SECURITIES AND EXCHANGE COMMISSION Washington DC 20549 FORM 10-QSB Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended August 31, 1998 Commission File No. 0-5920 LANCER ORTHODONTICS, INC. (Exact Name of Small Business Issuer as Specified in its Charter) CALIFORNIA 95-2497155 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 253 Pawnee Street, San Marcos, California 92069 (Address of Principal Executive Offices) Issuer's telephone number, including area code: (760) 744-5585 Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports, and (2) has been subject to such filing requirements for the past 90 days. Yes X No State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date: 2,117,040 Traditional small business disclosure format (check one): Yes X No PART I. FINANCIAL INFORMATION Item 1. SUMMARIZED FINANCIAL INFORMATION LANCER ORTHODONTICS, INC. CONDENSED BALANCE SHEETS (UNAUDITED) 8/31/98 ASSETS CURRENT ASSETS: Cash $ 108,816 Accounts Receivable, less allowances for sales returns and doubtful receivables of $99,825 1,333,509 Inventories 2,076,955 Prepaid Expenses 34,232 Total Current Assets 3,553,512 PROPERTY AND EQUIPMENT, at cost 2,330,494 Less: Accumulated depreciation (2,133,365) 197,129 INTANGIBLE ASSETS: Marketing and Distribution Rights, net 153,550 Technology Use Rights, net 210,990 364,540 OTHER ASSETS 6,560 Total Assets $4,121,741 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts Payable and Accrued Liabilities $ 581,458 Line of Credit 100,000 Total Current Liabilities 681,458 COMMITMENTS AND CONTINGENCIES -- STOCKHOLDERS' EQUITY: Redeemable Convertible Preferred Stock, Series C, $.06 noncumulative annual dividend; $.75 par value: Authorized 250,000 shares; no shares issued and outstanding ($.75 liquidation preference) -- Redeemable Convertible Preferred Stock, Series D, $.04 noncumulative annual dividend; $.50 par value: Authorized 500,000 shares; 370,483 issued and outstanding ($.50 liquidation preference: aggregate liquidation preference of $185,242) 185,242 Common Stock, no par value: Authorized 50,000,000 shares; issued and outstanding 2,117,040 4,700,906 Accumulated Deficit (1,445,865) Total Stockholders' Equity 3,440,283 Total Liabilities and Stockholders' Equity $4,121,741 LANCER ORTHODONTICS, INC. CONDENSED STATEMENTS OF OPERATIONS AND CONDENSED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED 8/31/98 8/31/97 NET SALES $1,540,302 $1,447,783 COST OF SALES 941,277 889,729 Gross Profit 599,025 558,054 OPERATING EXPENSES: Selling, General & Administrative 523,569 504,566 Product Development 32,322 39,642 TOTAL OPERATING EXPENSES 555,891 544,208 INCOME (LOSS) FROM OPERATIONS 43,134 13,846 OTHER INCOME (EXPENSE): Interest Expense ( 1,979) ( 9,473) Other Income (Expense), net ( 132) ( 1,099) TOTAL OTHER INCOME (EXPENSE) ( 2,111) ( 10,572) INCOME BEFORE INCOME TAXES 41,023 3,274 INCOME TAXES 800 800 NET INCOME 40,223 2,474 OTHER COMPREHENSIVE INCOME -- -- COMPREHENSIVE INCOME $ 40,223 $ 2,474 WEIGHTED AVERAGE SHARES OF COMMON SHARE BASIC $ .019 $ .001 DILUTED $ .019 $ .001 LANCER ORTHODONTICS, INC. CONDENSED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED 8/31/98 8/31/97 CASH FLOWS FROM OPERATING ACTIVITIES: Net Income $ 40,223 $ 2,474 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 40,719 64,389 Provision for doubtful accounts 20,175 750 Changes in assets and liabilities: Decrease (increase) in accounts receivable ( 50,834) 13,409 Increase in inventories (280,161) ( 41,322) Decrease in prepaid expenses 33,525 27,064 Decrease in accounts payable and accrued liabilities ( 2,764) ( 26,892) CASH FLOWS PROVIDED BY OPERATING ACTIVITIES (199,117) 39,872 CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property and equipment ( 8,615) ( 29,616) CASH FLOWS FROM FINANCING ACTIVITIES: Principal payments on note payable to bank -- ( 70,000) Principal payments of capital leases -- ( 5,804) Repurchase of common stock ( 4,488) -- CASH FLOWS USED IN FINANCING ACTIVITIES ( 4,488) ( 75,804) INCREASE (DECREASE) IN CASH (212,220) ( 65,548) CASH AT BEGINNING OF PERIOD 321,036 154,761 CASH AT END OF PERIOD $108,816 $ 89,213 LANCER ORTHODONTICS, INC. NOTES TO FINANCIAL STATEMENTS (A) BASIS OF PRESENTATION The accompanying unaudited condensed financial statements have been prepared in accordance with the instructions to Form 10-QSB and therefore do not include all information and notes necessary for a fair presentation of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. The unaudited condensed financial statements include the accounts of Lancer Orthodontics, Inc. (the "Company"). The operating results for interim periods are unaudited and are not necessarily an indication of the results to be expected for the full fiscal year. In the opinion of management, the results of operations as reported for the interim periods reflect all adjustments which are necessary for a fair presentation of operating results. (B) ORGANIZATION The Company was incorporated on August 25, 1967, in the state of California, for the purpose of engaging in the design, manufacture, and distribution of orthodontic products. The Company has a manufacturing facility in Mexico where a majority of its inventory is manufactured (Note I). The Company also purchases certain orthodontic and dental products for purposes of resale. Sales are made directly to orthodontists world-wide through Company representatives and independent distributors. The Company also sells certain of its products on a private label basis. (C) USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP"), requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by the Company's management include, but are not limited to, allowances for doubtful accounts, allowances for sales returns, the valuation of inventories, and the realizeability of property and equipment through future operations. Actual results could materially differ from those estimates. (D) STOCK BASED COMPENSATION The Company accounts for stock based compensation under Statement of Financial Accounting Standards No. 123 ("SFAS 123"). SFAS 123 defines a fair value based method of accounting for stock based compensation. However, SFAS 123 allows an entity to continue to measure compensation cost related to stock and stock options issued to employees using the intrinsic method of accounting prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees". Entities electing to remain with the accounting method of APB 25 must make pro forma disclosures of net income and earnings per share, as if the fair value method of accounting defined in SFAS 123 had been applied. The Company has elected to account for its stock based compensation to employees under APB 25. LANCER ORTHODONTICS, INC. NOTES TO FINANCIAL STATEMENTS - continued (E) ONE-FOR-SEVEN REVERSE STOCK SPLIT On November 15, 1996, the Company effected a one-for-seven reverse stock split of its common stock. For all periods presented, that components of shareholders' equity have been adjusted to reflect the reverse stock split. (F) LINE OF CREDIT At August 31, 1998, the Company had a $300,000 line of credit with a bank. Borrowings are made at prime plus 1% (9.5% at August 31, 1998) and are limited to specified percentages of eligible accounts receivable. The unused portion available under the line of credit at August 31, 1998 was $153,318. The line of credit expires on December 1, 1998. The Company is not required to maintain compensating balances in connection with this borrowing arrangement. The line of credit is collateralized by substantially all the assets of the Company, including inventories, receivables, and equipment. The lending agreement for the line of credit requires, among other things, that the Company maintain a tangible net worth of $2,250,000, a debt to tangible net worth ratio of no more than .75 to 1, and a current ration of at least 2 to 1. The Company is not required to maintain compensating balances in connection with this lending agreement. (G) NOTE PAYABLE TO BANK At February 28, 1998, all unpaid principal and accrued interest on the note payable to a bank was paid. The note required monthly payments of $18,889 plus interest at prime plus 1% (9.5% at August 31, 1997). (H) CAPITAL LEASE The Company was the lessee of equipment under a capital lease which expired in January 1998. The assets and liabilities under the capital lease were recorded at the lower of the present value of the minimum lease payments or the fair market value of the asset. The asset was depreciated over its estimated useful life. Depreciation of the asset is included in depreciation expense for the period ended August 31, 1997. (I) COMMITMENTS AND CONTINGENCIES MANUFACTURING AGREEMENT - In May 1990, the Company entered into a manufacturing subcontractor agreement whereby, the subcontractor agreed to provide manufacturing services to the Company through its affiliated entities located in Mexicali, B.C., Mexico. The Company has moved the majority of its manufacturing operations to Mexico. Under the terms of the original agreement, the subcontractor manufactured the Company's products based on an hourly rate per employee based on the number of employees in the subcontractor's workforce. As the number of employees increased, the hourly rate decreased. In December 1992, the Company renegotiated the agreement changing from an hourly rate per employee to a pass through of LANCER ORTHODONTICS, INC. NOTES TO FINANCIAL STATEMENTS - continued (I) COMMITMENTS AND CONTINGENCIES - continued actual costs plus a weekly administrative fee. The amended agreement gives the Company greater control over all costs associated with the manufacturing operation. In July 1994, the Company again renegotiated the agreement, reducing the administrative fee and extending the agreement through June 30, 1998. In March 1996, the Company agreed to extend the agreement through October 1998, to coincide with the building lease. Effective April 1, 1996, the Company leased the Mexicali facility under a separate arrangement. The Company has retained the option to convert the manufacturing operation to a wholly-owned subsidiary at any time. Should the Company discontinue operations in Mexico, it is responsible for the accumulated employee seniority obligation as prescribed by Mexican law. At August 31, 1998, this obligation was approximately $280,000. Such obligation is contingent in nature and accordingly has not been accrued in the accompanying balance sheet. LEASES - The Company leases its main facility under a non-cancelable operating lease expiring December 31, 2003, which requires monthly rental payments that increase annually, from $2,900 per month in 1994 to $6,317 per month in 2003. The Company also leases its Mexico facility under a non-cancelable operating lease expiring October 31, 1998, which requires average monthly rentals of approximately $5,200. The rentals are subject to annual increases based on the United States Consumer Price Index. Future aggregate minimum annual cash lease payments are as follows: Years ending May 31, 1999 $76,031 May 31, 2000 $65,880 May 31, 2001 $68,512 May 31, 2002 $71,252 May 31, 2003 $74,105 Thereafter $44,219 YEAR 2000 ISSUES _ Certain computerized systems use only two digits to record the year in date fields. Such systems may not be able to accurately process dates ending in the year 2000 and after. The effects of this issue will vary from system to system and may adversely affect an entity's operations as well as its ability to prepare financial statements. The Company has begun the process of upgrading its hardware and software in order to obtain year 2000 compliance in 1999 and does not anticipate to incur significant additional costs to by year 2000 compliant. (J) INCOME TAXES At May 31, 1998, the Company had net tax operating loss carryforwards of approximately $2,153,000 and business tax credits of approximately $161,000 available to offset future Federal taxable income and tax liabilities, respectively. The Federal carryforwards expire in varying amounts from 1998 to 2008. As of May 31, 1998, the Company had business tax credits of approximately $23,000 available to offset future state income tax liabilities. The Company's state net operating loss carryforward totaling approximately $354,000 expired during the year ended May 31, 1998. LANCER ORTHODONTICS, INC. NOTES TO FINANCIAL STATEMENTS - continued (K)NET INCOME PER COMMON SHARE AND DIVIDENDS The Company calculates earnings per share in accordance with Statement of Financial Accounting Standards ("SFAS 128"). SFAS 128 replaces the presentation of primary and fully diluted earnings per share with the presentation of basic and diluted earnings per share. Basic earnings per share excludes dilution and is calculated by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. In connection with the implementation of SFAS 128, the basic and diluted earnings per share for the three months ended August 31, 1997 were not materially different from the earnings per share previously reported for such period. EARNINGS PER SHARE (UNAUDITED) FOR THE THREE MONTHS ENDED 8/31/98 8/31/97 BASIC EARNINGS PER SHARE: Net income $ 40,223 $ 2,474 Net income applicable to common shareholders $ 40,223 $ 2,474 Weighted average number of common shares 2,118,280 2,125,712 Basic Earnings per Share $ .019 $ .001 DILUTED EARNINGS PER SHARE: Net income (loss) from primary income per common share $ 40,223 $ 2,474 Net income (loss) for diluted earnings per share $ 40,223 $ 2,474 Weighted average number of shares used in calculation of basic earnings per common share 2,118,280 2,125,712 Add: Common equivalent shares 52,926 52,926 Weighted average number of shares used in calculation of diluted earnings per share 2,171,206 2,178,638 Diluted earnings per share $ .019 $ .001 LANCER ORTHODONTICS, INC. NOTES TO FINANCIAL STATEMENTS - continued (L) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES FOR THE THREE MONTHS ENDED 8/31/98 8/31/97 Sales to unaffiliated customers: United States $ 871,154 $ 903,355 Europe 348,766 255,884 South America 185,549 138,506 Other Foreign 134,833 150,038 $1,540,302 $1,447,783 No other geographic concentrations exist where net sales exceed 10% of total net sales. Sales or transfers between geographic areas none none Operating profit: United States $ 64,001 $ 90,707 Europe ( 10,875) ( 36,125) South America ( 5,784) ( 19,553) Other Foreign ( 4,208) ( 21,183) $ 43,134 $ 13,846 (M) NEW DISCLOSURE STANDARDS In June 1997, SFAS No. 130 (SFAS 130"), "Comprehensive Income" was issued which is effective for fiscal years beginning after December 15, 1997, and requires reclassification of earlier financial statements for comparative purposes. SFAS 130 requires that changes in the amounts of certain items, including foreign currency translation adjustments and gains and losses on certain securities, be shown in the financial statements. SFAS 130 does not require a specific format for the financial statement in which comprehensive income is reported, but does require that an amount representing total comprehensive income be reported in that statement. The implementation of SFAS 130 did not have a material effect upon the Company's financial statements. In June 1997, SFAS No. 131 ("SFAS 131"), "Disclosure about Segments of an Enterprise and Related Information" was issued. This statement will change the way public companies report information about segments of their business in their annual financial statements and requires them to report selected segment information in their quarterly reports issued to shareholders. It also requires entity-wide disclosures about the product, services an entity provides, the material countries in which it holds assets and reports revenues, and its major customers. SFAS 131 is effective for fiscal years beginning after December 15, 1997. The implementation of SFAS 131 will not have a material effect upon the Company's financial statements. LANCER ORTHODONTICS, INC. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for historical information contained herein, the statements in this Form 10-QSB are forward-looking statements that are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward- looking statements involve known and unknown risks and uncertainties which may cause the Company's actual results in future periods to differ materially from forecasted results. These risks and uncertainties include, among other things, the continued demand for the Company's products, availability of raw materials and the state of the economy. These and other risks are described in the Company's Annual Report on Form 10-KSB and in the Company's other filings with the Securities and Exchange Commission. RESULTS OF OPERATIONS For the three months ended August 31, 1998, net income increased $37,749 as compared to the year earlier period. The increase in net income is primarily attributable to the increase in sales. For the three months ended August 31, 1998, net sales increased $92,519 (6.4%) as compared to the year earlier period. The Company continues to search for and add new distributors, private label customers, and sales representatives. The Company remains very active in investigating new products that will contribute strategically to its product line, believing that a larger and more diverse product line will appeal to a wider range of customers. For the three months ended August 31, 1998, cost of sales as a percentage of sales totaled 61.1%, a decrease of .4% as compared to the year earlier period which totaled 61.5%. The Company is in the process of automating several of its manufacturing processes which should reduce future cost of sales. For the three months ended August 31, 1998, selling and general and administrative expenses increased $19,003 (3.8%) as compared to the year earlier period. The increase is attributable to an expansion of sales territories and costs related to increased sales. For the three months ended August 31, 1998, product development expenses decreased $7,320 (18.5%) as compared to the year earlier period. The decrease is attributable to a decrease in wage costs. For the three months ended August 31, 1998, interest expense decreased $7,494 (79.1%) as compared to the year earlier period. The decrease is attributable to reduced debt. LANCER ORTHODONTICS, INC. FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES The Company's financial condition at August 31, 1998 and its previous two fiscal year ends was as follows: 08/31/98 05/31/98 05/31/97 Current Assets $3,553,512 $3,488,437 $3,217,057 Current Liabilities 681,458 684,222 800,050 Working Capital 2,872,054 2,804,215 2,417,007 Bank Debt & Capitalized Leases 100,000 100,000 415,848 Shareholder Equity 3,440,283 3,404,548 3,150,283 Total Assets 4,121,741 4,088,770 3,950,333 Working capital increased $67,839 during the three months ended August 31, 1998, primarily attributable to an increase in sales, partially offset by the paydown of bank debt. The Company is currently considering investing from $200,000 to $300,000 in replacement equipment. Funds for this investment will come from cash flow and new borrowings. The Company expects to meet the rest of its cash requirements out of its cash reserves, cash flow, and line of credit. PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS Not Applicable Item 2. CHANGES IN SECURITIES Not Applicable Item 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable Item 5. OTHER INFORMATION Not Applicable Item 6. EXHIBITS AND REPORTS ON FORM 8-K There were no Form 8-k reports filed during the quarter. 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. LANCER ORTHODONTICS, INC. Registrant Date October 14, 1998 By /s/ Douglas D. Miller Douglas D. Miller, President and Chief Operating Officer