U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-QSB
| x | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934: For the Quarterly Period Ended September 30, 2003 |
| ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT |
For the transition period from to .
Commission File Number 1-13012
H.E.R.C. PRODUCTS INCORPORATED
(Name of small business issuer as specified in its charter)
| State of Incorporation: Delaware | IRS Employer Identification Number: 86-0570800 |
1420 Columbus Avenue
Portsmouth, Virginia 23704
(Address of principal executive offices)
(757) 393-0002
(Issuer’s telephone number)
Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). YES ¨ NO x
State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.
| Class | Outstanding at October 1, 2003 | |
| Common Stock, $.01 par value | 12,365,586 |
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Index To Consolidated Financial Statements
| PART I. FINANCIAL INFORMATION | Page | |
Item 1. Financial Statements | ||
Consolidated Financial Statements: | ||
Consolidated Balance Sheets September 30, 2003 and December 31, 2002 | 3 | |
Consolidated Statements of Operations Three Months and Nine Months Ended September 30, 2003 and 2002 | 4 | |
Consolidated Statements of Cash Flows Nine Months Ended September 30, 2003 and 2002 | 5 | |
| 6 | ||
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations | 11 | |
Item 3.Controls and Procedures | 17 | |
PART II. OTHER INFORMATION | ||
Item 2 -Changes in Securities | 17 | |
Item 6 -Exhibits and Reports on Form 8-K | 17 | |
| 17 | ||
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PART 1: FINANCIAL INFORMATION
Item 1: Financial Statements
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Balance Sheets
September 30, 2003 | December 31, 2002 | |||||||
| (Unaudited) | ||||||||
Assets | ||||||||
Current Assets | ||||||||
Cash and cash equivalents | $ | 18,476 | $ | 254,859 | ||||
Trade accounts receivable, net of allowance for doubtful accounts of $88,540 and $100,996, respectively | 268,782 | 341,503 | ||||||
Inventories | 73,472 | 46,304 | ||||||
Costs of uncompleted contracts | 92,930 | 110,243 | ||||||
Other receivables | 491,288 | 170,203 | ||||||
Prepaid expenses | 181,864 | 47,191 | ||||||
Total Current Assets | 1,126,812 | 970,303 | ||||||
Equipment and Furniture | ||||||||
Equipment and furniture | 1,551,158 | 1,505,129 | ||||||
Less: accumulated depreciation | (1,265,695 | ) | (1,119,917 | ) | ||||
Net Property and Equipment | 285,463 | 385,212 | ||||||
Other Assets | ||||||||
Patents, net of accumulated amortization of $135,442 and $121,963, respectively | 88,693 | 102,172 | ||||||
Patents pending | 136,506 | 126,871 | ||||||
Refundable deposits | 4,766 | 9,892 | ||||||
Total Other Assets | 229,965 | 238,935 | ||||||
| $ | 1,642,240 | $ | 1,594,450 | |||||
Liabilities and Stockholders’ Equity | ||||||||
Current Liabilities | ||||||||
Accounts payable | $ | 660,600 | $ | 312,960 | ||||
Accrued wages | 140,993 | 48,524 | ||||||
Short term notes payable | 439,039 | 13,189 | ||||||
Accrued waste disposal | 114,500 | 114,500 | ||||||
Other accrued expenses | 239,042 | 222,722 | ||||||
Total Current Liabilities | 1,594,174 | 711,895 | ||||||
Commitments and Contingencies | ||||||||
Stockholders’ Equity | ||||||||
Preferred stock, $0.01 par value; authorized 1,000,000 shares;issued and outstanding zero shares | — | — | ||||||
Common stock, $0.01 par value; authorized 40,000,000 shares; issued and outstanding 12,279,873, and 12,054,843 shares, respectively | 122,799 | 120,549 | ||||||
Additional paid-in capital | 14,050,817 | 14,030,564 | ||||||
Accumulated deficit | (14,125,549 | ) | (13,268,558 | ) | ||||
Total Stockholders’ Equity | 48,066 | 882,555 | ||||||
| $ | 1,642,240 | $ | 1,594,450 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
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H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)
| Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||
Sales | $ | 1,537,046 | $ | 1,770,863 | $ | 3,979,453 | $ | 4,943,250 | ||||||||
Cost of Sales | 1,239,196 | 927,071 | 2,841,510 | 2,713,420 | ||||||||||||
Gross Profit | 297,850 | 843,792 | 1,137,943 | 2,229,830 | ||||||||||||
Selling Expenses | 98,579 | 123,471 | 282,008 | 378,811 | ||||||||||||
General and Administrative Expenses | 561,079 | 762,759 | 1,636,472 | 1,943,022 | ||||||||||||
Operating Income (Loss) | (361,808 | ) | (42,438 | ) | (780,537 | ) | (92,003 | ) | ||||||||
Other Income (Expense) | ||||||||||||||||
Interest expense | (31,654 | ) | (18,110 | ) | (73,357 | ) | (58,171 | ) | ||||||||
Miscellaneous | (120 | ) | 262 | (3,098 | ) | 225,952 | ||||||||||
Total Other Income (Expense) | (31,774 | ) | (17,848 | ) | (76,455 | ) | 167,781 | |||||||||
Net Income (Loss) before Income Taxes | (393,582 | ) | (60,286 | ) | (856,992 | ) | 75,778 | |||||||||
Income tax provision | — | — | — | — | ||||||||||||
Net Income (Loss) | $ | (393,582 | ) | $ | (60,286 | ) | $ | (856,992 | ) | $ | 75,778 | |||||
Net Income (Loss) per Common Share–Basic and Diluted | $ | (0.03 | ) | $ | (0.01 | ) | $ | (0.07 | ) | $ | 0.01 | |||||
Weighted Average Common Shares Outstanding: | ||||||||||||||||
Basic | 12,205,422 | 12,004,872 | 12,279,873 | 11,951,905 | ||||||||||||
Diluted | 12,205,422 | 12,004,872 | 12,279,873 | 12,025,470 | ||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
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H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
| Nine Months Ended September 30, | ||||||||
| 2003 | 2002 | |||||||
Cash Flows From Operating Activities | ||||||||
Net income (loss) | $ | (856,992 | ) | $ | 75,778 | |||
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities | ||||||||
Depreciation and amortization | 159,257 | 180,976 | ||||||
Gain on sale of Chlor-Rid® royalty rights | — | (225,000 | ) | |||||
Common stock issued for services | 22,503 | 14,000 | ||||||
Bad debt expense | 9,553 | 89,069 | ||||||
Change in working capital components | ||||||||
Trade accounts receivable | 63,168 | (289,127 | ) | |||||
Inventories | (27,168 | ) | (25,679 | ) | ||||
Costs of uncompleted contracts | 17,313 | 43,001 | ||||||
Costs and estimated earnings in excess of billings on uncompleted contracts | — | 39,707 | ||||||
Other receivables | (321,085 | ) | 12,260 | |||||
Prepaid expenses | (134,673 | ) | 170,076 | |||||
Refundable deposits and other assets | 5,126 | 1,218 | ||||||
Accounts payable | 347,640 | 129,967 | ||||||
Accrued wages and other accrued expenses | 108,790 | 100,669 | ||||||
Customer deposits | — | — | ||||||
Net cash provided by (used in) operating activities | (606,568 | ) | 316,915 | |||||
Cash Flows From Investing Activities | ||||||||
Purchase of equipment and furniture | (46,030 | ) | (160,707 | ) | ||||
Cash received from sale of Chlor-Rid® royalty rights | — | 225,000 | ||||||
Expenditures related to patents and patents pending | (9,635 | ) | (14,088 | ) | ||||
Net cash provided by (used in) investing activities | (55,665 | ) | 50,205 | |||||
Cash Flows From Financing Activities | ||||||||
Proceeds from issuance of notes payable | 799,600 | — | ||||||
Principal payments under notes payable | (373,750 | ) | (321,721 | ) | ||||
Net cash provided by (used in) financing activities | 425,850 | (321,721 | ) | |||||
Net increase (decrease) in cash and cash equivalents | (236,383 | ) | 45,399 | |||||
Cash at beginning of period | 254,859 | 75,759 | ||||||
Cash at end of period | $ | 18,476 | $ | 121,158 | ||||
Supplemental Disclosures of Cash Flow Information | ||||||||
Cash paid during the period for interest | $ | 70,622 | $ | 58,171 | ||||
Cash paid during the period for income taxes | $ | — | $ | — | ||||
Supplemental Schedule of Noncash Investing and Financing Activities | ||||||||
Prepaid insurance financed with note payable | $ | 369,600 | $ | 369,114 | ||||
The accompanying notes are an integral part of these consolidated financial statements
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NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS
(Unaudited)
September 30, 2003
1. Basis of Presentation
The accompanying unaudited consolidated financial statements (except for the balance sheet at December 31, 2002, which is derived from audited financial statements) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the requirements of Regulation S-B and the rules of Form 10-QSB of the Securities and Exchange Commission and consequently do not include all of the disclosures normally made in complete annual financial statement filing. Accordingly, the consolidated financial statements of H.E.R.C. Products Incorporated included herein should be reviewed in conjunction with the consolidated financial statements and the accompanying footnotes included within the Company’s Form 10-KSB for the year ended December 31, 2002.
In the opinion of management, the consolidated financial statements reflect all adjustments necessary to fairly report the Company’s financial position and results of operations for the interim period. All such adjustments are normal and recurring in nature. The interim consolidated results of operations are not necessarily indicative of results to be expected for the year ending December 31, 2003.
2. Revenue Recognition
For chemical product sales, the Company recognizes revenue at the time products are shipped to customers. For most service projects, the Company recognizes revenue and costs when the services are completed. For fixed price contracts in excess of 3 month duration, revenue is recognized on the percentage of completion method, measured by the percentage of cost incurred to date to estimated total cost for each contract. This method is used because management considers total cost to be the best available measure of progress on these contracts.
Contract costs include all direct material, subcontract labor and other costs related to contract performance, such as indirect labor, supplies, tools and repairs. Selling, general and administrative costs are charged to expense as incurred. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements may result in revisions to estimates of contract costs and profits and are recognized in the period in which the revisions are determined.
The current asset, “costs and estimated earnings in excess of billings on uncompleted contracts” represents revenue recognized in excess of amounts billed. The current liability, “billings in excess of costs on uncompleted contracts,” represents billings in excess of revenue recognized.
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3. Allowance for Doubtful Accounts
The Company analyzes accounts receivable to determine the ultimate collectibility of those accounts. If information is available to the Company to make a determination that there exists a reasonable probability that an account will not be collectible, the Company creates a reserve for that account at the time of the determination and recognize a related expense. If the account is later collected, the reserve and expense are reversed in the current accounting period. Since the Company must use its best judgment as to which accounts will be collected, there exists the risk that some accounts might not be collected and thus could have a negative impact on the Company’s liquidity and results of operations.
4. Agreement with Factor
The Company has an arrangement for a factoring facility whereby the factor purchases eligible receivables and advances 85% of the purchased amount to the Company. Purchased receivables may not exceed $1,500,000 at any one time. Either party may cancel the arrangement with 30 days notice. At September 30, 2003, there was $1,096,664 of factored receivables ($616,401 at September 30, 2002), of which the Company has received $932,164 from the factor ($523,941 at September 30, 2002). This $932,164 and $8,225 in interest expense ($523,941 and $4,623 at September 30, 2002) are not shown as receivables. This arrangement is accounted for as a sale of receivables on which the factor has recourse to the 15% residual of aggregate receivables purchased and outstanding. Interest payable by the Company to the factor is calculated as a fixed discount fee equal to 0.75% of the amount of the receivable factored plus a variable (1.5% above the institutions base rate, with a minimum of 7%) discount fee computed on the amount advanced to the Company and accruing on the basis of actual days elapsed from the date of the 85% advance until 3 days after collection of such account receivable by the factor at a per annum rate equal to an internal rate set by the factor. The rate at September 30, 2003 was 7%. In connection with this agreement, the Company is required to maintain certain financial covenants. In the event of a breach of representation, warranty or agreement, the institution has a security interest in the Company’s assets.
5. Segment Information
Information by segment for the three months ended and as of September 30, 2003:
Pipe Cleaning | Tank Cleaning | Industrial Chemical | Corporate | Consolidated | |||||||||||||||
Sales | $ | 762,964 | $ | 733,501 | $ | 40,581 | $ | — | $ | 1,537,046 | |||||||||
Income (loss) from continuing operations | 53,721 | (39,572 | ) | (23,385 | ) | (384,346 | ) | (393,582 | ) | ||||||||||
Total assets | 609,927 | 547,062 | 42,701 | 442,550 | 1,642,240 | ||||||||||||||
Depreciation and amortization | 32,550 | 16,381 | 1,495 | 14,385 | 64,811 | ||||||||||||||
Capital expenditures | 5,352 | 2,000 | — | — | 7,352 | ||||||||||||||
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Information by segment for the three months ended and as of September 30, 2002:
Pipe Cleaning | Tank Cleaning | Industrial Chemical | Corporate | Consolidated | |||||||||||||||
Sales | $ | 352,779 | $ | 1,384,485 | $ | 33,599 | $ | — | $ | 1,770,863 | |||||||||
Income (loss) from continuing operations | (200,133 | ) | 508,870 | (28,615 | ) | (340,408 | ) | $ | (60,286 | ) | |||||||||
Total assets | 494,272 | 919,995 | 31,764 | 640,501 | $ | 2,086,532 | |||||||||||||
Depreciation and amortization | 39,341 | 18,458 | 1,643 | 9,136 | $ | 68,578 | |||||||||||||
Capital expenditures | 2,050 | 96,966 | — | — | $ | 99,016 | |||||||||||||
Information by segment for the nine months ended and as of September 30, 2002:
Pipe Cleaning | Tank Cleaning | Industrial Chemical | Corporate | Consolidated | |||||||||||||
Sales | $ | 1,637,897 | $ | 2,154,327 | $ | 187,230 | $ | — | $ | 3,979,453 | |||||||
Income (loss) from continuing operations | 12,243 | 172,857 | 74,172 | (1,116,264 | ) | $ | (856,992 | ) | |||||||||
Total assets | 609,927 | 547,062 | 42,701 | 442,550 | $ | 1,642,240 | |||||||||||
Depreciation and amortization | 95,817 | 45,999 | 4,484 | 12,957 | $ | 159,257 | |||||||||||
Capital expenditures | 37,628 | 8,402 | — | — | $ | 46,030 | |||||||||||
Information by segment for the nine months ended and as of September 30, 2002:
Pipe Cleaning | Tank Cleaning | Industrial Chemical | Corporate | Consolidated | ||||||||||||
Sales | $ | 2,174,887 | $ | 2,653,132 | $ | 115,231 | $ | — | $ | 4,943,250 | ||||||
Income (loss) from continuing operations | 217,021 | 842,243 | 139,131 | (1,122,617 | ) | 75,778 | ||||||||||
Total assets | 494,272 | 919,995 | 31,764 | 640,501 | 2,086,532 | |||||||||||
Depreciation and amortization | 117,497 | 31,133 | 4,928 | 27,418 | 180,976 | |||||||||||
Capital expenditures | 52,328 | 104,221 | — | 4,158 | 160,707 | |||||||||||
Segment profitability is determined before allocation of corporate overhead.
6. Earnings Per Share
A reconciliation of the basic and diluted loss per share (EPS) computation for the three and nine months ended September 30, 2003 and 2002 are as follows:
| Three Months Ended September 30, 2003 | ||||||||||
Net Loss (Numerator) | Shares (Denominator) | Per Share Amount | ||||||||
Basic EPS | $ | (393,582 | ) | 12,205,422 | $ | (0.03 | ) | |||
Effect of stock options and warrants | — | — | ||||||||
Diluted EPS | $ | (393,582 | ) | 12,205,422 | $ | (0.03 | ) | |||
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| Three Months Ended September 30, 2002 | ||||||||||
Net Loss (Numerator) | Shares (Denominator) | Per Share Amount | ||||||||
Basic EPS | $ | (60,286 | ) | 12,004,872 | $ | (0.01 | ) | |||
Effect of stock options and warrants | — | — | ||||||||
Diluted EPS | $ | (60,286 | ) | 12,004,872 | $ | (0.01 | ) | |||
| Nine Months Ended September 30, 2003 | ||||||||||
Net Loss (Numerator) | Shares (Denominator) | Per Share Amount | ||||||||
Basic EPS | $ | (856,992 | ) | 12,205,473 | $ | (0.07 | ) | |||
Effect of stock options and warrants | — | — | ||||||||
Diluted EPS | $ | (856,992 | ) | 12,205,473 | $ | (0.07 | ) | |||
| Nine Months Ended September 30, 2002 | ||||||||||
Net Loss (Numerator) | Shares (Denominator) | Per Share Amount | ||||||||
Basic EPS | $ | 75,778 | 11,951,905 | $ | 0.01 | |||||
Effect of stock options and warrants | — | 73,565 | ||||||||
Diluted EPS | $ | 75,778 | 12,025,470 | $ | 0.01 | |||||
The Company accounts for its employee stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”. Had the Company used the method prescribed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”, there would have been no effect on earnings per share.
7. Notes Payable
On September 12, 2003, the Company entered into a Promissory Demand Note for $30,000 with the Chief Executive Officer. The proceeds were used to support the working capital needs in the Company’s current operations.
8. Commitments and Contingencies
Litigation
From time to time, the Company is involved in various legal proceedings that, in the opinion of management, are ordinary routine matters incidental to the normal course of business. The Company does not believe the outcome of any pending matters will have a material adverse effect on its operations. At this time the Company is not involved in any litigation as a party defendant.
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9. Income Taxes
The Company was in a consolidated tax loss position for the nine months ended September 30, 2003 and therefore has no current federal income tax expense. Deferred tax assets as of September 30, 2003 arising primarily from loss carry forward benefits have not been recorded because of the uncertainty of realizing such benefits.
| Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Statement Regarding Forward-Looking Statements
Portions of this report describe historical information, such as the 2002 and 2003 operating results, and we believe the descriptions to be accurate. In contrast to describing the past, some statements in this report may be forward-looking, indicating that we believe that events or financial results are likely to occur in the future. These statements typically use words or phrases like “believe,” “expects,” “anticipates,” “estimates,” “will continue” and similar expressions. Statements using those words or similar expressions are intended to identify “forward-looking statements” as that term is used in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include projections of operating results for 2003 and beyond, either concerning a specific segment of our business, or concerning our Company as a whole.
Actual results, however, may be materially different from the results projected in the forward-looking statements, due to a variety of risks and uncertainties. These risks and uncertainties include those set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
The forward-looking statements in this report are current only as of the date this report is filed with the Securities and Exchange Commission. After the filing of this report, our expectations and beliefs may change, and we may come to believe that certain forward-looking statements in this report are no longer accurate. We do not have an obligation to correct or revise any forward-looking statements in this report, even if we believe the forward looking statements are no longer true.
Overview
We derive the majority of our revenue from two sources, cleaning vacuum sewer “CHT” systems on U.S. Navy and U.S. Coast Guard vessels and cleaning bilge, fuel, oil, catapult and CHT tanks on ships. A significant portion of the pipe cleaning has been performed pursuant to a new worldwide contract with the U.S. Navy awarded to us together with a non-public company competitor under a “multiple award” on September 30, 2002. This multiple award has subjected us to certain business risks that have caused volatility in our revenue stream and our gross margins. We have also been subject to the deployment and servicing schedules of the U.S. Navy as well as the available maintenance funds in the Navy budget. These factors can cause revenue to change dramatically from one quarter to the next. Additionally, we have been required by our 2002 Portsmouth CHT contract to perform work on different classes of ships. Performing work on different classes of ships can cause our gross margins to vary widely from one quarter to the next because we realize higher gross margins on certain classes of ships than on others. Moreover, we are often asked to perform work on ships outside of the state of Virginia. When we perform work under the 2002 Portsmouth CHT contract outside of the state of Virginia, we incur certain reimbursable travel costs that are included in both revenue and cost of goods sold. These reimbursable travel costs cause gross margins to be lower than the margins that would have otherwise been recognized had the work been performed in Virginia.
The benefit of being publicly held to a small company in today’s financial environment is questionable. The ability of a small company to utilize the public financial markets to raise capital is almost non-existent. The cost of compliance with SEC requirements, especially in light of new requirements as a result of the Sarbanes-Oxley Act of 2002, is high and continues to increase. The requirement of public disclosure of financial cash flow, profitability, capital and debt information, together with statements regarding management business objectives and strategies places us at a comparative competitive disadvantage with numerous similarly situated non-public competitors in our various product and service markets. These factors make it difficult to justify remaining a publicly held company.
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Critical Accounting Judgments and Estimates
We consider the following accounting policies to be critical to an understanding of our financial statements because their application places the most significant demands on our judgment, with financial reporting results relying on estimates about the effect of matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. For all of these policies, we caution that future events rarely develop exactly as forecast, and the best estimates routinely require adjustment.
Revenue Recognition
For chemical product sales, we recognize revenue at the time products are shipped to customers. For most service projects, we recognize revenue when the services are completed. For fixed price contracts that are in excess of three months, we recognize revenue on the percentage of completion method, measured as the percentage of cost incurred to date of the estimated total cost for each contract. We use this method because we consider the percentage of the total cost to be the best available measure of progress on these contracts.
Contract costs include all direct material, subcontract labor, and other costs related to contract performance, such as indirect labor, supplies, tools, and repairs. Selling, general, and administrative costs are charged to expense as incurred. Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions and final contract settlements may result in revisions to estimates of contract costs and profits and are recognized in the period in which the revisions are determined.
The current asset, “costs and estimated earnings in excess of billings on uncompleted contracts” represents revenue recognized in excess of amounts billed. The current liability, “billings in excess of costs on uncompleted contracts,” represents billings in excess of revenue recognized.
Allowance for Doubtful Accounts
We analyze accounts receivable to determine the ultimate collectibility of those accounts. If information is available to us to make a determination that there exists a reasonable probability that an account will not be collectible, we create a reserve for that account at the time of the determination and recognize a related expense. If the account is later collected, the reserve and expense are reversed in the current accounting period. Since we must use our best judgment as to which accounts will be collected, there exists the risk that some accounts might not be collected and thus could have a negative impact on our liquidity and results of operations.
Deferred Tax Assets
Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when it is determined to be more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Impairment of Long-Lived Assets
We periodically evaluate the carrying value of long-lived assets and intangibles. We review long-lived assets and certain identifiable intangible assets to be held and used in operations for potential impairment whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. An impairment loss is recognized if the sum of the expected long-term undiscounted cash flows is less than the carrying amount of the long-lived assets being evaluated. Future losses may be recorded if cash flows are less than expected.
Accruals
Loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Disclosure is required when there is a reasonable possibility that the
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ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as regulators.
Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to a complete understanding of the financial statements.
Results of Operations
Three Months Ended September 30, 2003 Compared with Three Months Ended September 30, 2002
Sales for the three months ended September 30, 2003 were $1,537,046 compared with $1,770,863 during the same period in 2002. Pipe cleaning services accounted for $762,964 during the three months ended September 30, 2003, of which $114,898 was billed under the 2002 Portsmouth CHT contract with the United States Navy. For the three months ended September 30, 2002, pipe cleaning services accounted for $352,779 of which $257,153 was billed under our previous five-year “sole source” 1997 Portsmouth CHT cleaning contract that expired on September 4, 2002. Tank cleaning services totaled $733,501 during the three months ended September 30, 2003 compared with $1,384,485 during the same period in 2002. Industrial chemical sales were $40,581 during the three months ended September 30, 2003 compared with $33,599 during the same period in 2002.
Consolidated sales during the third quarter of 2003 were 13% lower than the same period in 2002. The impact of the war in the Middle East had a significant impact upon our business, since many of the U.S. Navy ships were at sea rather than being in port where maintenance could be performed. In September, our overall business level began to increase. As a result, we expect sales during the fourth quarter to increase, as compared to the third quarter.
Pipe cleaning pursuant to the 2002 Portsmouth CHT contract with the U.S. Navy was 7% of consolidated sales during the three months ended September 30, 2003 compared to 15% of pipe cleaning services under the 1997 Portsmouth CHT contract during the three months ended September 30, 2002.
Sales of pipe cleaning services increased 116% during the three months ended September 30, 2003 compared to the same period in 2002. Sales of tank cleaning services decreased 47% during the three months ended September 30, 2003 compared to the same period in 2002. The increase in pipe cleaning revenue reflects a volume increase over the prior period resulting from the award of the 2002 Portsmouth CHT contract and the reduced volume of third quarter 2002 task orders under our 1997 Portsmouth CHT contract that expired on September 4, 2002. The Navy significantly decreased the volume of task orders in the third quarter of 2002 while anticipating the new solicitation award of the 2002 Portsmouth CHT contract. The decline in tank cleaning services was due largely to the overall decrease in the volume of marine business with the U.S. Navy as a result of deployments related to operations involving the Middle East.
Sales from tank cleaning during the third quarter of 2003 were 4% less than sales from pipe cleaning. Our continued efforts to diversify our revenue base in marine vessel pipe and tank cleaning with our primary customer are being achieved. However, we continue to depend on the availability of our primary customer for both pipe cleaning and tank cleaning services.
Consolidated gross margins were 19% during the three months ended September 30, 2003 compared with 48% during the same period in 2002. Fewer U.S. Navy ships being in port and available for maintenance resulted in a significant increase in the competitiveness for both pipe and tank cleaning services during the third quarter of 2003. This situation had a significant effect on both sales and margins during the three months ended September 30, 2003. We anticipate that future gross margins from pipe cleaning and tank cleaning will fluctuate with changes in revenue mix and certain operational factors.
Performing pipe-cleaning services on different classes of ships in various ports of service can cause our gross margins to vary widely from one quarter to the next because we generate higher gross margins on certain classes of ships and certain ports of service than we do on others. Margins are impacted due to the fact we receive service awards under various government contracts either directly with the Navy or through subcontracts with
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shipyards, all of which are subject to differing contract pricing limitations and factors of competition in the award markets. Additionally, when we perform work under the 2002 Portsmouth CHT contract outside of the state of Virginia, we incur certain reimbursable travel costs that are included in both revenue and cost of goods sold. These reimbursable travel costs cause gross margins to be lower than the margins that would have otherwise been recognized had the work been performed in Virginia.
Gross profit decreased to $297,850 during the three months ended September 30, 2003 from $843,792 during the same period in 2002. The drop in sales and the margin pressures that we experienced during the third quarter of 2003 contributed significantly to this decline. Decreased profit margins in pipe cleaning services have resulted from competition on task orders issued under the multiple award of the 2002 Portsmouth CHT contract in contrast to our sole source award of the 1997 Portsmouth CHT contract that expired on September 4, 2002. Decreased profit margins in the tank cleaning services were due to price-cutting among tank cleaning competitors for shipyard subcontract awards as a result of lack of business volume preceding the return of Navy vessels from overseas deployments associated with operations in the Middle East.
Total selling, general and administrative expenses during the three months ended September 30, 2003 declined to $659,658 from $886,230 during the same period in 2002. Selling expenses decreased to $98,579 during the three months ended September 30, 2003 from $123,471 during the same period in 2002, while general and administrative expenses decreased to $561,079 for the three months ended September 30, 2003 from $762,759 during the same period in 2002. The decrease in selling expenses was primarily the result of one less sales person and related marketing expenses. The decrease in general and administrative expenses resulted from lower headcount and legal and professional expenses, partially offset by increases in travel and corporate insurance, primarily.
For the three months ended September 30, 2003, we incurred a net loss of $393,582, compared to net loss of $60,286 during the same period in 2002. The net loss of 2002 includes a $225,000 one time gain on the sale of all remaining retained royalty rights associated with the Chlor*Rid patent previously sold and assigned to Chlor*Rid International, Inc. in 1998. The retained royalty rights sold in 2002 had no associated cost basis as the Chlor*Rid patent asset was removed from our balance sheet pursuant to the sale of the patent in 1998.
Nine Months Ended September 30, 2003 Compared with Nine Months Ended September 30, 2002,
Sales for the nine months ended September 30, 2003 were $3,979,453 compared with $4,943,250 during the same period in 2002. Pipe cleaning services accounted for $1,637,897 during the nine months ended September 30, 2003, of which $656,181 was billed under the 2002 Portsmouth CHT contract with the United States Navy. For the nine months ended September 30, 2002, pipe cleaning services accounted for $2,174,887 of which $1,744,211 was billed under the 1997 Portsmouth CHT contract. Tank cleaning services totaled $2,154,327 during the nine months ended September 30, 2003 compared with $2,653,132 during the same period in 2002. Industrial chemical sales were $187,230 during the nine months ended September 30, 2003 compared with $115,231 during the same period in 2002.
Consolidated sales during the first nine months of 2003 were 19% lower than the same period in 2002, primarily as result of the expiration of the sole source 1997 Portsmouth CHT contract and international military commitments of our primary customer. The impact of the war in the Middle East had a significant impact upon our business, since many of the U.S. Navy ships were at sea rather than being in port where maintenance could be performed. In September, our overall business level began to increase. As a result, we expect sales during the last quarter of the year to increase, as compared to the first nine months.
Pipe cleaning pursuant to the multiple award 2002 Portsmouth CHT contract with the U.S. Navy was 16% of consolidated sales during the nine months ended September 30, 2003 compared to 35% during the nine months ended September 30, 2002 under the sole source 1997 Portsmouth CHT contract. Our continued efforts to diversify our revenue base between pipe cleaning and tank cleaning services are being achieved, although competition within both markets has increased significantly.
Sales of pipe cleaning services decreased 25% during the nine months ended September 30, 2003 compared to the same period in 2002. The decrease in pipe cleaning revenue reflects an increased competitiveness resulting from the dual sourcing of our 2002 Portsmouth CHT contract and fewer U.S. Navy and U.S. Coast Guard
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vessels being in port. Sales of tank cleaning services decreased 19% during the nine months ended September 30, 2003 compared to the same period in 2002, largely due to aggressive pricing competition for new business after the U.S. Navy’s fleet return from overseas deployment in the Middle East. Sales of industrial chemicals increased 62% during the nine months ended September 30, 2003 compared to the same period in 2002 as a result of increased marketing efforts and product demand.
Consolidated gross margin was 29% during the nine months ended September 30, 2003 compared with 45% during the same period in 2002. Fewer U.S. Navy ships being in port and available for maintenance resulted in a significant increase in the competitiveness for both pipe and tank cleaning services during the first three quarters of 2003. This situation had a significant effect on both sales and margins during the nine months ended September 30, 2003. We anticipate that future gross margins from pipe cleaning and tank cleaning will fluctuate with changes in revenue mix and certain operational factors.
Gross profit decreased to $1,137,943 during the nine months ended September 30, 2003 from $2,229,830 during the same period in 2002. The drop in sales and the margin pressures that we experienced during the third quarter of 2003 contributed significantly to this decline. Decreased profit margins in pipe cleaning services have resulted from competition on task orders issued under the multiple award of the 2002 Portsmouth CHT contract in contrast to our sole source award of the 1997 Portsmouth CHT contract that expired on September 4, 2002. Decreased profit margins in the tank cleaning services were due to price-cutting among tank cleaning competitors for shipyard subcontract awards as a response to lack of business volume preceding the return of Navy vessels from overseas deployments associated with operations in the Middle East.
Total selling, general and administrative expenses during the nine months ended September 30, 2003 declined to $1,918,480 from $2,321,833 during the same period in 2002. Selling expenses decreased to $282,008 during the nine months ended September 30, 2003 from $378,811 during the same period in 2002, while general and administrative expenses decreased to $1,636,472 for the nine months ended September 30, 2003 from $1,943,022 during the same period in 2002. The decrease in selling expenses was primarily the result of one less sales person and related marketing expenses. The general and administrative expense reduction resulted from lower headcount and legal and professional expenses, offset partially by increases in corporate insurance and travel, primarily.
For the nine months ended September 30, 2003, we incurred a net loss of $856,992 compared to a net profit of $75,778 for the same time period in 2002. The 2002 net profit includes a one-time gain of $225,000 from the sale of retained royalty rights associated with the Chlor*Rid patent previously sold and assigned to Chlor*Rid International, Inc. in 1998. The retained royalty rights sold in 2002 had no associated cost basis as the Chlor*Rid patent asset was removed from our balance sheet pursuant to the sale of the patent in 1998.
Liquidity and Capital Resources
We have historically relied primarily on our internally generated operating cash flow and our factoring arrangement to fund our operations and our business. Due to revenue constraints associated with the Navy deployment in the Middle East, during the first three quarters of 2003 we primarily relied on the $400,000 and $30,000 notes from related parties in addition to our factoring arrangement to fund our operations and business. While we currently contract with a few major customers responsible for a large percentage of our revenue and anticipate the high concentration levels to continue, we expect to return to internally generated operating cash flow and our factoring arrangement to fund our operations. Thus, any material delay, cancellation or reduction of orders from these customers, such as that experienced during the Navy deployment to the Middle East, could have a material adverse effect on our liquidity and operations. We expect that our liquidity position will improve during the fourth quarter after we incur additional costs of securing, training and transporting the workforce necessary for the increased business activity during the third quarter of 2003 as a result of the return of Navy ships from overseas deployment. This increase in volume of Navy ship pipe and tank cleaning work experienced during the third quarter is expected to continue into the fourth quarter with revenue recognition on work commenced in the third quarter and completed in the fourth quarter. We implemented cost cutting measures and workforce reductions in executive and administrative personnel during the third quarter due to the decreased business activity and consequential cash flow constraints associated with the Navy deployment during the first six months of 2003. Executive personnel reductions included the position of Chief Financial Officer. Our Chief Executive Officer is now serving as the Acting Chief Financial Officer.
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Cash was $18,476 at September 30, 2003 and $254,859 at December 31, 2002, while working capital was $(467,362) and $258,408 on those respective dates. The decrease in cash and working capital is primarily the result of our net loss, offset by the additional financings.
The impact of the war in the Middle East had a significant impact upon our cash and working capital position at September 30, 2003, since many of the U.S. Navy ships were at sea rather than being in port where maintenance could be performed. In September, our overall business level began to increase. As a result, we expect our cash and working capital situation during the last quarter of the year to increase, as compared to the first nine months.
We have an arrangement for a factoring facility whereby the factor purchases eligible receivables and advances 85% of the purchased amount to us. Purchased receivables may not exceed $1,500,000 at any one time. Either party may cancel the arrangement with 30 days notice. At September 30, 2003, there was $1,096,664 of factored receivables ($616,401 at September 30, 2002), of which we received $932,164 from the factor ($523,941 at September 30, 2002). This $932,164 and $8,225 in interest expense ($523,941 and $4,623 at September 30, 2002) are not shown as receivables. This arrangement is accounted for as a sale of receivables on which the factor has recourse to the 15% residual of aggregate receivables purchased and outstanding. Interest payable by to the factor is calculated as a fixed discount fee equal to 0.75% of the amount of the receivable factored plus a variable (1.5% above the institutions base rate, with a minimum of 7%) discount fee computed on the amount advanced to us and accruing on the basis of actual days elapsed from the date of the 85% advance until 3 days after collection of such account receivable by the factor at a per annum rate equal to an internal rate set by the factor. The rate at September 30, 2003 was 7%. In connection with this agreement, we are required to maintain certain financial covenants. In the event of a breach of representation, warranty or agreement, the institution has a security interest in our assets.
On January 15, 2003 we financed $338,205 of corporate insurance premiums payable in nine monthly installments of $38,157 at an annual percentage rate of 3.68%.
On February 27, 2003 we entered into a one-year renewable Interest Only Non-Recourse Promissory Note and Security Agreement for $400,000 with one of our Directors. Interest is at a stated rate of 8% per annum payable monthly. The maturity date of the principal obligation is one year from the date of the note. The note can be renewed at the end of the original term by the mutual agreement of both parties. The parties have entered into discussions regarding an extension of time to pay the principal obligation by renewal. The proceeds were used to expand our CHT and tank cleaning business on the West Coast and support working capital needs in our current operations.
On May 19, 2003 we financed $31,395 of Directors and Officers insurance premiums payable in seven monthly installments of $4,540 at an annual percentage rate of 3.68%.
On September 12, 2003, we entered into a Promissory Demand Note for $30,000 with the Chief Executive Officer on a non-recourse basis without pledge of a security interest. Interest is at a stated rate of 8% per annum payable on demand. The principal obligation is payable on demand. The proceeds were used to support the working capital needs in our current operations.
The table below describes our contractual obligations as of September 30, 2003 to make future payments under contracts such as debt and lease agreements:
| Payments Due in Fiscal Year | |||||||||
Contractual Obligations | 2003 | 2004 | 2005 | ||||||
Insurance and Financing Agreements | $ | 54,705 | $ | 1,509 | $ | — | |||
Capital Lease Obligations | — | — | — | ||||||
Operating Leases | 18,300 | 6,100 | — | ||||||
Renewable Note and Demand Note | — | 430,000 | — | ||||||
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While we believe that we will not need to raise additional capital because our current financings, cash and expected cash flows generated from operations are anticipated to be sufficient for the foreseeable future, we may, in the future, sell additional securities to raise capital. Any such sale, if necessary, could substantially dilute the interest of our existing stockholders. We cannot provide any assurance that we will be able to sell additional securities at terms acceptable to us. We may, in the future, make acquisitions by utilizing debt financing if available. Any such acquisition and debt financing could have a material adverse impact on our liquidity and results of operations.
| Item 3. | Controls and procedures |
We have evaluated, with the participation of our Chief Executive Officer who is the Acting Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of September 30, 2003. Based on this evaluation, he has concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our quarterly reports filed under the Securities Exchange Act within the time periods specified by the Securities and Exchange Commission’s rules and forms. During the quarterly period covered by this report, there have not been any significant changes in our internal controls over financial reporting that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II: OTHER INFORMATION
| Item 2. | Changes in Securities |
Recent Sales of Unregistered Securities
During the third quarter of 2003, we issued 75,000 shares of common stock as compensation to our outside Board of Directors. These shares were issued under an exemption from registration pursuant to Section 4(2) of the Securities Act of 1933.
| Item 6. | Exhibits and Reports on Form 8-K |
Reports on Form 8-K: None
Exhibits:
10.21 | Promissory Demand Note for $30,000 dated September 12, 2003. | |
31.1 | Certification of Chief Executive Officer and acting Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended. | |
32.1 | Certification of Chief Financial Officer and acting Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
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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.
H.E.R.C. Products, Incorporated (Registrant) | ||||||||
| Date: | November 14, 2003 | By: | /s/ S. Steven Carl | |||||
S. Steven Carl Chief Executive Officer (Principal Executive Officer) and Acting Chief Financial Officer (Principal Financial Officer) | ||||||||
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