Our water quality product group includes tests to detect toxicity in drinking water, industrial process water and wastewater, and tests to detect specific traits in soil and other waste matter for use at environmental remediation projects, hazardous waste operations and other applications.
Our antibody product group provides a wide array of antibodies and antibody services, including hybridoma development, calibrators, antigens and reagents and the production of monoclonal and polyclonal antibodies. Such antibodies are incorporated into test kits we manufacture as described above and diagnostic and therapeutic products, and used in clinical research.
We sell products and services in the food safety, water quality and antibody market categories through our U.S. direct sales force, a network of over 50 distributors in Canada, Mexico, Latin America, Europe and Asia and our corporate partners. These products and services are sold to a wide range of customers including water utilities, food processors, pharmaceutical, biotechnology and diagnostic companies and major biomedical research centers.
For the third quarter of 2005, gross profit (defined as total revenues less manufacturing costs) increased 11.1% to $3.33 million, compared to $3.00 million in the third quarter of 2004, and gross margins increased from 53.7% in the third quarter of 2004 to 54.7% in the third quarter of 2005. The increase is a result of the benefits the Company is beginning to see from its supply chain improvement initiatives and continuing efforts to minimize low margin business.
Operating expenses for the third quarter of 2005 increased 10.9% to $5.77 million, compared to $5.21 million for the third quarter of 2004. Part of the increase was due to research expenses of $151,000 related to the Company’s investment in the commercialization of new technologies and high throughput production of antibodies and the investment in a software upgrade for the Microtox® test system totaling $79,000.
Research and development spending was $664,000, or 10.9% of net revenues, in the third quarter of 2005, compared to $508,000, or 9.1% of net revenues, in the third quarter of 2004. This level of investment reflects the Company’s continued commitment to customer-centric product development.
Selling, general and administrative expenses were $2.35 million in the 2005 quarter, compared to $2.11 million for the same quarter in 2004. In the third quarter of 2005, the Company recorded $86,000 of costs primarily related to the previously announced closing of its equipment manufacturing facility in July 2005.
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We recorded interest income, net of interest expense, of $59,000 in the third quarter of 2005 compared to interest income of $17,000 in the prior year third quarter primarily due to higher levels of invested cash during the 2005 period.
Pre-tax income totaled $379,000 for the third quarter of 2005, compared to pre-tax income of $395,000 for the same period in 2004.
Our effective tax rate of 16% for the third quarter of 2005 is below the federal and state statutory rates primarily due to research and development credits and the utilization of foreign net operating losses not previously benefited.
Net income in the third quarter of 2005 was $319,000, compared to $297,000 for the same period in 2004, or $0.02 per diluted share for each quarter.
Nine Months Ended September 30, 2005 vs. September 30, 2004
Revenues for the nine months ended September 30, 2005 increased 9.2% to $18.95 million, compared to $17.35 million for the same period in 2004. Included in revenues in the nine month period ended September 30, 2004 was $249,000 of sales associated with certain “catalog” antibody inventories that were written off in the fourth quarter of 2003 with substantially no associated cost of goods sold. StarLink™ sales, as described above, decreased to $715,000 for the nine month period ended September 30, 2005, compared to $874,000 for the same period in 2004. Sales of the Company’s test kits used in agriculture applications continue to be impacted by the competitive pressures of a market where new product introduction has slowed, and existing applications have seen a decrease in testing demand.
Gross profit for the nine months ended September 30, 2005 totaled $10.47 million, as compared to $9.46 million in the first nine months of 2005, an increase of $1.01 million. Gross margins increased to 55.3% in 2005 from 54.5% in 2004.
For the nine months ended September 30, 2005, operating expenses increased 10.1% to $17.91 million, compared to $16.27 million in the same period in 2004, partially due to research expenses of $448,000 related to the Company’s investment in the commercialization of new technologies and high throughput production of antibodies and the investment in a software upgrade for the Microtox® test system totaling $358,000.
For the nine months ended September 30, 2005, research and development spending was $2.32 million, or 12.3%, of net revenues, compared to $1.60 million, or 9.2%, for the same period in 2004.
Selling, general and administrative expenses were $7.11 million for the nine months ended September 30, 2005, compared to $6.79 million for the same period in 2004.
We recorded interest income, net of interest expense, of $130,000 for the nine months ended September 30, 2005 compared to $31,000 for the nine months ended September 30, 2004, due to higher levels of invested cash during the 2005 period.
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Pre-tax income totaled $1.17 million for the nine months ended September 30, 2005, compared to $1.10 million for the same period in 2004.
Our effective tax rate of 25% for the nine months ended September 30, 2005 is below the federal and state statutory rates primarily due to research and development credits and the utilization of foreign net operating losses not previously benefited.
Net income in the nine months ended September 30, 2005 was $876,000, or $0.04 per diluted share, compared to $796,000 for the same period in 2004, or $0.04 per diluted share.Diluted shares totaling 19,793,000 and 19,605,000 were used in the computation for the first nine months of 2005 and 2004, respectively.
Product Groups
Food Safety Products- Food safety revenues were $2.32 million in the third quarter of 2005, compared to $1.74 million in the third quarter of 2004, an increase of 33.2%. For the nine months ended September 30, 2005, food safety revenues were $6.68 million, compared to $5.39 million for the same period in 2004, an increase of 23.9%. These increases were driven by food pathogen test sales in the third quarter of 2005 and the nine months ended September 30, 2005, which were up 111.8% and 119.7%, respectively, compared to the same periods of 2004.
Water and Environmental Products– Revenue decreased 15.3% to $1.09 million for the third quarter of 2005, compared to $1.29 million for the same quarter in 2004, and decreased 9.0% to $3.95 million for the nine month period ended September 30, 2005, compared to $4.34 million for the same period in 2004. The previously announced US Biosystems (now Genapure) initiative was commercially launched to the Florida market in July 2005 and the Company is aggressively working with our partner to gain traction in other markets. Although the Company’s efforts to develop new channels to market, add new products and add sales professionals began to have a positive impact on revenues in the 2nd quarter of 2005, they were not yet enough to offset this product group’s historically high customer attrition rate.
Antibody Products- Antibody revenues increased 5.1% to $2.68 million for the third quarter of 2005 compared to $2.55 million for the same quarter in 2004, and increased 9.2% to $8.32 million in the nine months ended September 30, 2005, compared to $7.62 million for the same period in the prior year. The increase in the first nine months of 2005 over the same period in 2004 is reflective of the improvement in the business from the steep decline in revenues in 2004 associated with the completion of several large, one-time customer projects in 2003, and the discontinuation of low margin business early in 2004.
Liquidity and Capital Resources
The net cash provided by operating activities of $960,000 for the nine months ended September 30, 2005 was primarily the result of the earnings before interest, taxes, depreciation and amortization (EBITDA) reduced by decreases in accounts payable and accrued expenses.
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Net cash used in investing activities of $322,000 for the nine months ended September 30, 2005 was driven by capital expenditures primarily for laboratory and manufacturing equipment, partially related to the Company’s investment in the commercialization of new technologies and high throughput production of antibodies, and facility improvements. This compares to net cash used in investing activities of $182,000 for the same period in 2004, which was driven by capital expenditures for the period primarily related to purchases of office and manufacturing equipment.
Net cash provided by financing activities of $1.19 million for the nine months ended September 30, 2005 was driven by proceeds from the exercise of stock options, which was partially offset by net repayments of outstanding debt. The $36,000 provided by financing activities for the same period in 2004 was primarily the result of acquiring a $551,000 loan to finance our 2004 business insurance program, net of debt repayments.
Our working capital, current assets less current liabilities, increased $2.60 million to $16.13 million at September 30, 2005 from $13.53 million at December 31, 2004, primarily due to the Company’s positive cash flow from operations and proceeds from the exercise of stock options for the 2005 period. Outstanding debt decreased $158,000 from $984,000 at December 31, 2004 to $826,000 on September 30, 2005, due to scheduled repayments.
On May 5, 2000, we entered into a financing agreement with a commercial bank. This agreement provided for a $4.00 million term loan, all of which had been paid on or before December 31, 2002, and for up to a $5.00 million revolving line of credit, none of which was outstanding and approximately $2.52 million of which was available at September 30, 2005, based on eligible assets.
The revolving line of credit bears a variable interest rate of between 1.75% and 2.75% over LIBOR depending upon the ratio of our funded debt to EBITDA, and is subject to a borrowing base determined by our eligible accounts receivable. Our annual effective rate of interest on this line of credit, taking into account the variable interest rate and LIBOR, was approximately 5.42% at September 30, 2005.
On December 13, 2001, we entered into an agreement with a commercial bank to finance the construction of new facilities at our Windham, Maine location. This agreement provided for up to $1.5 million in financing, $826,000 of which was outstanding at September 30, 2005, and is repayable over seven years, with principal payments that began on October 1, 2002. The loan bears a variable interest rate of between 2% and 3% over LIBOR depending upon the ratio of our funded debt to EBITDA. Payments are due monthly, with equal amortization of principal payments plus interest. Our annual effective rate of interest on this loan at September 30, 2005 was approximately 5.67%.
Under the terms of the above financing, as amended, we are required to meet certain quarterly financial covenants that include a ratio of EBITDA to current maturities of debt plus interest and cash paid for taxes greater than 1.50 and a ratio of funded debt to EBITDA not to exceed 3.25. We met all of our financial covenants with respect to this indebtedness at September 30, 2005 and expect that we will be able to meet all of our financial covenants with respect to this indebtedness for the remainder of 2005. As a result of the delay in filing Form 10-Q as of and for the quarter ended September 30, 2005, the Company was not in compliance with its timely filing covenant. On February 15, 2006, the Comapny obtained a waiver from the bank for the covenant as of September 30, 2005.
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For the nine months ended September 30, 2005, we satisfied all of our cash requirements from cash provided by operating activities and cash available and on-hand. At September 30, 2005, we had $615,000 in long-term debt and stockholders’ equity of $33.92 million. We have no material commitments for capital expenditures at September 30, 2005.
Based upon our cash on hand, credit facilities, current product sales and the anticipated sales of new products, we believe we have, or have access to, sufficient resources to meet our operating requirements at least through October 2006. Our ability to meet our long-term capital needs will depend on a number of factors, including compliance with existing and new loan covenants, the success of our current and future products, the focus and direction of our research and development programs, competitive and technological advances, future relationships with corporate partners, government regulation, our marketing and distribution strategy, our successful sale of additional common stock and/or our successfully locating and obtaining other financing, and the success of our plan to make future acquisitions. Accordingly, no assurance can be given that we will be able to meet the future liquidity requirements that may arise from these inherent and similar uncertainties.
Non-GAAP Financial Measures
EBITDA measures are presented as we believe this provides investors and our management with additional information to assess our liquidity. EBITDA measures are not a measure of performance under GAAP, and therefore should not be considered in isolation or as a substitute for net income or cash flows from operations. Additionally, our EBITDA calculations may differ from the EBITDA calculations of other companies.
The calculation of our EBITDA measure (as discussed above), and the reconciliation of our EBITDA measure to net cash provided by operating activities for the nine months ended September 30, 2005 and 2004, respectively, is as follows:
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| | | | Nine Months Ended September 30, | |
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| | | | 2005 | | | 2004 | |
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| Net cash provided by operating activities | | $ | 960 | | $ | 2,423 | |
| Changes in assets and liabilities: | | | | | | | |
| Receivables | | | 291 | | | (137 | ) |
| Inventories | | | 70 | | | (122 | ) |
| Other current assets | | | 273 | | | (39 | ) |
| Other assets | | | 3 | | | — | |
| Accounts payable | | | 475 | | | 77 | |
| Accrued expenses | | | (100 | ) | | (388 | ) |
| Stock compensation expense | | | (146 | ) | | (58 | ) |
| Interest income, net | | | (130 | ) | | (31 | ) |
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| EBITDA | | $ | 1,696 | | $ | 1,725 | |
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
We have exposure to changing interest rates, and are currently not engaged in hedging activities. Interest on approximately $826,000 of outstanding indebtedness is at a variable rate of between 2% to 3% over the published London Interbank Offered Rate (LIBOR), based upon our ratio of funded debt to EBITDA, and was 3% over LIBOR on average for the year. At our current level of indebtedness, each 1% change in the variable interest rate will have an effect of $8,300 on our annual interest expense charges.
We conduct operations in the United Kingdom. The consolidated financial statements are presented in U.S. dollars and changes in exchange rates between foreign countries and the U.S. dollar will affect the translation of financial results of foreign subsidiaries into U.S. dollars for purposes of recording our consolidated financial results. Historically, the effects of translation have not been material to the consolidated financial results.
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Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
Following a series of discussions with the U.S. Securities and Exchange Commission, the Company determined on December 15, 2005 that it would change its method of accounting for revenue on certain custom antibody arrangements. The Company changed its revenue recognition policy for custom antibody projects to utilize a methodology whereby revenue is recognized when a project’s specifications have been met and the related antibodies have been shipped, rather than on the percentage-of-completion methodology the Company had used since 1996.
As a result of the ongoing consideration of the appropriate accounting methodology leading up to the December 15, 2005 determination, the Company did not file this Form 10-Q for the third quarter of 2005 by the required filing date.
The Company has amended its annual report on Form 10-K for the year ended December 31, 2004 to restate its consolidated financial statements for the years ended December 31, 2002, 2003 and 2004 and the related disclosures, and has amended its interim reports on Form 10-Q for the three month periods ended March 31, 2005 and 2004, and the three and six month periods ended June 30, 2005 and 2004, and the related disclosures. The consolidated interim financial statements for the three and nine month periods ended September 30, 2004 have also been restated.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Act of 1934, as amended, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report were not functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management, including our principal executive and financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
(b) Change in Internal Control over Financial Reporting
No change in the Company’s internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.
Subsequent to September 30, 2005, management has instituted additional annual review procedures for revenue recognition and software capitalization accounting policies to ensure that we continually evaluate such policies and their compliance with generally accepted accounting principles.
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PART II – OTHER INFORMATION
Item 6.Exhibits
| 10.1 | | | Strategic Diagnostics Inc. Change of Control Severance Agreement (Management Contract or Compensatory Plan) | |
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| 31.1 | | | Certifications of the Chief Executive Officer of Strategic Diagnostics Inc. required by Rule 13a-14(a) under the Securities Exchange Act of 1934 | |
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| 31.2 | | | Certifications of the Chief Financial Officer of Strategic Diagnostics Inc. required by Rule 13a-14(a) under the Securities Exchange Act of 1934 | |
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| 32.1 | | | Certification of the Chief Executive Officer of Strategic Diagnostics Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002 | |
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| 32.2 | | | Certification of the Chief Financial Officer of Strategic Diagnostics Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002 | |
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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.
| | STRATEGIC DIAGNOSTICS INC. |
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| Date: March 16, 2006 | /s/ Matthew H. Knight |
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| | Matthew H. Knight |
| | President, Chief Executive Officer
(Principal Executive Officer) |
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| Date: March 16, 2006 | /s/ Anthony J. Simonetta |
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| | Anthony J. Simonetta |
| | Vice President – Finance and Chief Financial Officer
(Principal Financial and Accounting Officer) |
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