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 MARCH 31, 2004
( ) 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
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State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date.
Outstanding at
Class May 1, 2004
----- ---------------
Common Stock, $.01 par value 12,551,298
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Index To Consolidated Financial Statements
PART I. FINANCIAL INFORMATION Page No.
Item 1. Financial Statements
Consolidated Financial Statements:
Consolidated Balance Sheets March 31, 2004 and December 31, 2003 3
Consolidated Statements of Operations Three Months Ended March 31,
2004 and 2003 5
Consolidated Statements of Cash Flows Three Months Ended March 31,
2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 13
Item 3. Controls and Procedures 19
PART II. OTHER INFORMATION
Item 2 - Changes in Securities 20
Item 6 - Exhibits and Reports on Form 8-K 20
Signatures 21
License Agreement 22
Schedules 35
Certifications 37
ITEM 1. FINANCIAL STATEMENTS
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Balance Sheet
March 31, December 31,
2004 2003
ASSETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Unaudited) (Note 1)
CURRENT ASSETS
Cash and cash equivalents $ 125,218 $ 49,534
Trade accounts receivable, net of allowance for
doubtful accounts of $169,000 and $169,000, respectively 485,428 614,660
Inventories 68,085 79,175
Costs of uncompleted contracts 83,023 102,204
Unbilled and other receivables 365,839 291,897
Prepaid expenses 246,434 43,160
Total current assets 1,374,027 1,180,630
-------------- -------------
EQUIPMENT AND LEASEHOLDS
Equipment and leaseholds 1,605,024 1,576,336
Less: accumulated depreciation (1,361,480) (1,316,322)
Net equipment and leaseholds 243,544 260,014
-------------- -------------
OTHER ASSETS
Patents, net of accumulated amortization of $144,297 and $140,100, respectively 86,524 84,029
Patents pending 148,005 146,488
Refundable deposits 14,932 13,722
Total other assets 249,461 244,239
-------------- -------------
$ 1,867,032 $ 1,684,883
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LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Notes payable $ 498,970 $ 180,000
Accounts payable 525,461 650,020
Accrued wages 118,693 100,184
Accrued waste disposal 114,500 114,500
Deferred royalty revenue 250,000 -
Other accrued expenses 46,246 77,376
Total current liabilities 1,553,870 1,122,080
-------------- -------------
LONG-TERM LIABILITIES
Notes payable 200,000 400,000
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 12,440,586, and 12,365,586 shares, respectively 124,406 123,656
Additional paid-in capital 14,056,706 14,051,457
Accumulated deficit (14,067,950) (14,012,310)
Total Stockholders' Equity 113,162 162,803
-------------- -------------
$ 1,867,032 $ 1,684,883
============= =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)
Three Months Ended March 31,
2004 2003
SALES. . . . . . . . . . . . . . . . . . . . . . $ 1,534,899 $ 1,243,260
COST OF SALES. . . . . . . . . . . . . . . . . . 988,402 743,798
GROSS PROFIT . . . . . . . . . . . . . . . . . . 546,497 499,462
------------ ------------
SELLING EXPENSES . . . . . . . . . . . . . . . . 78,127 97,874
GENERAL AND ADMINISTRATIVE EXPENSES. . . . . . . 484,871 568,935
OPERATING LOSS . . . . . . . . . . . . . . . . . (16,501) (167,347)
------------ ------------
OTHER EXPENSE
Interest expense. . . . . . . . . . . . . . . . (39,139) (19,099)
Total Other Expense . . . . . . . . . . (39,139) (19,099)
------------ ------------
NET LOSS BEFORE INCOME TAXES . . . . . . . . . . (55,640) (186,446)
------------ ------------
Income tax provision. . . . . . . . . . . . - -
NET LOSS . . . . . . . . . . . . . . . . . . . . $ (55,640) $ (186,446)
============ ============
NET LOSS PER COMMON SHARE -BASIC AND DILUTED . . $ (0.00) $ (0.02)
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
BASIC. . . . . . . . . . . . . . . . . . . . . . 12,440,586 12,129,873
DILUTED. . . . . . . . . . . . . . . . . . . . . 12,440,586 12,129,873
============ ============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
H.E.R.C. PRODUCTS INCORPORATED AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
Three Months Ended March 31,
2004 2003
----------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . $ (55,640) $(186,446)
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization. . . . . . . . . . . . . . 49,309 51,050
Common stock issued for services . . . . . . . . . . . . 5,999 7,503
(Increase) decrease in assets
Trade accounts receivable. . . . . . . . . . . . . . 129,232 (18,321)
Inventories. . . . . . . . . . . . . . . . . . . . . 11,090 (37,784)
Costs of uncompleted contracts . . . . . . . . . . . 19,181 95,745
Unbilled and other receivables . . . . . . . . . . . (73,942) (255,535)
Prepaid expenses . . . . . . . . . . . . . . . . . . (203,274) (325,201)
Refundable deposits and other assets . . . . . . . . (1,210) 5,993
Increase (decrease) in liabilities
Accounts payable . . . . . . . . . . . . . . . . . . (124,559) (20,193)
Accrued wages and other accrued expenses . . . . . . (12,621) 10,964
Deferred royalty revenue . . . . . . . . . . . . . . 250,000 -
Net cash used in operating activities . . . (6,435) (672,225)
------------------ ----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures . . . . . . . . . . . . . . . . . . . . (28,688) (38,677)
Expenditures related to patents and patents pending. . . . . (8,163) (1,302)
Net cash used in investing activities . . . (36,851) (39,979)
----------------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of notes payable. . . . . . . . . . . 166,917 738,205
Principal payments under notes payable . . . . . . . . . . . (47,947) (124,890)
Net cash provided by financing activities . 118,970 613,315
----------------- ----------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS . . . . . . . . 75,684 (98,889)
----------------- ----------
CASH AT BEGINNING OF PERIOD. . . . . . . . . . . . . . . . . . . . . 49,534 254,859
CASH AT END OF PERIOD. . . . . . . . . . . . . . . . . . . . . . . . $ 125,218 $ 155,970
----------------- ----------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest . . . . . . . . . . . . . . $ 39,139 $ 17,920
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Prepaid insurance financed with note payable . . . . . . . . . . . . $ 166,917 $ 338,205
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
MARCH 31, 2004
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements (except for the
balance sheet at December 31, 2003, 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 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, 2003.
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, 2004.
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issues to Employees" and related interpretations to account for its stock
option plans. The Company grants options for common stock at an option price
equal to the fair market value of the stock at the date of grant. Accordingly,
the Company does not record stock-based compensation expense for these options.
The Company's stock option plans are more fully described in the Company's
Annual Report on Form 10-KSB for fiscal year 2003.
The following table illustrates the effect on net earnings, net earnings per
basic common share and net earnings per diluted common share, as if compensation
cost for all options had been determined based on the fair market value
recognition provision of a 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:"
Three months ended March 31,
2004 2003
Net loss applicable to common stockholders. . . . . . $ (55,640) $(186,446)
Deduct: Total stock-based employee expense
determined under the fair value based method
for all awards, net of related tax benefits. . . . (1,060) (1,631)
Pro-forma net loss applicable to common
Stockholders . . . . . . . . . . . . . . . . . . . $ (56,700) $(188,077)
Basic and diluted earnings per common share . . . . . $ - $ (0.02)
----------------- ----------
Pro-forma basic and diluted earnings per common share $ - $ (0.02)
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, "unbilled receivables" represents revenue recognized in
excess of amounts billed. Royalty revenue is recorded when the licensee
acknowledges that royalties have been earned on their related sales. Royalties
are calculated based upon a certain percentage of the related licensee sales.
3. 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 March 31, 2004,
there was $638,379 of factored receivables ($363,415 at March 31, 2003), of
which the Company has received $632,796 from the factor. This $632,796 and the
$5,583 in interest expense 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 March 31, 2004 was 7%. In connection with this
agreement, the Company is required to maintain certain financial covenants. The
Company was in violation of the tangible net worth financial covenant at March
31, 2004. In the event of a breach of representation, warranty or agreement, the
institution has a security interest in the Company's assets.
On April 5, 2004, the Company executed a third Amendment to its factoring
agreement. The Amendment increased the fixed discount rate from 0.75% to 1.0% in
exchange for the removal of the tangible net worth financial covenant.
4. SEGMENT INFORMATION
Information by segment for the three months ended March 31, 2004:
Pipe Tank Industrial
Cleaning Cleaning Chemical Corporate Consolidated
Sales. . . . . . . . . . . . . . . . . . $ 616,039 $ 833,288 $ 85,572 $ - $ 1,534,899
Income (loss) from continuing operations (39,041) 220,509 82,567 (319,675) ( 55,640)
Total assets . . . . . . . . . . . . . . 487,097 659,862 69,333 650,740 1,867,032
Depreciation and amortization. . . . . . 24,978 16,716 1,360 6,255 49,309
Capital expenditures . . . . . . . . . . - 22,975 - 5,713 28,688
Information by segment for the three months ended March 31, 2003:
Pipe Tank Industrial
Cleaning Cleaning Chemical Corporate Consolidated
Sales. . . . . . . . . . . . . . . . . . $ 379,034 $ 781,399 $ 82,827 $ - $ 1,243,260
Income (loss) from continuing operations (10,785) 185,643 32,959 (394,263) (186,446)
Total assets . . . . . . . . . . . . . . 442,939 666,152 127,178 783,324 2,019,593
Depreciation and amortization. . . . . . 29,711 13,891 1,051 6,397 51,050
Capital expenditures . . . . . . . . . . 32,275 6,402 - - 38,677
Segment profitability is determined before allocation of corporate overhead.
5. EARNINGS PER SHARE
A reconciliation of the basic and diluted loss per share (EPS) computation for
the quarter ended March 31, 2004 and 2003 is as follows:
Three Months Ended March 31, 2004
---------------------------------------------------------
Net Income Shares Per Share
---------------------------------------------------------
(Numerator) (Denominator) Amount
Basic EPS. . . . . . . . . . . . . . . $ (55,640) 12,440,586 $ (0.00)
Effect of stock options and warrants . - -
Diluted EPS. . . . . . . . . . . . . . $ (55,640) 12,440,586 $ (0.00)
----------------------------------- --------------------
Three Months Ended March 31, 2004
---------------------------------------------------------
Net Income Shares Per Share
---------------------------------------------------------
(Numerator) (Denominator) Amount
Basic EPS. . . . . . . . . . . . . . . $ (186,446) 12,129,873 $ (0.02)
Effect of stock options and warrants . - -
Diluted EPS. . . . . . . . . . . . . . $ (186,446) 12,129,873 $ (0.02)
----------------------------------- --------------------
6. NOTES PAYABLE
During the month of January 2004, we financed $64,673 of insurance premiums
payable in ten monthly installments of $6,586 at an annual percentage rate of
4.0%.
During the month of January 2004, we financed $72,150 of insurance premiums
payable in nine monthly installments of $8,017 at an annual percentage rate of
4.0%.
During the month of January 2004, we financed $30,094 of insurance premiums
payable in nine monthly installments of $3,344 at an annual percentage rate of
4.0%.
On February 23, 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. The note is secured by a second position security interest behind the
secured interest of our accounts receivable factor and was renewable at the end
of the original term by the mutual agreement of both parties. On February 23,
2004 the note was renewed by extension until February 23, 2005 and the parties
agreed to extend the term of $200,000 of principal to be due on February 23,
2007.
On September 12, 2003, we entered into a Promissory Demand Note for $30,000 with
our Chief Executive Officer and Board Chairman. The proceeds will be used to
expand our CHT and tank cleaning business on the west coast and support working
capital needs in our current operations.
On December 2, 2003, we entered into a Promissory Demand Note for $50,000 with
our Chief Executive Officer and Board Chairman. The proceeds will be used to
expand our CHT and tank cleaning business on the west coast and support working
capital needs in our current operations.
On December 8, 2003, we entered into a six-month renewable Promissory Term Note
for $50,000 with one of our directors. The note can be renewed at the end of the
original term by the mutual agreement of both parties. The proceeds will be used
to expand our CHT and tank cleaning business on the west coast and support
working capital needs in our current operations.
On December 17, 2003, we entered into a six-month renewable promissory term note
for $50,000 with the spouse of one of our directors. The note can be renewed at
the end of the original term by the mutual agreement of both parties. The
proceeds will be used to expand our CHT and tank cleaning business on the West
Coast and support working capital needs in our current operations.
7. COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
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 is involved in one legal proceeding arising out
of operations in the ordinary course of business as a defendant on a claim for
$35,000 and believes the Company has meritorious defenses against that claim as
well as valid cross claims. The Company is also involved in one legal
proceeding, arising out of operations in the ordinary course of business, in
which the Company is the complainant party. The suit, which seeks injunctive
relief and damages, was brought to preclude or otherwise limit the benefits the
Company believes were wrongfully obtained by the defendants as a result of the
misappropriation and use of our confidential information and trade secrets by a
former employee.
8. INCOME TAXES
The Company was in a consolidated tax loss position for the three months ended
March 31, 2004 and therefore has no current federal income tax expense.
Deferred tax assets as of March 31, 2004 arising primarily from loss carry
forward benefits have not been recorded because of the uncertainty of realizing
such benefits.
9. DEFERRED REVENUE
During January 2004, the Company granted a five-year exclusive license to Seiwa
Pro, Ltd. of Osaka, Japan to use substantially all of the Company's chemical
cleaning patents and technology to clean marine ship piping systems, municipal
potable distribution systems, commercial, institutional and industrial
infrastructure and facilities piping, water well rehabilitation, and fire
protection sprinkler systems in Japan, China, Taiwan, Korea, Singapore and
Malaysia. The license agreement provides that Seiwa will pay the Company
royalties at rates designated in the agreement ranging from 3-10% of sales, such
royalty percentage rates decreasing as sales volume increases. Seiwa will
prepay royalties of $500,000, payable in two equal installments of $250,000 net
of total treaty withholding taxes of $50,000. The first installment was
received in February 2004, and accrues interest for the benefit of Seiwa at the
rate of 2.25% per annum. The second installment is due and payable during July
2004, and once paid, the total deferred royalty revenue will accrue interest at
a rate of 4.5% per annum. Any interest accrued on the deferred royalty revenue
will increase the amount of the deferred royalty revenue. The agreement
requires Seiwa to meet minimum royalties of $50,000 in 2005 and $100,000 in each
of 2006, 2007, and 2008. Under the agreement if at the end of the primary term
there is any remaining deferred royalty revenue balance after application of
credit for minimum royalties, the Company will repay to Seiwa the balance plus
accrued interest. Alternatively under the agreement, in the event the parties
agree on applicable terms, the Company may permit Seiwa to convert any unearned
deferred royalty revenue balance into shares of the Company's common stock.
10. MANAGEMENT'S PLANS
The Company is financially recovering from the decline of revenue resulting from
the extended Middle East military deployment in 2003 that reduced the
availability of United States Navy ships on which to provide marine pipe and
tank cleaning services from the fourth quarter of 2002 to the fourth quarter of
2003. The recovery results from cost reductions implemented in 2003 and revenue
expansion opportunities in late 2003 and 2004 with the return of the Navy.
During 2003, the Company down-sized personnel by $620,000 and cut property,
casualty and liability insurance premiums by $100,000 to save cash totaling
$720,000 on an annualized basis. During 2004, the Company anticipates reducing
specialty and potable division sales and marketing costs by about $180,000, and
the Company's most significant affiliate lender has agreed to extend $200,000 of
his $400,000 one year term note to a term of three years. Revenue expansion
will focus on providing more marine pipe and tank cleaning services to the U.S.
Navy worldwide. The most significant expansion of revenue is anticipated in the
Navy's west coast and Japanese ports that will be serviced through the Company's
new offices near San Diego, California. The Company intends to expand both
sales and marketing services to marine customers, and intends to expand the menu
of services offered to augment pipe and tank cleaning. The Company will
actively seek new licensees for specialty and potable water pipe and fire
protection cleaning technologies through anticipated licensing of the Company's
patents in foreign and domestic markets in addition to servicing existing
specialty and potable customers. The Company will continue to support sales and
marketing efforts to existing and new industrial chemical customers.
11. MAJOR CUSTOMERS
The Company's strategy has involved concentrating its efforts on providing
pipeline rehabilitation and other system cleaning services to a diverse group of
customers. The Company has undertaken and continues to undertake substantial
efforts to diversify its customer base and expand its markets. For the quarters
ended March 31, 2004 and 2003, sales to the U.S. Navy under the Portsmouth CIS
contract were 5% and 38%, respectively, of consolidated sales. Other major
customer's sales for the quarter ended March 31, 2004 include Metro Machine at
11% of revenue; MHI at 10% of revenue; GSA at 18% of revenue; Earl Industries at
12% of revenue, and Continental Maritime at 22% of revenue.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The statements contained in this report on Form 10-KSB that are not purely
historical are forward-looking statements within the meaning of the securities
laws. These statements typically use words or phrases like "believe,"
"expects," "anticipates," "estimates," "will continue" and similar expressions.
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 Item 1, "Description of
Business-Risk Factors," in Item 6, "Management's Discussion and Analysis," and
elsewhere in this report.
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 provide chemical cleaning services for water pipe systems, waste water
systems, cooling towers and HVAC systems, tanks and boilers, and other
water-based and industrial chemical process systems using our proprietary line
of specialty chemical products and chemical cleaning processes. We use our
patented and proprietary chemical products and chemical cleaning processes to
remove scale and corrosion from pipeline systems, water systems, and surfaces.
Chemical cleaning service markets are the main source of our revenue, which
include municipal, industrial, governmental, commercial, and other customers
serviced directly and through strategic marketing alliances. Our largest
customer is currently the U.S. Navy. We provide chemical cleaning services for
pipe systems and tanks on U.S. Navy and U.S. Coast Guard vessels.
We derive the majority of our revenue from two sources, cleaning sewer, "CHT",
systems on U.S. Navy and U.S. Coast Guard vessels (pipe cleaning) and cleaning
bilge, fuel, oil, catapult and CHT tanks on ships (tank cleaning). We have been
particularly subject to the deployment and servicing schedules of the U.S. Navy
as well as the available maintenance funds in the Navy budget. The impact of
the Navy deployment to the Middle East in support of the Afghanistan and Iraq
military engagements in the first three quarters of 2003 significantly reduced
the availability of ships in port for maintenance and consequently our service
opportunities with our primary customer. We have experienced increased service
opportunities with our largest customer beginning in the fourth quarter of 2003
and the first quarter of 2004 after the return of much of the Navy fleet from
these extended deployments.
Over time most water and water-based systems, such as potable water delivery
systems, fire sprinkler systems, waste systems, process water systems, holding
tanks, and water wells develop internal surface scale, corrosion, and
tuberculation. These corrosive substances reduce the diameter through which
water and waste can travel through the pipes, causing a less efficient or
non-functioning system. Our cleaning methodologies remove the corrosion and
restore the efficiency and flow characteristics of the system.
We use patented and other proprietary chemical products and processes in our
cleaning services. Our chemical formulation, when circulated through an
obstructed pipe system, dissolves and removes scale and corrosion build-up in
solution until flushed from the system. The system may then be treated with
other chemical products that retard corrosion or suppress the environment that
supports biological growth. Most of the chemicals that we use are non-fuming,
non-abrasive, and non-flammable. Most of our chemical products are certified
biodegradable by Scientific Certification Systems.
While the year ended December 2003 was a very difficult one for our Company due
to the lengthy U.S. military commitment in the Middle East in fourth quarter of
2002 and the first three quarters of 2003, and particularly the extended
deployment of the fleet of our primary customer, the Navy. The lack of
availability of the Navy fleet on which to perform marine services from the
fourth quarter of 2002 until late in the third quarter of 2003 caused a dramatic
slowdown in revenue opportunities for pipe and tanking cleaning. During the
operational aspect of the conduct of the U.S. Navy military effort in the Middle
East in 2003, we believe as much as 75% of the total Naval ships worldwide were
on station and out of port on deployment. This circumstance stands in stark
contrast to the Navy's routine peacetime maintenance and deployment schedules.
The Navy fleet began returning in July and August of 2003 and resulting
maintenance purchase orders were not actively solicited by the Navy until the
fourth quarter of 2003 and first quarter of 2004.
As a result of this extended Navy deployment and the financial stress that
resulted, we engaged in large scale cost reductions in our administration and
operations in order to preserve cash on a going forward basis. Operations
related layoffs of two supervisors and one administrative employee in the first
quarter of 2003 resulted in over $140,000 of annual cash savings. The
responsibilities of these employees were reallocated to other personnel. During
the third quarter of 2003, we terminated a supervisor, a division manager, an
assistant sales manager, and the Chief Financial Officer, and we re-assigned the
Controller from a full-time position to part-time for a total annual savings of
$440,000. The responsibilities of all terminated positions were reallocated to
current personnel with the Chief Executive Officer serving as the Acting Chief
Financial Officer, and all payroll functions were assumed by administrative
personnel. In the fourth quarter of 2003, we initiated a review of our company's
property, casualty, and liability insurance coverage for 2004, resulting in
premium savings of over $100,000 annually. These Navy deployment-related cost
reductions in operations and administration resulted in almost $700,000 of total
annual cash preservation.
In the pipe cleaning segment of our business, we derive the majority of our
revenue from chemical cleaning of marine CHT systems on U.S. Navy and U.S. Coast
Guard vessels. Since we commenced marine CHT cleaning in 1997 and tank cleaning
in 2000, our most profitable operations have been in these marine related
markets, despite the Navy deployment to the Middle East in 2003 that
significantly reduced the availability of ships in port for maintenance and, as
a direct consequence, for our service opportunities with our primary customers.
Our non-marine pipe cleaning service division, which has relied to an
extraordinary degree on the cash generated from the marine related service
markets, has yet to demonstrate any consistent positive cash flow apart from
marine services. We intend to reduce costs in non-marine related services
operations in favor of expanding these services through patent licensing. In the
first quarter of 2004, we decided to reduce direct sales and marketing expense
in the Specialty and Potable division for the U.S. market. While we will
continue to support non-marine service operations to satisfy customer demands
for these services, we will redirect our efforts to promote these patented
technologies through licensing agreements in domestic and foreign markets with
relationships we have developed in the business over the last three years. Such
efforts have yielded an eastern Canadian license in the fourth quarter of 2003
and a license of Far East markets to Seiwa Pro, Ltd. in Japan in 2004. The
reduction in sales and marketing expense in this business segment will
approximate a savings of $180,000 annually. See Notes to Consolidated Financial
Statements, Footnote 4 regarding Segment Information.
We now are focusing our efforts on increasing revenue. We have increased service
opportunities with our largest customer after the return from the extended
Middle East deployments in late 2003. We believe there is the long-term demand
and customer satisfaction with our services, and we, therefore, intend to expand
our marketing and sales efforts in the marine services aspect of our pipe
cleaning business. As work schedules have increased since the return of the
ships, the ship repair and maintenance business is busy in all ports with much
less competitive pricing due to the demand for marine services. We anticipate
higher gross margins in comparison to marine market cleaning services offered to
the Navy in full deployment. In addition, we anticipate increased work on ships
as we execute the basic purchase order specifications. We believe the Navy is
behind in maintenance work due to the extended deployments and must catch up. We
believe Navy budgets have increased and should increase significantly for the
2005 fiscal year beginning in October 2004. We expect more demand for ship
maintenance needs with expanding military budgets that may cover two or three
fiscal years of defense budgeting.
Our annualized cost reductions of almost $900,000 greatly exceed the amounts of
affiliate borrowing of $580,000 in 2003. At the present time, we do not expect
to require external financing during the current fiscal year. The holder of the
$400,000 one year term note dated February 23, 2003, as extended to February 23,
2005, has agreed to restructure $200,000 of the debt to a due date of February
23, 2007. Other debt restructuring will necessarily depend on the favorable
circumstances we anticipate as a result of the return of the Navy to port for
the maintenance services we provide. Significantly, we have demonstrated a
history of operations since 1997 without requiring external debt financing prior
to the 2003 extended deployment of the U.S. Navy.
Our chemical products and chemical cleaning processes were developed to provide
a more cost effective and efficient means of cleaning pipe systems in contrast
to replacement, mechanical scraping, pigging, hydro blasting, or other pipe
cleaning methods. Additionally, our chemical products and chemical cleaning
processes are safer than many other chemical cleaning methods. Our chemical
products include the following:
- - Pipe-Klean and Well-Klean, which remove encrustation from water pumping
and distribution systems;
- - Compound 360 and Compound 400 which clean and maintain cooling and other
water treatment systems; and
- - Line-Out which cleans drip irrigation systems and removes salt from soil
surfaces.
We also sell private label chemical products utilizing our patented and
proprietary formulations or products complementary to our formulations for key
customers.
We market our products and services through our marketing and sales staff,
independent distributors, sales representatives, strategic partnerships, and
licensing and marketing agreements. While we generate most of our revenue from
relatively few customers, we expect the high concentration levels to lessen in
the future as we expand the menu of marine services we provide to our existing
customers through multiple governmental procurement contract vehicles and
private contracting, and by licensing both our marine and land-based pipe
cleaning technologies to third-parties. Nonetheless, any material delay,
cancellation, or reduction of orders from these customers due to lack of
opportunity to perform routine maintenance on marine vessels out of port on
extended military deployments in the future or other factors could have a
material adverse effect on our results of operations and financial position.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
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.
We base our estimates on historical experience and on various other assumptions
that we believe are reasonable under the circumstances. The results form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results could differ
significantly from those estimates under different assumptions and conditions.
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. The terms of products sales are F.O.B. shipping point,
and we believe that revenue recognition is fully justified after the product has
left our blending plant with attendant financial risks assumed by our
purchasers.
For most marine, industrial and municipal service projects conducted at fixed
prices within a short period of time, we recognize revenue when the services are
completed. Most of these service engagements have a scope of performance time
less than three months and are not otherwise readily capable of reasonably
estimating percentages of completion based on costs incurred. 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. Due to the time length and
revenue size of these contracts, as an exception to our usual experience of
contract lengths of less duration and smaller revenue, we believe the percentage
of completion method more accurately matches revenue with costs that would
otherwise distort our financial reporting awaiting contract completion for
revenue recognition. We use this method because we consider the percentage of
the total cost to be the best available measure of progress on these contracts.
Our experience indicates that the percentage of completion method is therefore
required to be used on marine service engagements involving large Navy surface
fleet vessels such as aircraft carriers.
Contract costs include all direct material, subcontract labor, and other costs
related to contract performance, such as indirect labor, supplies, tools, and
repairs under the job order method of cost accounting. Selling, general, and
administrative costs are charged to overall corporate expenses as incurred, and
are not considered job order related costs. Provisions for estimated losses on
uncompleted contracts are made in the period in which such losses are
determined. Circumstances requiring provisions for estimated losses on
percentage of completion marine service jobs could arise when we are required by
our 2002 Portsmouth CHT contract to perform fixed price work on certain classes
of ships with inherently low gross profit margins resulting from the amount of
labor required to service the ship due largely to the age of the ship and its
systems. 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.
Allowance for Doubtful Accounts
We estimate the possible losses resulting from non-payment of outstanding
accounts receivable. We analyze accounts receivable customers to determine the
ultimate collectibility of those accounts. While most of our accounts
receivable stem from federal and local government contracts where collection is
reasonably assured, we perform ongoing evaluations of our customers for credit
worthiness, economic trends, changes in our customer payment terms, and
historical collection experience when evaluating the adequacy of our allowance
for doubtful accounts. Experience indicates that federal military contract
receivables are almost always paid within the expected time for collection when
we are the contracting party with the agency. Subcontracting on federal
military contracts within private shipyards subjects our Company to the risks of
the shipyard, and while most of our private shipyard payments are virtually
never in doubt, we have had occasion to experience uncollectible accounts from
certain federal contractors in this market. Municipal job experiences have been
less predictable for our Company as a subcontractor, yielding more provision for
doubtful 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.
Impairment of Long-Lived Assets
We periodically evaluate the carrying value of tangible assets dedicated to
chemical pipe and tank cleaning, and intangible patents and trademarks. 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.
While we may determine that employing certain long-lived assets that remain
unprofitable requires the realization of the impairment of these assets, or the
consideration of strategic transactions involving these assets in an attempt to
recover these capitalized costs, we have determined to license some of our
patent assets and to continue to support our licensees while reducing certain
marketing and sales for non-marine operations involving these intangible assets.
We have not had, and do not have at this time, any plans to sell assets in order
to recoup capital costs. We do plan on continuing to license patents that we
have for rehabilitating water pipe systems in several countries and the United
States. The recent license agreement with Seiwa Pro, Ltd. for the Far East is an
example. The success of our cleaning process on water mains and fire protection
systems in 2003 has resulted in our representing the technology to potential
licensees. The Seiwa Pro license paid $250,000 of prepaid royalty and is
anticipated to produce the $250,000 balance of prepaid royalties in the third
quarter of this year. The potential issuance of other license agreements would
depend upon our patent position in the country of location of the intended
licensor, the profile and competence of the licensor, and the economic terms of
the license.
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 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.
RESULTS OF OPERATIONS
Three Months Ended March 31, 2004 Compared with Three Months Ended March 31,
2003
Sales for the three months ended March 31, 2004 were $1,534,899 compared
with $1,243,260 during the same period in 2003. Pipe cleaning services
accounted for $616,039 during the three months ended March 31, 2004, of which
$76,323 was billed under the Portsmouth CHT contract with the United States
Navy. For the three months ended March 31, 2003, pipe-cleaning services
accounted for $379,034 of which $369,961 was billed under the Portsmouth CHT
contract. Tank cleaning services totaled $833,288 during the three months ended
March 31, 2004 compared with $781,399 during the same period in 2003.
Industrial chemical sales were $85,572 during the three months ended March 31,
2004 compared with $82,827 during the same period in 2003.
Consolidated sales during the first quarter of 2004 were 23% higher than the
same period in 2003. While 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 in 2003, the return of the fleet available for
servicing in the fourth quarter of 2003 and the first quarter of 2004 provided
increase service opportunities. Consolidated gross margins were 36% during the
three months ended March 31, 2004 compared with 40% during the same period in
2003. Gross margins for our tank cleaning services increased to 42% in 2004 from
37% in 2003. Gross margins for our pipe cleaning services were 19% in 2004
compared with 43% in 2003. This decrease reflects the price competitiveness of
the pipe cleaning business resulting from the split award if the 2002 Portsmouth
CHT cleaning contract. We anticipate that, while future margins may fluctuate
with changes in revenue mix and other operational factors, the return of the
Navy from the long deployment will provide increased demand for marine services
resulting in increased gross margins in 2004.
Sales of pipe cleaning services increased 63% during the three months ended
March 31, 2004 compared to the same period in 2003. Sales of tank cleaning
services increased 7% during the three months ended March 31, 2004 compared to
the same period in 2003. We are continuing efforts to diversify our revenue
base by offering different services to our customers in multiple service markets
in order to reduce our dependence on one marine service provided to one customer
location.
We are currently focusing specific sales and marketing efforts in the areas of
marine and land based tank cleaning. Due to liquidity and cash flow constraints
and the continuing absence of profitability in the areas of industrial and
municipal markets of our pipe cleaning business segment, we are in the process
of reducing the related sales and marketing expenses in favor of licensing these
services to third parties. While we will scale back our non-marine pipe
cleaning operations, we will continue to support existing licensees and customer
demands for these services. In the future, we plan to continue our efforts to
diversify our revenue sources and thereby our reliance on one large customer.
Gross profit increased to $546,497 during the three months ended March 31, 2004
from $499,462 during the same period in 2003.
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 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.
Total selling, general and administrative expenses during the three months ended
March 31, 2004 declined to $562,998 from $666,809 during the same period in
2003. Selling expenses decreased to $78,127 during the three months ended March
31, 2004 from $97,874 during the same period in 2003, while general and
administrative expenses decreased to $484,871 for the three months ended March
31, 2004 from $568,935 during the same period in 2003. The decrease in selling
expenses was primarily the result of one less sales person and related marketing
expenses. General and administrative expenses were lower as a result of
decreases in corporate insurance expenses and the reduction of salaried
executive and management personnel in an effort to tighten controls and reduce
spending, including the severance of the Chief Financial Officer in September
2003 and the assumption of the duties and responsibilities of that office by the
Chief Executive Officer.
Other income and expense in the first quarter of 2004 reflected expense of
$39,139 versus expense of $19,099 in the first quarter of 2003.
For the three months ended March 31, 2004, we incurred a net loss of ($55,640),
compared to net loss of ($186,446) during the same period in 2003.
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 fiscal year ended 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. Our liquidity position improved during the first quarter of 2004
after we incurred additional costs in the fourth quarter of 2003 securing,
training and transporting the workforce necessary for the anticipated increased
business activity 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 first quarter is expected to continue into the second
quarter with revenue recognition on work commenced in the first quarter and
completed in the second quarter. Under our license agreement with Seiwa Pro
Ltd., we anticipate the receipt of the second installment of prepaid royalty in
the amount of $225,000 net of $25,000 of withholding taxes in July of 2004.
Cash was $125,218 at March 31, 2004 and $49,534 at December 31, 2003 on
those respective dates. The increase in cash is primarily the result of a
reduction in net operating losses, an acceleration in collections for the
quarter resulting from fourth quarter 2003 services rendered on Navy vessels
returning form the Middle East, and deferred royalty revenue on our license in
Japan. On January 29, 2004 we executed a license agreement that granted certain
foreign patents in exchange for cash payment of $250,000 net of withholding
taxes of $25,000 as deferred royalty revenue from Seiwa Pro, Ltd.
In January 2004, we financed $64,673 of corporate insurance premiums payable in
ten monthly installments of $6,586 at an annual percentage rate of 4.0%
In January 2004, we financed $72,150 of workmen's compensation - Virginia
insurance premiums payable in nine monthly installments of $8,017 at an annual
percentage rate of 4.0%.
In January 2004, we financed $30,094 of workmen's compensation - California
insurance premiums payable in nine monthly installments of $3,344 at an annual
percentage rate of 4.0%.
During 2002, we modified our factoring agreement. The initial payment when the
factor purchases eligible accounts receivable remained at 85%; the total amount
of the facility was increased from $1,000,000 to $1,500,000; the fixed discount
remained the same at 0.75% of the gross face amount payable; and interest
payable was reduced from the lender's Base Rate plus 2.0% to Base Rate plus
1.5%. Interest on the outstanding balance accrues on the basis of actual days
elapsed from the date of the advance until three days after collection of such
account. Our inventory, accounts receivable, contract rights, and other general
intangibles secure the amounts factored under the agreement. We are required to
maintain tangible net worth of not less than $750,000 during the term of the
agreement. On April 5, 2004, we executed a third amendment to our factoring
agreement wherein the fixed discount rate was increased from 0.75% to 1.0% in
exchange for the complete removal of the tangible net worth financial covenant.
We rely primarily on our internally generated operating cash flow and our
factoring arrangement to fund our operations. In 2003, we borrowed a total of
$580,000 from shareholders in an effort to expand our west coast operations.
On February 23, 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. The note is secured by a second position security interest behind the
secured interest of our accounts receivable factor and was renewable at the end
of the original term by the mutual agreement of both parties. The note was
renewed by extension until February 23, 2005 and the parties agreed to extend
the term of $200,000 of principal to be due on February 23, 2007. The proceeds
will be used to expand our CHT and tank cleaning business on the west coast and
support working capital needs in our current operations. On September 12, 2003,
we entered into a Promissory Demand Note for $30,000 with our Chief Executive
Officer and Board Chairman. The proceeds will be used to expand our CHT and tank
cleaning business on the west coast and support working capital needs in our
current operations. On December 2, 2003, we entered into a Promissory Demand
Note for $50,000 with our Chief Executive Officer and Board Chairman. The
proceeds will be used to expand our CHT and tank cleaning business on the west
coast and support working capital needs in our current operations. On December
8, 2003, we entered into a six-month renewable Promissory Term Note for $50,000
with one of our directors. The note can be renewed at the end of the original
term by the mutual agreement of both parties. The proceeds will be used to
expand our CHT and tank cleaning business on the west coast and support working
capital needs in our current operations. On December 17, 2003, we entered into
a six-month renewable promissory term note for $50,000 with the spouse of one of
our directors. The note can be renewed at the end of the original term by the
mutual agreement of both parties. The proceeds will be used to expand our CHT
and tank cleaning business on the West Coast and support working capital needs
in our current operations.
Although we expect that our annual rate of cash utilization will continue to
decrease during fiscal 2004 compared with fiscal 2003, we may be required to
reduce our operations or to obtain additional financing if our cash forecast
proves inaccurate for any reason, including the following:
- - our revenue fails to meet our forecast and continues to decline;
- - our gross profit fails to meet our forecast and continues to erode;
- - our operating expenses exceed our forecast;
- - our inability to acquire, compensate and retain a chief financial officer;
- - our inability to maintain our status as a publicly traded company; or
- - unanticipated events adversely effect our operations or cash flows.
We may, however, sell additional debt or equity securities or take other steps
to raise capital. Any such sale of equity, 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. Any
such acquisition or other debt financing could have a material adverse impact on
our liquidity and results of operations.
ITEM 3. CONTROLS AND PROCEDURES
As a result of a decrease in our operating cost structure, during the third
quarter of fiscal 2003 we terminated our relationship with our Chief Financial
Officer and reduced our Controller from full-time to part-time employment. The
responsibilities of the Chief Financial Officer were assumed by our Chief
Executive Officer, who has been acting as our Chief Financial Officer since that
time. As a result, our lack of employing a Chief Financial Officer separate
from our Chief Executive Officer and our reduction of our Controller's time
could, in the future, materially effect our internal control over financial
reporting.
As of the end of the period covered by this report, we reviewed under the
supervision of our Chief Executive Officer as acting Chief Financial Officer and
our Controller, the Company's disclosure controls and procedures. Based on this
evaluation, our Chief Executive Officer as acting Chief Financial Officer and
Controller concluded that our disclosure controls and procedures were effective,
and except as discussed below, were adequate and timely in alerting them to
material information relating to the Company required to be included in our
periodic filings with the Securities and Exchange Commission. In reviewing the
disclosure controls and procedures, our management recognized that any controls
and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and our
management necessarily was required to apply its judgment in evaluating the
cost-benefit relationship of possible controls and procedures. We reviewed our
disclosure controls and procedures to reach a level of reasonable assurance of
achieving desired control objectives and, based on the referenced review, our
Chief Executive Officer as acting Chief Financial Officer and Controller believe
that our disclosure controls and procedures were effective at reaching that
level of reasonable assurance, except as discussed below.
In conjunction with our annual audit, we have identified four potential
deficiencies within our internal control framework. The first two relate to
segregation of duties deficiencies. As previously discussed, we have had limited
financial resources and have limited personnel resources within certain areas.
As a result, we are aware there are instances where certain duties performed by
the Controller that should be split between the Controller and the acting Chief
Financial Officer to strengthen the overall internal control framework. We have
implemented routine testing by the acting Chief Financial Officer of financial
transactions originally performed by the Controller to verify accuracy and
timeliness of recording. Additionally, we are aware there are instances where
certain duties performed by the payroll clerk that should be split between the
clerk for ordinary payroll preparation and another individual for manual payroll
check preparation. We have implemented a split of these functions between
different payroll personnel.
The third potential deficiency related to inadequate preparation of supporting
documentation to assure the proper timing of accounting for certain transactions
involving payroll transfers between multi-state bank accounts. As a result,
management has reorganized specific areas to assure proper and timely
documentation of these transfers to address these deficiencies in order to
confirm accountability and will continue to adequately monitor internal
controls.
The fourth potential deficiency related to inadequate documentation of approval
of certain expenses. In response management has implemented use of approval for
payment forms for routine application to expense payment documentation.
PART II: OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES
RECENT SALES OF UNREGISTERED SECURITIES
During the first quarter of 2004 the Company issued 75,000 shares of common
stock as compensation to its 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:
10.29 License Agreement, as amended, by and between the Registrant and Seiwa
Pro, Ltd. dated January 29, 2004.
31 Certification of the Chief Executive Officer and Acting Chief
Financial Officer of the Registrant, pursuant to Rule 13a-14(a) and Rule
15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended.
32 Certification of the Chief Executive Officer and Acting Chief
Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Signature
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
- --------------------------------
Date: May 14, 2004
By: /s/ S. Steven Carl
---------------------------
S. Steven Carl
Chief Executive Officer, and
Acting Chief Financial Officer
(Principal Executive
and Accounting Officer)