<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Quarter Ended September 30, 1998 Commission File Number 0-27642
TRANSDERM LABORATORIES CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 13-3518345
(State of Incorporation) (I.R.S. Employer Identification No.)
1212 Avenue of the Americas, 24th Floor, New York, NY 10036
(Address of principal executive offices)
Registrant's Telephone Number: 212-398-0700
The registrant 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,
and has been subject to such filing requirements for the past 90 days.
As of October 31, 1998, 40,000,000 shares of Common Stock, $.001 Par Value,
were outstanding.
Page 1<PAGE>
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<TABLE>
TRANSDERM LABORATORIES CORPORATION Part I
CONSOLIDATED BALANCE SHEETS (Unaudited) Item 1
(In thousands) Page 2
September 30, December 31,
1998 1997
ASSETS
<S> <C> <C>
CURRENT ASSETS
Cash $ 16 $ 18
Accounts receivable, net 1,079 751
Inventories (Note 3) 961 759
Other current assets 3 0
Total Current Assets 2,059 1,528
PROPERTY, PLANT & EQUIPMENT
Land and building 2,854 2,854
Other property, plant & equipment 8,362 7,909
Total Property, Plant & Equipment 11,216 10,763
Less accumulated depreciation & amortization 6,542 6,105
Net Property, Plant & Equipment 4,674 4,658
NON-CURRENT ASSETS 0 1
TOTAL ASSETS $ 6,733 $ 6,187
LIABILITIES AND STOCKHOLDERS' EQUITY <DEFICIENCY>
CURRENT LIABILITIES
Accounts payable $ 784 $ 639
Accrued expenses and other current liabilities 352 462
Current portion of redeemable preferred stock 2,000 1,000
Preferred dividends payable 730 446
Total Current Liabilities 3,866 2,547
LONG-TERM LIABILITIES
Subordinated promissory note 7,000 7,000
Long-term payable - Health-Chem 3,141 2,087
Other long-term debt 10 21
REDEEMABLE PREFERRED STOCK 6,500 7,500
STOCKHOLDERS' EQUITY <DEFICIENCY>
Common stock 40 40
Retained deficit <13,824> <13,008>
Total Stockholders' Equity <Deficiency> <13,784> <12,968>
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
<DEFICIENCY> $ 6,733 $ 6,187
<FN>
See Notes to Consolidated Financial Statements.
<PAGE>
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</TABLE>
<TABLE>
TRANSDERM LABORATORIES CORPORATION Part I
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Item 1
(In thousands, except per share data) Page 3
For the Nine Months
Ended September 30,
<S> 1998 1997
REVENUE: <C> <C>
Net sales $ 4,879 $ 3,365
Cost of goods sold 2,986 2,028
Gross profit 1,893 1,337
OPERATING EXPENSES:
Selling, general and administrative expense 1,006 1,030
Legal expense 262 166
Research and development expense 598 1,753
Net interest expense 610 561
Total operating expenses 2,476 3,510
LOSS FROM OPERATIONS <583> <2,173>
Other income, net 188 71
LOSS FROM OPERATIONS BEFORE TAXES <395> <2,102>
Income tax <benefit> provision (Note 2) <25> 172
NET LOSS <370> <2,274>
PREFERRED DIVIDENDS 446 464
NET LOSS APPLICABLE TO COMMON STOCKHOLDERS $ <816> $<2,738>
Earnings per Common Share (basic & diluted)
(Note 4):
NET LOSS PER COMMON SHARE $ <0.02> $ <0.07>
Average number of common shares outstanding
(basic and diluted) (Note 4) 40,000 40,000
<FN>
See Notes to Consolidated Financial Statements.
<PAGE>
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</TABLE>
<TABLE>
TRANSDERM LABORATORIES CORPORATION Part I
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Item 1
(In thousands, except per share data) Page 4
For the Three Months
<S> Ended September 30,
1998 1997
REVENUE: <C> <C>
Net sales $ 1,430 $ 811
Cost of goods sold 1,305 515
Gross profit 125 296
OPERATING EXPENSES:
Selling, general and administrative expense 270 314
Legal expense 42 52
Research and development expense 226 757
Net interest expense 213 202
Total operating expenses 751 1,325
LOSS FROM OPERATIONS <626> <1,029>
Other income <expense> 94 <24>
LOSS FROM OPERATIONS BEFORE TAXES <532> <1,053>
Income tax benefit 0 3
NET LOSS <532> <1,050>
PREFERRED DIVIDENDS 148 149
NET LOSS APPLICABLE TO COMMON STOCKHOLDERS $ <680> $<1,199>
Earnings per Common Share (basic & diluted)
(Note 4):
NET LOSS PER COMMON SHARE $ <0.02> $ <0.03>
Average number of common shares outstanding
(basic and diluted) (Note 4) 40,000 40,000
<FN>
See Notes to Consolidated Financial Statements.
<PAGE>
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</TABLE>
<TABLE>
TRANSDERM LABORATORIES CORPORATION Part I
CONSOLIDATED CASH FLOW STATEMENTS (Unaudited) Item 1
(In thousands) Page 5
For the Nine Months
Ended September 30,
<S> 1998 1997
Cash was <Used for> Provided by: <C> <C>
OPERATIONS:
Net loss $ <370> $<2,274>
Adjustments to reconcile net loss to net cash
used for operations:
Depreciation and amortization 437 454
Deferred income taxes 0 175
Loss on disposal of property, plant and
equipment, net 0 10
Changes in:
Accounts receivable <328> 443
Inventories <202> 158
Other current assets <3> 3
Other non-current assets 1 <1>
Accounts payable 145 <441>
Accrued expenses and other current liabilities <112> <71>
Income taxes payable 0 <3>
Net cash used for operations <432> <1,547>
INVESTING:
Additions to property, plant and equipment <453> <118>
Disposal of property, plant and equipment 0 121
Net cash <used for> provided by investing <453> 3
FINANCING:
Borrowings from affiliates, net 1,054 2,878
Other long-term debt payments <9> <7>
Redemption of preferred stock 0 <1,000>
Preferred dividends paid <162> <333>
Net cash provided by financing 883 1,538
Net Decrease in Cash <2> <6>
Cash at beginning of period 18 21
Cash at end of period $ 16 $ 15
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Interest $ 767 $ 723
Income taxes 1 1
Supplemental Schedule of Noncash Investing and
Financing:
Acquisition of fixed assets through capital
lease obligations $ 0 $ 45
<FN>
See Notes to Consolidated Financial Statements.
<PAGE>
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 1
(Unaudited) Page 6
1. Basis of Presentation and Nature of Operations
The consolidated financial statements include the accounts of Transderm
Laboratories Corporation and its subsidiary, Hercon Laboratories
Corporation ("Hercon"). Transderm Laboratories Corporation and Hercon
Laboratories Corporation are sometimes hereinafter referred to
collectively as the "Company". The Company is an indirect 90% owned
subsidiary of Health-Chem Corporation ("Health-Chem").
The Consolidated Balance Sheet as of September 30, 1998, the
Consolidated Statements of Operations and the Consolidated Cash Flow
Statements for the interim periods ended September 30, 1998 and 1997
have been prepared by the Company, without audit. In the opinion of the
Company, all necessary adjustments, consisting of normal recurring
items, have been made to present fairly the financial position, results
of operations and cash flows at September 30, 1998 and for all periods
presented. Certain amounts included in the consolidated financial
statements relating to prior periods have been reclassified to conform
to the current presentation.
Certain information and note disclosures normally included in financial
statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted. It is suggested that these
consolidated financial statements be read in conjunction with the
consolidated financial statements and notes thereto included in the
Company's December 31, 1997 Annual Report on Form 10-K. The results of
operations for the periods ended September 30, 1998 and 1997 are not
necessarily indicative of the operating results for the full years.
2. Taxes on Income (In thousands) For the Nine Months
Ended September 30,
1998 1997
Taxes on income include
provision <benefit> for:
Federal income taxes $ 0 $ 160
State and local income taxes <25> 12
Total $ <25> $ 172
Taxes on income are comprised of:
Current $ <25> $ <3>
Deferred 0 175
Total $ <25> $ 172
A reconciliation of taxes on income to the federal statutory rate is as
follows:
For the Nine Months
Ended September 30,
1998 1997
Tax benefit at statutory rate $ <134> $ <715>
<Decrease> increase resulting from:
State and local taxes, net of federal
tax benefit <47> 13
Provision for valuation allowance 156 874
Tax <benefit> provision $ <25> $ 172
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 1
(Unaudited) Page 7
At September 30, 1998, the net valuation allowance relating to tax loss
and tax credit carryforwards was $1,365,000. This net valuation
allowance consists of a $1,464,000 decrease in tax loss and tax credit
carryforwards, partially offset by a $99,000 decrease in a payable to
Health-Chem, which is only payable as certain net operating loss and tax
credit carryforwards are used. Management determined the valuation
allowance was necessary as a result of delays in the anticipated
approvals from the United States Food and Drug Administration ("FDA")
for the sale of the Company's new transdermal nitroglycerin patches and
the lack of a favorable resolution to the Key Pharmaceuticals, Inc.
litigation, with such matters contributing to the operating losses of
the Company in 1997.
3. Inventories (In thousands)
September 30, 1998 December 31, 1997
Raw materials $ 718 $ 526
Finished goods and work in process 243 233
Total inventories $ 961 $ 759
4. Earnings Per Share
On December 31, 1997, the Company adopted Statement of Financial
Accounting Standards No. 128 "Earnings Per Share" ("SFAS 128"). SFAS
128 establishes standards for computing and presenting earnings per
share and applies to entities with publicly-held common stock or
potential common stock. SFAS 128 simplifies the standards for computing
earnings per share previously found in APB Opinion No. 15, "Earnings Per
Share", by replacing the presentation of primary earnings per share with
a presentation of basic earnings per share. It also requires dual
presentation of basic and diluted earnings per share on the face of the
income statement for all entities with complex capital structures.
Restatement of all prior-period earnings per share data is required upon
adoption. The impact of adopting SFAS 128 on the Company's earnings per
share data is not material.
Basic and diluted earnings per share are computed based upon the
weighted average number of common shares outstanding after adjustment
for any dilutive effect of the Company's stock options.
<PAGE>
<PAGE> TRANSDERM LABORATORIES CORPORATION Part I
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 1
(Unaudited) Page 8
A reconciliation of the numerators and denominators of the basic and
diluted earnings per common share computations for loss from continuing
operations for the periods ended September 30, 1998 and 1997 is
presented below (in thousands, except per share amounts):
For the For the
Nine Months Ended Three Months Ended
September 30, September 30,
1998 1997 1998 1997
Net Loss Applicable to
Common Stockholders:
Net loss $ <370> $<2,274> $ <532> $<1,050>
Preferred stock dividends 446 464 148 149
Loss applicable to common
stockholders $ <816> $<2,738> $ <680> $<1,199>
Basic Earnings Per Common
Share:
Weighted average number of
common shares outstanding 40,000 40,000 40,000 40,000
Basic loss per common share $ <0.02> $ <0.07> $ <0.02> $ <0.03>
Diluted Earnings Per Common
Share:
Weighted average number of
common shares outstanding 40,000 40,000 40,000 40,000
Stock options 0 0 0 0
Weighted average number of
common shares outstanding
- diluted 40,000 40,000 40,000 40,000
Diluted loss per common
share $ <0.02> $ <0.07> $ <0.02> $ <0.03>
Options to purchase 11,450,000 and 11,400,000 shares of common stock
were outstanding at September 30, 1998 and 1997, respectively. No
options were included in the computation of diluted earnings per common
share because the Company reported a loss from continuing operations for
all periods presented.
5. Litigation
In August 1995, Key Pharmaceuticals, Inc. a subsidiary of Schering-
Plough Corporation ("Key") commenced an action against Hercon in the
United States District Court for the District of Delaware ("Delaware
District Court") alleging that Hercon's submission to the FDA of three
Abbreviated New Drug Applications ("ANDAs") relating to some of Hercon's
transdermal nitroglycerin products, and for which the Company is
awaiting FDA approval, constituted infringement of Key's patent for its
Nitro-Dur(R) products. Key sought certain injunctive relief, monetary
damages if commercial manufacture, use or sale occurs, and a judgment
that the effective date for FDA approval of the above-referenced ANDAs
be not earlier than February 16, 2010, the expiration date of Key's
patent. Hercon denied the material allegations of the complaint,
asserting, among other things, that the Key patent is invalid and
unenforceable and that Hercon had not infringed and did not infringe any
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 1
(Unaudited) Page 9
claim of the patent. Hercon counterclaimed against Key for declaratory
judgment of patent noninfringement, invalidity and unenforceability. On
September 30, 1997, the Delaware District Court ruled in favor of Key
both on its infringement claim and on Hercon's claim that Key's patent
is invalid and unenforceable. On December 17, 1997, the Delaware
District Court issued an injunction, enjoining Hercon, except as
provided for by statute, from making, using, offering for sale, selling
or importing any transdermal nitroglycerin patches that have been found
to infringe claim 14 of Key's patent, before the expiration of Key's
patent on February 16, 2010. Hercon has appealed to the United States
Court of Appeals for the Federal Circuit in Washington, D.C. from both
the September 30, 1997 judgment and the December 17, 1997 injunction.
Oral argument on the consolidated appeals was heard by the appellate
court on August 5, 1998. Hercon is awaiting decision by the court.
Management continues to believe that Hercon has strong grounds for
prevailing on appeal.
<PAGE>
<PAGE> TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 10
In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, the Company provides the following cautionary
remarks regarding important factors which, among others, could cause future
results to differ materially from the forward-looking statements, expectations
and assumptions expressed or implied herein. The following discussion
includes certain forward-looking statements. Such forward-looking statements
are subject to a number of factors, including material risks and
uncertainties, including those referred to herein and in the Company's Reports
on Form 10-K, which could cause actual results to differ materially from the
forward-looking statements.
Results of Operations
Net sales increased $1,514,000 for the nine months ended September 30, 1998 as
compared to the same period in 1997. The increase in net sales consists of a
$1,271,000 increase in volume and $243,000 in higher selling prices. The net
sales increase is due to increases in sales of transdermal nitroglycerin
patches of $354,000 and initial sales of over-the-counter pharmaceutical and
cosmetic products of $1,160,000. The transdermal nitroglycerin patch sales
increase is due primarily to higher foreign sales volumes. During the first
half of 1997, in anticipation of increased market pressures and delays in
approvals from the FDA for the sale of new nitroglycerin patches, Hercon
undertook an organizational restructuring which reduced annual payroll-related
expenses by $1,100,000. On October 30, 1998, the Company received FDA market
approval for its improved nitroglycerin patches. The Company's newly-approved
patches have been rated by the FDA as an accepted generic alternative to
Novartis Pharmaceutical Corporation's Transderm Nitro(R) products. The
Company's ability to commercially exploit its newly-improved nitroglycerin
products is currently being adversely affected by the absence of a favorable
resolution to its litigation with Key (the "Key Litigation") (See Note 5 above
and discussion below). Current orders for over-the-counter pharmaceutical and
cosmetic products are expected to contribute in excess of $1,500,000 in net
sales during the fourth quarter of 1998, with additional orders anticipated
for delivery in 1999.
Net sales increased $619,000 for the quarter ended September 30, 1998 as
compared to the same period in 1997. The increase in net sales consists of a
$423,000 increase in volume and $196,000 in higher selling prices. The net
sales increase is due to initial sales of over-the-counter pharmaceutical and
cosmetic products of $1,160,000, partially offset by decreases in sales of
transdermal nitroglycerin patches of $541,000. The transdermal nitroglycerin
patch sales decrease is due to lower domestic sales volumes.
Gross profit increased $556,000, or 42%, for the nine months ended September
30, 1998 as compared to the same period in 1997. Gross profit as a percentage
of net sales decreased from 40% for 1997 to 39% for 1998. Gross profit
increased primarily due to initial sales of over-the-counter pharmaceutical
and cosmetic products. Lower margins reflect an increase in lower margin
business.
Gross profit decreased $171,000, or 58%, for the quarter ended September 30,
1998 as compared to the same period in 1997. Gross profit as a percentage of
net sales decreased from 36% for 1997 to 9% for 1998. These decreases are
attributable to an increase in lower margin business.
Selling, general and administrative expenses, excluding legal expenses,
decreased $24,000 for the nine months ended September 30, 1998 as compared to
the same period in 1997. This decrease is due primarily to lower general and
administrative expenses of $97,000, partially offset by a higher allocation of
expenses from affiliates of $81,000. Pursuant to a Corporate Services
Agreement between the Company and Health-Chem, selling, general and
administrative expenses incurred by Health-Chem which cannot be directly
attributed to a specific subsidiary are allocated to the Company based upon
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 11
its net sales as a percentage of Health-Chem's consolidated net sales. The
Company's allocation of Health-Chem's total expenses for the nine months ended
September 30, 1998 was higher than the comparable period in 1997 due to the
Company's share of these expenses increasing from 12% in 1997 to 17% in 1998,
partially offset by Health-Chem's total expenses being lower. The decrease in
general and administrative expenses is due primarily to lower payroll-related
costs which reflect, in part, the organizational restructuring. For the
quarter ended September 30, 1998, selling, general and administrative
expenses, excluding legal expenses, decreased $44,000 due primarily to lower
payroll-related costs.
Legal expenses increased $96,000 for the nine months ended September 30, 1998
as compared to the same period in 1997. The increased legal expenses are due
primarily to additional activity associated with the Key Litigation. For the
quarter ended September 30, 1998, legal expenses decreased $10,000. This
decrease is due to lower general legal matter expenses of $25,000, partially
offset by higher Key Litigation expenses of $15,000.
Research and development expenses for the nine months and quarter ended
September 30, 1998 decreased $1,155,000 and $531,000, respectively, as
compared to the same periods in 1997. These decreases are due primarily to
lower payroll-related, outside testing and clinical materials expenses.
Payroll-related expenses decreased $413,000 and $26,000, respectively,
reflecting the organizational restructuring changes. The Company expects
total research and development expenses in 1998 to be lower than 1997 levels.
Net interest expense for the nine months and quarter ended September 30, 1998
increased $49,000 and $11,000, respectively, as compared to the same periods
in 1997. These increases are due primarily to higher average outstanding
balances on borrowings from affiliates.
The $188,000 other income for the nine months ended September 30, 1998
pertains to $94,000 of development work income in each of the second and third
quarters of 1998. The $71,000 other income, net for the nine months ended
September 30, 1997 consists primarily of nonrecurring proceeds of $75,000
received in the second quarter of 1997 related to a distribution agreement and
first quarter 1997 nonrecurring insurance recovery proceeds of $14,000,
partially offset by a loss of $24,000 on the disposal of equipment in the
third quarter of 1997. For the quarter ended September 30, 1998, other income
increased $118,000 due to the reasons described above.
Loss from operations before taxes decreased $1,707,000 and $521,000 for the
nine months and quarter ended September 30, 1998, respectively, as compared to
the same periods in 1997 due primarily to the factors discussed above. The
Company reported a $25,000 tax benefit on a $395,000 loss from operations for
the nine months ended September 30, 1998 as compared to a $172,000 tax
provision on a $2,102,000 loss from operations for the same period in 1997.
Income tax provision or benefit varies with the amount and nature of the
components of income or loss from operations before income taxes. At
September 30, 1998, the Company recorded a $156,000 net valuation allowance
due to losses incurred during the nine months ended September 30, 1998.
Preferred dividends of $446,000 and $148,000 for the nine months and quarter
ended September 30, 1998, respectively, reflect dividends accumulated on the
Company's Redeemable Preferred Stock, $10.00 par value. Annual dividend
payments required are $.70 per share.
The results of operations for the periods ended September 30, 1998 and 1997
are not necessarily indicative of the operating results for the full years.
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 12
Liquidity and Capital Resources
The following measures of liquidity are drawn from the Company's consolidated
financial statements:
September 30, December 31,
1998 1997
Working capital deficit (in thousands)
(Current assets less current liabilities) $<1,807> $<1,019>
Current ratio
(Current assets/current liabilities) 0.5 0.6
Quick ratio
(Cash and receivables/current liabilities) 0.3 0.3
Working capital deficit increased $788,000 from December 31, 1997 to September
30, 1998 due to a $1,319,000 increase in current liabilities, partially offset
by a $531,000 increase in current assets. Cash decreased $2,000 while
accounts receivable, inventories and other current assets increased $328,000,
$202,000 and $3,000, respectively. The increase in accounts receivable
resulted from an increase in sales in the month of September 1998 as compared
to the month of December 1997. The increase in inventory reflects an increase
in raw material purchases related to the production of over-the-counter
pharmaceutical and cosmetic products. The increase in current liabilities is
due to increases in accounts payable, the current portion of the redeemable
preferred stock and preferred dividends payable of $145,000, $1,000,000 and
$284,000, respectively, partially offset by a decrease in accrued expenses of
$110,000.
Cash used for operations for the nine months ended September 30, 1998 was
$432,000.
The Company has not paid cash dividends on its Common Stock and does not
anticipate doing so in the foreseeable future.
The Company has financed its capital requirements primarily from cash flow
generated from operations and borrowings from its affiliates.
Capital expenditures in 1998 for property, plant and equipment are projected
to be approximately $700,000. The majority of these capital expenditures will
consist of equipment needed to assemble and package the Company's second
generation nitroglycerin products and over-the-counter pharmaceutical and
cosmetic products.
Health-Chem is a borrower along with its affiliates, including the Company,
under the terms of a secured financing agreement with IBJ Schroder Business
Credit Corporation (as successor in interest to IBJ Schroder Bank & Trust
Company) (the "Bank"). The Revolving Credit, Term Loan and Security Agreement
(the "Loan Agreement") which was entered into effective January 9, 1997, was
comprised of up to $7,000,000 in term loans and up to $8,000,000 in revolving
credit. The line of credit's borrowing base is limited to the sum of 85% of
eligible accounts receivable and 50% of eligible inventory on a consolidated
Health-Chem basis. Borrowings under the Loan Agreement are collateralized by
a pledge of substantially all of the assets of Health-Chem, the Company and
Health-Chem's other operating subsidiaries. The Loan Agreement, which expires
on January 9, 2002, contained various financial covenants. On January 21,
1998, Health-Chem entered into a First Amendment (the "Amendment") to the Loan
<PAGE> TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 13
Agreement with the Bank. The Amendment, among other things, amended the terms
for drawing upon the term loan and amended certain financial covenants. At
September 30, 1998, Health-Chem and its affiliates were in compliance with the
covenants, as amended, except for the net worth, current ratio, fixed charge
coverage and minimum level of earnings before taxes, depreciation and
amortization covenants. This resulted in Health-Chem reclassifying amounts
outstanding under the line of credit and term loan to current liabilities.
The Company is currently in negotiations with the Bank to amend the facility.
An unfavorable resolution with the Bank would have a material adverse effect
on the financial condition and operations of the Company. Pursuant to the
Amendment, the maximum term loans amount was reduced from $7,000,000 to
$3,998,000, providing a revised aggregate of up to $11,998,000 in senior
secured financing. The revolving credit line interest rate was increased to
the Bank's prime rate plus .50% and the term loans interest rate was increased
to the Bank's prime rate plus .875%. These rates are subject to a .25%
decrease upon the Bank's satisfactory review of Health-Chem's financial
statements for the year ended December 31, 1998.
The Company is required to make semi-annual interest payments each March and
September on its $7,000,000, 9% Subordinated Promissory Note. The Company
made the required 1998 semi-annual interest payments in March and September.
On May 12, 1998, Hercon and Health-Chem entered into an amendment to the
Subordinated Promissory Note, whereby the maturity date of the note and
corresponding $7,000,000 principal payment were extended from March 31, 1999
to March 31, 2002.
The Company is required to make semi-annual preferred dividend payments out of
funds legally available therefor each March and September at the annual rate
of $.70 per share on the then-outstanding shares of its redeemable preferred
stock, $10.00 par value. As of June 30, 1998, $162,000 was available for the
payment of preferred dividends. In August 1998 the Company declared and paid
a dividend of $162,000 in respect of dividends in arrears that were due on
September 30, 1997. Legally available funds were not available to make the
March 1998 and September 1998 preferred dividend payments, nor were they
available to make the required $1,000,000 redemption payment in March 1998.
Additional required redemption payments are $1,000,000 annually in 1999
through 2004 and $1,500,000 in 2005. The terms of the preferred stock provide
that if either dividends payable on the preferred stock shall be in default in
an amount equal to two full semi-annual dividend payments or a mandatory
redemption payment is not made, the holder of all of the outstanding shares of
the preferred stock shall be entitled to elect the smallest number of
Directors necessary to constitute a majority of the Company's Board of
Directors until such time as the default is cured. Health-Chem waived this
right since, as a practical matter, it already possessed such power.
Pursuant to a Corporate Services Agreement between the Company and Health-
Chem, Health-Chem provides or otherwise makes available to the Company certain
general corporate services provided by Health-Chem's corporate staff,
including, but not limited to, accounting, tax, corporate communications,
legal, data processing, purchasing, human resources, financial and other
administrative staff functions, and arranges for administration of insurance
and employee benefit programs. The Company reimburses Health-Chem for the
actual out-of-pocket cost to Health-Chem or for those services not directly
attributable to the Company, reimburses them based upon a method (allocation
based upon the Company's net sales as a percentage of Health-Chem's
consolidated net sales) which is considered by the Company to be reasonable.
The Company reimbursed Health-Chem approximately $429,000 and $348,000 for the
nine months ended September 30, 1998 and 1997, respectively. The Agreement
had an initial term that expired on December 31, 1997 and automatically
renewed for a one-year term. The agreement will continue to automatically
renew for successive one-year terms unless notice of non-renewal is given by
either party.
<PAGE>
TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 14
Pursuant to a tax sharing agreement between the Company and Health-Chem, the
Company is required to pay Health-Chem as the Company uses its net operating
loss and tax credit carryforwards to offset future taxable income. At
September 30, 1998, the maximum amount of such payments which may be made in
the future was $99,000.
The semi-annual interest payment on the subordinated promissory note is
$315,000 and the semi-annual dividend on the preferred stock currently
outstanding is $297,500. In addition to the cumulative dividends and interest
payments, the Company is obligated to redeem the preferred stock and repay the
promissory note as described above. Internally generated funds are not
currently sufficient to provide the Company with cash to meet all of these
retirement and redemption obligations and thus the Company will need to either
continue to obtain waivers and amendments of some of these payment obligations
or raise additional capital from third parties.
Update on the Impact of the Year 2000 Issue
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a
system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices, or engage in similar normal business activities.
Pursuant to a Corporate Services Agreement between the Company and Health-
Chem, Health-Chem provides or otherwise makes available to the Company certain
general corporate services provided by Health-Chem's corporate staff,
including data processing functions. Health-Chem has assessed the Year 2000
issue and has determined that it will be required to modify or replace
significant portions of its software so that its computer systems will
properly utilize dates beyond December 31, 1999. The conversion process is
considered to have five phases: (1) installation of upgrade to computer
operating system; (2) installation of test environment; (3) testing and
modifying manufacturing and financial package programs; (4) upgrading
manufacturing and financial package programs to live system; and (5) upgrading
customized reports and programs. Health-Chem's total cost of converting the
software to be Year 2000 compatible is estimated at $100,000. Health-Chem's
cost incurred to date is approximately $18,000. Pursuant to the Corporate
Services Agreement, the Company reimburses Health-Chem for data processing
services based upon an allocation method of the Company's net sales as a
percentage of Health-Chem's consolidated net sales. The Company's share of
these expenses for the nine months ended September 30, 1998 and 1997 were 17%
and 12%, respectively. The Company's portion of Health-Chem's Year 2000
project costs will be expensed as incurred through 1999 and is not expected to
have a material effect on the results of operations of the Company.
Through September 30, 1998, Health-Chem has completed phases one and two of
the Year 2000 project. In January, the upgrade for the computer operating
system was installed. In August, consultants from the software manufacturer
installed the test environment. Management information system personnel have
commenced phase three by prioritizing programs that have a material effect on
daily production, inventory control and invoicing. Health-Chem has targeted
completion of the Year 2000 project for June 1999. Health-Chem presently
believes that with modifications to existing software and conversions to new
software, the Year 2000 issue can be resolved. If such modifications and
conversions are not made, or are not completed on a timely basis, the Year
2000 issue could have a material adverse effect on the operations of the
<PAGE> TRANSDERM LABORATORIES CORPORATION Part I
MANAGEMENT'S DISCUSSION AND ANALYSIS OF Item 2
FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page 15
Company. Although Health-Chem is uncertain about the duration of a worst case
scenario, the Company's most reasonable likely worst case scenario would be to
lose temporarily the ability to process transactions, send invoices, or engage
in similar normal business activities. Health-Chem is developing a
contingency plan which will include, but is not limited to, maintaining
records on a manual system until a portion or all of the computer system
recovers. Health-Chem believes a worst case scenario is unlikely but if it
did occur it could have a material adverse effect on the operations of the
Company.
The Company is assessing the effect of the Year 2000 issue on its non-
information technology systems, however the Company believes that it will not
have a material impact on the operations of the Company. The Company is
addressing Year 2000 issues relating to third parties with which it has a
material relationship by sending questionnaires to vendors, suppliers and
customers who would have a material impact on the Company's operations if
their operations were disrupted. The Company's operations could be adversely
affected if such vendors, suppliers and customers do not prepare for the
impact of the Year 2000. Companies responding to the Company's questionnaire
have indicated an awareness of and preliminary preparation for dealing with
the impact of the Year 2000 on their operations.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
(a) Reference is made to Note 5 of the Notes to Consolidated Financial
Statements for information concerning the litigation between Key
Pharmaceuticals, Inc. and Hercon Laboratories Corporation.
(b) In October 1995, Gershon Yormack, a stockholder of the Company's parent,
Health-Chem Corporation ("Health-Chem") initiated an action against Health-
Chem, its directors and the Company in the Delaware Chancery Court (New Castle
County) in which he sought injunctive and declaratory relief with respect to
certain options to purchase Common Stock of the Company granted to each of
Marvin M. Speiser, Health-Chem's Chairman of the Board and President, and
Robert D. Speiser, the Company's President and Health-Chem's Executive Vice
President. Pursuant to Employment Agreements entered into in April 1995, in
November 1995 Health-Chem caused the Company to issue an option to purchase
shares of the Company's Common Stock at an exercise price of $.10 per share to
each of Marvin M. Speiser and Robert D. Speiser (the "Options"). The
plaintiff alleged that this price for Common Stock of the Company offered by
Health-Chem to its stockholders under a registered subscription rights
offering (via a prospectus dated September 18, 1995) was substantially less
than the fair market value of such Company Common Stock.
In October 1998, plaintiff and defendants reached a settlement, subject to
court approval, of this derivative action. The major terms of the settlement
are that: (i) the exercise price of the Options shall be increased to an
average of $0.15 per share; (ii) the Company and Robert D. and Marvin M.
Speiser will agree that no additional options to purcahse the Company's stock
will be issued to the Speisers during the term of the Options; (iii) the
Speisers will not exercise the Options before April 4, 2000, unless there is
a transaction in which the Company is acquired, in which case the number of
Options exercisable will be limited to 20% of the total Options for each year
that has passed subsequent to their authorization; (iv) the action will be
dismissed, with prejudice, thereby releasing defendants from liability for all
claims which were or could have been asserted in the action; and (v)
plaintiff's counsel will apply to the Court for attorneys' fees and expenses
in the amount of $70,000, to be paid by Health-Chem.
A hearing is scheduled to be held before the Court of Chancery on November 18,
1998 to determine whether the Court should approve the proposed settlement.
<PAGE>
Part II
Item 6
Page 16
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None.
(b) During the quarter ended September 30, 1998, the Company did not file
any reports on Form 8-K.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
TRANSDERM LABORATORIES CORPORATION
November 9, 1998 /s/ Robert D. Speiser
By: Robert D. Speiser
President
(Principal Executive Officer)
/s/ Ronald J. Burghauser
By: Ronald J. Burghauser
Vice President-Finance
(Principal Financial Officer)
(Principal Accounting Officer)
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