principal
payments are due until maturity and interest is payable quarterly. 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.
These additional borrowings were utilized to pay a portion of the debt under
the Settlement described above. See Note 4 of the Notes to Condensed
Consolidated Financial Statements.
15
<PAGE> 17
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, $8.1
million of debt will become due and payable. The Company is exploring various
means to either refinance or payoff 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 decreased to $483,000 during the
three months ended March 31, 1997, from $645,000 for the same period a year ago
primarily due to a reduction in the level of accounts payable by $1,004,000 in
the 1997 period.
Net cash provided by investing activities increased to $288,000 during the
three months ended March 31, 1997, compared to a net use of cash during 1996 of
$833,000. This increase resulted from two factors. First, the Company reduced
its use of cash for capital expenditures from $413,000 during 1996 to $128,000
during 1997, a decrease of $285,000. Second, the Company during the 1997 period
was a net seller of marketable securities which provided cash of $416,000 while
in the 1996 period, the Company was a net purchaser of marketable securities
which used cash of $420,000.
Net cash used in financing activities for the three months ended March 31,
1997, was $936,000 while financing activities during the same period in 1996
provided net cash of $459,000. This decrease was primarily due to the use of
$1,286,000 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.
FORWARD-LOOKING STATEMENTS
The following is a "safe harbor" statement under the Private Securities
Litigation Reform Act of 1995: Other than historical information, the matters
discussed in this Management's Discussion and Analysis of Financial Condition
and Results of Operations are forward-looking statements that are based on
management assumptions and involve risks and uncertainties, including but 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; continued growth in ANS revenues;
accelerating the adoption of MPS systems and the related disposables utilizing
one-year rental agreements; successfully developing the infrastructure at ANS
to enable the Company to grow the business into a solid player in the SCS
market; 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
16
<PAGE> 18
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 March 31, 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: MAY 13, 1997 BY: /s/ F. ROBERT MERRILL III
-----------------------------------
F. ROBERT MERRILL III
SENIOR VICE PRESIDENT FINANCE/CHIEF
FINANCIAL OFFICER AND TREASURER
19
<PAGE> 21
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
27 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> MAR-31-1997
<CASH> 530,705
<SECURITIES> 954,161
<RECEIVABLES> 4,430,334
<ALLOWANCES> 174,337
<INVENTORY> 8,321,738
<CURRENT-ASSETS> 15,299,203
<PP&E> 16,144,951
<DEPRECIATION> 5,157,817
<TOTAL-ASSETS> 47,273,357
<CURRENT-LIABILITIES> 11,744,954
<BONDS> 0
417,797
0
<COMMON> 0
<OTHER-SE> 30,754,145
<TOTAL-LIABILITY-AND-EQUITY> 47,273,357
<SALES> 6,669,133
<TOTAL-REVENUES> 6,669,133
<CGS> 2,806,803
<TOTAL-COSTS> 2,806,803
<OTHER-EXPENSES> 3,449,936
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 237,978
<INCOME-PRETAX> 151,109
<INCOME-TAX> 56,743
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 94,366
<EPS-PRIMARY> .01
<EPS-DILUTED> .01
</TABLE>
